Tories & the pound

Are the Tories planning on a huge fall in the pound? This is one question raise by Giles Wilkes’ paper, Slash and Grow, in which he argues that it’s unlikely that capital spending and/or net exports will grow sufficiently to keep GDP growing well in the face of government spending cuts.
Giles is, in effect, arguing against this recent paper (pdf) by Alberto Alesina and Silvia Ardgna, which shows that there have been several precedents for cuts in public spending proving expansionary.
My hunch is that he’s right to do so.
In the 1980s and 90s, it was possible for spending cuts to be accompanied by economic growth because: monetary policy could loosen in response; government bond yields could fall, thus crowding in capital spending; and because household debt was on a rising trend because, in many cases, consumer debt markets had only just been liberalized.
However, Giles rightly says these offsets are not so readily available to a future government. Index-linked yields are already zero for shorter-term maturities, so there’s no chance for orthodox crowding in.  Monetary policy is already loose, and even optimists can’t see much chance of significant increases in consumer borrowing.
There is, though, one other mechanism through which government spending cuts might be expansionary - if they cause a collapse in sterling.
Imagine it's 2010-11, and Osborne announces big spending cuts. The Bank of England responds by keeping interest rates low. However, the Fed and ECB start to raise rates. The UK could soon end up with almost the lowest rates in  the world. Carry traders around the world will then short sterling. The pound will fall, possibly very sharply. This effect would almost certainly swamp any uplift the pound gets from improved confidence about the public finances.
Would this boost growth by raising net exports?
Only to a limited degree. For one thing, there are long lags between exchange rate moves and export performance. During these lags, FX markets will question whether sterling is helping, and might therefore sell pound even more.
Also, many exporters respond to a lower exchange rate by raising prices more than expanding sales.
And even if sales do rise, many UK exports have a high import content - think of all the imported raw materials and components - which mitigates the effect on growth.
All of this means that the pound would have to fall a very long way indeed to offset any fiscal tightening.
Which poses my question. Is this what the Tories are hoping for? And if it isn’t, what is the mechanism through which a fiscal tightening will boost growth, given that the obvious ones can’t be as powerful now as they were years ago?

Comments

[Diversity]

The Tories have been painting themselves into this corner; though I find it impossible to credit that they intend to go there or that they understand what they have been seying on macro-economic policy.

The fun point is tha there is a logical way out - join the euro at around 1 euro = 1 pound, and the price advantage for UK goods and tradeable services could be sufficient to expand exports enough in the new, much bigger "home market" for our exporters.

Pity that all leading Conservatives bar Ken Clarke have ruled out joining the euro; and that Cameron has left all the major European Governemnts so distrusting of him tha they would not let him in.

[Econoclast]

I think the important thing here is that politicians have to be honest with the electorate. The economic 'miracle' of 1997-2007 has collapsed and the country now has to adjust to a fall in its relative living standards, just like the other 'overspenders' (the US, Spain, Ireland, Iceland).

That will involve cuts in public spending, broad-based tax hikes and some other mechanism. We might consider doing what Spain and Ireland will have to do, given that they are in the euro. They will have to deflate their domestic economies and accept much higher unemployment as a way of reducing their relative living standards.

Alternatively, we can do what most UK policymakers have done since 1967 - engineer a fall in the pound. This delivers the needed adjustment in real living standards without too much pain in terms of higher unemployment or lost output. But as you say, the pound will have to fall a long way to deliver these benefits. Perhaps our politicians should be more honest about the economic policy 'choices' we have.

[Luis Enrique]

Econoclast,

I think there's some truth in that. With a booming financial sector and a strong pound, we were able to import the productivity of (low wage) countries. If we are going to correct our imbalances (see Martin Wolf today: http://www.ft.com/cms/s/0/a7977fc6-c8c2-11de-8f9d-00144feabdc0.html ) we are going to have to live with a lower pound, and get by on our own level of productivity, and this could well mean a decline in material living standards. I'm not sure whether this scenario entail higher unemployment, though.

[botogol]

whatever the opinion (or hopes) of the Tories, the pound surely WILL fall, given the financial policy currently being pursued.

Look at this and tell me whether the pound is a 'buy' or a 'sell'
http://burningourmoney.blogspot.com/2009/11/worst-in-world.html

I jolly well hope the Tories are planning what to do in the event of a collapse in sterling.

[Giles]

But why should a large fiscal deficit lead to a fall in the pound? It may mean higher rates, and a higher pound. See the Reagan Dollar (I think).

Econoclast is right: lower currency values are sometimes a neat way of forcing down living standards, if that is necessary. But they can happen anyway: e.g. germany 2001 onwards.