Sterling, profits & mechanisms

There's one point raised by sterling's fall this year which deserves more attention than it's had - it's that sometimes (often!) quite powerful correlations can break down.

My chart shows what I mean. It plots the share of profits in GDP against the inverse of sterling's trade-weighted index. You can see that from the mid-70s to the mid-90s, there was a close link between the two. A weak pound raised the profit share, and a strong pound cut it. There are good reasons why this should be:

- a fall in the pound helps insulate domestic firms from foreign competition, thus raising their monopoly power and hence allowing them to mark up prices more.

- higher import costs are seen as a fair (pdf) reason for a firm to raise prices.

- exporters who price to market must cut sterling prices of exports when sterling rises, thus suffering a margin squeeze, but can raise margins when sterling falls.

However, this relationship broke down in the late 90s. Sterling's rise then did not squeeze profits as much as you'd expect from past behaviour.

This might be partly because the supply of labour from emerging markets shifted the balance of class power in favour of capital then. But this is unlikely to be the whole story, because sterling's slump in 2008 did not much raise profit margins. Instead, I suspect what's going on is a change in the nature of international trade. A lot of trade now occurs within (pdf) firms, as multinationals (pdf) ship in components from their overseas branches, sometimes at shadow rather than market prices.This makes prices, and hence income shares, less responsive to exchange rates.

The precise reasons for the change, however, aren't really my point. Instead, I merely want to point out that even strong empirical relationships with sound theoretical support can sometimes break down.This is why the study of economics must be a study of mechanisms - which are often local and temporary - rather than of apparent statistical regularities.

* Strictly speaking, I should be using the real rather than nominal exchange rate, but I doubt doing so would make much difference. 

Comments

[paulc156]

We are still very reliant on trade with the Euro area as opposed to Germany for instance who do so much trade with the BRICs. This must place a real limit on the benefits of any reduction in Sterling since the Euro area is in such dire straits. We will however suffer the consequences of higher import costs [including fuel prices]as households take the brunt.

[Twist Barbie]

That increased level of intra-firm trade is generally supposed to be transfer-proced on an OECD/arm's length basis - ie at a market price. But if it the case that the increased intra-firm trade causes a previously well-validated indicator to break down, might it not mean that the intra-firm trade is mis-priced (against a true economic price) so that if it were priced properly then the correlation would reappear? (so you have found a diagnostic showing that the transfer price is "wrong").

[Blissex]

BAH! I think that intra-firm trade may be a small factor, but my guess is mostly that 1997 to 2007 are the ten years where:

* Sterling was strong because of the large profits from the second North Sea oil export boom as this extremely important graph shows:
http://mazamascience.com/OilExport/output_en/Exports_BP_2011_oil_mtoe_GB_MZM_NONE_auto__.png
In 1997 to 2007 sterling was in effect a petrocurrency.

* Financial sector profits were strongest due to exceptionally loose policy, as to both economic and regulatory policy, with an extraordinary credit boom fueled by insane leverage ratios and sterling's very strength.

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