Sterling's effects

Angus Armstrong has a good piece on sterling’s fall. I just want to add one point, which my chart makes.

It plots sterling’s trade-weighted index against UK non-oil exports relative to world trade volumes.  

If a fall in the pound leads to a significant rise in exports, you’d expect to see the blue line rise after sterling’s fall in 2008-09. But it’s hard to discern any such significant move. Certainly, there doesn’t seem to have been any major long-lasting effect. As the ONS wrote (pdf) in 2013, the depreciation of 2008-09 “appears to have had little impact on the overall balance of trade.”

There are good reasons for this. One is pricing to market. Sterling’s fall has not raised the price of marmite: instead, Tesco and Unilever have absorbed the effect of higher import costs on their profit margins. What’s true of them is true of many other businesses: UK exporters will use sterling’s rise to increase profit margins, not just cut prices for foreign customers.  

This is good news in one respect: it will mitigate the impact of sterling’s fall upon inflation. But if prices in the shops don’t change much, nor will demand.

But this isn’t the whole story. Even to the extent that prices do change, trade volumes don’t change much. The OBR estimates that a one per cent fall in relative export prices raises non-oil export goods volumes by only 0.41% after nine quarters, whilst a 1% rise in relative import prices cuts import volumes by only 0.2% (pages 32-37 of this pdf).

There are several reasons for this. One is simply that demand for tradeable goods isn’t very price-elastic, perhaps in part because monopolistic competition means that UK exports aren’t close substitutes for overseas goods. Even if sterling’s fall does lead to (say) Glaxo cutting the foreign currency prices of its drugs, they won’t sell very many more; Germans aren’t going to get more cancer because sterling has fallen.

Another is that the decision to export is an investment decision; firms must invest time and money in sales and marketing. And the same fall in sterling that appears to make exporting profitable also throws sand into the wheels of this mechanism.

Back in 2009, firms didn’t increase their exports much in response to the lower pound because the same financial crisis that depressed the pound also made firms worry that the bank loans they needed in order to increase exports wouldn’t be available. Likewise, uncertainty about future trading rules today might inhibit firms from investing in export marketing.

We can put all this another way. The current account balance – which is massively correlated with the trade balance – is, by definition, equal to the gap between savings and investment. This tells us that a weaker exchange rate can only reduce the current account deficit if it either increases savings or reduces investment. There is a mechanism whereby this can happen. Historically, rises in inflation – of the sort that (slightly) follows a fall in sterling have caused rises in the savings ratio. But this isn’t a very strong mechanism.

In a sense, the very fact that sterling has fallen so much is consistent with what I’m saying. As Paul Krugman said back in 1989 in a book that strongly influenced my thinking on these matters, “exchange rates can move so much precisely because they seem to matter so little.”

This isn’t to deny any beneficial effect of sterling’s fall. In the social sciences, the question is often not “is this true?” but rather “how true is it?” And the idea that sterling’s fall will give a big boost to the economy isn’t very true. Yes, sterling is a shock absorber – but it’s not a very powerful one.

In this respect, Brexiters who claim to the contrary are at least consistent. One feature of rightist thinking is elasticity optimism. The belief that minimum wages destroy lots of jobs, or that tax cuts have big effects upon labour supply are both examples of this. And the idea that sterling’s fall will be a very good thing is another. Sadly, though, there are good reasons to doubt it.  

Comments

[Neil Wilson]

"is, by definition, equal to the gap between savings and investment."

Or alternatively equivalent to the amount of foreign savings - once you get away from the standard economist view of a country operating in one currency and nobody else operating in that currency.

In other words you stop treating people in Manchester, New Hampshire differently from those in Manchester, England.

Once you see Sterling Savings as an export product things become a lot clearer.

In a floating rate currency there can be no trade imbalance. It's just that one of the export products is 'invisible'.

[Almar]

It is total saving versus investment that is related to the current account balance. Savings can increase even if the savings ratio does not increase. This ccould happen if a rise in demand for our net exports leads to an increase in real income. Obviously the chance of this happening depends on how much slack there is in relevant sectors of the economy and how quickly resources (including labour) can move between sectors

[Tony Maher]

The sheer scale of the GFC (post 2008) suppressed global demand. A very big shock cannot be absorbed by a local depreciation in the same way that smaller one's can e.g. ERM exit (and potentially Brexit now). If 2008 was an atypical global event then discounting the likely impact of the current depreciation because of the poor responsiveness of the trade figures to the 2008 depreciation is surely questionable.

[Nanikore]

Warm words for Paul Krugman. But there is little doubt that the MIT project to formalise trade and international monetary economics has been little more than a macho and egotistical project and has certainly reduced our knowledge of exchange rates, how they are determined, and their causal links (in both directions) with trade more than it has added to it.