To what extent does the UK have a supply-side problem – falling productivity – and to what extent a demand problem? In theory, sterling’s fall – the trade-weighted index has dropped 3.6 per cent since early November – should help us find out. If our problem is merely weak demand, sterling’s fall should boost output by cutting the price of exports and import-substitutes, thus allowing UK firms to expand output. If, however, we have a supply-side problem, the fall will merely raise prices.
Markets seem ambivalent about which it is. On the one hand, inflation expectations have risen since early November; the breakeven inflation rate has jumped from two to 2.7 percentage points for three-year gilts. However, this might also tell us that growth expectations have improved; breakeven inflation rates are cyclical. And the fact that the All-share index has slightly out-performed world markets since early November is consistent more with increased optimism about growth (among many other things) than worries about inflation.
The latest CBI survey of exporters is also ambiguous. On an optimistic note, it found that 56 per cent say that orders are constrained by prices. A weaker pound should relieve this problem. However, 24 per cent said that delivery dates were a problem, which suggests that a significant minority of firms will be unable to take much advantage of lower export prices.
Personally, I fear that the fall won’t boost exports much at all, and not just because it has, so far, been so small.
I say this for a simple reason. Exporting takes effort. You don’t export merely by waiting for a low exchange rate to make your products seem good value. You have to invest time and money in marketing and sales networks. So, will firms do this in response to the weak pound?
There’s a precedent for thinking not. In late 2008, sterling fell very sharply, and yet it’s hard to discern any significant improvement in net exports thereafter. This was because a combination of a lack of credit and deep pessimism about overseas demand stopped firms investing more in export effort.
Fortunately, these constraints on exporting have declined recently. The latest CBI survey found only five per cent of exporters constrained by credit and a surprisingly low 31 per cent constrained by “political and economic conditions abroad.”
However, something else might well prevent that increased export effort – ordinary exchange rate volatility. So far, sterling’s fall has been so small as to give exporters only a slight advantage. And there’s little point investing time and money to exploit a small edge if you think that there’s a chance that edge will be reversed by a rising exchange rate.
This helps explain why sterling’s fall after it was booted out of the exchange rate mechanism in 1992 led to a big jump in net exports – export volumes rose 25 per cent between 1992 and 1995 whilst imports grew just 15.5 per cent – whilst other exchange rate moves haven’t had such an effect. Exporters thought that devaluation was permanent – in fact it wasn’t, but that’s another tale - and so responded in a way they did not to other moves.
This reasonable fear that sterling might recover will, I suspect, prevent exports rising much. Which suggests sterling’s fall might do more to raise inflation than activity.
This will not, however, tell us that the economy is more supply-constrained that demand-constrained – but merely about the nature of exporting.
Nor does it mean that the Bank of England should try to stop sterling falling. Surely, one lesson from economic history – be it the 1960s or early 90s – is that attempts to manage exchange rates do more harm than good.
Instead, it reminds us of a general fact that makes economics both interesting and awkward. The response of exports to exchange rate moves is not a hard fact that can be captured by a single number. Instead, it varies from time to time depending upon what mechanisms are operating: the availability of credit, animal spirits, exchange rate expectations and so on. As I’ve said, economics is about mechanisms, not models.
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Chris blogs at http://stumblingandmumbling.typepad.com