The trade taboo

The textbooks have it that there are five key ‘macroeconomic policy objectives’: low and stable inflation, sustainable growth, low unemployment, sound government finances and a satisfactory balance of payments position. Things are looking bad for the UK on all counts. So bad, in fact, that Rishi Sunak used his first speech as prime minister to declare that “our country is facing a profound economic crisis”. 

Inflation remains above 10 per cent, and is expected to stay there for the next 12 months. The UK economy stands poised to enter a winter recession, and the government’s fiscal position is precarious – unfunded tax cuts proved Liz Truss’s undoing, and Sunak and chancellor Jeremy Hunt are striving desperately to restore economic credibility. Even our low unemployment rate is a double-edged sword: a tight labour market is fuelling domestic inflationary pressures and masking the UK’s inactivity problem. Trade, it seems, is the least of our worries. But it shouldn’t be.

Admittedly, trade is unlikely to be most people's favourite topic: trade figures are complex and abstruse, and often hard to make sense of. 

Each country has a balance of payments – a statement of all transactions made between the individuals, companies and governments in that country and the rest of the world. The balance of payments is made up of three components: the current, financial and capital accounts. The ‘current account’ covers the bits that usually spring to mind when we think about trade: it records the UK’s imports and exports of goods and services, plus investment incomes and current transfers. A trade deficit (often called a current account deficit) occurs when a country’s imports exceed its exports. And as the first chart shows, the UK economy is wrestling with a huge one. 

Our import addiction is nothing new. Even in our heyday as the ‘workshop of the world’, the UK imported more goods than we exported. Martin Daunton, emeritus professor of economic history at the University of Cambridge, reminds us that even before the outbreak of the First World War, the UK had a deficit in the trade of goods, thanks to our status as a major importer of food, raw materials and industrial products. Even a century ago, we offset this with exports of banking, shipping and insurance services. As the chart above shows, the UK still imports far more goods than it exports, but consistently runs a surplus in our trade of services. 

For the UK consumer, the ability to import cheap goods has long exerted a benign force on our standard of living. Recent research from the Bank of England shows that between the 1960s and 2010s, import prices fell dramatically relative to the price of domestically produced output. These cheaper global prices left UK consumers feeling better off, and for 50 years, we took the ability to bring in cheap goods from overseas for granted. But now the trend has gone into reverse: over the past two years, the price of UK imports has risen by 20 per cent more than the average price of domestic output. The rising prices of imported goods and energy are rapidly making us worse off. As a result, our trade deficit has widened, hitting £7.1bn in August. 

UK exporters are also struggling to recover from the shock of the pandemic. According to Office for Budget Responsibility (OBR) figures, goods export volumes fell by 20 per cent during the first wave of Covid-19, as the second chart below shows. By the end of 2021, trade volumes in advanced economies had rebounded to 3 per cent above their pre-pandemic levels, but UK exports remained 12 per cent below. 

At the same time, sterling has tumbled (especially against the dollar). A falling pound is usually good news for trade: exports become more competitive and import demand is curbed as prices rise. But weak sterling won’t ride to the rescue today. Firstly, UK exporters tend to rely on inputs sourced from overseas, which will become even more expensive as the pound depreciates. This means that their ability to price competitively is limited. 

What’s more, we are hardly in an environment of exuberant global demand. Jack Sirett, head of dealing at financial services firm Ebury, argues that “sluggish demand from trading partners and a looming global recession will also hold back demand and act as another drag on UK exports”. An October report from the Institute of Directors notes that “faced with the fallout of leaving the EU, a global pandemic, and a war in Ukraine, it has become increasingly difficult for businesses to send and receive goods and services to and from the UK”. 

Higher prices will do little to curb our insatiable demand for imports, either. The UK is heavily reliant on food and energy imports, and these cannot be easily substituted for UK-produced goods. Analysis by Gabriella Dickens, senior UK economist at Pantheon Macroeconomics, suggests that the UK trade deficit will widen in the months ahead – despite the weak pound. 

This current account deficit means that the UK is a ‘net borrower’ with the rest of the world. To finance our current account deficit, we must attract financial inflows – and if we can’t, a balance of payments crisis beckons. Sterling would, in theory, have to depreciate enough to close the gap in our external accounts. This would mean a hefty drop: Deutsche Bank analysts estimated that in the extreme case of a sudden stop of capital inflows, the pound would need to fall by 30 per cent to bring the current account to balance. 

Fears of this kind of balance of payments crisis are overblown, but the UK can’t take investor confidence for granted.  A Deutsche Bank strategist recently caused ripples when he argued that the UK risked a “balance of payments crisis whereby foreigners would refuse to fund the UK external deficit”. And the fall-out from the “mini” Budget made things even worse. Paul Johnson, director of the Institute for Fiscal Studies think tank, argued that “concurrent large fiscal and current account deficits made markets seriously nervous when big, unfunded tax cuts were announced”. 

The balance of payments position is messy – at once too abstract and too detailed to comfortably grasp. But these figures are where global political and economic realities collide. And they deserve our attention.

Trade trilemma

We used to care a lot more about trade: before inflation rose to prominence in the 1970s, the balance of payments and unemployment were the UK’s key macroeconomic indicators. Keeping the UK’s balance of trade in check often required tough trade-offs, linked to the stop-go interest rate policies of the 1950s and 1960s. Periods of high growth and low unemployment would fuel import demand, leading the government to impose a ‘stop’ of higher interest rates, which would improve the current account position.

These trade-offs are closely linked to something that economists call the ‘policy trilemma’ or the ‘impossible trinity’. The terminology is ostentatious, but the idea is relatively simple: policymakers have to choose between fixed exchange rates, international capital mobility and ‘domestic’ monetary policy. As the diagram below shows, only two of the three corners of the triangle are attainable at any given time. 

Take option B. If a country wants a fixed exchange rate and free capital movements (as the UK had under the gold standard before 1914), it cannot use monetary policy as a tool to stimulate the domestic economy. Cutting rates to encourage growth would lead to higher import demand, putting downward pressure on sterling – threatening the fixed exchange rate regime. 

Under the Bretton Woods system, economies opted for option C: economies pegged their currencies to the US dollar and set monetary policy domestically – a system that worked because international capital flows were negligible. The UK today has chosen option A: monetary policy is free to tackle domestic issues (specifically the inflation rate) and we retain free capital movement. As a result, we sacrifice a fixed exchange rate: the pound is free to float, or sink, and the current account balance moves with it. 

Daunton argues that “debates over trade cannot be separated from the relationship with the trilemma”. After all, trade figures are inexorably linked to exchange rate regimes, capital controls and policy measures to target inflation and competitiveness. Today, we have chosen a corner of the triangle that gives us less control over our current account position. Is this one of the reasons why we overlook trade? 

Matters are not helped by the fact that trade statistics are fairly indigestible, with short-term movements often at odds with longer-term trends. Take August’s figures: despite the overall gloomy picture for trade, UK goods exports rose above their pre-Covid and pre-Brexit levels for the first time since the pandemic. Taken at face value, this looks like good news, but the reality is less reassuring. Pantheon Macroeconomics’ Gabriella Dickens points out that the increase was the result of a jump in exports of aircraft to Qatar and art to the US and South Korea – both trends that are likely to reverse. 

Trying to abstract the impacts of Brexit and the pandemic is also a minefield. As the first chart shows, the UK’s current account balance swung into surplus during the pandemic – the economic shock of lockdowns enough to buck a long trend of deficits. Since then, the UK’s trade in services has fallen more with EU countries than it has with the rest of the world. But it is very hard to establish how much of this is the fault of Brexit. The OBR notes that much of the decline probably reflects the impact of the pandemic, with figures for transport services particularly hard hit. 

And even for its advocates, Brexit was always going to be a waiting game. Conservative MP Jacob Rees-Mogg memorably claimed that it would take 50 years to feel the benefits, and many potential downsides will take years to materialise, too. The OBR forecasts that Brexit will precipitate a 15 per cent reduction in trade intensity, but cautions that “these effects are likely to take several years to be fully realised”. With the government facing a host of pressing economic problems, it is all too easy to overlook noisy and inconclusive trade figures.

This is compounded by the fact that for the Conservative party, Brexit is the elephant in the room. The leadership (in all of its recent manifestations) continues its quest for sunlit uplands, with Sunak pledging in his first speech as PM to build “an economy that embraces the opportunities of Brexit”. Yet he made no mention of the very real difficulties it is presenting: according to the Institute of Directors, 47 per cent of members are finding Brexit a challenge, and only a third believe that they will see future opportunities arising from leaving the EU. Why is a sober look at the UK’s trade position still so politically unpalatable? 

A 2021 book by Chris Grey, emeritus professor of organisation studies at Royal Holloway, argues that the promise of Brexit has slowly dissolved, creating discontent on all sides. In Brexit Unfolded, Grey argues that any warnings of the economic damage from Brexit were labelled ‘Project Fear’ by the Vote Leave campaign. But this branding proved so successful that any rational debate on how to execute Brexit became all but impossible. Grey says that as a result we find ourselves treating Brexit unlike any other political decision, for fear of any balancing of costs and benefits being branded as overly partisan. 

Grey argues neither Brexiteers nor remainers have got what they want from the current deal. Yet there is little political will to renegotiate from either side: the Conservative government is considering legislation to revoke all EU law in the UK by the end of 2023, and in July Labour leader Keir Starmer ruled out rejoining the single market. As Grey puts it, “that country, that world, of 23 June 2016 has gone forever”. If there is no turning back, the UK needs to forge forwards. But where can trade policy go next? 

Moving on?

Martin Daunton argues that today’s trade policy is implicated in much wider debates about deindustrialisation and the winners and losers from globalisation. But this complexity means that there is no obvious next step: do we return to a free trade policy to recapture markets; should we turn to public spending to regenerate deindustrialised areas and invest in skills; or do we turn inwards and develop an alternative economic strategy?

Although it went down like a lead balloon, Truss did (however briefly) try a new kind of post-Brexit economic strategy. Guy Hands, founder and chairman of Terra Firma Capital Partners, argued last month that this sort of low-tax, low-benefit economy was a long-held dream of Brexiteers, adding that Truss had at least “to be fair to her, tried it”. But Hands says that “the British people have never voted, or ever shown any inclination to vote, for the sort of extreme Thatcherism that Brexit needed”. He concludes that if this ‘type’ of Brexit is impossible, we have to accept that “the Brexit that was done is completely hopeless and will only drive Britain into a disastrous economic state”.

Some of Hand’s warnings (the need for an International Monetary Fund bailout and the UK becoming the ‘sick man of Europe’) are extreme, but he raises an important point: with Sunak pledging to “place economic stability and confidence at the heart of this government’s agenda”, any radical macroeconomic strategy required to make Brexit work looks vanishingly unlikely before the next election.

Sector-by-sector policies might prove a more realistic prospect. PwC strategy partner, Matt Alabaster, argued last year that the move to net zero could provide a huge opportunity for UK export growth. According to the PwC research, the UK is now the world’s biggest market for offshore wind, yet none of the world’s top 15 turbine manufacturers are British. Although this was a missed opportunity, Alabaster argues that the UK is well-placed to become a world leader in other high-growth, high-tech industries: think next-generation batteries, hydrogen and sustainable aviation fuels. But the struggles seen at the likes of battery start-up Britishvolt and hydrogen hopeful ITM Power (ITM) this year emphasise that the path to success won’t be simple.

A 2022 report from the Resolution Foundation suggests that the idea of a high-tech manufacturing revolution might be wishful thinking. Its research found that Brexit would lead to the UK becoming around 7 percentage points less open as an economy by 2030. As a result, the only types of manufacturing that will see substantial gains are those that focus on the domestic market and benefit from less EU competition –  more food and drink than futuristic tech. The think tank anticipates that the UK economy will pivot from higher productivity to lower productivity manufacturing sectors, and singles out some losers: it expects firms producing electrical equipment to suffer a 7 per cent output shock as a result of Brexit. 

Could it be an opportune moment to regenerate areas and invest in skills? PwC’s Alabaster describes the levelling-up agenda as being “bang on aligned to trade and investment”, and argues that exporting companies are both more productive and job-creating than non-exporting ones. It won’t be lost on the government that policies to revitalise trade and deprived areas could go hand in hand – but whether levelling-up policies will ultimately survive the government's imminent fiscal belt-tightening is another matter. 

This all raises the thornier issue of who should actually set trade policy. Stephen Woolcock, associate professor of international relations at the London School of Economics, reminds us that trade policy was once the preserve of civil servants in a specialist trade department. These bureaucrats were trusted to make informed judgments on the balance of losses and gains from trade policy, and from 1940 onwards “trade seldom played an important role in voting intentions or elections and thus in party politics”.

But times have changed. Woolcock characterises today’s “new trade policy” as a far more polarised and heated affair, seen as the preserve of the voting public and party politics. What’s more, the ‘right’ of a policy elite to decide trade policy has been fiercely challenged since Brexit: who can forget Michael Gove’s insistence that “the people in this country have had enough of experts” in the run-up to the referendum? 

Woolcock warns that trade relations have assumed a higher profile since Brexit, but there is now “a risk that the polarisation of public opinion and between the political parties created by Brexit will spill over into trade and investment policy”. Brexit may well have dragged trade policy from the domain of experts into the public sphere, but we have abandoned it there ever since. 

Trade is hard to understand, tough to tackle and politically difficult to discuss. But on all counts, we must try.