Would a weaker GBP help the UK economy?

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Many commentators suggest that a weaker pound should be used as a tool to rebalance the UK economy, helping it to export its way out of recession. They take it for granted that the UK’s balance of payments can be materially boosted by depreciation.

Sterling’s place in the FX space 4 of 5

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In the jargon, this view assumes that something called the “Marshall-Lerner” conditions hold. They state how sensitive a country’s trade needs to be to changes in the price of its exports and imports in order for higher export earnings to offset the cost of more expensive imports. It seems intuitive that this should be the case. In practice, however, big swings in the pound have often had a much smaller impact on UK trade than pundits hoped for. For example, since its peak in 2007, GBP has been the weakest G10 currency by a considerable margin (down by 20% in trade-weighted terms, more than enough to offset the UK’s higher inflation rate over the period and so to deliver a “real” depreciation – Figures 1 and 2), yet net trade has not materially contributed to UK GDP.

Over such a long period, the disappointing response is unlikely to have simply been the result of the so-called “J-curve” effect. A process whereby the good news on exports takes longer to come through than the immediate hit to the import bill that occurs as depreciation pushes up the cost of essential imports.

Changes in aggregate demand can more than offset the impact of a cheaper currency, and this has likely occurred for the UK

One possible explanation is that trade simply isn’t as price-sensitive as is assumed: the Marshall-Lerner conditions may not hold. Econometric analysis has in the past supported this assessment – and it is plausible.

Manufactured products in particular are not sold simply on price: competitiveness is also driven by all sorts of qualitative considerations.

Germany is an exporting powerhouse, for example, not because it sells cheap cars or machine tools, but because the cars and machine tools it sells are of sufficiently high quality as to be demanded partly irrespective of the price.
In another example, Ireland’s hugely successful export sector is also driven by supply-side considerations, not cheapness per se – in this case, the willingness of multinational companies to make Ireland the location of their European manufacturing operations because of its low taxes and flexible, English-speaking workforce.

Another very important consideration is that in practice, the “ceteris paribus” assumption beloved of the economics textbooks doesn’t hold: other things are not equal. Specifically, changes in aggregate demand can more than offset the impact of a cheaper currency, and this has likely occurred for the UK, whose key export markets in the euro area have been particularly soft in the last few years. If overseas consumers and businesses are spending less across the board, being a little bit cheaper is not going to be of that much use to a hard-pressed exporter.

Overall, assuming that a weaker currency will directly translate into an improved trade balance is an oversimplification. Not only does demand for exports and imports appear relatively inelastic with respect to changes in price, but a huge amount depends on the situation of one’s key trading partners.

Calls for weaker GBP as a policy tool may be missing the point – as they have done in this respect, arguably, for the last half century at least. The same, of course, applies to at least one other prominent developed economy with a persistent current account deficit….

Figure 1: UK recorded highest inflation since 2007...
Average Inflation 2007-2012

Source: Barclays, OECD

Figure 82: ...thus reducing benefits of weaker GBP

Source: Barclays, EcoWin