Higher productivity and lower rates: why the pound should be above politics

Economic View

Low productivity has been the Achilles heel of the UK for at last a generation (Getty Images)

The pound is riding high against the euro. It is back above €1.40, not that far from the trading range around €1.45 that it sustained before the crash in 2007-08, and a long way from the near-parity that it hit in December 2008.

The recovery against the dollar has been less marked, for at $1.54 it is in the middle of its range over the past 20 years, rather than at the top of it. That is a function of the strength of the dollar, which has been particularly strong against the euro this year. However, the overall impact of this climb against the euro has been for the pound to recover about three-quarters of the devaluation we experienced in 2007-08. As you can see from the top graph, the trade-weighted index is around 93.5, having dipped below 75 in the dark days at the end of 2008.

Politically this is popular. We like having a strong currency, and governments that devalue usually pay a political penalty. Currency weakness is associated with a failure in economic management, as John Major and Gordon Brown both discovered.

Exporters traditionally do not like it and the rise against the euro over the past few months has led to some concerns. Certainly our trade deficit with the eurozone, including both goods and services, has risen steadily, whereas our earlier deficit with the rest of the world has been eliminated and become a surplus, as you can see in the bottom graph. Thanks to the success in exporting outside the eurozone, there has, if anything, been a slight overall narrowing of the deficit, from about 3 per cent of GDP in 2007-08 to about 2 per cent now. (Our overall current account deficit is somewhat larger as we have gone from having a surplus on investment income to having a deficit. It is not yet clear whether this is a temporary or lasting switch.)

This leads to a string of questions. Will having a strong, or at least strong-ish, currency matter? It may be politically popular but if it damages the economy, that’s not much use. Will the pound become even stronger, particularly against the euro if the eurozone continues to languish? And given the sophistication of the world economy now, do exchange rates matter as much as they used to?

Start with that last one. There is some evidence that they don’t. The decline in sterling after 2008 did not bring the boost to the economy that many expected, and growth does not seem to have been damaged, at least so far, by the recent climb in the pound. The sudden revaluation of the Swiss franc this year did check that country’s growth but, contrary to predictions, it escaped recession this summer. Quite why this should be is unclear. It may simply be that companies that trade across borders have become accustomed to swings in exchange rates and adapt in various ways, including trying to match costs with revenues in different markets. It may also be that in high-tech products the price is less important than the quality of both the product and the service associated with it.

That is not to say that in some products price matters very much. Part of the reason why the British steel industry is in such dire trouble is that the pound has risen against the euro. But a larger part seems to be the cost of energy in the UK. Companies that ought to have benefited from cheaper energy in sterling terms as a result of the rise in the pound have not done so, for reasons which include policies that have pushed up electricity prices. The point is that exchange rates do matter, but companies can sometimes find ways of offsetting their negative effects.

There is a twist to this, which is that a strong exchange rate has often been a spur to greater efficiency. Germany is a great example of that, for it joined the euro at what was accepted at the time as too high a rate. Germany then spent 10 years crunching down costs, including wages, and shipping a lot of jobs to Eastern Europe, until it became competitive again. It is now super-competitive, with a current account surplus of nearly 8 per cent of GDP. People argue that has an unfair advantage being in the eurozone because that holds down its exchange rate. Were it to have retained the German mark it would have been forced to revalue by now. While that is true enough, it ignores the point that it is Germany’s efforts that have made it so competitive, rather than membership of the eurozone.

So what will this mean for Britain, assuming sterling remains reasonably strong? The big issue is whether it will put pressure on companies to improve productivity. Low productivity has been the Achilles heel of the UK for at last a generation. There is a debate at the moment as to how serious a problem this is, and successive upward revisions to output suggest that it is not quite as grave as it once seemed. But it must be a problem, nonetheless.

One of the ideas behind the Living Wage is to put pressure on employers to use labour more efficiently. That will affect all companies, including those that don’t export. A higher pound, on the other hand, principally affects exporters. The combination of the two forces must have some effect in pushing up productivity, and the fascinating thing will be by how much it does so.

More immediately, the strong pound may slow the timing of the next interest rate increase in the UK. A rising exchange rate to some extent damps down an economy, just as a rising interest rate would. So we have already had some tightening of monetary policy, and the Bank of England may have reservations about pushing the pound up further. We’ll see. Maybe the Federal Reserve will clear the way in December.

Finally there is an issue that goes beyond economics, and that is whether the exchange rate will become a political issue in the run-up to the referendum. It shouldn’t. Currencies ought to rise and fall as a result of economic and monetary forces, not political ones. But the possibility of leaving the EU might have the effect of weakening sterling, which is not at all what the “leavers” would want.