Stephen King: How industry could gain in a post-oil economy

A prolonged period of sterling weakness would help end UK manufacturing's endless decline
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The Independent Online

In the 1970s, the UK stumbled upon something that promised to make the nation rich. No, it wasn't the Austin Allegro. I'm thinking, instead, of North Sea oil. Oil companies had known for some time that something was lurking underneath the North Sea. But it wasn't really until 1973, when global oil prices quadrupled following the Arab oil embargo, that oil companies began drilling in earnest. Suddenly, the idea of spending half a year stuck out on an oil rig in howling gales became quite attractive: drilling for oil in the North Sea became a very profitable enterprise indeed.

In the 1970s, the UK stumbled upon something that promised to make the nation rich. No, it wasn't the Austin Allegro. I'm thinking, instead, of North Sea oil. Oil companies had known for some time that something was lurking underneath the North Sea. But it wasn't really until 1973, when global oil prices quadrupled following the Arab oil embargo, that oil companies began drilling in earnest. Suddenly, the idea of spending half a year stuck out on an oil rig in howling gales became quite attractive: drilling for oil in the North Sea became a very profitable enterprise indeed.

North Sea oil had the potential to deliver plentiful benefits to the UK economy. As production began to rise (left-hand chart), the UK moved into a trade surplus on oil, exporting more than it imported (right-hand chart). The trade surplus in oil peaked in the early-1980s - reflecting the period of maximum oil prices seen between the Iranian revolution and the 1985-86 oil price collapse - but production didn't peak until the end of the 1990s.

Oil did not, however, have a straightforward impact on the UK economy. To understand why, it's worth thinking about the laws of comparative advantage. Put simply, if we suddenly discover that we're rather better than everyone else at producing oil, there should be some mechanism that ensures that we devote more resources to oil production and fewer resources to areas where our comparative advantage is lacking - we're better off in these circumstances buying these goods from foreigners.

There are those of you who, perhaps, yearn for a mustard yellow Austin Allegro with the revolutionary square steering wheel but, in the 1970s, it was fairly clear that manufacturing activity was an area where Britain did not have a comparative advantage. As a nation, we were better off thinking about how to extract oil than thinking about how to take on the Japanese at car production. But while this conclusion seemed obvious, the mechanism by which this new reality would be reached was a little less clear.

In a market economy, the invisible hand - the price mechanism - ultimately determines the allocation of resources. And in the early 1980s, when oil production really began to take off and we could all, apparently, sit back and enjoy the spoils, the price mechanism really did go to work. The surprise, perhaps, was just how brutal the price mechanism could be.

The price that changed, of course, was the exchange rate. Helped along by the abolition of exchange controls in 1979, financial markets moved quickly to re-rate sterling, turning it into a petrocurrency, a status helped along by the impact of the second oil shock in 1979. Sterling went up for other reasons too, notably in response to the imposition of very tight monetary conditions (although not as a result of the introduction of monetarism - Dennis Healey did that long before Margaret Thatcher got hold of the reins of power), but oil doubtless played a crucial role.

Sterling's rise was a simple way of delivering terms of trade benefits to the UK economy. But its impact was severe. Sterling's rise brutalised manufacturing. Production went into steady decline. Jobs haemorrhaged. The nation's unemployment rate surged. Even when the economy pulled out of recession in the early 1980s and enjoyed many years of sustained overall economic expansion, manufacturing continued to wither on the vine.

In other words, although oil made the nation better off, the benefits were heavily skewed towards some people and communities but away from others. The 1980s marked the point at which the UK's economic decline relative to its European brethren came to an end. This did not, however, prevent the emergence of huge pockets of economic pain and hardship - driven along by the speed of reaction within the foreign exchange markets and the inflexibility of domestic labour and product markets.

You might be wondering why I have spent so long revisiting history. The answer comes from my charts. The latest trade figures - for the month of July - show that the UK has gone back into a trade deficit on oil, despite the substantially higher oil price over the last year or so. With UK oil production slipping back and with the UK economy continuing to expand at a reasonable rate, perhaps this is not so surprising. Nevertheless, it raises the obvious question: if the discovery and production of oil had a profound impact on the UK economic landscape, what happens when the oil starts to run out? What happens when the UK becomes a net oil importer rather than an exporter?

The answer doesn't come from replaying history in reverse. The UK isn't about to re-impose exchange controls, for example, and nor is there any great surprise about the decline in oil production, so there is unlikely to be a massive and swift sterling adjustment of the kind that we saw at the beginning of the 1980s.

The first part of any answer comes from assessing whether we saved some of the benefits of North Sea oil or, instead, whether we frittered them away. In the 1980s, you may recall the big debate about outward investment: with money leaving the country, people felt that, somehow, financial markets weren't being patriotic.

This, though, was surely the wrong conclusion: the combination of higher oil production and a strong exchange rate provided the UK with a unique opportunity to acquire foreign assets at "knockdown" prices. Arguably, the benefits of this have been coming through in recent years: since 1994, there has been a substantial increase in investment income from abroad - primarily income from direct investment - that brings in a net £20bn or so to the UK on an annual basis. This doesn't stop us being in current account deficit, but it certainly helps to reduce the scale of that deficit. That, in turn, means that the benefits of North Sea oil will be with us beyond the point at which we become energy consumers.

Second, if the trade balance in oil really is going to get into bigger and bigger deficit, driven by falling production, it seems reasonable to conclude that we're losing our comparative advantage in oil. If so, we need to ask the same question as before: what is the mechanism that steers us towards other sources of economic endeavour and away from oil? Once again, we come back to the exchange rate. If the oil surplus years were associated with sterling strength, perhaps we should now expect years of sterling weakness.

If so, the demise of oil will create opportunities for expansion in other areas. This doesn't necessarily give the green light for a manufacturing renaissance, but a prolonged period of appropriate sterling weakness would certainly help to end UK manufacturing's seemingly endless relative decline. High-quality services should also be able to flourish, particularly if this involves the export of our expertise to newly-emerging manufacturing nations such as China.

A softer sterling might, therefore, be part of the solution to Britain's post-oil economy. It is, though, no panacea. Softer sterling implies a loss in the UK's terms of trade - making consumers worse off because imports become more expensive. And, even if exports become more competitively priced, there are some things - the stunning Austin Allegro, for example - that you just can't sell at any price.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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