Stephen Says...

Stephen Says...

This is my blog

sharing occasional thoughts about things that interest me

Labour’s Damaging Economic Doublethink

the state of the countryPosted by Stephen Thu, January 14, 2016 10:48:53

On the on hand John McDonnell has called for “a New Economics, laying the economic foundations of a prosperous, fairer and sustainable society”. On the other hand he has promised to “demand that the Office of Budget Responsibility and the Bank of England put their resources at our disposal to test, test and test again to demonstrate our plans are workable and affordable”. But John McDonnell misses the point: it’s the Old Economics of the Treasury, the OBR and the Bank of England (what Gavyn Davies has usefully termed ‘the standard apparatus’) that is at the root of the country’s economic policy problems. Giving the OBR and the Bank responsibility for judging Labour policy involves a prior commitment to seeing things their way. And their way is completely wrong.

For as long as sterling remains a sovereign currency the exchange rate will be a significant factor affecting the country’s economic circumstances. But unfortunately both the Treasury (and hence the OBR) and the Bank (and hence the MPC) hold to the heartfelt belief that “devaluation makes our exports cheaper” (as Robert Chote puts it with technical precision, it causes “a change in the relative prices of domestic and foreign goods”). This erroneous preconception leads them to suppose that any depreciation of sterling will expand sales volumes for British goods and services (because they’re cheaper) thus boosting economic activity and employment. Such thinking is completely bogus.

Not only are the official expectations without justification in terms of economic theory, they are also directly contradicted by the evidence provided by the Office for National Statistics. The figures below amply illustrate my point.

The ONS figures indicate that the standard expectations are completely refuted. The devaluation of sterling in the aftermath of the Great Financial Crisis has been substantial: from $1.87 in the years before the crisis (2004-2007) to $1.57 in the years after it (2009-2012); from €1.47 in the years before the crisis (2004-2007) to €1.17 in the years after it (2009-2012). This devaluation raised the prices of goods imported and goods exported alike: there has been no “change in the relative prices of domestic and foreign goods”.

The traded goods price index for exports went from 74.7 in the years before the crisis (2004-2007) to 94.9 in the years after it (2009-2012); the traded goods price index for imports went from 74.4 in the years before the crisis (2004-2007) to 94.9 in the years after it (2009-2012). In technical terminology, the terms of trade remained unchanged. And this ought to come as no surprise since you only need seven types of product to account for more than half of UK exports and you only need the same seven to account for more than half of the UK’s imports as well. The categories are: Mechanical machinery; Electrical machinery; Cars; Medicinal & pharmaceutical products; Refined oil; Crude oil; and Other miscellaneous manufactures. So no wonder prices of imports and exports move together: their prices are those of the same types of products and come from the same world markets.

In fact, the ONS data is entirely consistent with the proper economic theory. In this, the crucial price-relativity affected by the exchange rate is that between tradables and non-tradables. Tradables being those things that are internationally portable (e.g. motor-vehicles; feed wheat; consultancy services etc.,). Non-tradables being those things irrevocably confined to our shores (e.g. residential property; domestic care services; the infrastructure of the public realm etc.,). The impact of sterling’s devaluation has been to raise the sterling prices of tradables across the board (i.e. both the things we buy from overseas and the things we sell abroad) because their prices are set in international markets (and not in sterling terms) and these are the prices which apply equally to ‘imports’ and ‘exports’ (translated into sterling terms by the same exchange rate), so there is no relative price change such as the official experts expect. And consider the significant difference that this makes: the flawed conventional wisdom believes devaluation is expansionary (increasing domestic output) whilst the correct theory says it isn’t (rather the opposite when you take’ income effects’ of price changes into account).

A more detailed consideration of the ONS data confirms that import and export prices within the same (tradable) product categories habitually move together (being basically the same international price of course), showing that the UK is well integrated into global market determination of producer prices for tradables. The pivotal role of the exchange rate is to alter the balance of activity in the UK economy between the tradables and the non-tradables sectors: this comes about because whilst prices in the latter (non-tradables) are inherently set in sterling, prices in the former (tradables) are translated into sterling from abroad by the exchange rate (thus changing when it changes: i.e. increasing when sterling is devalued).

Tradables and non-tradables each account for about half of national income (GDP) so the scale of this problem posed by this price change is significant. And because the government itself is responsible for a large part of the national infrastructure (non-tradable) and for purchases of (non-tradable) educational and healthcare services (on behalf of the population at large) this is an issue bearing directly on the economic responsibilities of government operation. So these observations are particularly pertinent for policy-makers of a social democratic persuasion. They provide a platform for a party with a purposive perspective on government: “a New Economics, laying the economic foundations of a prosperous, fairer and sustainable society” (John McDonnell MP speaking at UCL on 20th November 2015).

It cannot be in the best interests of the Labour Party or the people that it aspires to represent that a false picture of the country’s economic circumstances should be used as the platform for evaluation of the policies that will affect so many important aspects of commercial performance as well as standards of individual, household and community life. Sadly there is no prospect that the reviews instituted by the Shadow Chancellor will challenge the official standard apparatus: their terms of reference preclude it. The prospects for the country remain as bleak as before: see (