Stephen Says...

Stephen Says...

This is my blog

sharing occasional thoughts about things that interest me

The Exchange Rate and the OBR

the state of the countryPosted by Stephen Sat, February 21, 2015 12:04:10

Given that it's universally accepted political wisdom that sterling should be sustained as an independent sovereign currency, you'd think that the economic significance of the exchange rate would be well understood. But I’ve lost count of the times it’s been said on the radio and TV News that “devaluation makes our exports cheaper” (with the implication that this means increased sales abroad, so contributing to domestic economic expansion with concomitant rises in employment, earnings and tax-revenues).

And Robert Chote (Chair of the Office for Budget Responsibility) states categorically that:

“The depreciation of sterling which began in 2007 has led to a change in the relative prices of domestic and foreign goods which will have had two effects:

(i) It will provide a boost (to) export growth as the relative price of exports of UK goods and services in foreign markets has fallen; and

(ii) It will reduce import growth as the relative price of imports to the UK from foreign markets has increased (often termed import-substitution)”

(source: email from Robert Chote received 4th April 2012)

But not only are these expectations without theoretical justification, they are also directly contradicted by the evidence.

The Monthly Review of External Trade Statistics November 2012 (published by the Office for National Statistics on January 15th 2013) reports the prices of UK Traded Goods as follows:

The ONS figures indicate that the OBR’s expectations are completely refuted. The devaluation of sterling in the aftermath of the Great Financial Crisis raised the prices of goods imported and goods exported alike: there has been no “change in the relative prices of domestic and foreign goods”.

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 care services; domestic property; the infrastructure of the public realm etc.,).

There is an important contrast in the way in which prices are determined for non-tradables and for tradables. For non-tradables, prices are set locally in sterling and so don’t involve the exchange rate. For tradables, prices are set internationally, not in sterling (usually in US$), and so require the use of the exchange rate to express them locally here in sterling. These observations allow us to appreciate the economic significance for Britain of sterling’s exchange rate. For when the exchange rate alters so do the prices of all tradables when expressed in sterling. And this means that prices in the tradables sector of the British economy have changed, whilst the prices of the non-tradables sector have not: so the relativity between the two sectors has been changed, creating pressure for economic readjustment between these two parts of the British economy (each responsible for roughly half of GDP).

As can be seen from the ONS figures, the impact of sterling’s devaluation has been to raise the sterling prices of tradables across the board (i.e. both the tradable things we buy from overseas and the tradable things we sell abroad) because their prices are set in international markets (and not in sterling terms) applying equally to ‘imports’ and ‘exports’ (translated into sterling terms by the same exchange rate), so there is no relative price change such as the OBR expects between domestic and foreign goods. A more detailed consideration of the ONS data not only confirms this but also indicates 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 language of ‘imports’ and ‘exports’ is beguiling: it obviously holds official thinking spellbound. However, I’d much rather believe the evidence of the ONS than take the word of the OBR. And consider the significant difference that this makes: the OBR believes devaluation is expansionary (increasing domestic output) whilst the correct theory says it isn’t (rather the opposite, when you take the depressing ’income effects’ of consumer price increases for tradables into account).

I protest because I’m sure this is important. To summarise my argument: it is fundamental to government economic policy to sustain sterling as a sovereign currency; this predicates the existence of exchange rates; this further requires that appraisals of the country’s economic situation ought to be developed using a proper understanding of the exchange rate’s effects; the OBR demonstrably does not have this proper understanding; the OBR is immune to criticism (forsworn by MPs on all sides to protect its “independence”); because decisions about public expenditure and taxation are dependent on the OBR’s flawed assessment of the country’s position they can’t command public confidence.

If you'd like to find out more about this topic:

I’ve had a go at making an assessment of the British situation based on the distinction between tradables and non-tradables (

and I’ve described my argument in technical terms using some A-level/undergraduate diagrams (

and I’ve prepared a tabulation giving detailed attention to the ONS data (