Vince Cable Thinks Devaluing The Pound Will Solve Britain's Problems - Here's Why He's Wrong
Unfortunately, recent history suggests he's wrong.
Speaking at the Liberal Democrat party's annual conference in Glasgow he said:
Arguably, the pound is overvalued by 10 to 15 percent on a trade-weighted basis. This feeds back into monetary policy. It is a significant problem that we can't directly address.
Cable's comments are likely earn him a place among the long line of politicians and policymakers who have been accused of attempting to "talk down the pound" over recent years. Fellow members of that club include former Labour Chancellor Alistair Darling, current Chancellor George Osborne and former Bank of England Governor Sir Mervyn King.
The theory behind the comments is fairly simple. A fall in the value of the pound against its trading partners should increase the cost of imports for the UK and decrease the cost of British goods abroad. This should lead to an improvement in the country's balance of trade as it earns more from goods sold than it pays out for goods coming in.
Yet in recent years, falls in the value of the pound have failed to significantly improve the country's trade balance. Post-1998, the yellow trade balance lines in this chart stay in negative territory even when the exchange rate falls:
Here is the Office for National Statistics' (ONS) summary of the dilemma:[Between] Q3 2007 and Q1 2009 the sterling effective exchange rate depreciated by 25%, at an average quarterly rate of 4.0%. This was the largest depreciation of sterling in recent history, more than reversing the appreciation of the late 1990s. Despite a brief increase between Q2 2007 and Q4 2008, the trade balance has remained around its pre-depreciation level and shows little clear evidence of the depreciation.
So despite falls in the value of the pound over the crisis, the promised improvement in trade failed to materialize. Indeed, since the ONS analysis was written Britain has seen its balance of payments deteriorate even further with domestic economic growth increasing the pace of imports faster than export growth can offset.
Why is this happening? There are a number of theories:
- Increased reliance on global supply chains - globalization has meant firms increasingly source goods and services from around the world. While a falling pound will make their final products cheaper for oversees buyers, the cost of their imports for raw materials will also rise offsetting these gains.
- Financial services exports took a big hit - although manufacturing has benefitted from falls in the pound, the financial crisis destroyed a chunk of the UK's financial services sector. Those lines of business no longer exist - so it doesn't matter how cheap the pound gets.
- Firms may have chosen to increase their prices (and thus their profit margins) rather than enjoy the benefit of more sales from weaker sterling.
- Oil prices - the 2008 oil price spike caused spot prices to increase 14.1% in dollar terms but 41.9% in sterling terms due to the pound's weakness against the greenback. This sharply raised energy costs for manufacturers and limited any gains from additional sales.
- And let's not forget the long-term economic weakness in Europe - one of Britain's key export markets has lurched from disaster to disaster over the last few years, limiting demand for UK goods and services in a huge part of the market.
Of course, it's possible that things could be different this time around. The financial services sector has had a few more years to recover and, with the economy picking up, firms might be more confident about the demand outlook.
But here is one big reason why Cable shouldn't be betting on that outcome - Europe is still flat-lining, as this chart of Euro Area GDP growth from 1995-2014, via the European Central Bank, shows:
ECB