Why devaluation is the right way: Britain's sagging competitiveness needs a substantial realignment of the pound now, argues the economist John Muellbauer

JOHN MAJOR will yet regret linking his political ego to sterling - though one can sympathise with his not wanting to be seen in the company of supposedly bankrupt Italian politicians this week.

The Government has been using an over-valued exchange rate to squeeze inflation out of the UK. There are two major problems with this. The first is that the domestic, less tradeable, parts of the economy pose no inflationary threat: they are in the deepest depression yet experienced.

Paradoxically, it is the very depth of the recession that is responsible for some of the pockets of inflation that remain: banks, insurance companies and British Rail are raising charges to try to restore their battered balance sheets.

The second problem is that our tradeable sector has been much shrunken already by being exposed to international competition on very tough terms for most of the past 13 years. The combination of the over-valued exchange rate and weak capacity leaves us with a trade deficit of more than pounds 10bn, even with such depressed domestic demand.

We cannot afford a domestic demand-led recovery: it would lead either to inflation because of our inability to supply, or massive trade deficits that we cannot support, given the depleted state of our international assets after six years of deficits.

Measures of competitiveness of UK manufacturing shown in the graph underline the severity of sterling's recent over-valuation. Indeed, competitiveness in UK manufacturing was notably worse than for Italy, even before the lira's devaluation.

The least pessimistic view comes from relative unit labour costs. At least on that measure 1991 does not appear as uncompetitive as 1981, when sterling was clearly grossly over-valued. But even on the relative labour cost measure it is clear that for most of the past 13 years UK manufacturing has faced very tough conditions by historical standards.

The graph also shows the Bank of England's measure (available from 1976) of labour costs relative to exchange rate mechanism countries. This gives the lie to the frequently expressed view that sterling has been over-valued only against the dollar bloc. Sterling has clearly been over-valued against ERM countries. With European trade frictions falling further, output and employment would have been even more affected than before.

Unfortunately for government apologists, the other measures of competitiveness - relative producer prices shown in the graph, the Goldman-Sachs indices of purchasing power and relative export prices - have shown only a minuscule improvement relative to 1981.

On many counts, these are more reliable and comprehensive indicators than unit labour costs: they are less subject to temporary fluctuations because of cyclical productivity charges; the data are much less heavily revised than are unit labour costs; they reflect also the cost of capital and of other domestically produced inputs, such as energy, services, transport and land; they reflect indirectly aspects of managerial efficiency.

More evidence for the over- valuation of sterling comes from Keith Church of ESRC Macroeconomic Modelling Bureau in the August National Institute Economic Review. His estimate of the 'Fundamental Equilibrium Exchange Rate' (Feer) suggests a sterling over-valuation of 15-18 per cent in the first quarter of 1991.

The Feer measure aims to compute the exchange rate consistent with macroeconomic equilibrium. It is a comprehensive measure taking into account competitiveness, trade performance, oil, capital flows and economic activity.

A devaluation of sterling is therefore right. For the UK, the inflationary risks are minimal. Three years of rising unemployment and falling cost of living increases are having their effect.

There are many examples of currency depreciations followed by falling inflation because of other deflationary forces: the UK in 1981-84 and the US and Finland recently are just a few. Deflationary forces will remain strong because European 'real' interest rates will remain high and because of the high levels of private sector debt.

And there are plenty of slack resources ready to move into a newly more profitable tradeable sector. Indeed, the lack of credibility of current government policy is partly due to the ferocity of the deflationary forces now operating. Financing a deficit soaring out of control as tax revenues shrink and social security spending rises is becoming ever more problematic without the tax increases, expenditure cuts or interest rate increases that can only intensify the depression.

Credibility demands that the realignment be large enough to make negligible the risk of a further, early devaluation of the pound. Together with the extent of sterling's overvaluation revealed by the graph, and factoring in the beneficial effects of North Sea oil, this suggests that sterling needs to fall to DM2.4 to DM2.5, the largest bilateral realignment in ERM experience. Depending on how other ERM currencies move, this would lower sterling's trade- weighted index by 8-12 per cent from today's level.

The credibility of the new exchange rate must be enhanced in several ways. We need to move to the narrow band in the ERM (a 2.25 per cent range on either side of the central rate). It is essential that the Government convinces the markets that it will not fritter away this gain in competitiveness in inflation. The recovery of the UK economy must be led by the supply side and not, as in the past, by consumer demand.

One step would be to lower VAT to 15 per cent but to recoup the revenue from higher income tax: this would eliminate almost all the effect on the retail price index from the fall in sterling. Another would be to give the Bank of England much greater independence and an explicit inflation-fighting brief.

A range of supply-side measures should be undertaken. Further moves towards a level playing field in the housing market are needed: the Government should make clear its commitment to regenerate the private rental sector by giving landlords depreciation allowances and allowing capital gains tax allowances to be cumulated. At the same time it must resist calls for extended subsidies to owner-occupiers and should cut the right-to-buy discount offered to council tenants.

The Government's commitment to resisting another speculative property boom would be strengthened by setting up a Royal Commission to recommend reforms of the land-use planning system.

The Office of Fair Trading should launch an immediate investigation into property contracts in the UK. With their upward-only rent reviews and the obligation of tenants for the rent payments of their successors, these contracts contributed to the ratcheting up of inflation in the 1980s.

An important signal in the Government's attitude to improving training and education would be to extend specific tax incentives to firms and individuals, paid for by an increase in general tax rates.

Thus it is nonsense to say that there are no alternatives to the old policy. The Government can take the credit for some important supply-side improvements in the economy, not least in labour markets. It cannot possibly believe that there is a danger of returning to the worst periods of the 1970s when higher wage demands fed into a depreciating pound, which in turn fed into wage demands.

In those days unemployment was low, union power at its peak and real interest rates negative. Inflation expectations were rampant after the oil and raw material price shocks and the house price boom of the early 1970s. Conditions now could scarcely be more different.

The blunders of the 1980s will also not be repeated in the foreseeable future: consumer debt is at record levels and borrowers, lenders and the Government have learnt salutary lessons.

A sterling devaluation is also clearly desired by the Bundesbank, which has been holding out the carrot of further interest rate cuts for which the rest of Europe is desperate.

John Muellbauer is a Fellow in Economics at Nuffield College, Oxford.

(Photograph omitted)