On June 24th, the day after the people of Britain took the momentous decision to leave the EU, the value of sterling plummeted. As international investors lost confidence in the long-term prospects of the UK economy, they sold their pounds and shifted their capital to greener pastures. With demand for sterling greatly diminished, the exchange rate fell. Six months on, the pound in your pocket buys around 15% less from abroad than it did on June 23rd.
For an economy as open as Britain’s, this presents an immediate problem. A weaker pound pushes up the price of imports, generating higher inflation. The Bank of England predicts that inflation will reach 2.7% in 2017, while other forecasters, such as the National Institute for Economic and Social Research, a think-tank, expect inflation to nearly quadruple from its current level to 4%. Not only does this eat away at the purchasing power of British households, but it also presents a dilemma for the Bank of England: if inflation levels rise too high, it will feel pressured to raise interest rates in order to cool down the economy, but this would exacerbate the Brexit-induced slump in investment, further adding to the economies woes and potentially tipping the economy into recession.
Not to fear, cries the Brexiteer. A weaker pound also makes British exports cheaper, and thus more competitive. Indeed, some of those in favour of leaving the EU made the argument that a Brexit-induced depreciation of sterling would be a neat way to reduce Britain’s yawning current account deficit, which stood at nearly 6% in mid-2016. The argument does contain a certain amount of logic: the method of boosting exports via a currency depreciation is one lifted straight out of an undergraduate economics textbook.
However, we don’t live in the simplified world of economics textbooks. The argument that a weaker pound will boost exports is erroneous for two reasons. Firstly, the price elasticity of UK exports is rather low, that is to say foreign demand for British goods is not very responsive to changes in price. The UK competes on non-price factors, such as quality, so any fall in the price of exports is unlikely to produce a massive boost in demand for British-made goods. Foreigners don’t buy Saville Row suits or an Aston Martins because they’re cheap.
Secondly, thanks to structural reforms enacted since the mid-1990s, British exporters are deeply integrated into global supply chains, meaning that much of the value of UK exports actually comes from imports. For example, a car manufactured in Britain will house all manner of foreign-made gadgets in its dashboard. Recent data from the OECD shows that the import content of British exports is around 23%, compared with 15% in America and Japan. Therefore, the average fall in export prices will only be around three-quarters of the size of the drop in the value of the pound, blunting any competitive advantage conferred on British firms by a weaker currency.
These gloomy predictions are supported by recent history as well. During the financial crisis, the value of sterling took an even greater tumble, falling in value by more than 25% between the third quarter of 2007 and the first quarter of 2009. Yet net exports hardly budged.
After such an eventful 2016, the people of Britain will head into the new year full of uncertainty. Yet, with forecasters no longer predicting a recession, perhaps there’s reason to be optimistic about the UK’s immediate economic prospects. But whatever new developments 2017 may bring, an export boom is unlikely to be one of them.