January 23, 2009

A Pound of Manufacturing Base, Please

Dean Baker writes about the strength of the pound as the cause of a weak manufacturing base in Britain:
The British Pound, like the U.S. dollar, had been seriously over-valued in recent years. That is why it had been running a large trade deficit.


In most contexts reporters are able to understand the relationship between higher prices and demand, but for some reason in the context of trade, they discuss the topic as though there is no relationship. Hence in an article on the falling British pound, the NYT tells readers that Britain's prosperity over the last decade "camouflaged a steadily weakening manufacturing base."

Of course, the prosperity did not just "camouflage" a weakening manufacturing base, to a large extent, the prosperity was directly related to the weakening manufacturing base (except for the laid-off manufacturing workers).

The over-valued pound allowed the British to buy imported goods at lower prices than their own industry could produce them. However, this led to a large current account deficit which could not be sustained indefinitely.
I both agree and disagree with this view. It is stupid of NYT to speak of Britain's “prosperity”.

In the case of “prosperity” (= access to liquidity) being directly related to a weakening manufacturing base, I would go even further. In a limited sense, the temporary “prosperity” is both directly and indirectly caused by diminishing assets, including the manufacturing base.

Liquidation of capital, like industrial machinery, is an easy and short-sighted way of getting hold of currency to spend on imported consumer goods. It's a simple case of eating your seed crop. You can get fat for a short while on such consumption. Until you run out.

This temporary “prosperity” is just a loan from the future. Most of these inter-temporal fund transfers are actual loans, but a liquidation of productive capital for the purposes of consumption is a loan from the future in an equally real sense. One might also ultimately need to liquidate assets to pay off a loan in the end, with identical results.

That's the way trade deficits go and ever will. You get more than you give at one time. Later you have to reciprocate. And you just might have some regrets when the time comes. (Just ask Icelanders.)

No current account deficit can ever be sustainable (in the sense of having less than infinite zero crossings in infinite time). Unfortunately there is no upper bound on the time span and the magnitude of a single era of imbalance. For the purposes of fairness, we should strive to keep them at less than a generation. (OK, I'm guessing. I don't have the mathematical proof for these claims.)

In what comes to the expensive pound as a cause for manufacturing weakness, I seriously object. I do agree that the pound has been too expensive, and that it does encourage eating into capital.

But how could the value of the pound be the ultimate cause of anything? Prices are like weightless particles, always at the mercy of external pressures. One has to search for the real cause from the factors that affect supply and demand, of which the price is merely a shadow.

When a price is “wrong” it is most certainly caused by a lack of information.

Overly high flexibility of credit is the key here. Loss of income and wealth due to eating into assets is too easily “camouflaged” by excess credit. Inefficiencies in the foreign exchange, like the pound being too expensive, are merely a symptom of such blindness.

Without credit, all overconsumption would be immediately reflected as a loss of assets. Credit has a way of complicating the process, but the fundamental effect is still there. More consumptions results in less assets later on. This can not be escaped.

These price distortions, which do exist, have an unfortunate reinforcing effect on the original cause by further encouraging people to eat into their assets. A high price encourages activity that decreases the underlying value, like over-construction. With credit as a disguise, this decrease in real value is not necessarily recognized by the market participants. The relative price is thus further increased. This is especially true in a mental environment where the “market is always right,” which encourages price-inelasticity.

In a sense it is even rational, to a degree, to eat into assets when the price is good. But the human mind is too biased for the near term and against the long term to ever make these kinds of trade-offs rationally. People do get greedy and they definitely do get regrets. (I know from personal experience.) Humans are not adapted to easy credit. It's an unnatural state of affairs.

“The over-valued pound allowed...” sounds quite too much like the pound has a will of its own. It is much more honest to just say that somebody overpaid. The British sold (or pledged) too much of what they had (or will earn) and used the proceeds for consumption. Now they have little left. The buyers (of the pound and ultimately British assets) probably overpaid because of a false sense of value generated by a seemingly insatiable demand from the very same Brits who are now impoverished.

Now everybody has regrets: The British, for having to pay for their past consumption from diminished income, and their trading partners, for receiving less from the British than they expected in return for the consumer goods provided earlier.

I think I have written this before but its worth repeating: Oversized credit facilities are to the economy like pulling a heavy trailer with a bungee cord.

In what comes to a reform of the existing credit system, a downturn is not the time to start making radical restrictions. These things have to be taken carefully, in a regulatory, a monetary and a fiscal sense. It's like fishing. Give it some slack when it's kicking, reel it in when the coming is good.

Unfortunately, in the US, the EMU, the UK and Japan, all three means, the monetary, the regulatory and the fiscal, are pretty much exhausted, due to giving up too much line in easy times. Deregulation has been taken to the limit, monetary policy is at the zero bound, and government deficits are already huge. The spool is approaching empty, and the line is in danger of snapping.

Whatever slack is given now, the most important thing is to start reeling in as soon as the situation improves. People really have to be dragged into austerity kicking and screaming. Otherwise the spool will get empty and the line will snap. (OK, enough bad fishing analogies. Anybody know if Keynes was a sports-fisher?)

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