U.K. Experience Casts Doubt on Viability of Keynesian Remedies
The plight of the United Kingdom’s economy is a useful rejoinder to those who believe the fixed exchange rate is the main driver of the economic problems in the euro zone. The U.K. responded to the financial crisis by running large fiscal deficits, cutting interest rates to zero, and “printing money” through several rounds of quantitative easing. Over this period, the result has been worse macroeconomic performance in the U.K. than in Spain, a country “trapped” in the euro straightjacket. This outcome is fundamentally inconsistent with the Keynesian view that the key to recovery in peripheral Europe is devaluation and monetary-financed deficit spending.
The weakness of the peripheral European economies – Spain, Greece, Italy, Portugal, and Ireland – is often attributed to an “uncompetitive” real exchange rate. The idea is that wages in these countries rose faster than productivity, which means that the cost of an hour of labor is too expensive relative to the value of its output. An extension of this logic train is that if the euro currency didn’t exist, it would be easy for these countries to solve their problems by simply devaluing their currency. Devaluation would allow the price of domestic labor to fall relative to an hour of labor in Germany, which would restore competitiveness by making it relatively less expensive to produce goods in peripheral economies to serve the common European Union market.
The U.K. economy provides an interesting test case for this theory because it is inside the European Union but has retained its own currency. Since the end of 2006, pound sterling has depreciated by about 20% relative to the Euro, with an average devaluation of 25% over this period. This devaluation was generated by monetary policy that sought to reduce domestic interest rates and make the pound a less attractive currency for foreign investors. The depreciation was designed to boost growth by increasing competitiveness and exports.
Chart 1: Pound Devaluation Relative to the Euro
In reality, the currency depreciation accomplished little beyond boosting inflation. Consumer prices have increased at an annualized rate in excess of 3% for every month since the beginning of 2010, with inflation running above 4% for nearly all of 2011.
The increase in the general price level meant that the real depreciation and increase in competitiveness were more modest than intended. Moreover, because of interlinked international supply chains and globalized commodity markets, currency devaluations often result in higher prices for inputs in production processes. The result in many cases is higher prices without any corresponding increase in output.
Depending on the relative composition of economic activity in a country, a currency devaluation that boosts the prices of key inputs could actually make the economy less competitive. Chart 2 (below) compares the U.K. trade deficit with that of Spain (both scaled to 100 in December 2006).
The U.K. trade deficit hit a peak of 115% in February 2008, while the Spanish deficit peaked at 117% one month later. Since that time, the U.K. deficit has bounced around, while the Spanish trade deficit has fallen substantially. Between December 2006 and December 2010, the Spanish trade deficit fell by 44%, while the U.K. deficit was essentially unchanged. As of April 2012, the Spanish trade deficit was just 45% of its December 2006 level (a 55% decline), while the U.K. trade deficit was down by just 15%, cumulatively.
Chart 2: UK and Spain Trade Deficit, 2007-2012
Spain’s outperformance on the external account has helped to dampen the impact of the collapse of the country’s real estate bubble. The precipitous drop in real estate prices not only reduced household spending, but also had an outsized impact on business investment since Spain’s construction sector is 74% larger as a share of the economy than in the U.K. In addition, bad real estate loans have led to the failure of major banks in Spain, like Bankia, and reduced credit availability. Despite these blows to consumer spending, businesses investment, and credit availability, Spain has actually managed to grow modestly since September 2010, while the U.K. economy has contracted by 0.5% cumulatively since that time.
While some may argue that the poor performance of the U.K. in recent periods is due to “austerity,” the actual national income data show that government spending has increased in four of the past five quarters. Over the twelve months ending in March, U.K. government spending increased by 3%, which made the government the fastest growing line item in the GDP accounts. In Q1, government contributed 0.4% to GDP growth, which helped to offset the declines from exports and household spending. The rhetoric on “austerity” does not match the reality, which points to rapid increases in government expenditures.
The U.K. is in a better position than Spain in two major respects: the U.K. has much lower unemployment and much lower borrowing costs. The unemployment differential is largely due to labor market regulations, which mandate that full-time Spanish workers receive very rigid lifetime contracts. By making it extraordinarily expensive to fire workers, Spanish law discourages hiring and has led Spanish businesses to rely on temporary employment contracts to a larger extent than businesses in other countries. The expiration of these contracts during a recession is what generates the job losses that cause the unemployment rate to spike. Spain could reduce the unemployment rate through structural reforms to the labor market that reduce the employment cost differential.
The difference in yields on government debt – the U.K. 10-year yield is 1.72% compared to 6.5% for Spain – is due to the Bank of England (BoE) quantitative easing program, which involves the unsterilized purchase of £325 billion in assets (21% of 2012 GDP). The ability to use the printing press to buy government debt eliminates credit risk and makes U.K. gilts essentially interest-bearing currency. An investor in U.K. government debt knows that the security can be converted into pound sterling at par upon maturity. In the euro zone, individual countries’ borrowings are not backed by a monetary authority, which means these countries generally have to place their debt in the market at prevailing interest rates. Low yields on U.K. debt represent confidence in the BoE’s willingness to print money, not confidence in the U.K economy.
As explained in previous editorials, the euro’s creation was partly motivated by a desire to circumscribe the central bank’s ability to print money and fix prices. Printing money provided governments with an escape valve that allowed them to avoid tough choices to correct labor market inefficiencies and fiscal imbalances.
During the 1970s and 1980s, Italy engineered massive quantitative easing programs and currency devaluations similar to those pursued by the U.K. today. Reformers like current Prime Minister Monti and others believed by transferring monetary policy decisions to a third party, Italian governments would be forced to institute fiscal and labor market reforms. As Italian Prime Minister Monti said to Corriere della Sera, if spending alone could deliver healthy economic growth then Italy, with a stock of debt equal to 120% of GDP, should have enjoyed growth of stratospheric proportions over the last decades.
The euro is quite obviously a deeply flawed regime that will need to evolve to survive. Yet, the fixed rate regime often receives blame that it does not deserve, as evidenced by the economic turnaround of Latvia and Estonia, which are growing rapidly in the absence of devaluation. The U.K. experience demonstrates that the supposed benefits of a floating rate regime are rarely as good as advertised. The resulting flexibility also allows the pursuit of policies that can be counterproductive in the long-run.