UK politics used to be dominated by the balance of payments figures. Governments would urge us to buy British, and to export to keep our jobs and maintain our living standards. Oppositions would pore over the small print of the monthly balance of payments figures, highlighting every weakness and warning of dire economic events to come if the figures were lacking in some respect.
In recent years under Labour and under the coalition the country has run large balance of payments current account deficits, importing more than it exports, with no apparent damage being done. So what has changed? Is this sustainable?
The main thing that has changed is the UK is now firmly wedded to having its own currency with a freely floating exchange rate. If we had surrendered the pound for the Euro we would have to put ourselves through tough austerity programmes to cut personal incomes, to curb our appetite for imports. That is exactly what happened in Greece and Spain, where they had substantial wage cuts in cash terms as one of the main weapons to correct their balance of payments deficit.
If we had kept to a managed exchange rate as we had in the 1960s and again under the Exchange Rate Mechanism then we would have to increase interest rates in an effort to hold up the value of the pound. This too would have enforced a kind of austerity on the country, hitting borrowers who are in the majority including the government. As rates rise so people with borrowings can afford fewer imports, and foreigners find it more attractive to deposit money and invest in the UK. Usually defending the pound proved to be both damaging and ultimately self defeating, as Labour discovered with their devaluation of the pound from $4 to $2.80 in 1949, and from $2.80 to $2.40 in 1967. In 1976 the pound fell to $1.63 under Labour as part of the IMF crisis. The devaluations then did cut UK living standards, making imports dearer and exports cheaper, to correct the balance of payments. It fell to $1.03 at its worst point under the Conservatives, but rallied strongly as more internal discipline was asserted over budgets.
So how does it work when you have a floating rate? In part it works by covert devaluation, making exports cheaper and imports dearer, as part of the adjustment. However, as we have seen, the pound has not fallen enough to correct the current account. It turns out the UK has been able to finance a current account deficit quite easily so far.
This happens by several means. Foreign buyers emerge who want to buy UK existing assets from UK people, government and companies who wish to spend more than they earn. Foreign investors also want to buy new assets which we produce to sell to them. I have commented before on the UK model of building lots of expensive flats in London to sell to foreign buyers, which has become one of our leading export industries rather like Germany selling such people top end cars. Our exports show up here in the investment flows, not the current account. Individuals and the UK government can also borrow from abroad to sustain higher consumption and investment. Some foreigners just want to deposit money in the UK banking system which helps finance us.
The present level of the current account deficit will doubtless generate both changes in the exchange rate and further substantial inflows of money from overseas. When considering changes to the exchange rate they are not necessarily all one way, as the relative valuations of paper currencies depends on considering the policies of both governments involved. The Japanese authorities and some in the Euro area wish to lower their exchange rate as a matter of policy.