The UK's high exchange rate has a lot to answer for

No-one can deny that liberal democracy is under serious threat from populist nationalism. The moderate left, in particular, is in the firing line. What is the single most important reason this is happening? It is that western politicians, commentators, the academic establishment and public opinion have—as a result of a combination of thoughtlessness and carelessness—pursued policies which have allowed the east comprehensively to out-compete the west where it really matters, which is in building up industrial strength.

It started in the 1970s when the Keynesian consensus broke down. The discipline provided by Bretton Woods then disappeared and there was a huge credit-driven boom—exacerbated by the Arab-Israeli Yom Kippur War and the OPEC oil price hike—all of which drove western opinion into the arms of monetarism. As the battle against inflation took centre-stage, interest rates peaked at 15 per cent in the UK—and 20 per cent in the USA—and western currencies massively revalued. The UK’s trade weighted real effective exchange rate rose by about 60 per cent between 1977 and 1981.

Meanwhile in the east the opposite was happening. China, in particular, joined the world trading system around 1980. A combination of improved efficiency, as market forces were introduced, and massive nominal devaluation, brought the real Chinese real exchange rate down by about 75 per cent by the early 1990s. As a result, China became extraordinarily competitive. It suddenly became cheaper to manufacture almost anything in the east than the west. British industry reeled under the strain. While in 1970 32 per cent of our GDP came from manufacturing, by 1990 only 20 per cent was left.

But worse was to come. Capital liberalisation, led by the Labour government abolishing the Monopolies and Mergers Commission in 1999, left the UK wide open for take-overs. Over the next decade we sold everything—our rail franchises, power companies, ports, airports, manufacturing companies and much else—to foreign interests. Between 2000 and 2010 net sales of UK portfolio assets, excluding direct investment in new assets such as machinery and buildings, came to £615bn. As a result, the exchange rate went up another 40 per cent to the dizzy $2.00-to-the-pound heights of the 2000s. By the early 2010s, UK manufacturing was down to barely 10 per cent of GDP.

Does deindustrialisation on this scale matter? Crucially, it does—and for three main reasons.

The first is that increases in productivity are much easier to achieve in manufacturing than in services. Ever since the start of the Industrial Revolution, rises in living standards have been largely driven only by a narrow range of investments—in mechanisation, technology and more efficient use of energy. This is why all modern diversified fast-growing economies have large manufacturing sectors. By running nearly all our non-high-tech manufacturing out of business we have foregone the increases in output per hour which it is uniquely capable of achieving. This is a major reason why UK productivity is almost static, real wages for most people are no higher than they were ten years ago and why growth in GDP, especially per head, has been so feeble.

Second, even though about 80 per cent of our economy is now services, most of our foreign earnings are goods and about 75 per cent of them are still manufactures. The problem nowadays is that we simply do not have enough to sell to the rest of the world to pay for our imports. This is why we have a huge balance of payments deficit, now running at almost 6 per cent of our national income. As a result, as a country, as consumers and through our government—since government borrowing mirrors the balance of payments deficit—we are accumulating debt much faster than our capacity to service or to repay it.

But third, and from a political point of view, the most serious effect of our grossly over-valued exchange rate has been that liberalisation and globalisation have had a hugely unequal impact on different people. For the well-heeled, service-sector orientated metropolitan elite it has been a dream come true, producing a plethora of well-paid, interesting and secure jobs and a life-style which anyone would envy. For those outside this charmed circle, however, the picture is very different.

There, far too many of the good jobs in manufacturing, providing stability and a purpose in life, have disappeared to the far east, to be replaced with much lower productivity, less satisfying, lower paid and more insecure service sector jobs. Manufacturing employment has fallen from about a quarter of the total in 1970 to 8 per cent nowadays—producing 10 per cent of UK total output, nevertheless, showing that manufacturing is still some 25 per cent more productive than the rest of the economy. With too few jobs like this, however, the median real wage is still well below what it was a decade ago. Illustrating just how divided the UK has become, in 2015 average gross value added per worker per year was £43,629 in London and £18,927 in the north east.

Nor is it just individuals who are suffering. Now that their manufacturing bases have disappeared, whole towns and cities in our erstwhile industrial areas have too little to sell to the rest of the world, leaving them dependent on government grants and subsidies. Inevitably, in these circumstances, services are being cut and social facilities are increasingly overstretched. Communal deprivation is thus added to static incomes and dwindling prospects. No wonder there is so much discontent, generating a tide of support for populist parties promising something fairer and better.

If those who aspire to liberal democratic ideals want to arrest the erosion of support for their values, therefore, a very urgent priority is to look much harder at what the almost total absence of an exchange rate policy in recent decades has done both for the UK and indeed for most of the western world. If we can’t rebalance our economy so that globalisation benefits everyone, instead of just the rich elite, liberal democracy may well be the next casualty.