Tories & the pound
Are the Tories planning on a huge fall in the pound? This is one question raise by Giles Wilkes’ paper, Slash and Grow, in which he argues that it’s unlikely that capital spending and/or net exports will grow sufficiently to keep GDP growing well in the face of government spending cuts.Giles is, in effect, arguing against this recent paper (pdf) by Alberto Alesina and Silvia Ardgna, which shows that there have been several precedents for cuts in public spending proving expansionary.My hunch is that he’s right to do so. In the 1980s and 90s, it was possible for spending cuts to be accompanied by economic growth because: monetary policy could loosen in response; government bond yields could fall, thus crowding in capital spending; and because household debt was on a rising trend because, in many cases, consumer debt markets had only just been liberalized. However, Giles rightly says these offsets are not so readily available to a future government. Index-linked yields are already zero for shorter-term maturities, so there’s no chance for orthodox crowding in. Monetary policy is already loose, and even optimists can’t see much chance of significant increases in consumer borrowing.There is, though, one other mechanism through which government spending cuts might be expansionary - if they cause a collapse in sterling.Imagine it's 2010-11, and Osborne announces big spending cuts. The Bank of England responds by keeping interest rates low. However, the Fed and ECB start to raise rates. The UK could soon end up with almost the lowest rates in the world. Carry traders around the world will then short sterling. The pound will fall, possibly very sharply. This effect would almost certainly swamp any uplift the pound gets from improved confidence about the public finances. Would this boost growth by raising net exports? Only to a limited degree. For one thing, there are long lags between exchange rate moves and export performance. During these lags, FX markets will question whether sterling is helping, and might therefore sell pound even more. Also, many exporters respond to a lower exchange rate by raising prices more than expanding sales.And even if sales do rise, many UK exports have a high import content - think of all the imported raw materials and components - which mitigates the effect on growth. All of this means that the pound would have to fall a very long way indeed to offset any fiscal tightening. Which poses my question. Is this what the Tories are hoping for? And if it isn’t, what is the mechanism through which a fiscal tightening will boost growth, given that the obvious ones can’t be as powerful now as they were years ago?