The UK Foreign Exchange Market

Too often in the study of economics, what is learnt in the classroom bears little resemblance to reality. Thus when learning about what determines a country’s foreign exchange market, one talks  about the demand and supply of currency and how these can be affected by confidence in the currency.This week’s movements in the foreign exchange market provide an example of this.  Following the EU negotiations and the announcements by Michael Gove and Boris Johnson that they were in favour of Brexit, thereby increasing its likelihood and the probability of increased uncertainty over the next few months, there was a significant fall in the value of sterling (from £1 = $1.44 to $1.41 once the markets opened over the weekend and a further fall this week to £1 = $1.38, the lowest rate against the dollar in 7 years.

The implications of the fall in the exchange rate for the economy are significant. Exporters will gain, particularly if they import relatively few components and raw materials. However consumers, particularly if planning a foreign holiday will lose out, as will retailers who sell imports and travel companies dealing in the overseas market.

Possibly most worrying should be the impact of the increased uncertainty and fall in the value of the pound on the financial account of the UK’s balance of payments (the section dealing with such things as lending, borrowing and the sale and purchase of financial assets). We have been able to run a current account deficit because foreigners have been happy to buy UK property, government bonds, shares, etc. If these flows start to diminish and the fall in the exchange rate is not enough to significantly reduce imports and increase exports, the impact on the exchange rate could be very interesting indeed.

The £:$ xchange rate over the last week



Unfamiliar ways forward | The Economist

Policymakers in rich economies need to consider some radical approaches to tackling the next downturn

Source: Unfamiliar ways forward | The Economist

With the global economic outlook gloomy, interest rates at record lows and high levels of public debt, policymakers will have to be creative should they decide the economy needs a ‘kick’.

What is going on with the UK Economy?

Once upon a time, macro-economics was relatively simple. Unemployment went down and wage rises and inflation went up, summarised neatly by the Phillips Curve, the inverse relationship between inflation and unemployment. This was subsequently modified to allow for a “natural” rate of unemployment – a rate at which inflation is stable – and which similar to the concept of the vertical long run aggregate supply curve introduced by neo-classical economists.

However recently life has become more complex. Imagine an economist who has just been rescued after being marooned on a desert island for two years. Like all good economists their first reaction is not to seek a good meal or even a drink but to head straight to a newspaper or the Office of National Statistics website to see what has happened to the economy. They would be confused.

If they looked at The Times then, in one edition, (Friday 19th Feb) they would find a report from the OECD cutting its growth forecast and urging governments to spend more which conflicts with George Osborne’s plan to cut the budget deficit. They have reduced the UK’s forecast growth by 0.3% to 2.1% and the USA forecast by 0.5% to 2.0%, but both economies are predicted to do better than other advanced economies. However an alternative forecast from last month suggests that UK economic growth will accelerate this year up to 2.6% while the Bank of England’s most recent forecast talked of a cut to 2.2%. Incidentally our shipwrecked economist would have missed the election and would possibly be surprised to find Mr Cameron in No 10 and Mr Osborne next door in No 11.

In the same paper there was also a report quoting a senior Bank of England official who was expecting interest rates to rise sooner than the City predicts and another highlighting the UK’s low level of productivity, indicating that the UK’s productivity has fallen further behind other leading Western economies that at any time in the last 25 years. While our recently-rescued economist might not be surprised by Germany (output per hour 36% higher than the UK) he or she would be amazed by France, Italy and even (31%, 10% and 5% respectively) higher than the UK). The low productivity was most pronounced in manufacturing (25% less productive than Germany and 45% less productive than the USA). A recent report from KPMG identified investment in education and the transport infrastructure as being crucial to remedy the situation. However all is not totally gloomy since the newspaper also contained an article highlighting the record growth in fast-growing businesses (companies with more than 10 staff ) growing at over 20% a year.

Unemployment has fallen consistently and, at 5.1%, the lowest for a decade, is only just above the 5% estimate of the natural rate; it is predicted to drop to 4.7% by 2018, the lowest level since 1975. Job vacancies are at a record high and the percentage of people in work rose to 74.1%, the highest level for 45 years (since records began). However wage growth remains low with the annual rate of pay growth slowing from 2.1% to 1.9%.  This could be because low inflation allows employers to offer lower pay rises, or because of an increased pool of labour from rising numbers of older workers, part-time workers, migrants and young people entering the labour market.

However inflation has remained persistently low, only rising from 0.2% in December to 0.3% in January but still way below the Bank of England’s 2% target which they do not expect to reach until early in 2018. Core inflation, which strips out volatile items such as food and energy fell last month from 1.4% to 1.2%. Furthermore pay increases continue to stagnate. The issue for economic policymakers is to try to predict when (or if) wage rates are likely to increase and, if so, when interest rates will need to be increased. Such an increase, when it comes, will need to be contrasted with the possible need for a stimulus if the  likely fall in UK economic growth occurs.

(Note how the inflation data provides an ideal example of how one can be mislead by headlines – how different does a rise from 0.2% to 0.3% sound from a 50% increase in the rate of inflation in one month!).



The Balance of Payments

The UK deficit in goods reached a record last year at £125bn. Therefore, despite a services surplus of £90bn, the overall trade deficit was £35bn. This has been partly explained by the slow-down in China, since they are now buying fewer of our exports but more significantly, these record deficit figures reflect the competitiveness of the UK economy. Possibly, if one feels optimistic, one could argue that the recent fall in the value of sterling will make us more competitive and our exports will increase. However evidence about the price elasticity of demand for exports is not promising. Our invisible surplus has declined in recent years, largely because of the falling contribution from net overseas income (interest, profit and dividends which have fallen as interest rates have dropped and  earnings from dividends and profits have been hit by the recession).

We have had a current account deficit for over thirty years so does it matter? If a country has a deficit, it must either  use its reserves, sell assets or borrow  to pay for the deficit. Fortunately foreign banks and individuals are happy to purchase UK assets, buying shares and government securities, and investing directly in the UK. However what might happen if the UK economic position deteriorates, the currency weakens (possibly because of fears of a possible exit from the EU) and banks start to sell sterling?

Nigeria: Why Nigeria Must Invest Heavily in the Forest Sector – Stakeholders –

Stakeholders in the forest sector, have urged governments at all levels to invest heavily in the sector because of its huge potential in addressing the nation’s emerging environmental, social and economic challenges.

Source: Nigeria: Why Nigeria Must Invest Heavily in the Forest Sector – Stakeholders –

Deforestation, climate change, and soil erosion reducing the productive capacity and potential output of Nigeria.

Thanks to Harry M.

The market for legal advice in the UK – competitive market or cozy cartel?

A report in today’s Independent newspaper suggests that the cost of legal advice from one of small number of well known firms in the UK, collectively known as the “Magic Circle”, has risen by around 100% in real terms since 2003.  The market structure for this industry seems to display all the hallmarks of an oligopoly, and one which might tend towards some form of collusion; demand is inelastic, there are a small number of interdependent firms and customers have difficulty collecting good information about substitutes.

In addition, beyond these largest firms a form of price leadership structure may be in operation.  As these large firms ratchet up their charges smaller firms outside the Magic Circle take the opportunity to increase their fees in a clear example of what is commonly referred to as Stackelberg equilibrium.  The economic rents enjoyed by these firms in the form of supernormal profits may be quite considerable.

The question is, as economists should we care, and if so, what can be done?  The availability of good legal advice at a reasonable price may well have positive externalities as it protects the functioning of a market economy and also allows smaller firms to compete in all markets with larger ones as they do not face the barrier to entry in any market of very high legal costs associated with operating in the market.  In short, high legal costs may make a host of markets much less contestable.

This suggests some government action is necessary.  Everyone with a knowledge of economics should be able to recommend lots of policies to make any given market more competitive, and the market for legal advice is no exception.  A reduction of barriers to entry, a requirement for transparency in pricing, an investigation into possible anti-competitive practices and the use of large fines for those found guilty might all be relevant.  However, as we have seen in the energy market action by consumers may also be needed.  A willingness by customers to shift their business to cheaper firms and an attempt to make firms move to a fixed price model by supporting those firms which do will certainly give the Magic Circle something to think about.

Ultimately, a combination of government action and consumer action will be needed but nobody should be under any illusion; the legal profession generally and the “Magic Circle” will fight against it tooth and nail.  Economic history suggests that those enjoying economic rent seldon give it up easily.