Something rather strange happened in Britain around the time of the financial crisis. The sterling tanked, import prices rose substantially and yet the inflation rate didn’t respond as much as we might assume.
Other weird stuff happened too. For example, export prices rose rather than fell and the trade deficit worsened. Although these two aspects seem to totally contradict macroeconomic theory I’m not as concerned about them. In our newly globalised world exports, outside of small open economies, don’t increase as much as economists might assume. I’ve known this since I started examining the data — and Nicholas Kaldor was well aware of this by the late-1970s and early-1980s too. The fact is that in modern developed economies price elasticities don’t matter nearly so much as they did in the past. I have some ideas as to why this is but I won’t get into it here.
I have never, however, come across an instance where a substantial depreciation of the currency has not resulted in substantial price increases in an import-dependent economy like Britain. Indeed, the Office of National Statistics thought that these trends were pretty weird too and so they published an excellent report entitled Explanation beyond exchange rates: trends in UK trade since 2007 which I will draw on for many of the graphs in what follows.
Okay, first of all let’s take a look at the exchange rate versus the trade balance. The period that we are interested in is between 2007 and 2008.
As we can see, there was a massive depreciation around 2007-2008 and the trade deficit stayed open. At the same time import prices went up by a fairly large amount as can be seen in the graph below. Export prices rose too, as we can see — which, of course, is not in line with economic theory.
Now, here’s where the mystery that concerns me comes in: while inflation rose in this period it did not rise as much as I would have expected. CPI inflation did more than double — which is by no means insignificant — but I would have expected it to rise maybe four or fivefold.
So, what is the explanation for all this? Well, I think it runs something like this.
First of all, companies that import goods to use in order produce goods that they export passed on the cost to foreign buyers. As we saw above and in contrast with macroeconomic theory, export prices rose after the depreciation by more than import prices. I think that we are seeing the pass-through effect in the data quite clearly.
Secondly, and most important from my point of view: companies selling on the domestic market used the sharp fall in wages in this period to absorb the higher costs so that they didn’t have to raise prices and could thus maintain market share. Take a look at the following graph plotting earnings against inflation in this period.
At the same time as firms saw their import prices increase they saw their wage bills fall dramatically. So, they didn’t have to increase prices too much because they just passed through the savings they were making on wage costs. Ultimately workers saw their standards of living fall dramatically but rather than see this manifest as maybe 8-10% price inflation, they saw instead 4-5% inflation and negative real wage growth which went from an average of about +2% to -2% — a decline of about 4%. The net effect on living standards was probably about the same, it just shows up in different data aggregates.
What is the key lesson from this? Well, it seems that the UK didn’t experience substantial price inflation in 2007-2008 after the depreciation of the sterling because of the unemployment and rock-bottom wage growth that occurred at the same time. The effects on actual living standards were probably largely the same as if there had been substantial inflation but you have to look for it in different data.
If a substantial depreciation of the sterling ever took place in a period when there was tight labour markets and healthy wage growth we would likely see a large uptick in inflation. We would also see feedback effects in that the trade deficit would rise as price rises were passed through to foreign buyers which would then put further pressure on the currency. The whole thing could get very ugly very quickly. And that’s not even to raise the specter of a wage-price spiral in a time of low unemployment.
This brings us to our final question: why was there a large depreciation of the sterling in this period? Well, because the value of the sterling is tied up with the price and turnover of financial assets in the City of London. The UK is not in a position like the US which has the world’s reserve currency and so when asset prices took at massive hit in 2007-2008 the sterling did too. This shows just how sensitive the sterling is to any chaos that might occur in the financial markets. It also shows just how sensitive the currency would be if a government ever moved to shut down the City.
The UK economy after Thatcher is hooked on finance. And it would take quite a bit of policy ingenuity to ween it off its drug of choice.
Fixing the Economists 
Yes, perhaps | am a pedant but would it not be use the word “depreciation” rather than “devaluation” to describe sterling’s fall in 2007/8?
Good point. Fixed.
“We would also see feedback effects in that the trade deficit would rise as price rises were passed through to foreign buyers which would then put further pressure on the currency.”
If there are price rises on UK exports then by definition somebody has to buy more Sterling to pay those prices. That removes Sterling quantity from the foreign exchange market.
Given that there is a margin on pass through and it is a percentage, then you will take more Sterling out of the foreign exchange market than is being injected by the import purchase price increases.
Floating currencies don’t move by magic. You have to show the supply and demand criteria that cause the move and who is taking the other side of the trade to allow the transaction to exist in the first place.
“The UK is not in a position like the US which has the world’s reserve currency and so when asset prices took at massive hit in 2007-2008 the sterling did too”
Did it, or did it just return to the value that it had in the mid 1990s once it had existing the ERM. In other words is the period 1997 to 2008 just a deregulated asset boom and now the UK is where it should be.
Because the next question that should be asked is why only 20% and why back to the same index value as the mid 1990s? We didn’t have failed banks in the mid 1990s.
(1) People will pay the price but quantities sold will fall. There was a fall in exports — quite a substantial one — after the depreciation.
(2) Yes, it was due to a run-up in asset prices but my point is that the value of the sterling is completely dependent on the City. The 2007-2008 depreciation showed that clearly.
There was a fall in imports as well – the net shifted from 2.8% of GDP to 0.7% of GDP.
“The 2007-2008 depreciation showed that clearly.”
Not sure it did. Again the question is why did it stop at exactly that point.
I think there is more to it.
But it is a fascinating dynamic that’s for sure. We should do this in the pub!
The fall in imports was due to an income contraction. We saw this in every country that experienced a major recession no matter what happened to their exchange rate.
Why did it stop at that point? Because the central bank stepped in and stabilised the financial markets and business went back to normal.
I wouldn’t say it was dependent on the City. More that capital flows dominate the currency markets across the world.
The most plausible explanation, for me, is a carry trade unwind – which fits with banks calling in loans as they collapse across the world, and it fits with the leap up in 1997 from the base established after the UK exited a fixed exchange rate period.
To me that fits with the way that floating rate currencies work, and how the supply and demand trades in the currency market have to work – calling in loans supporting a carry causes a destruction of the source currency, but not the target currency. That shifts the supply and demand forces.
Far too much currency discussion takes place without considering the dynamics of a currency market – primarily who is taking the other side of the trade and why.
Nice post, Phil.
I’d agree with the analysis of the role of wages. The exchange rate movement was a significant contributory factor to a significant decline in real wage growth in the UK over this period. It’s doubtful this could have occurred without the dire employment situation. Had real wages maintained their earlier growth rate, the depreciation would have likely had a much more marked impact on output prices.
I did some of my own stuff last year (http://monetaryreflections.blogspot.co.uk/2013/07/uk-trade-elasticities.html) on the depreciation impact on trade volume and prices. The second graph there estimates the impact of the depreciation stripping out the effects of the fall in GDP and world trade volume.
Also, a good discussion on possible reasons for the depreciation is here: http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb090303.pdf
Fantastic Nick! Always great to have your analysis confirmed by someone you know can do proper analysis. It makes sure that you didn’t miss anything.
I did the above research for a Guardian article I did related to this whole mess. It goes up on Comment is Free tomorrow morning. Keep an eye out. I’m trying to make policymakers aware of these dynamics. I might be able to use connections to get it through to the Labour Party but we’ll see.
Do you live in London by the way?
I live near London.
We should meet up for a coffee or a drink or something. I’ve been telling the Rethinking Economics crowd about you. They’re interested in who is doing unorthodox blogs in the UK. And maybe we can get a conference going on or something…
Maybe send me a mail through the contact form on my blog.
By the way, it was from doing tests of the Marshall-Lerner conditions in my econometrics class that I found the standard story of trade imbalances and currency fluctuations to be complete nonsense. But then I realised that Kaldor had noted this in the late-1970s and that Thirlwall was making the case strongly today.
“It’s doubtful this could have occurred without the dire employment situation. ”
It’s doubtful there would be a situation where the two don’t occur at the same time. Firstly they are not independent events – but all artefacts of the same issue – a Minsky Moment. And secondly there will always be a dire employment situation after this sort of event – because lots of businesses start to go bust. And importantly should be allowed to do so so that the distributional structure realigns to the new reality.
Reading that Bank of England publication feels like it always does when discussion turns to currency rates. Desperately flailing around in the dark trying to fit the curves to the theories without much consideration of the transactions required in the currency markets and who would be taking the other side.
Of all of them the carry trade unwind seems the most plausible, which fits with the leap up in 1997. At least that does involve some borrowing and demand and supply in the currency markets – and the calling of all that in because the banks were in trouble across the globe.
I think you’re mostly right. It would be weird if a big crash was outside of a Minsky collapse — and hence the unemployment/low wages thing. Nevertheless, that’s what happened in the 70s. We must be prepared…
I hope your cat’s feeling less confused now.
Ever so slightly. There is a dissertation that could get publication in a major journals on this case study. Students take note!
This area and why the UK unemployment figures didn’t go up, but productivity went down will keep students in PhD’s for years to come.
But I’ll wager that the tired old neo-classical explanations, wedded as they are to fixed exchange models, will still survive regardless of the evidence against them.
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