Let me start with one of the plainest economics
truisms in the whole subject of trade; if a country makes things more expensive
to produce domestically, it becomes less competitive, increases trade deficits
with other countries, and confers an advantage on countries that produce those
equivalent things less expensively.
Consequently, it shouldn’t be hard to get the
Brexiters/Remainers debaters to concur that, as UK costs are in pounds and,
say, French costs are in Euros, what determines the exchange rate between them
is, among other things, the cost of producing things. We can put aside here
that while inflation reduces the value of the pound, it doesn’t always
translate to reduced demand for UK goods if the exchange rate adjusts
appropriately (remember that in the cases when inflation leads to a
depreciation of the pound, whereby it can initially boost foreign demand for UK
goods due to their relative cheapness, the very same inflation will also raise
production costs domestically, which will have a cancelling effect of the
competitiveness gains from currency depreciation). But the upshot here is, it is
always the case that economic policy errors that increase the cost of producing
things for your own domestic citizens are counter-productive and inimical to
healthy trade.
For ease, let’s forget about all the other trades
that UK and France make with other nations, and make the point with a simple
trade flow between these two nations (and for further ease, we can put aside
the fact that because multiple countries use the Euro as their currency, this
complicates the relationship between production costs and exchange rates, and
just focus on a simple case, which could be applied to any 2 currencies).
In this model, the only reason Brits want to buy
Euros with pounds is to buy French goods, and the only reason France want to sell
Euros for pounds is to buy British goods. If Brits try to buy more Euros than
the French want to sell, the price of Euros in pounds goes up. If the French
want to sell more Euros than Brits want to buy, the price goes down, as it does
in other markets. The price of Euros in pounds, the exchange rate, ends up at
the price at which supply equals demand, which means that Brits are importing
the same pound (and Euro) value of goods that they are exporting.
Suppose the UK government mistakenly decides to
impose a tariff on French imports. French goods are now more expensive to
Brits, which is obviously bad for Brits. Since they want to buy less from
France, they don’t need as many Euros, so the demand for the Euro goes down, and the price of Euros in pounds goes down, which reduces the cost of French goods
to Brits (remember this is just a consideration of UK and France – for this
exercise, forget that other European nations use the Euro)*.
Suppose the UK becomes less good at making things
due to bad political policies (a scenario that, sadly, doesn’t need much
imagining). Pound prices of UK goods in the UK go up, which makes UK goods more
expensive to French purchasers, so they buy fewer of them, decreasing the
demand for pounds on the pound/Euro market. This shifts the exchange rate,
where pounds are now less valuable, so their price falls. This doesn’t mean we
are less competitive in the short term, but it does erode domestic purchasing
power, which is particularly problematic in an import-dependent economy like
the UK.
One of the main follies of getting trade wrong, especially uttered by bombastic politicians who want to give the impression of ‘putting our country first’ is that language is distorted, so terms like competition are often confused with combative ‘zero sum’ language, inaccurately framing trade as a “them vs. us” scenario. When that happens, political attempts to apply tariffs or regulations to confer domestic advantage are confused due to bad analogical thinking, which usually ends up reducing domestic productivity and thinly spreading costs of bad policies onto domestic citizens.
And finally, of course, the sure fire way to
devalue the pound even more is to inflate the currency, which has happened off
the scale in recent years in the UK. What that does is lower the value of the
pound in international trade, but it does not make our goods more attractive to
foreigners — they get more pounds for their currency, but need more of their
currency to buy our goods, since prices have gone up – which is a bad thing for
just about everyone.
*It’s true that exchange rates are influenced by
more than just trade flows and production costs (especially capital flows and
interest rate differentials) and inflation’s effects on exchange rates and
competitiveness are complex, but that doesn’t undermine the argument above, and
is beyond the scope of this article.
