The Case for UK Import Substitution

LONDON – The most dramatic economic effect of the United Kingdom’s Brexit vote has been the collapse of sterling. Since June, the pound has fallen by 16% against a basket of currencies. Mervyn King, the previous governor of the Bank of England, hailed the lower exchange rate as a “welcome change.” Indeed, with Britain’s current-account deficit running at over 7% of GDP – by far the largest since data started being collected in 1955 – depreciation could be regarded as a boon. But is it?

Economists would typically argue that the way to balance a country’s external accounts is through a fall in its currency, which would make imports more expensive and exports cheaper, causing the former to fall and the latter to rise. Higher import prices – a net loss for the country – would be offset by the higher employment and wages generated by the more competitive position of the country’s exports.

But in order for currency depreciation to work its magic, more demand for exports must be forthcoming when the exchange rate falls (or, as economists say, the price elasticity of demand for exports must be high). But various studies have shown that the price elasticity of demand for UK exports is low. For example, a recent paper by Francesco Aiello, Graziella Bonanno, and Alessia Via of the European Trade Study Group finds that “the long-run level of exports appears to be unrelated to the real exchange rate for the UK.”

This means that British consumers and producers will have to bear the entire brunt of devaluation: their import consumption will be rationed through a sharp rise in price inflation, with no offsetting gain for exports. This is by no means merely a theoretical proposition. In 2008-09, when the rest of the world was on the verge of deflation, the UK was enduring an inflationary recession, with GDP contracting at a top rate of 6.1% annually, while inflation reached some 5.1%. This occurred because sterling fell more than 21%, peak to trough, from 2007 to 2008.