January 11, 2008
Why sterling is the next dollar
By Martin Wolf
Will sterling follow the US dollar? As Willem Buiter pointed out last week (The silver lining in sterling’s decline, January 4), this is highly likely. Movements in exchange rates are, to put it mildly, unpredictable. But this one ought to happen. It should also be welcomed. This possibility was, indeed, why the UK had to keep out of the eurozone.
Like the US, the UK has had buoyant credit growth, huge rises in house prices, low private and national savings and a sizeable current account deficit. Like the US, it also absorbed the surplus savings of much of the rest of the world in the 2000s. It is, in short, one of the canonical “Anglo-Saxon” economies.
Yet, in many respects, the UK position is worse than that of the US. The run-up in UK house prices, for example, was much bigger than in the US. On almost any measure, housing valuations and household indebtedness are still more extreme. To take one example, at the end of 2006, household mortgage debt was 126 per cent of disposable income, against a mere 104 per cent in the US.
Moreover, the UK’s current account deficit, at 5.7 per cent of GDP in the third quarter of 2007, was bigger than that of the US. Indeed, it was bigger even than it seems. As Andrew Smithers of London-based research company Smithers & Co argues, the deficit is significantly understated by current statistical conventions. Retained earnings of direct investment are included in data on investment income, but this is not the case for portfolio investment. Since a high proportion of UK-based multinationals are owned by foreign portfolio investors, this exaggerates the UK’s net investment income. The UK’s true current account deficit may have been close to 7 per cent of GDP.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Wynne Godley: It seems Andrew Smithers would have it that the UK’s current account deficit, properly measured, reached nearly 7% of GDP in the third quarter - about £4 billion (quarterly rate) above the official estimate.
I don’t think Smithers’s estimates should be admitted to the public discussion unless he publishes the underlying calculations for all to see. £4 billion looks large (though not impossible) in relation to the £1 billion deficit in net distributed profits.
Undistributed profits do not affect the exchange rate at least in the short term, so the Smithers’s version of the deficit is not conceptually in equivalence with the official one.
Posted by: Wynne Godley | January 11th, 2008 at 4:52 pm | Report this commentAndrew Smithers: What I wrote about the UK current account deficit was as follows:
The internationally agreed system for recording international income transfers leads to the UK current account deficit being understated. This is because the UK is, for its size, home to a relatively large number of important international companies, such as BP. Under the agreed international system (“SNA”), the retained earnings of direct investment are included in the data on investment income, while this is not done in the case of portfolio investment. If direct investments were wholly owned by UK nationals, this would not cause any distortion. But a high proportion of UK internationals are in fact owned by foreigners. If we could adjust the figure for “the earnings of UK direct investments retained abroad” for the proportion of those companies which are not owned by British nationals, we would have a truer picture of the real size of the UK’s current account deficit.
While we do not have data on the foreign ownership of UK companies in the detail necessary to construct their effective ownership of those UK companies which have large overseas profits, we have data on the foreign ownership of UK quoted companies. (I illustrated this with a cart showing that UK companies were far more heavily owned - 40% - than those of Japan and the US - the sources were the ONS for the UK, The US Z1 Flow of Funds Accounts and the Tokyo Stock Exchange Fact book for Japan.) I then assumed that the foreign ownership of the large UK internationals is above the average for UK companies as a whole.
I then made the “rough assumption” that any resulting understatement will be balanced by the ownership by UK citizens of foreign multinationals operating in the UK; we are left with the likelihood that an amount equal to 40% of the “reinvested profits of UK direct investments abroad” are in fact attributable to foreign rather than UK ownership.
The most recent data we have from the ONS on the reinvested profits of UK direct investments abroad is for Q2 2007 and it was then 4% of GDP. If my previous assumptions are reasonable, then this would imply that the “true” current account deficit of the UK was understated by 1.6% of GDP.
I have no reason to believe that there was any marked change, either positive or negative, in the level of retentions in Q3 2007. If it was unchanged and my other assumptions are reasonable, the underlying current account deficit of the UK would have exceeded 7% of GDP (i.e. it would have been 7.3%).
It is reasonable to argue that the treatment of direct investment income, which includes the reinvested income as a capital outflow, is more correct than the treatment of portfolio investment which excludes it. However, the net portfolio income is only a small negative and the inclusion of reinvested income thus seems unlikely to make much impact.
I emphasised that I don’t know what the “true” size of the UK deficit is. I have merely done my best, from the data that are available, to make a reasonable guess at the probable order of magnitude. If I have made any errors in my understanding or reading of the data, or in my calculations, or if there are better ways of approaching the issue, or other data of which I should have been aware, I would, though filled with chagrin, be most grateful to have my errors corrected.
Posted by: Andrew Smithers | January 14th, 2008 at 5:41 pm | Report this commentWynne Godley: Andrew Smithers seems not to have noticed that new and revised figures were published by the ONS on December 20 which would have a big effect on his conclusions.
The conceptual issues are far more important than revisions to the figures. Andrew’s calculations, which are not transparent (at least to me) appear to assume that the ONS fails to allow for ownership when estimating the retentions that accrue on FDI assets and liabilities. But this, surely, is mistaken.
FDI retentions are struck in proportion to the equity share owned by the direct investor. According to the European System of Accounts 1995 para 4.66, “Actual distributions may be made out of entrepreneurial income of foreign investment enterprises in the form of dividends…. In addition, retained earnings are treated as if they were distributed in the form of dividends or withdrawals of income from quasi-corporations to direct investors in proportion to their ownership of the equity of the enterprise and then reinvested by them (my italics).
I don’t think, at the moment, there is any reason to suppose that the UK’s current account deficit was greater than 5.7% of GDP in the third quarter.
Posted by: Wynne Godley | January 17th, 2008 at 12:21 pm | Report this commentDidier Dufau, e-toile (guest contributor) “Movements in exchange rates are, to put it mildly, unpredictable. But this one ought to happen. It should also be welcomed. This possibility was, indeed, why the UK had to keep out of the eurozone.”
This statement is highly ideological and doesn’t take into account important facts. Since the international monetary system set at Bretton Woods exploded in 1971, a de facto and so called “floating currency system” is the mainframe of the global economy.
Since then the exchange rates of the main currencies are bouncing in impredictable ways creating havoc in the financiel markets and the international commercial exchanges. It is ludicrous to pretend as we can read so often that changes in rates are kindly “anticipated” by economic agents thru clever technical ploys. When the Euro moves frome 80 to 1.40 dollars, in little more than a year no firm can cope with that nicely. When dollar started to move up steeply in 1997-98 the economies who were borrowing in dollar could not repay. When dollar slumped to record low back in 1973, oil producers had to find some ways to keep their revenues. The various crisis were named with funny names : oil crisis, emergent countries crisis etc. All of them were actually dollar crisis and a consequence of the IMS structural flaws.
If they are bouncing, currencies are also sinking. Gold ounce was 35 dollars back in 71 and to day round 900 ! A 96% devaluation of the dollar evaluated in gold ! Just try to find an economist ready to assert : what a boon, with our IMS within in the next 30 years dollar will see its value in gold again divided by 25 and gold ounce will cost 22,500.00 dollars…
It is not only true for the dollar but for every currency, pound included, even if some of them are temporarily up in the bouncing game.
The floating system is self destructive. The day of reckoning has come. What makes the current crisis so deep is that everyone understands that the “solutions” used in 1974, 1992 and 2001 are of no use. We are at the end of this particular story.
Floading the world with other abyssal US deficits will only foster retaliation and further disruptions.
The only solution is to create a new IMS stable currency framework far from the ideology of free floating markets, creating some kind of intergovernmental disciplines. The US can’t be the anchor of the new system and only “primum inter pares”. Only quick international initiatives in this direction can spare a deep worldwide recession, by sending to the markets a clear sign that there won’t be any more “benign neglect” on tne money markets.
Otherwide, floating system being deprived of any mechanism to stop disruptions, panic will be the rule and depression the only result.
Posted by: Didier Dufau | January 23rd, 2008 at 5:12 pm | Report this comment