Book review: “The Elephant in the Room” by John Mills
John argues that this could be achieved by shifting about 4% of annual UK GDP from consumer spending to investment in manufacturing, triggered by a substantial devaluation of the pound. The eponymous pachyderm of this book is therefore an overvalued exchange rate.
I like John’s style. He is one of the few people writing about the challenges facing the UK economy who actually has any experience of building a successful business. His work is based on a meticulous analysis of economic history and real-world data, and he is not afraid to propose radical policy solutions. This latest book is a typically easy read. Nonetheless, I still disagree on four main points.
First, John argues that only certain types of investment in privately-owned light industry – specifically those involving mechanisation, technology and power – are likely to provide significant benefits in terms of future economic growth, higher wages and a stronger tax base, or even in the form of better and cheaper products.
This is an extraordinary claim. John is surely right that, in the past, a disproportionate share of the gains in productivity have come from the manufacturing sector. But this may not be true in the future, given diminishing returns here and the scope for new technologies and working practices to transform productivity in the rest of the economy.
In other words, this is a backward-looking view of economic development. Similarly, John’s suggestion that “reindustrialisation” is key to tackling regional inequalities appears to regard the (often exaggerated) North/South divide between manufacturing and services as something set in stone.
It is also perfectly normal for the share of manufacturing to decline as countries become richer. Basic economics tells us that countries should specialise in activities in which they have a comparative advantage – which is something best determined by the markets – instead of trying to replicate the composition of GDP in a selection of competitors.
Second, John crunches the numbers to suggest that the annual “social returns” on his favoured types of manufacturing investment are as high as 50%. This is the basis of the claim that the redirection of just 4% of GDP to light industry could boost GDP by as much 2%, year after year. The maths may work, but doesn’t this just sound too good to be true?
Third, and in stark contrast to his enthusiasm for manufacturing, John argues that the social returns from most other investments barely cover the cost of the capital required (even though real interest rates are currently negative). These include investments in better road and rail infrastructure, schools, hospitals, and housing.
That is very hard to square with the extensive evidence that investment in these sectors can have substantial multiplier effects on economic growth, even without taking account of the wider social benefits. It also prompts the question of why the government should ever want to get involved in these activities if their returns are indeed so low.
Fourth, John places too much faith in exchange rate intervention. He argues that the main reason why we are missing out on high potential returns from manufacturing is that it is unprofitable for private firms to invest more at the current exchange rate (even though sterling’s trade-weighted indices are already near record lows). John concludes that a substantial devaluation of the pound could transform the prospects for productivity and growth.
There are multiple problems with this. For a start, John is vague about exactly how the UK authorities could get the exchange rate down. He cites the example of Japan, which has occasionally intervened to weaken the yen, but usually with the agreement of other countries. An active policy of currency intervention would break commitments that the UK has made (as a member of the G7) not to target exchange rates for competitive purposes. Indeed, it is hard to see how weakening the pound can help the UK without making someone else worse off.
Even if the UK authorities can get the nominal exchange rate down, how can it be kept there? Other countries could simply respond by devaluing their own currencies. After all, if the UK is seen to benefit to the extent of boosting the sustainable growth rate by 2% every year, why wouldn’t other countries follow this lead?
Finally, suppose that the UK can keep the nominal exchange rate down, what is to stop any boost to competitiveness from being offset by higher inflation, leaving the real exchange rate unchanged?
There have, of course, been historical examples where a devaluation has had lasting benefits, including sterling’s exit from the ERM in 1992. However, this depends crucially on the exchange rate being substantially over-valued to begin with, and there being plenty of spare capacity in the economy so that the inflationary response is muted.
It might be argued that the Covid recession has created the spare capacity that would allow the economy to grow more quickly without generating more inflation – and even that an increase in inflation might now be a welcome way to reduce the real burden of higher debt. But this argument would presumably apply to other countries too. I doubt they would take kindly to the UK trying to steal a march by devaluing the pound in the midst of a global pandemic.
In summary, I believe that The Elephant in the Room exaggerates both the importance of manufacturing and the scope for exchange rate manipulation to transform the economy. It makes more sense to focus on free-market solutions to boost growth, rather than resort to a tried and failed tool of state intervention. However, why not download a copy and make up your own mind? You can also view a debate here between John Mills and Mark Littlewood of the IEA, which provides a good overview of the issues too.