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Quality counts: Marshall-Lerner and the trade balance

The balance of trade does not attract much attention these days. Maybe it should. The UK has run a deficit in traded goods every single year since 1983.

In recent years, this has soared, to over £60 billion a year since 2004, exceeding 5 per cent of GDP. Fortunately, there are two substantial offsets. First, our services sector. From architecture to video game design, our exports of services comfortably exceed our imports. Second, our overseas assets bring in a comfortable flow of revenue.

Even so, there is something strange going on in trade. Between 2007 and 2009, sterling fell by 20 per cent. This was both against the dollar and the wide basket of currencies which make up the ‘effective exchange rate’.

But the trade balance has not improved. Leaving out so-called erratic items, the trade deficit was £85 billion in 2007, and is running at an annual rate of £90 billion in both 2012 as whole and in the first four months of 2013. In volume terms, exports of goods have risen in response to the devaluation, being 8 per cent higher in 2012 than in 2007. But the volume of imports is essentially flat.

The concept of the ‘J-curve’ used to figure prominently in discussions of the balance of trade. Following a devaluation, a given basket of exports earns less in foreign currency, and imports cost more. The idea was that purchasing decisions on the volume of exports and imports took time to adjust to the new prices. So, temporarily, the balance of payments would worsen, only to improve once the volume of exports rose and that of imports fell. Now, there is not the slightest sign of the J-curve existing.

We are thrown back on the so-called the Marshall-Lerner conditions, a seemingly abstract bit of economic theory which has interesting practical implications for both companies and governments. The conditions state that a devaluation will only improve the trade balance if the sum of the price elasticities of demand for exports and imports exceed one (in absolute terms). They are derived by a neat piece of simple algebra and, unlike much of economic theory, provide a genuine scientific insight into what is going on.

The failure of the balance of trade to improve after the 20 per cent devaluation 2007-2009 strongly suggests that the price elasticity of demand for both exports and imports is very low. The Marshall-Lerner conditions are not met.

Most international trade does not involve businesses selling direct to consumers but is in so-called intermediate products, business to business selling. The sophistication of many modern products means that purchasers are making their decisions on attributes of the product other than price. High quality goods in the right niche are the keys to export success. And in so far as they are able to, governments should aim for a strong rather than a weak currency. The trade balance may even improve, and we would all be richer in terms of what we can buy from the rest of the world.

Paul Ormerod

As published in City Am on Wednesday 12th June 2013

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