Brexit means…higher prices

The economic impact of devaluations
Oct 13th 2016, 10:29 BY BUTTONWOOD

The Economist

THE economic arguments for and against Brexit in the course of the referendum campaign were quite esoteric and confusing to the average voter. Similarly, sterling’s decline in the currency markets might seem like the kind of thing that only concerns City traders.

So the row that has broken out between Tesco, Britain’s biggest supermarket chain, and Unilever, the Anglo-Dutch multinational, has made the story concrete in ways that were not apparent before. Unilever wants to raise prices across a range of goods to reflect the fall in the pound, which has dropped from around $1.50 on the day of the referendum to less than $1.22 at the time of writing. Similar falls have been seen against the euro; indeed travellers who change their money at the airport are getting less than a euro per pound.



The row has centered on Marmite, a salty yeast-based spread that is loved by some, but not all, Britons including this blogger. (I have yet to meet an American who can stand it.) But Marmite isn’t the best example as it is made in this country. PG Tips, one of Britain’s favourite tea brands (pictured), is a better example; that is grown overseas.

So why did Unilever suggest an across-the-board price hike instead of targeting only overseas-sourced brands? It is not completely illogical. As you can see from its quarterly results, Unilever reports in euros. So even if the cost of producing Marmite has not risen because of the falling pound, the sterling proceeds of Marmite sales are worth less than before. It is thus not surprising that Unilever is trying to get that money back. Nor is it surprising that Tesco, trapped in a price war with discounters like Aldi and Lidl, is resisting. The only surprise is that the news has leaked out, largely it seems because Tesco is refusing to stock Unilever brands.

This can’t last for long and eventually there will be a compromise. Unilever will cut its price demands and Tesco will absorb some of the hit. But supermarket margins aren’t high and Britons will end up paying more, just as they will for petrol (the initial post-referendum plunge in sterling coincided with weakness in the oil price but now the latter has rebounded).

Of course, that is what devaluation (strictly speaking, depreciation) means. Britain’s exports are worth less (in foreign currency terms) and its imports cost more. This is a good thing for exporters only to the extent that they can gain market share via lower prices and that this volume boost is not offset by the greater cost of components (eg a widget-maker has to pay more for the metals that go into the widget).

In a recent column, Paul Krugman saw the pound’s fall as a necessary adjustment. But it is worth reading why he thinks that

In one of the models I laid out in that old paper, the way this worked out was not that all production left the smaller economy, but rather that the smaller economy paid lower wages and therefore made up in competitiveness what it lacked in market access. In effect, it used a weaker currency to make up for its smaller market.In Britain’s case, I’d suggest that we think of financial services as the industry in question. Such services are subject to both internal and external economies of scale, which tends to concentrate them in a handful of huge financial centres around the world, one of which is, of course, the City of London. But now we face the prospect of seriously increased transaction costs between Britain and the rest of Europe, which creates an incentive to move those services away from the smaller economy (Britain) and into the larger (Europe). Britain therefore needs a weaker currency to offset this adverse impact.Does this make Britain poorer? Yes. It’s not just the efficiency effect of barriers to trade, there’s also a terms-of-trade effect as the real exchange rate depreciates.
In other words, Brexit is a shock. And Britain needs to react to this shock by lowering its prices. That could be done by getting employers to cut wages in nominal terms but that would be incredibly difficult and would throw up all sorts of other problems (workers’ debts would still be fixed in nominal terms so could not be repaid). Better to let the exchange rate take the strain. The analogy is the euro crisis where, because of the single currency, Greece and Spain couldn’t devalue and had to take a painful hit to the real economy.

But as Mr Krugman says, Britons are still poorer. Brexit means not just Brexit but higher prices. Since wages are unlikely to rise to compensate, real disposable income will be squeezed; economists are talking of a 2.5-3% inflation rate next year.

Some will cite the 1992 example, when Britain left the Exchange Rate Mechanism, as showing that a weaker currency can be a good thing. But the great boon of 1992 was that it allowed the Bank of England to cut interest rates from their sky-high 12% levels. There is not such scope now (indeed, Brexiteers complained about the quarter point cut the Bank did make). Nor did the pound seem to be overvalued before the referendum vote either on our Big Mac index or, more scientifically, on the OECD’s measure of purchasing power parity, which suggested $1.43.