British pound, Dutch Disease

Willem Buiter's latest salvo on the value of Britain's Sterling currency, which has been falling rather sharply recently, notes something that we have been writing about for some time. He says:

"It is premature to say that a sterling crisis has already started. It is true, as is clear from Chart 1, that the depreciation of sterling’s effective exchange rate this past year is larger than that in the year following the UK’s exit from ERMI in 1992. . . . in these data there is nothing that cannot be explained as a (long overdue) correction of a persistent overvaluation of sterling - a misalignment that has biased the economic playing field against industries, both exporting and import competing, that would have had a fairer crack of the whip at a more reasonable exchange rate."

That is one of Britain's great worries: an excessive reliance on financial services appears to have squeezed out other sectors that might be better placed to take up the slack, at least in the medium term. Why might this be?

"One interpretation of the drivers of this persistent overvaluation would be a Dutch disease story, where the role of the natural resource sector in the standard version of the Dutch disease is taking by the UK banking sector. In this interpretation, a long financial industry bubble in the UK has driven up the real exchange rate in the whole economy and crowded out other sectors producing internationally tradable commodities. The recent sharp depreciation of sterling corrects this long-standing anomaly. Clearly, this conjecture requires further thought and research."

Well, we've written a fair bit about the Dutch Disease in the context of tax havens. A recent blog of ours explained the essence of the problem like this:

"It is part of a wider phenomenon known as the Paradox of Plenty: more money can sometimes actually make you poorer. It goes something like this: large inflows of money (in the case of, say, Angola, it's oil money; in Jersey's case it's money owned by rich Angolan politicians and others from around the world who love Jersey's tax haven status) cause prices to rise - either through a shift in the exchange rate, or through inflation, or both. The effect is to make everything produced locally more expensive, and so these sectors -- like agriculture or tourism -- can't compete. They wither. The tourists stop coming because it's too expensive. And so on."

More research is certainly needed on this. And where better to look for the problems associated with a dominant financial industry than . . . tax havens? Last year TJN's John Christensen published a paper in the Annals of Tourism Research which explores this in more detail. Although it doesn't use the term "Dutch Disease" by name, the same analysis is involved.

Here are a few choice quotes from the report, which contains much hard data too:

"Financial capitalism appears to be able to out-compete other industries, particularly tourism, to gain dominance within the local political economy."

This is just what dominant oil industiries do in places like Nigeria and Angola. A couple of anecdotes illustrates the point: Nigeria's agriculture export sector fell by around half in just a few years during the 1970s oil boom, as the oil money started flooding in. More than 99.5% of Angola's exports are made up of oil, refined oil products, diamonds, and other minerals. There's almost nothing else - and this from a country with fabulously fertile soils and good rainfall, which in the pre-independence period was one of Africa's export powerhouses. Here are some more specific symptoms, from the article in the Annals of Tourism Research.

"The macroeconomic consequences of crowding-out in a small island economy include labour cost inflation, widening income disparity, chronic labor shortages, and severe pressure on the island's land and real estate markets."

Anyone familiar with oil-dependent nations in the developing world will recognise these symptoms immediately. TJN contains experts in both the tax haven world, and the oil-in-Africa world, and we have been astonished by the extraordinary similarities of these countries with such different backgrounds and experiences. Here is another important point from the article:

"Despite their remoteness and lack of comparative advantage, small islands exist simultaneously, and paradoxically, both at the margins of advanced captialism and at its very center."

What these secrecy jurisdictions have become is the crucibles of the deregulated global economy. And this is where they can differ a bit from the mineral-dependent nations. Because of the small scale of tax haven islands like Jersey, and the huge crowding-out that happens, they have become the most captive states of them all, in political terms. The politicians are extraordinarly vulnerable to the lobby groups. In Jersey's case we are talking about the banks, the Jersey Bankers' Association, the Society of Trust and Estate Practitioners (STEP,) a group made up largely of solicitors, who wine and dine these places' hapless politicians in the world's most expensive restaurants.

Dutch Disease effects can take many years to reverse: once you've killed off manufacturing, agriculture, tourism, and so on, it isn't easy to rebuild it, even once the exchange rate has changed again. Worrying times indeed. A full copy of the tourism research paper is here.