Wednesday, February 10, 2010

Why Hasn't The U.K. External Deficit Declined?

Edmund Conway seems perplexed that the U.K. trade deficit is in fact increasing, despite the weak pound. That it wouldn't immediately drop was perhaps to be expected given the J-curve effect, but by now the effects of the dramatic depreciation of the pound should appear.

Considering that the euro area with its much stronger currency by contrast have seen its trade balance strengthen considerably, with the previous deficit turned into a surplus, this would at first glance seem strange.

There are two reasons for this: One is that Britain have had much higher inflation than in the euro area (With euro area consumer prices rising 2.5% in 2 years, versus 6.1% in the U.K.), meaning that the pound has depreciated less in real terms than in nominal terms.

The second, and more important reason for this pattern, is that the exchange rate is not the only monetary mechanism affecting trade balances. Real interest rates matters as well, with higher real interest rates limiting both domestic investments and consumption and instead increasing net exports. And because real interest rates in the U.K. have been much lower (negative) than in the Euro area, it should not be surprising that the U.K. trade and current account deficit doesn't fall, despite the debased exchange rate of the pound.