Advocating import substitution to lower UK current account deficit…really?

For a Indian economy student,  import substitution is like a big bad word. We are often told how this one strategy killed Indian economy for a long time. By using this, we pushed our industry into making products in which we had no comparative advantage. This only started to change in 1980s and then the big changes came post 1991. Since then, we have been told by endless stream of economists how we should just open up whatever markets we have. Each time we dilly dally, we are reminded of mistakes pre 1980s.

It was all going well till 2008 happened. The crisis opened up many problems for the so called advanced world. So much so they are increasingly looking at solutions which they have advised us against strongly. We have looked at exchange rate targeting, excessive fiscal and monetary stimulus, bail-outs and what not. It is not limited to economics alone. One just read about an economist advocating a kind of central reservation to address racial inequality.

In another of such instances, Robert Skildesky advocates import substitution to lower UK’s CAD:

…although the current-account deficit narrowed to around 1.7% of GDP in 2011, the improvement was only temporary. After 2011, the current account deficit started to widen once more, even though the pound never clawed back its losses. In economics jargon, the UK seems to be suffering from an extreme variant of the Houthakker-Magee effect – named after two economists who discovered in 1969 that price elasticities for imports and exports could diverge substantially, giving rise to a permanent tendency toward current-account imbalance.

The reason appears to be the massive contraction of the UK manufacturing sector – from around 28% of gross value added in 1978 to less than 10% today. As the economist Nicholas Kaldor pointed out long ago, because manufacturing has higher returns to scale than services, manufacturing exporters tend to beat service exporters.

In addition, structural reforms since the mid-1990s have ensured that British exporters are deeply integrated within global supply chains. As a result, many of Britain’s exports require imported inputs; so when sterling depreciates and import prices rise, the knock-on effect on export prices renders them less competitive. The most recent OECD data show that the import content of UK exports is around 23%, compared to around 15% for US and Japanese exports.

For now, the UK is relying on capital inflows into the City of London to limit sterling’s fall. But, as the exchange-rate collapse of 2008 showed, this source of foreign demand for sterling is highly unstable. When the worm inevitably turns and these flows reverse, both sterling and exports will take another hit.

What to do? Import substitution:

What is to be done? Only rapid government action to substitute goods currently imported with domestically produced goods will do the trick. The classic solution is import controls. But other measures that are less damaging to trade rules and international amity are available.

The national investment bank which the Labour Party is now advocating could be given a mandate to invest in industries with a high import substitution potential. An alternative would be to subsidize such industries directly from the Exchequer, with subsidies tied to the quality-adjusted price of the import being substituted. As the domestically produced goods became competitive with the foreign goods, the subsidies would gradually be removed and the industry allowed stand on its own two feet.

Ideally, the British government should aim to bring down imports as a percentage of GDP from the current high of around 30% to pre-1974 levels of around 20%. This may prove too ambitious, and the UK may have to settle for somewhere around 25% of GDP. But if something is not done, Britain risks permanent impairment of prosperity.

A depressed economy can be reflated, and an inflationary economy can be depressed. But losing access to crucial foreign markets as a result of currency movements outside the country’s control is largely irreversible.

Really? I had to reread the whole thing. Unbelievable stuff. These ideas are just so antithetical to the whole image of this country being heart of global capital and trade..

There seems to be more and more requirement in the advanced world for Indian economists of pre-1990s. I don’t mean this as a bad thing. Just to indicate how much times have changed..

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