The North Sea
Free-market economists often argue that the contribution of North Sea oil to the UK balance of payments has meant inevitable decline for some sectors of the economy. The mechanism of decline is usually attributed to the exchange rate, with the improvement in the UK visible balance (via removal of the oil deficit) bringing upward pressure on sterling.
In terms of the foreign exchange market, higher exports of oil increase the demand for sterling, and lower imports of oil decrease the supply of sterling. The net effect has been a higher sterling exchange rate than would otherwise have been the case, particularly in the late 1970s and early 1980s. The status of sterling as a petro-currency may also attract an increased capital inflow, further raising the demand for sterling, and with it the sterling exchange rate. The higher price of sterling then makes UK exports more expensive abroad, and imports cheaper in the UK. United Kingdom producers of industrial exports, and import substitutes, are the most seriously disadvantaged by a high pound, since the major part of UK trade is in industrial products (around two-thirds of both exports and imports). In this way a higher pound produces a decline in industrial output and employment.The argument that North Sea oil, through its effect on the exchange rate, inevitably resulted in the decline in UK manufacturing output and employment observed in the late 1970s and early 1980s is rather simplistic. The government could have directed surplus foreign exchange created by oil revenues towards imported capital equipment. This increase in imports of capital equipment would have eased the upward pressure on the pound,4 whilst providing a basis for increased future competitiveness and economic recovery. Equally, the upward pressure on sterling could have been alleviated by macroeconomic policies aimed at raising aggregate demand, and with it spending on imports, or by lower interest rates aimed at reducing capital inflow.
North Sea oil cannot be wholly to blame for the observed decline in UK industrial output and employment. These structural changes began in the mid- 1960s, yet North Sea oil only became a significant factor in the UK balance of payments in 1978. The periods of high exchange rate between 1978 and 1981, whilst certainly contributing to industrial decline, were by no means an inevitable consequence of North Sea oil. Different macroeconomic policies could, as we have seen, have produced a lower exchange rate, as happened after withdrawal from the Exchange Rate Mechanism in September 1992.