Pound’s fall a symptom of crisis, not a problem in itself

January 28, 2009


–Vincent Cable is Deputy Leader of Britain’s Liberal Democrats. He is a former economist who is also the party’s spokesman on economics and finance. The views expressed are his own. –

Most of Britain’s moments of high economic drama in the 20th century centred on sterling: the Gold Standard in the inter war period; the various balance of payments crises of 1949 and 1967; Black Monday and the ERM.  It is perhaps understandable that commentators should reach for these folk memories and attach the word “crisis” to the current fall of sterling against the main trading currencies particularly the Euro.  Understandable; but wrong.

Britain certainly faces very deep and painful economic problems  which may prove as serious as any since the second world war: a sharp contraction in output; high unemployment; perhaps, for the first time since the 1930’s, sustained price deflation; serious depressed asset markets, as for equities and housing; and, not least, a virtual collapse of the banking system.

It may well be that the sharp fall in sterling reflects market perceptions that Britain is exceptionally vulnerable even in a major global recession because of its exposure to financial shocks through the City and an extreme ‘bubble’ in house prices and personal debt preceding the crisis.  Markets can clearly see that the Bank of England has been forced to cut interest rates more aggressively than the Eurozone.  Sterling’s fall is a symptom of this vulnerability rather than a problem in itself.

Since the ejection of Sterling from the ERM, Sterling has been allowed to float.  When the independence of the Bank of England was institutionalised in 1997, with the Monetary Policy Committee setting interest rates, it was made explicit that the exchange rate was not a policy objective.  Interest rates were to be used to meet the inflation target, not an exchange rate objective.

For most of the last decade the consequence of monetary policy has been a strong exchange rate in real effective terms – that is taking account of relative inflation and the exchange rates of different trading partners.  One (apparent) benefit was lower inflation, in sterling for imported goods, enabling the Bank of England to cut interest rates (but helping to fuel the disastrous bubble in house prices).  The cost was a severe squeeze on manufacturing industry which suffered a major loss of competitiveness and shed one and a half million jobs in 10 years.

The sharp fall in the exchange rate has reversed the costs and benefits.  Imports cost more in sterling terms, oil for example. And that is potentially inflationary except for the fact that this is a deflationary environment and the Bank of England is cutting, not raising, interest rates.

A more competitive currency should, by contrast, help traded activities like manufacturing – exports and import competing – tourism – including British people taking holidays at home – farming or universities seeking to attract foreign students.  In a contracting world market the benefits to exports are less apparent but experience suggests – from the mid 1990’s for example – that, after a time lag, the fall in sterling will provide a powerful stimulus.  An additional stimulus comes from the fact that a cheap currency increases the attraction to foreign investors of acquiring UK assets denominated in sterling.  It is not unreasonable to argue that weak sterling is one of the few potential sources of growth and opportunity in the stricken British economy and a long overdue and necessary adjustment.

Such a relaxed view of the exchange rate is far from universally shared.  The British Conservatives have portrayed the recent fall in sterling as a national disaster.  Their motives are transparently political.  Embarrassment over the ERM fiasco is still there and it would be enormously helpful to them if the Labour government could be blamed for making the same mistakes.  They may succeed politically.  But in reality the two situations are totally different.  John Major and Norman Lamont were trying to defend a fixed exchange rate with high interest rates – which reached 15% – but failed.  Speculators were offered a one-way bet on the currency.  None of those conditions apply today. Perhaps a closer analogy is to the 1975 balance of payments problem when a 30% fall in the value of sterling preceded the crisis and helped to precipitate it, a problem resolved only by securing an IMF loan.

The other source of criticism has come from the UK’s trading partners, notably France, arguing that devaluation is ‘unfair’.  There is some legitimate concern over the use of exchange rates as a beggar-my-neighbour weapon.  Conflict with China is building over this issue.  But it is misplaced in the UK context.  There is no suggestion that the UK authorities are deliberately forcing down the rate.  Moreover for a decade or more sterling was ‘over valued’ from the point of view of trade competitiveness.  The French did not complain then.

There is one significant worry about Sterling nonetheless.  Floating exchange rates tend to overshoot especially in times of uncertainty and panic.  The government may start to have difficulty selling government bonds in international markets to finance the large budget deficit if foreign investors worry that the exchange rate could plunge much further.  The UK no longer has the luxury, like the USA, of an international reserve currency, able to borrow internationally in its own money.  Were markets to worry about the UK’s vulnerability the cost of government borrowing could rise sharply.  There is little sign of that happening, however, and Britain is very far from the extreme situation of Iceland, portrayed as ‘national bankruptcy’.

One indirect consequence of the revival of currency politics may be to resurrect the Euro debate.  Although there are advantages in exchange rate flexibility and monetary independence, as described above, these can be overstated especially in a context where the currency lurches from significant overvaluation to undervaluation and where the monetary authorities lose credibility.  An argument is gathering strength that in order to avoid an Icelandic fate, a consequence of over dependence on financial services and the City, the currency should be locked into the Euro zone.

That is of course only one argument for membership among others for and against it. Moreover it remains to be seen if the Euro zone does any better in this crisis.  Its more vulnerable members have the opposite problem to the UK: they cannot use monetary independence and a floating exchange rate to adjust.  The Euro zone may or may not survive the strains being put on it.  If it does, and if it recovers from the crisis more quickly than the UK, Euro zone membership will be back on the UK political agenda.


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