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.


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

Mr Cable states ” 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.”

This is only viable of course if our benighted politicians do not ask the people of Great Britain, who in many polls have stated overwhelmingly they do not want to join the euro zone. Of course they can do what they did with the Lisbon Treaty, which also the vast majority of British people wanted a say on, and use a whipped vote in the Commons and Lords to get it passed.
Should we trust these people to do what is right:-
Only as a rabbit trust a weasel.

Posted by Ray, Coventry, England | Report as abusive

Mr. Cable,

excellent and carefully explained.

Of course people forget easily that a week currancy means that there is another stronger one out there.

I cannot see why anyone would like to invest in any British investment product – just putting money without interest in a EURO account performs much better.
25% gain in the last 6months would be the norm without risk. Contrary I have lost in my British pension investment 25% – So in real European terms I have lost 50%. I am currently reviewing my pension investments and will choose non UK products as in any crisis the USD and the EUR will perform better, because they are reserve currancies.

New labour, which is responsible for the macro economics and the lack of finacial regulations in this country alone over all this years clearly must be finished. They no longer can spin their way out of this mess. People should be worried to receive enormous debt in return for saving bad banks and pay their bonuses without changing their responsible management.

Finally if today people would be asked to decide if they would like the EURO or keep the weak pound I am sure the majority will decide pro EURO. Only the Finacial Service Industry is a benefactor and that is not enough in terms of numbers in a democracy. Personally I have never met a a pro GBP person to argue with in the last 5 years…

Posted by Karlheinz Lamprecht | Report as abusive

As always Mr. Cable provides thought provoking facts and theories. Without doubt the bloated house prices and consequent rise in unsustainable personal debt has placed the UK in a much worse position to weather the storm than it’s peers. This has been augmented by a thoughtless increase in public costs primarily fuelled by a huge increase in payroll and pensions liabilities when compared to the private sector. These increases have seen most growth in labour heartlands and marginal constituencies and the political objectives are obvious.
In other words the economy has been totally mismanaged and a spending and debt binge has developed the like of which has never before been witnessed in the U.K.
This coupled with an incompetent level of regulation within the finance sector is responsible for the drop in Sterling.
It has nothing to do with the Global situation otherwise parity would be maintained. There is no such thing as an over valued or under valued floating currency. The market rate is the correct value for a floating currency and reflects the strength of the economy which supports it.
In other words at the moment both our economy and Sterling stink and the responsibility for this rests fairly and squarely with the present Government.

Posted by katrina | Report as abusive

Excellent , I hope someone, VC would be good, will write a “Don’t Panic” guide to bubbles and central bankers.

Posted by Ian Calvert | Report as abusive

Nice article!
Thanks for sharing it 😉

Posted by Claire | Report as abusive

Having been attracted by the fulsome praise in the comments, I then read the Cable article carefully (twice) in an effort to extract the pearls of wisdom which I thought must surely be there.

I was disappointed. The article is nothing more than what passes for financial journalism, ie a restating of historical events which tells us nothing new, with the inevitable slant to bolster his own political aims. And what are those aims? Simply to secure the future for his Liberal Party in Europe, in this instance by using British membership of the Euro as another link in the chains which will bind Britain and other European nations irrevocably together under the control of unelected leaders.

Beware of political skulduggery dressed up as financial
advice. Have we learned nothing from the credit crunch?

Posted by Jason | Report as abusive

Does Vince Cable think this Government is corrupt, inept or both ?

I can’t understand why they just gave the banks taxpayers money without strict conditions,

particularly considering most bankruptcy proceedings against companies & individuals
are initiated by HMRC, 52% now – up from 37% in 1997.

Maybe Brown, Darling & the reptile Mandelson will quietly become better off,
after they’ve been kicked out of parliament
– I hope the police keep an eye on this.

It just feels like the biggest con ever !

Posted by David | Report as abusive

Party political lobbying cleverly disguised as a “neutral” article…

The LibDems would love us to join the euro, of course – we’d then be practically locked in to the European system they love so well. Massive centralised government, high tax, high expense accounts for thousands of politicians and bureaucrats, no real freedom or democracy for mere “ordinary” people… And you know what is the worst thing of all? You’d NEVER be able to change it.

It’s the euro, not the pound, that is virtually dead. If the French are screaming about the pound, think what it’s like for the Spanish, the Portuguese and the Poles. The Irish are about to default on their sovereign debt. The one-size fits all currency is a straitjacket and a prison, and so is a one-size fits all Europe.

Posted by Matthew | Report as abusive

It’s nice to see the Lib Dems in full flow as they point the finger.

The current exchange rate of the pound has it’s pro’s and cons, I tink saying that it is not causing economic stress is childish at best though.


Posted by Freelance Writer | Report as abusive