The Great Debate UK

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

–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.