Be careful what you wish for in cheering on sterling’s slump
Will economic pundits please stop welcoming the ongoing fall in the value of the pound. There is very little long-term economic advantage to be had from a weaker currency and, in the meantime, it just makes us poorer.
Yesterday, the pound fell to a new eight-year low against the euro following remarks over the weekend from Mario Draghi, president of the European Central Bank, which markets read as signalling the beginning of the end of the ECB’S hitherto ultraexpansionist monetary stance.
The way things are going, we could soon be approaching parity, a level last seen in the wake of the collapse of Northern Rock nearly 10 years ago, when it seemed that Britain was on the verge of financial Armageddon. Strangely, it was then assumed that Europe had dodged the bullet and somehow managed to avoid the widening financial crisis. It wasn’t long, however, before this European conceit was disabused; the tables soon reversed.
But now we’ve got Brexit, which rightly or wrongly markets think will be bad for economic prospects; growth has slowed, real wages are being squeezed again, and the eurozone has miraculously risen from its sick bed. For much of the European economy, growth prospects have improved and political risk has eased. Memories of the single currency’s near death experience just a few short years back have faded.
By contrast, it is Britain which is for now seen to be most at risk of political instability and a deteriorating economy.
If nothing else, this demonstrates just how fickle and “of the moment” foreign exchange markets can be; we shouldn’t perhaps read too much into these short-term movements. Today’s deterioration is in any case more a reflection of euro strength than sterling weakness. Currency markets are prone to overshoot, and there are plenty of reasons for thinking the pound now oversold.
Even so, the present sell-off is beginning to look like more than just a passing squall; the pound is also weak against the dollar, leaving its trade- weighted value – as measured against its biggest trading partners – close to a record low.
Good, say proponents of devaluation. This will help exports and investment, “rebalancing” the economy away from the supposed evils of debt-fuelled consumption.
That was also the view of Harold Wilson nearly 50 years ago when in announcing a 14pc devaluation against the dollar the British prime minister as then was said that “it does not mean that the pound here in Britain, in your pocket or purse or in your bank, has been devalued. What it does mean is that we shall now be able to sell more goods abroad on a competitive basis”. What is more, it would enable Britain to “break out from the straitjacket” of boom and bust economics.
Despite the fact that he was proved comprehensively wrong on all counts, this way of thinking has set the tone for all subsequent justification of devaluation. Whenever it occurs, optimists have been quick to declare the silver lining of a boost to exports and a more competitive economy. The argument is taken to its logical extreme by the businessman John Mills in his new book, Britain’s Achilles’ Heel; Our Uncompetitive Pound.
To Mills, an overvalued pound is at the root of virtually all our contemporary economic ills. If imports become more expensive, and exports more competitive, then it should in theory allow the UK economy to rebalance and for the trade deficit to shrink. This in turn would make the UK more attractive to foreign investors and in time the pound would therefore rebound. Regrettably, the evidence of currency depreciation working in this way is thin on the ground.
There are only really two exceptions in Britain’s near 100-year history of progressive devaluation – abandoning the gold standard in 1931 and leaving the ERM in 1992. On both occasions, economic revival followed soon after. Yet both these devaluations also
‘For much of the European economy, growth prospects have improved and political risk has eased’
represented liberation from fixed exchange-rate regimes under which the correct exercise of domestic policy – monetary, fiscal and structural – had become impossible. This time around, we already have a floating exchange rate; there is no such constraint on policy.
Exports have admittedly risen somewhat since the post-referendum collapse in sterling, but this is largely because the eurozone, our biggest trading partner, has returned to growth. The wider picture is in any case far from encouraging. So far, exporters have tended to book the extra profit and hoard the cash from devaluation rather than boost volumes. Furthermore, there has been virtually no evidence of a devaluation dividend from import substitution. In the second quarter, imports were 4.5pc higher in volume terms than in the fourth quarter of 2015, despite an 11pc jump in prices. Optimists point to survey evidence of a surge in export orders, and figure this should in time prompt an equally robust increase in business investment to service the extra demand.
Yet as Samuel Tombs, of Pantheon Economics, points out, much of the extra profit generated from exports is not being converted into sterling, suggesting that companies are more inclined to invest in new operations overseas than to expand production in Britain. On the evidence so far, he finds the case for expecting a significant boost to the economy from net trade unconvincing.
And as it happens, the idea that devaluation boosts competitiveness looks suspect even in theory, let alone practice. Just as likely, it gives uncompetitive business which frankly doesn’t deserve to survive a further lease of life, embedding poor levels of productivity and competitiveness.
Anyone who has just returned from holidaying on the continent will already have experienced first hand the uncomfortable effects of devaluation on their spending power; we don’t need to feel too sorry for them. The much wider concern is that UK assets are now worth much less than they used to be. The stock market has done OK, admittedly, but that’s substantially because its components derive much of their profit from overseas.
No, the main mechanism by which citizens get poorer is because imports become more expensive, with the effect that real wages get squeezed. In such circumstances, it is never long before domestic costs start rising faster than the costs of Britain’s trading partners, thereby eroding any short-term advantage.
None of this is to argue that we should fight devaluation; let the market decide is a reasonable rule of thumb in economics. But the belief in devaluation as a panacea is misguided. At best it provides a breathing space, an opportunity to smooth the adjustment to economic shocks. Too often, that opportunity is squandered, and there is no long-term gain to productivity and competitiveness.
The worry about Brexit is that it is proving so all-consuming that policymakers seem to have forgotten the more important need for deep and far-reaching economic reform.
What is more, a devaluation that turns into a rout, or sterling crisis, is the worst of all possible worlds. At that point, it becomes impossible to fund the trade or budget deficits on reasonable terms and interest rates rise precipitously, driving the UK into recession. Be careful what you wish for in cheering on devaluation.