The British should stop being so relaxed about the weak pound
The writer, former Permanent Secretary to the Treasury, is Visiting Professor at King’s College London
Last week’s interest rate hike by the Bank of England has given the pound a temporary reprieve. But the pound is still 10 percent weaker against the US dollar from its January peak, and 3 percent weaker against the euro.
Aside from the occasional shrug at the cost of a pint of lager in Marbella or a ticket to Disney World in Florida, the British people always seem deeply relaxed about devaluation. Why is this the case? And are they right?
British history of the past hundred years can be neatly divided into two periods. Until 1972, the exchange rate of the pound was generally fixed, first under the gold standard and then under the Bretton Woods system. Britain’s addiction to consumption rather than investment and its chronic productivity problems meant that balance of payments problems tended to arise for any given exchange rate.
Governments would oppose devaluation in the pursuit of credibility, arguing that it was different this time. But sooner or later the dam would burst, with successive devaluations in 1931, 1949 and 1967. Devaluation was humiliating for the government and traumatizing for the electorate, who tended to punish the government accordingly.
British politicians were not the cause of the break-up of the Bretton Woods system in 1972, but they were its main beneficiaries. The pound floated. The value fluctuated. If the British economy got into trouble, the pound would fall. The British people were more tolerant of devaluation through stealth. The British state took note.
It wasn’t until John Major tied sterling and himself to the mast of the European exchange rate mechanism in 1990 that there was a brief return to the old days of making the exchange rate fetish. But sterling didn’t stay on track. Major pressed the eject button in 1992, and to this day governments have made a virtue of not having an exchange rate target.
From a political point of view, a downward trend in sterling is the perfect policy tool. It allows the economy to adapt after a period of living beyond its means. I saw this first hand in the Treasury in the early 1990s and again after the financial crisis. We saw it again with the Brexit referendum. But it comes at a price that may have increased over time.
First, the devaluation tended to favor exporters, helping to reduce, albeit briefly, Britain’s lingering trade deficit. However, there are signs that exports have become less sensitive to recent devaluations, either because the service economy is behaving differently from the old industrial economy or because of trade barriers after Brexit.
Second, a weak exchange rate increases the cost of living. In the summer of 2008, the oil price in dollars was much higher than it is today. But because the pound has fallen 40 percent against the dollar, the price at the pumps is about 50 percent higher than 15 years ago.
While current inflation in the UK is not yet diverging from that of the US or the Eurozone, there are reasons to believe that inflation will remain higher than our competitors for longer.
Labor markets are much more flexible than in the second half of the 20th century. That means we probably won’t witness the structural unemployment of the 1930s or 1980s. But the flip side is that in the absence of a strong union movement, the real wages of those who work are likely to fall at a potentially alarming rate.
There are also other consequences. Britain tends to save less than other industrialized countries. So we need foreign investors to buy up our government debt. As former BoE governor Mark Carney memorably put it, we rely on the kindness of strangers. But as nice as those strangers are, they need a premium to buy bonds in a depreciating currency. You don’t have to agree with the Bank of America’s claim that sterling has become an emerging market currency to acknowledge that they may be onto something. In its March forecast, the Office for Budget Responsibility suggested this year’s record debt interest rate would be an anomaly. Debt interest rates would fall by £30bn next year if inflation eased. But with interest rates and inflation rising further and faster than expected, Finance Minister Rishi Sunak will fear the fall forecast of the OBR.
Faced with a drop in living standards and debt interest draining resources that could be better spent on the NHS and education, the British people may begin to reflect on the implications of devaluation. Maybe it’s not a free lunch. Maybe it’s time to embrace sound money.