Boris Johnson’s chaotic government and its equally chaotic collapse are not the only source of panic in the UK today. Concern is also growing about the exchange rate of the British pound.
Since it peaked last spring, the pound has depreciated by around 10% against the dollar. “The British currency has been slaughtered in international markets,” we were told. Of the five currencies underlying the International Monetary Fund’s reserve asset, special drawing rights, only the Japanese yen underperformed the pound.
Traders appear to view sterling more as the currency of a troubled emerging market than a stable advanced economy. And now, with Johnson’s resignation and the accompanying political uncertainty, sterling is set to sink further.
Of course, such views are subject to exaggeration. Sterling is not alone in weakening against the dollar. A 10% decline against the greenback is not a disaster.
But sterling’s slide is almost certainly not over. In addition, the pound is often an indicator of Britain’s economic problems. Four times in the last century, crises in the pound exposed the cracks in the economy. The Depression of 1931 took place against the backdrop of a crushing unemployment rate of 21%. There was much discussion then as to whether high unemployment reflected low British productivity or a global depression.
In fact, it reflected both. The crux of the matter was that, with unemployment at stratospheric levels, the Bank of England could not accept higher interest rates to support the pound when chronic budget deficits and reports of a mutiny in the Atlantic Fleet created a crisis of confidence. Currency speculators knew this, so they pounced, pushing the pound off the gold standard.
The crisis that broke out in 1949 troubled the British government, which was trying to restore the role of the pound as an international currency. The financial barrier was the monumental overhang of sterling debt held by the country’s wartime allies, which the UK tried to close, unsuccessfully, with capital and exchange controls. The pounds sterling with which these countries paid for Britain’s exports could not be used to buy goods from the US, where British cars and other industrial exports were uncompetitive.
Britain was also short of dollars. Once the possibility of a devaluation was mooted, the BoE experienced an uncontrollable drain on its reserves.
The 1967 crisis was personally embarrassing for Prime Minister Harold Wilson. Wilson worried that higher import prices would undermine the living standards of his supporters. He couldn’t prevent it though. This crisis also had multiple causes, from the Six Day War to the UK dock strike.
But the main problem was once again weak productivity growth, which was reflected in uncompetitive exports, trade deficits and unemployment. To stimulate demand and growth, the Wilson Labor government cut interest rates and eased restrictions on borrowing for car purchases. This led, predictably, to a further deterioration of the trade balance and another incursion by the central bank. Wilson sought to reassure the public that the “pound in your pocket” was as solid as ever. Labour’s subsequent election defeat suggests voters saw through the pretense.
The 1992 crisis, when sterling was kicked out of the European Exchange Rate Mechanism, happened again amid a poor UK performance. Output per hour worked fell from 96% of German levels in the early 1970s to just 87% by 1992. Pegging the lira to the German mark, Europe’s main currency, thus meant a cumulative loss of competitiveness. A weak US dollar and high German interest rates, which boosted the mark, then further increased the difficulty of maintaining the peg.
To protect sterling, the BoE may have raised interest rates. As in 1967, however, internal and external goals are at odds. Higher interest rates would lead to more unemployment and demand higher mortgage payments from Prime Minister John Major’s Conservative supporters. The BoE and the Treasury backed down, and with pressure from George Soros, so did sterling.
This story offers a guide to understanding the current and future prospects of the pound. Essentially, Britain is suffering from slow productivity growth. This malaise, while not new, has been unusually severe since 2008 and especially since 2016. The reasons for it are numerous, from unstable labor relations and outdated infrastructure to poor investment and a shortage of properly trained workers. It is now compounded by the frictions and inefficiencies created by Brexit.
Therefore, to maintain demand for its output, the UK needs to price its goods more competitively. This requires either less inflation than abroad or a weaker exchange rate. But less inflation is not happening because Britain has been hit hard by the global energy price shock and because unions, after a decade or more of austerity, are demanding higher wages. Hence the fall in the pound.
The BoE could still confound currency traders. It could raise interest rates faster than currently expected, reducing inflation and supporting the currency, albeit at the cost of a recession. Anything is possible. But a century of UK history suggests this scenario is unlikely.
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Barry Eichengreen is a professor of economics at the University of California, Berkeley and a former senior policy advisor at the IMF.
© Project Syndicate
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