The chaotic government of Boris Johnson, and its equally chaotic collapse, are not the only source of panic in the UK today. There is also growing anxiety about the exchange rate of the British pound.
Since peaking in the spring of last year, the pound has depreciated by about 10% against the dollar. “The British currency is being massacred in international markets,” we are told. Of the five currencies underlying the International Monetary Fund’s reserve assets, special drawing rights, only the Japanese yen has done worse than the pound.
It seems that traders consider the pound sterling more as the currency of a troubled emerging market than as a stable advanced economy. And now, with Johnson’s resignation and the political uncertainty that accompanies it, the pound sterling is about to sink even further.
It is true that these opinions are subject to exaggeration. The pound is not the only one to weaken against the dollar. A 10% fall against the green dollar is no catastrophe.
But the fall in the pound sterling is almost certainly not over. In addition, the pound is often an indicator of the UK’s economic problems. Four times over the past century, the pound sterling crises have exposed the failures of the economy. The crisis of 1931 took place against the backdrop of an unemployment rate of 21%. There was much discussion at the time as to whether high unemployment reflected the poor performance of UK productivity or the 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 afford higher interest rates to support the pound sterling when chronic budget deficits and reports of a riot in the Atlantic fleet created a crisis of confidence. Currency speculators knew this, so they threw themselves, making the pound out of the gold standard.
The crisis that erupted in 1949 embarrassed a British government that sought to restore the role of the pound sterling as an international currency. The financial cable was the monumental excess of the allied pound debt of the allies in times of war in the country, which the United Kingdom had tried to bottle, unsuccessfully, with capital controls and changes. The pound sterling that these countries used to pay for British exports could not be used to buy goods from the US, where British cars and other manufactured exports were not competitive.
In addition, Britain lacked dollars. Once the possibility of devaluation was raised, the BoE experienced an uncontrollable run of its reserves.
The 1967 crisis personally embarrassed Prime Minister Harold Wilson. Wilson was concerned that higher import prices could undermine the standard of living of his supporters. Still, he couldn’t help it. This crisis also had multiple causes, from the six-day war to a strike on UK docks.
But the fundamental problem, once again, was the weak growth in productivity, which was reflected in uncompetitive exports, trade deficit and unemployment. To stimulate demand and growth, Wilson’s Labor government cut interest rates and eased lending restrictions on car purchases. This led, as was to be expected, to a further deterioration in the trade balance and another rush to the central bank. Wilson tried to reassure the audience that “the pound in his pocket” was as solid as ever. The subsequent electoral defeat of Labor suggests that voters saw through the pretension.
The 1992 crisis, when the pound sterling was kicked out of the European Exchange Rate Mechanism, resurfaced against the backdrop of the UK’s poor productivity performance. Production per hour worked had fallen from 96% of German levels in the early 1970s to only 87% in 1992. The link between the pound sterling and the German mark, Europe’s anchor currency, meant a loss. accumulated competitiveness. The weakness of the US dollar and high German interest rates, which strengthened the brand, further increased the difficulty of maintaining anchorage.
To defend the pound sterling, the BoE could have raised interest rates. As in 1967, however, internal and external goals were at odds. Higher interest rates would have meant more unemployment and would have demanded higher mortgage payments from Conservative supporters of Prime Minister John Major. The BoE and Treasury gave in and, with a push from George Soros, so did the pound sterling.
This story provides a guide to understanding Sterling’s current and future prospects. Basically, Britain is experiencing slow productivity growth. This unrest, while not new, has been unusually severe since 2008, and especially since 2016. It has multiple causes, from conflicting labor relations and outdated infrastructure to weak investment and the shortage of properly trained workers. Now the frictions and inefficiencies caused by Brexit are added.
To keep up with the demand for its production, the UK needs to put a more competitive price on its products. This requires either less inflation than abroad or a weaker exchange rate. But there is no less inflation, because Britain is being hit hard by the global clash of energy prices and because unions, after a decade or more of austerity, are demanding higher wages. Hence the fall of the pound sterling.
The BoE could still hurt foreign exchange traders. It could raise interest rates faster than currently expected, easing inflation and supporting the currency, albeit at the expense of a recession. Everything 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 IMF policy advisor.
© Project Syndicate