Are the recent falls in sterling a good or bad thing?
In the days before the EU referendum, there were around $1.50 to the pound and around 1.30 euros. At the time of writing (8.16 BST, 9 October) there are $1.2434 dollars to the pound and 1.11 euros. To put it another way, sterling has fallen by around 16.5% against the dollar and around 14.5% against the euro.
Some say this is a good thing, others say it is bad.
Let’s look at the good side first. To understand why the fall in sterling is arguably a good thing, we need to consider some bad news. In the final quarter of last year, the UK posted its highest ever current account deficit to GDP. It has improved a little since then, but then the improvement really was small. In the latest quarter, the UK’s current account deficit was worth around 5.9% of GDP. This means that the UK is buying more than it is producing.
Under usual circumstances, that dire current account deficit would spark major falls in the currency. But the UK is also seen as a safe haven, a reliable place for investors to put their money in times of uncertainty. So money flows into the UK, propping up sterling. The Brexit vote created fears that foreign investors may look less favorably on the UK, while the recent Conservative Party Conference, with its anti-immigration tone, had a double impact. For one thing, it increased fears of a hard Brexit, which is seen as being bad for UK exports in the shorter term. For another thing, it has made many foreign investors feel as if they are not welcome in the UK. It is certainly the case that immigrants, by increasing the productive capacity of the UK, have a positive effect on the UK’s current account, and if immigrants were to embark on some kind of UK exodus, the current account would be a loser.
But a cheaper pound will afford exporters a major terms of trade advantage, and in theory, as a result, they will be able to trade off the cheaper pound and increase sales abroad. This, in turn, will help create jobs, and hopefully, it will create well-paid jobs.
So that’s the advantage.
The disadvantage is that the falling pound will hit household’s real income. In the short term holiday makers and Brits living abroad, but receiving an income in sterling, will lose out. In the medium term, prices in the UK will jump and there is a risk that real wage growth will go negative.
This is what happened in the years after the last time sterling fell sharply, in the latter months of 2008.
Between July 2008 and January 2009, sterling fell from a peak of around $2.00 to $1.40, that was a fall of around 30%. For sterling’s falls to be comparable to what we saw in 2008/09 it would need to fall to around $1.10, or by another 14 cents or so. Against the euro, the comparison with 2008 is less favorable. In fact, the euro/sterling exchange rate before the crash of 2008 was much the same as it was before the EU referendum. Although sterling went close to parity with the euro in early 2009, it soon settled so that it traded in a corridor of between 1.08 and 1.12 euros. Sterling is now within that range.
As a result, it is likely that UK inflation will pick up to near 3% in the latter months of next year, and may go above 4%, even higher, in the following year or two. If this happens, UK household spending will surely suffer.
There is another way of looking at it; and that is to heed the lesson of history.
Sterling has crashed, or been devalued – which is a more formal procedure, but the end effect is much the same, – many times before. Some of the more famous occasions are 1931, when the UK left the gold standard, 1967, when the pound was devalued, 1992, when the UK was ejected from the ERM (a kind of forerunner of the euro), 2008 and today.
Two of those experiences were good: leaving the gold standard and the ERM, had a very positive effect on the UK economy.
The 1967 devaluation seems to have led to inflation. At the time of this devaluation, the then Prime Minister, Harold Wilson, famously said that the move would not “affect the pound in your pocket or purses.” But in fact it did, the ‘67 devaluation may have sparked off a very serious period of inflation in the UK.
Across the world, there are many examples of how a currency devaluation had little positive effect.
The idea that a fall in the pound will be good for the UK is lazy thinking – it might be good, but a price will be paid, and that price is that in the short and medium term households will be worse off. A devaluation is in effect a back door way of pushing down on wages, and creating a competitive advantage via a cheaper labour force.
Unless the UK can also fix the underlying causes of its current account deficit – which probably relate to its poor level of productivity – a fall in sterling will simply mask some of the more serious symptoms.