Originally published at Project-Syndicate | July 8th, 2022
Investors appear to view the British pound more like the currency of a troubled emerging market than of a stable advanced economy. And now, with Prime Minister Boris Johnson’s resignation and the attendant political uncertainty, sterling is poised to sink further.
BERKELEY – British Prime Minister Boris Johnson’s chaotic government, and its equally chaotic collapse, are not the only source of panic in the United Kingdom nowadays. There is growing anxiety about the exchange rate of the British pound as well.
Since peaking in the spring of last year, the pound has depreciated by about 10% against the dollar. “Britain’s currency is getting slaughtered on international markets,” we are told. Of the five currencies underlying the International Monetary Fund’s reserve asset, special drawing rights, only the Japanese yen has done worse than the pound.
Traders appear to view sterling more like the currency of a troubled emerging market than of a stable advanced economy. And now, with Johnson’s resignation and the attendant political uncertainty, sterling is poised to sink further.
Admittedly, such views are subject to exaggeration. Sterling is not alone in weakening against the dollar. A 10% fall against the greenback is no catastrophe.
But sterling’s decline is almost surely not over. Moreover, the pound is often an indicator of Britain’s economic problems. Four times in the last century, sterling crises have exposed the economy’s fault lines. The 1931 crisis took place against the backdrop of a crushing 21% unemployment rate. There was much discussion then of whether high unemployment reflected Britain’s poor productivity performance 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 couldn’t countenance higher interest rates to support sterling when chronic budget deficits and reports of a mutiny in the Atlantic Fleet created a crisis of confidence. Currency speculators knew it, so they pounced, driving the pound off the gold standard.
The crisis that erupted in 1949 embarrassed a British government that was seeking to restore sterling’s role as an international currency. The financial tripwire was the monumental overhang of sterling debt held by the country’s World War II allies, which the UK had sought to bottle up, unsuccessfully, with capital and exchange controls. The sterling these countries used to pay for Britain’s exports couldn’t be used to purchase goods from the United States, where British motor cars and other manufactured exports were uncompetitive.
Moreover, Britain was short of dollars. Once the possibility of devaluation was mooted, the BOE experienced an uncontrollable run on its reserves.
The 1967 crisis was embarrassing to Prime Minister Harold Wilson personally. Wilson worried that higher import prices would undermine his supporters’ living standards. Still, he couldn’t prevent it. This crisis, too, had multiple causes, from the Six-Day War to a UK dock strike.
But the fundamental problem, once again, was weak productivity growth, which was reflected in uncompetitive exports, a trade deficit, and unemployment. To stimulate demand and growth, Wilson’s Labour government cut interest rates and relaxed restrictions on borrowing for automobile purchases. This led, predictably, to further deterioration of the trade balance and another run on 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 that voters saw through the pretense.
The 1992 crisis, when sterling was driven out of the European Exchange Rate Mechanism, again occurred against the backdrop of poor UK productivity performance. Output per hour worked had fallen from 96% of German levels in the early 1970s to just 87% by 1992. Pegging sterling to the Deutsche Mark, Europe’s anchor currency, thus meant a cumulative loss of competitiveness. A weak US dollar and high German interest rates, which strengthened the Deutsche Mark, then further heightened the difficulty of maintaining the peg.
To defend sterling, the BOE might have raised interest rates. As in 1967, however, internal and external objectives were at odds. Higher interest rates would have meant more unemployment and required higher mortgage payments of the Conservative supporters of Prime Minister John Major. The BOE and Treasury caved in, and, with a push from George Soros, so did sterling.
This history offers a guide to understanding sterling’s current and future prospects. Fundamentally, Britain suffers from slow productivity growth. This malaise, though not new, has been unusually severe since 2008, and especially since 2016. It has multiple causes, from fractious labor relations and antiquated infrastructure to weak investment and shortages of suitably trained workers. It is now compounded by the frictions and inefficiencies brought about by Brexit.
To sustain demand for its output, the UK therefore 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 is being 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 sterling.
The BOE still could wrong-foot currency traders. It could raise interest rates faster than currently expected, tamping down inflation and supporting the currency, albeit at the cost of a recession. Anything is possible. But a century of UK history suggests that this scenario is unlikely.
Barry Eichengreen: Professor of Economics at the University of California, Berkeley, is a former senior policy adviser at the International Monetary Fund. He is the author of many books, including In Defense of Public Debt (Oxford University Press, 2021).