Sunny Uplands and Baloney Economics: whence the falling Pound?

The pound has hit a 2-year low and is the worst performing currency this year and there are still strong headwinds ahead for sterling, particularly if a No Deal Brexit ensues.

The circumstances facing the UK economy and the exchange rate remind me more about country risk scenarios that I faced for dodgy Emerging or Transition Economies, not a developed and mature economy such as the UK. 

All bar our more mature colleagues will have no memory of the dark days of the IMF led bailout of the UK in the 1960s. It’s worth therefore sketching out what the economic-cum-financial risks lie ahead if the “Sunny Uplands” scenario of Prime Minister Johnson starts to take shape, based on his statements and promises since his speech at the doors of 10 Downing Street.

The pound’s value in terms of other currencies is based several factors. Right now, the increasing risk of a “no deal” is scaring away demand for sterling and for sterling assets, thus pushing down the price or exchange rate in terms of other currencies – but the markets sense that there’ll still be a resolution or a further extension.

However, in the event of a “no deal” we will face a genuine currency crisis as investors pile out of sterling assets. These events tend to lead to an initial “overshooting” of the depreciation and we could easily see a further drop of 10, 15 or 20% – nobody really knows. With liberalised exchange rates there’s nothing to really hold back the initial loss of the pound’s value.

Ignoring the immediate hit for UK holiday makers facing a steep rise in the cost of holiday spending, what are the likely consequences for a no Deal as far as the pound is concerned?

  1. Impact on prices: a cheaper pound means higher imported prices for Britain, give-or-take a 1% hit on inflation means a 10% reduction of the pound against a basket of other currencies. Producer prices will rise because of imported energy and consumer prices will rise – putting an end to the recent rise in real wages (ie wages rising above inflation) and hitting the poorer particularly hard since the UK is a food importer and the consumption basket of poorer households has a higher proportion of their weekly spend allocated to food.
  2. Forget the trade impact of a cheaper pound: there is not huge evidence that the 2016 devaluation that followed the Brexit vote had a massive impact on improving trade competitiveness – which is what a competitive devaluation can potentially do. A no-deal Brexit would in effect create major obstacles to the operational Single Market for UK trade, even in the event of contingency agreements for the continued flow of medicines or food supplies. For integrated supply chains the cost of imported parts would rise even if that of UK produced bits might rise (assuming sudden tariffs don’t just kill the supply chains)
  3. Impact on Financial Markets: A cheaper pound makes sterling value of foreign earnings higher and this is the reason why the FTSE stock market is higher when the pound tanks. For a No Deal we will be in a completely unknown environment in the modern era and so expect a major rush for the doors by investors to dump UK assets and a commensurate initial sharp fall in the price of shares and other assets. Bond markets? The risk premium will rise on UK debt meaning higher cost of future Public Debt, in turn reducing the fiscal headroom for Boris’s promised goodies to farmers, the police et al.
  4. Limited wiggle room for Monetary Policy: the Bank of England’s firepower to soften the economic hit will be fairly limited. UK base interest rate is 0.75% and the Bank would likely reduce it to 0.25% or even 0% – and not raise rates (the standard response in the face of rising inflation). Strong but not comparable to the firepower of reducing interest rates by 5.25% to 0.5% following the Financial Crisis in 2007-09. As the “lender of last resort” the Bank can simply hand out oodles of cash or liquidity in case of potential bank runs (remember Northern Rock?). Lets ignore the “perfect storm” scenario the Bank has played out of ripple effects from an escalated trade war between between the EU and or China with the US.
  5. Housing Market: the great feeder of the UK consumer in terms of housing loans and equity releases for cars and holidays, expect a further collapse in demand coupled with increasingly illiquid and risk-averse lenders facing falling prices of security.
  6. Fiscal Policy: This will be the only recourse available to the Boris government. However, leaving aside the math of spending promises, the simple fact remains that budget deficits – and therefore public debt – will have to massively rise. Rising budget deficits and rising debt go hand-in-hand with further falls in the currency.

In short, the falling pound is the ‘canary in the coalmine’. We need to continue to ensure that Britain’s economic credibility is not shot to pieces as a direct consequence of a No Deal Brexit and to expose the immediate impact of Boris’ flaky economics.

In the next piece I’ll draw out the likely macro-fiscal picture.

* With experience across academia, think tanks, central banking, EU Accession and reforms across 40 developing and transition countries, Dr Rupinder Singh works with multilateral organisations and governments as an independent adviser.

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18 Comments

  • Two thoughts
    1. Currency any currency ( and that includes gold) is worth what people believe it is worth.
    2. We need more affordable housing both too rent and buy and if that means the landlords take a hit, good can’t come to soon.

  • Nigel Jones 2nd Aug '19 - 5:16pm

    I agree it’s good to see detailed analysis of what a no-deal Brexit means for living standards. No one spells this out to the public, though Rupinder’s language would need simplifying for the general public. People do not believe it when we simply say that a particular expert says the consequences will be bad. The Brecon by-election shows that very many people still do not believe that a no deal is bad.
    I also agree with Joseph that housing cost is a major factor in people’s living standards and must be one of a number of messages to show that we as a party are not simply focussed on Brexit.

  • Peter Martin 2nd Aug '19 - 9:32pm

    I’ve often made the point that the prevailing attitude in the UK is one “the higher the better” as regards the £’s value on the forex market. This article is a further illustration of that general view. Of course, we all like to have a high pound when we go off on an overseas holiday, but that’s of limited benefit if we return to find we’ve lost our job in a manufacturing industry which is no longer competitive in the international market.

    A high pound wouldn’t be so bad if there was a better general appreciation of the macroenonomics involved in doing that. For example, statements like:

    “the simple fact remains that budget deficits – and therefore public debt – will have to massively rise. Rising budget deficits and rising debt go hand-in-hand with further falls in the currency.”

    are quite wrong. Most of us have heard of the current account which, in the UK, is usually associated with the word ‘deficit’. There is also the capital account which has to be in surplus to balance it. If the pound is freely floating, the two have to balance naturally. If there is a tendency for imbalance the £’s value will change on the forex markets. If the Govt tries to fix the currency, the two won’t balance without Govt intervention. This can give rise to a “balance of payments” problem which we don’t have with a floating currency.

    Therefore, it is an influx of possibly “hot” overseas money leads both to increased levels of debt and a high pound. Not the other way around as is commonly supposed. No-one is just going to give us the money. They will want it back at some point. If no one wanted to put their money into the UK via our capital account, ie we had a balanced account, the current account would have to balance too. I’ts just arithmetic. The trade deficit would disappear. It has to. That may or may not be a good thing!

    There’s really nothing wrong with running a current account deficit if everyone knows and understands that this will almost certainly mean the Govt has to run a deficit in its spending too. Just to keep the economy topped up with enough money to function. The snag is, at this article shows, they don’t!

  • Steve Trevethan 3rd Aug '19 - 8:04am

    Thank you for an interesting and important article.
    People with lots of money have backed Brexit.
    As they have lots of money, it is reasonable to assume that they are money/finance savvy.
    Why are they backing Brexit?
    Who benefits?

  • Peter Martin 3rd Aug '19 - 12:48pm

    @ Rupinder,

    I must admit I can never remember my “whences” and “whithers” 🙂

    But to get it right:

    Whence means “from what place or source”

    Whither means “to what place or state”

    So if you’re speculating on where the pound is going shouldn’t your title be “whither the falling pound” ?

  • Good question, Steve, and nicely put. Could it be that the banks were bailed out after the calamity they helped to create ten years ago, and the poor made to pay for it with ten years of “Austerity”, and those with the savvy think Boris will work a repetition?

  • ‘Oh ye of little faith’…Following in the footsteps of his Moses tribute act (in dividing the waters at Whaley Bridge and saving the village), with nothing more than a positive attitude, Mr. Johnson has produced another £1.8 billion for the NHS.

    Soon the world will realise that, far from being a disaster, his no-deal Brexit will lead us to the sunny uplands of the promised land. The pound will rise, prices fall and the new opportunities of full employment will have happy workers singing the ‘Hi-Ho song’.

    BTW… My new medication seems to be working wonders.

  • Peter Hirst 4th Aug '19 - 4:20pm

    Like it or not, our economy cannot be ignored. We need to trade and the promise of self determination will seem like a dream if we are faced with increasing poverty, inequality and poorer public services. We need to continue our fight to acknowledge basic economic facts and show the delusion of a prosperous Brexit for what it is.

  • Peter Martin 4th Aug '19 - 6:29pm

    @ peter huggins

    “One economic phenomenon that never quite seems to work like the textbook is a drop in the exchange rate.”

    It works exactly as you’d expect it to. If the currency has a low value then it makes sense to export your wares, for higher prices, rather than sell them on the home market, at lower prices. It doesn’t make sense for exporters in other countries to sell their produce in a country with a cheap exchange rate. It doesn’t make sense to import expensive products when similar products are available for cheaper prices domestically. Exports will exceed imports.

    All the world’s big net exporters have policy on their exchange rate. They’ll peg it to another currency, Denmark for example, at a cheaper rate than the market would dictate. Germany uses the euro. If Germany had its own currency it would be a more expensive currency. Some countries, like Sweden and Singapore have a policy of a ‘managed’ exchange rate. Some oil producers export capital into a so called “sovereign wealth fund”. The purpose is primarily to export capital and keep the currency from rising too much.

    On the other hand, if the currency has a high value the opposite applies. Imports will exceed exports. Because most net exporters will manipulate their currencies downwards any country which lets its currency genuinely float will likely end up with a relatively high value currency and so will run a trade deficit.

  • Peter Martin 5th Aug '19 - 6:55am

    @ Peter Huggins,

    If you want to run a large export surplus then you have to have a currency which is priced lower on the forex markets than its free market value. So your ” other effect” of inflation isn’t really an “other effect” at all. If there is high inflation a currency will depreciate in value anyway. It doesn’t mean its below its free market value. Do you know of any large net exporter which genuinely lets its currency float?

    The “other effect” of loss of business confidence is connected to what business needs to feel confident about. The economic history of the UK doesn’t give manufacturers much confidence that the UK is a good place for them. On the other hand, the record of German govts is much more positive from their POV. It takes more than a single devaluation to change that.

    Erhard, and other Germans economists and politicians, are only right about what’s good for Germany. It’s the worse possible economy to have at the centre of the EU. It’s arithmetically impossible for everyone to have an export led economy. Keynes understood that and took a wider international view. He presented interesting suggestions to prevent German type mercantislism at the 1944 Breton Woods conference which were unfortunately vetoed by the Americans.

  • Peter Martin 5th Aug '19 - 10:41am

    @ Peter Huggins,

    You’re mistaken. The German economy is a black hole for euros. They go into it but don’t come out as they should. This leaves their trading partners short of euros to keep their economies functioning. They’re then forced to borrow them back putting them in violation of EU debt rules.

    As Wolfgang Munchau explains in this FT article:

    Through its dominance of the euro system, Germany is exporting ordoliberal ideology to the rest of the single currency bloc. It is hard to think of a doctrine that is more ill suited to a monetary union with such diverse legal traditions, political system and economic conditions than this one. And it is equally hard to see Germany ever giving up on this. As a result the economic costs of crisis resolution will be extremely large.

    https://www.ft.com/content/e257ed96-6b2c-11e4-be68-00144feabdc0

  • Peter Martin 6th Aug '19 - 8:37am

    @ Peter Huggins,

    Anyone with an interest in the EU, and the workings of the euro, would be well advised to take a look at how the dollar works in the USA. The EU is supposed to promote a sense of European solidarity but instead we have a lot of finger pointing at supposedly spendthrift, lazy Greeks and Italians who need “disciplining”, as you put it, by the more virtuous Nordic EU members.

    A intelligent child of six can understand that, if some countries are net exporters, we need net importers to balance things up. Penny for penny. So the Germans should be thanking all of us who make their net exports possible!

    In the USA, a.k.a. the dollar common currency union, we have the richer states like California, NY State, and New Jersey. They correspond to Germany and Holland in the EU. We have the poorer states like Louisiana and Mississippi. They are Greece and Italy.
    The way it works is that Louisiana and Mississippi are net beneficiaries. California etc are the net contributors. There’s no point in lending the money. It won’t ever be repaid because it can’t be repaid. It has to be a financial transfer.

    Of course no single individual is going to do that voluntarily. That’s an infantile argument. The Federal Govt makes it happen. Anyone refusing to pay taxes can be jailed. That’s how it is done.

    You might argue that the USA is a single country whereas the EU isn’t. But that’s to miss the point. The creation of a single currency, the euro, does, in effect, create the same conditions as a single country. No doubt that’s why it was introduced in the first place. The problem is that the Germans don’t seem to understand that.

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