Does the fall in the pound presage a financial meltdown?

The British pound is now at its lowest effective (i.e. trade-weighted) level ever, according the Bank of England’s 168 year index. There was a sharp initial fall after the referendum to leave the EU, and then a further fall over the last week after the prime minister’s conference speeches pointed toward a quicker and harder exit than expected. Is this just a routine fluctuation that can be shrugged off, as bigger falls have been in the past, or does it portend something nasty? It is, of course, too early to tell.

The pound’s fall has been seized on by supporters of Remain as the sole piece of substantive evidence to support their prediction that exit would make Britain worse off. Leavers are predictably unimpressed. Of course both sides seek to gather every scrap of evidence to justify the stand they took in the campaign, and this argument leaves us none the wiser. This blogger is not beyond such things, of course, but I do try to set a higher standard.

The first question posed by the depreciation is what was the pound doing so high before the referendum anyway. The country has a large current account deficit. In other words, as a nation we are spending more foreign currency in imports than we are getting in exports and investment income (or persuading foreigners to accept more sterling than they want to spend on British imports – it boils down to the same thing). In theory this suggests that the currency’s real exchange rate is too high. This has been a persistent and to me perplexing phenomenon since the late 1990s. Demand for sterling has remained high, notwithstanding the deficit. Investment by foreigners in property and business assets (or Britons selling off overseas assets and repatriating the proceeds) has kept the pound afloat for 20 years – though at a much higher level before the financial crisis of 2007-09.

This is, literally, a confidence trick. Investors have had sufficient confidence in the British economy to think that their assets will grow in value in terms of their home currency, rather than ours. It is hard to pin down why for sure. Britain is an easy place for foreigners to do business – we don’t have a xenophobic attitude to foreign investment, sometimes seen in countries as close as France. That encourages footloose capital in our direction. We have seen many takeovers of great British businesses (notably this year the chip designer ARM). Buoyant high-end property values have no doubt encouraged investors too, though it is hard to quantify.

Britain’s membership of the EU is doubtless part of the charm of Britain, for business investors at least. They can set up operations here with ready access to European markets, free of tariff and non-tariff barriers. Leaving the EU, and its single market, must surely dent the country’s attraction. But we don’t know by how much. It won’t change the ease with which foreigners can buy assets here. By itself it should not affect high-end property either.

There is, therefore, a clear case to keep calm. As sterling takes a fall, it makes British assets cheaper. This should be a compensation enough for British exit to the EU, though you might be wise to stay clear of some businesses, like motor manufacturing. A lower exchange rate should help rebalance the economy, reducing the current account deficit, and the country’s dependence on foreign investment flows. This is all self-correcting. And if you are a true Brexiteer you will be confident that a more efficient, better balanced economy will eventually emerge from any transitional wobbles. That may be right – I always thought that the hair-shirt case for Brexit, as I called it, was intellectually their most persuasive argument (referencing a post I made in March which stands the test of time). Could EU membership have caused that current account gap, or allowed it to persist, leaving us with an unbalanced economy?

There is a problem, though. Capital markets are not rational. Nobody really understands how they work, and they are at least as influenced by a complex game of second-guessing short-term movements as they are by cool, calm assessment of long-term prospects. They are prone to bubbles: excessive periods of confidence followed by excessive pessimism.

You can see this by the way market observers talk about movements in prices being persistent trends, rather than asking what the right price is. This is at its most striking in the property market, where price movements are talked as “performance” rather than finding an appropriate level. A long view investor might say that the pound has simply found a new and more appropriate level. A short view investor might suggest that the pound has been performing badly, so that further falls are to be expected. In the former case you have would expect the fall to be limited, in the latter the fall becomes a self-reinforcing trend. And the difference comes down to a not entirely rational quality: confidence.

Confidence is not a nice, mathematically well-behaved quantity. It is prone to behaving in a very non-linear way. It can disappear suddenly. Confidence in Greek government bonds used to be nearly as rock-solid as German ones. And then it disappeared. Could confidence in the pound, and then other British financial investments, like government and corporate bonds, disappear just as quickly? Could the 20 year bubble burst? It doesn’t have to be rational. If it does the wider consequences would be severe. Inflation could take off as the monetary floodgates are opened (by the government funding itself directly through the Bank of England); bank lending could simultaneously dry up causing a recession. Back to the 1970s in other words when, amongst other things, a massive rise in oil prices caused a rapid rebalancing. Is Brexit a similar shock? (even accepting, as with high oil prices in the 1970s, we end up in a better place).

It is hard to believe that things will turn out like this. There are some signs of vulnerability: property prices are high; the budget deficit remains high by historic standards, and so is the level of the national debt. There is little scope to restore financial markets by cutting interest rates. Gilt yields have been rising recently – suggesting that confidence in government finances is starting to fade. And yet the overall statistics do not suggest alarm – foreign exchange reserves, for example, look plentiful. But ultimately if the country has a current account deficit, and if foreign investors don’t want to finance it, there will be defaults or inflation or both.

As the FT’s Martin Wolf points out, a financial meltdown is not likely, but the risk of it has risen in the last week. The capital markets have given Britain an easy ride through its recent troubles, but that could change quickly. The government needs to be very careful about how it handles Brexit. Sovereignty in an interconnected world is always incomplete.