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.


5 thoughts on “Does the fall in the pound presage a financial meltdown?”

  1. Matthew,

    For once we seem to be in reasonable agreement. There is no need to panic. There is a good case, as you say, to be made that the pound has been too high in the last 20 years or so and unfortunately we have got much too used to that.

    In our economy we can have low deficits, full employment and a high pound. But we can’t have all three simultaneously. Our problem of the last decade is to think we can. Hardly anyone, and certainly no prominent politician, dared say that if we want to have lower deficits (both govt and trade) without having a depressed economy then the pound needs to be much lower in value.

    That seems now to be happening anyway and there’ll be benefits as well as costs. For example, UK steel making may well become economically viable once more as imported steel becomes more expensive.

  2. “The British pound is now at its lowest effective (i.e. trade-weighted) level ever, according the Bank of England’s 168 year index.”

    OK but just what does this mean exactly? How do we weight the value of the pound by trade? The UK’s Current Account Deficit is still substantial. A high pound will make imports cheaper and more affordable. It will make our exports more expensive and less affordable.

    It will be the other way around for a lower pound. We’d have a current account surplus. So there must be a value of the £, which we could define as £o , at which imports and exports exactly balance. It’s perhaps too early to tell for sure, but I would expect that the value of the pound at US$1.22 is still higher than £o.

    There must have been sometime in the last 168 years when it has been less.

    1. Yes there is a touch of sensationalism about my line. The graph that went with it in the FT showed that the recent fall wasn’t all that dramatic, looking at that 168 year history. It is roughly back at the level it was following the 2008 crash – which is the sort of level I always thought it should be before joining the Euro.

      I don’t know what the Bank’s methodology is. But the idea of the level being lower than at any time in 168 years I think is reflected in the USD to the pound – which used to 5. We might well ask what it actually means. Partly it must be trends in relative productivity, but presumably there are relative inflation effects in there too. But if the developing world is in the process of catch-up, you would expect developed world currencies to depreciate. That reflects a reversal of gains from trade… which is a whole other story!

  3. 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.

    Well yes. It is also worth mentioning that these “foreign investment flows” (although I’m not sure if they really are investments. Maybe more just money parking?) means that any reduction leads to the government’s deficit falling too. It’s back to the sectoral balances again.

    If and when this happens, no doubt the government will make the most of this too.

    1. Actually I think Britain has been quite successful in attracting genuine investment. as we are learning from the rise of the FTSE whenever the £ falls, most portfolio investment in british shares supports foreign investment rather than domestic. Where you put people buying into property developments is another matter.

      As you know, I am wary of drawing conclusions based on sectoral analysis as there are always alternative ways to skin the cat, and it matters very much exactly how rebalancing happens. Reducing the trade deficit won’t necessarily reduce the budget deficit; it might simply rebalance the private sector.

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