The writer, a former Permanent Secretary to the Treasury, is a Visiting Professor at King’s College London
The Bank of England’s interest rate hike last week gave sterling a temporary rebound. But the pound is still 10 percent weaker against the US dollar from its peak in January and 3 percent weaker against the euro.
Aside from the occasional shrug about the cost of a pint of lager in Marbella or a ticket to Disney World in Florida, Britons always seem deeply relaxed about devaluation. Why is that? And are they right?
The last hundred years of British history can be neatly divided into two periods. Until 1972 the exchange rate of the pound was generally fixed, first under the gold standard and then under the Bretton Woods system. Britain’s consumerism over investment and its chronic productivity problems meant that balance of payments difficulties cropped up at any given exchange rate.
Governments would resist devaluation in the pursuit of credibility, arguing that this time it was different. But sooner or later the dam would burst, with successive devaluations in 1931, 1949 and 1967. The devaluation was humiliating for the government and traumatizing for the electorate, who tended to punish the government accordingly.
British politicians did not cause the collapse of the Bretton Woods system in 1972, but they were major beneficiaries. The pound swam. Its value fluctuated. When the UK economy ran into trouble, the pound sterling fell. The British people were more tolerant of covert devaluation. The British State took due note of this.
It wasn’t until John Major tied sterling and himself to the mast of the European Exchange Rate Mechanism in 1990 that there was a brief return to the old days of fetishizing the exchange rate. But sterling did not stay the course. Major hit the eject button in 1992, and to this day governments have made a virtue of not having an exchange rate target.
From the politicians’ point of view, a devaluation of the pound sterling is the perfect political tool. It allows the economy to adjust after a period in which the country has been living beyond its means. I saw this first hand in the Treasury in the early 1990s and again after the financial crisis. We saw it again in the Brexit referendum. But it comes at a cost that may have increased over time.
First, the depreciation tended to benefit exporters and helped narrow the UK’s ongoing trade deficit, albeit briefly. However, there are signs that exports are less responsive to the recent devaluations, either because the service economy is behaving differently than the legacy industrial economy or because post-Brexit trade barriers are in place.
Second, a weak exchange rate increases the cost of living. In the summer of 2008, the price of oil in dollar terms was much higher than it is today. But because the pound has fallen 40 percent against the dollar, the price at the pump is about 50 percent higher than it was 15 years ago.
While the UK’s current rate of inflation has not yet moved away from that of the US or the Eurozone, there is reason to believe that inflation will remain higher than that of our peers for longer.
Labor markets are much more flexible than they were in the second half of the 20th century. That means we’re unlikely to see the structural unemployment of the 1930s or 1980s. But the downside is that in the absence of a strong union movement, workers’ real wages are likely to fall at potentially alarming rates.
There are other consequences too. Great Britain tends to save less than other industrialized nations. We therefore need foreign investors to buy our national debt. As former BoE Governor Mark Carney memorably put it, we rely on the kindness of strangers. But as friendly as these strangers are, they charge a premium to buy bonds in a depreciating currency. You don’t have to agree with Bank of America’s claim that sterling has become an emerging market currency to see that they may be on to something. In its March forecast, the Office for Fiscal Responsibility indicated that this year’s record debt interest bill would be a misstep. Debt rates would fall by £30bn next year as inflation eases. But with interest rates and inflation rising further and faster than expected, Finance Minister Rishi Sunak will fear the OBR’s autumn forecast.
With falling living standards and interest on debt eroding resources that should be better spent on the NHS and education, the British people may be starting to ponder the consequences of devaluation. Maybe it’s not a free lunch. Maybe it’s time to embrace sound money.