Devaluation?. Blessing or Curse?

In my Money Week column this week, I've been examing the devaluation of sterling. Lots of people seem to think that is part of policy mix that will eventually lead to the recovery of the UK economy. I diagree, as I explain in this piece.

How low can the pound sink?
At the start of this decade, a pound bought 1.70 euros. At the start of this week, it would buy only 1.08. Parity with the euro, an outcome that would have looked unimaginable when the single currency was launched, now looks inevitable at some point in the next few months.
Right now, British economic policy is to welcome that. The government looks on with benign neglect. The Governor of the Bank of England, Mervyn King, even appears to be talking the currency down. Devaluation is seen as part of the policy mix, along with printing money, that will eventually lead to recovery.
That is playing with fire – and it is the UK economy that is likely to be burned. In reality, it is a sterling crisis that remains the most likely catalyst for turning a nasty recession into a full-blown crisis. The benefits of devaluation have been massively over-sold. And if confidence in sterling collapses completely, as it well might, then the government and the Bank will have no choice but to step in and defend the currency with interest rate hikes that will plunge the economy into depression.
The markets have certainly latched onto sterling as the new whipping boy of the trading floors. Its weakness against the dollar has been masked, to a degree, by the fragility of the American currency, but it is against the euro, the currency in which most of Britain’s trade is carried out, that reveals how friendless sterling has become. It has been falling steadily against the single currency for most of this year. After recovering slightly from the all-time low of 1.02 at the height of the financial crisis, it has resumed its decline. Parity with the euro now looks a certain bet.
In many ways, that is a rational response to the dismal economic outlook the UK now faces. Whilst France and Germany were badly hit by the crisis, their economies are starting to recover. Their public sector deficits, while serious, are nothing like as bad as the UK’s. Their economies weren’t anything like so dependent on the bubbles in property and financial service. And the European Central Bank has proved a far sturdier defender of monetary stability than the Bank of England. It is little surprise that investors are selling sterling.
More surprising is the tacit encouragement from the Bank of England. In a newspaper interview last week, King described the fall in the value of the pound as ‘helpful’. Not surprisingly, currency traders, who still fret about the cost of finding themselves on the wrong side of a fight with a central bank, took note, and gave the pound another shove downwards.
In fairness, King was only expressing the mainstream view among policy-makers and the economic establishment. A cheaper pound, so it is said, will revive manufacturing and kick-start a more general rebalancing of the British economy.
That is nonsense – and dangerous nonsense as well.
Comparisons are regularly made with the early 1990s, when Britain’s humiliating ejection from the European exchange-rate mechanism, and the big fall in the pound that followed, helped trigger the long upswing of the 1990s.
But the comparison is bonkers. The pound then had been fixed at too high a rate against the German deutschemark. The UK had a structurally reformed economy held back by an over-valued currency. That certainly isn’t true now. There is no reason to suppose the pound was over-valued a year ago. And as for the fundamentals of our economy, let’s not even go there. This looks much more like an old-fashioned sterling collapse, of the sort the UK witnessed repeatedly throughout the 1960s and the 1970s. And they never heralded any sort of revival – they were part of the problem.
To imagine that a developed, service based economy such as the UK can devalue its way out of trouble is nonsensical. Britain is barely a manufacturing economy anymore, and certainly not one that can compete with Eastern European or Asian factories on price. It is an exporter of high-value, intellectual property: financial services, insurance, legal advice, media and science. What manufactured goods it does export are high-tech and design-intensive. They aren’t being sold on price: if they were, there wouldn’t be any orders at all. All you do when you devalue the currency is reduce the income of those sectors to the extent they price their work in sterling. That makes the country poorer, not richer. Too imagine that Britain is suddenly going to become a low-cost manufacturing centre implies a savage reduction in living standards – and that presumably isn’t what the advocates of devaluation want.
In the meantime, the government and the Bank of England should be keeping a far closer eye on sterling. If there is a serious collapse of confidence in the UK, and if the International Monetary Fund does have to bail the country out, it will be the currency markets that pull the trigger.
Britain is critically depended on foreign capital. It is running a trade deficit of £6.5 billion a month, close to record levels. There is no sign of it closing despite the massive fall in the value of the pound.
Worse, the UK is critically dependent on foreigners to finance its yawning budget deficit. Savings are so low that there is no way the British can buy £200 billion of government debt a year – even before the crisis, foreigners accounted for a third of all gilt sales. Whilst the Bank buys up gilts with freshly minted money, that might not matter. When it stops, as it must soon, then there won’t be many buyers for all the debt in a depreciating currency.
The big risk remains a sudden collapse of confidence in sterling. If that happens, the Bank would have to hike interest rates sharply to defend the currency. And the government would have to slash spending immediately to restore faith in the markets. Either would turn a recession into a full-blown depression. Both together would be a catastrophe.
In truth, talk of a lower pound being part of the solution is fanciful. Just like printing money, it is part of a strategy of debauching the currency. It is part of the problem – and if it gets out of hand, could yet provoke a real crisis.