The sterling exchange rate has been intimately linked with the most dramatic turns in British politics for many decades, including the fall of several prime ministers. In his classic 1997 history Politics and the Pound, Philip Stephens concluded that “the pound has haunted British politicians for most of this century”.
The value of sterling is so central to national events that it even plays a role in Netflix’s new series of The Crown, where Harold Wilson is shown as a prime minister desperate to secure US financial support to prop up the currency in the mid-1960s. He didn’t succeed, and sterling was devalued in 1967. The outcome was seen as a major national humiliation, the economic equivalent of Suez.
Since then, there have been further notable occasions when sterling has fallen by 15 per cent or more in 12 months: the IMF crisis in 1976, the UK’s ejection from the Exchange Rate Mechanism in 1992, the financial crash in 2008 and the EU referendum in 2016.
Not all of these qualify as a “crisis”. In fact, the sterling collapses in 2008 and 2016 were clearly condoned by the Bank of England because they helped to ease monetary conditions following severe shocks to economic confidence.
Nevertheless, memories of earlier sterling crises (see box below), when monetary and fiscal policy had to be sharply tightened to end a run on the pound, strike dread into the hearts of British politicians and investors alike.
John Llewellyn and Russell Jones at Llewellyn Consulting released a note last week suggesting that some of the ingredients of a new sterling crisis may be coming into view. They point out that currency collapses have often been preceded by periods in which countries have experienced deficits in the current account of the balance of payments (broadly the difference between imports and exports), and/or the government deficit (again, broadly the difference between taxes and spending), exceeding 4 per cent of gross domestic product.
The central idea behind this “rule of four” is that a current account deficit will drive the currency down, unless fully offset by private capital inflows. The risk is greater if this deficit is accompanied by a government deficit that might eventually be monetised by the central bank, causing a rise in inflation.
Post-election Britain will not emerge well on these criteria.
The UK’s 2019 balance of payments deficit is running above 5 per cent of GDP, the highest among the major advanced economies, and it still seems to be on a deteriorating long-term path.
Furthermore, the current UK election campaign has turned into an extreme bidding war between the main parties on extra public spending. Previous fiscal rules have been entirely abandoned.
If these spending promises are kept, especially those for extra public investment that is not funded by tax increases, the government deficit is headed to 3 per cent of GDP. This will happen even under the Tories, and even in a good economic environment. But in any downturn for the economy, the deficit would substantially exceed the 4 per cent threshold and, in the unlikely event of a Labour majority, the deficit would be much higher.
The key question, though, is whether the twin deficits will, this time, cause an implosion in confidence in the pound. I think it is unlikely.
Currency crises have almost entirely disappeared from the major advanced economies in recent decades — the last such crisis — in Sweden and Finland — occurred a quarter of a century ago, in 1993.
The main reason for this change is that the credibility of the inflation targets of the major central banks in the advanced economies has enormously improved. This means that high and rising government deficits are not expected to result in rising inflation, even if they cause widening current account imbalances.
Instead, they now lead to tighter monetary policy, which holds inflation in check, and attracts capital inflows that finance the balance of payments problem. The self-feeding loop in which twin deficits caused a collapsing exchange rate, higher inflation and a further drop in the currency is no longer likely to happen. Confidence is much more robust and speculative outflows of short-term capital appear more contained. The twin deficits are financed more securely than before.
There is one more factor that reduces the likelihood of a sterling crisis in the current environment. Following the large drop in the currency immediately after the referendum in 2016, the pound has continued to trade about 20 per cent below its fundamental equilibrium levels, according to Fulcrum’s exchange rate valuation models. This cheapness makes it less vulnerable to a sudden crisis, even in a bad scenario for the twin deficits.
To the extent that a decline in sterling may be needed to reflect Brexit and the twin deficits, it may already have happened.
Sterling’s effective exchange rate has fallen steadily since the early 1960s, with sudden drops of around 15 or more per cent occurring on at least five separate occasions.
Several of these (in 1967, 1976 and 1992) can be characterised as sterling “crises” that necessitated a tightening in macroeconomic policy and resulted in a slowdown or recession in the economy. Other episodes (in 2008 and 2016) resulted from a deliberate easing in monetary policy, and therefore cannot be characterised as full-blown currency crises.
The “twin deficits” in the balance of payments and the government budget have sometimes given warning signals that sterling would come under market pressure. If expansionary fiscal plans are implemented, the twin deficits will rise to worrying levels after the election.