We're facing a financial death spiral

The recent depreciation of the pound is the latest in a long line of traumatic incidents for successive UK governments. British politicians were repeatedly confronted with the terrible threat of currency depreciation during the postwar era of 'fixed but changeable' exchange rates.

The recent depreciation of the pound is the latest in a long line of traumatic incidents for successive UK governments. British politicians were repeatedly confronted with the terrible threat of currency depreciation during the postwar era of "fixed but changeable" exchange rates. Poor underlying competitiveness resulted in large trade deficits for consecutive administrations. Devaluation was one "fix," a process that made exports cheaper for overseas purchasers while making imports more expensive for British consumers. However, devaluation felt like a national shame. Governments tried to avoid it whenever possible. The 1956 Suez Crisis became a major issue because the Americans, who were unimpressed with Britain's colonial ambitions, threatened to withhold the financial backing needed to keep the pound from falling.

When sterling finally succumbed eleven years later, Prime Minister Harold Wilson attempted to persuade the British public that the 14% drop "doesn't mean... that the pound here in Britain, in your pocket or purse or in your bank, has been devalued," possibly one of the most blundering statements ever made by a politician. The Conservative government was rocked when Sterling exited the European Exchange Rate Mechanism in 1992. Its previous reputation for economic competence was completely shattered, which aided the election of New Labour in 1997.

Recently, sterling has been sitting on the sidelines, floating around indifferently against other currencies. What occurs with inflation, rather than what happens on the currency markets, is the current test of economic performance.

Inflation has become a major issue after decades of excellent behavior. Something is clearly wrong when the Bank of England predicts double-digit growth later this year, despite the economy momentarily contracting. Of course, it's extremely easy to claim that the UK's problems are global in scope. What matters in currency markets is not how awful things are at home, but how bad they are in comparison to what's going on abroad.

Given that global inflation has been rising, it's easy to imagine that currency "vigilantes" — bond market investors who can "punish" governments that exhibit evidence of financial misbehavior — will just shrug and look for easier prey elsewhere.

Nonetheless, they have become hooked on sterling, thinking it to be one of the most susceptible currencies in the international herd. The pound has started to tumble at an alarming rate against the US currency. Sterling was worth $1.35 at the beginning of the year. It was worth less than $1.24 at the end of last week.

One argument for the abrupt drop in value is that Russia's invasion of Ukraine poses a far greater threat to European economies than it does to American economies. However, in recent days, pound has began to lose ground against the euro. The influence of Brexit is another explanation. Sterling has been both weak and powerful since the 2016 referendum.

Alternatively, the vigilantes may simply refuse to believe what the British authorities want us to think. While the Federal Reserve in the United States has dropped all references to "transitory" inflation and has become increasingly vocal about the need for more monetary tightening, the Bank of England has remained more blasé, insisting that inflation will eventually fall below its 2% target in response to only minor interest rate increases.

Perhaps the Federal Reserve is incorrect. However, for the time being, this will not assist sterling. More of the world's inflation is "imported" into the UK when the pound falls in response to the Bank's perceived complacency. That's what happened in the mid-1970s, when the authorities determined, like they do now, that inflation wasn't a long-term threat. The vigilantes of the 1970s forced a reassessment by selling sterling. A rapidly declining currency fueled domestic inflation, leading to more currency weakening. It was a financial "doomsday circle." Could something similar happen today? Hopefully not, but if vigilantes have their way, the Bank of England may be compelled to admit that history does repeat itself from time to time.

=====

Related Video:

Follow us on Google News

Filed under

Recent Search