The writer, a former permanent secretary to the Treasury, is a visiting professor at King’s College London
Last week’s interest rate rise by the Bank of England has provided some temporary respite to sterling. But the pound is still 10 per cent weaker against the US dollar compared with its January peak, and 3 per cent weaker against the euro.
Apart from the occasional shrug about the cost of a pint of lager in Marbella or an entry ticket to Disney World in Florida, the British people always seem profoundly relaxed about devaluation. Why is this the case? And are they right?
The past hundred years of British history divides neatly into two periods. Until 1972, the pound’s exchange rate was generally fixed, first under the gold standard and then under the Bretton Woods system. Britain’s addiction to consumption over investment and its chronic productivity problems meant that balance of payment difficulties tended to emerge for any given exchange rate.
Governments would resist devaluation in 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. Devaluation was humiliating for the government and traumatising for the electorate, who tended to punish the government accordingly.
British politicians did not cause the break-up of the Bretton Woods system in 1972, but they were major beneficiaries. The pound floated. Its value gyrated. When the British economy encountered problems, sterling would fall. The British people were more tolerant of devaluation by stealth. The British state duly took note.
Only when John Major tied sterling and himself to the mast of the European exchange rate mechanism in 1990 was there a brief reversion to the old days of making a fetish of the exchange rate. But sterling did not stay the course. Major pushed the ejector 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 downward drift in sterling is the perfect policy instrument. It allows the economy to adjust after a period when the country has been living beyond its means. I saw this at first hand in the Treasury in the early 1990s and again after the financial crisis. We saw it again with the Brexit referendum. But it carries a cost and one which has potentially increased over time.
First, devaluation tended to benefit exporters, helping to reduce, albeit briefly, Britain’s persistent trade deficit. However, there are signs that exports have become less responsive to recent devaluations either because the service economy behaves differently from the old industrial economy, or because of post-Brexit trade barriers.
Second, a weak exchange rate increases the cost of living. Back in the summer of 2008 the oil price was much higher in dollar terms than it is now. But because the pound has fallen by 40 per cent against the dollar, the price at the pumps is approximately 50 per cent higher than it was 14 years ago.
Although the UK’s current inflation rate has not yet diverged from that of the US or the eurozone, there are grounds for thinking that inflation will remain higher for longer than that of our competitors.
Labour markets are much more flexible than they were in the latter half of the 20th century. That means we are unlikely to witness the structural unemployment of the 1930s or the 1980s. But the flip side is that in the absence of a strong trades union movement, real wages of those working are likely to fall at potentially alarming rates.
There are other consequences, too. Britain tends to save less than other industrialised nations. We therefore need foreign investors to buy our public debt. As former BoE governor Mark Carney memorably put it, we rely on the kindness of strangers. But however kind those strangers are, they require a premium to buy bonds in a depreciating currency. You don’t have to agree with the Bank of America’s claim that sterling has become an emerging market currency to recognise they may be on to something. In its March forecast, the Office for Budget Responsibility suggested this year’s record debt interest bill would be an aberration. Debt interest would fall back by £30bn next year as inflation receded. But with interest rates and inflation rising further and faster than expected, chancellor of the exchequer Rishi Sunak will be dreading the OBR’s autumn forecast.
Faced with a drop in living standards, and debt interest eating into resources better spent on the NHS and education, the British people may begin to reflect on the consequences of devaluation. Maybe it’s not a free lunch. Maybe it’s time to embrace sound money.