How Low Can We Go?

Good news and bad news are generated endlessly by the foreign exchange markets. Some currencies go up and some go down, and newspapers boo and cheer. Almost invariably, the tacit assumption of the headline writers is that a fall in the exchange rate is bad news. The pound’s fall since the EU membership referendum on June 23 is taken as a blot on Brexit, just as its tumble in 1992 after its expulsion from the European exchange rate mechanism (on so-called “Black Wednesday”, September 16) was seen long afterwards as a national humiliation.

In a recent pamphlet from the Civitas think tank about what they term The Real Sterling Crisis, Roger Bootle and John Mills turn the newspaper stereotype on its head. Their worry is that the pound has been too high in recent years. In their view the real crisis is not that the pound has fallen, but that it has not fallen enough. They want Britain to export more, in order to eliminate (or at any rate to reduce) the large balance-of-payments deficit that Britain is now running. This deficit totalled just above £100 billion in 2015 on the current account, equivalent to more than 5 per cent of national output.

Roger Bootle is well-known as the founder of Capital Economics and he writes an influential column for the Daily Telegraph. John Mills, a successful entrepreneur and long-time supporter of the Labour Party, has for decades been an advocate of devaluation as a means of boosting export competitiveness.

It may be a little unfair to say that Mills applies the Trotskyist notion of permanent revolution to economic policy. But to say that he believes in “permanent devaluation” does capture the flavour of his recipe. Is there any exchange rate that Bootle and Mills regard as too low? 

As long as Britain has a current account deficit on the balance of payments, their answers are “no” and “never”.  Any depreciation in the pound, no matter how large, is in their view to be greeted with enthusiasm. The risk here is that currency depreciation becomes self-reinforcing. The currency goes down, which drives up domestic inflation, which reduces the gain in competitiveness, which encourages policymakers to push the currency down again, which drives up domestic inflation once more, which again reduces the gain in competitiveness, which encourages policymakers to embark on more depreciation, and so on. The attempt to achieve export competitiveness results in ever-accelerating inflation.

Nations with permanently devaluing currencies (as with many Latin American republics) have also been nations with permanently high inflation. By contrast, nations committed to low growth of the quantity of money in order to maintain price stability — most conspicuously in the second half of the 20th century, Germany and Switzerland — reconciled almost unremitting currency appreciation with export dynamism. Bootle’s and Mills’s pamphlet ranges widely, with discussion of episodes as far apart as Britain’s departure from the gold standard in the 1930s, and Argentina’s and Iceland’s devaluations after macroeconomic traumas in 2002 and 2008 respectively. But their treatment of Germany is cursory and amounts to little more than a complaint about its balance-of-payment surplus.

In fact, the experience of Germany and the UK since the Great Financial Crisis makes a mockery of their entire argument. From July 2007 to December 2008 the international value of the pound fell by 30 per cent, and today it remains down by about the same amount relative to its mid-2007 level. By contrast, Germany’s currency, the euro, was worth more in December 2008 than it was in July 2007 and it is now only about 10 per cent off from its level then. Yet the UK has a big current account deficit, while Germany has a mammoth current account surplus of more than 8 per cent of national output. Indeed, Germany’s current account surplus has risen despite the relative stability of its currency, whereas the British current account deficit has expanded since the large devaluation of late 2007 and 2008. No mechanical relationship holds between currency movements and changes in nations’ current account balances.

The Bootle-Mills advocacy of permanent devaluation comes to much the same thing as the advocacy of an inflation rate in Britain that is always to run at a higher rate than in its European neighbours. Their policy approach was discredited in the 1970s when runaway money growth led to a plunge in the pound and the very real sterling crisis of summer 1976. If Britain is to make a success of Brexit, it should return to the policies seen in the first half of the Thatcher government, with the aim being stable growth of the quantity of money at a low, non-inflationary rate, supported by strong public finances, low taxes and light regulation.

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