Still selling England by the Pound
25 January 2013
About two years ago, as a member of the Monetary Policy Committee, I used the title of the classic 1970s Genesis album “Selling England by the Pound” to draw attention to the way in which the weakness of sterling was pushing up our inflation rate.
Between mid-2007 and early 2009, sterling depreciated by over 25% - the biggest fall in its external value over a short period of time since we left the Gold Standard in 1931.
The pound remained weak through 2010 and 2011, and then recovered somewhat in 2012. This modest rise in our currency helped to reinforce the decline in the inflation rate we saw over the course of last year. But sterling is now falling again – and there is a danger that this renewed decline in the pound continues and pushes inflation higher this year.
Why has sterling weakened recently? Three main factors appear to be at work. First, as the euro crisis took hold in late 2011 and 2012, sterling benefited from a “safe haven” effect – attracting short-term flows of finance looking for a more stable home outside the euro area. With signs that the euro situation may be stabilising, these “safe haven” currency flows are reversing – with the pound falling below €1.20 last week for the first time since last March.
Second, the UK has seen weak growth and relatively high inflation economy over the recovery so far. This contributes to the view in financial markets that we are likely to see a similar pattern in the future – and that UK economic fundamentals are not very healthy.
Third, and most crucially, a weak pound appears to be an important ingredient of official economic policy. Government ministers, including the Chancellor, have talked of rebalancing the economy and emphasised the role of a competitive currency in achieving this. The Governor of the Bank of England has argued along the same lines. In his major speech earlier this week, he argued that the 25% fall in the value of the pound was “certainly necessary for a full rebalancing of our economy”.
Unfortunately, this is a flawed policy. The thinking behind it is that a competitive pound will spur exporters into action and pave the way for an export-led recovery. But exporters in a mature industrialised economy like the UK do not respond to short-term currency movements in this way.
British exports are also not highly price-sensitive. Within manufacturing, our main exports are high value-added products which sell on the basis of quality and technology. Services exports – with the possible exception of tourism – also rely mainly on the professionalism, high quality and new ideas which UK firms can offer relative to their major competitors.
Exporters need much stronger long-term reasons than a temporary price advantage to expand into new export markets. They need the confidence that there will be a sustainable demand for their products and services which will underpin profitable growth.
In addition, the experience of UK exporters from the past has been that currency depreciations can be quickly reversed. The depreciation of sterling in 1992/3 following the UK’s exit from the ERM was wiped out 4 years later when the pound appreciated again in 1996/7.
So it is not surprising that the much hoped-for export-led growth has not materialised. However, what we have seen very clearly in response to a weakened pound has been a prolonged period of high inflation. Over the past five years, UK inflation has averaged around 3.5% compared to the 2% target. The excess inflation of 1.5% per year has been a severe drag on consumer spending and growth in the UK economy.
If we are to avoid a continuation of this consumer squeeze, the UK government and the Bank of England should stop talking down sterling and avoid actions – like repeated rounds of QE – which weaken our currency on the foreign exchanges. We should recognise that a strong currency and a strong economy generally go hand in hand. Previous attempts by the UK to devalue our way out of economic problems – starting in 1967 and continuing through the 1970s and into the 1980s – did not work.
In his speech earlier this week welcoming the depreciation of the pound, Mervyn King also noted that “currency wars” - in which countries seek to out-devalue each other - are a recipe for economic turmoil and conflict. He is right on that point. What we now need to do is apply this insight to our own currency. A stronger pound could have many benefits for the UK economy – easing the upward pressure on inflation and supporting the growth of consumer spending. So we should stop “Selling England by the Pound”.