Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 11 August 2016

Brexit harm denial and the exchange rate

There seems at the moment some confusion in the Brexit camp: is all the bad news just wishful imagination by Remainers, or is it real but caused by Remainers. Some specific thoughts on the extraordinary Telegraph editorial are here, but one event that was not in anyone’s imagination was the depreciation in sterling as the result became known. Brexiters tend to think markets know what they are doing, so they have resorted to all kinds of arguments why this depreciation was not really bad news.

First, the reason why it is bad news. A depreciation in sterling makes everyone in the UK poorer, because the goods we buy that are made overseas or sold in world markets (oil) will cost more. That this depreciation happened as a result of the vote is beyond dispute. So what do Leave apologists have to say in response? So far I have heard the following.

The depreciation has a good side, because it gives a boost to our exporters.

Economists say never reason from a price change, but instead ask why prices have changed. There are two possible reasons why sterling may have depreciated immediately the vote was announced. The first is that markets think UK exporters need to become more competitive in the longer term to offset the impact of Brexit, because Brexit will make it harder to export to the EU. In short, we are poorer because of Brexit.

Now it is true that markets are anticipating a future event (Brexit has not happened yet), so in theory there will be a short term boost to exports as firms benefit from the depreciation now, but the costs of Brexit come later. But that brings us to the second reason for a depreciation: markets believe Brexit will cause an economic downturn in the UK, implying lower levels of UK interest rates. (In this they have been proved correct). The fact that they were expecting lower interest rates even though exporters get a short term boost tells you that this boost is at best just going to make things a bit less bad than they might otherwise be.

Either way, any short term benefits from the depreciation do not offset the fact that we are all poorer as a result.

Sterling was overvalued anyway

This is an argument put forward by Daniel Hannan. The idea is that a depreciation was going to happen anyway. It is an argument that makes no sense. Suppose you think the price of coffee is too low because markets have underestimated future demand from the US. An unexpected blight then wipes out half the coffee trees in Latin America, and the price shoots up. It is ludicrous to then say no problem, the price was too low anyway. The markets are still underestimating future demand from the US, and when they realise this the price will rise further still.

Sterling is only back to where it was ….

Imagine your earnings vary from month to month because of bonuses. Your boss cuts your basic pay, and tells you not to worry because when you add in the average bonus it is still going to be higher than when bonuses were really low. If you think that actually means your pay has not been cut, then you will be convinced by this argument.

It is just a temporary problem before things become clearer

This argument might just work, but only if you admit things that Leavers tend not to admit. First, it seems reasonable to assume that the short term economic downturn is because firms do not yet know what kind of Brexit we will get, and are putting things on hold until they do. Putting things on hold causes the Brexit Bust, which means the Bank cuts rates, which depreciates sterling. Now move forward to the date where things become clearer, and suppose the outcome is much better for trade than it might have been. (Basically we stay in the single market and accept free movement of labour.) The economy then recovers, interest rates rise, and sterling appreciates. If that happens (and it is a big if), all we need to do is ask who was responsible for all this uncertainty and the temporary damage it caused.   


  1. Arguments about minor points.

    Please accept you exaggerated the effects of Brexit.

  2. Brexit harm denial, the exchange rate and the UK balance of payments would have been a better article, imho.

  3. To think about whether the net effect of the devaluation is positive it is best to think outside neo-classical economics (which tends to put too much emphasis on Mundell ISLMBP types of reasoning). Such theories are particularly limited in value for the UK. The better way to think about this is in terms of the Marshall-Lerner Condition (explained in wikipedia).

    I AGREE with your conclusion: the net effect on a major importer like the UK which cannot find domestic substitutes for vital goods it imports will be negative. This will outweigh the positive competitiveness effects on exports from exchange rate depreciation. And the net effect will be especially negative, I believe, over the long term.


  4. UK had a current account deficit or not?
    As Daniel Hannan said UK had to devalue £ to restrict this deficit, and (re)start producing things that now are a bit more expensive to buy abroad, like german cars.
    This incidentally will create new jobs in UK, which seems to be a proble for labour party, if Leave will result in more quality jobs for UK residents..

    1. The UK had a current account deficit, the effect will not be that we restart producing things that are sourced oversees, the effect will be we pay more or do not purchase said things.

      If you were investing in productive capacity as a business, would you choose the UK whose external trades agreements are now in doubt until the exit from the EU is complete? The answer is NO. You would expect external investment in UK productive capacity to decrease dramatically during the uncertain period and for some UK invest to move aboard.

      Maybe exporters will use the fall in the pound to increase profit margin (no cost) as opposed to reduce prices (and profits) and increase productive capacity. I'm pretty certain the higher profit route has taken precedence after the 2007 depreciation.

      So Mr Hannan may make an argument as to the benefits of devaluation, but they may well be hollow claims.

  5. But after Black Wednesday (ermexit, devaluation) economists said much the same - that it was a disaster - but somehow, it wasn't. Or was it?

    1. It was a completely different situation. Before Black Wednesday we had a recession induced by trying to stay in the ERM at an overvalued exchange rate. I argued this at the time, and also that Black Wednesday would lead to a strong recovery - it did.

    2. After Black Wednesday, it wasn't the lower exchange rates that stimulated demand to lead a strong recovery, it was a forced restructuring of the economy from the recession which led recovery.
      The Exchange rate crisis was simply a big crisis that helped make radical structural change sufficiently palatable to the public. The recession forced uneconomic manufacturing, mining and other unionised jobs out of the economy, and then financial degregulation invented a new industry of financial jobs that has powered the service economy for 30 years.

      Lower exchange rates had little to do with recovery and didn't significantly increase demand - Deregulation was a 'new' industry developed and expanded which created new profitable jobs, to drive the economy recovery irrespective of exchange rates - which gradually rose with the strengthening economy.

  6. 'If nothing else works, a total pig-headed unwillingness to look facts in the face will see us through.' Behind every joke there is an underlying truth.

  7. Wow, I always took the economist smearing with a pinch of salt, but this is really simplistic analysis.

  8. Devil's advocate here. Even if a weaker pound does only partially offset the Brexit-induced slowdown, the quality of growth be more sustainable and hence desirable.

    The reason is that many economists are fond of saying that the UK needs to rebalance away from consumption towards exports, and a weaker pound will aid that process. Arguably we need this sooner rather than later, as the current account deficit has ballooned in recent years and that means we are losing wealth to the rest of the world at a faster rate.


  9. All of your argument, Simon, is based on a single flawed ideological position: that you are right about the EU (both politically and economically) and the Leave side are wrong. But suppose you are the one that is wrong. I have outlined my reasoning why I think you are in these posts.

    Suppose that in the long run the UK is better off leaving the EU now because if it remains inside then the damage the EU will wreak will get larger and larger, and the pain of leaving at some later date will get greater and greater. No reasonable person ever thought that leaving would be easy or painless, but like visiting the dentist it is always better to get corrective treatment done earlier rather than later. Using current market volatility to try and claim that this means you were right is therefore a poor line of reasoning. The markets were always going to over-react particularly given their woeful failure to predict the outcome of the referendum, and there was always going to be some short-term (up to 5 years) pain due to the Brexit process.

    As for the recent exchange rate fall, I would suggest it is even more real than you suggest as capital markets rarely succumb to speculation for long. But that does not mean it will be permanent. If the exchange rate has changed it is likely to be because either capital inflows have reduced or outflows have increased. As this is unlikely to be due to changes in trade volumes in the last few weeks, I suggest it is more likely to be because less money is being sucked into the UK financial sector and property market (a theory that is supported by recent falls in equity prices in the property and construction sectors) or speculative foreign capital is leaving the country. In which case Daniel Hannan is probably right (for once) to claim that sterling was overvalued, particularly given our balance of trade problem, as the previous high exchange rate was clearly a product of asset price inflation and not economic output.

    1. "No reasonable person ever thought that leaving would be easy or painless." The very issue of SWL is exactly on the claim that leaving would be painless, AND that these persons were not reasonable.

    2. "All of your argument, Simon, is based on a single flawed ideological position: that you are right about the EU (both politically and economically) and the Leave side are wrong."

      You believe this because it is how you do your analysis: you take your preconceptions ("Leave is correct") and then try to build a case for it.

      On the other hand, the author works the other way around, from the evidence to the conclusions. It is why you find so few economists who are taking your position, and why you find that the ones who are tend to be the ones who have been so provably wrong about so many things in the past.

    3. So arguing against Brexit on pre Brexit known macro is 'a single flawed ideological position' but arguing with supposition about alledged EU wrecking is not ?

      Ludovic Coval

  10. On the subject of the exchange rate I would also make this point. There seems to me to be direct correlation between government borrowing from the overseas bond market and our current account deficit. The amounts are remarkably comparable though not necessarily correlated, and so it is not unreasonable to think that the former drives the latter. Given that borrowing from overseas artificially raises our exchange rate because it sucks in foreign currency (otherwise euphemistically referred to as inward investment LOL), I would suggest that our exchange rate has been too high for far too long partly as a result of excessive government debt financing of the wrong type, particularly during the pre-2007 boom. Of course a policy of MMT where governments were prohibited from using the bond market for debt financing would probably solve all these problems and allow our currency to trade at its true rate.

    So Simon, you may be right to equate our wealth (or more accurately our spending power) to our exchange rate, but if that is true then given our persistent borrowing from overseas since 1985 we have clearly been using debt to artificially boost our spending power for most of that time. Sooner or later that has to stop. It could also be argued that the benefit of this debt created high exchange rate (i.e. greater overseas spending power) is more than offset by a counteracting loss of spending power arising from the interest payments we need to pay to the very overseas investors who finance our debt.

    In short, your fixation on the exchange rate without considering the other detrimental factors that produce that inflated exchange rate does seem somewhat short-sighted economically. UK citizens may be worse off in the short term with a lower exchange rate but they could be better off in the longer term if it leads to, or was the consequence of, a more sustainable economic policy (like MMT).

    1. However Simon might support leave, his arguments all come from a neutral stance, they are basic economic facts. It is actually your argumentation that is problematic. Just because you politically think EU is bad, you resemble Brexit to a dentist appointment. You start with an assumption that EU is rotten, while Simon starts from basic economics.

  11. Brave attempt to tackle the Brexit claptrap. But the real Brexit damage is still to come, so keep your powder dry.

    Sterling is now trading below $1.30. Some banks predict $1.20 by year end. H2 results for the FT250 will be bad as everyone stops spending. Expect profit warnings by November, and expect the stock market to fall in Q4. By Q1 next year, the expectations about Article 50 will mount. Confidence will drop as a result. So, by Q2 next year, things will look really bad.

    The thing about the Brexit arguments is that Brexiteers think they know about economics - and they may indeed have passed exams in the subject and so forth. But they know nothing about how economies work. And there is a world of difference between these two things, as I think JMK was trying politely to point out in the General Theory.

  12. EU projections for UK population in 2050 here. its up 16M at 80.1M

    What kind of country will my children experience in 2050 If we stay in the EU? With an extra two cities the site of London in the UK will they be able to afford to buy a home? What kind of democratic rights will they have? What opportunities for professional advancement and reward will there be?

    What does it say about the EU that there solution to their failed economic and social policies is to force one country to pick up all the economic and social costs? If this is what the EU are predicting now what will they be predicting in a few years when the project really hits the buffers?

    Prediction of short-term consequences not really answering the major concerns many Leavers have.

    1. Anonymous 14 Aug 04.28, there is much misplaced concern in your post. For example, your children will have job opportunities because working people, migrants or otherwise, create demand in the economy. This simple point often gets missed by Leavers, who only see competitive pressures and nothing more. I'm afraid you're simply proving Mark Edelsten's point.

    2. I think you've replied to the wrong article

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