Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 14 October 2016

Brexit and Sterling

Is the Brexit induced decline in Sterling a blessing in disguise? So argues Ashoka Mody, and to a lesser extent Paul Krugman. Their basic argument is that Brexit will hit the City, and it is the City that has created an unbalanced economy and an overvalued currency. Reducing the size of the financial sector is a necessary condition to rebalancing the economy, and Brexit can achieve this.

Ashoka Mody’s disdain for the City is absolutely clear. He writes: “The banking-property complex has been a parasite on the British economy, creating pathologies of financial vulnerability and exchange rate overvaluation.” We can see the overvaluation in the large UK current account deficit. Paul Krugman is less pejorative. The City is just an important UK exporter that Brexit will cut down to size, so we will need to make other UK exporters more competitive to fill the gap.

Neither author disagrees that, because the depreciation of Sterling will raise import prices (in economic speak it will lead to a deterioration in the terms of trade), people in the UK will be poorer. But there is also a difference in mechanisms between the two authors, which has implications for how you view this effect. For Mody the City has caused Sterling to be temporarily overvalued as a result of a “finance-property bubble”. As this is a temporary effect (bubble), sterling was bound to fall at some point anyway. As a result, Brexit has only brought forward the day that UK citizens became poorer.

Krugman on the other hand does not argue that sterling was overvalued in this sense: the City is just an important export industry that will particularly suffer from Brexit. As a result, Brexit does make the average citizen poorer permanently. But he notes that, to the extent that this depreciation also results in a redistribution from the City to more dispersed manufacturing, it might benefit some of the parts of the UK that heavily voted for Brexit.

There is nothing wrong with the logic of both arguments, as you would expect given the authors. The key question is whether they are empirically appropriate in this case. I have argued, prior to Brexit, that Sterling was overvalued, and it also seems that the IMF agrees as well. The key issue is why it was overvalued. If the reason for the overvaluation was something Brexit has ‘cured’, then Brexit has indeed ended that overvaluation. If Brexit has not taken away the reason for overvaluation, then the correction to that overvaluation has still to come.

Paul Krugman’s logic is closer to the one I have also used in arguing that the Brexit depreciation is a result of Brexit making it more difficult for UK industry to export. The twist Paul applies is a distributional one: rather than Brexit making it more difficult to export across the board, it hits one particular industry, allowing other industries to grow. Once again the key issue is whether Brexit does have this distributional effect, hitting the City harder than UK manufacturing.

Suppose there is something in what both authors suggest. I would make a very basic point. If we wanted to cut the City down to size, we didn’t have to achieve this using Brexit. We could instead have imposed much stronger regulations on the UK financial sector (basically higher capital requirements), and watch some of the industry leave in disgust. That way we would have avoided all the additional costs that Brexit will impose (recently restated by the Treasury, but only now considered ‘news’ by the Times), and with the additional benefit of having a financial sector that was not too big to fail. My fear is that after Brexit the opposite will happen: policymakers will go even easier on City regulation in an effort to make up for the damage Brexit will do. So I’m still finding it hard to see any silver lining in the Brexit decision.


  1. I found Frances Coppola's arguments about the distributional benefits of devaluation very interesting:

  2. If a devaluation of the £ was desirable, surely there were rather better ways of achieving it? Such as by printing lots and lots of £s and spending it on infrastructure? That would have caused the devaluation and we'd have had all the lovely shiny roads and so forth?

    So *this* devaluation, which is caused by the loss of confidence because the UK has shot itself in the face by voting for Brexit, is unequivocally a bad thing, as measured by the billions and billions of £s worth of goodies we now no longer buy to achieve the same end?

  3. UK has a big trade deficit, ie spends more than it produces. To rebalance, some reduction in spending is needed (unless you can achieve a big jump in production - not possibile in a short timeframe). Pound devaluation and possibly a diminished role for the City means spending reduction will affects much more fat cats in the financial environment instead of lower-paid workers, who can actually benefit as manufacturing becomes more competitive. So, pound devaluation is an healthy rebalancing act.

    1. Well, no. The 'fat cats' will have no difficulty in finding extremely lucrative jobs elsewhere, but the vast majority of the 360,000 people who commute into the City aren't fat cats. Many of them will lose their jobs, as some construction workers in the City already have, and there is no apparent recognition of this inconvenient fact.

      Of course, the City does much more than financial services; we have a lot of lawyers. Foreign companies with no link to Britain enter into contracts under the law of England and Wales because our Courts have centuries of experience in resolving contractual disputes, and thus offer a stability which is highly prized. Sterling tanking is simply another expression of that fact.

      The problem seems to me to be that people do not actually understand what the City does; the Lord Mayor of London should have done a lot more to explain to the general public, but the Government itself seems to be utterly clueless about it as well, which is inexcusable. No doubt the prospect of losing a hefty chunk of the tax take will be concentrating the minds of the people in the Treasury quite wonderfully, but at present the BRexiteers are oblivious to this; they are happy to take the line that sterling was overpriced anyway, though none of them mentioned it before the referendum. I do not think that anything good is going to come of this; had Government wanted to rein in the financial sector it could have done so, as Simon has noted.

      Incidentally, the Big Mac method of determining whether a currency is overpriced suggests that sterling was underpriced on the day of the referendum.

    2. "No doubt the prospect of losing a hefty chunk of the tax take will be concentrating the minds of the people in the Treasury quite wonderfully, but at present the BRexiteers are oblivious to this"

      Blackmail. Wonderful. We have no need of the The City - it should be shut down except for bank lending for new projects. Then we reassign the people and resources for more useful tasks.

      "Government wanted to rein in the financial sector it could have done so, as Simon has noted."

      Yep and you know how, by banning forms of lending - asset side regulations. Simon of course does not recommend that.

    3. Look, there is no 'balance of trade deficit' or overprice or underprice. There never can be one in a floating rate exchange system. You just missed the invisible export - Sterling Savings.

      So you make sure Sterling Savings provide no income to foreigners. You make them as distasteful as possible.

      Then if they still keep holding them it is because there is nowhere else in the world they can shift their stuff other than with you. In other words it is a consequence of an export led policy by other nations - who want to give you stuff in return for pieces of paper they can discount for their own currency at their own central bank.

  4. If you look a the composition of the 48% compared to the 52%, they are younger, richer, and have a higher level of qualifications.

    Now, the Thatcherites have a long history of not caring for those younger and better qualified than their average voter, but the affluence issue is one that 'national-interest May' will not have had to deal with in her political career.

    I foresee a continued fall in the circulation of Brexit-supporting newspapers as prices begin to rise in the immediate term, and May struggling to hold her typically united business-backers together as she pushes for a hard Brexit.

    And all this in a country which still cannot even decide how to pronounce Brecsit/Bregsit.

    1. I think the composition myth had been debunked with a very good portion of the 52% being ABC1s / middle class.

  5. The UK is an island economy that exports demand to the rest of the world. In a world short of demand that means the rest of the world has to retain access to that demand somehow — or they have to take the economic impact on their own export led strategies.

    The problem is that central bank policy makers are still talking about shocks and equilibrium. They talk about pass through for exchange costs and there is apparently an extensive literature on the subject. But there seems to be little analysis of pass back (volume/price impact on the export side) because that would require acknowledging that the demand side matters — contrary to dogma.

    Last year there was a suggestion that entities may respond to the exchange rate in different ways and this may change the response profile. Apparently this a revolutionary concept (!) Eventually they’ll realise that you can get supply from more than one foreign country and they may just compete with one another for your business. But putting more than one foreign country in the model is a bit much apparently. Perhaps that is next year’s revolutionary concept. Use this idea for personal gain Simon, you have my permission.

    For a country to have excess exports it has no choice but to save other currency denominations to excess. Otherwise its own currency goes sky high and kills the excess exports. This is why there are ‘sovereign wealth funds’ and huge hoards of currency and financial assets held by offshore entities. They are a consequence of excess export policies across the world and the currency management that enables them to exist.
    If you ban UK exports to your nation, or you refuse to take them, or you put extra taxes on them, or you refuse to buy Sterling assets then that means you have to save more Sterling if you want to continue to export to excess to the UK.

    What economists always get wrong is the idea of funding. A current account deficit isn’t funded. For it to exists at all it must already have been funded. Every short has to have a corresponding long. Similarly for every excess import of goods and services into a currency zone there has to be a corresponding external sector held asset denominated in the currency of the import zone. One cannot exist without the other. It is a simultaneous requirement in a floating system. If any step along the way fails the whole deal falls through, eliminating both sides instantly.

  6. The Treasury was completely wrong with their short term forecast about what the impact of Brexit would be, so it's hardly surprising the Times has only just considered it 'news' they have restated all the additional costs they think Brexit will cause. No reason to expect them to be correct this time around either.

  7. Neil Wilson nails it

  8. Could you comment on how having tax haven abodes to avoid tax,may also help by keeping more money in the (Britain)system,if paying tax is more profitable than exchanging sterling in tax havens?

  9. I tend to agree with you, and I believe most informed people would. Brexit was a nightmare outcome for people in the FCO and I suspect for HM Treasury as well, made even more unbelievable in that it was self-inflicted by hubris in the Tory party.

    I am suspicious of Krugman's reasoning because it is guided by Model, not an informed knowledge of this country and its history. The Dutch Disease does have some analogy with the City, but I do not believes he understands the key causes of the unbalanced economy and its relationship with the pound.

    Deindustrialisation lies behind the dominance of the City. The reasons for deindustrialisation are complex, and require deep factually informed historical understanding. The erosion of the British industrial base began for complex reasons in the 1950s and 1960s.

    A low pound will be a problem with a country that has many non-substitutable imports. This is stuff you cannot possibly understand with ISLM and post 1980s trade models.

    On the pound, large imports have not been a problem due to a surplus on the invisibles accounts. These are now being greatly reduced - one reason is that assets have been sold to foreigners.

    Separating us from a huge integrated goods and services market will be harmful this country as we try to develop new industries from which we want to create export manufacturing. Any attempt to achieve this through import substitution policies (such as tariffs and non-tariff barriers) will be met with a sharp response on what exports we do already have. We will not have the ntegotitating force of the EU on our side.

    This is a brave new world. We are now price takers in the system, and we are out in the cold.


  10. Aren't the key expressions in your final paragraph 'could have' and 'would have'? Since there was no appetite in government to take the measures you refer to, we must assume that, without Brexit, the imbalances that Mody discusses would have continued. Mody clearly says that the benefits he is describing are entirely fortuitous. Nonetheless, if real, they can certainly be described as a silver lining, can they not?

  11. Brexit is actually a celtic word, and loosely translates in English as 'buggered'.

  12. I think you're (understandably) being too kind to Krugman. He states "a weaker pound shouldn’t be viewed as an additional cost from Brexit, it’s just part of the adjustment". It clearly is an additional cost because, as you and he both state, the fall in the pound will make everyone in Britain poorer.

  13. Krugman's argument that the result of all this will be a welcome adjustment to the economy in the shape of a smaller financial sector and a larger manufacturing sector is typical ivory tower economics. The economy currently suffers from low productivity and a low skilled workforce - the two presumably go hand in hand. So how will a significant fall in the pound help to turn this around? A better trained, better educated workforce has been the holy grail of successive governments for decades now, and successive governments have thrown a lot of money at the problem - with scant success to date. This is of course the reason why there has been a large influx of foreign workers - from bankers to brickies. We need their skills. So NOT a good moment to introduce an aggressive anti-immigration policy.

  14. Until recently I found it mysterious that we could run a trade deficit for so long without it automatically re-valuing the point. Then it occurred to me that those who sell to us might be happy to accept sterling and invest it in UK. Until suddenly they pull out. (See

  15. Isn't there another possibility why the associated fall in sterling may be a boon for the economy? Say we were at $1.50 before the vote. The vote has damaged our trading prospects to some extent, and the new exchange rate, justified by economic fundamentals, is $1.40. But because of the well known tendency of forex markets to overshoot for uncertain periods of time, combined with the presence of uncertainty, the exchange rate has gone down to $1.25. Wouldn't that, if sustained, then be a boon for producers of tradeable goods and the economy as a whole?


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