The news that John McDonnell was looking at a scenario where the election of a Labour government was met with a run on Sterling was all over the news yesterday. The Conservatives, who of course know all about runs on Sterling having created one just a year ago with the Brexit vote, immediately grasped the political gift they had been given.
Paranoia on the left meets prejudice on the right. But what would really happen to Sterling if Labour were to win the next election? Given announced policies, the answer is quite clear: Sterling would appreciate. The main reason is that under Labour there would be a large fiscal expansion: for certain in term of public investment and to a lesser extent with current spending. (I assume by then interest rates will be above their ZLB: if they are not, the fiscal expansion could be even larger.) There would also be a balanced budget fiscal expansion: even if government spending increases are financed by tax increases, this is likely to be expansionary to some extent because some of the tax will come out of savings.
This fiscal expansion, together perhaps with other labour market measures, would put upward pressure on inflation, prompting higher interest rates from the Monetary Policy Committee of the Bank of England. It is the prospect of those higher interest rates that would make Sterling appreciate. How much inflation rather than output would rise depends on how pessimistic you are about the supply side. If the MPC were doing their job properly, that increase in interest rates plus the appreciation would stop inflation rising very much. We will finally get the rebalancing between monetary and fiscal policy that we should have had for the last decade.
If we are also in a transition period for Brexit, with the final destination unclear, then Labour being elected would also lead to an appreciation because Labour are softer on Brexit than the Conservatives.
So where does the run on Sterling idea come from? The idea that all those traders in currency will get together and engineer one because they do not like a Labour government is nonsense. They may not like a Labour government, but they dislike losing money even more. Capital flight? You might see the share price of power or rail companies fall, but that is not going to be enough to move a currency like sterling. Any depreciation in sterling would be the equivalent of pound notes waiting to be picked up in the City and Wall Street: with higher expected interest rates and a likely future appreciation, who wouldn’t buy sterling?
The only way I can see that you could get a run on Sterling is if enough traders in the markets came to believe that Labour was going to abolish BoE independence because it wanted to keep interest rates low. In that case you could get significantly higher inflation under Labour, which would justify a nominal Sterling depreciation.
Which, of course, is why McDonnell committed to keeping Bank of England independence as one of the first things he did. And which is also why he was very foolish to say what he said, because it might lead some to speculate that he might renege on that commitment. Something tells me he is missing his Economic Advisory Council.