Is sterling overvalued?

One of the reasons that steel plants have been closing in the UK rather than Germany or France, and that UK manufacturing output has fallen for the last two quarters, is the strength of sterling and the weakness of the Euro. The weakness of the euro relative to the dollar could be explained (at least qualitatively) by interest rate expectations: whenever interest rates do rise in the US, they will surely rise well before they do in the Eurozone. When domestic interest rates are expected to rise relative to overseas rates, a currency should appreciate.

The same logic could be applied to sterling. Indeed some still believe interest rates could rise in the UK before they rise in the US. If the UK looks like the US, you would expect on these grounds for the pound relative to the dollar to be roughly stable, but sterling to follow the dollar in appreciating against the Euro. To a first approximation that is what has happened.

The only problem comes if you look at the UK’s external performance. The current account deficit as a percentage of GDP has wobbled around 2% for most of this century, but in the last few years it has increased sharply, coming in at over 5% of GDP in 2014. All these deficits are taking their toll on the UK’s net financial position: twenty years ago we owned about as many overseas assets as there were UK assets owned overseas, but we are now a net debtor by an amount that will just get larger if we continue to run large current account deficits. (For more on this, see Felix Martin in the FT.)

When I calculated an equilibrium sterling euro rate in 2003, my estimate was 1.365 E/£. As current rates are close to that, and given the point about expected interest rates, what is the problem? Unfortunately there are three. First, that calculation was based on an assumption that the sustainable UK current account was balance. In other words, if the rate had stayed at 1.365 E/£, then over time and on average the current account should have been in balance. Instead we have had persistent deficits. In the early 2000s that might have been partly explicable because sterling was a little stronger than my estimate, but since the beginning of 2008 quite the reverse has been true, but we have still run deficits. That either suggests my estimate was wrong (the equilibrium E/£ rate should have been lower), or the equilibrium rate has depreciated since 2003.

Second, persistent current account deficits that weaken our net foreign asset position will in any case imply a gradual depreciation in the equilibrium exchange rate. The worse our net asset position gets, the greater the trade surplus we need to pay interest on that net debt. Third, and perhaps more speculatively, if the recent stagnation in productivity also represents a stagnation in innovation in the variety and quality of goods produced in the UK, that will also mean a depreciation in the equilibrium exchange rate.

All this suggests to me that sterling may currently be overvalued. How can I say this when there are a huge number of people in that market trying to make money from getting the ‘right’ rate? Quite simply from experience. The market is totally focused on very short term movements, and pays very little attention to estimates of equilibrium rates. When I did my equilibrium rate calculation in 2002, the actual rate was wandering around 1.6 E/£, and there was no clear reason why it should be so much higher than the equilibrium rate. So, even allowing for expectations about interest rates, it would be quite possible for sterling to be currently overvalued.          

Money as Credit

The relationship between money and macroeconomics is very strange. At one time money was thought to be central to the discipline - advanced courses in macroeconomics were often called monetary economics. We had monetarism. Then gradually money slowly faded away. We had real business cycle models that were just real, and if we wanted to make them nominal you just added money as a ‘medium of exchange’. Then even Keynesian models with sticky prices began to dispense with money altogether, becoming cashless. Money seemed both essential - for example to the concept of inflation and to why Says Law did not hold - but also dispensable.

These thoughts followed from reading a book called ‘Money: The Unauthorised Biography’ by Felix Martin. 

The first thing to say is that this book is a great read, and one that I think non-economists will find completely accessible. Much of the book, as you would expect from the title, involves a historical discussion of how money evolved, was developed and was understood in particular societies at different times. Some of this I was familiar with - like the stones of Yap - but a great deal was new to me. But this is a biography with a message. Money is not fundamentally a commodity medium of exchange that made exchange more efficient compared to barter, but a particular form of credit, a system of clearing accounts (transferable credit). Yet, Martin argues, the dominant view since Adam Smith has been of money as a commodity medium of exchange, and this has enabled macroeconomics to largely ignore financial crises, until they actually happen. Here is a passage:

“From the moneyless economics of the classical school there evolved modern, orthodox macroeconomics: the science of monetary society taught in universities and deployed in central banks. From the practitioners’ economics of Bagehot, meanwhile, there evolved the academic discipline of finance - the tools of the trade taught in business schools, used by bankers and bond traders. One was an intellectual framework for understanding the economy without money, banks and finance. The other was a framework for understanding money, banks, and finance, without the rest of the economy. The result of this intellectual apartheid was that when in 2008 a crisis in the financial sector caused the biggest macroeconomic crash in history, and when the economy failed to recover afterwards because the banking sector was broken, neither modern macroeconomics nor modern finance could make head or tail of it.”

Some of this will be familiar, although what was new for me (but perhaps not to followers of Minsky or MMT) - and quite challenging - was the idea that this could all be traced back historically to a misconceived view of money itself. (According to Martin, the 17th century philosopher John Locke has a lot to answer for.) The threads developed from the historical account of the origins of money are numerous. For example money as credit is inevitably social, and so its value is bound to be politically determined. In a financial crisis, when the size of debts begin to encumber the economy, it is therefore quite logical and natural to adjust the value of money to redistribute between creditors and debtors.

So this is a big ideas, big picture kind of book. Inevitably, therefore, some of the brushstrokes may be a little too broad or bold for some. The story of macroeconomics as essentially classical and real with only a brief incursion by Keynes is I think too simple and easy, and I would have liked to know his take on the explosion of macro work on financial frictions since the crisis. But the historical detail is fascinating, and the ideas they are used to illustrate are clear and thought provoking, so I’m very glad I read it.