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.

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.   

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.