Brexit and Sterling: The Disaster Hypothesis
Many, and especially Brexit opponents, point to the sharp depreciation of sterling as evidence of imminent economic turmoil leading to disaster. For some depreciation itself is disaster, “The pound is the share price of UK plc,” according to David Blanchflower, former member of the Bank of England Monetary Policy Committee.
More analytical than this rather mercantilist “strong currency equals strong country” syllogism or anxieties over more expensive holidays are fears of the impact of sterling depreciation on employment and living standards, made by one of the UK’s most distinguished economists Robert Skidelsky, as well as sometime sterling speculator George Soros.
How sterling depreciation affects employment and living standards cannot be predicted with certainty because of the complex relationship between exchange rates and the aggregate economy. The high anxiety over these and other economic consequences comes from the perceived severity of the drop in sterling exchange rates since the 23 June referendum and the presumption that Brexit was the main if not the sole cause.
ABCs of Exchange Rate Adjustment
During the postwar era of fixed exchange rates, 1945-1971 (so-called Bretton Woods system), regulatory policies severely restricted international capital flows. In Britain restrictions on the inflow and outflow of funds continued until their abrupt elimination by the Thatcher government in late 1979.
In that by-gone era budding economists learned in their classrooms that the balance of trade flows governed exchange rates. The story was a simple one. When country A imported more than it exported, its national currency accumulated abroad. The holders of the idle currency of country A would exchange it for their own national currency creating downward pressure on the exchange rates of country A. The government of country A could prevent depreciation of its currency by using its foreign reserves (i.e. US dollars) to buy back its own currency. If the trade deficit persisted, the government of country A would deplete its reserves and have no choice but to devalue (an administrative measure by a government, while depreciation refers to a market adjustment).
In the Bretton Woods era it could be argued that a “strong currency” indicated a “strong economy”. An export surplus would mean accumulation of foreign reserves and signal pressure for appreciation or revaluation (“strengthening” of the currency). The presumption that a trade surplus came from greater efficiency in national production completed the argument:
strong economy leads to strong currency
National efficiency → trade surplus → currency appreciation
The post-war appreciation of the Japanese Yen was frequently cited as the outstanding example of this argument in operation, though causality ran the other way, from a managed exchange rate and industrial policy to a stronger economy (see chronology of Japanese policy).
Whatever might have been the causality between national economic performance and national currencies in the postwar years, for the last three decades (going on four) trade flows have not determined the movement of exchange rates in the major countries. In the wake of eliminating exchange regulations, capital flows are the overwhelming determinant of international currency movements.
For no country does this generalization apply more than Britain, where the City serves as a global conduit for financial flows. The chart below partially indicates the extent to which financial flows dominate the British balance of payments and, therefore, movements in the exchange rate. The difference between net and gross is essential to understanding the impact of financial flows (see link in Chart 1 to Bank of England explanatory web page).
Every day in Britain money flows in and out of the City. The daily net flow understates financial movements and the longer the time period the more misleading is the net measure. For example, in 2015 net money movement in and out of Britain was minus US$79 billion while gross movements measured quarterly summed to over US$1 trillion (inflows and outflows added together rather than subtracted). Net financial flow or any time period short or long is only a statistic; the flows themselves influence exchange rates.
The enormous difference between net and gross only hints at the size and impact of capital flows, for it would increase arithmetically if we summed across months or days. The same is not true for trade flows, which involve an activity in form of a physical commodity or payment for a one-off service. Except for the category of “re-exports,” small for all major countries, there is no difference between net and gross exports or imports.
In Chart 1 the blue line shows total trade in goods and services (exports plus imports), measured in US dollars (as done in the source table). The currency movements associated with gross flows of goods and services are very stable. The quarterly average is US$413 billion and the standard deviation only 19 billion. By contrast, gross financial flows (the dashed red line) show great volatility, averaging US$314 billion across quarters with a standard deviation of 159 billion. Were statistics readily available by month they would probably show that financial flows far exceed trade flows.
Because currency flows consist of a stable component and a variable one, the latter will determine movements (an obvious inference validated by taking the first difference or differential). The temptation should be resisted to assign movements in the pound to volatile capital flows and the average level of the pound to relatively stable trade. The interactive relationship among the three—money flows, trade, and the sterling rate—is far more complex. In my opinion, the most likely causality is that financial flows determine short term exchange rates and short term exchange rates are one of many influences on trade flows.
Chart 1. UK: Quarterly Gross Trade and Financial Flows, 2012-2016 (Billions of US$)
Notes: Gross trade is sum of exports and imports of goods and services. Gross financial flows are sum of inflows and outflows of primary income, secondary income, direct investment and portfolio investment. For any time period the latter increases with chronological disaggregation and the former does not.
Source: IMF and Bank of England (definitions).
Sterling Exchange Rates: A Four-Decade Perspective
Having established the context for analysis, I turn to inspection of movements in the pound exchange rate over several decades. This inspection suggests that the fall in sterling since the referendum was not as extreme as some have suggested and not without precedent during the era of flexible exchange rates.
The Bretton Woods system in which governments pegged their exchange rates to the US dollar (itself linked to gold) ended in the early 1970s. After experiments with other mechanisms for fixing rates, most of the non-socialist countries adopted so-called flexible exchange rates.
Chart 2 shows the US dollar to sterling exchange rate during the forty-two years of “floating” rates. The chart suggests that the two periods of Conservative government coincided with depreciations of the pound (“weakening”), while the Callaghan and Blair years coincided with appreciation.
The policy induced recession of the early 1980s resulted in a five year decline in the dollar-sterling rate to near parity in February 1985. After a rise to almost US$1.90 in May 1990 four years of instability followed. This instability was punctuated by the pound dropping out of the exchange rate mechanism in September 1992. Most commentators attributed the recovery from the deep recession of the early 1990s in part to the sharp fall in sterling during 1992-93.
In the era of flexible exchange rates the longest period of pound appreciation occurred during 2001-2007 (with a brief drop in 2005). As during previous recessions the Global Financial Crisis brought a sudden and severe decline in sterling, though far less than in the Thatcher years. The latest bout of depreciation began not with Brexit but in August 2014, 16 months before Parliament passed the enabling bill for the referendum.
Chart 2. Monthly US Dollar to Sterling rate, January 1975 – January 2016
Source: Bank of England
The chart suggests that before the current depreciation episode recession has been the major cause of sterling decline. It is possible that expectation of Brexit might explain the timing of the recent depreciation and Brexit itself the extent of the fall. If Brexit caused the recent depreciation, we would expect to find substantial capital outflow in the months immediately following the referendum. These data are not yet available in sufficient detail for rigorous assessment.
The “Brexit Depreciation” Inspected
In the absence of recent financial flow statistics that might confirm or reject the “Brexit caused sterling to collapse” hypothesis, an interim question presents itself. How often if ever has depreciation occurred of the magnitude of the post-referendum decline?
This is not the same as asking “when did sterling last have a US dollar exchange rate so low”, found in an alarm-sounding Guardian article. The level of the nominal rate tells one relatively little about the purchasing power of a currency (its “strength”) over several decades because of different rates of inflation in the trading countries. One presumes that the Guardian assertion that “[the] Brexit vote is already damaging the UK economy” refers to change and the rapidity of change, not to the level. A small fall to match a “21-year low against the dollar” would be little more than a curiosity.
Just prior to the 23 June referendum the dollar-sterling spot rate was 1.46, falling to 1.21 in October, a decline of 17.1 or 20.7%, depending on which is used as the denominator (18.8% if one uses the logarithmic rate of change). The largest Brexit one month decline was 7.5% (June-July). In the era of flexible exchange rates how often has the dollar-sterling rate fallen by more than 7.5% over one month?
Chart 3 inspects changes in the monthly dollar-sterling rate for the entire period of flexible exchange rates, 1975-2017, using the common measure with the later month in the numerator. It shows that on three occasions depreciation exceeded the Brexit fall: in two consecutive months in 1992 (-10.7 and -7.9, the Soros crash) and in late 2008 (-9.2%, in response to the Global Financial Crash).
Chart 3: Brexit & Other Large & Rapid Depreciations, 1975-2017 (month-on-month percentages)
Source: Bank of England
For many, the fourth worst monthly depreciation over 504 months may seem to qualify as a disastrous collapse. Closer inspection of the chart yields a more nuanced conclusion. The Brexit depreciation persisted for three months (end of May to the end of June, June to July, and July to August, -2.1, -7.5 and -0.3%, respectively). Over the same 504 months depreciation episodes longer than three months occurred 15 times, the longest beginning in January 1983 and lasting fifteen months. Under the self-proclaimed steady hands of George Osborne, two episodes of sterling depreciation continued for six months, the first (beginning August 2014) resulted in an 11.3% cumulative fall of the dollar-sterling rate.
Two obvious messages come from the review of the 43 years. First, since 1980 the largest depreciation of the pound occurred under the Thatcher government. As the table reports, from February 1981 through October 1984 the dollar-sterling rate depreciated in 37 of 44 months with a cumulative fall of 63% (from 2.29 to 1.22). Second, the sterling-pound rate has a pronounced tendency to streaks of depreciation. Over the 504 months the rate depreciated in 256 (not significantly different from half). Forty percent of these depreciations occurred in streaks of four months or more, which suggests instability beyond the random.
Episodes with Consecutive Months of Sterling Depreciation Longer than Brexit, 1975-2017
Note: Last column reports the simple average monthly depreciation, and averages greater than Brexit in bold.
Source: Bank of England
Assessing the Brexit Depreciation
While the Brexit one month depreciation June to July was unusually large, it was not unprecedented. Further, the dollar-sterling rate has been at its present nominal level several times in the last thirty years. The episodes of depreciation in 2014 and 2015 support the conclusion of Nils Pratley that the pound had been at an unsustainable level for several years before the June referendum.
I use the term “unsustainable level” rather than “over-valued” because the use of latter term almost always incorporates a concept of equilibrium. Under the Bretton Woods system of fixed exchange rates the most common analytical approach treated the balance of trade flows as the equilibrating mechanism.
As more and more governments applied policies of current and capital account liberalization, emphasis shifted to stock adjustment models. This analysis treated balance of payments flows as short term responses to economic “agents” adjusting their portfolios; i.e., their holdings of different financial assets.
While the “portfolio” approach appears a step forward from the out-of-date emphasis on trade, its use of equilibrium is a thinly veiled ideological defence of financial speculation. The huge daily capital movements in and out of City of London financial houses represent destabilizing speculation not portfolio equilibrating mechanisms.
The dollar-sterling rate is especially unstable because almost all the short term money flows come in dollars. The unexpected outcome of the June referendum did not cause sterling instability. Financial speculation thrives on short term gambling in currencies in response to political and economic changes be they large or small.
The Brexit depreciation was analogous to tossing a large stone into turbulent waters. It caused a transitory increase in the magnitude of the turbulence but this is not the source of the turbulence; turbulence comes from the system itself, financial speculation facilitated by lack of effective regulations.
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