Monday, 11 March 2013

Weak sterling is a reflection of a weak economy, not a policy objective

As sterling hits another new low against the dollar many have started question whether the supposed benefits of a weak currency have been overstated.

Among the voices within the sceptic camp is Andrew Sentance, former Monetary Policy Committee member and currently senior economic adviser at PWC. In a recent blog post Sentance suggests that while Britain’s economic weakness and reduced fear over a eurozone collapse have both played their part in lowering the value of sterling, there has also been a concerted effort by policymakers to “talk down the pound”.

He writes:

“[A] weak pound appears to be an important ingredient of official economic policy. Government ministers, including the Chancellor, have talked of rebalancing the economy and emphasised the role of a competitive currency in achieving this. The Governor of the Bank of England has argued along the same lines. In his major speech earlier this week, he argued that the 25% fall in the value of the pound was “certainly necessary for a full rebalancing of our economy”.”

In order to understand his point we need to look at the measures taken by the government and the Bank. It is certainly the case that under normal circumstances a central bank issuing £375 billion of new money into an economy might be expected to lower the exchange rate value of a currency.

However, this idea relies on the notion that the Bank of England has somehow managed to outcompete other central banks through its easing programme. The figures would suggest that this is far from the case.

It is undeniably true that the Bank’s balance sheet has swelled to around £400 billion but this is dwarfed by the Federal Reserve’s $2.92 trillion (£1.96 trillion) or the European Central Bank’s €2.77 trillion (£2.42 trillion). Moreover, unlike its American counterpart, the Bank has resisted increasing its stock of asset purchases since the £50 billion boost last July.

In fact sterling’s recent falls against the dollar have predominantly been a 2013 phenomenon, after the latest batch of asset purchases had already ceased (see chart below).

To claim that Mervyn King has managed to influence its trajectory you have to believe that foreign exchange markets are reading the tea leaves of future policy rather than responding to central bank actions. Otherwise the dollar would surely be in freefall after the Fed’s announcement of “Unlimited QE” in September last year that will see the balance sheet grow by $85 billion a month until unemployment falls below 6.5%.

For those who support the notion of rational markets is it not more likely that markets are instead responding to repeated demonstrations of Britain’s economic fragility?

Official figures suggest the UK saw a meagre 0.2 per cent growth last year versus a 2.2 per cent rise in the US’s national output. This disappointing economic performance has undermined government efforts to improve the national finances and, much to the chagrin of the Chancellor, cost Britain its AAA rating from Moody’s last month.

Here a report from the International Monetary Fund (IMF) last week could perhaps shed some light on why the UK has fared so badly in the post financial crisis environment. Building on the Fund's earlier work on fiscal multipliers, it suggests that key forecasts for the effects of government cuts may have been optimistic and that the actual impact of fiscal tightening policies have been much more severe than anticipated:

“The negative impact of fiscal tightening on economic activity in the near term is indeed amplified by some features of the current environment, including the proportion of credit-constrained agents, the depressed external demand, and the limited room for monetary policy to be more accommodative…It may also lead country authorities to engage in repeated rounds of tightening in an effort to get the debt ratio to converge to the official target. Not explicitly taking into account multipliers or underestimating their value may lead policymakers to set unachievable debt targets and miscalculate the amount of adjustment necessary to bring the debt ratio down.”

It should be noted that the paper is not a critique of the UK government’s plan and indeed the authors are keen to stress that it does not make a comprehensive case against fiscal consolidation. Rather it serves as a warning that under current circumstances cutting government spending can significantly lower output in the short term and worsen a nation’s debt dynamics before it improves them.

From this line of argument one could perhaps conclude that if George Osborne chooses to continue with current policy in his Budget then he is indeed targeting weaker sterling in the short term in order to prompt a sharp boost to the UK's trade balance. If so he might consider listening to Sentance’s warning that “exporters in a mature industrialised economy like the UK do not respond to short-term currency movements in this way”.

As he says, businesses need the longer-term reassurance of strong, stable demand for their products in existing markets before they look to expand operations elsewhere. If the fiscal multiplier is high then far from promoting an export-led recovery government cuts may be helping to erode confidence and force the private sector into its own bout of consolidation.

Weak sterling is not a policy objective, save as a get-out-of-jail-free card for politicians wedded to the dogma of austerity. So far it has failed to provide even that.

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