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22 October 2018updated 07 Jun 2021 3:14pm

Why a collapse in the value of the pound doesn’t always spell disaster

By Grace Blakeley

The UK’s exchange rate has been the bane of many a government. In 1967 Harold Wilson was forced to devalue sterling with a balance of payments crisis, giving his famous “pound in your pocket” speech to a nation now convinced of Labour’s economic incompetence. In September 1992, just after John Major had shocked the country by securing another term in office for the Conservatives, he was forced to pull sterling out of the European Exchange Rate Mechanism, leading to “Black Wednesday”, which cost the UK £3.4bn.

After a decade of stability before the crash, the newly volatile pound is today centre stage again. Last week, John McDonnell hit back against warnings from the City that a Labour government would lead to a collapse in the pound. Labour’s plans to strengthen the British economy, rebuild its manufacturing base and promote long-term investment would instead “see… sterling strengthening”, he claimed.

Boris Johnson is also being troubled by the pound. Sterling fell by 1 per cent against the dollar on 16 July, bringing it to a two-year low, amid concern about his apparent enthusiasm for a no-deal Brexit.

The exchange rate is taken to be a bellwether for the state of the economy as a whole. Despite Harold Wilson’s insistence to the contrary, the idea that a falling pound means a less valuable pound in your pocket is deeply ingrained into the national psyche.

But what do fluctuations in the exchange rate really signify? What does a fall in the pound mean for the economy?

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Since the pound was floated in 1972 its value has been determined by the forces of supply and demand. If investors start to demand more of our exports or assets, demand for sterling will rise; but if people in the UK start to demand more imports or assets from the rest of the world, demand for sterling will fall.

We’ve had a strong currency and a huge trade deficit since the 1980s – clearly demand for sterling is not determined primarily by demand for British exports. Instead, the most important determinant of its price is demand for British assets.

Before the crisis, the high value of sterling was driven by demand for financial securities (particularly mortgage-backed securities issued by British banks) and property. In 2008 this demand collapsed and took sterling with it.

But British markets have recovered somewhat, and sterling remained fairly stable from 2008 up to 2016. At this point, it collapsed as a result of the UK’s decision to leave the EU. Investors judged that the restrictions on capital and trade between the UK and Europe would limit future returns.

In a sense, then, the collapse in the value of sterling reflects investors’ predictions about the health of the British economy, based on the returns they expect to gain from their holdings of British assets. Sterling was very strong before 2008 – but that’s because the economy was gripped by one of the largest bubbles in history. Many commentators are sure the collapse of sterling spells disaster for the British economy, but this view is also worth treating with caution.

A strong currency makes imports cheap for consumers, and therefore acts as a check on inflation, but it also makes our exports seem expensive. An overvalued currency – such as sterling before 2008 – suppresses demand in the domestic economy by making our exports less competitive and encouraging consumers to rely on imports instead.

Facing an overvalued currency, our manufacturers – concentrated in the regions – found it harder to compete internationally. As a result, the UK is now the most regionally unequal country in Europe, measured by output (gross value added). In 2015 we had the largest peacetime trade deficit in our history. Our manufacturing sector has collapsed. Instead of producing goods, the UK sells assets and imports from the rest of the world – increasing Britain’s carbon footprint.

The collapse in the pound won’t solve these problems. British manufacturing is not going to recover overnight – not while our finance and real estate sectors remain so dominant. But with the right industrial strategy, pursued as part of a Green New Deal, a socialist government could solve many of these problems; but trying to convince investors to buy up sterling in order to purchase our assets will only make them worse. 

This article appears in the 24 Jul 2019 issue of the New Statesman, Shame of the nation