“If you’re looking for a currency that’s got a stable effective exchange rate you couldn’t do better than look at sterling,” said Mervyn King, governor of the Bank of England, on November 14. He was tempting fate. Since then, the effective exchange rate has fallen by 6 per cent, and sterling’s decade of stability has come to an abrupt halt. The UK is a small, open economy. Monetary and fiscal policymakers will have to be mindful that the pound is, once again, in play – and it may fall a lot further.
On fundamental measures such as purchasing power parity – no matter how unreliable they are as short-term exchange rate forecasts – sterling remains overvalued against the dollar and a host of other currencies. Statistical revisions that show the UK’s current account deficit is 5.7 per cent of output, and that net investment income is negative, were a revelation. The pound’s previous level was not sustainable.
Falls in sterling affect the UK far more than falls in the dollar affect the US because the economy is so open. The decline in sterling will be a sizeable stimulus to UK exports.
On one hand this is well-timed: consumer demand, on which the economy has been heavily reliant, is weakening. Even were it not an opportune boost to growth, a rebalancing of the economy towards exports would be welcome.
On the other hand, falls in sterling can trigger inflation if rising import prices set off a cycle of wage and price rises, or if demand for exports overheats the economy. So far, there is little chance of that happening, but the lower pound will mean that interest rates stay higher than they otherwise would.
The danger, as it is for the dollar, is that foreign investors decide to dump the currency. That could turn a gentle, benign slide in sterling into an unpleasant, inflationary rout. The country still has to finance that yawning current account deficit, and international investors like a stable currency.
Risks to sterling mean that the UK can no longer afford slapdash economic management. The eroded credibility of the fiscal golden rule – that public spending, minus investment, should be no more than revenues over the economic cycle – must be restored. That does not mean raising taxes in the face of a downturn; it does mean a thoroughgoing reform of the fiscal framework.
A more volatile pound may also become a problem for British companies, which have enjoyed a remarkable run of stability against the euro. The slide in the pound is a reminder that, if and when sterling were to join the single currency, it must do so at an appropriate rate.