Notes
Maybe sterling has overshot a bit. Currencies do that sort of thing and we should not worry unduly. Maybe sterling has fallen because people have no confidence in the long-term ability of the UK government to repay debt. But that would seem odd given that most eurozone countries and Japan are in a worse situation than we are – at least as far as the stock of debt is concerned. In fact, I think there is a perfectly good market explanation for the fall in sterling that has hardly been mentioned.

Households are deleveraging and real consumer spending appears to be falling rapidly. If this happens in a closed economy, the equilibrium level of interest rates would fall and you would get more capital investment as households save more – think of Japan in the 1980s. But, we are an open economy.

For many years the excess of the nation’s borrowing over our saving has been financed by capital flows from overseas (including foreigners buying formerly British businesses and so on). The counterpart to this has been a balance of payments deficit facilitated by a higher level of sterling which was pushed up by the capital inflows. This process might well be reversing. We may well be borrowing less from abroad as the gap between domestic spending and domestic income falls. This would cause the exchange rate to fall, other things being equal, and this facilitates the reduction in the balance of payments deficit that is a necessary counterpart of the reduction in the gap between domestic spending and income.

It seems to me that the impact on sterling would be greater if domestic investment is not responsive to changes in domestic saving (as seems likely in the current circumstances) and that this might explain the dramatic fall. This process facilitates a restructuring of economic activity which is bound to happen in a recession and which is necessary given that households are over-borrowed due to earlier slack-money policies.

Policies that try to prevent this adjustment (for example by increasing government spending to replace private consumer spending) just mean that we have to go through longer and more protracted adjustment processes. So let’s just be pleased that, as a result of Milton Friedman’s intellectual legacy, we have a floating exchange rate. It will probably mean a more benign response to our current economic difficulties than might otherwise have been the case.

Philip Booth 154x154

Academic and Research Director, IEA

Philip Booth is Academic and Research Director at the Institute of Economic Affairs and Professor of Finance, Public Policy and Ethics at St. Mary's University, Twickenham. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. Previously, Philip Booth worked for the Bank of England as an advisor on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs and on the editorial boards of various other academic journals. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

6 thoughts on “Who cares about the pound? I don’t”

  1. Posted 22/12/2008 at 10:54 | Permalink

    For sure, sterling has either already overshot or will overshoot in the next weeks and months. That’s not the question. The question is, when does the sensible currency speculator pile back in to sterling again? (click link above for more)

    …a higher level of sterling which was pushed up by the capital inflows. That doesn’t really compute, outflows and inflows always net off to nil, surely?

  2. Posted 22/12/2008 at 10:54 | Permalink

    For sure, sterling has either already overshot or will overshoot in the next weeks and months. That’s not the question. The question is, when does the sensible currency speculator pile back in to sterling again? (click link above for more)

    …a higher level of sterling which was pushed up by the capital inflows. That doesn’t really compute, outflows and inflows always net off to nil, surely?

  3. Posted 22/12/2008 at 12:27 | Permalink

    Philip, your argument seems sound to me, but don’t completely discount the politics: as the Germans have shown not everyone believes Gordon has saved the world.

  4. Posted 22/12/2008 at 12:27 | Permalink

    Philip, your argument seems sound to me, but don’t completely discount the politics: as the Germans have shown not everyone believes Gordon has saved the world.

  5. Posted 23/12/2008 at 14:23 | Permalink

    Mark – we can have positive net capital inflows which must be equal and opposite to the balance of payments deficit. This is what happens to a country that is a net borrower(UK, US). Arguably the mechanism that brings about the b of p deficit is the rise in the value of the currency as the country borrows from abroad (rise in price level when exchange rates are fixed). Of course, if lenders worry about default/inflation, the currency can then collapse (which relates to Peter’s point.

  6. Posted 23/12/2008 at 14:23 | Permalink

    Mark – we can have positive net capital inflows which must be equal and opposite to the balance of payments deficit. This is what happens to a country that is a net borrower(UK, US). Arguably the mechanism that brings about the b of p deficit is the rise in the value of the currency as the country borrows from abroad (rise in price level when exchange rates are fixed). Of course, if lenders worry about default/inflation, the currency can then collapse (which relates to Peter’s point.

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