UK: Currency Markets and the Price of Independence

Here in Britain, the euro project is seen to be not so much a basket of formerly independent currencies — but as more of a basket case.

At the heart of the UK’s argument against joining the euro has always been the fear of losing independence or sovereignty over the country’s monetary and fiscal policy.

This concerns crucial matters such as setting interest rates, opting for QE as well as fiscal expansion (or contraction) and even the external value of the Pound Sterling – the exchange rate.

It is fully understandable that a proud nation like Britain – similar to Switzerland and the Nordic countries – wants to preserve that independence. But there is a high price to pay.

It is useful to remember that, after WWII, Britain in particular built up large, unsustainable current account deficits. Before long, in 1967, it had to devalue the pound by around 14% against the dollar and the deutschmark.

That marked the beginning of the end of fixed exchange rates. It was the intention and hope that the flexible exchange rates that followed would eradicate imbalances quickly.

The idea was that currency revaluations in the surplus countries and devaluations in the deficit countries would ensure that an equilibrium would be reached through the adjustments in the terms of trade.

A difficult task ahead

The ensuing decades proved that achieving this goal wasn’t so easy. As far as Britain was concerned, devaluations chased one another. There was only one period of short reprieve, when North Sea Oil gave a boost to the UK trade balance.

Then, there were currency speculators to contend with. Elsewhere in Europe, it was recognised that the uncertainty brought about by speculative surges was bad for investment, trade and business generally.

It had become clear that the financial tail was the wagging “dog,” i.e., the real economy. To relieve their national economies from these pressures, key European countries moved to institutionalize the euro in 2000. It has given its members currency stability not seen for decades.

To be sure, the recession of 2007/8 highlighted a number of weaknesses in the euro concept. In retrospect, this crisis proved a blessing, as the necessary adjustments were politically possible only in a crisis situation.

The euro area, in spite of the big recession and problems in the periphery countries, has now moved from a current account deficit to a surplus, which is forecast to reach €200 billion this year. It has returned to growth as well.

An important factor in all this is that companies from eurozone countries do not have to absorb the transaction costs when exporting or importing to each other.

No expensive forward buying or hedging is necessary for the largest part of their trade, giving them a clear competitive edge against their neighbors outside the euro area.

What Britain is losing out on

In addition, the euro now offers the advantage of a weak currency, while the non-eurozone neighbors are suffering from speculative revaluations of their currencies.

Britain is probably worst off. The country’s current account deficit is heading for a new record of close to 6% of GDP, total of £100 billion (or €140 billion).

Britain is thus a country with a growing, unsustainable deficit and an ultra-strong currency that, across the channel, faces an area with a growing current account surplus and a weak currency.

Not only are the financial markets not eliminating the trade imbalances worldwide, as was hoped for, they are making them worse. Indeed, more often than not, these markets are at least one of the root causes of these deficits.

By what economic logic should the British pound have had a significant 36% revaluation to above €1.40 since its low point in 2008 against the euro? This simply does not square with the overriding realities of a rising current account deficit and anaemic productivity growth.

This exchange rate makes British exports to Europe and elsewhere uncompetitive. And it allows importers to gain market share in the UK, which they will not give up again, even if and when the pound comes down again in value.

The reason for this irrational behaviour in the currency markets is that interest rate expectations — rather than the real economy — have become the drivers of exchange rates. That is inflicting huge damage on Britain’s businesses.

Danger on the horizon?

Mark Carney, the head of the Bank of England, has done a huge dis-favor to the government’s aim of trying to re-balance the economy with his forward guidance on interest rates.

Although the UK economy looks healthy and sported a 0.4% growth rate in the first quarter of this year, there are some dark clouds gathering on the horizon.

What is Britain’s government or the Bank of England doing about counteracting these dangers? As far as I can see, they act as if they are helpless. Following the United States economy on the path of moving interest rates up is surely not the answer.

In conclusion, Britain is paying a high price for its independence from Europe and opting to walk in the direction of the United States of America. There is more pain and turbulence to come, which might undo some of the good work the government has otherwise done lately.