Who cares about exchange rates?

Who cares about exchange rates?

Currency crises were supposed to be a thing of the past. Few major economies now try to fix their exchange rates.

That ended for most of Europe (Germany, France, Italy and 16 other countries) with the creation of the euro in 1999, and for the UK with a return to a free float in 1992.  But since 2007 “floating” hasn’t seemed quite the right word: erratically but persistently, the pound has fallen from over $2 to under $1.40 a year ago, and after the new Government’s please-don’t-call-it-a-Budget statement, it briefly touched an all-time low of $1.03 on September 26th.  Does that matter?  And if so, what can be done about it?

Economists have been struggling to explain exchange rates ever since currencies ceased to be small weighable pieces of precious metal.  For a long time the dominant notion was that “purchasing power parity (PPP)” - the exchange rate at which the same shopping basket could be filled in each country - represented a natural equilibrium.  That gave way to a supply-and-demand type analysis of the balance of payments, which in turn gave way to monetary models and then to the ”portfolio balance” approach, which at least allowed for different risk premia to be attached to domestic and foreign assets.

The decidedly limited predictive success achieved by any of these models meant that few economists got rich using them, and any outperformance of a random walk tended to be deemed a cause for satisfaction. But all of these theories carried some insights, or glimpses of what should be blindingly obvious; but continue, it seems, not always to be so to governments.

The first is that if (like the UK) you want to import a lot more than you export, that has to be matched by inflows from foreign earnings or (on the capital side of the balance of payments) inflows of foreign investment.  As the former Governor of the Bank of England, Mark Carney, put it this summer, the UK depends on “the kindness of strangers”.  Except that, as he well understands, there’s no kindness in currency traders.

In theory, at least, governments can try to keep control by selling foreign reserves to buy their own currencies.  The UK’s foreign exchange reserves are now much larger than they were 30 years ago, when it last tried to do this in order to honour its obligations under the European Exchange-Rate Mechanism (ERM), but so is the scale of the global currency market that it would have to take on in a currency spending battle, and no one seriously supposes it is going to try.

The lesson of the ERM was plain: either abolish your currency altogether, or let it find its own level. The best you can do to influence it is to have an economically credible mix of policies.  Purchasing power parity analysis encouraged governments to see trade deficits as evidence that their currencies were overvalued, and depreciation the simplest way to increase competitiveness, boosting growth through exports. But that assumed perfect competition, and ignored the fact that trade deficits are driven by other factors as well as price: trade barriers and resource availability to name two.

And despite US suspicion of “competitive devaluations” by Asian economies, depreciation isn’t a free lunch.  Gaining a market advantage this way requires the extra inflation imported through a falling exchange rate to be swallowed and not regurgitated: i.e., it means a fall in real wages.  Achieving that requires robust counter-inflationary policies.  And meanwhile all exchange-rate models have difficulty in making allowance for expectations and overshooting.

These factors are critical if (again like the UK), the investment you most need to attract is in government debt.  Inflation and loose fiscal policy are a toxic combination, as the UK is rediscovering.  In the 1970s, another “dash for growth” by a Tory Chancellor was followed by a Labour election victory and spending surge, which ended with the UK having to join the Latin American queue for emergency loans from the International Monetary Fund (IMF).  So it’s not surprising that the IMF has made its view on current UK risks clear, with a frankness it rarely uses towards the biggest economies.

If there’s no kindness in markets, there can be trust: but that has to be earned.  A combination of inflation and an increasing deficit makes investors demand higher interest payments on government debt; add a falling exchange rate, and the risk of a bond strike is clear.  By September 27th, spreads on UK gilts had widened farther than on Italian government bonds, despite the fact that Italian government debt levels were higher, and Italy was going through what, on the face of it, an even more dramatic change in government. 

So do the markets have greater faith in the independence and robustness of the European Central Bank (ECB) than of the Bank of England?  That might seem harsh, given that the ECB has been even more hesitant to raise interest rates.  And the euro has also slid against the dollar, for pretty obvious reasons: with far less energy security and more dependence on Russian gas than the US, inflation and downturn were always likely to be more severe in Europe.

But the pound has fallen farther and faster.  Announcing tax cuts without saying how you are going to pay for them has clearly affected the sentiment in the markets.  The Bank of England isn’t without its critics, too, and not only amongst those Government supporters desperately looking for someone else to blame.  The Bank’s interest rate decisions have twice fallen short of market expectations, last November and again this September, when it followed the announcement of feisty 0.75% rate increases by both the US Federal Reserve and the ECB with a limp-wristed British half-point, despite knowing that the UK Government was going to announce a big fiscal loosening the following day. 

The effect of this loosening on bond markets was dire.  And it brought home a critical distinction: if you can affect benign neglect of your exchange rate, you don’t have that option when it comes to disorderly domestic financial markets. The rapid withdrawal of mortgage products was bad enough.  But the risk that collapsing bond prices might, given pension funds’ use of derivatives, trigger defaults in that sector demanded hasty action.

By September 28th, the Bank of England had had to completely reverse its plan to tighten monetary policy discreetly by selling part of the mountain of debt it had built up through Quantitative Easing.  Instead, it had to offer to buy again, in (theoretically) unlimited amounts. While that intervention began remarkably successfully, bringing long-term bond rates down a full percentage point on the first day, we’re certainly not out of the woods.

That, of course, is true in other markets too.  The Federal Reserve hasn’t escaped criticism, while given the diverse degrees of vulnerability in different parts of the Eurozone, the ECB will be lucky to get through these hard times without a crisis.  And meanwhile you could argue that the Bank of England has been politically rather clever, acting low-key and leaving the politicians and financial markets between them to share the blame for driving interest rates to the point where so many mortgage-holders face extra costs that will swamp their promised tax cuts. 

But it’s all left monetary policy in a bit of a mess.  Of course the Bank was in a fix: markets don’t like it when governments and central banks are at loggerheads.  As my colleague Gus O’Donnell has said, if one pushes the accelerator and the other the brake, there’s a nasty smell of burning rubber. But if the Bank doesn’t use the brake, there’s a nasty smash ahead.  Markets need to know that a central bank is there to do something more than stand by to mop up a government’s messes.  It’s independent for a reason, which is to speak truth unto power, and at whatever cost to its popularity with government and people, to bring inflation under control.

Guest Author: Baroness Sarah Hogg, Former Frontier Economics Chairman

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