Monday, 24 February 2014

The long decline of the Great British Pound

This chart caught my eye:



It's the GBP/USD exchange rate from 1915 to the present day. Accompanying this chart on Twitter was the comment "quite shocking though how much the pound has been devalued since 1945".


This is a fine example of the way in which economic indicators can be misinterpreted when the historical narrative underlying them is ignored. What this chart shows is indeed shocking, but not because the value of the pound has fallen. It is shocking because it graphically depicts the decline of British global influence. And it charts the desperate attempts of British politicians to maintain global dominance by propping up the value of the currency. 


The start point of this graph - 1915 - was during the First World War and immediately after the failure of the classical gold standard in 1914. Britain borrowed heavily and suffered high inflation during the First World War, and was forced to devalue the pound considerably towards the end of the war. You can see that drop clearly. But instead of accepting devaluation of the pound as part of the cost of fighting a ruinous war, British politicians decided to try to restore the pound to its pre-war value. They imposed severe fiscal and monetary austerity upon the war-damaged British economy, causing a depression that lasted for much of the 1920s. The pound did indeed recover most of its pre-war value, and Britain returned to the gold standard at the 1915 rate in 1925. You can see that the graph flatlines from 1925 to 1932. That was the last time Britain was on a gold standard. 


But if Murray Rothbard is to be believed, the price the world paid for Britain's determination to restore its former glory was the Wall Street Crash and the Great Depression. Rothbard claims that the Fed loosened monetary policy at Britain's behest, and in so doing caused a credit bubble that burst in 1929. I think blaming the Wall Street Crash entirely on Britain's need for loose monetary policy is rather far-fetched: Rothbard seems to have a bit of a chip on his shoulder. But Britain's ill-judged return to the gold standard was almost certainly a contributory factor. 


The onset of the Great Depression following the Wall Street Crash placed the British economy, like everyone else's, under great pressure. Like everyone else, initially Britain tightened monetary policy to preserve the value of the pound. But eventually it was forced to devalue. It came off the gold standard in 1931 and the pound promptly dropped considerably. Barry Eichengreen has documented the role of the gold standard in the Great Depression: it seems clear that those countries that came off the gold standard early, such as Britain, fared much better than countries that remained on it for longer, such as the US. The lesson from this is that a fixed currency regime after a financial crisis and recession is economically disastrous. Sadly we don't seem to have learned from this. The Euro area is busy repeating exactly the same mistake - it isn't called a gold standard, but it behaves much like one. 


The pound did recover its value as Britain came out of the Depression. But it's worth remembering at this point that there are two sides to any exchange rate. This is GBP versus USD. The strength of the pound in the later 1930s was due to the weakness of the US dollar as the US first reflated (FDR's New Deal) and then dipped back into recession again. 


Not surprisingly, the value of the pound fell sharply on the outbreak of World War 2. It is quite normal for currencies to devalue in wars: the currency itself becomes riskier because of the uncertainty around the outcome of the war, and economic fundamentals in the countries concerned usually worsen considerably despite the fiscal stimulus caused by the war effort. Wars are expensive: GDP collapses, inflation rises and countries become highly indebted. Britain was no exception. It ended the war heavily in debt to the United States and with a massive balance of payments deficit. This was ON TOP OF the outstanding debt it was still carrying from WW1, which it had never managed to unload. Two world wars and a depression had caused enormous damage to the British economy. It was in pretty poor shape. 


In 1944, Britain entered into the Bretton Woods managed exchange rate system. This fixed the pound's exchange value to the dollar, which in turn was linked to gold. Once again, British politicians were determined to show that Britain was still a force to be reckoned with, so the exchange rate was set too high for such a damaged economy. Britain was forced to devalue the pound by 30% in 1949. But even that was not enough. The next 18 years were characterised by persistent balance of payments problems and sterling crises: Britain was forced to seek assistance from the IMF more than once. Wilson finally devalued the pound again in 1967. But by this time, inflation was already rising and was made worse by the devaluation. The next 15 years were to be a period of high inflation and dismal economic performance.    


In 1971, Nixon suspended convertibility of the dollar to gold, effectively ending the Bretton Woods system. But even after this, Britain continued to prop up the pound against a market that clearly wished it to be lower. The currency simply did not warrant the value that Britain wished it to have, yet successive Chancellors* refused to allow it to float freely, fearing a sterling collapse. In 1976, the Chancellor of the Exchequer called in the IMF to help arrest persistent runs on sterling. On the advice of the IMF, the Chancellor imposed austerity measures, which reduced inflation and improved economic performance. The IMF's loan was never fully drawn. The pound recovered - but only temporarily. Against a background of rising unemployment, the famous "Winter of Discontent" in 1978 sounded the death knell for the Labour government. In 1979, the Conservatives under Margaret Thatcher won the election. 


1979 was a turning point for the pound. Exchange controls were lifted, and for the first time it was allowed to float. And it promptly fell. It takes a great deal of nerve for a Chancellor to allow a previously managed currency to fall freely, but Geoffrey Howe allowed it to do so. But again, we should be mindful that there are two sides to any exchange rate. The fall of sterling in the 1980s was due to the growing strength of the dollar, which climbed steadily against all currencies (not just the pound) until 1985. But in 1985, currency management started again. The Plaza Accord of 1985 introduced active depreciation of the dollar against all major currencies including the pound, a strategy which only ended with the Louvre Accord of 1987. 


Howe's successor, Lawson, was - and remains - a fan of managed exchange rates. From 1987 onwards he unofficially pegged the pound to the German Deutschmark. This caused inflation, a credit bubble and a property market boom which eventually crashed in 1990, followed by a recession. Despite this, Lawson's successor, John Major, continued to shadow the Deutschmark and eventually joined the European Exchange Rate Mechanism (ERM) at what it soon became clear was too high a rate. 


But it didn't last. Britain's brief membership of the ERM ended ignominiously when the pound was forced out by sustained speculative attacks. Major's successor, Norman Lamont, reportedly said he was "singing in the bath" after the pound crashed out of the ERM. It promptly sank to an exchange rate more appropriate for the state of the economy.
The independence of the Bank of England in 1997 removed the value of the pound - both its domestic value (inflation) and its external value (exchange rate) - from direct political control. The Bank of England now primarily manages the domestic value of the pound and allows the international value to adjust to domestic economic conditions. 

What is perhaps most surprising is how little evidence there is of long-term decline in the value of the pound since exchange controls were lifted in 1979. It looks very much as if most of the needed devaluation had already happened (painfully) by then. In which case the IMF's intervention in 1976 to halt the slide of the pound was ill-judged. The pound should have been allowed to fall. It would have found its own level eventually. 

For me, what this chart proves is that provided monetary authorities are credible, a free float is far and away the best way of managing a currency. What is shocking about this chart is not how much the pound has devalued. It is how long it took to do it, and the economic cost of trying to prevent its fall. 


But the real story behind this chart is the end of the British empire and the loss of the pound's reserve currency status. Prior to WW1 Britain was the dominant economy in the world, controlling the largest empire in recorded history, and the pound was the global reserve currency. The empire gradually disintegrated over the course of the 20th Century, and the pound was supplanted by the US dollar as global reserve currency. The pound had to devalue, and substantially, because of Britain's diminishing status in the world and the US's growing dominance. But politicians were unwilling to accept this.  

Britain's history is one of constantly trying to punch above its weight internationally, even at the cost of wrecking its domestic economy. The Geddes axe and ensuing depression of the 1920s, the refusal to devalue throughout the 1950s and 60s, the attempt to prop up the exchange rate in the 1970s, and finally the disastrous entry to the ERM at too high a rate: all of these failed, some disastrously. And all of them had ghastly consequences for the economy. Even today, Britain still tries to act like a larger and more dominant player than it really is. 


Britain is no longer a superpower. Indeed it hasn't been one for a long time, though it doesn't know it. It is time people recognised this, and stopped hankering after past glories. The value of the pound in 1945 was too high even for Britain as it was then, let alone now. It is time to put the past behind us, and move on. 


Related reading:

Currency wars and the fall of empires - Pieria



* Until the independence of the Bank of England in 1997, monetary policy was under the control of the Chancellor, not the Bank. 

17 comments:

  1. Cheap food won votes, as do cheap foreign holidays etc. more recently, When the voters were told that the government would "plan" industry to keep jobs, i.e. prop up those damaged by the sterling policy they believed that as well. These days the property market is the saviour of the pound and the guarantee of cheaper food. This will go to the wall (sic) as well.

    ReplyDelete
  2. I am not sure I entirely buy this narrative. One thing that strikes me is that some of the periods of fixed exchange rate lasted a very long time. 1940-50 is a long time and so is 1950-68. If the period of float after 1979 represents what the market "wants" the exchange rate to be - and I think that is so - then the Treasury was far more successful than I would have expected in resisting the market during the periods of fixed exchange rate. One thing I think would be very useful here is a second chart showing the total UK currency reserves and how they evolved during the periods of fixed exchange rate.

    A couple of points about ERM. It's not clear that the UK actually *joined* ERM at "too high a rate". What really happened was that it joined ERM at what seemed to be a reasonable rate, after which the German Government took fright at signs of inflation and raised interest rates, which pulled up the DMark/Dollar rate and thus the Sterling/Dollar rate. In your chart, you can see the Sterling/Dollar rate just touching $2.00 which was far too high, just before ERM exit.

    Also, like a lot of people you describe ERM exit in terms that make it seem like an exclusively Sterling issue, when in fact half a dozen currencies either devalued sharply within ERM or left ERM at the same time as Sterling, and when ERM was put back together, it was with such a wide allowable exchange rate margin that it really wasn't ERM at all.

    And by the way, although I agree that the euro is repeating many of the errors of the Gold Standard, I think it is also repeating the errors of ERM. That is, a single currency without a common fiscal governance produces a situation where the single currency works only until divergences in competitiveness emerge, after which it becomes under-priced for the most competitive members and overpriced for the least competitive, and so becomes an engine driving its own disintegration.

    ReplyDelete
  3. Good comment by Mr Livesey, but the case for floating exchange rates is proven to my mind, unadulterated chartalist that I am. Currencies fluctuate for a reason, market rigging excepted, and often a weak currency is a blessing in times of recession. there is also a reason central banks tend to intervene which is more about protecting vested interests than an economic rationale. As with most things it comes down to sectorial balances.

    The problems arise when everyone decides to have an "export led recovery" at the same time, if everyone devalues all at once it's a zero sum game. There will be countries that cheat, via mercantilism, but that's usually America. They seem very fond of accusing the Chines of doing exactly what they do. There will be no agreement anytime soon sadly.
    bill40

    ReplyDelete
    Replies
    1. Bill, if everyone devalues at once we have the very definition of coordinated monetary stimulus. This is exactly what is needed at the moment.

      Delete
    2. Mercantilism is Germany's raison d'etre!

      Delete
  4. Nice article. I have often thought the same, that the UK paid a high price for trying to stay relevant post WW1. I think this approach was at the root of the poor labour relations that the UK had from the 1950's through the seventies and also the big North/South divide that there is today. Essentially the high exchange rate made industry uncompetitive and the economy moved to finance, which was less interest rate sensitive. The slow growth of industrial UK relative to its peers is particularly remarkable, essentially the only way industries could survive was through automation.

    ReplyDelete
  5. Lurking at the back of all this is the difference between currency/fiscal issues and economic issues. Did the UK keep Sterling at too high a level "to stay relevant" or did a poor economy ensure that the Sterling exchange rate had to decline over time and therefore always seemed "too high"?

    The trap here is that the exchange rate is a single number which is easy to talk about, and so journalists and the public focus on it, whereas economic problems tend to be difficult to make sense of, and so are either ignored or are talked about in non-technical "morality play" terms.

    I think that one hint here is that entry into ERM punctuated a period of "DMark-envy" during which the British public fell for a fallacy that lies behind the euro today. this fallacy is that if you adopt a "strong" currency then sooner or later oyu will find you have a "strong" economy. In reality, as the UK found out via ERM and the peripheral countries are finding out today, it's the other way round; you need a strong economy to survive using a strong currency.

    The more I look at the exchange rate chart, the more it seems to make sense. The UK ended WWII with a very large overhang of Commonwealth Sterling balances and about 250% sovereign debt/GDP. That had to be worked off through a combination of above average inflation and economic growth. But high inflation implies high nominal wage settlements and aggressive organized labour, which the UK suffered from until the Eighties.

    Bretton Woods was a convenient way of giving Sterling sufficient credibility that its needed decline could be managed and not lead to chaos. By about 1970, it was safe to float Sterling. Since then it has fluctuated in a range between $1.10 and $2.00, and as Ms Coppola points out, that is partly to do with Sterling and partly to do with what was going on with other currencies. And I don't think its any accident that a currency that no longer continuously declines has led to more moderate nominal wage settlements and less industrial action.

    Since exit from ERM the Sterling exchange rate chart looks "normal" to me, so I would conclude that the stresses built up during WWII have been unwound, and from now on the Sterling exchange rate will be driven by the UK's fairly open and healthy economy. Considering what could have happened to Sterling post-1945, I think we got off quite well and the treasury showed a lot of skill in managing the situation.

    ReplyDelete
  6. Hi Frances, you mention the Euro area repeating the same mistakes. What is the solution of this? Adoption of common Eurobond & more unity. A United States of Europe? Would this provide the best solution for it's constituents?

    ReplyDelete
    Replies
    1. Either full integration (United States of Europe) or breakup. The halfway house will simply result in unending depression.

      Delete
  7. Piece from 20 years ago, recycled? Really the last 20 years - and the last 5 especially - have seen a period of remarkable stability, given the real extremes of monetary policy experimented with. The dog that did not bark... why no exchange rate crises in an era where fiat currencies are being minted like no tomorrow? What's stopping us from a blast of hyperinflation to wipe out that odious debt and get on with the next asset bubble?

    ReplyDelete
    Replies
    1. "Piece from 20 years ago, recycled". You missed what I said about the importance of the independence of the Bank of England, then, and the approach to exchange rate management since, then?

      Why no exchange rate crises? Precisely BECAUSE there are floating exchange rates. Currency values adjust to each other all the time in a floating exchange rate system - you can see that in the chart: the "noise" level increases considerably after 1979. I don't agree with all of Jon Livesey's remarks - I do think politicians were too wedded to the idea that a strong pound meant a strong economy - but I think he is right that the pound has now found its correct level and that is why the exchange rate is not varying as much as it used to.

      The hyperinflation question is entirely different and way beyond the subject of this post.

      Delete
  8. Oh dear where to start? 'Cable' (USD/GBP) is no longer the be-all and end all since the rise of the Euro and the advent of floating rates. Cable is now the residual of EUR/USD and EUR/GBP. I would have thought the level of sterling in the last few years was as much about the Fed loosening as the Bank of England doing something (?anything) right. The Old Lady has neglected exchange rates (in the same way she ignored asset price bubbles until recently) as a result of being fixated on the inflation target.

    There's no such thing as a 'correct' level as the mix of imports exports and non-tradeable goods changes all the time and it is relative prices of those that drives exchange rates.

    We should also factor in some politics & history. The UK was bled white as the price of making the world safe for democracy twice in the twentieth century; and the US was the rising Great Power doing most of the bleeding. (I'm looking at you, Harry Dexter White!).

    There will be no ear muffs big enough to blot out the sound of the squealing when the US wakes up to the fact that they are now in the position vis-a-vis China that the UK was in vis-a-vis the US in the second half of the twentieth century. History doesn't repeat itself - but it does rhyme.

    Wall Street crash the result of a British plot? Please, take responsibility for your domestic policy choices.

    The UK made a very serious effort to revive the pre- Kaiser's War arrangements by leadership. It was only when these efforts were unsuccessful that tariff reform and 'Imperial Preference' came to dominate and free-ish trade disappeared for a generation.

    ReplyDelete
  9. I enjoyed this, had just a few thoughts.

    Using the $ rate of course means that you pick up US related trends in particular as well. Looking at the sterling index instead would give a somewhat different and more meaningful picture though the underlying story would still be the same.

    Following the abolition of exchange control sterling rose in the next few years. This was in large degree responsible for the disastrous performance of British industry in the early 1980s and the return of mass unemployment at levels not seen since the 1930s.

    During the early 1980s the authorities followed a policy of 'leaning in to the wind', reflecting the correct perception that markets overshoot. By buying sterling when it was weak and selling when it was strong, the UK did rather well.

    I am bemused by comments suggesting the UK economy is healthy. Have you not noticed the appaling performance since 2007, falling living standards, falling GDP per capita over a period of numerous years, a major housing crisis in the South East? Interest rates still at emergency levels?

    ReplyDelete
  10. The City, and other ex-colonial economic interests with assets overseas certainly did not want the pound to fall. Peter Hall has written excellently about this, in Governing the Economy (1987)

    ReplyDelete
  11. I suspect the pound will be worth way less than $1 in the next 20 years. I think English will be replaced by German, Japanese, Chinese.

    ReplyDelete
  12. Floating is beter than sinking.

    ReplyDelete
  13. I like the question, "measured in what"?

    In the chart it is dollars. It could be bread, labor, houses, chocolate, comodity index, oil, or silver (thats sterling).

    ReplyDelete