January 29, 2008 | posted by Michael Baxter in Sterling | comments (0) |

There is a mystery a-brewing. US interest rates are falling like a pig, shorn of its wings, from the sky. And yet the dollar has not fallen in tandem. If you take into account interest rate expectations, then this really becomes quite surprising. Fed chairman, Ben Bernanke, has metaphorically chartered a fleet of helicopters carrying monetary stimulus to try and boost the US economy, but, by contrast, the central bank in the UK still seems to be fretting over inflation and this moral hazard argument – that banks are being bailed out through encouraging them to do more of the same things that created the mess in the first place.

Put all that together and it would appear the gap between US and UK interest rates is set to climb.   Then take into account that Until March last year, US and UK interest rates were the same. Then the Fed lowered rates while the Bank of England raised them.

In the short term there seem to be two main reasons for money to flow into a country. Money will flow in to chase higher interest payments, and it will flow in if the recipient country is seen to be having good economic prospects.

Bear that in mind, and all of a sudden the reasons for the sharp fall in the dollar relative to the pound last year become clear.

But the pound has since dropped back, falling from $2.10 last autumn to this morning’s price of 1.98. So if the expectations for US interest rates are so low, while at the same time the outlook for the US economy seems awful, why has the pound weakened?

It seems there are three possible explanations. Explanation 1: markets believe the Bank of England will change its tune, and will soon join the Fed in a race to see who can cut interest rates the quickest. Explanation 2: markets expect the UK economy to go the way of the US, and slow, possibly even toying with recession. Explanation 3: things are actually working the way the economic text books say they should, and the pound is at last responding to the fact the UK suffers from a massive deficit on its current account.

Recently, the deficit in Britain’s balance of payments current account as a percentage of GDP overtook the deficit seen in the US, but even that doesn’t tell the full story. One theory doing the rounds is that the official figures on Britain’s balance of payments deficits understate the reality, because the figures don’t accurately reflect the extent to which UK company profits have occurred overseas.

It was about this time last year that Warren Buffett said he was getting out of dollars; there was no magical reason for his decision. He decided the US current account deficit was too high.

Economists have for some time dismissed current account deficits as not really mattering  if capital flows into the country with the deficit increase.  It is certainly the case that both the US and UK are on the receiving end of massive capital flows.

Maybe, though, investors have become more discerning. Sovereign Wealth Funds are demanding an awful lot more bang for their buck, while the dollar and perhaps the pound have lost much of their appeal to investors.

Maybe this is the true reason for the credit crunch, foreigners are no longer happy to pump money into the economies of the Anglo Saxon world for such a lousy return.

And what is the lesson for this story? It is that in the long run, deficits in the balance of payments current account do matter, after all. For years, economists have dismissed as groundless, fears that the US balance of payments deficit would end in tears, saying this was as about as likely as pigs flying. Well, it seems that just may have happened. The economic pig may have taken to the wing.