The pound closed in on its lowest value against the dollar in almost two years yesterday; meanwhile, in the US, inflation hit a 17-year high. The two are connected, and their connection throws light on what may well happen next as Stage 2 in the credit crunch unfolds.
Economists once coined the phrase Dutch Disease to describe what happens when an economy’s currency is driven so high by one particular sector – in the case of Holland it was oil – that the rest of the economy is rendered uncompetitive. Well, in the UK too, oil drove up the price of the pound. Such was the jump in sterling and the resulting loss of competitiveness for UK manufacturing that some have argued North Sea oil was a mixed blessing for the UK.
The pound surely stopped being a petro currency two or three years ago now, yet it stayed high. It stayed high despite surging consumer spending, and the resulting massive deficit in the UK’s current account. Many have argued, including this publication, that sterling is due a sharp correction.
For the last few years, though, it seems that the pound ceased being a petro currency and became a kind of bankers’ currency instead. Money surged into the UK, and was lent to British banks and business at low interest rates. The UK was considered low risk, so money lent to the UK carried a low premium.
The UK, on the other hand, enjoyed much higher returns on assets its citizens held abroad.
But during the credit crunch, this changed. Post credit crunch, presumably it will change some more. Less money is flowing into the UK, and much of the money that is coming in is being invested via sovereign wealth funds into buying assets on the cheap. The result will be a much greater flow of dividends leaving the UK in future years.
It seems then there are good reasons to think the pound has been due a correction, and that once corrected the change will stay in place for the foreseeable future.
It may be this correction is what we are witnessing, right now.
The pound has of course been falling against the euro for some time, but until recently actually rose against the dollar. Now even this has gone into sharp reverse.
It seems likely that the main reason why the pound initially gained against the dollar, even though the two economies have similar structural problems, is that the US economic cycle is 18 months to 2 years ahead of the UK. Maybe we are now simply seeing the UK experience the kind of falls the US suffered from earlier in 2007.
It is both good and bad news. It is bad news for Brits travelling abroad, and it is bad news for inflation. As the pound falls, foreign goods become more expensive, pushing up prices yet again. This will in turn make it much harder for the Bank of England to lower interest rates.
On the other hand, our exporters should experience a healthy boost as a result. It won’t happen straight away, for as long as the Eurozone is contracting, it is difficult to see how the UK can enjoy export-led expansion. But if the Eurozone recovers, as was predicted in the article above, the result will then be surging exports.
The pressure a falling pound will exert on the Bank of England to up interest rates may be a good thing in the long-run too. The savings ratio in the UK is too low. It may be that this can only be corrected through higher interest rates – well, that and a shortage of credit. So a weaker pound will at least help in that respect.
But it is difficult to see how the UK economy can continue to expand if its high-spending consumers turn to thrifty savers.
That is why exports are so important. And that is why the telling point will be how rapidly the Eurozone can recover, in an environment where its two main external customers are losing steam.
As for the dollar, this has of course risen sharply in recent days, not just against the pound, but against the euro. This has largely been caused by the bad economic news from the Eurozone and Japan.
But, if the analysis above on an imminent Eurozone recovery is right, the dollar’s resurgence may be short-lived, at least against the euro – maybe not against the pound.
US inflation hit a 17-year high in July. The annual US consumer price index was 5.6 per cent higher than a year ago last month. Prices surged by 0.8 per cent in July alone. Even if you strip out food and energy, prices rose by 0.3 per cent in the month.
Then again, with oil and food falling in price, there are good reasons for thinking the index will fall soon. For that reason, it seems unlikely the Fed will tighten interest rates.
The US is simply seeing the same inflation picture that the rest of us are experiencing. The fight against inflation is in full flow. It is being fought in the form of falling real income levels, meaning the resulting fall in demand will lead to lower prices in the future.
The US has avoided recession so far, and the Eurozone experienced recession for two simple reasons. The US government gave out a huge tax credit – something that most Eurozone governments are unable to do because the EU Stability Pact does not allow them the scope to up their borrowing by the amount required to fund this credit. Secondly, the ECB has been much firmer with inflation.
There is one of two possible outcomes. Either the ECB has been foolishly tough on inflation and the Stability Pact is unnecessarily restrictive with its rules. Or rather, this tighter approach will pay dividends in the longer-term.
Right now, it seems the odds are with the latter possibility; this suggests the Eurozone will recover while the US and UK remain in the doldrums. If that is right, then presumably the dollar will fall back against the euro.
Comments
Trackbacks