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Martin Wolf

Why sterling is the next dollar

By Martin Wolf

Published: January 10 2008 19:46 | Last updated: January 10 2008 19:46

Will sterling follow the US dollar? As Willem Buiter pointed out last week (“The silver lining in sterling’s decline”, January 4), this is highly likely. Movements in exchange rates are, to put it mildly, unpredictable. But this one ought to happen. It should also be welcomed. This possibility was, indeed, why the UK had to keep out of the eurozone.

Like the US, the UK has had buoyant credit growth, huge rises in house prices, low private and national savings and a sizeable current account deficit. Like the US, it also absorbed the surplus savings of much of the rest of the world in the 2000s. It is, in short, one of the canonical “Anglo-Saxon” economies.

Yet, in many respects, the UK position is worse than that of the US. The run-up in UK house prices, for example, was much bigger than in the US. On almost any measure, housing valuations and household indebtedness are still more extreme. To take one example, at the end of 2006, household mortgage debt was 126 per cent of gross domestic product, against a mere 104 per cent in the US.

Moreover, the UK’s current account deficit, at 5.7 per cent of GDP in the third quarter of 2007, was bigger than that of the US. Indeed, it was bigger even than it seems. As Andrew Smithers of London-based research company Smithers & Co argues, the deficit is significantly understated by current statistical conventions*. Retained earnings of direct investment are included in data on investment income, but this is not the case for portfolio investment. Since a high proportion of UK-based multinationals are owned by foreign portfolio investors, this exaggerates the UK’s net investment income. The UK’s true current account deficit may have been close to 7 per cent of GDP.

Yet, until recently, sterling was a very strong currency. Even last December, the trade-weighted real exchange rate calculated by JPMorgan was 7 per cent above its average since 1970. A year ago it was almost 14 per cent above that average. Over the past 37 years, sterling’s real exchange rate was as high as a year ago only in early 2004, between mid-1997 and mid-2000 and from mid-1980 to mid-1981. Against the dollar, sterling peaked last November at $2.11. This was higher than at any time since 1981 and more than 50 per cent higher than in mid-2001.

Such high valuations were unlikely to last and have not done so. The strength was driven by the country’s stable economy, open capital markets and the highest nominal interest rates in the Group of Seven leading high-income countries. But now growth seems likely to slow sharply, short-term interest rates are set to fall and capital markets are suffering credit-crunch blues.

Should anybody worry about a continued slide in sterling? Definitely no, is my answer. Those used to cheap holidays abroad will be unhappy. But these were in effect financed on credit. That could not last. It is probable that the credit squeeze and associated correction in the housing market will weaken consumption sharply this year. But since the UK’s private sector is running a financial deficit of 3 per cent of GDP and household savings in the third quarter of 2007 were a mere 3.4 per cent of disposable incomes, this is also highly desirable. In the short to medium run, such a correction is also likely to mean a significant slowdown in the economy, possibly even negative growth in one or more quarters. Offsetting fiscal action is virtually impossible, without scrapping the fiscal rules, though the automatic stabilisers might still work. Indeed, even if the rules were put to one side, fiscal action would be dangerous, since it could endanger the credibility of low inflation. But comments by Gordon Brown, prime minister, and Alistair Darling, chancellor of the exchequer, on prospects for inflation and monetary policy, of the kind heard this week, are at least as big a danger, particularly since reappointment of the governor of the Bank of England is still up in the air.

Yet I do not want to be too critical of Mr Brown, since he saved the UK from the euro. The difficulties of the next year or two will, no doubt, reawaken the pro-euro lobby. But if the UK had been in the eurozone and so experienced even lower interest rates, the credit boom would have been even bigger and the adjustment ahead even more painful.

The UK must now shift to an economy with lower real house prices, higher savings, a smaller current account deficit and a weaker real exchange rate. This adjustment is far better achieved through a decline in the nominal exchange rate than through the years of “competitive disinflation” that Spain, to take one example, is likely to suffer.

British policymakers must focus only on preserving credibly low inflation. That is essential if a sterling retreat is not to become a rout. The external adjustment is most unlikely to be big enough or fast enough to offset the slowdown in domestic demand, particularly given the constraints on fiscal action. So be it: unbalanced growth cannot last forever. The UK must simply keep its nerve while the economy and currency come down to earth. So, too, should the government.

*Why Sterling Should Weaken, January 9 2008, http://www.smithers.co.uk/(restricted distribution)

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