Sterling’s recent tumble is just the latest in a saga of painful episodes for successive UK governments. During the post-war era of “fixed but adjustable” exchange rates, British politicians were regularly faced with the terrifying risk of a currency devaluation. Poor underlying competitiveness left successive administrations facing severe trade deficits. One “fix” was devaluation, a mechanism that, temporarily, would make exports cheaper for foreign buyers and imports more expensive for British consumers. Devaluation, however, felt like a national humiliation. Whenever they could, governments tried to avoid it. The 1956 Suez Crisis was ultimately a huge problem because the Americans, unenthusiastic about Britain’s imperial adventures, threatened to withdraw the financial support necessary to prevent sterling tumbling.
Eleven years later, when sterling finally succumbed, Harold Wilson, the Prime Minister, attempted to persuade the British public that the 14 per cent drop “doesn’t mean … that the pound here in Britain, in your pocket or purse or in your bank, has been devalued”, possibly one of the most foolish comments ever uttered by a politician. Sterling’s 1992 departure from Europe’s Exchange Rate Mechanism left the Conservative government reeling. Its prior reputation for economic competence was totally shredded, a factor that helped usher in New Labour in 1997.
More recently, sterling has been on the side-lines, innocuously floating against other currencies. The modern test of economic competence is not what happens on the currency markets but, instead, what happens with inflation.
After many decades of good behaviour, inflation is now a big problem. With the Bank of England warning of double-digit outcomes later this year — even as the economy temporarily shrinks — it’s rather clear that something has gone wrong. It’s very easy, of course, to argue that the UK’s problems are global in nature. For currency markets, what matters is not so much how bad things are at home but, rather, how bad they are relative to what’s happening elsewhere.
Given that inflation has been heading higher all over the world, it’s tempting to believe that currency “vigilantes” — bond market investors who can “punish” governments showing signs of financial misbehaviour — will simply shrug their shoulders and hunt for easier prey elsewhere.
Yet they are now fixated on sterling, increasingly believing that it is one of the more vulnerable currencies within the international herd. Against the US dollar, the pound has begun to fall at an alarming pace. At the beginning of the year, sterling would buy you $1.35. At the end of last week, it would buy you less than $1.24.
One explanation for this sudden loss of value is simply that Russia’s invasion of Ukraine presents a far bigger threat to European economies than it does to the US. In recent days, however, sterling has also begun to weaken against the euro. Another explanation is the impact of Brexit. Yet, since the 2016 referendum, sterling has been both weak and strong.
More plausibly, the vigilantes simply don’t believe what the British authorities want us to believe. While America’s Federal Reserve has abandoned all reference to the idea that inflation is “transitory”, becoming increasingly strident about the need for more monetary tightening, the Bank of England is rather more blasé, continuing to insist that inflation will eventually tumble below its two per cent target in response to only very limited interest rate increases.
Maybe the Federal Reserve is wrong. For the time being, however, that won’t help sterling. As the pound falls — a response to the Bank’s perceived complacency — more of the world’s inflation is “imported” into the UK. That’s what happened in the mid-Seventies when, as now, the authorities decided that inflation really wasn’t a lasting problem. By selling sterling, the Seventies vigilantes forced a rethink. A rapidly falling currency contributed to surging inflation at home, triggering further currency weakness. It was a financial “circle of doom”. Could the same happen today? Hopefully not, but if the vigilantes have their way, the Bank of England could be forced to accept that, sometimes, history does repeat itself.
Stephen King is HSBC’s senior economic adviser and author of Grave New World