Weak Sterling and Economic Growth

Recent figures appear give the UK fairly healthy GDP growth projections for this year relative to other OECD members. While this has been interpreted by Brexit apologists as a sign of prosperity to come, such an interpretation is gravely mistaken.

Britain’s current ‘growth’ comes down to two things: the basic math behind growth accounting and the weak pound.

The £ and FOREX

We’ll look at the latter first. A currency’s value is determined on the foreign exchange (FOREX) market. Governments can choose from a range of policy options when it comes to managing the currency on this market, ranging from letting market forces fully determine its value (a ‘pure float’) to fixing its value to that of another currency (known as a ‘peg’).(1)

The UK government generally adopts a policy that allows the pound to freely float on the FOREX market.(2) It manages monetary policy by targeting an interest rate and adjusting the available supply of money. The value of the currency itself is set by the clearing of supply and demand on the FOREX market. FOREX supply and demand are driven by international flows that require a particular currency, such as trade, investment, tourism, and remittances. Tourism in the UK and export sales increase demand for the pound and are, in turn, bolstered by its relatively weak position when compared to other major currencies.

So why, then, is the pound’s value low? Low interest rates reduce returns on pound-denominated investments, although interest rates are low across the developed world. The effect is usually to spur investment in physical or human capital, but this is not happening; the lack of foreign investment in the UK is a particularly noticeable source of the pound’s low rate of exchange.(3) Investors are scared away by uncertainty surrounding (hard) Brexit; as I mentioned in a previous post, foreign investment is likely to be highly inelastic (unresponsive) to normal adjustments to monetary policy.

Growth Accounting

A (very) simple growth equation can be expressed as a function like the following:

Y = L + I + T

L = Labor (including human capital)
I = Investment (both domestic and foreign)
T = X – M (trade balance), where X = export value and M = import value

The weak pound is a consequence of both the Bank of England’s expansionary monetary policy and a lack of foreign demand for the £ on the foreign exchange market (driven primarily by a lack of foreign investment in the UK). This has a direct effect on the trade balance, boosting exports and suppressing imports. Consequently short-term growth looks much better than the long-term fundamentals would suggest. The trade balance itself is not particularly sustainable, as the most globally engaged firms trade in both directions. Inputs are frequently imported, and a weak currency increases costs, driving up export prices to compensate. Exports will not remain high post-Brexit as the UK will no longer be a part of the European Common Market, and will have to negotiate trade agreements with key trading partners to regain access to important export (and import) markets. The foremost of these is the EU/EEA, with the US and China close behind; the Brexiteers’ dreams of a ‘new Commonwealth’ built on trade agreements would do nothing to replace the role played by these essential economic partners.

Investment, as discussed above, remains suppressed, especially in the case of foreign sources. Investment and labor are generally the sources of sustained growth; because the labor supply depends on population growth and education, investment is usually promoted as a cheaper means of achieving quicker growth.(4)

The growth contribution of labor comes down to the labor supply (size of the work force) and the abundance of human capital – skilled or educated workers. One of the central planks of the UK government’s Brexit strategy (to the extent that one remains) is increasingly limited immigration, both from the EU and from non-EU and non-Commonwealth countries. Non-EU/Commonwealth immigration to the UK is largely made up of highly-skilled workers or those with significant available resources for investment in the UK economy. Discouraging this sort of human capital inflow where there is an obvious domestic shortage is not a growth-friendly strategy. Neither is the current climate of rampant nationalism, xenophobia, and racism the government’s current discourse both fosters and encourages. On top of the likely event that skilled jobs and workers are relocated to the EU in response to Brexit, numerous existing immigrants are likely to reconsider their futures in an unwelcoming UK, magnifying the policy’s harmful economic effects.(5)

To summarize:
The pound’s weakness is not successfully stimulating activities that would generate sustainable economic growth.
Brexit will reduce the UK’s economic growth by harming trade prospects, hindering investment, and significantly harming the quality of the labor force.(6)

(1) Pegging a currency to gold or another commodity has been advocated by fringe politicians, primarily in the United States, but this is a stupid idea. It was achieved with a fair amount of success in the latter half of the 19th century, but the trade-offs inherent in adopting the Gold Standard led to its unraveling; a similar system was adopted following WWII, which similarly led to significant problems.
(2) In the closing years of the 20th century, it has engaged in what is known as a ‘managed float’, intervening to prevent significant shifts in the pound’s value. Prior to its exit from the European currency mechanism (that later led to the euro), the pound was even pegged to the Deutschemark with bands set to allow for some market-based fluctuations.
(3) It is worth mentioning that most of the listings traded on the FTSE are denominated in US dollars; this is why the FTSE responded very positively to the pound’s ‘flash crash’. Exchange rate-based gains will not sustain the FTSE in the medium term, with Brexit-related fears a more dominant source.
(4) I’m ignoring productivity here, as that is endogenous to both investment and human capital.
(5) EU/EEA and Commonwealth immigrants are also, on average, more skilled/educated than the native British population. Despite the government’s complaints to the contrary, immigration is a net fiscal positive.
(6) If we were to augment this growth model to a more realistic version, productivity would multiply the effects of under-investment and reduced human capital.

Weak Sterling and Economic Growth

Investment and the Bank of England

While the Bank of England elected to maintain the 0.25% base interest rate, there’s been consistent speculation over a rate cut from the Bank of England (BoE) – from 0.25% to 0.10%. This comes in light of a lot of doubts over central bankers’ dwindling powers, particularly in the face of some of the more unique features of the contemporary global economy: the rise of cryptocurrencies and fintech, global low central-bank rates, the broaching of the 0% lower bound, questions relating to the breakdown of the Phillips Curve (which describes the inverse relationship between inflation and unemployment), etc.

The post-Brexit environment presents two key difficulties for the BoE. First, investment is depressed due to the political/institutional uncertainty surrounding the triggering of Article 50 and the lack of clarity surrounding the potential Brexit deal. Second, the pound’s value is depressed due to the same concerns. This means the elasticity (responsiveness) of both investment and exchange-rate value to base rate will be significantly reduced when compared to normal periods.

The aspect of this that tends to be overlooked on the academic side is what this means for the individual. Base interest rates near 0 penalise savers, although those heavily invested in stocks tend to benefit (the effects of negative rates are even more pronounced, but the BoE governor has – so far – distanced himself from these). With cash ISAs often making up a disproportionate amount of savers’ investments (particularly among the less well-off), extended periods of very low interest rates exascerbate monetary policy’s distributional and political effects. It is very likely that this is one of the (admittedly many) causes of the pronounced dissatisfaction with the UK government, as well as the divisions within Labour.

The low value of the pound, relative to other currencies, on the other hand, is something that directly factors into the academic literature on central banking. For consumers, the pound’s drop since the Brexit vote has led to a significant increase in the real cost of living (probably 10-20% depending on the basket of goods). When combined with minimal returns to savings and investments, this could be viewed as an important determinant in the testy battle over Labour’s leadership.

And all of this to promote investment? Well, exports respond positively to a weak currency, but I wouldn’t hold my breath over investment doing the same in this case. Because the lack of new investment is driven uncertainty over unresolved issues, much larger economic incentives would be required to persuade risk-averse investors that Britain is safe for further investment. In view of this, avoiding base-rate reductions on the BoE’s part is the right move. What happens next is dependent on how the UK economy responds (probably not much) and how the Brexit negotiations continue to unfold.

Investment and the Bank of England