Sunday, 19 June 2016

Would a weaker Pound really be all that bad?

Lately the blog has gone a bit political and it really needs to shift back to defence. At the same time, I'm sick of hearing 'Remain' campaigners talking about the "economic consequences of leaving the EU" when most can't actually explain what they are. So I set myself a challenge; to try and mix the two elements - economics of a 'Brexit' and UK defence - into one post, preferably without using any swear words this time. Which being the clever bastar... clever bugg... clever dic... clever so and so that I am, I think I've managed.

I was also inspired to write this piece because I'm getting pretty fed up with a narrative that's been going around for about the last two months or so; degree educated people are more likely to vote to stay in the EU, while those without degrees are in favour of leaving, the implication being (and often explicitly stated) that if you plan to vote 'Leave' then clearly it's because you're dumb and should probably just leave such important decisions to the well educated people who know best.

As someone without a degree this really, really gets up my snout. Luckily as an ex-bouncer I'm well trained in conflict resolution and de-escalation measures, and as all of you who've been following this blog (or discovered it in recent days) will know, I am a calm, peaceful, measured, reasonable kind of guy...



Firstly, your possession of a degree doesn't automatically qualify you as intelligent, it simply makes you knowledgeable about a certain subject. There is a huge difference between those two things. Secondly, your degree in Baking, or Philosophy, or English Literature is wonderful and I am genuinely impressed with you for seeing it through and getting your reward for your hard work, but now let me ask you a couple of questions. Question one; can you explain in some quite boring and onerous detail what caused the 2008 financial crisis? Question two; can you explain how the yield on a bond can change, generally and over the life of the bond, when the coupon on the bond is actually fixed?

Because I can. 

And if you can't then do me a favour and answer this third question; although admittedly the previous two questions were highly selective, they do indicate your general ability to understand finance and commerce on a national and international level, so if you couldn't answer either question then pray do tell, why on Earth should I listen to your advice about the economics of a 'Brexit'? You can have an opinion and that is completely fine, but don't try and tell me that your degree in sports science makes you 'smarter' and better qualified to comment on the economic arguments of a 'Brexit'.

Like people's obsession with the value of the Pound Sterling for example.

There have been many warnings about the "dire economic consequences" of a 'Brexit' and chief among these have been warnings about the reduction in the value of the Pound. I suspect this is mainly just due to language. "A fall in the strength/value of the Pound" is a useful phrase for those on the 'Remain' side chiefly because it sounds like a bad thing. Surely the Pound should be strong, right? Surely it being valuable is a good thing, right? It's a trick of PR that's been around for many, many years now. For example if you were asked to pick a side in the US abortion rights debate, would you rather be described as 'pro-life' or 'Anti-choice'? 'Anti-life' or 'Pro-freedom'? Yes it's semantics, but research has firmly shown that semantics matters.

So is a fall in the strength/value of Sterling really that bad? Well, a lot of that depends on how far it falls and which side of the fence you're on. Movements in the value of a currency always help some people and hurt others. There has never been a currency shift that I know of that has helped everyone at the same time, at least not immediately. Generally speaking though a fall in the value of the Pound versus the Dollar or European currencies like the old Deutschemark, or now the Euro, have historically been good for Britain.

The European Exchange Rate Mechanism
Back in 1978 Britain was mulling over the possibility of joining the European Exchange Rate Mechanism (ERM, not EERM, because... Europe) which was due to begin in 1979. The ERM was designed to reduce currency instability across Europe by keeping the various currencies within a certain range of one another, considered favourable in its own right and especially so with an eye to the future and possible greater European integration. The ERM would, in theory, smooth the transition from national currencies towards a single European currency.

There was a problem though.

Denis Healey was the Chancellor of the UK at the time and later claimed that he was tipped off by a German minister that the ERM was far less to do with currency harmony in Europe and far more to do with protecting Germany's economic position. West Germany at the time had been enjoying decades of strong growth, but problems were beginning to bubble on the horizon. The exchange rate between the Deutsche Mark (DM) and the US Dollar ($) had shifted significantly over the previous years. At the start of 1971 $1 would get you around DM 3.6. That meant for example that a DM 5 product would only cost a US buyer about $1.38. By 1978 the exchange rate had moved to just over DM 2 per dollar. That DM 5 product would now cost a US buyer almost $2.50, nearly double the price. 

The problem is that as the DM progressively strengthened against the dollar it made German exports more expensive to buyers paying in dollars. But the dollar wasn't the only currency that the DM was strengthening against. The Pound, the French Franc, the Italian Lira, pretty much every currency in Europe was losing its value compared to the rapidly appreciating DM, reducing the purchasing power of these currencies on German products. The strength and rapid growth of the German economy was also becoming the cause of its likely downfall. If this pace continued then German products would soon be unaffordable to anyone but Germans.

The ERM had the potential to change all that by tying the DM closely to the currencies of its neighbours, and them to it. This would do two important things; it would slow the appreciation of the DM and it would strengthen the currencies of Germany's major export markets across Europe. By suppressing the value of the DM and raising the value of neighbouring currencies it would keep German goods affordable, at least in the short term. Healey wisely spotted the potential danger for the Pound and opted not to enter the ERM when it began in March of 1979. 

The result worked pretty well for both parties. Although the DM continued to appreciate against the Dollar for the first few years, during which time German GDP growth faltered, by 1985 the DM had once again reached an exchange rate of just over DM 3 to US$1 and German growth had returned in earnest. The Pound meanwhile fell in value against the Dollar throughout the first half of the 1980's, almost reaching parity in 1985 (when UK GDP growth was nearly 4%) before rising again as the decade worn on, driving annual GDP growth that fluctuated between 2 and 6%. 

Black Wednesday
In October 1990 the UK finally entered into the ERM as desired by then Chancellor John Major, who was soon to become the Prime Minister (and is now on the 'Remain' side of the referendum). Major was convinced by assessments from both the Bank of England and the Organisation for Economic Cooperation and Development (OECD) (both of whom have warned about the negative consequences of a 'Brexit') that joining the ERM would bring stability to the Pound and provide the monetary discipline necessary to control rising inflation, in particular the accompanying wage inflation. 

The Pound went in pegged at DM 2.95, with wiggle room to rise and fall by just 6% from this figure. The UK government was thus obliged to stop the Pound falling below an exchange rate of DM 2.773. This was too high and pretty much everyone knew it, especially the currency speculators. Against this background, and with a number of systemic issues already in place, the economy began to nose dive. Unemployment rose by 700,000 between 1990 and 1991. By the second quarter of 1992, GDP fell by 3.6% from its 1990 level. Inflation was however falling rapidly, mainly because a lot of people were now out of work and had no money to spend. Joining the ERM had achieved what it was supposed to - control inflation - but at a fearsome price.

Meanwhile in Germany, fears over a massive rise in inflation due to the country's reunification were being tackled aggressively by the German government. Interest rates were kept high to keep inflation low and the DM began to appreciate as a result. This forced many countries, including Britain, to enact measures to appreciate their own currencies in order to stay within the exchange rate margins demanded by the ERM. Even as the recession in Britain deepened and the Pound strengthened against the Dollar, which in turn hurt British exports and applied yet more pressure on the economy, the government found it was powerless to act (sound familiar? Greece?). It couldn't lower interest rates in an effort to stimulate liquidity (spending. Basically) as this would have driven inflation back up and devalued the Pound compared to the DM, breaking the conditions of the ERM. The British economy was now caught in a bizarre death cycle.

At this point the writing was on the wall. It was inevitable that sooner or later the UK would have to devalue its currency. And the speculators pounced.

Speculators like George Soros, whose hedge fund "Quantum" had built up a massive 'short' position against the Pound, in essence borrowing Pounds from other people on the promise to return the same amount at a fixed point in the future. The key to a short position is that you take the borrowed asset and sell it off, hoping the price will go down (and indeed driving it down yourself in the process). You then wait till you think the price has gone as low as it can (or as low as you dare to go) before repurchasing the assets. The assets are then returned to the original owner and you pocket the difference between the original selling price and the lower repurchasing price.

On Tuesday the 15th of September, 1992, Soros began to unload his Sterling holdings and the price of Sterling began to collapse. The next day, Wednesday the 16th, "Black Wednesday", the government attempted to fight back by buying up Sterling. But Soros and others were selling it too fast and in too great a quantity. An attempt to raise interest rates to tempt savers and investors to buy into the Pound failed. By the end of the day the Chancellor Norman Lamont was forced to announce that the UK would leave the ERM, having failed to keep the Pound within the necessary limits. Soros later estimated his profit from the event at around US$1billion.

The country meanwhile seemed to be on the verge of ruin.

But in actual fact the opposite happened. Free from the need to track the DM the Bank of England slashed interest rates to around 6%, stimulating spending while at the same time exports increased significantly due to the devalued pound. The UK economy grew steadily over the ensuing years, unemployment fell, and by the time Labour took power in 1997 the government was actually running a budget surplus.

The Coming Storm
As we approach the final days before the referendum, it's clear that a similar storm is brewing in the financial markets. With some opinion polls pointing towards a win for the 'Leave' campaign, many companies have already moved their money into foreign reserves in anticipation of a large devaluation of the Pound. Stocks in UK companies have been sold off as people look for safer havens. German government bonds currently have negative yields, that is to say that people are actually prepared to lose money on them just to secure their cash.

Perhaps most ominously, many traders are already preparing for the day after the referendum result. Companies have been commissioning their own opinion polls. Some have booked hotels for their traders to use for rest overnight. Catering companies are doing a healthy business offering to provide all night services. The best and the brightest are being drafted in for what promises to be a massive day on the financial markets. In the event of a 'Leave' vote, the Pound is expected to take an absolute kicking. Estimates at this point could see the Pound fall to parity with the Euro (currently £1:EU 1.27) and down as low US$1.20 (currently £1:$1.43). That's a fall of about 21% and 16% respectively.

It sounds like a nightmare. It's on par with a lot of the warnings that have been issued about the consequences of a Brexit. But there is one slight problem with those warnings; most of them focus almost exclusively on the increased cost of imports. What everyone seems to be forgetting is how the devaluation of the Pound can affect both exports and drive the domestic economy. 

Think about it this way. You now live in a country that uses the Euro as it's currency (sorry about that by the way). You've been eyeing up a British made car but baulked at the current 10,000 Euro asking price (the more computer savvy among you will have realised by this point that I don't have a shortcut for the Euro sign). If the Pound does indeed fall to parity with the Euro, that car has just become 21% cheaper. Overnight it has dropped in price to just 7,900 Euro and now looks a lot more attractive.

Now granted this is a slight simplification. Aside from the fact that no sane person would pay the full forecourt price for a new car, we also have to consider that the materials used in the car have also become more expensive, the labour will eventually become more expensive, and the Pound is likely to rally a little in the future once the initial wave of speculation and panic selling has passed. But ultimately the car will still end up cheaper. Interestingly it will likely finish more than 10% cheaper. That's relevant because the EU import tariff on finished automobiles is 10%. 

So contrary to many of the 'Remain' scare stories, British cars are actually likely to become cheaper to export, not more expensive. And now you know why most car manufacturers are so relaxed about the possibility of a 'Brexit', because most of them will have already run the numbers and realised that in a perverse and counter-intuitive way a 'Brexit' vote has the potential to actually boost their sales abroad. At the very worst, assuming the Pound recovers strongly, the damage is likely to be much less than many people think, with a real terms increase in export costs potentially under the 2% range compared to 'pre-Brexit'.

As for the domestic economy, inflation is the key word here. You've probably heard all the warnings about inflation by now from the 'Remain' side, inflation that would be triggered by a fall in the Pound. But here's the kicker; inflation is generally considered good for economies, at least up to a point. One of the problems that the UK has had over the last few years is that inflation has been near zero and stubbornly refused to budge from that spot. That's why the Bank of England interest rate is so low, because the government and the Bank are desperate to try and get liquidity back into the market, to kick start inflation and get people spending again. The Bank of England's target rate for inflation is actually 2%. The current rate is 0.3%.

But why does this matter? How is inflation in prices good for an economy? It sounds, does it not, like a terrible thing for prices to constantly be rising. The answer is simple; because inflation promotes spending. 

Let's go back to the car scenario from earlier, except that now you're back in good old Blighty and looking to spend your hard earned pennies on a new set of wheels. You're 'hmming'. You're 'ahhing'. You're wondering whether you really want that new car that badly. If you get it on finance you might be able to afford it, but then you might have to cancel the Sky subscription to make room in your budget. You're just about to walk away and procrastinate the decision off till another day, maybe even another year, when the dealer comes over to you and explains that the £10,000 car you're eyeing up now will cost £10,200 in 12 months time. Still want to walk away now?

That is the fundamental affect of inflation. It promotes spending now, not later. It encourages people to make big purchases as soon as they can, under the expectation that the price of the item in question will only rise if you don't buy it now. It also helps to explain why deflation - a reduction in prices over the long run - is so hugely damaging to an economy. Why buy a car today for £10,000 when in six months time it might be drop in price to £9,900? In that case putting off purchases actually saves you money and this can cause a vicious cycle of spending restraint that begins to drag the economy towards recession.

It's a grand irony then that the Bank of England has been trying to promote inflation for years and yet now that the target inflation rate might be handed to it on a plate it's warning of the possible consequences! Granted you don't want inflation to go up too high, but I've thought for a long while now that 2% is probably too low of a target, and that anything up to 5% might actually be desirable. To put this into perspective the Treasury's recently released "shock" scenario estimated a rise in inflation to 2.3%, while it's "severe shock" scenario estimated a rise in inflation to 2.7%. If you're looking at those numbers and saying to yourself "hang on, isn't that pretty close to the Bank of England's target rate? And certainly closer than 0.3%" then you'd be right. Interesting isn't it? And perhaps now some would understand better why I considered that documents warnings of deep recessions to be laughable

It's also worth considering the impact of a depreciation of the Pound on imports. In a nutshell, everything becomes more expensive to import. This will be one of the prime drivers of inflation in the economy. It's important to note though that certain products will inflate more than others. Some are produced domestically and as such a rise in import prices will simply make these domestic products more desirable. Beef and milk for example will rise in price, but probably not as much as you might expect. Goods that can't or wont be produced domestically will by comparison be the most severely hit. 

But rising import prices is another one of these things that has been touted as a huge negative, when it actually might prove to be a boon. Let's go back to the rather exhausted car scenario from earlier, except that now you're planning to buy a car that was imported from abroad. With the reduced purchasing power of the Pound versus say the Euro, cars made abroad become more expensive. If this currency shift lasts until the UK actually formally leaves the EU then you might be looking at an import tariff on top of the exchange rate cost, driving up the price of foreign produced cars even more. Which will lead to what? Aye, more people looking to buy the cheaper, British made cars. 

It's also worth noting that Cameron's moan about the increased cost of going abroad has a flip side to it, one that unsurprisingly he's not interested in talking about. Yes, if the Pound falls in value against the Euro then holidays in Europe will become more expensive. But that will in turn do what? That's right, encourage more people to holiday at home. Look out Wales, Scotland, Cornwall etc. At the same time the cost of flights, hotels, attractions etc will be reduced for foreign visitors. Their spending money will also stretch a little further. All things that are likely to encourage an upswing in global tourism to the UK.

A weaker Pound is also likely to affect asset prices in the UK such as stocks. While the stock market might take a kicking at the start, the increased purchasing power for those abroad is likely to soon recover that. At that point UK stocks actually become quite an attractive long term investment, especially for those banking on a recovery of the Pound in the long run. And while we're on assets and investments, let's just address the scare mongering about pensions shall we. The state pension is protected by a triple lock of measures designed to maintain its value. One of those locks is inflation. So no, inflation won't erode the state pension, the state pension will simply rise exactly in line with it. Indeed compared to much of the population pensioners would see their relative purchasing power increase.

What about house prices though? Well that's a lot harder to predict. If asset prices are pushed up over time then you can expect people like the banks to go looking elsewhere for more profitable uses of their money. That means mortgage lending. That means continued rises in house prices. It should also be pointed out that the main reason property prices are so high at the minute is because demand significantly outstrips supply, a problem that is being fuelled by the governments help to buy scheme. This dynamic is unlikely to change any time soon, so expect property prices to remain (artificially) high. 

The biggest risk to the housing market would be an over reaction by the Bank of England to counter inflation. If it jacks up interest rates then many people might find their mortgages being less affordable, or even unaffordable. If borrowing slows enough that house prices begin to fall then it could also cause some people to get caught in a negative equity trap (paying for a mortgage that is now more expensive than your actual home). This was one of the leading causes of defaults during the US sub-prime mortgage crisis that lead eventually to the 2008 financial crisis. 

Inevitably though we have to face the reality that the UK housing market is over heated. This is not going away, 'Brexit' or not. There is a bubble and eventually that bubble is going to burst. Of course a 'Brexit' will make a convenient scapegoat if it happens, but with careful management it should be possible for the Bank of England and the government to work together to gradually deflate the bubble in a controlled manner. Just as long as they don't pop it!

The Defence Angle
Now I did promise this would be related back to defence, and here we are. Hopefully you've already guessed what I'm about to say, because you're clever like that. A 'Brexit' triggered run on the pound doesn't just have the potential to make things like car exports cheaper. It would also make UK defence exports cheaper. A decent sized drop in the Pound might make BAE think twice about their decision not to invest in the fabled 'Frigate Factory' at Scotstoun. A weaker Pound might just be the ticket to making such a production facility viable in the long term and persuade foreign buyers to take the leap. 

This has great promise for the simple reason of economies of scale. A 10% reduction in the value of the Pound versus say the Dollar (just for arguments sake) might only make a $10,000 car drop to being a $9,000 car, but in the world of warships it can suddenly make a $550 million frigate into a $495 million frigate. Or an order for 4 frigates at $2.2 billion into an order for 4 frigates at $1.98 billion. Those are fairly substantial savings, savings which can be ploughed into other areas of a nations defence budget.

Obviously it's not just frigates that become more attractive. Aircraft, armoured vehicles, sub-components, the works. A thriving defence export industry would not only drive down prices for the UK government through increased orders, but it also has the potential to attract more players into the UK market, creating additional competition. It also has the potential to stir innovation and to slowly help British defence companies to reduce their dependence on the government for orders. Generally you could expect this to make the industry as a whole more innovative and more inclined to take risks over time, combining well respected British engineering talent and quality of work with lower prices to create a winning combination for the future. Even so-called "gold plated" equipment designed to meet British standards would be likely to come in at an affordable price. Indeed that combination of quality, capability and price might be the tipping factor for many.

I'll keep it brief; leave or remain, I hope speculators do kick the crap out of the Pound on June 24th. It might just be the kick up the arse our economy needs.


  1. Oh thank you at last someone who understands National/Goverment workings and yes it realy is not like your household income.
    If you can just get the morons at the BoE to not over react we might be in business. 40yrs of petro pound and BoE mismangement might just be un done fingers crossed.

    1. BoE has said publicly that it won't step in to adjust the market unless things go incredibly bad. Whether they will actually stick to that or not is up for debate.