Sunday, 27 September 2009

British Pound Devaluation Delusions

"It does not mean that the pound here in Britain, in your pocket or purse or in your bank, has been devalued."
Harold Wilson, British Prime Minister, after the Pounds devaluation in 1967

"A weak currency arises from a weak economy which in turn is the result of a weak Government."
Gordon Brown, During the Pounds devaluation after it was withdrawn from the ERM

Mervyn King the Bank of England's Governor has been causing a stir in the markets this week. Despite Sterling being a flawed currency it hasn't stopped Mervyn King from making comments that he feels a weaker currency is beneficial for the UK. Undeterred by the pound losing around a quarter of its value, it seems that the BoE still feel the need to send it lower. US-centric reporting has been emphasising the Federal Reserves draconian monetary actions, but yet it is the UK that leads the way in QE and the destruction of its currency. Labour Governments always seem to be in power when the pound gets a pounding. 1931, 1967, 1976 and recently 2008 and beyond. If Neil Kinnock had won the 1992 election like so many believed at the time, they would have got the whole set for the past one hundred years. So what does it matter that the pound has devalued of late? Is it as black and white as 'it will boost our exports', that the media and business pundits proclaim? I agree with the quote above, not Harold Wilson's, but Gordon Browns. Over the long term, Governments that use their currencies to try and solve their economic troubles are doomed to fail. If you try to alleviate trade deficits with this mechanism over the short term it may succeed, but eventually more devaluations will be required in order to 'boost' exports again.

Implications of Devaluations

An examination of the devaluation is required to understand what benefits/disadvantages it brings. Governments always claim that this will lower the cost of our exports, which it does, but no analysis is paid to what actually occurs. If we examine a factory that exports goods, they may be struggling to compete, say against similar German products. A devaluation would instantly lower the cost of the good on the export market. The German Government, for example, may hold steadfast and are not willing to allow their currency to depreciate by the same margin. The British company without doing anything have instantly gained a cost advantage, in effect a free handout. The German company on the other hand has to look for savings itself. Management immediately begin cost cutting, increase productivity or improving their processes. They look at their product, they start to innovate or add extra features or improve the quality to justify the short term price dynamic that has just occurred. The British management does not need to do the above. They can produce the exact same product, using the same processes as there is no immediate need to innovate.

Also something much worse occurs. For the sake of the example say the two products, German and British, now are priced at €500 and €400 respectively after the devaluation, whilst previously they were €500 and €550 respectively. The British management now can increase the price over the short term, to say €450 as they are still cheaper than the German products. This extra margin may go into inflating workers pay, or other company benefits. Not only have no product or business improvements happened, but the British company is also rewarding itself.

The Import Dynamic

Misreporting in the media leads us to believe that the cost of our overseas holiday is the biggest headache when the value of our currency goes down - if only. When the currency takes a fall the whole nation is immediately given a pay cut, all our imports now go up in price. If we have to buy raw materials or products produced abroad it now costs us more, our purchasing power has effectively fallen. In the example given above, if the British company has to import any materials to produce its end product these will drive up their costs. Also the public now have to pay more for the product in question. The cost may seem to have reduced to €450 but remember its all relative, the British people are still getting paid in pounds. People can't buy the same amount of products as imports go up. A price spiral starts. The mechanic who imports car parts from abroad must now charge the public more for car repair work. There are an infinite number of other business transactions that take the same format as the given example. All these costs eventually come back to the British company as their workers require higher wages to cope with the higher prices. This in turn keeps driving the cost of the product higher. Meanwhile in Germany, they have continued innovating lowering their costs through business improvements, driving costs down in order to compete and in turn producing a better end product. The end products cost after a year or two, could now be say €400 and €500, for the German and British companies respectively. The British company is back where it started but in a worse condition, as they have fallen further behind in terms of productivity and end product quality.

The above process can develop into a vicious spiral, with the British company loosing further export share and demanding further devaluation in order to 'boost' exports. There is no simple fix, if a currency goes down in value it doesn't help anyone.

What needs to occur is to let the market take the pain, not the currency. This may mean higher unemployment in the short term, but people and companies get competitive again. Any nation in history who has enjoyed an export boom has done so on the back of a strong domestic currency. Britain during the 19th Century, Germany and Japan through the second half of the 20th Century, the US when they rose as the global superpower. However times change. For the past 30 years or so US politicians have put forward the benefits of a lower Dollar for jobs and exports, but over the years it hasn't worked. Workers wages continue to decline, and US companies continue to disappear.

In Japan from the end of the second world war up until just before the lost two decades, the Yen dramatically appreciated against the US dollar. Yet Japanese exports during the same time frame also increased. Westerners used to joke that Japan only produced kimonos or tiny cheap ornaments. Japan subsequently underwent a huge economic development, beating the West on car manufacture and electronics to such a point that it has now become hard to name a handful of Western electronics companies. In 1970 the Yen was valued at around 357 to the US dollar. Within 20 years it was 146, more than doubling in value. During the lost two decades it hasn't moved much further, to around 90, however its worrying that its still appreciating despite the stagnation of the Japanese economy during this time.

Where does this leave the British Pound?

It's worrying when the people responsible for the defence of a currency welcome devaluation and even believe that this will solve the economic imbalances we face. You can't solve a domestic economies shortcomings by debasing the currency. The British Pound has resumed what it was prior to the late seventies and early eighties. It's once again the whipping boy in the currency markets. Investors beware, the British Pound will not be a place to be for the foreseeable future.


  1. very nice post. I sometimes wonder if King is shorting the pound. everytime the bugger opens his mouth, it goes down!
    I appreciate your analysis is descriptive, but dont lets forget that countries' exporting prowess isnt always about innovation and cost cutting, plenty of foreign governments employ a beggar my neighbour strategy via export credits and the like. germany perhaps?

  2. Roym,

    Governments play all sorts of shenanigans such as tariffs and the like to try and make overseas exports more expensive, but all these policies do is make society poorer as people's purchasing power falls. It also shelters the domestic industries and makes them even more uncompetitive. Good export countries are always the ones who make innovate and/or competitive products. All I'm saying in this post is that the UK can't export its way by devaluing the pound. They did this throughout the 60's and 70's and it ruined our export industries.

    Whats propped the pound up recently has been the north sea oil and gas, and perceived investment returns, much like Iceland. This has given the pound an artificially high value. In fact the recent recovery in the pound is due to investors getting an appetite for risk again. However I suspect there should be another sell off at some point, and the pound will fare badly compared with other currencies.

    The other problem the pound will face in the coming years, will be when the UK can no longer pay back the money we have all borrowed. Essentially the UK is going to go broke at some point in the future and markets will pick up on this at some point.

    Have a look at Japan for example. When their crunch hit in 1990, their government had similar levels of debt to ours in 2007, but only began to run a double digit deficit 8 years after while we are already on a 13% deficit. They only started printing money in 2001 - we have already have printed £175B. Most of Japanese government debt is owned by their citizens - foreigners only hold around 7% of the debt. The UK has around 40% owned to foreigners. While Japan are able to go up to 200% government debt, our government will go broke before that, I would hazard a guess at when it starts approaching 100% GDP. At that point markets will say its over. I suspect the government will pull some desperate measures, capital controls, exchange pegs, higher taxes and so on.

    There has been recent discussions of the government selling more of their assets to try and cover the deficit, but this just makes things worse as the government don't try and solve the problems and put off the hard decisions therefore all the structural issues are still present. What happens when they run out of assets to sell? How much will the public put with the selling of state assets?

    Your best bet will be to get some or most of your money out of the pound.

  3. Thanks u very much.
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  4. Good post, but I can't help thinking that the Pound is grotesquely overvalued. Although a strong pound is attractive to the British people because it allows for many imports, I don't see how Britain can carry on with its huge deficits. In the short-run a devaluing of the pound is unattractive; nevertheless, Britain needs to look to the future- the rest of the world is catching up!

    Under Margaret Thatcher, Britain moved from a highly industrious nation to a think-box- a country that would give ideas, not products. This romantic notion was a failure. Other countries work harder and I can't help being dismayed by the rise of Asian countries such as South Korea, Singapore etc.

    Britain needs to become more competitive, a devaluing of the pound needs to come- and it will come! As John Maynard Keynes said: "We're all dead in the long run".

    Our children, our grandchildren, and their children, however, won't be.

  5. I am wondering what mechanism caused the devaluation? Who or what drove it and how?