Thursday, January 22, 2009

Should Government Protect Pound?

Readers Question: How far can the pound fall before the government has to protect its citizens from the effects of a worthless currency?

The first issue is whether the government can actually do anything meaningful to influence the exchange rate.

The first option is to Buy Pounds on the Foreign Exchange. However, compared to international currency flows, government reserves are only a fraction of the total value. It could use its foreign currency reserves to buy Pound sterling but this would only have a limited impact on raising the value of the Pound. In 1992, when the government spent £21 billion on buying Sterling, investors just saw the government as a source of easy profit. People made like George Soros made a fortune out of the government's attempt to buck the market. (government lost about £3.5 billion during this period)

The second option would be to raise interest rates. The fall in interest rates is a significant factor behind the current fall in the Pound. Higher rates would attract hot money flows and raise the value of sterling. However, the cost of raising rates in the midst of a recession is very high. Even with rate cuts output is falling at the fastest rate since the war. Increasing interest rates could push the economy from a recession into a real depression. Even if interest rates were increased the markets may feel it is unsustainable and so only likely to last for a short time.

The third option would be to introduce exchange controls and try limit the amount of pounds leaving the economy. China uses exchange controls to keep the Yuan undervalued. It means it is difficult to exchange Yuan into other currencies. (my Chinese students have to goto Hong Kong to get British Pounds to study in the UK)

(Fourth option - is to reduce government debt and liabilities. The risk of debt default is a potential cause of Sterling collapsing. Unfortunately the second bank bailout have diminished the prospects of Sterling)

The problem is that government attempts to influence the exchange rate often fail or cause serious side-effects. The lessons of Britain's attempt to stay in the ERM in 1992 are a good example.

Exchange Rates are Not the Problem but the Symptom.

Often a depreciation in the exchange rate is the symptom of other problems.
  • A balance of payments crisis e.g. a country cannot finance its current account deficit - like Iceland
  • A plunge into recession which causes interest rates to fall and hot money flows to leak out.
  • A decline in competitiveness high inflation.
Therefore trying to influence the value of the exchange rate deals with the effect rather than the cause. It's like trying to deal with a leaky pipe by mopping up the water - It would be more effective to mend the leak.

How much is exchange Rate falling?

The other issues is how much the exchange rate is falling, a gradual depreciation like the Dollar since 2001 or the Pound since summer 2008, is different to a collapse in the currency like the Icelandic Krona earlier in the year bought about by a balance of payments crisis.

Is An Exchange Rate Decline the End of the World?

There is an assumption that a falling exchange rate is bad for the economy. It is certainly bad for people importing from Europe, and definitely bad for those living in Europe. But, others benefit. It is good for exporters. In a recession, the government is likely to be glad from the boost to domestic demand that a falling currency brings. In a boom they may worry about the inflationary effects, but not in a recession.

It may be little comfort for those trying to live in Europe on a declining Sterling based income, but the government has to consider all stakeholders in the exchange rate.

However, there does come a point when a slumping pound may start to undermine the credibility of UK economic policy. This is a problem and makes all policy more difficult.

Update: I wrote this piece at the weekend. Since writing it, Sterling's prospects have nosedived after large government underwriting of bank debt. Whatever you think about the merits of this action, it is probably going to weaken sterling in the coming months.

Update 2 Also Sterling has fallen on prospects of quantitative easing. I will post another post later today on this.

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