A few years ago, I wrote a report for the Institute for Public Policy Research (IPPR) about how capital flows into the UK housing and finance sectors had pushed up the value of the currency, with damaging effects for our exporters.
This phenomenon — a boom in one sector leading to a decline in another — is known as “Dutch disease.” Its name is in reference to the Dutch experience after the discovery of natural gas in the 1970s.
The booming sector absorbs workers and pushes up growth and prices, leading to higher interest rates, which in turn increases the value of the currency. These dynamics encourage consumers to purchase more imports, and they also make exports seem less competitive to international buyers, reducing export earnings in the non-booming sectors.
The UK experienced its own Dutch disease throughout the 1980s and ’90s, as a result of both the discovery of North Sea Oil and the not unrelated boom in the finance and real estate sectors. The relationship between higher oil revenues, a growing services sector, higher mortgage lending, rising house prices, rising imports, falling exports, and rising interest and exchange rates became self-reinforcing.
Ultimately, this cycle should have been self-correcting. When a country runs a current account deficit, demand for the currency should fall (as people don’t want pounds, because they don’t want to purchase UK goods). But in the UK, this never happened.
Capital flooded into the UK economy in anticipation of ever-increasing returns in highly internationalized financial, real estate, and commodities markets until the financial crisis, when a sudden correction sent sterling tumbling.
But the currency still held up as the British state attempted to restart the pre-crisis financialized growth model. By 2015, Deutsche Bank called sterling the most overvalued currency in the world. It simply didn’t make sense for the pound to be worth so much given that the UK was importing far more goods than it was exporting.
The Conservative Party’s bungled hard Brexit was the first event to lead to a “correction” in the value of the pound, as investors expected growth to be permanently lower in the UK over the long run.
The political turmoil that followed Brexit, and the ongoing dire economic conditions, didn’t help matters. The dramatic increases in government spending seen during the pandemic didn’t help either. And then when the Federal Reserve started to increase interest rates earlier than the Bank of England, the pound suffered even more.
And then came Liz Truss. Two weeks ago, after Truss’s euphemistically named “mini-budget,” £1 was worth just $1.07 — the lowest level since 1985, when unemployment was at around 12 percent as a result of Margaret Thatcher’s recession.
There are many reasons for the loss in confidence in sterling. First, it represents an “incompetence premium.” Markets are punishing Truss’s government because it looks like they don’t know what they’re doing.
Second, markets are pricing in longer-term higher inflation as a result of Truss’s economic policy. The combination of her payouts to the energy companies with another attempt at financial deregulation will encourage higher profits and higher spending among the wealthy, pushing up prices for everyone else. And, all else being equal, higher inflation makes a currency less valuable. (On Friday, Truss partially reversed course, firing Finance Minister Kwasi Kwarteng and pledging to raise corporate taxes to pay for other tax cuts.)
Third, none of this spending has been directed toward anything productive. The UK has been experiencing a long-term productivity and investment problem and this government has done nothing to solve the issue. Slower growth leads to lower real interest rates over the long run, which means less demand for the currency.
All in all, markets have deemed that the UK is a stagnant, inflation-ridden economy governed by incompetents. Sterling has fallen sharply and suddenly as a result. And this fall has come after several years of downward pressure on the pound, and on top of a long-term decline from pre-crisis heights.
But shouldn’t we be welcoming the correction in the value of sterling? Shouldn’t this allow our exporters finally to compete on international markets, rebalancing our economy away from rentier sectors like commodities and financial services?
Unfortunately, it’s not that simple. After several decades of Dutch disease, UK manufacturing and exporting had shrunk to a shadow of its former self. What’s more, most of our exporters are highly dependent upon imports of inputs, which means a less valuable currency also means higher costs. The Tories’ hard Brexit was the death knell for many struggling exporters.
Without a comprehensive industrial strategy to support manufacturers and exporters, they will not be able to benefit from a more competitive exchange rate.
Instead, the UK, which is heavily dependent on imports, will find itself paying far more for the goods we buy from the rest of the world. This is going to mean higher food and fuel prices for everyone.
The reason many observers are calling the UK an emerging market economy is not because it is in any way “emerging.” It is because these are the kinds of challenges you often find in low-growth, high-inflation, debt-distressed economies.
The exchange rate tumbles, imports and debt repayments become more expensive, and foreign exchange — which is used to repay debts to international creditors — dries up. The central bank is forced to raise interest rates to attract capital, but this strangles growth. Ultimately, this can become a self-reinforcing downward spiral leading to default.
Such an eventuality is not a danger to the UK as our debts are denominated in our domestic currency (an indication of the imperial nature of the world economy). But we do face a downward spiral of a falling exchange rate leading to higher import costs, pushing up inflation, leading to higher interest rates, which strangle growth, and yet which are never high enough in real terms to arrest the falling currency value.
In other words, without a significant shift in economic policy (ironically of the kind laid out in 2017 and 2019), the UK will have to get used to being a poor, declining country.