By Frances Coppola, Proprietor, Coppola Comment
This chart caught my eye:
It’s the GBP/USD exchange rate from 1915 to the present day. Accompanying this chart on Twitter was the comment “quite shocking though how much the pound has been devalued since 1945”.
This is a fine example of the way in which economic indicators can be misinterpreted when the historical narrative underlying them is ignored. What this chart shows is indeed shocking, but not because the value of the pound has fallen. It is shocking because it graphically depicts the decline of British global influence. And it charts the desperate attempts of British politicians to maintain global dominance by propping up the value of the currency.
The start point of this graph – 1915 – was during the First World War and immediately after the failure of the classical gold standard in 1914. Britain borrowed heavily and suffered high inflation during the First World War, and was forced to devalue the pound considerably towards the end of the war. You can see that drop clearly. But instead of accepting devaluation of the pound as part of the cost of fighting a ruinous war, British politicians decided to try to restore the pound to its pre-war value. They imposed severe fiscal and monetary austerity upon the war-damaged British economy, causing a depression that lasted for much of the 1920s. The pound did indeed recover most of its pre-war value, and Britain returned to the gold standard at the 1915 rate in 1925. You can see that the graph flatlines from 1925 to 1932. That was the last time Britain was on a gold standard.
But if Murray Rothbard is to be believed, the price the world paid for Britain’s determination to restore its former glory was the Wall Street Crash and the Great Depression. Rothbard claims that the Fed loosened monetary policy at Britain’s behest, and in so doing caused a credit bubble that burst in 1929. I think blaming the Wall Street Crash entirely on Britain’s need for loose monetary policy is rather far-fetched: Rothbard seems to have a bit of a chip on his shoulder. But Britain’s ill-judged return to the gold standard was almost certainly a contributory factor.
The onset of the Great Depression following the Wall Street Crash placed the British economy, like everyone else’s, under great pressure. Like everyone else, initially Britain tightened monetary policy to preserve the value of the pound. But eventually it was forced to devalue. It came off the gold standard in 1931 and the pound promptly dropped considerably. Barry Eichengreen has documented the role of the gold standard in the Great Depression: it seems clear that those countries that came off the gold standard early, such as Britain, fared much better than countries that remained on it for longer, such as the US. The lesson from this is that a fixed currency regime after a financial crisis and recession is economically disastrous. Sadly we don’t seem to have learned from this. The Euro area is busy repeating exactly the same mistake – it isn’t called a gold standard, but it behaves much like one.
The pound did recover its value as Britain came out of the Depression. But it’s worth remembering at this point that there are two sides to any exchange rate. This is GBP versus USD. The strength of the pound in the later 1930s was due to the weakness of the US dollar as the US first reflated (FDR’s New Deal) and then dipped back into recession again.
Not surprisingly, the value of the pound fell sharply on the outbreak of World War 2. It is quite normal for currencies to devalue in wars: the currency itself becomes riskier because of the uncertainty around the outcome of the war, and economic fundamentals in the countries concerned usually worsen considerably despite the fiscal stimulus caused by the war effort. Wars are expensive: GDP collapses, inflation rises and countries become highly indebted. Britain was no exception. It ended the war heavily in debt to the United States and with a massive balance of payments deficit. This was ON TOP OF the outstanding debt it was still carrying from WW1, which it had never managed to unload. Two world wars and a depression had caused enormous damage to the British economy. It was in pretty poor shape.
In 1944, Britain entered into the Bretton Woods managed exchange rate system. This fixed the pound’s exchange value to the dollar, which in turn was linked to gold. Once again, British politicians were determined to show that Britain was still a force to be reckoned with, so the exchange rate was set too high for such a damaged economy. Britain was forced to devalue the pound by 30% in 1949. But even that was not enough. The next 18 years were characterised by persistent balance of payments problems and sterling crises: Britain was forced to seek assistance from the IMF more than once. Wilson finally devalued the pound again in 1967. But by this time, inflation was already rising and was made worse by the devaluation. The next 15 years were to be a period of high inflation and dismal economic performance.
In 1971, Nixon suspended convertibility of the dollar to gold, effectively ending the Bretton Woods system. But even after this, Britain continued to prop up the pound against a market that clearly wished it to be lower. The currency simply did not warrant the value that Britain wished it to have, yet successive Chancellors* refused to allow it to float freely, fearing a sterling collapse. In 1976, the Chancellor of the Exchequer called in the IMF to help arrest persistent runs on sterling. On the advice of the IMF, the Chancellor imposed austerity measures, which reduced inflation and improved economic performance. The IMF’s loan was never fully drawn. The pound recovered – but only temporarily. Against a background of rising unemployment, the famous “Winter of Discontent” in 1978 sounded the death knell for the Labour government. In 1979, the Conservatives under Margaret Thatcher won the election.
1979 was a turning point for the pound. Exchange controls were lifted, and for the first time it was allowed to float. And it promptly fell. It takes a great deal of nerve for a Chancellor to allow a previously managed currency to fall freely, but Geoffrey Howe allowed it to do so. But again, we should be mindful that there are two sides to any exchange rate. The fall of sterling in the 1980s was due to the growing strength of the dollar, which climbed steadily against all currencies (not just the pound) until 1985. But in 1985, currency management started again. The Plaza Accord of 1985 introduced active depreciation of the dollar against all major currencies including the pound, a strategy which only ended with the Louvre Accord of 1987.
Howe’s successor, Lawson, was – and remains – a fan of managed exchange rates. From 1987 onwards he unofficially pegged the pound to the German Deutschmark. This caused inflation, a credit bubble and a property market boom which eventually crashed in 1990, followed by a recession. Despite this, Lawson’s successor, John Major, continued to shadow the Deutschmark and eventually joined the European Exchange Rate Mechanism (ERM) at what it soon became clear was too high a rate.
But it didn’t last. Britain’s brief membership of the ERM ended ignominiously when the pound was forced out by sustained speculative attacks. Major’s successor, Norman Lamont, reportedly said he was “singing in the bath” after the pound crashed out of the ERM. It promptly sank to an exchange rate more appropriate for the state of the economy. The independence of the Bank of England in 1997 removed the value of the pound – both its domestic value (inflation) and its external value (exchange rate) – from direct political control. The Bank of England now primarily manages the domestic value of the pound and allows the international value to adjust to domestic economic conditions.
What is perhaps most surprising is how little evidence there is of long-term decline in the value of the pound since exchange controls were lifted in 1979. It looks very much as if most of the needed devaluation had already happened (painfully) by then. In which case the IMF’s intervention in 1976 to halt the slide of the pound was ill-judged. The pound should have been allowed to fall. It would have found its own level eventually.
For me, what this chart proves is that provided monetary authorities are credible, a free float is far and away the best way of managing a currency. What is shocking about this chart is not how much the pound has devalued. It is how long it took to do it, and the economic cost of trying to prevent its fall.
But the real story behind this chart is the end of the British empire and the loss of the pound’s reserve currency status. Prior to WW1 Britain was the dominant economy in the world, controlling the largest empire in recorded history, and the pound was the global reserve currency. The empire gradually disintegrated over the course of the 20th Century, and the pound was supplanted by the US dollar as global reserve currency. The pound had to devalue, and substantially, because of Britain’s diminishing status in the world and the US’s growing dominance. But politicians were unwilling to accept this.
Britain’s history is one of constantly trying to punch above its weight internationally, even at the cost of wrecking its domestic economy. The Geddes axe and ensuing depression of the 1920s, the refusal to devalue throughout the 1950s and 60s, the attempt to prop up the exchange rate in the 1970s, and finally the disastrous entry to the ERM at too high a rate: all of these failed, some disastrously. And all of them had ghastly consequences for the economy. Even today, Britain still tries to act like a larger and more dominant player than it really is.
Britain is no longer a superpower. Indeed it hasn’t been one for a long time, though it doesn’t know it. It is time people recognised this, and stopped hankering after past glories. The value of the pound in 1945 was too high even for Britain as it was then, let alone now. It is time to put the past behind us, and move on.
* Until the independence of the Bank of England in 1997, monetary policy was under the control of the Chancellor, not the Bank.