The pound is sinking, and not even a new government can save it
A general election won’t restore an ailing pound. Britain’s crisis is far deeper than that
The pound is cheap, very cheap – but that does not mean that it won’t get cheaper still in the next few weeks. In the short run, the prime minister calling a snap election might well weaken it further.
Sterling has become the prime indicator of the level of uncertainties in British politics. Markets hate uncertainty and the tortured path to Brexit has delivered that in spades. The rule of thumb is that the greater the prospect of the UK leaving the EU without an agreement, the weaker the pound. But there are several twists to this story, including the possibility of a sudden bounce as and when the fog clears.
There are two broad ways of valuing a currency. One is to look at its historic range; the other to calculate its intrinsic value.
On the first, sterling has traded between $2 and $1.30 for most of the time since the early 1980s. It briefly dipped to $1.05 in February 1985, and briefly went above $2 in the early 1990s and again in 2007. But generally the range was narrower still, between $1.70 and $1.40, so a level of below $1.20 is historically very low.
On the second, the conventional valuation is on purchasing power parity, a sophisticated version of The Economist magazine’s Big Mac Index. The latter looks at the price of a Big Mac in different countries and gives a surprisingly similar result to the purchasing power parity (which looks at the price of all traded items) calculations. On my back-of-an-envelope tally the pound should be about $1.50 on the Big Mac Index. A more formal calculation of its PPP value suggests the current dollar rate should be a little lower than that, say $1.45.
You can argue about the detail. The UK is running a current account deficit of 4 per cent of GDP, so in theory it needs a relatively cheap currency to boost its competitiveness. But the US current account deficit is 2.5 per cent of GDP and that has not held down the dollar, while the eurozone has a surplus of 3 per cent of GDP and that has not particularly boosted the euro.
The conclusion that flows from this is not only that the pound is undervalued, but at some stage it will climb back. Do not, however, expect the prime minister calling a snap election to trigger such a move. Something bigger has to happen: there has to be a more general return of confidence in the UK.
There is a wall of money out there hunting for good investment propositions. Under normal circumstances the UK would be getting its fair share, probably rather more than its fair share. But the combination of Brexit, and even more damagingly the incompetence of the government in negotiating the exit agreement and then the inability to get it through parliament, has inevitably meant that investors hold off. Result: the pound falls.
I don’t think confidence will return suddenly. Even assuming a fairly favourable news flow, including some sort of deal with Europe, there will be a lingering suspicion of the UK. Margaret Thatcher’s time in office was dogged by doubts about her effectiveness and durability: witness the pound plunging to $1.05 in 1985 – after she had won re-election.
Even after a Brexit deal there has to be the more important issue of the future trading relationship, and the UK’s political fissures will hold down confidence in sterling for a while to come. Paradoxically, a second referendum might well weaken sterling further because it would prolong the uncertainty – though global business clearly would have preferred the first referendum to have gone the other way.
Does a week pound matter? Two points.
One is that having a competitive currency may be no bad thing if we are heading into a global downturn, which in some measure seems likely.
The other is that just as we should be concerned about excessive market fears, we should also be concerned about market euphoria. The pound above $2 in 2007? Remember what happened next. A financial crash and stonking recession in 2008-09.