First Greece, now Britain. As the markets wait to see whether the Germans and the French will bail out the weakest of the eurozone countries, currency traders are already turning their guns on to the next country with a massive fiscal deficit, a huge trade gap, and no clear plan for bringing its finances under control. A full-scale sterling crisis is now a real possibility. And one that I welcome.
Sterling has dropped like a stone over the past two years. From a high of more than $2 to the pound, it has plunged back through $1.50, revisiting the lows set in the immediate aftermath of the credit crunch. Against the euro area – with which the bulk of British trade is conducted – the decline has been just as dramatic. When the single currency was launched, £1 bought you around e1.70. Now it brings e1.10, and parity may well not be far away. As anyone who has gone abroad in the past year will know, our money is not worth much any more. Meanwhile, the index of wagers against the pound by hedge funds and other speculators is at a ten-year high. Investors are betting big that the pound is going to fall a lot further.
The reasons are straightforward. The UK has one of the largest budget deficits in the developed world: at more than 12% of GDP, it is as big as the Greek deficit, and wider than the Portuguese or Spanish. The recession has been as deep here as anywhere and the recovery pitiful. More seriously, the British show no willingness to tackle their problems. The Irish are getting to grips with their deficit. The Greeks are being forced to get their spending under control. The UK, meanwhile, has been propped up by the prospect of a change of government in a May election. But with the polls narrowing, that no longer looks like the certainty it once was. And even if the Conservative Party does manage to win the election, it is far from clear that David Cameron’s government will have the kind of public support needed to slash 10% to 15% from public spending.
Indeed, the UK looks like it might be the Lehman Brothers of the rolling sovereign debt crisis. It isn’t small enough to be easily rescued, like Greece. Nor is it too big to fail like Japan and the US. It is precisely the right size for the markets to make an example of it. It’s sometimes argued that the UK can’t have a sterling crisis, because we have our own floating currency, and our own central bank; the markets may well push sterling down, but since Britain doesn’t target any particular rate, it doesn’t matter very much. Indeed, the more sterling falls, the sooner an export-led recovery can get started.
Dream on. If you think the markets can’t punish you, you are living on fantasy island. The UK is critically dependent on foreign money. We haven’t even begun to save enough to finance our massive budget deficit. Of the outstanding stock of government debt, £200bn is held overseas, and that’s even after the Bank of England started buying all the gilts it could get its hands on. You can’t just print money to fund the deficit in perpetuity, nor can it be bought by British investors, because we don’t save enough. It has to be funded abroad – but no one will want to buy gilts in a fast-depreciating currency.
And the UK has a massive trade deficit to boot. We import most of our manufactured goods and much of our food as well. Even the oil is running out: for the past five years, Britain has been a net importer of oil and gas. If sterling falls too far, the cost of everything we import will soar, creating a big spike in inflation. Again, you could just ignore it. But you run the risk that the rest of the world will just stop accepting your money. At a certain point, the Bank of England would be forced to jack up interest rates to defend the pound, pushing the economy back into deep recession.
Britain has a long history of sterling crashes. In 1967, the Labour government of Harold Wilson was blown off course when it had to devalue the pound against the dollar. In 1976, the IMF was called in to bail out a country close to financial collapse. In 1992, the UK was forced out of the European Exchange Rate Mechanism as the cost of shadowing the deutschemark became too high. Each crisis had one thing in common. It blew apart an economic consensus. In the 1960s, we thought we had to maintain sterling’s role in the world. Then in the 1970s we thought we could only manage the economy by appeasing the unions, and finally in the 1990s we believed we had to link our monetary policy to Germany’s, whatever the damage inflicted on our economy. In each case, the consensus was wrong. It took a sterling crisis to change it. But once it changed, the country could start to recover.
And now? The consensus is that the government must keep spending and the Bank of England continue printing money for the country to recover. An endless succession of economists keeps telling us that we can’t reduce the deficit too quickly, and that if ‘quantitative easing’ isn’t working, that just shows we need more of it. That’s nonsense, just as pandering to the unions was in the 1970s, and tying the pound to the deutschemark was in the 1990s. Only a sterling crisis will force the UK to change course. Bring it on.