There’s something undeniably pleasing about seeing the pound back up close to $2. It’s not just the prospect of cheaper sangria on the beach this summer, or the pleasure of hearing American tourists complaining about the cost of their taxi into London. It’s because a strong currency is a kind of international virility symbol. When the rest of the world has confidence in you, it tends to put a bit of a swagger in the national step.
The strong pound: reasons for sterling to fall
But Britons should savour the moment. It is unlikely to last for long. That’s because the reasons are so ephemeral. The first is that Britain has just started to raise rates, at the very moment the US has decided to stop, at least for now. And with the Bank of England’s latest inflation report pointing to further rate rises, sterling is likely to become more attractive in the short-term. The second reason is that central bankers are, understandably, turning against the dollar and are looking to diversify their reserves. As one of the most liquid currencies in the world, sterling fits the bill.
But neither of these explanations point to a sustained rise in the pound. Real interest rates may be high in Britain now, but either inflation will pick up as forecast, in which case real interest rates will fall, or inflation will be squeezed and nominal rates will fall. Any yield advantage is likely to be short-lived. But will the pound fare any better as a result of central bank reserve diversification? It’s hard to see why it should. In many respects, the UK is a mini-US. Our trade deficit in goods, at 6%, is about the same size as America’s – and widening all the time. Our manufacturing output has been falling, making us more dependent on imports. The big difference between us and America is that our trade deficit is largely supported by the earnings of the City. Betting on the pound is a bet on the City being able to keep growing so fast.
The strength of the City: don’t take success for granted
On the face of it, that’s not a bad bet. The City goes from strength to strength. Perhaps the best barometer of its success is London house prices, which are once again going through the roof. London dominates key financial markets, such as foreign exchange and equities trading.
It is the lead player in the restructuring of the European economy and the drive to create a single market. It is starting to rival New York as a centre for the hedge fund and private equity industries. And it is where the international super-rich from Russia and the Middle East come to invest – and spend – their petrodollars.
But the City’s success can’t be taken for granted. On a mundane level, there’s a risk we get careless and drive business elsewhere with burdensome regulation or by failing to invest in our infrastructure. But the bigger risk is that the City’s boom turns to bust. That boom was fuelled by ultra-low interest rates and cheap debt. Indeed, the real boost to London’s fortunes occurred not during the boom years of the late 1990s, but the supposedly tough years that followed. That was when the private equity and hedge fund industries exploded into life on the back of inexhaustible credit. Now that global interest rates are rising, life is getting trickier. The City may come in for some knocks.
The strength of the City: the importance of immigration
The snag is that the UK economy is far less able to withstand a knock to the City than it was even a decade ago. As the City has grown in importance, other sectors of the economy have withered, particularly those that actually make things. Indeed, the two are linked. The City’s success has helped keep the exchange rate high, which in turn makes many of our traditional exports uncompetitive. Economists call this the “Dutch disease”. It usually refers to countries with huge natural resources wealth, but it could just as easily apply to the destabilising effect of the success of the City.
But the City’s success is also symptomatic of a wider problem in Britain. Much of our growth, and a good deal of our paltry productivity gains, are due to immigrants. The City is the most open market for talent in the world. And the UK is the most open country. Immigrants tend to be willing to work harder for longer hours, often for less pay, at the same time as the indigenous population wants an easier life. That’s as true among the middle classes as it is among unskilled workers. A dispiriting survey published in the FT last week showed that the City is the career of choice for Asian students in Britain, but what white students want is a career in the public sector.
This tension between the demands of the majority, who look to the state to ensure them a pampered, easy life of welfare and benefits, and an ambitious minority, who are prepared to work incredibly hard to get rich is both a political challenge and an economic one. To thrive, the City needs low taxes and relaxed immigration. Politics points the other way. The strong pound is partly a reflection that, for the moment, the City is winning. But for how much longer?
Simon Nixon is executive editor of Breaking views.com