Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 27 September 2017

A Labour run on Sterling?

The news that John McDonnell was looking at a scenario where the election of a Labour government was met with a run on Sterling was all over the news yesterday. The Conservatives, who of course know all about runs on Sterling having created one just a year ago with the Brexit vote, immediately grasped the political gift they had been given.

Paranoia on the left meets prejudice on the right. But what would really happen to Sterling if Labour were to win the next election? Given announced policies, the answer is quite clear: Sterling would appreciate. The main reason is that under Labour there would be a large fiscal expansion: for certain in term of public investment and to a lesser extent with current spending. (I assume by then interest rates will be above their ZLB: if they are not, the fiscal expansion could be even larger.) There would also be a balanced budget fiscal expansion: even if government spending increases are financed by tax increases, this is likely to be expansionary to some extent because some of the tax will come out of savings.

This fiscal expansion, together perhaps with other labour market measures, would put upward pressure on inflation, prompting higher interest rates from the Monetary Policy Committee of the Bank of England. It is the prospect of those higher interest rates that would make Sterling appreciate. How much inflation rather than output would rise depends on how pessimistic you are about the supply side. If the MPC were doing their job properly, that increase in interest rates plus the appreciation would stop inflation rising very much. We will finally get the rebalancing between monetary and fiscal policy that we should have had for the last decade.

If we are also in a transition period for Brexit, with the final destination unclear, then Labour being elected would also lead to an appreciation because Labour are softer on Brexit than the Conservatives.

So where does the run on Sterling idea come from? The idea that all those traders in currency will get together and engineer one because they do not like a Labour government is nonsense. They may not like a Labour government, but they dislike losing money even more. Capital flight? You might see the share price of power or rail companies fall, but that is not going to be enough to move a currency like sterling. Any depreciation in sterling would be the equivalent of pound notes waiting to be picked up in the City and Wall Street: with higher expected interest rates and a likely future appreciation, who wouldn’t buy sterling?

The only way I can see that you could get a run on Sterling is if enough traders in the markets came to believe that Labour was going to abolish BoE independence because it wanted to keep interest rates low. In that case you could get significantly higher inflation under Labour, which would justify a nominal Sterling depreciation.

Which, of course, is why McDonnell committed to keeping Bank of England independence as one of the first things he did. And which is also why he was very foolish to say what he said, because it might lead some to speculate that he might renege on that commitment. Something tells me he is missing his Economic Advisory Council.




19 comments:

  1. McDonnell is a longstanding opponent of Bank of England independence, and authored a piece in 2015 calling for it to end. Not to even mention that is surprising.

    I doubt he'd end it on day one, but the fear that he would undermine it from the start is real. There is no reason to think that he has changed his longstanding view, anymore than he and Corbyn have changed their minds on the EU. They say things that are now required of them because of their office.

    Which is why the pound would fall. (Although this may already be priced in before labour wins if it becomes clear in the polls.)

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  2. My God what a better world it would be if the BBC had you on explaining this rather than the utter guff they present as 'analysis'.

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  3. Despite what you say it's clear to me that many will see the fiscal expansion you mention as bad for sterling. It will increase the stock of debt going forward and, as in the past, there will be no effective rule to balance spending and tax over a cycle or two; in other words it will be seen as typical Labour fiscal irresponsibility. This means at some time in the future the interest cost may impact on public services due to the combined effect of a larger debt stock and higher interest rates; in other words trouble down the road.

    As far as Brexit is concerned I think most would agree that having Labour in charge would be a shambles but they perceive this is not just about Brexit; they see Labour as unfit to manage the public finances anyway; in this case it is a question of BAU.

    With inflation you will get a resistance to increase interest rates anyway. I believe that you will only get an increase in rates if there is a wage/price spiral or a collapse in sterling but because of the effect on the various asset bubbles around there will be a considerable reluctance to increase rates at all and I think the tolerance level is higher than you assume.

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  4. Something tells me he is missing his Economic Advisory Council.

    Well, don't be shy! Somebody has to be the one to pick up the phone...

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  5. "Something tells me he is missing his Economic Advisory Council."

    Are you available? I'd love to see you get involved.

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  6. I think you'll find they have very high rates in a lot of countries pursing populist policies - and their currencies don't appreciate..

    Your theory make me wonder if Gove might have been onto something when he said we've had enough of experts. If you can be a professor at Oxford while not understanding anything about the currency markets then it suggest that economics is not objectively a subject.

    If you really believe the pound would appreciate if Labour elected you are (for now) free to put your money where your mouth is. Don't bet with money you can't afford to lose, because you are going to lose it.

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  7. Why does the interest rate effect outweight the inflation effect? (I see

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  8. We are a long way from an election.
    However, when we get closer to the day I will consider making a large, non-Sterling investment ahead of election day.

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  9. How much money did George Soros make by engineering a run on the pound?

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  10. asocialdemocraticfuture28 September 2017 at 09:24

    Quite an assumption that interest rates will be above their ZLB by even 2022 McDonell may have spoken due to confidence or hope that labour gets into power due to conservative brexit-induced implosion before then. Would be interested to understand the trajectory by which rates would actually rise above ZLB and at what level given current conservative macro-economic framework and continuing brexit uncertainty.

    One possible danger with a corbyn government is that their combined reforms to the 'gig' economy, £10 minimum wage, and trade union links, will induce unsustainable wage inflation in the unionised sector, leading to higher interest rates and higher unemployment for labour market outsiders.

    Agree that John mcDonell and his advisers should be concentrating their minds on managing that risk rather than fretting about a 'run on sterling'.

    To be fair Angela Rayner was forthright and open in making it clear that a labour government would not be giving 5% across the board pay rises to public sector workers.

    And an incoming labour government could steady city nerves by confirming that UK will remain in the single market and custom union until economic conditions make it beneficial for us to leave. In that vein, just come back from brighton and it seemed on the whole that the party approach to europe was verging on the united and canny in terms of holding fire until conservatives provide the best target but maintaining option to stay in single market and customs union.


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    1. You aren't going to get much if any inflation from raising wages at the bottom of the wage structure. If for some reason you did then tighten taxes at the top.

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  11. You will see an immediate fall in the exchange rate on a Labour victory. That's why I'll short the pound five seconds after this occurs, take a profit and then look for a bottom so I can go long for the medium-term. Foreign exchange markets will panic, and then over some period of time (I no longer underestimate the capacity of those markets to remain stuck in irrationality much longer than one would think sane) they'll get it through their heads that Fox Business doesn't know what it's talking about when it screams a Labour government means communist revolution.

    It will take time to sort out but sort out it will and things will be fine.

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  12. I would ask the question, What does it matter if there was a run on the pound? We have a sovereign currency and in the words of Alan Greenspan can meet any obligation in respect of our currency without limit.

    In other words if the currency is devalued it would improve our export potential, and unlike in the days when the currency was linked to the gold standard, and the fact that we don't have to resort to real printing presses to create money, we can never go broke.

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    1. Devaluation doesn't have the positive impact on exports it once did, not when the commodities and materials to produce those goods are themselves imports.

      I doubt any drop in the exchange rate will be particularly severe or prolonged as people have had time to get used to the idea of a Labour government. Certainly not to the level of Brexit.

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    2. Whilst agreeing with the points you make, it of course has no bearing on our ability to create enough money to pay for the balance of payments. In Greenspan's own words, we can meet any obligation without limit. The obvious example of that is the exchange rate between Britain and India 1 GBP =86.3999INR the difference in reality is just numbers on a computer.

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  13. Your analysis would hold, were it not for one thing. - You presume that a Labour government would be happy for interest rates to rise to an extent that would be sufficient to buttress the pound in the face of their spending plans and potential 'People's QE.' In reality, however, it's likely that the necessary increase in rates would create real pain among Britain's highly indebted populace. In turn, this would create tension between the government and the Bank of England. In this situation, do you really think that the current governor, Mark Carney, a Canadian former Goldman Sachs banker who's already likely to leave soon after June 2019, would stay on with John McDonnell as Chancellor of the Exchequer? Equally, do you think McDonnell would choose someone of Carney's ilk as a replacement? No. As Chancellor, McDonnell seems highly likely to select a different kind of governor - potentially someone from the Marxist academic community. Like it or not, that new governor may not have the "confidence of the markets" Carney has. Equally, McDonnell may not want the new governor (Marxist or not) to raise interest rates to the extent that's necessary to shore up the pound. Your argument is not without reason, but ultimately it smells strongly of wishful thinking.

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  14. «Labour was going to abolish BoE independence because it wanted to keep interest rates low. In that case you could get significantly higher inflation under Labour,»

    They could simply change the BoE inflation target from 2% to something like 4%, without abolishing the BoE's independence.
    Some influential of Economists think that a 4% inflation target is a better one. It could be a good post-exit idea precisely to drive down the exchange rate.

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  15. Well, maybe they find it more acceptable to wargame run on pound as a result of Labour victory than a result of hard brexit (which would have a high likelyhood of triggering immediate elections I'd say). This way they can't be accused of pro-EU scaremongering, and the likely stuff they would have to deal with is similar.

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  16. As always a good piece.
    This doesn't address the gap between a rational response as you describe or the real life response which could be a lot less rational.

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