The good, the bad and the ugly of a stronger pound

The days are getting shorter and Labour’s attempt to cheer us all up has merely confirmed, to adapt PG Wodehouse, that its senior figures are no rays of sunshine. But, and I am aware I risk jinxing it, the pound continues to be the best-performing major currency, and there are some things to be mildly cheerful about.
I shall return to the pound in a moment. Everybody is worried about the October 30 budget, but pre-budget bark is often worse than bite, and there are few budgets that fundamentally change the economy’s direction.
In the meantime, one cause for celebration is that the economy has adjusted quite well to an abrupt change in the interest rate regime. After years of near-zero official rates, we are now back at a “normal” 5 per cent for now at least and, contrary to the fears of a couple of years ago, the sky has not fallen in.
And, while we are yet to see a coherent growth strategy from the government, the economy’s growth and inflation performance over this parliament must surely be better than over the last one. Whether it is good enough, remains a big question. The OECD has revised up growth to 1.1 per cent this year, 1.2 per cent next, better but not that much to write home about.
Whether it is these factors, or that Goldman Sachs is predicting a $1.40 pound, or developments elsewhere, including the troubled German economy and the Federal Reserve’s decision to cut US interest rates by an aggressive 50 basis points this month, the pound is riding high.
As I write this, sterling is close to $1.34 against the dollar and roughly €1.20 against the euro. This is a far cry from two years ago this month when, in the wake of the Liz Truss-Kwasi Kwarteng mini-budget the pound fell to an all-time low of $1.03 in Asian trading, and a London close of $1.07.
While the pound is doing much better than a couple of years ago, current levels do not represent new highs, even this decade. The pound was at $1.42 in May 2021 when there was confidence that thanks to a rapid vaccine rollout, the UK was leading the world out of Covid. The optimism did not last, Boris Johnson’s government was soon falling apart, and the wind came out of the pound’s sails.
There is good, bad and ugly about the pound’s current strength. The good would be that it reflects what Rachel Reeves and Sir Keir Starmer think of as the stability they have brought to UK politics after the soap opera of the Tory years, and this is an international vote of confidence in their ability to turn over a new economic and political leaf.
There may be something in that, but things were stable, at least on the surface, when Rishi Sunak and Jeremy Hunt were in charge, and Labour has had the rockiest honeymoon since Elizabeth Taylor and Richard Burton. Admittedly, there was always the threat of a putsch against Sunak, and the Tories appeared to be in a permanent leadership battle.
The bad part of sterling’s strength is that it could just be that markets fear inflation and interest rates will fall more slowly in the UK than elsewhere. The pound is thus strong for the wrong reasons. The OECD’s forecast, as well as lifting UK growth higher, has also pushed up its forecast for actual and “core” inflation next year to 2.4 per cent and 2.8 per cent respectively.
Then there is what some would regard as the ugly aspect of the pound’s strength, which is that it is the last thing you need when growth is the priority and export volumes of goods and services in the latest three months are running below a year ago.
Ugly is how it looks to John Mills, the veteran businessman of JML fame, Labour donor and supporter, and prominent Brexiteer. He wrote to me a few days ago to remind me of his book, How to Make the Economy Grow, published by his Institute for Prosperity.
As he put it: “There is a simple and straightforward reason why the performance of the UK economy is so poor. It is that our exchange rate is — and has been for a long time — far too high. Our exports are therefore too expensive. This is why, decade after decade, we have lost share of world trade. Weak export performance has caused both chronic balance of payments deficits and excessive borrowing while depressing levels of investment, thus holding back future increases in output.“If we carry on like this, we will have little or no economic growth as far ahead as we can see. Household incomes will stagnate or fall. Government debt will increase, and income inequality will inexorably rise.”
This is not a new argument from Mills. He has, in fact, been making it for a very long time. In response, I have tended to point out that if devaluation was the key to export-led growth, the UK should be world champion. I have also pointed out the traditional Treasury response to this, which is that any gains from devaluation are cancelled out by the higher costs of imported material and components, as well as knock-on effects on wages, that result from a lower pound.
In the past few years, we have had a real-life experiment in currency depreciation. Sterling fell very sharply on the June 2016 referendum vote, and again when Theresa May ruled out single-market or customs union membership. Its revival now leaves it still well below pre-referendum levels. In the slightly more than eight years since June 2016 it has averaged $1.29, compared with $1.58 over the previous eight years. That is an 18 per cent devaluation against the dollar and, while not as much against a basket of currencies, there is a significant fall nonetheless.
We cannot know, whether in the absence of Brexit, sterling’s fall would have given us a similar disappointing export performance. We cannot know, because the fall would not have happened.
And this is the other thing about the “one-off deep devaluation” advocated by Mills. How do you achieve it in a floating era without slashing interest rates, risking much higher inflation and undermining confidence in the UK? You can’t. We may not like what the exchange-rate gods inflict on us, but we must live with it.
My few days away were more eventful than expected. It involved dodging wildfires in the countryside around Porto, grey and smoky skies, a broken-down bus and a cancelled return flight home at the last minute, which left us becalmed until the next day
Anyway, despite all this, my trip solved a mystery. One of the most famous pieces of economics is David Ricardo’s law of comparative advantage, or comparative cost, published more than 200 years ago in 1817. Ricardo, one of Britain’s most eminent “classical” economists, was also an MP and very rich, and one of his homes, which he had rebuilt, was Gatcombe Park in Gloucestershire, now the residence of Princess Anne.
Ricardo’s law explained why countries trade even when, on the face of it, there is no advantage to one of them doing so. In his example, it took Portugal 90 hours of work to produce one unit of cloth, and 80 hours to produce a unit of wine. In each the unit is an agreed quantity, but I don’t think he specified what.
For England, in contrast, it took 100 hours to produce a unit of cloth and 120 for a unit of wine. Portugal clearly had a better climate and soil for wine production but was also more efficient at cloth production. So why trade?
Ricardo’s breakthrough was to demonstrate that because Portugal was comparatively much more efficient at producing wine than it was cloth, it made sense for it to specialise in wine production and for England to prioritise cloth. Portugal produced wine in two-thirds of the hours England took to do so, but in only nine-tenths of the hours required for cloth. Trade and specialisation would benefit both countries.
The puzzle I had was why Ricardo chose Portugal rather than claret-producing France. The answer is that in his day there was a booming Port wine trade driven by British businesses such as Taylor’s, Sandeman and Croft, whose names are still dotted around the Douro Valley vineyards and Porto wine cellars today.
I wondered whether climate change and the revival of English wine production would change Ricardo’s calculations today. But English wine is still relatively expensive, and we do not produce anything like the amount of cloth we used to.
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