Sterling’s Legacy of Crisis

March 2, 2010

Britain’s periodic fiscal problems,chronic large trade deficits, comparatively high inflation and the enormous offshore holdings of sterling have made that currency an object of speculative selling through the ages.

Prior to the modern era of floating dollar exchange rates, the pound devalued sharply after Britain quit the gold standard in 1931 for a second time.  After the Second World War, sterling devalued another 30.5% in September 1949 from $4.03 to $2.80 and by a further 14.3% to $2.40 in November 1967.  That was close to its mean level in 1Q73, when the governments of the advanced economies adopted flexible, market-determined exchange rates.

A year earlier, however, between the dollar’s first and second devaluations in December 1971 and February 1973, European nations arranged to let their currencies fluctuate in narrow +/- 2.25% bands against one another.  Sterling joined the so-called “snake within a dollar tunnel” on May 1, 1972 but was forced to leave just seven and a half weeks in the boxing equivalent of a first round knockout at the hands of speculative sellers.

The pound experienced heavy downward pressure in the 1970’s especially after press reports in April 1975 that the government reportedly favored a weaker exchange rate.  Sterling’s decline became a rout in March 1976 when Bank of England intervention seemingly nudged the currency’s passage through the key $2.00 level for the first time.  A $5.3 billion sterling support package from other governments in June 1976 didn’t arrest the plunging pound, which fell to $1.5550 in October 1976.  An IMF package later that year with mandated austerity measures plus the prospect of North Sea oil production and exports turned around sterling’s fortunes in the latter years of the decade.  It helped, too, that speculators turned their sights on the dollar, and investors viewed Maggie Thatcher’s Conservative Party victory in May 1979 in very favorable terms.  Remaining British exchange controls were lifted in October 1979.

The pound’s peak came in October 1980 at $2.4565.  It had come all the way back to its level at the start of floating rates and managed to record an average value for 1973-79 of $2.0861, thus surpassing $2.00.  Against the German mark, sterling’s mean value in 1973-79 was DEM 4.9067.  The better tone could not be sustained.

Like many other currencies, sterling faired poorly against the dollar in the early 1980’s, collapsing all the way to $1.0345 on February 26, 1985, a cumulative move of 58% from its 1980 peak.  Markets sat vigil for what many expected to be an inevitable drop through parity that never happened.  Fearing a repeat of the bloodbath when the pound penetrated $2.00 for the first time in 1976, Bank of England officials ratcheted up key interest rates by 450 basis points within a couple of weeks and engaged in heavy coordinated intervention support with other central banks.  During the whole decade of the 1980’s, sterling posted average values of $1.6777 and DEM 3.6809, down 19.6% and 25.0%, respectively, from its 1973-79 means.

Sterling experienced further disgrace in the early 1990s.  To be in contention for common currency membership in the future, the pound entered the European Exchange Rate Mechanism (ERM) in October 1990 with a central parity of DEM 2.95 but failed to survive two full years.  Britain’s political leadership was forced to remove sterling from the joint float on September 16, 1992.  Sterling slumped sharply that fall and would eventually hit bottom at DEM 2.1640 in November 1995.

The exodus from ERM had a silver lining.  Although a political Waterloo for the Conservatives, who’ve been in exile since May 1997, the pound’s sharp depreciation made Britain more competitive because a period of global price stability short-circuited the usual vicious cycle of currency depreciation and domestic inflation.  It helped, too, that the Bank of England was finally granted independent jurisdiction over interest rate policy in 1997.  During the 1990s, the pound averaged $1.6397, just 2.3% less than in the 1980s, but it lost a further 27% on average against the mark, averaging DEM 2.6868.

The last decade was a difficult one for advanced economies but a comparatively gentle one for Britain until the financial crisis hit in 2007.  The U.K. avoided recessions experienced in the United States and elsewhere in Europe.  Then Chancellor of the Exchequer Gordon Brown boasted that the boom-bust pattern of Britain’s economy had been ended.  Fiscal discipline became a casualty of those exuberant salad days.  Economic growth was also helped by excesses in financial services, which comprise a greater share of the British economy than most other advanced economies.

The U.K. was a sitting duck when a global meltdown of financial markets triggered the Great Recession.  Real GDP fell 5.0% in 2009 and eked out non-annualized growth of only 0.3% last quarter.  With the U.K. current account in deficit, a budget gap wider than 10% of GDP, CPI inflation at 3.5% on year versus 2.6% in the United States and 0.9% in Euroland, and central bank officials who continue to mull the possibility of doing more quantitative easing, sterling came under selling pressure in the latter part of 2009.  The latest in a series of U.K. currency crises is not apparent in comparisons of the pound’s average value in the noughties to the mean of the 1990s, which shows a gain of 3.7% to $1.7010 and 5.8% against the synthetic mark to DEM 2.8418. 

The adage, the higher they fly, the harder they fall applied here and in spades.  From a decade-high of $2.1160 reached during 2007 and $1.7043 as recently as last August, sterling had fallen as low as $1.4778 yesterday.  It’s still a distance above the 2008 and 2009 lows of 0.9803 and 0.9649 against the euro, but its synthetic D-mark value is weaker than the low of DEM 2.1640 hit in late 1995. 

The circumstances in which sterling now finds itself are somewhat reminiscent of the move through $2.00 in early 1976.  Then, like now, speculative attention did not initially begin with sterling.  There had been a lira depreciation of more than 20% in January-February, and other members of the EC snake like the French franc, Belgian franc and Dutch guilder also came under fire before the guns were turned on sterling.  Until recently, attention had been aimed at Greece and other peripheral members of the euro.  Speculation against a currency union is vented mostly in fixed income securities.  The currency play is like shooting the moon in hearts, all or nothing.  The target has to be pried away from the pack, and heavy resources can be assembled to prevent such.  That’s not to say the scenario is impossible.  The permitted failure of Lehman Brothers was also considered highly dubious.  Sterling, however, offers a better chance because it floats independently and has very poor economic fundamentals.  An attack to knock the sterling domino over could be justified on economic grounds and the pound’s isolation, but that’s not all.  A parliamentary election, which must be held by June, figures to produce a government that will be too weak to push through a credible long-term plan to cut the deficitSooner or later, the pound was going to be tested before that vote.

A final thought reflecting on this history lesson is that after sterling was punished in 1976, the next target was the dollar.  The U.S. had a big and growing current account deficit then.  The present shortfall is in danger of swelling sharply by yearend.  The Democratic Party controlled both the Congress and the White House back then but was too fractious to enact major legislation.  The final element, and admittedly biggest factor behind the dollar’s swoon in the late 1970’s was the inflation problem.  I believe inflationary concerns in the Treasury market will prove to be way over-stated, but with so many unique parameters at the moment, its doubtful those worries are going to fade.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



2 Responses to “Sterling’s Legacy of Crisis”

  1. Simon says:

    Great stuff Larry. A fantastic history lesson.

    Thank you