Anti-Brexit anxieties have become a self-fulfilling prophecy
What sterling’s ‘flash crash’ tells us about the state of economic life.
The headlines were dominated at the end of last week by the news of the British pound’s ‘flash crash’ on Friday. In early morning Asian markets, sterling fell by more than six per cent against the US dollar over a couple of minutes, before recovering most of its losses. This capped a week when the pound had already fallen by nearly five per cent, triggered, it seemed, by prime minister Theresa May’s ‘tough’ Brexit rhetoric at the Conservative Party conference.
The consequence is that, compared to referendum day, the pound is now trading about 15 per cent down against the dollar, at levels not seen since 1985. Much media speculation followed. Brexit jitters were being realised, observers claimed. Apparently the economic damage widely predicted to follow Brexit was starting to be more fully appreciated by the ‘markets’. And where currency traders began, others will follow. Foreign investors, businesses and well-off individuals will reduce or reverse relationships with an economy that is going to the dogs, we are told. Was the sterling crash the beginning of the end?
First, let’s disentangle the technical mechanisms of a ‘flash crash’ from the possible causes of sterling’s general weakness. There has been lots of talk over whether the flash crash could have been a ‘fat finger’ trade (where someone makes an entry error in their trading instruction) or down to a glitch in electronic trading, where programmed algorithms get carried away with themselves, rapidly reinforcing ‘normal’ market movements. We might never know for sure. But this doesn’t really matter – outside the traders whose fingers, and cash accounts, got burnt – because the ‘flash crash’ was followed over the next few minutes by a ‘flash jump’, as most of the loss was quickly reversed. Nevertheless, sterling’s value is decisively down over the year, so that is something to assess.
The more substantial ‘technical’ point is that there is more movement and volatility in financial markets today than there was 30 years ago. This is mainly because we live in a more financialised economy, where more liquidity is devoted to financial activities than to investing in production and trading in goods and services. Hence economic professionals and commentators become more focused on movements in the prices of financial assets, like bonds and shares, while some physical assets, like houses and commercial property, and even fine wine and art, acquire financial asset-type features.
In the same way, currencies get traded much more for financial reasons than for fulfilling their conventional role as a means of international exchange. According to data from the Bank for International Settlements, foreign exchange markets trade about $5 trillion each day, while the world trade in goods and services that require currency transactions only totals about five times that each year. After adding the currency trading that facilitates the smaller amount of international capital flows, it is clear that foreign exchange trading is a huge speculative business in its own terms.
Ironically, the greater amount of overall liquidity devoted to speculation in currencies and other financial prices coexists with occasional liquidity droughts. In these circumstances it can be difficult for sellers to find buyers, and prices can fall precipitately and sharply. This is probably what happened last Friday, in less-liquid early-morning Asian markets at a time when trading in Europe and the US was shut. Tighter post-2008 financial regulations and banks’ reluctance to act as market makers aggravate any liquidity squeezes. The consequent price movements were probably exaggerated by trading carried out by computer programs, rather than by people who are more likely to use their judgement to say: let’s wait a few minutes and try again later when prices are less volatile. Sterling sellers don’t want to give unnecessary money away.
Aside from the technical factors, why specifically did the crash happen last week? The common explanation given is that May’s speech about triggering Article 50 before the end of next March, and the implications for Single Market membership of her pledge to restore some control of British laws back to Westminster, caused this greater economic uncertainty. Others added that Friday’s fall could also have been triggered by remarks made by the French president Francois Hollande, who said he was minded to pursue a hard stance during Brexit negotiations.
None of these explanations is particularly convincing, however, since such things have been implied or openly said before. It is fanciful to believe that forex dealers were labouring over the summer under the belief that Brexit, and therefore its predicted damaging economic effects, would never occur, and then last week the scales fell away from their eyes.
Rather, last week’s ‘flash crash’, and in fact the cumulative value decline of the pound this year, was something that was waiting to happen. The pound has been overvalued for some time, and the undercurrent of anxieties over Brexit made this clear. It is striking that the US Commodity Futures Trading Commission reported that bets against the pound had hit six-month highs the week before May’s Tory Party conference comments.
Over the longer term, currencies reflect the relative condition of the fundamentals of their home economy, specifically the levels of productivity, productivity growth, and the state of its external current account that reflects the consequential global competitiveness of its goods and services. In this sense, relative currency valuations are proxies for the relative health of their domestic economies. Sterling has been overvalued for some time based on Britain’s dismal performance in productivity since at least the 2008 crash. It is seeing things through Remainer-tinted glasses to think that the pound’s fall confirms the inevitable adverse effects that arise from leaving the EU.
In the short term, on a day-to-day, even month-to-month level, currencies can fluctuate for all sorts of substantial or ephemeral reasons – some solid, others influenced by current fads and transient perceptions. This also means that currency movements based on productivity fundamentals only work through over very long periods. They can never be exactly anticipated. And when they do happen, they are not precise and usually overshoot.
Currency realignments are even more tenuous these days because none of the currencies of the large mature economies – the dollar, the yen and the euro – has a strong home economy to sustain it. This makes predicting movements in currency markets even harder (or sillier, if you want to gamble on them). There is little at the level of economic fundamentals underpinning any mature economy currency. Over the next month, prospects of a Trump victory in the US elections could hit the dollar, as could the perception that the US Federal Reserve is going to delay even longer from increasing official interest rates. Both these circumstances would drive up the relative value of the pound against the dollar.
Or a resumption of the Italian or German banking troubles, or some other manifestation of the Eurozone crisis, could hit the value of the euro, and also drive up the relative value of the pound. Currency markets these days are about whose clothes look the least dirty at a particular time. Recently, Britain happens to be looking the dirtiest of a pretty dirty laundry basket. Attention could therefore easily stay focused on the perceived difficulties facing the British economy from Brexit, or from some substantial cause, and the pound could continue to fall.
Currency movements can simply reflect people’s perceptions of where the economy is going. A falling currency doesn’t illustrate or anticipate anything about the actual costs of Brexit. The falls since 23 June really express the consensus outlook that Brexit will damage the British economy. In practice, though, a lower currency is of little more determining value than all those economic forecasts that assume in their models that Brexit will have a harmful effect. Lo and behold, the forecasts produced from those models show a deteriorating performance. The falling value of a currency has pretty much the same faulty predictive power.
I say ‘pretty much’ because the difference with an economic forecast is that movements in a currency’s value impact on an economy in some tangible ways. For example, the falling value of the pound does reduce the cost to foreigners of buying British goods and services with a fixed sterling price, and it increases the sterling cost of foreign goods. Hence the impact of sterling’s fall in value this year has been to boost the competitiveness of exports, while increasing the price of imports.
This is why depreciating currencies can boost local manufacturing and temporarily narrow the trade deficit, as well as increasing the retail price of imported goods. Ironically, given all the anxious speculation it has reinforced, sterling’s value fall has been one of the unstated goals governments have been seeking from ultra-easy monetary policies: international competitiveness is enhanced while inflation is bolstered, helping to reduce the real value of debt, not least public debt. It is perhaps not surprising that government ministers have so far expressed so little concern over sterling’s recent decline.
Given the discussion to come it is worth recognising that the positive effects of currency falls for export competitiveness are not as great as in the past, before the 1980s. This is because the import intensity of goods produced in Britain has expanded significantly. Many British products are assembled not from indigenous components but mostly from foreign imported ones. As a result, the rise in the price of the imported parts that go into British production offsets much of the export benefit of a lower value currency.
Moreover, currency depreciations can only provide temporary relief from productive weakness. They don’t fix the production factors that drive relative productivity levels. Hence it is complacent for some Brexiteers to welcome sterling’s fall as a good thing that will in itself put right the economy.
Last week’s flash crash was no ‘flash in the pan’. There is likely to be more of this over the coming months and years. Even without such precipitate drops, the value of the pound will probably fall further. But a lower currency level is no proof of the inevitability of sustained economic damage from Brexit. However, it should alert us to how the consensus of anxieties over the adverse effects of Brexit can be self-fulfilling.
This can have even bigger consequences than on the value of the currency. In the short term, financing Britain’s external deficits could become much more problematic – deficits which of course didn’t begin this year, but back in 1984. For the medium term, more seriously, the near single-minded Brexit focus of economic discussion continues to evade the radical policies needed to reset production at a higher level of productivity. The development of such policies has been overdue, since long before the EU referendum.
Phil Mullan is the author of The Imaginary Time Bomb: Why an Ageing Population Is Not a Social Problem, published by IB Tauris, 2000. (Buy this book from Amazon UK or Amazon USA.) His forthcoming book, Creative Destruction: How to Start an Economic Renaissance, will be published by Policy Press in 2017.