The writer is an economist at Oxford university and London Business School, and author of ‘The Great Economists: How Their Ideas Can Help Us Today’
Last week, the pound sank as low as $1.14. This year alone, sterling has fallen 15 per cent against the US dollar, dropping to its weakest level since 1985. The pound-dollar exchange rate has surpassed the lows reached in March 2020 at the onset of the pandemic.
Against its trading partners, though, sterling’s low point was in October 2016. The pound’s weakness began with the financial crisis. After a brief and partial recovery, it fell to a record low following the Brexit referendum, about 30 per cent below its January 2007 level.
Sterling’s weakness is therefore a reflection of the strong dollar and of the uncertain economic outlook. The former is beyond the control of British policymakers, but the latter is not. The fortunes of the pound highlight the need to set out a robust plan for economic growth.
During times of uncertainty the dollar tends to strengthen as it is the world’s reserve currency. Also, dollar-denominated assets are bought as a safe haven. The start of 2022 has seen sizeable shocks, notably Russia’s invasion of Ukraine that compounded the cost of living crisis that was already under way due to pandemic-related supply chain disruptions.
The US Federal Reserve’s aggressive interest rate rises have added support to the dollar, while the unwinding of quantitative easing further contributes to tighter monetary policy.
However, the weakness of sterling is not solely due to the strong dollar. The pound has still not recovered to its pre-crisis level. That period of slow recovery was punctuated by the uncertainty around Brexit, followed by Covid-19.
New data show that the economic effects of the pandemic were worse than originally estimated. The Office for National Statistics has revised down UK gross domestic product for 2020 to a contraction of 11 per cent, the biggest fall in national output since 1709 and the worst among G7 countries.
What has also weighed down the pound is the forecasted lengthy recession. The Bank of England expects the economy to contract for 15 months from the last quarter of the year. That is longer than the average recession and comparable to the protracted downturn that followed the 2008 crisis. Worryingly, the bank estimates that growth is expected to be “very weak by historical standards”, so that by the third quarter of 2025, the economy would be 0.8 per cent smaller than before the pandemic.
One consequence of a weak pound is more expensive imports. The UK is an open economy with a relatively high trade-to-GDP ratio. As BoE governor Andrew Bailey has stressed, 80 per cent or so of inflation is due to global factors. So, a weak pound adds to the cost of imports, which contributes to inflation being higher than in the rest of the G7 since more inflation is imported.
The new government has stressed the centrality of economic growth to its fiscal and regulatory plans. Any such plans would need to increase investment and productivity growth, and the two are related. Business investment has been about 10 per cent of GDP versus 13 per cent in France, Germany and the US, all of which have higher productivity growth.
Investment in the UK remains about 9 per cent below its pre-pandemic level, and 8 per cent below where it was in early 2016 before the EU referendum, reflecting high business uncertainty. Reducing uncertainty through a clear economic strategy would go a long way to raising productivity and therefore economic growth.
While the weak pound reflects the strong dollar, it is also an indicator of how markets see the UK’s prospects. As the new government embarks on a pro-growth agenda, its success may well be first seen in the reaction of sterling.
Source: Economy - ft.com
