In the currency markets, the British pound has been one of the biggest victims of the financial crisis. It is down almost 30% against the USD over the past 12 months, and is hovering near parity with the Euro for the first time since the common currency's inception. The explanations are numerous: no horizon for the financial crisis, housing prices in free fall, fears of prolonged deflation, the BoE chasing the Fed, swelling deficits, etc etc etc. All the standard culprits.
While confidence in the UK economy, and currency, has been falling for some time (understatement of the year?), there is growing concern that a sterling run is imminent. Sterling fell below $1.40 today to its lowest level in over 7 years. Before paring losses in late trading, it was headed towards it worst day against the dollar since 1992. In a widely quoted interview, investor Jim Rogers summed up his thoughts on the pound, "I would urge you to sell any sterling you might have. It's finished. I hate to say it, but I would not put any money in the UK." Ouch. There is also speculation that the UK is facing a downgrade (Spain and Greece were downgraded last week, with Ireland and Portugal in the firing line).
In my opinion, this sterling pessimism is well-placed. Public sector debt is expected to balloon to more than 50% of GDP by 2011. The government just announced a second bail out of the banking system, a day after shares in RBS fell 66%, and amidst calls for a complete nationalization of RBS and Lloyds. While Brown has been more proactive than US policymakers in addressing the banking system (i.e. nationalization), he has yet to fully address the fundamental toxin in the system: bad assets. Until banks are compelled to fully disclose the steaming piles of crap they are sitting on, confidence in the banking system will remain nil.
So, if we are confronting a sterling collapse, what are the implications? Politically, Labour would be toast. Economically, a tiny boost to British manufacturing/exports would follow, but plunging consumer confidence and global demand would more than cancel this out. Financially, an already weakened City of London would see its influence as the global capital of finance (sorry New York) severely diminished. Fiscally, the government would find it increasingly difficult to finance its massive response to the crisis.
And what of the currency itself? One of the more interesting questions is whether a sterling collapse could lead Britain to reconsider the Euro. A group of academics, journalists, and politicians have revisited this argument in the report, "10 Years of the Euro: new perspectives for Britain". Organized by LSE Chairman Sir Peter Sutherland, and including contributions from LSE Prof and IPE Journal favorite Willem Buiter, the report argues that the country "should urgently reconsider the case for joining the single European currency". Buiter sums up his case succinctly, "It is time to revisit the five tests, to declare them passed and…for the UK to adopt the Euro." He dismisses the argument that an independent monetary policy is necessary for a country like Britain to respond to financial shocks, and discounts the effectiveness of exchange rate control by saying, "Even a gun fired at random by a drunk may, from time to time, hit the target. This is what we have seen in the UK with the exchange rate this past year."
Sutherland argues that Britain will lose its financial and regulatory influence under the emerging (re)regulatory consensus and eurozone fiscal convergence. His argument is essentially this: join the club and have a powerful seat at the table, or get left behind, powerless and throwing stones at the castle wall.
While Euro adoption may be in Britain's long term interest, is joining the Euro viable in the short term? I say no. Adopting the Euro would be political suicide for Labour, and it is unimaginable that Brown would risk his already shaky resurgence with such a bold stroke of statesmanship. The British also have an historic, deep attachment to the pound. Once the reserve and primary settlement currency under the gold standard, sterling's prestige is deeply ingrained in the British consciousness (nowhere more so than in the City of London). You could say it is the last vestige of the empire. And let us not forget that the Euro project itself will be under real strain in the coming year. Full and sustained eurozone fiscal coordination is anything but certain, and anti-Euro sentiment will undoubtedly rise in countries like Italy and Greece. Will the Euro enjoy the same credibility 12 months from now?
A lot of important questions. Luckily, sterling's decline guarantees that Euro adoption will return to the discourse in 2009. If the minds behind the report are correct, Britain should take a serious look at accession.
Picture Source: neftos
