The great Brexit devaluation mystery

A James Alexander post

Simon Wren-Lewis has an interesting post, Brexit harm denial and the exchange rate, where he discusses some popular notions about the great British devaluation after the Brexit vote.

I have already discussed it here and explained that part is a pessimistic reading of the future trade deals that the UK might strike. If you are pessimistic then fair enough. But this is not really about economics but futurology.

For a more optimistic, but very realistic understanding of the issues involved in trade deals Dr Richard North and his colleagues at EUReferendum have an excellent blog and series of monographs on Brexit, or Flexcit as they call it.

Wren-Lewis who, as far as I can tell, has never written a blog post on the economics of wealth creation out of the hundreds that he has posted, is not a great guide to the workings of the market – even if, to his credit, he is occasionally sympathetic to NGDP Targeting. Wealth creation is mysterious to him, a grubby business at best, full of overpaid CEOs, neoliberalism at worst. Perhaps it just happens by chance? According to him “99% of economics is about market failure” [in a reply on his blog to a comment of mine]: the modern dismal science epitomised, and his flirtations with Corbyn explained.

What caused the price change?

While it is utterly wrong to argue from a price change, it is very right to try and understand what caused the price change. Why did holders of Sterling sell? Political uncertainty was a factor, but that was relatively quickly sorted out and Sterling remains at the lows. Have other factors like US Dollar strength taken over, preventing a Sterling rally. Maybe.

Perhaps it was expectations that Mark Carney would dramatically ease monetary policy? In which case, the devaluation was not caused by Brexit but by the BoE’s expected stance. Although Carney had campaigned for Remain he made it clear he was ready to act if Remain lost. And he did act decisively, both on the day with interviews and somewhat grudgingly followed up with actions.

A relaxed monetary policy is quite a big step for a BoE that had been tightening all through 2015, if not quite a much as the US. In that sense, Brexit got Carney off the hook of having to make a more obvious u-turn. Carney had heavily overestimated UK economic strength during 2015 and early 2016 and was going to have ease in 2016 anyway.

Perhaps Sterling fell because market participants expected the UK economy to be smaller years ahead. Maybe, but it’s hard to see, practically speaking why they sold Sterling now on such an uncertain outcome, years ahead. Safe-haven buying of UK government bonds pushed down yields, which rather goes against this argument.

At the end of the day, the depreciation was only 10%, not that big in longer run historical contexts. Sterling fell 25% vs the US Dollar during both the 2008 financial crisis and after the ERM exit. It often moves on unexpected political news. The mild shock of a Tory victory in May 2015 drove it up 4%.

On Wren-Lewis’ specific four points:

  1. 1. “Depreciation has a good side, because it gives a boost to our exporters”

Well, he admits this is true. There will be a short term boost to exports thanks to the depreciation. And this will be good for the economy as the costs of Brexit, when it happens, will only come later. He says that “we are poorer because of Brexit”, but only because the markets expect us to be poorer and hence drove down the currency. He may be right in his interpretation, but those markets could turn out to be wrong about that piece of futurology. It is still very encouraging that Wren-Lewis recognises that market expectations can have real effects, just like market expectations about nominal growth.

He also claims that “markets believe Brexit will cause an economic downturn in the UK, implying lower levels of UK interest rates. (In this they have been proved correct).” One hates to disagree with such an eminent economist in his interpretations of market moves, but the Bank of England was very confident that Brexit would cause a rise in gilt yields due to fear about the UK economy and its credit rating. Remainers like Wren-Lewis and the BoE seem like they want to be right about the negative consequences of Brexit whatever gilt yields did.

What Wren-Lewis specifically fails to mention is the benefit to domestic demand of a depreciation, nicely expressed by Britmouse at Uneconomical back in January this year. Currency devaluation is a way of boosting AD, by forcing consumers to switch from overseas goods and services to domestic goods and services. This is the classic benefit of devaluation, not that it is good for exporters. The overall impact on the balance of trade is hard to tell given the inelasticity of much import demand. What tends to happen on a devaluation is that the value (in the devaluing currency) of both exports and imports rises, thus raising AD. If the devaluation was due to Carney’s expected reaction, then good.

  1. “Sterling was overvalued anyway”

While it is “ludicrous” to suggest that the problem of overvaluation, if it existed, was overcome by the Brexit devaluation, it isn’t ludicrous to suggest that devaluation will offset some of the pain. See 1.

3. “Sterling is only back to where it was …”

Wren-Lewis makes an obscure argument by analogy, something about having your basic pay cut but the boss promises it won’t be that bad as bonuses will be higher. The UK may be 10% poorer in $ terms but is it really relevant when Britons are paid in Sterling and wages in Sterling didn’t move at all. The UK is a massive holder of overseas investments, was the UK richer after the devaluation also?

And, yes, Sterling in Euro terms (the purple line) really only was “back to where it was”. In US Dollar terms (the blue line) it has been falling for a long while, mostly due to much more US monetary tightening versus the UK. To be fair, it does depend where one starts to draw the line, but then an argument about that issue doesn’t really lead very far as more and more “noise” enters the discussion.

JA Brexit Devaluation

  1. It is just a temporary problem before things become clearer”

Wren-Lewis now lays his cards on the table (I think) and assumes there will be a short term economic downturn until the UK accepts the single market and free movement, at which point “the economy then recovers, interest rates rise, and sterling appreciates”. Brexiteers can then be blamed “for all this uncertainty and the temporary damage”.

Again, Wren-Lewis engages in a lot of futurology. Who knows if there will be much of a significant economic downturn from Brexit. Were we due one anyway given the weak NGDP growth over the last 15 months? A fact that Wren-Lewis and other macro-economists have been awfully silent over.

Who is to say what “free movement” means once it is up for negotiation? Does it mean exactly what we have now, with full access to UK welfare benefits for all and any EU citizens who move to the UK? Once we have agreed the trade deal with the EU will the EU prevent us negotiating deals with third party countries and blocs that the EU has so signally failed to do itself? Would this be bad for the UK?

The answers to these questions and many more will inevitably colour the macro-economic outcome, but these are political questions and macro-economists (and the Bank of England) would do well to make clear their political judgements on these issues before sounding off with such certainty about the economic outcomes.

Brexit devaluation is monetary offset in action

A James Alexander post

I agree with Scott Sumner in his strong belief in the Efficient Market Hypothesis. The market is always right. But quite what it is “right” about is not always easy to tell. Sure, on central bank announcements the immediate market reaction is very telling. The market reaction is the policy, and this is not always what the central banks thinks is the policy.

The surprise Brexit vote did lead to some huge movements as markets opened on Friday 24th June and then more on Monday 27th after a weekend of follow-up news and reflection. But what were the markets signalling, especially the GBP devaluation and the large drops in the most domestically-oriented equities?

Scott Sumner wrote:

Brexit will reduce the foreign demand for British goods, services and assets. Since one needs pounds to buy British stuff, this reduces the value of the pound, as well as the quantity of exports. Think of it as a leftward shift in the demand for pounds, on an S&D diagram.

I am willing to admit less demand for pounds due to expected less FDI, as some global firms who based their EU businesses in the UK think of moving that production to inside the newly shrunk EU ex-UK. This is not a domestic demand shock directly as businesses would be choosing to produce less goods and services in the UK that were then exported.

Exports would also be expected to fall, further weakening demand for pounds, already weakened from less expected FDI.

The indirect effect is a demand shock for labour in the UK, that in turn reduces demand for goods and services within the UK.

UK workers are not less productive, there is just less demand for them. It is very hard to claim that the potentially lost UK export industries are more or less productive than average UK industry.

Other things being equal, less FDI, less exports and a potential, indirect, demand shock will shrink the size of the UK real economy. The drops of 10%-30% in some domestic-focused UK shares in particular sectors like commercial and residential real estate (British Land and Barret Developments), retail (Tesco and Marks & Spencer), banks (Lloyds Bank and Close Brothers) and media (Sky and ITV) illustrate this fear well.

However, care needs to be taken when looking at these sectors and judging the stock price falls. Property companies and banks are leveraged plays on the local economy, so that any local economy weakness gets magnified, sometimes greatly. Retail companies have been suffering from weak NGDP for years, as well as from the secular change to internet retailing, and so their equity prices may be particularly vulnerable to small changes in AD.

And care also needs to be taken not to assume the worst. Both the outcome of the negotiations with the EU and the eventual trade agreements with the Rest of the World will alter greatly these worst-case scenarios. In the absence of a government, fear and uncertainty get free reign but will dissipate over time, perhaps more quickly than many expected. if the latest news on Mrs May’s unopposed path to the top job is anything to go by.

Here comes the offset

But as Scott knows well a leftward shift in the demand curve for pounds is not like a shift in the demand curve for apples. A devaluation will lead to major monetary offset in the country experiencing the devaluation – even if these benefits are not immediately apparent – or understood by many commentators. The benefits will still accrue unless the devaluation is artificially prevented. So far the signs from the Bank of England are that it will be encouraged.

The current account may or may not improve following a devaluation as Chris Giles succinctly explained in the FT last week. He was echoing many macro experts. Unfortunately, Giles, like most economists and commentators who understand the subtleties of devaluation on trade deficits missed the bigger picture. The main benefit of a devaluation is something else.

In early 2014 in a discussion about Abenomics Scott re-posted a classic comment from the legendary Mark Sadowski. The punchline is very clear:

Devaluation improves a country’s trade balance only if the Marshall-Lerner condition on trade elasticities holds, and research shows that they’re not met in the majority of cases, either past or present:

That’s not to say that currency devaluation isn’t beneficial, of course it is, but the benefit flows primarily from increased domestic demand. 

Chris Giles does understand, and in fact warns in a follow-up  piece about higher inflation in the UK as a consequence of the devaluation and how it might hurt households:

In summary, Brexit has unleashed a different sort of currency depreciation, according to modern economics, one that is less likely to encourage domestic investment for exports, is more likely to raise inflation and will be more painful for hard-pressed families.

But it will drive up NGDP up, as domestic demand has to rise in nominal terms, and this, given wage and price stickiness, will drag up GDP in real terms too.

In fact, this rising nominal demand will be especially welcome in a UK economy starved  of nominal growth for the last 12 months. Something on which Giles and most of the UK macro-economic commentariat have been notably, not to say shamefully, silent.

Around the same time as the Sadowski re-post but on a different subject, Britmouse over at uneconomical also had an excellent post making a related point:

It is not that a[negative]productivity shock causes a rise in unemployment.  A productivity shock causes a tightening of monetary policy which causes a rise in unemployment.  

Brexit may cause a supply shock but there will only be a rise in unemployment if monetary policy is also tightened. If monetary policy is eased there will be moves within the economy from one job to another, but not an overall reduction in employment. That is the benefit of stable nominal growth, some people may experience low or no nominal wage growth but they will not be made unemployed.

Will the UK be poorer on leaving the EU? Maybe, but economies are quick to adjust as long as nominal growth is maintained at a suitable level. Unilateral free trade would also help as sagely proposed by the economists for Brexit.