Cause and Effect … Stormy times ahead?

Very little that happens in life is purely serendipitous, totally without cause or effect. Sometimes we might have to rely on chaos theory and blame the storm on a butterfly flapping it's wings in another part of the world. What has always surprised me, however, is our singular inability to learn from history. I would like to look at the future in the light of two historical events.

Recently I was reminded of the UK economy crash of 1990/1992, this crash was largely blamed on Lawson joining the ERM. Surely it would have been more accurate to say the excessively high exchange rate that the UK used to to join the ERM was the cause, while the crash was the effect of that flawed decision. Simply cause and effect.

Margaret Thatcher's government, certainly in the initial years, was characterized by strongly monetarist views. Tight control over money supply coupled with a balanced budget (Austerity in todays terminology) would ensure a sustainable and viable economy. After the Big Bang the emphasis tended to switch from control over money supply to deregulation of the Financial Services Industry and targeted exchange rates.

Ultimately the excessively high exchange rate target (3DM to 1£) resulted in the UK running into deficit on current account, which in the absence of tight control over money supply in the internal economy resulted in increased inflationary pressures. The attempt to bring that under control lifted interest rates to 15% resulting in the severe recession 1990/1992, culminating with George Soros making $1 billion betting against Sterling and John Major taking the UK out of the ERM.

Consider the graphic below which shows the UK current account at plus/minus zero for the ten years preceeding Big Bang and thereafter going into decline. The result of this decline was that the UK was borrowing foreign money to fund it's consumption expenditure sharply increasing money supply in the internal economy.

Historical Data Chart

Before getting too hung up about the later part of this graph let us consider whether 1990/1992 slump was as a result of joining the ERM … or was there a lesson we should have learnt from History that we had ignored?

In 1925 Churchill returned the UK to a quasi Gold Standard as regards foreign trade he did so at a rate some 20% higher he was being advised which culminated in a run on Sterling in 1931 and a 23% devaluation on removing from the Gold Standard.

Cause and effect the two situations are mirror images, in both cases the UK attempted to sustain an unsustainable exchange rate … in both cases culminated with an effective run on Sterling resulting in 20% plus devaluations as the Central Bank did not have sufficient reserves to withstand the run. In each case the devaluation resulted in fairly rapid recovery in the economy.

In my mind I am convinced that neither the re-adoption of a Gold Standard in 1925 nor the joining of the ERM in 1987 were wrong … both were good decisions, the error lay in a belief that we must punch above our weight and in both cases we chose exchange rates that the economy could not sustain. The discipline of an asset based currency or a rules based currency, must always be good, as it places politicians under an obligation to manage the economy.

If you look at the graphic above and consider the sharp fall in the current account deficit since 2010, you would see very clearly that we are once again in a situation where there is potential for speculators to bet against Sterling. Probably the time has come to start hedging against a likely devaluation of Sterling, either forced by markets or talked down by BoE. When the crash in the value of sterling comes it will once again be a case of cause and effect, or another mirror of history where excessive exchange rates have nasty consequences!







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