Maybe sterling has overshot a bit. Currencies do that sort of thing and we should not worry unduly. Maybe sterling has fallen because people have no confidence in the long-term ability of the UK government to repay debt. But that would seem odd given that most eurozone countries and Japan are in a worse situation than we are – at least as far as the stock of debt is concerned. In fact, I think there is a perfectly good market explanation for the fall in sterling that has hardly been mentioned.
Households are deleveraging and real consumer spending appears to be falling rapidly. If this happens in a closed economy, the equilibrium level of interest rates would fall and you would get more capital investment as households save more – think of Japan in the 1980s. But, we are an open economy.
For many years the excess of the nation’s borrowing over our saving has been financed by capital flows from overseas (including foreigners buying formerly British businesses and so on). The counterpart to this has been a balance of payments deficit facilitated by a higher level of sterling which was pushed up by the capital inflows. This process might well be reversing. We may well be borrowing less from abroad as the gap between domestic spending and domestic income falls. This would cause the exchange rate to fall, other things being equal, and this facilitates the reduction in the balance of payments deficit that is a necessary counterpart of the reduction in the gap between domestic spending and income.
It seems to me that the impact on sterling would be greater if domestic investment is not responsive to changes in domestic saving (as seems likely in the current circumstances) and that this might explain the dramatic fall. This process facilitates a restructuring of economic activity which is bound to happen in a recession and which is necessary given that households are over-borrowed due to earlier slack-money policies.
Policies that try to prevent this adjustment (for example by increasing government spending to replace private consumer spending) just mean that we have to go through longer and more protracted adjustment processes. So let’s just be pleased that, as a result of Milton Friedman’s intellectual legacy, we have a floating exchange rate. It will probably mean a more benign response to our current economic difficulties than might otherwise have been the case.