Stephen King: Another British currency crisis – it's enough to make you feel nostalgic

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The Independent Online

Stick your head out of the window, inhale deeply, and enjoy the sweet, yet sickly, scent of nostalgia. It's everywhere. On a Saturday night, you can settle down in front of the television to watch the X Factor or Strictly Come Dancing, throwbacks to the days of Opportunity Knocks, New Faces and the BBC's Seaside Special. You can bask in the reflected glory of our summer Olympians who won the most British medals since the 1908 Olympics when the tug o' war was, apparently, taken rather seriously. Or you can look at sterling's sudden collapse and think of the seemingly countless occasions when Britain's economic prospects were undone as a result of a currency crisis.

Sterling has plummeted over the last few weeks, becoming, in the minds of currency investors, public enemy number one. It's collapsed against all-comers, down more than 25 per cent against the dollar, over 15 per cent against the euro and 33 per cent against an all-conquering yen since the end of last year. While sterling's decline raises all sorts of questions, the most obvious is this: if the global economic crisis was made in America, as is so often argued, why is sterling in so much trouble?

In part, the answer lies with the rolling nature of the financial crisis. When the phrase "sub-prime" became part of the common vernacular, the US housing market was about to go into freefall, but the UK market was seemingly still managing to tread water. For a while, then, it was possible to argue that the UK had, in some sense, decoupled from America's economic problems. If the UK was to slow down, it would only be as a result of declining US demand for UK exports, not the result of home-grown difficulties. This, though, was a fool's paradise. To understand why, it's worth considering the ways in which the UK's housing market boom was funded. We hear a lot about excessive lending by greedy banks. The banks, though, could only lend because they were flush with funds. Those funds, in turn, often came from abroad. International investors, hungry for returns, were happy to pour their money into countries which offered relatively high interest rates. The UK did exactly that.

Hot money is one of the biggest challenges facing the central banking fraternity. It breaks the link between policy rates and the broader economy. Money flows in from abroad, leaving the banking system awash with liquidity. Inevitably, the money is lent out. The more hot money there is, the greater the likelihood the money chases the wrong kinds of investments. Australia, New Zealand and, Iceland face similar challenges.

You might, perhaps, think that countries with high interest rates would have tighter monetary conditions and, therefore, be less prone to housing bubbles and busts. In the topsy-turvy world of modern international finance, though, this is simply not so. When hot money is pouring into an economy, it's not so much the price of credit that determines financial conditions but, rather, its availability. Quantity matters: if money is pouring into an economy by the bucket load, lending terms will become easier. Hot money partly explains the availability in the middle of this decade of 100 per cent loan-to-value mortgages, mortgages at five or more times annual income and a housing market that had taken leave of its senses.

As hot money pours into an economy, the central bank typically feels rather pleased with itself. The currency tends to strengthen, seemingly a vote of confidence in the central bank's own abilities. Moreover, a stronger currency leads to lower import prices and, hence, lower inflation. For an economy, hot money is like a dangerous narcotic: it creates a high, a moment of euphoria. Its disappearance leaves only devastation in its wake.

A typical defence is to argue that hot money doesn't threaten the overall health of an economy because what it adds to inflation on the one hand – looser lending conditions – is matched by subtractions on the other hand – via a stronger exchange rate. Overall, then, there is no lasting threat to price stability.

This argument, though, cannot be right. First, it's decidedly unbalanced. We end up with a housing boom while exporters' prospects are choked off. Put another way, we end up with a fleeting surge in consumer demand paid for by a possibly permanent loss of market share in world export markets. Second, even if price stability is achieved in the short term, there may be longer-term costs: if exports have been pulverised and the housing market starts to collapse, it won't be long before short-term inflation concerns give way to longer-term deflationary concerns, a point implicitly accepted in the Bank of England's latest Inflation Report.

Sterling's collapse is primarily a reflection of this lack of balance. Having managed to attract hot money for so many years, conditions have suddenly changed. No longer can the UK's authorities pretend that the economy will avoid "boom and bust". New Labour got lucky during the 2001 world recession, when an earlier fortuitously-timed loosening of fiscal policy kept UK demand chugging along while other economies wilted. Its luck has now run out. Both the Bank and the Treasury now accept that we're in recession, and with recession comes remarkably low interest rates. Hot money suddenly becomes very cold indeed.

George Osborne, the shadow Chancellor of the Exchequer, suggests that Gordon Brown's new-found desire to borrow his way out of trouble will prompt a run on the pound. The trouble, though, lies not so much with future government borrowing but with earlier hot money lending. The credit crunch is an international event. Everyone is hoarding cash. Countries which, earlier, had managed to live off borrowed time are now in considerable trouble.

It's undoubtedly true that, other things being equal, the more the Government borrows, the bigger the UK's balance of payments deficit. Purely mechanically, then, there's a risk that sterling will go down. In current circumstances, though, other things are not equal. Even allowing for a huge increase in government borrowing, there's still a chance the UK's balance of payments deficit will narrow if only because higher government borrowing may be more than matched by higher savings from households and companies, either willingly or, as a result of the credit crunch, through the coercion of financial markets. If no one else can borrow, the government has a responsibility to step in.

Moreover, choosing not to act can lead to perverse results. Through its 1990s crisis, Japan's policymakers did very little to bail out the economy. Japanese companies, desperately trying to stay solvent, started repatriating their foreign assets. As the money came home, demand for yen increased and the Japanese currency went up. Japan's export prospects went down the toilet and the economy went from bad to worse. Japan may not have had a yen crisis, but its currency victory was decidedly hollow.

Still, at worst, if sterling really does collapse, there's no need to worry about the sudden loss of foreign holiday opportunities. Just reach for the remote control and settle down to some choice light entertainment...

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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