Sterling flexibility has a cost

Take a look at this Chart put together by Ed Conway at Sky News:

It shows the history of the sterling/dollar exchange rate since 1791 and the very long history of sterling devaluations. This is not accidental. UK policymakers prize the safety valve of currency flexibility very highly and have used it frequently in the past 140 years. It’s a key reason why the UK didn’t join the euro.

Now think about this: if you knew about this chart, wouldn’t you require a higher rate of return on sterling assets compared with dollar or euro assets to compensate for the higher devaluation risk? And wouldn’t that risk premium be higher for less liquid, longer term investments which you couldn’t sell quickly? For sure. That’s how the market thinks too.

This is a key reason why UK investment levels are much lower than in other countries where the authorities seek to maintain currency stability. The risk of devaluation means that investors expect much higher rates of return from investment in sterling assets compared with dollar or euro assets – and this results in much lower levels of investment in UK based projects that otherwise have similar risks to those in other countries.

Of course, ‘higher rates of return’ is just another way of saying that investors expect shorter payback periods from UK investments. Call it ‘short termism’ if you like, but it reflects real risks that affect the UK more than elsewhere. And lower investment rates in real assets (plant,machinery, equipment and factories) are a very important reason why the UK has lower productivity than other big rich countries.

In short, the fact that the UK has a very casual attitude to devaluation has given its policy makers the opportunity to avoid tackling big underlying structural weaknesses – in education and in the housing market that have undermined its productivity. But of course devaluations buy breathing room in a crisis for long term structural reforms, they don’t by themselves improve productivity.

It’s just worth remembering also that the people that know the UK best – domestic firms and individuals – are the ones that invest the least. Foreigners on the other hand invest much more – in the car industry, in the City and in property. And of course these investors get clobbered when sterling falls.

Result? They only do it once.

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