A Sterling Performance

Why you can ignore most of what is written about floating rate currencies and why the commentariat always gets it wrong.

The UK is an island economy that exports demand to the rest of the world. In a world short of demand that means the rest of the world has to retain access to that demand somehow — or they have to take the economic impact on their own export led strategies.

For a country to have excess exports it has no choice but to save other currency denominations to excess. Otherwise its own currency goes sky high and kills the excess exports. This is why there are ‘sovereign wealth funds’ and huge hoards of currency and financial assets held by offshore entities. They are a consequence of excess export policies across the world and the currency management that enables them to exist.

If you ban UK exports to your nation, or you refuse to take them, or you put extra taxes on them, or you refuse to buy Sterling assets then that means you have to save more Sterling if you want to continue to export to excess to the UK.

What economists always get wrong is the idea of funding. A current account deficit isn’t funded. For it to exists at all it must already have been funded. Every short has to have a corresponding long. Similarly for every excess import of goods and services into a currency zone there has to be a corresponding external sector held asset denominated in the currency of the import zone. One cannot exist without the other. It is a simultaneous requirement in a floating system. If any step along the way fails the whole deal falls through, eliminating both sides instantly.

At the moment the speculators are playing silly games laying on shorts in Sterling. They will do so until there is nobody is prepared to take the other side, no soft holders to panic out of their savings and no more flash crashes allowing dealers to close open long positions. In other words until the liquidity drains away until all that is left is that required for the underlying trade flows.

Then you will get the mother of all bear squeezes.

The game, of course, is to tempt the patsy of last resort — the central bank — into the speculation market to throw fresh salmon to the bears. A wise central bank will avoid doing this. Instead it will offer to clear needed trade flows with its reserves on a strict national policy basis — food and power: yes, Learjets: no. It will offer refinancing to firms who have foreign currency loans, as long as they go through administration first so that the foreign currency loan is wiped out and the foreign bank is force to take the loss. A wise central bank would do everything it can to ensure the squeeze stays on track. It would make its intentions known — there will be no liquidity for speculation outside the ‘natural’ supply. And that means, in an over-the-counter market of foreign exchange, liquidity may run out.

A wise central bank understands that is the responsibility of the other central bank with the high currency value and an excess export policy to decide what they want to do. A wise central bank will keeps it head while all around are losing theirs.

The problem is that central bank policy makers are still talking about shocks and equilibrium. They talk about pass through for exchange costs and there is apparently an extensive literature on the subject. But there seems to be little analysis of pass back (volume/price impact on the export side) because that would require acknowledging that the demand side matters — contrary to dogma.

Last year there was a suggestion that entities may respond to the exchange rate in different ways and this may change the response profile. Apparently this a revolutionary concept (!) Eventually they’ll realise that you can get supply from more than one foreign country and they may just compete with one another for your business. But putting more than one foreign country in the model is a bit much apparently. Perhaps that is next year’s revolutionary concept.

So we still have central bank following policies guided by incorrect thinking and developed using unbelievably primitive models. We are still trying to fly aircraft with techniques developed for riding a horse. Is it any wonder the commentary around Sterling has more in keeping with witchcraft than science?


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