21st May 2015
Much has been said of global currency wars in the past few years writes Stephanie Flanders, chief market strategist for Europe at J.P. Morgan Asset Management…
If there has been such a war, then arguably the UK fired the opening shot with a trade-weighted depreciation in the value of the pound of nearly 30% between the summer of 2007 and the end of 2008. This was one of the most dramatic depreciations the UK has seen in peacetime.
However, hopes that this seismic change in competitiveness would power the UK out of recession proved far off the mark. Though exports did grow, imports grew faster and by 2013 the trade deficit was around 2% of GDP – roughly the same as it was in 2008.
Later studies by Bank of England economists and others found that the volume of exports had been affected by the more competitive level of the currency but that the strength of overseas demand mattered a lot more. The cheaper exchange rate after 2008 helped exporters, but not nearly as much as the collapse in European demand hurt them. We have seen the same dynamic in reverse since 2013; so far the recovery in European demand for UK goods has more than made up for the negative consequences of sterling’s steady move upwards against the euro.
While the depreciation of the pound at the start of the financial crisis may not have helped much on the trade deficit front, it did perform one very valuable service: it helped deliver higher inflation at a time when most of the developed world was battling to avoid outright deflation. We believe this may have been a decisive factor in helping to price people into work and preserve employment at a time of depressed global and domestic demand.
Many factors may help explain the sizeable gap in divergence between US and UK real wage growth since the onset of recession in the UK in early 2008, but a prominent contender, in our view, is the fact that prices were growing significantly faster in the UK for most of this period: indeed, the roughly 10 percentage-point difference in cumulative inflation over the period is very similar to the difference in real wage growth.
Both the US and the UK labour markets are highly flexible, by international standards. But even in flexible labour environments, it is well known that real wages are “sticky downwards” when inflation is very low because workers do not like to accept cash pay cuts. The higher the level of inflation, the further that real wages can fall without nominal wages needing to be cut. By the end of 2013, UK private sector employment was 5% – more than 1 million – higher than at the start of 2008, whereas US private sector employment had barely grown at all. That’s despite Britain suffering a much deeper recession than the US during this period, and a slower recovery.
This experience can help shed a little light on recent developments in the eurozone and the depreciation of the euro. By any measure, the eurozone does not “need” a cheaper exchange rate on competitiveness grounds: the IMF reckons it will have a current account surplus of 3.3% of GDP in 2015 and most independent estimates would suggest the currency is already below its fair value.
But in the absence of more stimulative fiscal policies, countries such as Spain and Italy are under pressure to squeeze labour costs to improve their competitiveness. It is a lot easier for them to do that when inflation is above 2% than when it is hovering at, or below, zero. A weak currency is not necessarily the best way to achieve that higher inflation. As we know in the context of Japan, raising household living costs also holds risks of its own. But as the IMF has concluded, depreciation might have a constructive role to play in raising prices and easing monetary conditions in a situation where fiscal stimulus has been ruled out and the central bank does not have many other weapons left.
So there are good reasons to hope that the weaker euro will do more good for Europe than it does harm to the US. But the stand-off over Greece is a reminder that we could have plenty more bumps on the road still to come.