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ERM and Brexit: this time it’s different

ERM and Brexit: this time it’s different

Despite a divided Conservative government, Britain decided to leave a European institution designed to foster greater economic integration. This was followed by a significant drop in the value of the pound, after which growth picked up materially. I am, of course, referring to Britain’s exit from the European Exchange Rate Mechanism (ERM) in 1992.

There may be parallels to our current situation, but there are also good reasons for thinking that the impact of sterling’s depreciation following the Brexit referendum will be very different. To understand why, you need to look at the underlying causes of the currency depreciation. This highlights an important concept in economic analysis: you cannot reason from a price change to an economic outcome.

Prices are not the cause of the current economic situation, they are the effect.

In other words, prices are not the cause of the current economic situation, they are the effect. Over time, prices tend to change for a reason; they are ultimately driven by developments in underlying supply and demand forces. Yet these underlying shifts not only cause prices to adjust, but also have other effects in their own right. A full assessment of the impact of a price change must also include an analysis of those underlying factors.

As an example, it is helpful to think through the impact of a change in oil prices on the global economy. All else equal, a fall in the oil price should boost economic activity as it reduces energy costs for households and businesses (although of course energy producers lose out). However, there is never an “all else equal” fall in the price of oil. The decline will generally reflect an increase in the supply of oil or a fall in demand for oil (or some combination of the two). A fall in the price of oil following a positive supply shock (e.g. finding a new oil deposit) will generally result in the “standard” positive boost to growth.

However, a fall in the price of oil following a negative demand shock might simply reflect lower growth, as a weaker economy requires less energy. This is what we saw following the big decline in the price of oil after the financial crisis in 2008, where cheaper energy costs did not offset the huge negative shock to the global economy. It is clear that tracking movements in the oil price alone is insufficient to predict economic outcomes.

The same logic applies to changes in exchange rates. A fall in the value of a currency tends to hurt households by increasing the cost of imported goods, while helping exporters by boosting overseas sales. . The impact on the economy depends on the relative size of these two effects. Economists typically believe that currency depreciations should be a net boost to growth, as the hit to household income is eventually outweighed by the boost to exporters. But, as with shifts in the oil prices, we need to consider the cause of the exchange rate move. The reason the Brexit-related fall in sterling is unlikely to have the same impact as the post-ERM depreciation is that the two were caused by very different underlying factors.

The ERM committed the UK to keep the sterling/Deutschmark exchange rate pegged in a tight band. To do this, UK monetary policy had to follow German monetary policy closely. However, the UK and German business cycles were not aligned, with Germany requiring much tighter monetary policy than the UK to deal with the after effects of German reunification.

The UK was forced to hike interest rates to defend the value of sterling even as its economy suffered from inappropriately tight policy. This created an unsustainable situation: the UK eventually crashed out of the ERM in 1992, with sterling falling by 15% in the immediate aftermath. The UK subsequently enjoyed a big pick-up in growth from 0.2% in 1992 to 2.6% in 1993 and 4% in 1994, which many have attributed to the fall in the currency.

However, it was not only the depreciation that boosted the economy. Leaving the ERM allowed the UK to set much easier monetary policy in accordance with its own domestic conditions. The authorities cut policy interest rates by four percentage points from 10% to 6% in the four months after the ERM exit. It was this monetary easing, along with the boost to exporters that came from the weaker sterling exchange rate, which helped strengthen the economy.

In contrast, the large decline in the pound in the month following the referendum (when sterling fell by nearly 10%) was because investors took the view that Brexit will impair the UK’s trading prospects and weaken growth in the long run. The currency’s fall should help net trade by boosting exporters and encouraging UK consumers to switch to domestically produced goods in response to higher import prices. This should boost the economy in the relatively short term – Bank of England staff estimate that net trade added 0.6 percentage points to GDP growth in the fourth quarter of 2016.

However, it is important to remember that sterling has weakened precisely because the economy is expected to be worse-off in the long run. It is hard to see how an event that is viewed as negative for the economy by markets can somehow be turned into a positive economic event by the price changes it brings about. So it would be a mistake to start from the sterling’s depreciation and expect this to end in a net long-run boost to the economy. The analysis must start with the reason for the price change.

Despite the superficial similarities between ERM and Brexit, there is a profound difference between weaker sterling caused by more appropriate monetary policy, and weaker sterling caused by investors’ expectations that the UK will be poorer in the long run as a result of Brexit. To reemphasise, it is the cause of the price change, not the price change itself, that matters for the overall economic outcome.

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