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Labour and sterling

A Labour government would not necessarily cause sterling to fall.
Labour and sterling

The possibility of a Labour election victory next month has prompted hyperventilating talk of trillions of pounds leaving the country in such an event. This is silly, and obscures the fact that the impact of a Labour win on sterling is more interesting than that.

The notion that money will leave the country is daft. The only way this can happen is for people to stuff suitcases with banknotes and carry them through ports and airports. Otherwise, anybody wanting to sell a pound, gilt or UK equity has to find a buyer. This trivial fact means that financial markets alone cannot deliver a net outflow of capital, as Nicholas Ford and Charles Horioka have pointed out (‘The ‘real’ explanation of the Feldstein-Horioka puzzle – and what it means’, May 2016).

Instead, any effort to sell sterling assets would simply cause sterling to fall, to a level at which buyers step in. But would this happen in the event of a Labour victory? Three things suggest not.

One is that Labour’s plans to raise public spending should strengthen sterling. This is simply because the increased aggregate demand caused by such extra spending would lead the Bank of England to raise interest rates to curb the threat of inflation. This mix of looser fiscal policy and tighter monetary policy is usually seen as a recipe for a stronger currency. This is the bog-standard economics of the Mundell-Fleming model taught to all undergraduates.

Secondly, Labour would remove the possibility of a no-deal Brexit and increase the chance of no Brexit at all. Given that sterling has fallen and risen this year as the probability of no-deal has risen and fallen, this too points to sterling rising.

Thirdly, sterling is already pricing in lots of bad news. Against the US dollar its real exchange rate (that is, adjusting for differences in inflation) is close to its lowest level since 1985. And against the euro it is near an eight-year low even though the region’s weak economy should be depressing the euro. In the past, low real exchange rates have led to rises in the nominal exchange rate.

 

So, does this mean pundits are wrong to say a Labour victory would weaken sterling?

Not quite. The problem is uncertainty. A Corbyn government would break with the economic policies we have been accustomed to since the 1980s. This alone generates uncertainty. And the cliché is right; markets really do hate uncertainty. We can measure policy uncertainty by an index constructed by US academics Nick Bloom, Scott Baker and Steven Davis. Since this index began in 1998 it has been significantly negatively correlated with the real $/£ rate. Higher uncertainty, then, means a weaker pound.

But how great would the uncertainty be? Here, we enter the dreaded culture wars. Some see in John McDonnell’s Marxist sympathies an affinity with mass murders, others merely with an interesting intellectual tradition. And whilst some see a worrying break with neoliberalism, others see increased public ownership and government spending as familiar parts of European social democracy. Whatever you own predilection, it is silly solipsism to pretend that the other side doesn’t exist.

Net, then, a Labour government might not greatly move sterling.

This of course is a mere hypothesis. But two facts corroborate it.

One is that sterling hasn’t fallen yet. And yet one would expect it to have done so if investors feared that Labour would crash the pound, or merely feared that others would fear it would do so. The other is that sterling’s implied volatility – as measured by the CBOE’s BPVIX index – has stayed low, but we’d expect it to be high if a Labour government was going to hurt sterling.

You might object that both these facts are consistent with investors expecting Labour to lose. The objection is wrong. The results of the 2016 referendum result and 2017 general election have taught us not to rely on opinion polls as predictors of results. We cannot therefore wholly rule out the possibility of a Labour government. And even the slightest chance of a big fall in sterling next month should show up in exchange rates and options prices today. So far, though, it hasn’t.

We must, though, keep perspective here. Many things other than the election can and will move sterling, not least of which are economic growth rates in the UK, US and eurozone. Not everything is about British politics – thankfully.