Mitchell’s Musings 10-17-16: Most Economists
Daniel J.B. Mitchell
I happened to hear a public radio broadcast from NPR recently on the recent depreciation of the British pound and the Brexit vote of last June. The program began with this sentence:
Since the U.K. voted to leave the European Union last summer, the country's currency - the pound - has lost about 16 percent of its value against the dollar. Most of the damage, according to economists, was self-inflicted.
It ended with this sentence:
The pound dropped again this morning trading below $1.23. Most economists think it has yet to hit bottom.
In between the beginning and the end, there was what you might expect. There were references to the Brexit vote of June, anecdotes on how foreign tourists in Britain were benefiting from reduced costs, etc. But let’s start with the beginning sentence which references the fall in the pound.
Source: XE.com as of October 11, 2016.
As the chart above shows, relative to the euro, the pound at this writing is about where it was during and in the aftermath of the Great Recession. Until the Brexit vote, it tended to rise relative to the euro. When the vote occurred, it fell. And the pound has generally fallen since.
The NPR program describes the fall in the pound as “damage” which was “self-inflicted.” There is no doubt that that the Brexit vote was an Act of Man rather than an Act of God. But is it correct to view a currency depreciation as “damage”? Note that if the pound declined relative to the euro, it is also true (by inversion of the pound/euro ratio) that the euro appreciated relative to the pound. So was the euro-zone “helped” by its currency’s appreciation?
Other things equal, the decline in the pound made British exports more competitive and imports to Britain less competitive. So on that dimension, you could just as well say Britain was helped and the euro-zone was damaged. Suppose you applied the same logic to the U.S. and its dollar that the NPR broadcast applied to Britain and its pound. The chart below shows an index of the U.S. dollar relative to the currencies of its trading partners since 2000.
If you equate the exchange rate with national welfare, we were never as well off as we were just after the dot-com bust and the related recession. During the recovery from that recession, things got progressively worse if we use the exchange rate as our measure. The Great Recession then gave our welfare a big boost temporarily. But the recovery from that recession made us worse off again. We didn’t see a big improvement until the 2015-16 election cycle made the future of U.S. economic policy uncertain. If nothing in that interpretation makes much sense to you, you now can see the folly of identifying exchange rate trends with national welfare.
Source: FRED database of the Federal Reserve Bank of St. Louis.
There seems to be an underlying assumption in the NPR broadcast that the fact that Brexit inherently changed some fundamental determinants of the British exchange rate means the pound must be lower than it was. However, the demand for the pound is ultimately a function of the demand for British exports and for British investment assets (British stocks, bonds, real property, etc.); the supply of the pound is ultimately a function of British demand for imports and foreign investment assets. How the demand and supply will balance out once the dust settles, i.e., what the eventual long-term exchange rate will be, is unknown. It will depend on such things as British inflation relative to that of its trading partners and rates of saving at home and abroad. But note that the question of whether or not Brexit was a good idea for Britain in terms of its national economic and political welfare is simply not the same thing as the exchange rate.
Well, that’s fundamentals. The broadcast closes with the idea that “most economists” think – was there a survey? – that the pound will fall further. That prognosis isn’t accompanied by a time period. Is it by tomorrow? By next week? Whatever the time period may be, it seems to be a short-term prediction. And if it is short term, it should also be the case that most economists are going short on the pound because they know it will soon fall. But is there any evidence that, for example, British economists have been putting their holdings in euros? Are they going further and borrowing pounds and then investing them in euro-denominated assets? If it were evident that the pound would be notably lower in value relative to the euro in the near future, the rush into euros would make it lower relative to the euro today.
1) Will the pound be lower tomorrow than it was today? If you say “yes,” you have about a 50-50 chance of being right.
2) Is it a Bad Thing for Britain that the pound exchange rate is lower than it was pre-Brexit? Other things equal, depreciation of the pound stimulates British exports and discourages imports. So let’s just say that the answer is more complicated than assuming that national welfare moves with the exchange rate.
3) Finally, what should NPR have said in its broadcast? Probably not much more than with the decline in the pound, Americans might want to consider a London holiday.
 “Brexit Results Prove Increasingly Costly to Britons,” Morning Edition, October 11, 2016. Available at: http://www.npr.org/2016/10/11/497487391/brexit-results-prove-increasingly-costly-to-britons.