Roger Bootle on the fall of the dollar and rise of the pound
James Ferguson - Thu 13 Jan, 2005
...Bootle sees the dollar falling a good deal further, thanks to Americas huge deficit and habit of living beyond its means. And if the dollar keeps falling, he says, theres a danger that the pound could rise up a long way against the falling dollar and even, as has happened recently, rise against the euro...
Bootle sees the dollar falling “a good deal further”, thanks to America’s huge deficit and habit of living beyond its means. And if the dollar keeps falling, he says, there’s a “danger that the pound could rise up a long way against the falling dollar and even, as has happened recently, rise against the euro”.
There are few more sensible voices to heed about this country’s economic outlook than Roger Bootle’s. The ex-HSBC chief economist and author of the indisputably prescient ‘Death of Inflation’ way back in 1996 now runs his own economic think-tank called Capital Economics. So when he says money markets are wrong to expect rates to stay up around 4.75% in 2005, only a fool would argue. Not least because, as Bootle himself writes, over the last 14 years the money markets “have had a persistent tendency to overestimate the coming level of base rates”.
Yet here I am, disagreeing with one of the wisest men around. It’s not a happy spot to be in.
Bootle sees the dollar falling “a good deal further”, thanks to America’s huge deficit and habit of living beyond its means. And if the dollar keeps falling, he says, there’s a “danger that the pound could be carried up a long way against the falling dollar and even, as has happened recently, rise against the euro”. A strong sterling would then virtually compel the Bank of England’s rate-setting Monetary Policy Committee (MPC) to cut rates.
“Although there is no controlling [foreign] exchange markets,” concludes Bootle, “the best way of forestalling this possibility [of a fast-rising pound] is for the MPC to be prepared to cut interest rates.” It should be prepared to tell the markets that it intends to do so, as well.
Roger Bootle on the fall of the dollar and rise of the pound: The UK economy
But Bootle is also relatively optimistic on the UK economy. He forecasts a slowdown in the US as interest-rates rise and the massive pre-election fiscal and monetary stimulus tails off. That will mean growth will slow everywhere else too. In the UK, he expects growth to slow from 3.2% in 2004 to 2% in 2005 as exports fall off along with world growth, and he thinks the growth effect from recent massive public spending will decline and house prices turn down. However, he no longer sees house prices falling dramatically. Instead, he sees them dribbling lower and consumer confidence wilting as a result. The upshot of this, according to Bootle, is no recession. “Growth may still be about 2% - a pretty reasonable performance by normal British standards.” This will make Britain, he says, an attractive place to invest relative to the eurozone and the US, thus keeping the pound in your pocket strong.There are three reasons why I believe Bootle’s optimism on the UK economy - and hence its currency, the pound - is unsound. Firstly, while most of the world may well suffer from a worsening US economy, the UK will suffer too, more than the eurozone. That will have negative consequences for sterling.
Secondly, the UK suffers from most of the symptoms of the US disease – galloping consumption. We have, for example, a large current account and fiscal deficit as well as record debt-servicing costs despite low nominal rates. This makes the UK, and sterling, very vulnerable to any shocks.
Thirdly, the UK is already suffering the beginnings of a housing shock, the sort of shock that has historically always propelled GDP deep into negative territory. The Government may want to stall this shock ahead of the General Election, of course, now expected in May. But it doesn’t have many bullets left.
Roger Bootle on the fall of the dollar and rise of the pound: employment rates
According to the independent think-tank Reform, public-sector employment rose by about 500,000 to 5.5 million in 2003. It is expected to rise a further 360,000 by 2006. Since 1998 the number of public-sector jobs has increased three times as quickly as in the private sector. That means Gordon Brown faces two options, neither of which can be delayed until too long after the up-coming early election: either he increases taxes to pay for these programmes, or he cuts back on his spending plans. Either way, this implies not so much a slowdown, as a net negative contribution to growth from fiscal policy over the coming year. Because the public sector is so much less efficient than the private sector, the negative effect on growth of taking the higher-tax route will be worse, though it is the more likely outcome.Of course, in the meantime the Chancellor does have one other option, which is to increase Government borrowing further. However, with estimates of the Exchequer’s shortfall already approaching £40bn - the equivalent of a 7p increase in income tax - he wouldn’t be wise...or indeed prudent...to do so. Increased Government borrowing would drive down the price of government bonds, and push up yields, which would weaken the economy still further.
Yet for the same reasons, almost everyone is now happy to be negative on the fate of the US dollar. The parlous state of America’s finances, despite the dollar already falling for two to three years now, means that the US currency is expected to tumble further. Indeed, “Twenty years ago the total debt of US households was equal to half the size of the economy,” wrote Paul Bostock of GMO London in The Daily Telegraph recently. “Today it is 85%.” But in the UK, that figure is over 100%. Add Britain’s sizeable current account and public-sector deficits to the picture - both worth about 3% of GDP - and the UK economy is really in no better position than America’s. Why would further dollar weakness automatically translate into sterling strength?
Indeed, the money markets like to rotate their targets and, now everyone has played the US dollar short, many hedge fund traders will be looking for another currency - ideally one that looks similarly vulnerable – to sell short. Sterling looks like an accident waiting to happen. An accident that perhaps only needs a nudge.
As we’ve already noted, the UK’s situation isn’t exactly terrible as yet. But our massive indebtedness makes our economy very vulnerable to shocks. A classic cyclical shock has already started unwinding in the shape of a house-price crash. We should note that in the last 45 years, every housing crash has sent unemployment up at least 40% and caused GDP to contract by at least 2%. When GDP figures disappoint like this, the downward pressure on the currency really kicks in.
Next, we can expect to get a little-appreciated side-effect of a weaker currency – inflation in the cost of living. It always peaks one to two years after the housing market and economic growth have peaked, thanks to the fact that a weaker exchange rate makes imports cost more in sterling terms. So while the official CPI inflation rate may be just 1.5%, here in the UK, trades unions are used to basing their wage demands on the RPIX, which is currently a rather more robust 3.4%. Indeed, if you strip out the ‘hedonic’ adjustments made to account for improvements in the computing power of home PCs, Mark Pragnell of the Centre for Economics and Business Research estimates the true cost of living is increasing at a rate of 4.4%. For middle-class families living in London, the gap between the official measure and reality is even bigger, he believes, with inflation possibly running nearer at 7%.
History shows that each of the last three UK housing downturns quickly impacted on household spending, unemployment and GDP, and in a major way. If house prices are dramatically lower at the end of 2005 - as I think they will be - the country will almost certainly be facing recession. Unfortunately, 2005 will also see us victim to a lot of late-cycle inflationary pressures, and these are likely to be exacerbated by the weaker pound, which itself will come as a result of the severe economic slowdown I expect.
A weak currency and stubborn inflation is not the environment for encouraging free-falling interest rates. These, I fear, will remain higher and stickier than Mr Bootle would like. Don’t bet on falling interest rates in the UK in 2005.
But do start preparing your defences against a falling pound.
Regards,
James Ferguson
for the Daily Reckoning
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