28 August 2019updated 07 Jun 2021 5:24pm

Why the falling pound offers an opportunity for Britain

LONDON, ENGLAND - JULY 30: A bureau de change on Oxford Street as British Pound Sterling has slumped to a 28-month low on July 30, 2019 in London, England. Sterling dropped below $1.23 against the US dollar and fell sharply against the euro to below 1.10 on the international currency markets on Monday, as cabinet ministers began meetings to prepare for a no-deal Brexit. (Photo by Chris J Ratcliffe/Getty Images)

One of the earliest casualties of Brexit has been the value of the pound. Sterling fell by more than 25 per cent in effective terms over the course of 2016.

Since then, it has remained relatively stable, fluctuating according to the apparent likelihood of no deal. But what will happen to the pound if the UK does crash out of the EU without an agreement? To answer that, you need to understand the factors that influence the value of currencies.

Exchange rates are driven by supply and demand – if lots of Americans start buying sterling, then the dollar exchange rate and sterling’s value will appreciate, and vice versa if lots of Britons buy dollars. According to traditional economic theory, supply and demand for a nation’s currency is determined by its balance of payments. When British consumers buy widgets from the US, for example, they have to convert their pounds to dollars, increasing the supply of dollars in the global market. If a country runs a large current account deficit it means that currency is flowing out of that country, reducing its value.

Over time, the relationship between the exchange rate and the current account should prevent the emergence of large deficits or surpluses. A large deficit usually means a weaker currency, which increases the competitiveness of a country’s exports in international markets. But the UK has had a growing current account deficit for nearly 30 years now.

This is because the value of sterling is not primarily determined by demand for British goods and services. In our finance-led economy it is driven instead by demand for British assets, such as stocks, bonds and real estate.

Prior to the financial crash in 2008, global capital flooded into the British economy to take advantage of the bubble then present in financial and real estate markets. Investors put their money in British property, banks and mortgage-backed securities.

These capital flows into British assets pushed the economy towards financial services, with devastating consequences for working people. The overvaluation of sterling meant that British exporters – particularly manufacturers – struggled to compete internationally.

Investment in UK assets also quickened the property and lending boom that lay behind the financial crisis. Capital flows into UK property have pushed up house prices in England and Wales by 20 per cent over the past 15 years. London property has become a sink for illicit money from all around the world – in 2015 the economic crime director at the National Crime Agency said “criminals are pushing up UK house prices with money laundering”.

But when the property bubble burst and the financial crisis began, much of this capital rapidly fled out of the UK economy, leading to a much greater collapse in sterling than its depreciation since 2016.

With such a lack of investment in British manufacturing over the years, the potential benefits of a devaluation have yet to be realised. A no-deal Brexit may curtail long-term growth rates and depress property prices. If there were a Jeremy Corbyn government – which would presumably try to clamp down on money laundering, tax avoidance and speculation over housing – it would likely be even more of a concern for investors and the market.

Yet the depreciation of the pound presents policymakers with an opportunity to finally confront the deep-seated structural problems in the British economy.

A weaker currency would support policies that sought to boost British manufacturing, as well as green energy and agricultural development. With enough investment channelled into the right places, a green industrial strategy could help to reduce Britain’s overdependence on extractive finance, and support the transition to a net-zero carbon economy.

But if a falling pound offers an opportunity, as with all things related to Brexit, the overall impact will depend on how it is managed. Unless the government takes steps to ensure incomes are not eroded by inflation in the short term, and implements an industrial strategy to rebalance the British economy away from City-led finance over the long term, the prospect of building a fairer society post-Brexit will pass us by.