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The Pound Gets Pounded

As the global currency war intensifies, the majority of attention has been paid to the 17% fall of the Japanese yen against the U.S. dollar over the past few months.The implosion has given cover to the sad performance of another once mighty currency: the British pound sterling.

But in many ways the travails of the pound is far more instructive to those pondering the fate of the U.S. currency.

Japan has a unique economic and demographic profile which makes it a poor stalking horse. Newly elected Prime Minister Shinzo Abe and the Bank of Japan have clearly and forcefully committed Japan to a policy of inflation at any cost.

Even in a world of serial money printers their plans stand out as exceptional. Britain, on the other hand, is charting a more conventional course to the same destination.

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The UK government, under conservative Prime Minister David Cameron and Chancellor of the Exchequer George Osborne, has succeeded in bringing marginal discipline to their budgetary imbalances.

From 2009 to 2012, British government expenditures rose a total of just 1.6%, which was far below the official pace of inflation. (In contrast, U.S. federal spending grew by 7.9% over that time period). Since 2009 the British have kept their debt-to-GDP ratio lower than America's and have cut into that metric at a faster rate.

But while the British are conservative when compared to their American cousins, they are hardly austere when compared to Germany (which continues to have a nearly balanced budget and extremely low debt to GDP). Paul Krugman blames Britain's lackluster economic performance on their misguided experiment with austerity.

The monetary side of the equation also puts the UK within the spectrum of its peers. Ever since the Great Recession began in 2008 the Bank of England, led by outgoing Governor Mervyn King, has been far more stimulative than the European Central Bankers in Frankfort (but not quite as much as the Federal Reserve or the Bank of Japan). In contrast to the permanent and ongoing bond-buying quantitative easing programs underway in the U.S. and Japan, the Bank of England has engaged in such measures only selectively.

Given the relatively moderate approach pursued by the British, the poor performance of their currency may be hard to fathom. The deciding factor may be that the Pound Sterling is not nearly as vital to investors, or as integrated into the global economy, as the U.S. dollar or the euro.

The greenback, being the world's reserve currency, has alwaysbenefitedfrom demand that is independent of its economic fundamentals. The euro benefits from the size of the euro zone and the legacy of German banking discipline. The pound enjoys no such privileges and as a result foreign central banks do not feel as pressured to prop it up.

As a result, over the past few years the pound has been… pounded. Since July 2008, the currency is down 26.7% against the U.S. dollar, and in recent months it has started falling faster than all other developed currencies except for the Abe-pummeled yen. Since October 1, 2012 the pound has fallen by 4% against the dollar and 8% against the euro.

The pound's health is made more suspect by the extreme challenges faced by the Bank of England as it tries to stimulate the most admittedly inflation prone economy among the major Western nations. Unlike the Federal Reserve, which is tasked by statute to combat both inflation and unemployment, the BofE has only a single mandate: to keep inflation contained. On that score it has been failing habitually.

Inflation in the UK has been north of its 2% target for the past five years (the current official rate is 2.7%). In its most recent inflation projections, Mr. King admitted that it will stay that way for years to come, and that it may exceed 3% this year and next. With its currency weakening and inflation accelerating, the mandate of the BofE would clearly indicate that the time has come for monetary tightening.

However, like all central bankers, Mr. King, and his successor, the Canadian Mark Carney, will not be bound by such triflings as statutory mandates and past promises. In his press conference last week, Mr. King spoke of "looking past" current inflation figures to a time when he expects inflation will moderate. When the choice is between inflation and the political pain of economic contraction, bankers (at least those who don't speak German) will choose inflation every time.

While the American media has poked fun at the Bank of England's backtracking, they somehow do not understand that the Federal Reserve would be doing the same if not for the advantages given to us by the dollar's reserve status. Our ability to monetize the vast majority of the annual government deficit while exporting our inflation through half trillion dollar trade deficits and the overseas sale of hundreds of billions of Treasury bonds annually means that we do not yet face the pressures bearing down on the Bank of England.

For now at least Cameron is sticking to his guns and making the politically difficult case to voters that today's hard choices will yield benefits down the road. This puts all the pressure on the Bank of England to satisfy the calls for stimulus. The Federal Reserve is fortunate in that the Obama Administration shares none of Cameron's fiscal determination.

But already the Fed has done plenty of backing off from its prior promises. Just a few months ago Ben Bernanke announced specific inflation and unemployment triggers that would apparently put monetary policy on automatic pilot. But just last week, Fed Vice Chairman Janet Yellen announced that those goalposts (6.5% unemployment and 2.5% inflation) should not be considered "triggers" but as thresholds past which the Fed "may consider" tightening. When U.S. prices start to rise in earnest, look for the denials and rationalizations to come in torrents.The Fed will never acknowledge high inflation no matter what the data, nor will it ever take any steps to combat it. The simple reason is that it will be unable to do so without bringing on the economic contraction that is so terrifying to the British.

However, as British inflation accelerates, the pressure on the Bank of England to change course will intensify. As monetary stimulus continues to take its toll on the pound, price pressures will mount, even as the economy continues to stagnate. In other words, it is charting a course to stagflation. Perversely, this will put even more pressure on the BofE to ease. However, more cheap money will not stimulate the economy but merely cripple it further by fueling the inflationary fire.

At some point the British will have to admit that stimulus doesn't work. To break the inflationary spiral and rescue the ailing pound, the BofE will be forced to aggressively raise rates, at which point the British government will have no choice but to slash spending more deeply than would have been the case had they taken their medicine sooner. However, if the BofE refuses to tighten even in the face of much higher official inflation, the pound may deteriorate further and the UK might be left with the embarrassing choice of adopting the euro.

As far as the United States is concerned, the U.K. is the canary in the coal mine. What they are going through now, and what they may be about to go through, we will surely experience in the years ahead. The only difference is that the leeway afforded to us by our special status simply gives us more rope to hang ourselves. When the noose finally tightens, the fall will be that much more painful.

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  1. H. Craig Bradley | February 21, 2013


    I have been hearing these dire financial warnings off and on at least since 1976. Some may already have disregarded your and others warnings as so much "crying wolf" because in the end, it never quite seems to happen. Still, we have indeed been warned as a country and collectively- so IF diaster strikes, then nobody will have a valid excuse will they?

    Nevertheless, a great many will still deny they were warned and similarly claim innocence. It won't help then and it won't save anyone alot of pain either. Bad news often comes in spades when it does come. Seldom does one thing fail. Instead, manys key systems often fail at once. Therefore, we should expect a number of "plagues" to hammer U.S. if we fail to heed the warnings we already have received.

    For example, SARS or Swine flu, or some other unexpected epidemic wiping out thousands of people, drought and/or food shortages or severe price inflation, fuel shortages or price escalation, power outages (brownouts), water shortages, financial system failures, EBT shutdowns, transportation closures, another domestic terrorist attack and huge losses of property or lives, panic, suffering and many,many resulting premature deaths.

    Sound scary enough to pay attention? History proves the masses do not pay attention to anything of serious importance, just their trivia. Sadly, it has happened before, in fact, many times before because human nature never really changes. So, eat, drink and be merry like the Roman residents of Pompeii did before the final eruption of volcano Vesuvious. In the end, we are all dead anyway.

  2. H. Craig Bradley | February 23, 2013

    GLOOM & DOOM: Part II

    Here is one possible scenario that could play-out for the United States, based upon a little bit of history (former President Jimmy Carter), scattered readings here, and a pinch of speculation.

    First, interest rates start to rise- as many claim is already happening on the long end of the maturity spectrum (TLT Barclays 20yr.+ Next, you have the much anticipated "Great Rotation" from bond funds into stock funds, pushing the indexes up to yet another "all-time" record
    (again, a work currently in progress). Then, suddenly-possibly in a year or two, the bond market is hit by crisis not much different from the late seventies in which bond buyers stop buying U.S. Debt (bonds). Demand dries up, but not supply. Prices crater and interest rates go through the roof.

    Interest rates spike-up 300 basis points in just 5-6 months time (according to Alan Greenspan). Panic sets in and the incompetents in office finally have the golden opportunity to "show their metal". In response to a deepening recession, the printing presses are running 24/7 in a desperate attempt to flood the streets with paper money and inflation spikes, possibly into the high double digits.

    Now, the pain is felt everywhere. Voters finally wish they had not reelected President Obama but its too late now. Their fate is sealed. Housing crashes, stock markets collapse, gold goes to $5,000/ounce for awhile. Obama then issues an Executive Order making it illegal (felony) for individuals to possess physical gold in the United States. Capital controls are invoked to prevent money or precious metals from being exported. Private tax deferred pension accounts are nationalized. Now we are like Greece or possibly Argentina and there is no going back. Too bad.

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