The Broader Market

by Jordan Eizenga

A (British) friend of mine tried to convince me that, unlike the US (whose currency is a global reserve currency), the UK has to implement austerity measures to save its currency from devaluation (Nick Clegg repeated this during an appearance on MSNBC).  As a precedent for such currency devaluation, my friend pointed to the events of “Black Wednesday” (September 16, 1992) in which there was a massive sell-off of the pound sterling.  My friend’s point was that investors will sell the pound sterling out of concern for the UK’s debt position - unless the government implements austerity measures now.

Aside from the fact that austerity measures could prove counterproductive in reducing deficit levels (see Martin Wolf’s piece for an explanation of this), there is a separate problem with this argument, namely, that it implies that the sell-off in 1992 was out of concern for the public debt.  Most students of this sell-off know that the concern of investors was not debt, but the overvaluation of the pound sterling due to a quasi-fixed exchange rate regime (called the European Exchange Rate Mechanism). 

Without going into the details, the German Deutsche Mark began to appreciate after a post-unification economic boom, while the UK was simultaneously in a recessionary period (a period usually characterized by low interest rates and a weaker currency).  Given that a fixed exchange rate regime requires that a currency be matched to the value of another currency, the appreciation of the Deutsche Mark artificially inflated the value of the stirling pound.  Currency traders saw this overvaluation and exploited the overvaluation by shorting the stirling pound and reaping huge returns.  The British Central Bank tried to prop up the value of the currency by buying up stirling pounds, but were ultimately unsuccessful and the UK was forced to abandon the Exchange Rate Mechanism.

Crudely, the lesson here has nothing to do with deficit reduction.  Rather, it has to do with the downsides of fixed exchange rates.  So, there may be valid arguments for immediate deficit reduction, but saving the currency is certainly not one of them.

Just saying.