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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.
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
always benefited from 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.
Peter Schiff is the CEO and Chief Global
Strategist of Euro Pacific Capital, best-selling author and host of
syndicated Peter Schiff Show.
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