Devaluation and the J-curve
On November 1967 the pound was devalued by around 14%. Almost 50 years later, following the Brexit referendum in June 2016, the pound also fell in value by around 14%. Does the post-1967 UK experience provide a guide to the likely effects of the post-referendum fall in the pound?
The main effects of any fall in the pound are on the UK’s inflation rate and the current account of its balance of payments. Both occur because the pound’s fall makes UK imports dearer and UK exports cheaper. By definition UK residents buy the imports but not the exports, so the initial effect of a fall in the pound will be a jump in the UK price level and hence a rise in the inflation rate measured over the next year. A year on, the mathematical effect of that jump in the price level will drop out of the inflation rate, but economically its effects may persist by inducing higher expectations of inflation and wage claims. In 1967 the devaluation led to a rise in inflation from 1.7% in the year before to 5.6% in the year after; and this higher inflation did persist.
By making imports more expensive and exports cheaper a fall in the pound’s value should encourage demand for UK exports and discourage imports. But decisions about new supply chains and expenditure patterns take time. So a fall in the pound might initially worsen the current account of the balance of payments because the UK will initially export and import roughly the same volumes of goods even though imports are dearer and exports cheaper. But if the patterns of trade eventually respond sufficiently strongly to the change in relative prices the current account deficit will fall and perhaps even turn into a surplus.
This pattern – an initial worsening of the deficit followed by a move towards a surplus – is known as the J-curve and is clearly observable in the post-1967 UK data. But note that it took over a year for the initial worsening to be reversed.
Will the post Brexit pattern be the same? The effect on the inflation rate is already apparent though it is more muted: it has risen from 1.4% in the year before the referendum to 3.8% in the year after. As yet there is no sign that this will persist. By late 2017 there was only slight evidence of the first stage of the J-curve – there was a short-lived worsening of the deficit – and so far very slight sign of the second. Many economists believe we never will see this second stage because trade patterns do not now respond sufficiently to price changes. The 1967 experience suggests a little more time is needed to tell if they are right, but if that experience is to be repeated then a more marked movement towards a surplus should start to be seen in 2018.