The 1976 sterling crisis was triggered by a blow-out in the fiscal deficit and excessively loose domestic monetary conditions, caused partly by government borrowing from the banking system. Sound familiar?
Fiscal concerns reflected a rise in public sector net borrowing to 7.0% of GDP in 1975-76 – far below the 12.4% officially projected for the current financial year.
The IMF rescue in late 1976 involved a currency stabilisation programme based on limits on "domestic credit expansion" (DCE). This is defined as bank lending to the private sector plus the portion of the fiscal deficit not financed by selling debt to domestic non-bank investors. The focus on DCE was appropriate because much of the liquidity created by credit buoyancy was flowing overseas, so money supply statistics did not fully reflect the scale of monetary laxity.
This perspective is relevant currently because of evidence that liquidity created by the Bank of England's quantitative easing (QE) programme has been flowing abroad, putting downward pressure on sterling. The table presents recent data on the relationship between DCE and money supply growth. The right-hand column covers the period from April to August, during which the Bank bought £120 billion of gilts.
The contractionary effect of liquidity outflows on broad money is captured by the "external and foreign currency counterparts". The impact amounted to £49 billion over the five months – significantly larger than the £24 billion increase in broad money over the same period.
It is possible that outflows would have occurred in the absence of QE. The external counterparts, however, had a positive monetary impact in the prior 12 months to March 2009. The timing of the swing into negative territory, and the consistent contractionary influence in each of the five months covered, suggests a linkage with QE.
This analysis supports the argument in a previous post that the Bank's gilt-buying is creating excess liquidity, which is being reflected in buoyant asset prices and sterling weakness but is not apparent from the broad money supply data. If the Bank expands QE further, the currency decline could accelerate.
The chart shows sterling's trade-weighted index together with the contribution of public sector DCE to annual broad money growth – a negative correlation is apparent. This contribution is now 10 percentage points, the highest since – 1976.
| Cumulative flows, £ billion, seasonally adjusted | |||
| April 2008 | April 2009 | ||
| - March 2009 | - August 2009 | ||
| 12 months | 5 months | ||
| Public sector net cash requirement | 168 | 57 | |
| - | Public sector debt sales to UK non-banks | 85 | -37 |
| = | Public sector domestic credit expansion | 83 | 94 |
| + | M4 lending to private sector (excluding intermediate OFCs) | 58 | 4 |
| = | Domestic credit expansion | 141 | 98 |
| + | External and foreign currency counterparts | 11 | -49 |
| + | Other counterparts & residual | -92 | -25 |
| = | M4 (excluding intermediate OFCs) | 60 | 24 |
