So, this morning I had a brief Twitter conversation with Simon Jack, the economics editor of the Today programme, about a metaphor he used to introduce an interview on the subject of the British Pound’s sharp devaluation as the EU exit referendum was launched. The line which annoyed me at seven o’clock this morning was:
“I think of the exchange rate as something like a national share price, and ours has been falling”
See below for why, although I understand the point he was trying to make, I think this is not a good way to think of exchange rates…
[Note: I am prepared, here, to set aside merely technical points, related to the fact that exchange rates, unlike share prices, are ratios. This means that there are always one fewer exchange rates than there are countries, and it’s not possible for them all to increase at the same time, something which isn’t true of share prices. This point of disanalogy does, in fact, annoy me, but I don’t think it’s particularly harmful for people to not know it].
The point that Simon was making, and one that I regard as basically valid, is that, like a share price, short term movements in the exchange rate (in this case, the sterling/dollar exchange rate) are usually caused by a temporary disequilibrium in net capital flows, which are themselves usually a result of changes in expectations or sentiment on the part of investors and/or speculators. So broadly speaking, the inference from “sterling fell” to “people in the market saw this whole referendum mess as bad news” is valid.
But the trouble is that both share prices and exchange rates have equilibrium states as well as movements in disequilibrium. And the equilibrium conditions are totally different. For a share price, it’s the capitalised value of future profits, and pretty unambiguously, higher is better and lower is worse. For an exchange rate, it’s the ratio of two sets of prices of tradable goods. And depending on all sorts of other things, it might be better or worse for the exchange rate to be higher or lower than it is today.
Which is why I don’t think this metaphor can be defended as a simplification for the layman. A layman hearing the report I heard will be reasonably well informed about this week’s currency fluctuations, but he will take away the message “an exchange rate is like a national share price”. As a result of using that rule of thumb, he is quite likely to develop very wrong beliefs about, say, whether it would be good for sterling to trade at US$2, or whether it would be good for the UK if the Chinese yuan appreciated (and therefore the pound depreciated). And, of course, because the definition of “a layman” in context is “someone who doesn’t regularly follow the financial news”, the economics editor of the Today program won’t get an opportunity to tell our imaginary listener when he’s got the metaphor wrong.
I’m not sure what a good metaphor would be. My best idea so far would be to think of the exchange rate as something like the national blood sugar level. If it surges or plumments in a short period of time, there’s usually a reason for that. It might need to be higher on average than it is now, or lower on average, but the important thing is not the absolute level but the need to get it in balance with what’s healthy for the system as a whole, and it’s usually a bad sign if it’s very volatile. This isn’t perfect by any means – it obviously leaves the hypothetical layman with a very wrong impression of the merits of fixed exchange rate regimes – so I’d be open to any suggestions. The correct communication of economic and financial information is a fascinating subject for me, and it’s the sort of thing I’d do a PhD in if the thought of doing experimental economics questionnaires with student volunteers didn’t seem so dispiriting.
If you absolutely must have a Brexit thread, I suppose this can be it, but for heaven’s sake try to keep it less intolerably mindless than the majority of British public debate on the subject.