Britain’s economic ghosts have a way of resurfacing just when we think we’ve buried them. The latest apparition comes in the form of the twin deficits: a current account shortfall of 2.7 per cent of GDP and a Budget deficit of 4.8 per cent.
For some older traders, the numbers evoke the spectre of 1976 — that summer of humiliation when the IMF was summoned to shore up a collapsing pound.
Rachel Reeves, the Chancellor, now faces a similar test of nerve. Sterling will be her barometer, a judgment on whether she can balance fiscal restraint with growth, all while keeping her party’s manifesto promises intact.
To understand the stakes, one must appreciate that sterling’s long history is not one of serene stability but of periodic collapse. As Robert Farago of Hargreaves Lansdown notes, currency markets “aren’t tranquil places.” Since the pound’s 1931 devaluation, each generation has learned that lesson anew. A century ago, Britain’s decline as an economic superpower set in motion a long downward drift for the currency. Central banks quietly sold their sterling holdings as the UK’s share of global output shrank.
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There were moments of acute drama. In 1931 and again in 1992, sterling’s fate was tied to unsustainable pegs: first under the gold standard, then within the European Exchange Rate Mechanism. In both cases, the currency was anchored at too high a rate, and the strain proved unbearable. When the links snapped, the pound plunged.
Sterling’s sternest test in years
But something changed in the aftermath of Black Wednesday. On 8 October 1992, Britain quietly began a new experiment: inflation targeting. Instead of trying to fix the exchange rate, policymakers aimed to fix prices. The Bank of England’s task became maintaining low and stable inflation, using interest rates as the main tool. It worked. Over the next three decades, sterling steadied, inflation fell, and monetary credibility (so long absent) was slowly rebuilt.
That framework remains intact, but it now faces its sternest test in years. The fear is that twin deficits could again spook markets into demanding higher returns for holding UK assets. Borrowing costs would rise, growth would falter, and the pound could tumble. Reeves’ problem is that her options are politically poisonous. An IMF-style rescue today would almost certainly demand hikes to at least one of the “big three” taxes — income, VAT or national insurance — breaching Labour’s election promises.
Yet markets, like voters, have limited patience. Without a credible plan to balance the books, sterling will suffer. The pound’s fate will hinge on whether Reeves can persuade investors that fiscal discipline and growth can coexist — a harder trick than it sounds when the public purse is already stretched.
Still, there is comfort in perspective. The pound has weathered worse. It is not pegged to gold or yoked to the euro. Inflation targeting provides flexibility that past Chancellors could only dream of. Currency crises are as much about confidence as arithmetic, and confidence — for now — remains intact.
Sterling’s direction, as Farago concedes, is hard to predict. But if Reeves can avoid the ghosts of 1976, she may yet prove that Britain’s economic story need not be one of perpetual decline.
