Surprising Persistence

The Decline of Sterling: Managing the Retreat of an International Currency, 1945-1992, Catherine R. Schenk, 2010.

The Wasteland II, Jeffrey Smart, 1945.

I am happy to announce that with a generous postgraduate scholarship I will be commencing an MSc in Economic History at the London School of Economics in September. As silly as it might sound, writing here certainly gave me confidence to get through the whole admissions/funding applications process, so thank you all for helping me to get there!

Packing up my life here in Australia and getting ready to move across the world has, however, involved a lot of admin. I had already been running on low due to my final undergraduate exams in June. So I am going to take a little pause here. My next post will not be for a month. But I hope it will not disappoint, especially if you are getting bored of modern monetary and financial history — because we will be wading into Chris Wickham’s work on the economic history of medieval Europe and the Mediterranean! For now, though, back to the twentieth century…

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If you peruse any economics blog, financial newspaper, or related podcast for five minutes, chances are that you will find somebody speculating on the fate of the dollar as a global reserve currency. For an entire cohort of pundits and public intellectuals, speculating on dedollarisation is not just a parlour game, it is a spectator sport. Recent global politics have only excited the crowd.

But the problem for all those making predictions is that, other than the dollar, there has only ever been one other international currency: pound sterling. All the wars, revolutions, financial crises, and depressions of history make plenty ammunition for any historian, economist or pundit looking to opine on a new war, revolution, financial crisis, or depression. The decline of an international currency, however, is a comparatively mysterious, n-equals-one scenario.

This only makes it more important to understand how and why sterling went from the preeminent international currency before the Second World War to a currency of little international significance by the 1980s. This is the history Catherine R. Schenk explains in the superb The Decline of Sterling: Managing the Retreat of an International Currency, 1945-1992. With masses of data from the archives of central banks and governments in more than four countries, The Decline of Sterling is a meticulously empirical narrative history. At the same time, however, it makes a vital historiographical intervention.

The book is, of course, tightly focussed on sterling, and as such largely avoids the big historical themes considered in Cain and Hopkins’ British Imperialism and Edgerton’s The Rise and Fall of the British Nation. On the face of it, it may seem that Schenk leans towards Cain and Hopkins, given her focus on money and finance. The Sterling Area and the Eurodollar market, for example, factor substantially in her narrative. But it is actually the other way around. The key revelation of her narrative — that Britain, far from seeking to restore primacy to sterling after the war, desired a controlled demolition — throws a spanner in the works of Cain and Hopkins’ argument that the City directed the British state to “[restore] sterling to its rightful position in the world”.

It is worth clarifying what makes a reserve currency. Fundamentally, it means that central banks hold that currency as a large part of their foreign exchange reserves (this was particularly important before the 1980s when central banks held substantial reserves to defend the fixed exchange rates of the time). Why a central bank chooses to hold a given currency as a reserve is more complex. To be as simplistic as possible, the long-term determinant is basically the size of the issuing country (in economic terms), and, from that, the significance of the currency in international trade.¹ This explains well how during the period of globalisation under British hegemony from 1860-1914, sterling came to be a global reserve currency in the first place.

What makes the history of sterling interesting, however, is that although from the 1940s Britain ceased to be a globally significant economy, sterling was still held as a substantial reserve by central banks well into the 70s. To explain this 'surprising persistence’ of sterling (as

Paul Krugman

memorably described it), Schenk argues, requires grasping how sterling fit not only within the Sterling Area (and the empire anchored to it), but in the global international monetary system itself. It is not just the story of the two devaluations as it is sometimes told (the devaluations of 1949 and 1967), but a longer, complicated, and deeply political process.

On its face, Bretton Woods was all about the dollar. From 1944 to 1971, holding dollars as reserves was quite literally the new Gold Standard. But the problem was there were only so many dollars — the US ran massive payment surpluses and did not issue substantial amounts of debt. Britain, on the other hand, had accumulated large international debts during the war, and sterling assets had long been held as reserves in the Commonwealth, Europe and South America. It was on this basis that the US sought to establish sterling as a ‘key currency’, a sort of proxy for the dollar, so that countries struggling to find dollars could hold relatively plentiful sterling instead, knowing sterling was itself nominally pegged to the dollar.

This did, however, put Britain in a difficult domestic situation. In fact, Schenk argues, it is during these crisis years of the immediate postwar period, 1945-50, that the key themes of sterling policy through the next decades are set in place. Sterling was thought to be overvalued before and after the devaluation of 1949, and so the overseas sterling liabilities entailed by key currency status were seen as a threat that made sterling vulnerable to speculation. Some saw this as exclusively a problem of wartime debts, which, if they could be wound down through diplomacy, would allow key currency status to not confer such speculative exchange risk. But, as Schenk points out, after 1948 the ‘overhang’ problem (as the overseas sterling liabilities were known) were more related to the current account (with Britain’s trade situation) than war debts. Combined with the widespread belief that sterling’s overvaluation was crushing Britain’s economic performance, this made overseas sterling holding — the essence of reserve currency status — not a symbol of status but an apparent problem for Britain and the international monetary system.

This leads to Schenk’s key insight: that the governments of Britain “were not committed to promoting the interests of the City of London by supporting a strong sterling exchange rate or encouraging the international use of the pound”. During the 50s, Britain in fact made many plans to discourage the use of sterling as a reserve asset, and Schenk details the — often bilateral — deals that were made or almost made with key sterling holders such as Hong Kong, Singapore, Australia and India, where the politics of sterling often overlapped with anti-colonial and nationalist agendas. These negotiations were generally difficult. Despite the misconception that sterling held on in the empire due to imperial nostalgia alone, both dominions with monetary policy independence like Australia, and newly independent states like Ghana without, held sterling when it was in their interest, and began to diversify when it was no longer so attractive.

But in the end, the determining factors of sterling’s persistence (and fall) were outside the Sterling Area. The international monetary system and the place of sterling within it changed substantially from the late 1940s to the 70s. As Cain and Hopkins observed, the growth of Europe and later Japan substantially re-oriented the trade of Britain away from its (increasingly former) subjects and vice versa, not to mention put pressure on the dollar and thus Bretton Woods itself.

As a result, pressure on the sterling exchange rate mounted. From 1961 to the devaluation of 1967, Britain defended the sterling rate through a combination of bilateral support from foreign central banks and IMF loans. It could do this in part due to the systemic significance of sterling and, fascinatingly, the war in Vietnam. The latter story is one of the most interesting told in The Decline of Sterling. Throughout the mid-60s, Britain used the threat of withdrawal of troops from East Asia — the famed retreat from ‘East of Suez’ — to negotiate with the US over financial support. When Britain finally did withdraw in 1967, President Johnson offered to ‘solve’ Britain’s financial problems if Britain sent two battalions to Vietnam! With this ‘option’ foreclosed, pressures to devalue rose as US financial support waned.

The other factor was Europe. To put it simply: as Britain’s desire to enter the European Economic Community (EEC) increased, so too did the salience of European calls to finally end sterling’s reserve role. As Schenk observes, “the management of sterling became an integral part of the reorientation of Britain as a European nation”. European nations, especially France, perceived sterling’s international role as an issue. In their view, it was inextricable from the long-standing policy of preferential capital flows within the empire. This made it antithetical to the European project. Britain could not be a European state while Australia had borrowing privileges in London. Further, integration would transfer the risk that Britain had been wrestling with since the war (an uncontrolled unwind of international sterling reserves) to European states. In the end, Britain had to commit itself publicly to ending the international role of sterling before entering the EEC in 1973.

These factors all coalesced in the final retreat of sterling, which started after the devaluation of 1967 and was consummated in the crisis years of the early 70s, when flexible exchange rates (introduced in 1972) began to cause serious depreciation after 1975. By the 1980s, the share of sterling in foreign exchange reserves was below 3%. Nearly a decade of persistent depreciations had made sterling no more attractive as a reserve than any other national currency. The next decades would see it have a career as a North Sea fuelled petrocurrency, and then an infamous crash out of the ERM in 1992. Schenk finishes the story there, although her insights on the legacy of this period on British attitude to Europe still ring true (with a slightly different tone) in the post-Brexit era.

The story I recounted above is highly stylised and egregiously incomplete. My summary is basically a highlights reel of Schenk’s very detailed narrative. Still, I hope it sheds some light on the peculiarity of sterling’s decline. Considering Britain’s diminishing economic role, the decline of sterling was inevitable. But by virtue of the postwar conjuncture, the final retreat was stayed off for more than two decades. Rather than a result of the pernicious influence of the City of London, this was a product of international actors pursuing their interests and a collective concern for the stability of the international system.

It is obviously alluring to make parallels from then to today. But staying sober, the differences between the decline of sterling and the ‘situation’ of the dollar now are more pronounced than any similarities. Schenk makes this argument in the context of 2010, but it still rings true. The most significant difference is perhaps the Cold War. The controlled demolition of sterling was a product of the shared interest of capitalist countries in economic stability brought about by the perceived threat of the Soviet Union. Today, even with rising tensions, there is no such solidarity — and China is much more integrated in the global trade and financial system than the USSR ever was.

Most importantly, pundits would do well to recall that there was, as Schenk writes, no single “tipping point” in the decline of sterling. From the 50s until the 70s, reserve currency diversification away from sterling in one place was accompanied by accumulation somewhere else. Neither devaluation led to a stampede for the exit. In the end, it was persistent inflation in the context of a long global crisis which condemned the reserve role of sterling. It went out not with a bang but a whimper, to abuse the old cliche. Studying it is another reminder that the lessons of history are mostly not of foresight, but humility.

Check out my supplemental to this review below!

1. This is reductive but essentially correct. I don’t want to dismiss the importance of network effects, financial market depth, and central bank credibility, etc — I just do not want to talk about all that here!