Why The Pound Is Overvalued

One of the more bizarre developments in the recent debt crisis is that government bonds from one of the countries with the most messed up public finances, Britain, has been considered a "safe haven", ignoring that not only have Britain a large debt and deficit, but it has also a central bank that relentlessly tries to lower the value of its currency, something that also means that anyone nstupid enough to buy British bonds will see the value of their investments reduced.

However, in recent years, though the Bank of England has been successfull in pushing up domestic price inflation to an average of 3.5% per year (a lot higher than in all other major advanced economies) the foreign exchange rate of the pound has actually increased the latest year, trading recently at 1.25 against the euro, up from the 1.10 to 1.15 range  This increase in the pounds exchange rate of course reflects the above mentioned "safe haven" status that causes investors to demand pound denominated assets.

The combination of much higher inflation and a significant nominal exchange rate appreciation is of course that the real exchange rate has soared, making British exports very uncompetitive. We should therefore not be surprised that the British trade deficit rose to a new high in April as exports plunged.

In some other countries with a strong currency, the effects on the trade balance is to a large extent cancelled out by the increase in real interest rates caused by disinflation/deflation , but as British real interest rates have been strongly negative.

With a rapidly increasing trade deficit and negative real interest rates, it seems clear that the British pound is one of the most overvalued currencies around.