15 July 2019

McDonnell’s startling sterling claims


One of the many problems with John McDonnell is that he doesn’t understand how markets work.

His latest outlandish claim is that Jeremy Corbyn becoming Prime Minister will increase the value of the pound. And this really, really, isn’t how things work.

In an interview with The Times he offers the following bit of soothsaying:

“I think what we’ll see is sterling strengthening, if anything, as a result of the plans we’ve laid out. We know what our programme will be. The market will know well in advance and will react appropriately, and it won’t be on the basis of capital flight or anything like that.”

There are, to put it mildly, a number of issues with Labour’s policies. Among other things, McDonnell wants to nationalise the water and electricity companies, force the sale of 10% of all quoted stocks into an employee trust fund and delist companies that don’t meet environmental standards.

But even if we allow that McDonnell genuinely thinks his policies would actually improve the economy, rather than just a means to epater les bourgeois, he’s still missing an extremely basic point – what values other people place on things are up to them, not him.

Valuations, like utility, are personal. In this case, we ought not to listen to what John McDonnell thinks of his own policies. Instead, we should listen to those who will be doing that valuing, the market participants. And the answer there is that no one does think that sterling will rise. Nor, obviously enough, that nationalising those commanding heights will benefit the economy as a whole.

Take, for example, the Labour Party insistence that the water companies will be better run under government control. “Better” here meaning the government will produce an optimal level of investment in the service. It’s as though they have forgotten why the companies were privatised in the first place – government wouldn’t invest enough in them. Indeed, investment rose substantially after privatisation.

There is one sense in which McDonnell is right though – there would not be much capital flight after Labour assumed power. But that’s because that capital flight will have already taken place before power is taken, not afterwards. Markets, after all, are forward-looking things.

Another way of saying the same thing is that the Efficient Markets Hypothesis is correct. The EMH simply states that markets process information over what prices should be efficiently. That is, information we already know is already reflected in prices. If it looks like McDonnell’s going to gain power, then a market collapse and capital flight would happen before he gets to Number 11, not afterwards.

All of which means the Shadow Chancellor was inadvertently right when he said “the market will know well in advance and will react appropriately”.

Now, if markets are efficient processors of information then we don’t want to replace them with the prejudices of politicians.

The important point is that McDonnell can tell us all he wants that these are going to be beneficial policies and that other people will not react to having their property stolen, but it’s not McDonnell who does that value determination, it’s everyone else who gets to do that.

Sterling moving up or down or capital fleeing the country is determined by the opinions of those affected by policies, not the politicians enacting them.

Perhaps we can excuse, if not forgive, McDonnell for not getting this. Because of course this is the way all markets work, values are determined by the beliefs and interactions of the participants, not what some politician believes they should do.

Then again, given that McDonnell doesn’t really believe that markets are the optimal way to organise economic life, it’s hardly surprising he should fail to grasp this basic point.

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Tim Worstall works for the Continental Telegraph and the Adam Smith Institute