Will the euro and pound languish against the US dollar?

The UK’s productivity performance in recent years has been poor, and it has been made even worse thanks to recent data revisions. Statistics have found that migration into the UK has been larger than previously estimated but, with GDP no higher, the consequence is that productivity has been even weaker. For instance, output per hour worked is now only 1.7% higher than the pre-pandemic level. That compares to a dismal, but slightly better, figure of 2.6% previously. While the UK’s productivity performance is particularly poor, it is indicative of the trend in many developed countries and especially those in Europe.

However, it is not a global trend as the US, for one, stands out as a strong productivity performer, and the gap between the US and UK is growing rapidly. Why such a big gap? There are likely to be many reasons; some we know about and some we might not. Investment is an obvious place to start and the US certainly outperforms here. Since 2000, US fixed investment has nearly doubled but the rise in the UK is closer to 50%. That’s a significant difference and, in the post-pandemic period at least, it seems that US firms have addressed the problem of low labour supply more assiduously than the UK by increasing productivity-enhancing investments.

It would seem to stand to reason that a better productivity performance in the US should mean a stronger US dollar. After all, productivity is arguably the truest measure of an economy’s performance and, if we assume that those countries that perform the best will have the strongest currencies, then the US dollar should be out in front. But does this always follow?

Steve Barrow, Head of Standard Bank G10 Strategy, is not so sure. For a start, relatively high US investment compared to other countries might create a productivity advantage, but investment is also high relative to the domestic savings – and this produces trade deficits. And, when you are a country as large as the US, that means a very big trade and current account deficit. For the deficiency of domestic savings implies hefty inflows of foreign savings and these can only be delivered if the overseas sector has a trade surplus with the US. Admittedly, there is a debate here that the US hardly needs to attract these huge capital inflows as overseas savers and investors are only too willing to send capital the US’s way.

Nonetheless, Steve Barrow feels that the need for hefty capital inflows means that the US almost needs to deliver a robust productivity performance in order to maintain US attractiveness, whether this reflects overseas companies wanting to invest directly in US firms, or because foreign investors want to buy US financial assets such as stocks. If this US ‘exceptionalism’ falters for any reason, it could conceivably weigh the dollar down pretty quickly. “The US dollar could also become vulnerable if US policymakers deliberately, or inadvertently reduce the available pool of capital that comes into the US. US policymakers might do this by blocking foreign takeovers of US firms, imposing tariffs, or weaponising the dollar through sanctions. All of these are on the table and only likely to increase once president-elect Trump takes power next year”, said Steve Barrow.

The bottom line is that, while US productivity outperformance is impressive and clearly a source of support for the US dollar, it does appear to come at a cost, which is reliance on foreign capital inflows. These inflows have not faltered for a long time but that does not mean that they are always bound to be sufficient to maintain a stable or stronger US dollar indefinitely.