The pound in your pocket will be worth more tomorrow

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EDDIE GEORGE would like the pound a bit weaker; Gordon Brown says that he won't do anything to make it weaker. Maybe the rest of us should lie back - preferably on a Mediterranean beach - and enjoy it.

The level of sterling, strong or weak, has been a great puzzle of the last decade. It comes in two parts. We were heaved out of the ERM because, according to the conventional wisdom of the markets, the pound was overvalued. Sterling plunged and the conventional wisdom then maintained that there would initially be an export-led boom (thanks to cheaper export prices) but that rising inflation would chip away these gains. As it turned out there was indeed an export boom, but there was hardly any inflationary price - puzzle number one.

Puzzle number two came later. Sterling suddenly rose back to its old ERM level and the conventional wisdom was that this would lead to both recession and a soaring current account deficit. In fact the UK managed to avoid recession last winter (something that Germany may not have done) and the current account, admittedly by a bit of a fluke, has remained in surplus.

So now we have the situation where manufacturers are naturally pretty worried and exports are flat, but the economy as a whole seems to go on growing. If the economy keeps growing, unemployment is at a record low (yesterday's figures), inflation is below the Government's target, maybe we cannot only live with the pound at this level. Maybe conventional wisdom is wrong yet again; maybe sterling isn't overvalued at all.

The puzzle takes on a powerful political dimension, for were Britain to switch to the euro, it would have to lock in at a single rate, never to be changed. It becomes rather important that, were this to happen, the rate should be the right rate - whatever that might be.

Enter the Bank of England and the Treasury. The Bank's view, articulated by both the Governor and the Monetary Committee, seems to be that sterling is indeed rather overvalued, and the presumption is that it will fall at some stage in the coming months. In the perception of the markets the Bank seems to be trying to talk sterling down. It is reinforced here by the International Monetary Fund's view that if the pound wanted to join the eurozone it should consider "specific actions" to weaken sterling.

Quite how you weaken a currency, of course, is another matter.

The view that sterling is overvalued also seems to be the general position of the Treasury, in so far, that is, as there is a single Treasury view. But the Chancellor was interesting in his speech to the CBI on Tuesday evening in that he said we should not make the mistake of having two targets, one for inflation and the other for the exchange rate, as we did in the late Eighties and early Nineties. He praised the way the Bank operated on its single target on inflation - which seemed to rule out any attempt to depress sterling.

But who is right? Many prices in Britain certainly seem high by international standards, as tourists endlessly tell us. Could conventional wisdom be wrong again and the pound in fact be reasonably fairly priced? Go further: maybe the natural long-term trend for sterling is slightly upwards?

The problem here is that we have very little understanding of how far structural changes in an economy affect exchange rates. We think of making goods at certain prices, and if the price is too high in other countries' currency then there is a trade imbalance and the exchange rate has to come down. That was the classic boom/ bust sterling cycle for much of the post-war period, a period during which sterling seemed inevitably to sink ever further. It had its ups and downs, but each down was lower than the previous one and each up not quite as high.

Nowadays there remain some of these effects, of course. To some extent the problems at Rover are currency-related, which is why its BMW owner is pressing for a lower pound. But leaving aside the fact that part of Rover's problem is not price but product, nowadays half our foreign earnings are not from exporting goods at all. They are from exporting services. After the US, we are the second-largest exporter of services in the world, way ahead of Germany, France and Italy.

In trade in services it is much harder to know how much price matters. Say we produce a bit of software for a video game. The manufacturing cost of exporting additional copies of that software is virtually zero. If it is simply downloaded across the Internet the manufacturing cost is in fact zero, and the shipping costs are the price of the phone call. So it does not matter what price you produce at; what matters is what your skilled video game writers can charge for their services. They are not competing against factories in low-labour-cost countries in the emerging markets in East Asia. They are competing against similarly skilled people living in ranches in Montana.

In this world where human capital has become the most important resource, the exchange rate becomes a much less precise matter. It has to be reasonable, of course, but the fact that London is, say, 15 per cent more expensive than Paris, becomes irrelevant to the thirty-something international banker who can double his or her pre-tax salary by moving across the Channel to Britain, and save another wodge through lower taxation.

There is, of course, a serious regional problem. Eddie George got himself into a spot of hot water a few months ago when he acknowledged that the right interest rate for the services-oriented South-east might be the wrong rate for the North of England. But you could apply exactly the same point to the exchange rate. The right rate for manufacturing may be the wrong rate for service industries.

So what is to be done? The answer is: nothing. We simply do not know what the right rate for sterling really is - or rather, we know only within broad bounds. My guess is that we are towards the top of the appropriate range, but that the long-term trend for sterling ought to be upwards, not down. That is the result of a number of different factors, including less unfavourable demography than the continental European countries, but particularly the strength in service activities, which are not very price-sensitive.

Conclusion? Yes, the pound is strong. Yes, it may come down a bit. But if we remain outside the eurozone we may find that sterling continues to be generally strong for a generation or more. Holidays on the Med will become even cheaper.