Economic View: Inflation takes the high road, sterling takes the low road – and it's time to holiday in Scotland

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The Independent Online

Shopping in New York won't be as much fun this week as it was a month ago for British holidaymakers. Say goodbye to the $2 pound, for sterling has fallen against the dollar for 11 days on the trot, the longest uninterrupted run for 37 years. As recently as mid-July, the pound was still at $2; on Friday it closed at $1.86.

Two things are happening. One is a reassessment of the dollar, for it is rising against the euro too. One reason for this is that US exports have been extremely strong on the back of the still cheap dollar: up more than 10 per cent in volume year-on-year. Astoundingly, US exports are now rising faster than those of China. A large current account deficit remains, but the correction is clearly in full swing. Another reason is that the US economy has been growing faster than those of other developed economies. The Japanese and eurozone economies shrank during the three months to end-June, while the UK economy only inched forward. Leading on from that is a shift in the perceived attractiveness of the US as a place to invest.

The other thing is what has happened here in the UK. Last week saw the Bank of England's latest Inflation Report, which was even more gloomy than expected about both inflation and growth. Inflation, which had risen to 4.4 per cent on the consumer price index measure, is expected to go to 5 per cent, and growth next year is expected to be "broadly flat" to use the words of Mervyn King, the Bank's Governor. On both inflation and growth, the Bank has now shown itself to be slightly more pessimistic than most financial commentators, whereas before it was rather more optimistic than the market.

The reaction has been interesting. The markets, rightly or wrongly, have read the report and the comments on it as suggesting that UK interest rates will come down earlier than expected, maybe even in November or December, as fears of a serious downturn next year will outweigh concerns about inflation. That is why sterling fell so much. In the short term, relative interest rates are an important determinant of exchange rates because the higher the rate, the more attractive the currency is as a place for international investors to park spare cash. But in the medium and longer terms, the value of a currency is more opaque. Ultimately, the purchasing power of a currency will be the anchor, but it is an anchor dragged by several forces.

The plunge of the pound against the dollar has been dramatic, but its weighted average over the past two decades is a more helpful guide to the future. Two things stand out. One is the similarity between the pound's ejection from the Exchange Rate Mechanism in 1992 and the present collapse – well, maybe collapse is too strong a word but the order of magnitude of the decline is similar. The other is the slight, upward, long-term trend.

As far as the sharp devaluation is concerned, the issue is whether we have managed to draw a "get out of jail" card early in the downturn. You may recall that the need to remain in the ERM forced the Major government to hold interest rates too high, with the result that the economy was pushed even deeper into recession. Once we were able to drop the exchange rate target and replace it with an inflation target, growth could be resumed. It did not feel like it at the time, but the long boom for the UK economy began in 1992.

We have dropped the exchange rate much earlier this time, before the downturn has really hit, and we still have control of our own interest rates. I would not claim that a weak pound will immediately lift things much, and it is embarrassing for the Government that the pound has been so savagely downgraded during the holiday season. Still, it is helpful for the economy as a whole to have a competitive currency as the world economy slows.

The longer-term, gradual climb of the weighted value of sterling will come as a surprise to anyone with memories of the 1960s and 1970s, or of the poor record on inflation that continued right through the 1980s. Since then, our record on inflation has been adequate by comparison with other developed countries, but not great. Our current account position has been generally weak, particularly since 1997 when we were close to balance. So how have we managed to engineer a gradual revaluation of the currency?

It must be partly the relative attractiveness of the UK as a place for inward investment, or to put the point less flatteringly, as a place where everything is for sale. Oil will have something to do with it too. But it may also be partly because the UK has managed to switch into exporting high-value services where price is not the prime consideration. So much of our income comes from investments and service exports that we may be less vulnerable than other countries to competition from lower-cost producers abroad.

But were we to lose discipline over inflation, that advantage would disappear, which brings us back with a bump. Until last month, the UK had a somewhat better performance on inflation than the eurozone and a markedly better one than the US. How will that be clawed back?

The general problem is that a weaker currency increases import costs and the price of raw materials, including oil. Timing is also an issue; the peak of inflation here may come in September. If it does, that is good news for pensioners and people on benefit, for September is the reference month for re-rating index-linked pensions and benefits. These are linked to the retail price index, which is significantly higher than the CPI – yet another burden on the public purse that was not factored into the Budget last March.

Nothing can be done about either, so we have to hope that wage settlements do not respond to this squeeze on incomes from higher prices, and that oil and other commodity prices will decline soon and fast. I think they probably will, enabling that first cut in rates before Christmas. But that will not stop next year being a difficult one for the economy.

And sterling? Well, it has had a period at the top of its range and it seems likely now to have a period towards the bottom of its range. Holidays abroad will remain more expensive. The only thing to do about that is holiday within the sterling area. I'm off to a country that still uses the pound, though it may eventually adopt the euro – Scotland. Back in September.

Future chancellors might even understand economics

The economic news may be troubling but there was some good news last week about economics as a subject. Amid the mass of stories about A-level students – the best pass rate ever, the grade escalation and so on – that that economics is becoming a much more popular subject rather escaped notice.

However, the number of AS students was up 10.6 per cent on 2007 at 24,449, and the number of A2 was up 6.3 per cent at 18,540. So economics along with maths has become one of the fastest-growing subjects at A-level. This is by contrast with recent years, where numbers have been pretty flat. The word from the schools is that the figure for next year will show an increase too.

So what is happening? I suppose the big point is that "doing serious" is back in fashion among the young. That is why maths is benefiting along with economics. "Easy" subjects are becoming, if not despised, at least recognised as such. This cannot be associated with tougher times because the decision to do the subject was taken two years ago at the top of the boom. But of course having "serious" A-levels does widen career opportunities. There is a mass of evidence that a maths A-level increases lifetime earnings.

The particular attraction of economics, of course, is that it is both a fascinating academic subject but also a meal ticket: at a time like this, people are at least interested in what the subject has to say.

But I think there has also been a rash of interest stimulated by books such as Freakonomics and The Logic of Life, which explain how economic incentives and responses help shape human behaviour.

It is common sense really but something that policymakers have often failed to understand. The whole enthusiasm for setting targets in the public sector and then paying bonuses related to these, rather than fostering competition, stems from a failure to understand how people react to economic stimuli. Sure they will meet the target, but the real quality of output may well get worse.

My main worry is access to the subject. A lot of schools, particularly in the maintained sector, don't offer it. Of course it is not necessary to do economics at school before going on to do it at university (I didn't), but it helps students to figure out whether this is really the subject for them and, as important, it lifts the general competence of the population with the subject. Who knows, better access and we might even have more bankers who realise there is such a thing as the economic cycle – and chancellors too.