The fall in sterling has become our "get out of jail" card. It may not have felt like that if you have been away on the Continent during the past few weeks and it may not feel like that at the petrol pumps. There are certainly costs to us all. The fall against the euro has done more than make holidays abroad more expensive and the fall against the dollar has done more than stop us benefiting from the decline in the price of oil, for of course everything we import becomes more expense in sterling terms. But the one thing a fall in the currency does is to boost demand – and at this stage in our economic cycle that is very much what we need.
To see why, just suppose the Bank of England had cut interest rates four times this summer, down from 5 to 4 per cent. That would not in itself have revived the housing market, for issues of affordability and mortgage availability would still be dominant. Nor would it have made us rush to the car showrooms, because people still feel nervous about making big purchases after all the dire warnings about the downturn. But the mood of both individuals and companies would be more chipper. We would recognise that while the squeeze on our living standards would continue a while yet, at least economic policy was being eased to help us through.
That has not happened. Last week the Bank held rates again (as did the European Central Bank, though at 4.25 per cent) and my own best guess for the first fall is now November at the earliest. But thanks to the fall in the pound, we have had
an easing of monetary policy during the summer that is equivalent to at least one percentage point off interest rates.
You see, a fall in the pound has much the same impact on demand as a fall in rates, and vice versa – though it does take a different form to lower interest rates for the main beneficiaries of a lower pound are exporters and other earners of foreign exchange, and UK producers that are in competition with imports. Exports become more profitable; imports less so. So there are not only more incentives to export; there are more opportunities to substitute domestic products and services for imported ones. The initial benefit goes to companies, and only as they respond, perhaps by taking on more staff, does the effect spread through to us as individuals.
With changes in rates, the impact is broader. Companies are helped by a fall because it cuts their borrowing costs, but those of us with floating-rate mortgages are also helped by the cut in monthly outgoings. So I suppose you could say that changes in exchange rates work mainly through the company sector, whereas changes in interest rates work more though individuals.
In addition, a stimulus through the exchange rate will reduce any current account deficit, whereas one through interest rates may increase it (because more domestic demand tends to suck in more imports). Since our current account deficit has been starting to cause some alarm, it is more appropriate. Indeed it is the "right" way to boost demand. Trying to rekindle the consumer boom by sharp interest rate cuts would be the wrong way. But it will take a while to come through.
How long? The best template for what might happen is the early 1990s. Sterling was kicked out of the European exchange rate mechanism in 1992, and there was a sharp fall. It took 18 months for exports to respond, though that was largely because the European recession bottomed out about two years after the UK one.
This time demand may come through a bit sooner, though the outlook on the Continent is discouraging at the moment. Not only did the eurozone economy shrink during the second quarter but consumer confidence has plummeted in recent weeks in quite a scary way. I know the OECD is more pessimistic about the UK than the other G7 countries, and its forecast of recession during the second half of this year shook the Chancellor. But my instinct is that it may be too gloomy and that a flat second half is more likely. I remain concerned about the prospects for next year and no less so because of the very rapid decline in housing.
Rather than look at predictions of house prices by the pundits, some who have been right but more wrong, the financial markets can show what people are prepared to bet on: you look not at what they say but what they do. Tradition, the London broker, produces price forecasts from trading in the derivatives market. This amounts to a fall of more than 20 per cent over the next three years but a recovery thereafter. In the past month the one-year outlook has deteriorated markedly, the longer-term outlook less so. So in effect the markets are saying the fall will be more front-end loaded than previously expected. It is already sharper than it was in the early 1990s, raising the interesting question as to whether it is better to get the adjustment over quickly and therefore begin to rebuild sooner.
The falls in both sterling and house prices have been sharper than appeared likely even a couple of months ago. The result will be more of a squeeze on living standards but also more of a boost to industry. It is bad news for the Chancellor, for the less we earn and spend, the less revenue the Treasury gets from taxation and the more dire the fiscal outlook next year. There is no "get out of jail" card for him. But it is good news for the economy as a whole, for it means that the recovery, when it comes, is more likely to be sustained.
When the pound was kicked out of the ERM, it appeared to many people a disaster, and in political terms it was for John Major's government. But we can now see that the devaluation of sterling was a crucial building block for the long boom – the first third under the Tories, the second two-thirds under Labour. I expect this devaluation will be an essential building block for the next expansion – just do not expect that to begin just yet.
Come next summer and shares should be on the turn
It was another grim week for equities, with the comments from US fund manager Bill Gross that America faced a "financial tsu-nami" more responsible for the gloom than Alistair Darling's comment that conditions were "arguably the worst they have been in 60 years". Mr Darling hit sterling, Mr Gross share prices. I have dealt with the sterling issue above; what about shares?
It is not realistic to expect any sustained recovery in this area until it is clear the world economy is turning up. Different markets will turn at different points but the usual pattern would be for the turn to come a few months ahead of the bottom in the real economy. Since a revival is not yet in sight, the prospects for global equities in the months ahead do not look glittering.
So what do you do? We know that on a very long view equities have produced better returns than cash or bonds, but if you go in at the wrong time you could be down for a decade. Apply that now and it would be neat if you could sit out the rest of the bear market and then jump in. The trouble with that is the risk of missing the first few days of recovery, for once markets have turned, they tend to snap back fast. Blink and you miss much of the subsequent recovery.
The two most unusual aspects of the bear market early this century were that shares fell for three years on the trot – something that had not happened in the UK since the War – and that was the worst decline since the 1970s, it was once-in-a-generation stuff. The two most unusual aspects of this bear market are that the decline in shares has been associated with a global house price crash and that glo-bal demand has been maintained by China, so pushing up commodity prices. So the question is whether the house price crash and the growth of the Chinese economy will in some way alter or extend the bear market.
As far as housing is concerned, we know the falls have weakened the banking system, though the idea of a "financial tsunami" seems over the top. We are perhaps two-thirds of the way through the banking morass.
I am more concerned about a fall in demand from Asia, even if that solved our inflation woes.
There will be more bad news but what will matter is the ability of markets to look across the dark valley to the sunlit uplands. Come next summer I would be surprised if they have not managed to do that.Reuse content