Jeremy Warner: Sterling crisis threatens Brown's reflationary plans

Outlook As Gordon Brown plans his reflationary strategy, an old bogey has returned to haunt the Government's ambitions – the possibility of a sterling crisis. With the pound falling to a new 12-year low against a trade-weighted basket of currencies and an all-time low against the euro, it might be argued that it has already arrived.

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The pound has always been an issue for Labour governments. So terrified was the current Labour regime of having its agenda once again frustrated by the foreign exchange markets that when it came to power it ceded control of monetary policy to an independent Bank of England and put in place strict fiscal rules to govern the public finances.

Up until quite recently, it seemed to work. The markets learned to love New Labour and foreign capital flowed into Britain as if it were Switzerland by the sea. In the process, it helped fund an explosion of credit, and pretty soon Britons became the most indebted individuals in the world. After a few years of hair-shirted self restraint, the Government caught the habit too, and turned the public spending taps to full on.

Labour returned to its bad old free spending ways, but amazingly the markets seemed to tolerate it. This led to much delusional thinking among policy makers to the effect that they had created a new and soundly based economic renaissance that would indefinitely allow the country to live beyond its means.

Mr Brown now proposes to fight the downturn by borrowing even more. According to reports, he's contemplating a £15bn reflationary package to be funded at a later stage by tax rises when the moment of greatest economic peril is past. The markets have got other ideas. According to research by Bank of New York Mellon (BNYM), the pattern of relatively stable inflows of foreign capital into UK fixed-income instruments reversed sharply in September, helping to explain the severe weakening in the pound that began to occur at about that time. Hard though these figures are to believe, BNYM estimates that outflows from UK fixed instruments since 10 September have reversed 75 per cent of the inflows from 2004 onwards.

If that's true, it amounts to a quite astonishing turnaround in foreign perceptions of the relative attractions of the UK economy. Even if the figures have been exaggerated by some statistical quirk, as seems likely, the point is well made.

An already ballooning budget deficit has been further swollen by the hundreds of billions being spent on bank bailouts. On top of that, the Government now proposes to spend even more reflating the economy. This may be the only way of avoiding a really bloody recession, but that doesn't make the markets any more inclined to fund it.

All over the world, foreigners have been repatriating money. Moving assets closer to home is part of the flight to safety which has become one of the defining features of the credit crunch. Previously available pools of foreign liquidity are drying up. For instance, the Chinese have started to spend some of their current account surplus on reflating their own domestic economy. With the declining oil price, Middle Eastern and Russian capital surpluses have also been chopped back to size.

As a consequence, the UK Government may be about to run into the same funding difficulties as have befallen the stricken banks. Like the banks, the country as a whole has become overly dependent on leverage and wholesale money markets. These sources of money are being fast withdrawn. At the very least, the Government may have to get used to paying a lot more for its money than it used to, notwithstanding the Bank of England's attempts to cut interest rates.

Currency devaluation can be a useful tool in fighting recession by making domestic goods and services more competitive. But if it turns into a rout, it has the opposite effect of being inflationary, raising interest rates and deterring foreign investment. The Prime Minister wants to be seen as bold and decisive in his response to the gathering financial and economic crisis.

The banks have become incapable of performing their usual function of borrowing to lend. Mr Brown hopes to fix the problem by having the Government do it instead. Yet it is a strange sort of solution to over-indebtedness that says we should be taking on even more of the stuff. The Government may be about to find out the hard way that it is still not possible for nations to buck the markets.