Jeremy Warner: Sterling was far too high. Now it may be going the other way
Thursday 04 December 2008
Outlook: Jose Manuel Barroso, head of the European Commission, thinks Britain is “closer than ever before” to joining the euro and even claims to have had conversations with senior members of the UK Government to that effect. Meanwhile, Christine Lagarde, the French finance minister, would be more than happy to welcome us in.
Could it be that the euro debate, reduced by political neglect to virtual non-existence over the past seven years, is about to be reopened? Not on your nelly, says even Lord Mandelson, whose pro-single currency views make him the chief suspect of Mr Barroso’s reference to senior Government figures.
According to Lord Mandelson, it remains a long-term Government policy objective to take Britain into the euro, “but not for now”. Pro-euro thinking is plainly still thought of as too politically dangerous for a country whose population and press remain predominantly eurosceptic. Besides, the economic downturn seems to make the case for an independent currency better than any Little Englander ever could.
By staying out of the euro, Britain is able to set interest rates to suit its own particular needs, rather than labour under a rate set for the eurozone as a whole, while the collapse in the exchange rate provides the impetus for the sort of export-led recovery that other European countries can only dream of. Our economic situation is already ruinous enough, the argument goes, but if we had been in the euro it would be even worse with little hope of redemption.
Yet the argument can equally well be made the other way. As it happens, Britain is probably more converged with the eurozone right now in terms of the economic cycle, interest rates
and the appropriateness of the exchange rate than it has ever been. Bank rates are within 25 basis points of one another, the exchange rate at around ¤1.17 to the pound, though a lot lower than we have become used to for our credit-fuelled foreign holidays and homes in the sun, is probably about right in terms of Britain’s long-term competitiveness, and even our economies are now in sync, in the sense that both Britain and the eurozone are in recession.
The floating exchange rate may seem a boon at a time when rapid devaluation provides hope of a reflationary boost to export industries, but it has also condemned the country to long periods of misalignment. With the benefit of hindsight, sterling was massively overvalued until about a year ago, both against the dollar and the euro, lulling the country into a false sense of prosperity, and, by helping to keep inflation and interest rates relatively low, contributing to the credit-fuelled boom.
We are now at a point where the exchange rate is in real danger of going the other way, and overshooting on the downside. There hasn’t been a
full-blown sterling crisis in Britain for an awfully long time, but in many respects we now seem set up for one, with the fiscal deficit ballooning and foreign investors increasingly nervous about the resilience of both the economy and the currency.
Willem Buiter, a founding member of the Monetary Policy Committee, has gone so far as to liken Britain to Iceland, in the sense that relative to their size both had become overly dependent on banking sectors sustained by large inflows of foreign deposits. There’s already been a run on Iceland, and there are unnerving signs of the same thing happening to Britain. Like banks, whole countries can go bust once confidence seeps away.
For the time being, the Bank of England is relatively relaxed about the fall in sterling, which it sees as a necessary and likely beneficial adjustment which will help rebalance the economy away from consumption. Demand is so damaged that the currency adjustment is unlikely to prove seriously inflationary. In any case, the fall experienced so far won’t deter the MPC from making another steep cut in interest rates at the conclusion of its monthly meeting today.
Yet if the adjustment turns into a rout, then things get much more difficult. Rates would have to rise steeply to support the Government’s ever-burgeoning borrowing requirements, choking off all possibility of an early economic recovery. In such circumstances, the euro begins to look rather attractive. The euro offers a degree of protection from the negative impact of currency swings and capital flows.
As I say, for the time being, the debate remains largely academic. Even if the political will to join existed, Britain would be excluded anyway. With the fiscal deficit swelling to per
haps as high as 10 per cent of GDP next year, we would drive a coach and horses through the already devalued Stability and Growth Pact rules.
Gordon Brown, the Prime Minister, might cite these restrictions as another excellent reason for staying out – at least it gives him the freedom to spend his way out of recession. One way or another, there will regrettably be a heavy price to pay for all this profligacy.
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