As he predicted in that speech, if the Government were to take sterling out of the ERM and then cut base rates, we could sit back and watch a run on the pound. Who says the Treasury has lost its ability to forecast?
The real debate in the Cabinet is not about the date of ERM re-entry, but about what to do in the meantime, and in particular about whether to pretend we are in the system while we are actually outside it. More specifically, it is about whether to try to stabilise sterling within a relatively tight (but unpublished) band, or simply to operate policy by reference to the immediate needs of the domestic economy.
The Governor of the Bank of England nailed his colours to the 'stable currency' mast last week, and my impression is that many senior officials at the Treasury probably agree with him. It seems that many former supporters of the ERM (myself included) are having a hard time adjusting to the completely new world that has been created by the collapse of the former strategy. But the longer I think about this, the less sensible it seems to be to try to recreate the main
features of the ERM now that the UK is outside the system.
Like it or not, a sea change has occurred. While sterling was inside the parity grid, it could be argued that the long- run gains to policy credibility associated with membership made it worthwhile to accept a considerable amount of short- run pain to achieve these gains. However, policy credibility has been completely shot, and will remain shot whether the pound eventually stabilises at DM2.40 or DM2.20. The Government should from now on seek to stabilise sterling only if the balance of national advantage - meaning the outlook for growth and inflation - seems to warrant it.
In the end, this boils down to the familiar question of whether further devaluation will inevitably lead to a sharp pick- up in inflation in the years ahead. David Walton, of Goldman Sachs, has recently completed interesting research on this issue. He has estimated a model that uses three explanatory variables to predict the rate of inflation: the exchange rate; the pressure of demand in the domestic economy; and past rates of inflation. Like other researchers, he concludes that the most important determinant of current inflation is its own history, reflecting the massive amount of inertia in the inflation process.
However, something has to set the spiral turning in the first place, and Walton finds that the pressure of domestic demand has a much greater impact on inflation than the behaviour of the exchange rate. In fact, a 1 per cent shock to output relative to its potential adds 0.14 per cent to inflation, while a 1 per cent depreciation in the exchange rate directly adds only 0.02 per cent to prices.
If this analysis is anywhere near correct, then it has an important implication for the future. At present, the domestic economy has more slack in it than it has had at any time since the war, and the full effects on the inflation rate have not yet been felt. Even if the economy grows fast enough to reduce economic slack (which seems unlikely), activity will inevitably be well below capacity for a long time to come, and as long as this remains true, past experience suggests that inflation will fall.
Mr Walton's model says that if sterling had remained inside the ERM, inflation would actually have been negative for several years after 1993. This may be too optimistic (since the relationship be
tween the pressure of demand and inflation may change in nature at very low inflation rates, with many prices simply refusing to fall in absolute terms regardless of the depth of the recession), but there can be no doubt that, under the old regime, inflation would have dropped to spectacularly low levels.
The direct effects of devaluation will not dramatically alter this path for inflation, but we must also remember that devaluation will have important indirect effects, since it will boost output, and therefore indirectly increase inflation via an increase in the pressure of domestic demand. The graph shows what might happen to inflation if the sterling devaluation eventually settles down at 10 and 20 per cent, respectively. In the former case, inflation settles at about 2-3 per cent over the medium term; in the latter, it runs at 3 per cent for a while, and then rises to about 5 per cent in the mid-1990s.
Two apparently contradictory conclusions are therefore simultaneously true. First, the eventual effects of devaluation on inflation will be quite large, when both the direct and indirect effects are combined. Sec
ond, because it was previously set to fall so far, the outlook for inflation may still be quite good, even with a 20 per cent devaluation.
This, and the bleak outlook for economic activity, suggests that Norman Lamont, the Chancellor, should probably lean in the direction of earlier rather than later base rate cuts.
Furthermore, the Government should recognise that the traditional link between higher interest rates and a firmer currency is not working in today's financial markets - either in the UK, or anywhere else in Europe.
The single most important factor undermining the currencies of Britain, France, Sweden, Finland, Spain, Ireland
and (to some extent) Italy is the presence of, or fear of, recession. In a recessionary environment, the markets are unimpressed by large rises in interest rates, since they do not believe that they can possibly be sustained. Therefore all the countries listed have found that currency weakness has persisted regardless of extremely high interest rates. What the Chancellor must now recognise is one simple, though unfamiliar, fact. Interest rate increases carry no credibility. Anything that weakens the economy will weaken the currency further, including base rate increases and public expenditure cuts.
This means that the Government is powerless to do anything about the weakness of sterling until the currency finds a level from which the markets spontaneously believe it is more likely to rise than fall.
Think about it this way. In the next 12 months the UK will need to attract about pounds 15bn of overseas capital to finance its trade deficit. Outside the ERM, this inflow will not be attracted by a small interest rate advantage on UK assets, since the exchange rate risk is much too great.
Therefore the only way to attract this money is to substitute expected currency appreciation for the interest rate risk premium that was sufficient to attract capital when we were inside the ERM.
And for this to happen, sterling must fall to a level from which the market believes it can subsequently rise - which could still be a long way down from here.