Economics: Could Britain become the new Germany?

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The Independent Online
Journalists rarely look back at what they wrote a few years ago. This is partly because short-term focus is the very nature of our craft; if we were historians we would write differently. But I suspect it is sometimes just a bit too embarrassing to see the extent to which we got things wrong.

Readers, however, have no such scruples. One wrote to me a few weeks ago to the effect that he would not take any of my predictions very seriously as he remembered how I had strongly defended the old ERM rate for sterling prior to the pound's humiliating removal on Black Wednesday. It seemed a pretty fair kick up the backside: sore enough for me to look back at what I had actually written. I had indeed defended what was then the official line of the Treasury and the Bank of England. This view was that the rate against the main European currencies, the mark and the franc, was perfectly acceptable, but there was a problem with the rate against the US dollar, then in the $1.90-$2.00 range.

Then, the week after the ejection I noted that although 95 per cent of the people in the financial markets expected "that Britain will slither slowly down the path of currency depreciation", the remaining 5 per cent had a rather different outlook. They thought that within 18 months sterling might be back at DM2.95. "That is such an unfashionable view at the moment that it might seem almost ridiculous to acknowledge it, but were the UK economy to recover ahead of the German, were the inflationary implications of the present devaluation not followed through in wage rises, and were the dollar to recover, it is just conceivable that the case for sterling's old ERM rate could be validated again by the markets."

Now sterling is indeed back in the ERM range, though it has taken a lot longer than 18 months and we are not yet back to the central rate of DM2.95. The UK economy did recover ahead of the German economy; the fall in sterling did not result in inflationary wage demands; and the dollar rebounded. The timing was completely wrong, but the logic behind that minority view was absolutely correct. Looking at the way the market has been moving, that DM2.95 benchmark appears perfectly plausible in the coming weeks.

So let's try to repeat the exercise. What do the 95 per cent of the people in the market think about the future for sterling, and what would the 5 per cent minority be saying?

The majority view is easy to sketch - that sterling has been propelled upwards by a combination of factors which are not really sustainable in the long run. One is higher interest rates, and the prospect of still higher ones to come, the result of an unsustainable boom. Britain is back to its bad habit of stop/go; with growth now running sharply above the long-term trend, inflation will pick up and sterling will need to depreciate again. The long-term downward slither of its overall value will continue. That trend is shown in solid line on the graph: were it not for the little jump over the past 12 months, the story of sterling over the past 17 years would be one of steady decline.

There is support for this majority view in last week's statistics. The very welcome fall in unemployment seems to be taking place at an unsustainable rate; the year-on-year rise in average earnings is now 5 per cent, up sharply from the 3.5 per cent of a year ago; house prices have shot up, particularly in London and the South-east; and while the rise in sterling has cut raw material costs and is holding down retail prices, that may just be concealing more inflation in the pipeline. It may be that the long-term decline of sterling will now proceed at a slower rate, but eventually this higher inflation will be reflected in a weaker pound.

If that view is right then the little upkick of the pound against the mark would eventually come to be seen as just that: a brief cyclical upturn in the middle of a long secular decline. But it may be wrong.

And what about the minority view, which is so unfashionable that it seems almost ridiculous to acknowledge it? People would differ as to the details, but the broad thrust might run like this.

It is that sterling has just made a gigantic shift, similar to the turning point that took place during the First World War, when it changed from being the strong currency of the previous 100 or so years to being a weak one. The reasons for that transformation are well known: the burden of two world wars, the relative decline as a manufacturing nation, what Paul Kennedy has dubbed "imperial overstretch" as a result of the empire, and so on. Now, the present period in many ways resembles the second half of the last century, with rapid globalisation of the world economy, great technical advance, and a huge increase in the importance of capital flows and international investment. Perhaps these conditions might favour the UK.

I don't think anyone believes sterling could return to anything like its position of the last century: that would be ridiculous. But you can imagine a situation where it gradually becomes a strongish currency for the next generation or more.

First, with the exception of the US, Britain has the least unfavourable demographic pattern of the Group of Seven countries: we are moving from being second only to France in the 1950s as the oldest of the G7, to being second only to the US as being the youngest, by the year 2020. Continental Europe (and Japan) will be facing an enormous struggle to maintain living standards with an increasingly smaller proportion of its population of working age. In fact it probably will not be able to do it and a whole generation will face a lower standard of living than their parents. This is not a recipe for strong individual European currencies, or for a strong euro, if it happens.

Second, the UK has made a lot of progress on the big structural changes which European countries (and Japan) are now having to make: downsizing big manufacturing industry and shutting coal mines, of course, but also building up service sector employment to replace the lost jobs. There is still a long way to go on the industrial side, for overall productivity levels are still below the world average. But some industries, such as chemicals, are already world class. And we do know that, for all its faults, the UK economy is good at creating service sector jobs.

Third, there has been a global shift in inflation, which is clearly on a long-term downward path. We may well move into a period of slowly falling prices, as in the last century, with people enjoying increases in standard of living (if at all) from lower prices rather than higher wages. In many ways that would be more equable; sharing the fruits of rising productivity will benefit the whole population, rather than just workers.

If prices in general start to fall, any remaining cultural propensity in the UK to inflate our way out of trouble will disappear. In a world of generally stable prices, exchange rates would simply reflect relative advantage, which for the reasons noted above, may be coming our way.

Of course all this is conjecture. But the idea that a strongish sterling might become the norm - that we will be the new Germany - is being taken on board by some of the more thoughtful British industrialists. Certainly any company planning on a weak pound is putting itself in peril.

Have another look at the chart. The solid line does indeed show a fairly continuous decline, but the other line, the pound against the dollar, does not. It may be that the early 1980s period, when the pound approached parity with the dollar, will be seen as a historical low, never again to be reached.

Finally, there is the small matter of the euro to be considered, but on reflection, perhaps that is a story best left for another day.