Many people were taught that the Government's defence of sterling in 1967 merely handed wads of the taxpayers' money to currency speculators. The Treasury, just as it did last week, borrowed foreign currencies to buy up the pounds which speculators were trying to sell. After the 14 per cent devaluation, the Government was left with debts in foreign currency which required more sterling to service. Those speculators who had 'shorted' sterling - entered into contracts to sell pounds in the future, in the hope of being able to buy at a lower price beforehand - made hay. It was, the critics said, a 'one-way bet'.
However, the apparent currency losses to the exchequer are often illusory, as was discovered during the period of 'dirty floating' in the 1970s and 1980s. We made intervention 'losses' after support buying of the dollar when it continued to fall, but those losses were subsequently recouped when the dollar went back through the point of intervention. If there is no devaluation of sterling, the Chancellor's borrowing actually makes some accounting sense. He will pay a slightly lower interest rate than he would do if borrowing the money in sterling.
But the argument for or against intervention in the foreign exchanges should never be confined to accounting profits and losses, because that calculus cannot capture all the benefits (or costs). Last week, for example, the Chancellor averted an interest rate rise, the consequences of which might have been a plunge in business confidence, a renewed downturn and sharp losses in tax revenues.
If that seems like hyperbole, consider what happened on Friday: the unexpectedly bad US employment figures triggered another slump in the dollar in the expectation that the already low 3.5 per cent interest rate would be cut still further. As funds flooded out of New York into Frankfurt, the mark again rose strongly against other European currencies. The Italians were forced to raise lire interest rates by 1.75 percentage points to 15 per cent to keep up with the DM. Thanks to the Lamont package, sterling rode out the storm. The markets were persuaded that the Chancellor really intended to hold the exchange rate, which made it easier for him to do so.
The danger has not wholly passed. So long as the US economy is mired in recession, its interest rates will be low, and there will be the danger of surging capital flows to Europe. Those flows are bound to benefit the mark more than any other currency, particularly while there is a serious risk of a French rejection of Maastricht in the referendum on 20 September. With a weakened commitment to monetary union and low inflation, several currencies will look less credibly fixed to the mark. The pressures for a mark revaluation could be intense.
But there is no reason to revise the judgement that the Chancellor should be able to get through to 21 September without either an interest rate rise or a realignment. The markets often underestimate the central banks' tactical advantages. The Bank of England can operate discreetly during thin markets - for example, in Tokyo overnight - to move the rate more sharply than it would be able to do in London or New York. It can thereby set the tone for a day's trading.
More fundamentally, the Bank of England knows about sensitive economic data before it is made public. The Bank can therefore anticipate the reaction of the market and operate a 'bear squeeze' - a way of causing substantial losses to those who have bet against sterling. Heavy support buying of pounds shortly after the publication of better-than-expected data or a supportive announcement can drive the pound up sharply, as occurred on Thursday. Any bank that had sold sterling short might also be panicked into buying sterling to cover its position.
ONE OF the battier ideas being floated by critics of our European Monetary System membership is that we are 'doing a Churchill': namely, trying to fix the pound at an unrealistically high rate, just as Chancellor Winston Churchill did when he put sterling back on the Gold Standard at the pre-First World War parity (of dollars 4.86) in 1925.
As Barry Eichengreen's splendid new history of the inter-war Gold Standard shows (1), the five-year effort to drive up sterling to its old parity was held to be essential for the City, the world monetary order and the Government's reputation. But it horribly squeezed much of Britain's manufacturing industry, helping to cause a drop in national output of more than a tenth in 1921 - the worst recession in recorded British economic history. This was far worse than 1929-31, which became more famous because it was worldwide, or the 2.4 per cent drop last year. Churchill was to comment later that he would have wished finance less proud and industry more content.
The two graphs compare the experience of sterling with the monetary benchmarks of the day: the dollar in the case of 1921 to 1925 and the mark today. I have shown the same proportionate scale in each case, so that movements in sterling can be compared directly across time. The most obvious point is that sterling was driven up by more than a fifth over the 1920s, whereas it has dropped by more than a fifth since the mid-1980s.
If UK prices were falling compared to others in the 1920s, and rising compared to others during the late 1980s, the effects on competitiveness of these movements in the exchange rate might have been cancelled out. But the evidence on overvaluation suggests that the 1920s were much worse than today.
In an article which uses some modern methods of assessment, John Redmond (2) finds that 'the pound was clearly overvalued . . . in 1925. Indeed, it is possible to argue that when Keynes asserted that the pound was overvalued by 10 per cent he may have understated the case, since some of the results . . . suggest that the pound may have been overvalued by as much as 25 per cent.'
Similar calculations of the exchange rate that would equate prices in Britain with those in our trading partners today - so-called purchasing power parity - show a 7 per cent overvaluation. However, about half of that figure is due to the undervaluation of the dollar which will right itself in time. The remaining gap is not large and can properly be closed by inflating less rapidly than our rivals.
(1) Barry Eichengreen, 'Golden Fetters: the gold standard and the great depression 1919-1939', Oxford.
(2) John Redmond, 'The sterling overvaluation in 1925', Economic History Review, 1984.