Economics: Recovery by devaluation risks inflation

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The Independent Online
THE financial markets - not least the stock market - have been taking the view that British economic policy is now likely to be much more relaxed than it was before Wednesday's crisis. As a result, the recovery will begin sooner and will be stronger. The cost is that inflation will be a little higher than it would otherwise have been.

But the stock market may be a little too optimistic. Wednesday's denouement may well mean slightly lower interest rates, benefiting most businesses. Exporters will gain from the lower pound. But it does little to alleviate the main factor depressing the UK economy: its burden of debt.

With households still paying twice as much of their incomes in debt service as they did at the beginning of the 1980s, a period of debt work-out is inevitable, whatever the mix of policy. A fall in interest rates may merely shorten the time needed to bring down debt, without leading to a rapid lift-off in spending. Nor is it yet clear by how much policy will be relaxed.

My instinct is that the outcome of today's French referendum is vital. If the French vote in favour of Maastricht, monetary union between the currencies that have not suffered from this week's turbulence - the mark, franc and lowlands currencies - may go ahead rapidly. The French will not want to run the risk that the franc and the mark could be blown apart by some other unexpected shock, and the British and the Italians are no longer in a position to say 'wait for us'.

We will effectively have a two-speed Europe, with Britain in the slow lane. Other countries could be linked to the new Franco-mark in the same way that the pound was linked to the mark: the difference would be that interest rates on the Franco-mark would be set for the whole of north-west continental Europe, and not merely for Germany, which would make the anchor currency less volatile.

Satellite countries could adopt the new Franco-mark when, to coin a phrase, conditions allowed. In Britain's case, those conditions would no doubt be as much political as economic. But we would be travelling the same road as we were last Tuesday, albeit more slowly.

Any policy relaxation would be modest. We might, for example, be looking at the second scenario in the box below: a small devaluation. Any easing in interest rates would be broadly similar to what might have occurred had we stayed within the ERM: British rate cuts might begin a little ahead of those in Germany, if the strength of sterling allowed it.

The Franco-mark is a much more credible route to a single currency than the one mapped out by the Maastricht treaty, under which the exchange rate mechanism was supposed to survive unchanged until 1997 or even 1999. Such a 'hard' ERM was stable only if the markets were convinced that exchange rates would stay the same until monetary union and that all the central banks were committed to its success.

This is important because central banks control the supply of their own currencies. If two monetary authorities are determined to exchange their currencies at a particular price, no market pressure in the world can budge them because they are the monopoly suppliers. Whichever currency is going down can be bought up using the currency that is rising. But if the central bank of the currency going up is not fully committed to supplying whatever the market wants, there is a weakness that the markets can exploit.

Last week, the markets realised that the Bundesbank's heart was not in the fight. As soon as Helmut Schlesinger's remarks to Handelsblatt about the possible need for a further realignment were reported, the speculation against sterling became acute. It was a blunder made all the more poignant by the support that Hans Tietmeyer, the vice-president, gave to the franc on Friday. He said that if there were any realignment, the franc should be upvalued.

In retrospect, the long transition period envisaged by Maastricht was a fatal flaw in its architecture. Asking the Bundesbank to run the 'hard' ERM was rather like asking a condemned man to throw the lever for his own execution. The biggest loser in Europe from monetary union would undoubtedly be Germany's independent central bank. It has no interest in success.

But what if the French vote against Maastricht, and hence the prospect of an accelerated move to a Franco-mark is ruled out? In those circumstances, I doubt that there will be much left of the ERM by Tuesday morning. The Dutch guilder and the Belgian franc and other small currencies may hold on to the mark's coat-tails, but it will be a rough ride even for them. The sharp revaluation of the mark that should have taken place after reunification would finally occur.

In these circumstances, there would be a fundamental reappraisal of Britain's European and anti-inflation policy. Without the prospect of monetary union, it will be rational for the Government to reconsider whether it wants inflation of 0-3 per cent or would settle instead for 4-5 per cent and higher growth. If the latter, it can treat the fall in sterling with equanimity.

There is, though, little prospect of fostering a sharp recovery in the economy without rekindling inflation, as the Ernst and Young Item club forecast (using the Treasury's own model) shows. The exact extent of the inflationary effect is controversial.

Many City economists believe the impact would be muted because the economy is so depressed. Businesses would be unable to pass on higher costs.

But it is hard to see why the rise in import prices would not fully reflect the pound's fall. Sterling has not been seriously overvalued, which means that importers do not have a cushion of extra profit as they did in 1981. Many of their markets are uncompetitive. So import prices will probably rise by about 7 per cent, which is the size of the effective devaluation compared with last year's average level - if sterling now stabilises at its present level. Imports are nearly a third of everything we buy, so overall prices could rise by 2- 2.5 per cent.

The recession is likely to mute the subsequent rise in other costs, prices, and wages. With luck, the Government might thus stop inflation from rising. After all, the strong deflationary forces in the economy would probably have pushed inflation down to 2-2.5 per cent by the end of next year had the old policy persisted. But the devaluation is enough to make any fall in inflation below 4 per cent short-lived.

Any further fall in the pound - any 'dash for growth' caused by sharper cuts in interest rates - might initially reduce inflation next year. The effect of the fall in mortgage rates on the retail price index would offset the rise in underlying inflation. But the story thereafter would be very different. Wage bargainers are not foolish. They know only too well what happened last week. The pound in their pockets has been devalued.

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