Fiscal stimulus a better bet than devaluation

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The Independent Online
The weakness of the economy is leading many to propose substantial changes in policy, and - with little hope of a significant reduction in German interest rates until the latter half of 1993 - the desirability of maintaining the present exchange rate is becoming increasingly questioned.

Why not devalue the pound to lower interest rates and increase the prospect of export-led growth due to improved UK competitiveness?

The basic answer is that such a policy would not work. Realignment to a central rate of, say, DM2.65 would be highly unlikely to lead to lower interest rates; it could well lead to higher rates as financial markets turned against sterling, following the huge loss in anti-inflationary credibility.

The effective floor for UK interest rates within the ERM is the rate in Germany, the dominant ERM country whose Lombard rate currently stands only one quarter of a percentage point below UK base rates. For UK rates to drop below this level, holders of sterling assets would have to be convinced that sterling was about to appreciate against the mark. Otherwise they would sell out of sterling to gain a higher yield elsewhere, and sterling would once again face devaluation.

In theory there might be some combination of a lower central parity for sterling and lower interest rates, at which sterling is at the bottom of its permitted band but yet still expected to appreciate. But where such a fortuitous combination lies is anyone's guess. And in the hurly-burly of a real-life devaluation, a more realistic outcome would be the movement of sterling to the floor of its newly instituted band, followed by rising interest rates to forestall any further depreciation.

The only option available to the Government that would bring interest rates down by the 2 to 4 per cent needed to have a significant effect on the economy is to leave the ERM altogether. Sterling could then fall to a level commensurate with the desired cut in interest rates.

Such a policy, however, would involve economic and political risks. Sterling could easily fall too far, as old fears of inflation and economic mismanagement were revived.

It would also be the death of the UK's participation in the Maastricht Treaty, and would force a fundamental reappraisal of our position in the European Community. So leaving the ERM appears an unlikely option, unless the recession drags on well into 1993.

So which route should our economic policymakers adopt? From a macro-economic perspective, there appears little sensible option but to sit tight and await an easing of German monetary policy over the next year. The alternatives appear risky and uncertain in their benefits.

This is not to say that nothing can be done to stimulate recovery or that current policies are beyond improvement. A particular area of concern is fiscal policy, where the debate has focused on the overall thrust of policy - as typically measured by the PSBR - rather than the nature and composition of the public spending that is actually taking place.

The Government could look at market-orientated ways of promoting private sector investment, such as an across-the-board subsidy to demonstrably new projects started in the next six months.

Whatever the options chosen, a gradual reduction of the government deficit, offset by measures to boost business investment and the supply side of the economy, might well - as the French have found - bear more fruit over the longer term than devaluation of the exchange rate.