Four years of speculation? We'll all be nervous wrecks
the risks for sterling as it waits on the sidelines of the single currency
Friday 08 May 1998
Its safe haven status will attract overseas investors, leaving us with the dubious accolade of a very strong currency for the foreseeable future. Rough for exporters, but rather flattering.
But there is a good case to be made for the view that staying outside the mammoth new currency will actually expose sterling to speculative frenzy. It all depends on what the mass of opinion in the financial markets decides to believe about the Government's policy towards the euro, and how credible that policy is.
The basics of an argument that speculators will decide to put the pound under pressure can be found in an essay by Paul Krugman, the eminent professor of economics at the Massachusetts Institute of Technology, in his entertaining and illuminating new book*.
Professor Krugman has been a long-standing mild sceptic about the euro, and in a chapter written last year argued that the likely member currencies were vulnerable to speculative attack.
That did not happen, but the same arguments apply to sterling during what the Government apparently intends to be a five-year period of preparation.
The argument starts with the simple observation that there are just two questions that matter about exchange rates. Is it helpful to the economy for them to be able to adjust? And do the currency markets get their judgements on the appropriate level for a given currency about right most of the time?
The second question is the easiest to answer: it has to be 'no'. It can be perfectly rational for individual investors to bid an exchange rate up or down excessively, based on a judgement about what other investors are going to do, without any reference to economic fundamentals.
The phenomenon of overshooting has been seen so often as to be beyond doubt. Take the pound during the 1990s. It has veered from a low of DM2.18 to a high of DM3.10, a 42 per cent swing in the course of about five years. Has the underlying performance of the economy altered that much? Of course not.
As Professor Krugman explains, many economists now accept that there can be self-fulfilling currency crises. Not only does a given level for the exchange rate hold only if the markets believe the authorities will do everything necessary to defend it, but the herd instinct means everybody will want out if they think everyone else wants out.
What about the first question? Here, the answer is less obvious. The possibility of devaluation allows extra flexibility in managing the economy, and can be a godsend during a recession - as the UK found after September 1992.
On the other hand, the possibility of devaluation can just offer a short- term escape from inflationary pressures which ends up making the price spiral even worse - as the UK discovered in previous devaluations. Economists can cheerfully argue this both ways indefinitely.
Depending on your answer to these two questions, you fall into one of four categories, as the diagram shows. For example, if you think exchange rates ought to be flexible and the markets are mostly sensible, you will be happy for the currency to find its own level - a "serene floater". If you think there is little advantage in the freedom to devalue, or that a flexible exchange rate involves a high cost, and you thoroughly mistrust the markets, then you will want a firmly fixed exchange rate - and preferably a single currency. This is the position of euro-cheerleaders.
I'm a "determined fixer", like other fans of single currency membership, but recognise that a majority of people fall into the "nervous wreck" category that offers the worst of both worlds - you think a flexible exchange rate is useful, but believe the currency market is likely to be periodically destructive if the rate can vary.
There are really only two possible cures in a world where traders can shift billions of dollars worth of funds between currencies in an instant. Either stop caring about the level of the currency - in other words, do not trust the market but do not mind where it takes you either. Or decide that the freedom of flexibility is not worth the candle and fix the level of the exchange rate with a totally credible policy, such as joining the single currency. Both amount to switching boxes, and becoming either a serene floater or a determined fixer.
It is staying in the nervous wreck box that makes a given currency such good sport for speculators. For example, the Asian currencies such as the Thai baht combined the theoretical possibility of devaluation with a policy of resisting it. As soon as the markets believed the fixed exchange rate was no longer credible, because the Thai government was not prepared to stick to economic policies consistent with it, it was only a matter of time until the baht bubble burst.
The British Government falls firmly into the vulnerable nervous wreck category at the moment and - even worse - until it holds a referendum on Emu membership and joins the single currency irrevocably. There is at least a four-year window of opportunity for speculation against sterling. By definition, the Government does not think it worth giving up its exchange rate freedom yet, or it would have joined the first wave. Nor is it happy with sterling finding its own level in the markets. Quite the reverse - it seems to have a pretty specific level for the pound, around DM2.60, in mind.
A long transition period; a policy likely to be targeted at an exchange rate that will require interest rates to be set at a level unsuitable on domestic grounds at some stage; and on top of that real political uncertainty about whether the Government as a whole - not just the Chancellor - truly wants to join the single currency. It is a recipe for what Professor Krugman describes as "speculative havoc".
He recommends instead what has become known as the Nike strategy: "just do it". If the UK is ever going to join Emu, it should just join.
It is advice likely to be ignored. The pound is strong now but watch out for a sterling crisis when it has drifted down to a more reasonable level and the speculation that the government is shadowing the euro begins.
* 'The Accidental Theorist', Paul Krugman, Norton pounds 16.95.
As Voltaire once said, “Ice cream is exquisite. What a pity it isn’t illegal”
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