Four years of speculation? We'll all be nervous wrecks

the risks for sterling as it waits on the sidelines of the single currency

ONE OF THE great unknowns about the single European currency is how its creation will affect those countries like the UK that are staying out for now. Pundits who do not really like the euro and think it doomed to disaster predict that Britain will look increasingly like an island of serenity in the storm-tossed seas of the financial markets.

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.

Jeremy Paxman has admitted he is a 'one-nation Tory' and complained that Newsnight is made by idealistic '13-year-olds' who foolishly think they can 'change the world'.
peopleFormer Newsnight presenter is being touted for a brand new role
Michael Buerk in the I'm A Celebrity jungle 2014
File: David Cameron offers a toast during a State Dinner in his honour March 14, 2012
voicesAnd nobody from Ukip said babies born to migrants should be classed as migrants, says Nigel Farage
Arts and Entertainment
Avatar grossed $2.8bn at the box office after its release in 2009
filmJames Cameron is excited
ebooksNow available in paperback
The Magna Carta
archaeologyContemporary account of historic signing discovered
Arts and Entertainment
Stik on the crane as he completed the mural
Arts and Entertainment
Phyllis Dorothy James on stage during a reading of her book 'Death Comes to Pemberley' last year
peopleJohn Walsh pays tribute to PD James, who died today
Benjamin Stambouli celebrates his goal for Tottenham last night
Life and Style
Dishing it out: the head chef in ‘Ratatouille’
food + drinkShould UK restaurants follow suit?
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Argyll Scott International: Service Desk Analyst

£20000 - £22000 per annum: Argyll Scott International: Service Desk Analyst Re...

Argyll Scott International: 2x Service Desk Analyst

£20000 - £22000 per annum: Argyll Scott International: Service Desk Analyst Re...

Recruitment Genius: Senior Execution Trader

£30000 - £250000 per annum: Recruitment Genius: A global Rolling Spot FX, Comm...

Citifocus Ltd: ACA - Financial Reporting

£Attractive Package: Citifocus Ltd: Chartered accountant (ACA or CPA), must be...

Day In a Page

Homeless Veterans Christmas Appeal: ‘We give them hope. They come to us when no one else can help’

Christmas Appeal

Meet the charity giving homeless veterans hope – and who they turn to when no one else can help
Should doctors and patients learn to plan humane, happier endings rather than trying to prolong life?

Is it always right to try to prolong life?

Most of us would prefer to die in our own beds, with our families beside us. But, as a GP, Margaret McCartney sees too many end their days in a medicalised battle
Thomas Cook's outgoing boss Harriet Green got by on four hours sleep a night - is that what it takes for women to get to the top?

What does it take for women to get to the top?

Thomas Cook's outgoing boss Harriet Green got by on four hours sleep a night and told women they had to do more if they wanted to get on
Christmas jumper craze: Inside the UK factory behind this year's multicultural must-have

Knitting pretty: British Christmas Jumpers

Simmy Richman visits Jack Masters, the company behind this year's multicultural must-have
French chefs have launched a campaign to end violence in kitchens - should British restaurants follow suit?

French chefs campaign against bullying

A group of top chefs signed a manifesto against violence in kitchens following the sacking of a chef at a Paris restaurant for scalding his kitchen assistant with a white-hot spoon
Radio 4 to broadcast 10-hour War and Peace on New Year's Day as Controller warns of cuts

Just what you need on a New Year hangover...

Radio 4 to broadcast 10-hour adaptation of War and Peace on first day of 2015
Cuba set to stage its first US musical in 50 years

Cuba to stage first US musical in 50 years

Claire Allfree finds out if the new production of Rent will hit the right note in Havana
Christmas 2014: 10 best educational toys

Learn and play: 10 best educational toys

Of course you want them to have fun, but even better if they can learn at the same time
Paul Scholes column: I like Brendan Rodgers as a manager but Liverpool seem to be going backwards not forwards this season

Paul Scholes column

I like Brendan Rodgers as a manager but Liverpool seem to be going backwards not forwards this season
Lewis Moody column: Stuart Lancaster has made all the right calls – now England must deliver

Lewis Moody: Lancaster has made all the right calls – now England must deliver

So what must the red-rose do differently? They have to take the points on offer 
Cameron, Miliband and Clegg join forces for Homeless Veterans campaign

Cameron, Miliband and Clegg join forces for Homeless Veterans campaign

It's in all our interests to look after servicemen and women who fall on hard times, say party leaders
Millionaire Sol Campbell wades into wealthy backlash against Labour's mansion tax

Sol Campbell cries foul at Labour's mansion tax

The former England defender joins Myleene Klass, Griff Rhys Jones and Melvyn Bragg in criticising proposals
Nicolas Sarkozy returns: The ex-President is preparing to fight for the leadership of France's main opposition party – but will he win big enough?

Sarkozy returns

The ex-President is preparing to fight for the leadership of France's main opposition party – but will he win big enough?
Is the criticism of Ed Miliband a coded form of anti-Semitism?

Is the criticism of Miliband anti-Semitic?

Attacks on the Labour leader have coalesced around a sense that he is different, weird, a man apart. But is the criticism more sinister?
Ouija boards are the must-have gift this Christmas, fuelled by a schlock horror film

Ouija boards are the must-have festive gift

Simon Usborne explores the appeal - and mysteries - of a century-old parlour game