Sterling service is resumed

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The Independent Online
It is time to take stock, isn't it? We have had the Budget and the plethora of comment that follows: first thoughts being contradicted by second and then doubtless being revised again. And we have had the market reaction, the distilled wisdom (well, distilled views at least) of the hundreds of people around the world whose job it is to analyse the finances of this country alongside those of other similar ones, and work out the implications.

A general view is starting to emerge which runs like this. The British economy is clearly in some sort of mini-boom. People can argue about the scale of the boom and its sustainability, but the fact that the economy is growing powerfully is not in dispute. A year ago it was still possible to hear worries about the lack of demand in the economy. Remember how the previous Chancellor justified his unwillingness to push up interest rates as quickly as the Bank of England wanted because of slow growth in demand for manufactured products. Remember how when estate agents said house prices were rising strongly at last, people responded by pointing out that they had been saying that for the previous seven years. But now that view has gone. It was wrong.

The question that follows is what, in macro-economic terms, should the Chancellor have done about it? The main criticism here has been that he should have increased taxation by more than he did and in particular should have skewed the burden on to consumers, rather than on to companies, as (despite the nominal cut in corporation tax) he has done. The result of this failure, it is argued, will mean that interest rates have to do the job instead. Result? In the short term, the surge in sterling that we are seeing now; in the long term, the sad, old boom-bust cycle that we have experienced so many times before.

This case for the prosecution, so to speak, was well put by Goldman Sachs, which picked out some charts showing the similarities between the present cycle and the late 1980s one. Three are shown here - consumer confidence, the output gap and the non-oil trade balance. Of course it is disturbing, particularly since this is the point in the economic cycle where we usually get things wrong. The failure of policy to tighten enough in 1986 and then the loosening of policy following the share crash of October 1987 created the mess. It could very easily be argued that we are heading again in the same direction - though Goldman believes that the Bank of England will tighten monetary policy sufficiently to check the boom.

The case for the defence picks up this view. People who wanted the Chancellor to squeeze consumers fail to note that, quite aside from the obvious political objections, the rise in taxation would have to be enormous to have much impact on consumption. Surely it is more appropriate to use small incremental changes in interest rates, which bear immediately on the whole economy, rather than the once-a-year Budget where the effects are lagged and partial. Besides, surely the principal purpose of the Budget should be to pay for government services, not to try and bend the economy a few degrees hither or thither - particularly since past experience suggests that when we try and fine-tune the economy through fiscal policy, we get it wrong.

My own view, for what it is worth, would side with the defence. Not only was it completely unrealistic to expect the Chancellor to clobber consumers, but looking round the world, fiscal policy no longer seems to be a very effective instrument for adjusting demand. Japan has had a very loose fiscal policy for several years but only now is there much sign of growth. France and Germany are seeing widening deficits as a result of slower- than-expected growth, but their efforts to scramble back by cutting spending and increasing taxes - exactly the opposite of what they ought to be doing on fiscal grounds - do not seem to be denting their albeit slow recoveries. There are legitimate reasons to carp at the detail of the Budget, but not to worry about the overall balance. Interest rates were always going to be the main weapon to slow the boom, and nothing in the Budget was going to make more than a marginal difference in the amount that they will have to rise. Those of us who believe this have, however, to answer a couple of tough questions. How much will rates have to rise? And what damage will that do?

The answer to the first turns on a whole string of issues. One is how much slack there is in the economy, and whether a service economy is able to increase capacity faster than a manufacturing one. This will affect inflation and there is a genuine worry that while inflation in the price of goods remains very low, inflation in the price of services is starting to climb in an alarming way. The amount of slack, or lack of it, will also show in the balance of payments. At the moment, while there is a modest deficit in visible trade, there is a small overall current account surplus thanks to strong invisible earnings. But it could swing very fast, as it did in the late 1980s.

A further element is the speed of the rise in rates: if they are pushed up quickly now, the need for still-larger rises later will be diminished. The markets are beginning to talk of rates peaking in the 8 per cent region next year, but if they are pushed up swiftly now maybe the big number will still be a 7.

An inevitable result of this will be that sterling will remain strong. When the pound was ejected from the ERM back in 1992 I wrote that there was no reason why it should not be back at the ERM mid-point against the DM in a couple of years. I got the rate right - we hit that on Thursday - but of course the timing was hopelessly wrong. But the present strength of the pound does raise some vital questions, and understanding whether this is the familiar roller-coaster or some seismic change in our national finances turns on the answer to these.

Conventional wisdom is that the pound is now too high, and while it will go higher, this is unsustainable and will end in tears. It will particularly end in tears for exporters that cannot compete and we will therefore see another round of damage to our industry. The current-account deficit will widen, interest rates will rise, sooner or later consumers will cut back ... the old stop-go cycle will repeat itself.

There is of course some truth in this, but before swallowing it whole, try this alternative view. It is that the pound may now be a bit high, but having a somewhat strong currency is actually a very good discipline on exporters, forcing them to lift their game. Periods of a somewhat overvalued currency have, on balance, been beneficial both to Japan and Germany. In the short term there is damage; in the long term the reverse. It makes people sell on quality, not on price, a policy which in any case Europe has to follow if it is to compete against lower-wage countries elsewhere in the world.

The UK is also somewhat insulated from the high pound because so much of our foreign income is not from traded goods but from services and investment. The currency conversion means that investment income does fall in sterling terms if the pound gets stronger, but it does not change in world terms. And service exports (with the exception of tourism) may be less price-sensitive than manufactured ones.

The big thing here is that we may have to get used to having a somewhat strong currency - that may become the new normality. Strange? Well, for anyone who has only post-war experience to go on, yes. But the British economy grew through the last century despite a strong pound and falling prices. Of course the pound is never going to return to being a global currency, anchored to gold, but the world does seem to be returning to the low inflation, large international capital flows environment of 100 years ago. So while sterling can be expected to swing around over the next 18 months, just like every other currency, maybe we should not regard the present rate as unsustainable. Maybe we will have to learn to live with it.

If so, the big event of the week was not the Budget. It was sterling passing its old mid-point on the ERM range.

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