Sterling's anchor in the euro storm

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The Independent Online
The great swirling debate over the euro clarified a little last week. While France and Germany traded assertions that all is well despite mounting evidence that neither country will meet the Maastricht criteria, the statement of our own government's position by Gordon Brown made it clear that even if EMU does start on time, sterling will not be an initial member.

I don't think that there is much that can sensibly be said about the French and German statements, except to note that there is a growing political investment in EMU in both countries. Whatever one thinks of the wisdom of the project - and the financial markets' doubts are now quite clear from the plunge of the mark in recent weeks - EMU may still happen, even if it thereafter falls apart.

There are, however, several points that can be made about the UK position. We cannot know for another year whether the euro will go ahead on time, but we can assume that there will be considerable suspicion about all potential candidates for membership for the next two or three years, and possibly longer. The fact that we will not join the first round means that sterling will therefore retain its "safe haven" status for at least that period. That might seem welcome, but it means that sterling is potentially vulnerable to each new rumour and twist in the euro story.

This has its funny side - it is amusing that the UK will be the only country, bar Luxembourg and possibly Finland, which will qualify for membership of EMU under a strict interpretation of Maastricht - but it is deeply unsatisfactory for UK business. Being a safe haven may be useful for others, but it is potentially very damaging to us.

So what should we do? There is, I suggest, a powerful case for seeking to anchor sterling, albeit loosely. And the most appropriate anchor is the US dollar.

What? This might seem a ridiculous idea. For a start, much more of our trade is with Europe, so we would seem to be linking to a currency which is much less appropriate than, say, the mark. And anyone suggesting the currency should be anchored to anything runs into the objection, heard during Britain's membership of the exchange rate mechanism (ERM), that you acquire an obligation without the means to fulfil it.

If, however, you look at the way sterling behaves in the real world, there are strong attractions. For a start, the US dollar remains the most important currency for international trade, with just under 50 per cent of world trade denominated in it. That is far more than any European currency, or indeed all European currencies put together. So if we want to see ourselves as global traders, the dollar remains the most appropriate peg. Thus, though 56 per cent of our physical trade is with Europe, part of that trade (our oil exports, for example, and most commodity imports) is denominated in dollars. Strategically, in any case, it would be sensible to nudge trade away from Europe because non-European markets are likely to grow more quickly than continental European ones over the next generation.

Second, although the majority of our physical trade is with Europe, the majority of our foreign assets (85 per cent) is elsewhere. Nearly half our foreign earnings comes from things other than physical exports: earnings from services and overseas investments. These earnings have tended to grow faster than traded ones, so that in a few years' time it is quite likely that they will be larger than physical trade.

Third, and perhaps most important, the UK economy behaves like a North American economy rather than a European one. Have a look at the graph, which shows real GDP growth through the last economic cycle. The British growth line, the one in the red, seems almost spot on the Canadian one and pretty close to the US, while the French, German and Italians all move pretty much in line with each other. Insofar as exchange rates are a function of interest rates, and interest rates have to be set in line with the state of the economic cycle, the more natural link would be with the two American currencies rather than the three European ones.

Why should this be? It is difficult to give a full explanation, but I suspect that the cultural and language ties tend to link consumer sentiment among English-speaking peoples, and so create a similarity of mood which then links the economic cycles. Far- fetched? Well, note that the relationship was clear even when sterling was linked to the mark and franc in 1990- 92.

This leads to the question of whether we should link to anything at all. Certainly shadowing the mark in the late 1980s proved catastrophic, because it encouraged too lax an interest-rate policy and exacerbated the boom. And, of course, formal membership of the ERM subsequently exacerbated the slump. Nevertheless, trying to keep a reasonably stable relationship with the dollar would make some sense, as it would give the markets some feel for what the UK authorities thought was the "right" level of sterling, checking the more ludicrous swings we have experienced in recent years.

One simple example: had sterling been linked to the dollar instead of the ERM, alarm bells would have rung much earlier in the 1990-92 period. The pound at DM3 was much less of a problem than the pound at $2. The killer punch in 1992 came from the dollar, not the mark.

But what sort of peg, and what sort of range? No peg, and no published range. Trying to commit to one particular central rate, within some explicit range, is a mug's game. You give the markets a target, and sooner or later you will be shot at.

No: instead there should be, in the Bank of England, a clear idea of where sterling should be against the dollar. The Bank should set - pencilled in, but never disclosed - a target band of where the pound should be against the dollar. I would suggest a range of $1.40 to $1.70, but with soft shoulders so that, say, anything between $1.35 and $1.75 would be acceptable. When sterling neared either boundary, policy should start to take this into account when setting interest rates. It should dribble the fact into the markets that stability against the dollar was now a policy objective, and every now and again nudge the currency with appropriate intervention.

If such a policy seemed anti-European, the commitment to the dollar could be wrapped up in some form of words about the general need for currency stability. People would get the message. Then, whatever happened to the European currencies as the turmoil of EMU increased, sterling would be reasonably secure.

There is nothing radical about this. All I am suggesting is that the UK needs to plan for a wide variety of different outcomes to the EMU game. If the euro is a wild success, it will have lost little by waiting until the UK economy synchronises with Europe and then joins at its leisure. In the meantime the pound will have been reasonably stable. If the currency union starts and then fails, it is much less of a problem if sterling has achieved reasonable stability beforehand.

After all, there would be no firm commitment to hold the pound in any particular relationship with any currency. I am suggesting a loose link to the dollar as a guide to policy. We cannot control the exchange rate. But we can have a view as to what is appropriate, and objectively the pound seems to behave more like a dollar-bloc currency than a European- bloc one.