The sound pound rises to its rightful place

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The Independent Online
You may not have noticed, unless you are slipping abroad for a quick break, but since the summer the pound has suddenly become stronger. The rise is not particularly notable against the dollar - around $1.58 rather than $1.55 in the summer - but against the continental currencies it has been sharper. A French franc rate of FF8.25 to the pound may not sound wonderful to anyone accustomed to the ten-to-one rule of thumb, but it is a sight better than the less than FF7.30 which some British visitors to France suffered earlier this year. What's up?

Economists may not have a wonderful record at predictions but they are pretty adept at explaining, after the event, why things have happened. So there is no shortage of explanations about what is going on now.

Here, in no particular order, are several candidates. One is that, following the party conferences, it has become slightly less unlikely that the Tories will win another term. Another is that following the self-same conferences, the Labour Party will presumably form the next government and would consider taking the pound into European Monetary Union on the first wave.

A third is that EMU is more likely to go ahead with countries such as Italy and Spain included, which will make it a weak currency: sterling will stay out and become a "safe haven" for risk-averse investors. A fourth is the rise of sterling as part of a general reassessment of all "fringe" currencies - those on the edges of Europe. Number five is a version of that: that the rise of the pound is largely a reflection of the weakness of the Deutschmark.

Six is that the relatively strong growth of the British economy means that the next move in base rates will have to be up rather than down and there will be a sharp rise in UK rates through next year. Seven is the rise in oil prices in recent weeks. Eight is the rise in UK equity and gilt prices, which is sucking money across the exchanges into sterling. And so on.

As you can see, this is a wide spread of ideas, and some of them are mutually exclusive. One can have an arcane discussion about the relative merits of each explanation, but that is pointless because no-one knows how to separate them.

I suspect that the strong growth of the UK economy (suggesting higher interest rates soon), plus the fact that people are cottoning on that the pound is somewhat undervalued against European currencies, are the main rational reasons for the rise. But I would add that currencies move in and out of fashion and it just happens to be our turn.

The much more interesting question concerns what happens next. On a long view, the best guide to a currency's value is purchasing power parity, or PPP. In the short-term it is a dreadful guide, and for the yen/dollar rate that short term seems to have lasted about 20 years.

There are problems, too, in calculating PPP: what do you leave in and what do you leave out? But in the case of the pound's standing against the main European currencies, PPP is not a bad guide - or at least a useful cross-check with reality.

The left-hand graph shows what has been happening to the pound against the DM over the past 20 years, and what has been happening to PPP. The first is a jagged decline, the second a steady one.

So if PPP is a bad guide to an exchange rate in any one year, it is a good one over the long term. In 1992, just before the pound was ejected from the European Exchange Rate Mechanism, it was a bit overvalued. Since then it has been considerably undervalued. A rate of DM2.70-2.80 would obviously not be too far out of line, and the DM2.20 region that the pound dropped towards earlier this year was clearly far too low.

This does not mean that the pound will rise to that level: merely that sterling could sustain a somewhat higher exchange rate against the DM without undue strain. Against the dollar, however, there is less scope for a rise on PPP grounds. Calculations again vary, but most suggest a PPP of around $1.50. If anything, the pound is already too high against the dollar.

If the normal practice of the currency markets were to repeat itself, the pound would carry on jumping up and down against the DM, spending a bit of time above its PPP and a bit below, just as it has over the past 20 years. But there are two reasons why it might not. One is the whole question of EMU, which will create strains of an unpredictable nature over the next few years. We do not even know whether it is going to happen. This may will generate instability but the other factor - inflation - should generate calm.

If you look at the PPP line, the pound fell sharply between 1976 and 1989. But since then there has not been much change. This is a reflection in part of a much better relative inflation record in the UK, but it is also a reflection of the fact that worldwide inflation has come down.

This leads to the biggest financial question of all: is inflation natural and inevitable, or is price stability the normal state of affairs? If there is going to be a world of continued inflation, it is inevitable that some countries will inflate a bit faster than others. So there will need to be currency adjustments. If, on the other hand, inflation is to disappear, then a much more stable currency regime becomes possible.

The right-hand graph shows just how unusual the past 50 years have been as far as prices are concerned. In both the UK and the US there was price stability through the whole of the last century, continuing until about 1938. Mervyn King, head of economics and executive director at the Bank of England, made a speech on Thursday advancing the case for monetary stability. As you might expect, he was in favour of it: central bankers always believe that monetary stability is of paramount importance.

But perhaps the most striking point he made was that inflation is abnormal. "For most of our history the price level was stationary - there were shocks, often violent ones, but no sustained upward trend. But in the post-war period the price level has been highly non-stationary."

Anyone who takes a long view of history would at least acknowledge the possibility that the old state of affairs - stable prices - will reassert itself. Through the last century - a time of wars, rapid population growth, rapid industrialisation and a revolution in communications - the price level in the UK fell by one-third of one per cent a year on average. In the US the fall was just under half of one per cent a year. We are not there yet, but it is certainly possible that that goal will be reached in the next 10 to 15 years.

If that is right, then the left-hand graph will become a thing of the past. PPPs will stay more or less the same and currencies will fluctuate in response to economic shocks - just as they did in the last century. EMU, if it happens, will be operating in a much more appropriate climate than the inflationary one of recent years. And currencies like sterling, which have, for the lifetime of all the readers of this newspaper, been rather weak, will become much more stable.

Looking ahead, some City analysts see the pound rising through the following months. I suspect that the convincing longer-term "bull" case for the pound has little to do with its present moment in the sun, and nothing at all to do with UK politics. Rather it is because sterling is a touch undervalued now and will need to float up a little to take its rightful place in a world of much more stable currencies.