Where will the pound be five years from now? Will it even exist?

HAMISH MCRAE ON THE STRENGTH OF STERLING

In those dark days in 1992, during the week before sterling was ejected from the European exchange rate mechanism, a top British official was trying to convince a sceptical Bundesbank audience that DM2.95 was the right rate for the pound. He duly showed all the graphs about UK competitiveness, seeking to make his case, and finished by declaring that amid all the uncertainties in the world, "the one thing you bet is the DM2.95 rate for the pound".

Well, a couple of days later the pound was devalued, and of course the sequel to the story is that yesterday the pound was back at DM2.98. The official was wrong on a five-day view, but right on a five-year one.

Which is more valid, the five- day perspective or the five-year one? The question arises because though the almost universal view at the moment is that the pound is seriously overvalued, it nevertheless seems likely to stay so for several months to come.

If that is right, then the damage to the economy that will accrue from the overvalued currency will gradually mount, until events (presumably in the shape of a sharp fall-off in growth and subsequent fall in interest rates) come along to reverse it.

There is, however, a minority view which holds that the pound may stay at these levels for a very long time, and that the present rate is not only sustainable, but desirable. Since we cannot do anything much about the exchange rate, the minority view is a more attractive one. It might even be right.

The mainstream view, that the pound is overvalued, would imply that there will be a sharp fall-off in growth next year. You can see the way in which the Treasury and the Bank of England both agree on this from the left- hand chart. They differ slightly on the profile of the decline, but their fundamental view is the same. They do, however, differ sharply on inflation (see graph): the Treasury thinks things will get worse, with underlying retail price inflation peaking at 3 per cent next year, while the Bank thinks things will be fine, with inflation falling below 2.5 per cent, the mid-point of the target range, through next year.

The main reason for the difference, apparently, is that the Bank thinks sterling will rise further in the early part of next year (promoted presumably by one or two further increases in rates) and this will hold down inflation. This would be consistent with the sharp slowdown in growth: the combination of higher interest rates, a further squeeze on exports and greater competition from imports certainly ought to slow the economy down.

But, as anyone with any experience in forecasting will appreciate, things are not always as they seem.

There seems to me to be three, maybe four, big uncertainties. The first is obviously the one identified above: the Treasury and the Bank's divergent views on inflation. There is clearly some sign of mounting pressure in the labour market and at some stage that ought, if past experience is any guide, to lead to upward wage pressure. But while there is also downward pricing pressure - the way in which any firm which ups its prices finds business running out of the door - this wage pressure may not be very marked.

Wages operate with a lag: we went on for a long time in the 1950s with very low levels of unemployment and without large wage increases because culturally there was not a climate of large wage demands. That climate seems to have been recreated today, a beneficial effect of all the job insecurity we have suffered.

Besides, there is still considerable room for boosting productivity. The Chancellor noted last week in his Green Budget that UK productivity was 20 per cent below continental competitors. If that is right, and in some industries it almost certainly is correct, then there is considerable scope for improvement. But it needs pressure to force out this productivity.

This is the second area of uncertainty. Will a strong sterling have a radical impact on industrial productivity? Three years ago there was a sudden surge in the German mark. This had a searing impact on Germany industry, coming simultaneously with an excessive pay settlement: the result was rapid downsizing of workforces, leading to the present levels of unemployment but also to sharply improved company performance. Once British firms are convinced that the pound may stay strong for some time, they will presumably take action to adjust their costs. The more radical that action, the more likely it is that the pound's strength will be sustained.

The third area of uncertainty has nothing to do with us: progress on the single European currency. The best working assumption is that sterling's "safe haven" status will be retained until the euro is so close to launch that the chances of the plan falling apart are minimal. That suggests that the pound's strength might be retained not just through next year but beyond into the first years of the next century. It would be helpful if one were able to cite historical precedents as a guide, but this is uncharted territory. Europe is heading on a journey without maps.

The fourth possible uncertainty is other external shocks: one might be more serious fall-out from the East Asian financial crisis than currently seems likely. Another would be a sharp fall in the dollar, maybe associated with repatriation of Japanese funds from the US. Sterling behaves like a dollar-bloc currency, just as the UK economy behaves like a mini version of the US. So if the dollar were to fall sharply it would probably drag the pound down with it.

On a five-year view then, where will the pound be? Have a poll among "opinion-formers" and I would expect the average on some weighted measure to be about 10 per cent below the present, maybe a bit lower still. My bet would be that it will be pretty much where it is now and just as likely to be higher as lower. That, at least, would be my bet assuming that the pound still exists. It remains just possible that it won't. Even in a democracy, do not under-estimate the ability of politicians to go against the electorate.