Inside Story: Making sense out of the muddle
Sunday 20 September 1992
To all but the most pedantic, the Government's decision to remove the pound from the European exchange rate mechanism and let it fall below what had been its lowest permitted level was a devaluation. The value of the pound against other leading currencies has fallen by between 5 and 10 per cent since we left the ERM on Wednesday night.
Technically, the pound is floating. If the Government goes back into the ERM with the pound at or below its present level, the devaluation will be formal and permanent. But, if today's French referendum goes against the Maastricht treaty, there may no longer be an ERM to re-enter.
How will the fall in the pound's value affect me?
The most immediate effect will be on people holidaying abroad. When they change pounds or sterling traveller's cheques, they will get less local currency.
At home, we are unlikely to notice any change for a while. But, eventually, the cost of most imported goods will rise.
What will happen to prices?
Almost a third of all spending goes on imports: some on goods or produce, some on the machine parts and raw materials that contribute to the cost of British products. If the pound is devalued by about 10 per cent, the price of imports is likely to rise by a similar proportion. This will add about 3 per cent to overall prices.
The effect will take months, or even years, to appear in the shops. Some commentators think that manufacturers and retailers, still desperate for business, will absorb the increased costs by squeezing profits. Others say this is unlikely because companies have already been squeezed.
The Government's fear is that people react to higher prices by demanding higher wages, thus pushing up prices still further. The higher inflation would then become permanent.
Will mortgage rates change?
Impossible to say, so far. Last week's yo-yo movements in interest rates will have no effect - the rates are back where they started.
Now that the Government is no longer trying to protect the pound, an interest rate cut is more likely - this week, some analysts say. If it were as much as 2 per cent, mortgages would be cheaper within days. If the reduction were less than 1 per cent, the building societies would probably wait before revising rates.
But the pound might possibly take another dive. At present all sides are waging a financial phoney war, waiting to see what happens next, particularly in the French referendum. If the pound fell, say, by 10 per cent more, the Government might decide to step in again. With its foreign reserves depleted by last week's crisis, the Bank of England will be reluctant to spend more dollars and marks to buy pounds. So ministers could again raise interest rates.
What will happen to jobs?
Lower interest rates - if we get them - should encourage greater economic activity which should generate jobs. But that will take time. Unemployment is likely to continue to rise for several more months at least. Though it will probably fall for a time, many commentators believe that it will move up again as inflation eats into firms' competitive edge against foreign rivals. By 1996, we could be back at square one.
Will the recession end?
That depends largely on an elusive, indefinable commodity: consumer and business confidence. If we are all convinced that things will get better, we shall start to spend and invest again.
A fall in the pound's value could certainly help exports by making them cheaper. A fall in interest rates would encourage businesses to borrow to invest in production and allow consumers to spend more as their mortgage repayments came down. It would also encourage more activity in the housing market - and, when people move home, they spend.
Once again, however, the danger is that these gains will be temporary. If inflation starts rising strongly, the Goverment may put on the brakes.
Will spending be squeezed on schools, health and other public services?
Highly possible. The Government was hoping that the high exchange rate would control inflation. Deprived of that weapon, it is likely to cut public spending.
How much money did the country lose in foreign reserves last week?
It is estimated that the Bank of England spent pounds 10bn of its German marks and other currencies in an attempt to stop sterling plummeting. (The official figure will be published next month.)
That sounds dramatic, but the money has not gone down a drain. It is held in devalued pounds which the Bank will have to sell at a loss - about pounds 500m, or more if the pound falls further.
Who gained from the crisis?
Anybody holding an uncashed cheque in German marks or US dollars would have found it worth more on Thursday morning. But the real money - millions of pounds - will be made by the big home and foreign financial institutions, including the high street banks. They are estimated to have made more than pounds 500m in a single day last week.
And who made a loss?
The Bank of England bought most of the pounds that speculators so frantically sold. The Bank is owned by the Government, which is funded by taxpayers. Who loses? We do.
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