Yesterday's devaluation reduced the amount of foreign currency you can buy with pounds 1 by about 5 per cent. If the pound stays low this will make it more expensive for British companies to import goods from abroad and make our goods more attractive to foreign buyers.
The resulting boost to exports and to companies who face foreign competition should help industry pull out of what is the longest recession since the Second World War. In part this benefit will feed through to higher profits, which can then be used to pay for investment in new plant and machinery, helping to boost industrial growth further in the future.
But devaluation has a cost which undermines its benefits - higher inflation - the main reason it was resisted for so long by Norman Lamont, the Chancellor, and John Major. Inflation automatically rises because imports become more expensive. This leads trade unions to demand larger wage increases from employers, which feeds through to companies' costs and the prices they charge in a vicious 'wage-price' spiral.
The boost to growth in national output, and resulting reduction in unemployment, is eroded if prices in Britain rise faster than in other countries, making goods less competitive. While most economists agree about the effects of a fall in the pound, they disagree about how large the boost to growth and inflation would be and how soon it would take effect.
The Ernst & Young ITEM Club, an independent economic forecasting group which uses the same computer model of the economy as the Treasury, believes any boost to growth from a 10 per cent devaluation would completely disappear by the time of a general election in 1997, and that Britain would be left with permanently higher inflation.
The graphs show that if interest rates were to stay at 10 per cent and the exchange rate were to remain around last night's close of DM2.6279, growth in 1993 and 1994 would be slightly higher than if we had remained committed to our old exchange rate mechanism bands. But growth would be the same in 1995 and lower by 1996.
The short-term boost to output is reflected in slightly lower unemployment. Maintaining the current level of devaluation would see unemployment of 3.29 million in 1995, compared to 3.36 million on old ERM parities. The boost to growth would widen the current account deficit slightly by sucking in more imports, but would have little impact on the amount the Government has to borrow to meet the shortfall between what it spends and raises from taxes.
The effects would be more dramatic if the Government used its freedom from the ERM's shackles to reduce interest rates and let the pound drop further. A cut in base rates from 10 to 7 per cent, accompanied by a drop in the pound to DM2.40, would see the economy grow by 2.6 per cent next year, compared to 0.8 per cent growth at the old ERM exchange rate. But under this projection, growth would start to slow in 1995 to levels near what they would have been at the old exchange rate. Inflation would also have risen to 6.6 per cent in 1995, more than double the figure forecast for the old regime.
Considerably quicker growth in 1993 and 1994 would also help to reduce the amount the Government had to borrow, by increasing tax revenue and holding down the increase in spending on unemployment benefit. The public sector borrowing requirement would be pounds 5.5bn lower in 1995 at pounds 24.7bn.
These calculations assume that the pound remains outside the ERM. 'If we went back quickly, investors would demand a risk premium and interest rates would probably have to rise from present levels,' Brian Pearce, Item Club's chief economist, said.
Ian Shepherdson, of Midland Montagu, believes the combination of 8 per cent interest rates and an exchange rate as low as DM2.50 would allow the economy to start recovering in the new year, rather than next summer. Economic conditions for the remainder of this year would be tougher, but growth would start to improve in 1993. He believes the impact on inflation would be limited because consumers would not be prepared to pay much higher prices while the economy remains relatively depressed.
Robert Lind, of UBS Phillips and Drew, said a similar fall in base rates and the exchange rate could mean growth of between 0.5 and 1 per cent next year, rather than a further fall in national output of 0.5 per cent. Inflation would still be below 4 per cent at the end of next year. Most economists expect the lower pound to have a subdued effect on inflation because the economy is so weak.
But Andrew Britton, director of the National Institute of Economic and Social Research, said its model showed that a 10 per cent devaluation would have very rapid effects on prices and inflation even if interest rates were held at 10 per cent. Rising import prices would allow domestic producers to raise their prices too. The average price level in the whole economy would be 10 per cent higher within two and a half years years, with an extra 5 per cent rise in prices by the end of the first year.
'Everyone who is involved in negotiating pay or prices now will know that inflationary pressures are mounting,' Mr Britton said. The institute's model incorporates such forward-looking effects so the inflationary impact is quick.
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