Letter: Arguments against devaluation

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Sir: The present debate on exchange-rate policy began as a political one about the desirability of European monetary union. Latterly, however, some of the opponents of monetary union, in their enthusiasm for the maintenance of monetary sovereignty, have begun to make claims as to the benefits to be obtained by devaluation that are highly dubious.

The most dubious is that a devaluation of sterling would make it possible for sterling interest rates to fall. In practice, a devaluation of sterling against the European currencies is likely to cause a substantial rise in interest rates until the market is convinced that no further downward movement is imminent. Thereafter, investors would be likely to look for a significant premium on sterling rates to compensate for the risk of further depreciation, for their experience is that within Europe devaluation is rarely reversed but often extended.

It may be argued that if the depreciation were large enough, an interest-rate premium would not be required as the market would anticipate a strong recovery, but this would only be the case if the depreciation had little effect on the domestic price level. The US dollar can fall substantially relative to the European currencies without a significant impact on the price level, so that a fall in the dollar remains consistent with a fall in dollar interest rates. This is not the case in the UK, where the impact of a decline in sterling on the domestic price level is powerful.

Indeed, our position vis-a-vis the European currencies is coming to resemble that of Canada vis-a-vis the US dollar, in that growing economic integration is constraining us to align our interest-and exchange-rate policies more closely with those of our major trading partner. It is worth noting that Switzerland is even more constrained than the UK, despite non-participation in the Exchange Rate Mechanism, because of its high degree of economic integration in the European economy.

The idea that sterling interest rates can be set in splendid isolation from those in Europe is a nostalgic delusion that can be sustained only by ignoring the integration that has already taken place between our economy and those of Europe. Whether or not the ERM survives the current bout of pressure unchanged, the hard truth is that depreciating European currencies will be forced for some years to offer the market higher interest rates than the appreciating currencies.

Yours faithfully,


London, NW3

6 August