The experience of other countries suggests it is not possible to reduce interest rates below German levels by devaluing, and remain in the ERM. But British interest rates could be pushed below German rates by leaving the ERM and loosening monetary policy. However, investors would only hold sterling assets that bear lower interest rates than German ones if they believe sterling will appreciate, and this expected appreciation compensates them for the lower interest rate.
For this to happen, sterling must rapidly depreciate by far more than is necessary in the long run, and then gradually appreciate (what economists call 'overshooting of the exchange rate'). Thus, a very large devaluation may be necessary to lower interest rates, almost certainly driving Britain's inflation rate back into double figures in one to two years' time. What would happen then? Would a further recession be engineered to bring inflation down?
Furthermore, if the ERM were abandoned, Britain's hard-gained reputation as a low-to-moderate inflation economy would be lost. Investors would regard British assets as fundamentally more risky than those of ERM member countries and would require a higher return to hold them, so imposing a significant long-term cost on the economy.
Leaving the ERM may provide a temporary palliative, but will solve none of the economy's underlying problems. It will lower international confidence in the British economy, lose us influence and standing in Europe, and almost certainly result in double-digit inflation and thus a further recession in the future.
Lecturer in Economics
Newcastle upon Tyne
14 JulyReuse content