The exchange rate of DM2.95 = pounds 1 is probably compatible with a price level lower than we have at the moment (which is why we have an external deficit in a slump). To bring prices down relative to Germany requires the economy to be depressed, perhaps by around 1 per cent per 1 per cent reduction in prices. So to bring prices down by 10 per cent would require 10 per cent off one year's output or 1 per cent off each of 10 years' output before the exchange rate would be right. A 10 per cent depreciation would correct this without any loss of output.
The second point concerns behaviour during this period of deflation. There will be repeated calls for fiscal expansion financed by a budget deficit in order to mitigate the effect of the slump. Mr Huhne has himself argued for fiscal stimulus.
If heeded, the economy will find itself burdened by an increased national debt on which interest has to be paid in perpetuity. This will slow, but prolong, the period of adjustment and leave the economy with a permanent charge.
The pressure for fiscal laxity may mean that the monetary adjustment is deferred indefinitely, and that we end up with a high level of consumption and a low level of saving. This will hardly inspire long-term confidence.
A depreciation would allow the spending cuts or tax increases which are needed to bring us within the Maastricht limit on the budget deficit. Otherwise such cuts would give a further twist to the slump
In the Sixties, it took more than one sterling crisis before government ministers accepted the inevitable, and the same is probably true today. But mistakes are usually better corrected sooner rather than later.
M. R. WEALE
Faculty of Economics and Politics
University of Cambridge
25 AugustReuse content