Jeremy Warner: Exchange rates reignite fears of protectionism

Outlook: Exchange rate worries swept back on to the international agenda this week with a leading financier opining that the pound was "finished", various eurozone nations expressing concern over sterling's dramatic devaluation, the new US Treasury Secretary accusing the Chinese of "manipulating" their currency to prevent it appreciating against the dollar, and the Japanese hinting at renewed currency intervention to stop the yen rising any further.

As can readily be seen, exchange rates have become a terrible muddle. As the world economy slumps, the potential for a downward spiral of competitive currency devaluation grows ever greater. Everyone wants their currency to be lower than the next guy's, so as to give export industries a competitive advantage. It's pointless, beggar-thy-neighbour stuff, but that's not going to stop it happening. The more the pound depreciates against the euro, the stronger the temptation becomes for the eurozone to put up protective barriers against sterling imports. To some extent, it is already happening. Car sales are plummeting across the globe, but for European auto manufacturers exporting to Britain, the situation is particularly dire as the price of their product has essentially become 25 per cent more expensive over the past year, all other things being equal.

French car-makers are therefore already being subsidised by the state, which in itself is a form of unfair competition. Government subsidy gives French car-makers a competitive advantage over their foreign counterparts. The "sterling" problem is even more acute when it comes to Ireland, which shares an easily accessible border with the UK and in most other respects too is still joined at the hip to the UK economy.

Tens of millions of pounds are leaching over the Northern Irish border each day while the shops in Dublin remain deserted. Ireland's exports to Britain are being poleaxed, while her imports from the UK are growing like topsy. These currency traumas are being mirrored in grander form throughout the world. For years, the Chinese have kept their currency artificially depressed against the dollar by selling renminbi and buying dollar assets so as to support their export industries.

Two or three years back, there was a change of heart, and a limited degree of currency appreciation began to be tolerated. With the economic downturn biting hard, that policy was brought to an abrupt halt last July. The dollar exchange rate has been pretty much the same ever since. The biggest losers in this rush to the bottom have been the Japanese and the Europeans. Both currencies have appreciated markedly which, combined with plummeting worldwide demand, has caused exports from these regions to collapse.

Not much can be done by way of currency intervention to reverse these trends. Past attempts either to prop up or deflate a currency through intervention have generally ended in failure. Central bank intervention against a currency adjustment in full flood is like spitting against the wind. The markets tend to have infinitely more fire power than the central bankers have reserves of foreign currency.

Intervention can be a little more effective if done with conviction in a co-ordinated way between nations, but such co-operation is notoriously difficult to achieve. The Chinese are a special case. They achieve results because very high rates of productivity growth across the Chinese economy limits the inflationary consequences of printing money to buy foreign assets. It's much less easy in mature, developed economies.

Even so, the Europeans could do more to help themselves. So far, the European Central Bank has been comparatively cautious in cutting interest rates. It's hard to see why. Inflation is even less of a concern in Europe than it is in Britain and the US.

And if the Europeans really want the euro a bit weaker, why doesn't the ECB act like the Chinese and simply turn on the printing presses, sell euros and buy sterling? This is not a frivolous suggestion. The Bank of England cannot hope to stand against the full force of the currency markets, and in any case has little incentive to do so unless the present devaluation threatens to turn into a rout. Devaluation is part of the UK's reflationary policy. But the ECB both has the incentive and the clout to make a difference.

The currency debate will ratchet up over the weeks ahead. Expect strong words but little action. Floating and fixed exchange rate systems both have their merits and flaws. The only long-term solution is a world currency, but given that nations cannot yet agree even on climate change and trade, let alone war and peace, a global currency would seem rather a long way off.