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Wed, 10 Feb 2010 | 06:37 GMT
Wed, Feb 10, 2010, 06:37 GMT
 

Business: Pound's Fall May Be Herald Of Recovery

 The Times News Service
 
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By Anatole Kaletsky

It's an ill wind that blows no good. The US Treasury's decision to bankrupt Lehman Brothers and expropriate the shareholders in Fannie Mae caused the worst financial crisis in history, but it also secured the presidency for Barack Obama and is now transforming the economic and political landscape of Britain. The dithering incompetence of Henry Paulson has, by force of contrast, restored the credibility of Gordon Brown, both as Prime Minister and as an international leader. The UK economy, which had previously looked more vulnerable to the global recession than any other G7 country, is now likely to suffer less than the rest of Europe, as a result of unprecedented policy stimulus from the lowest interest rates in history, a super-competitive currency and a big reduction in tax. Meanwhile, the Conservative Opposition in Britain has been confused, discredited and splintered by the financial crisis as badly as John McCain's campaign.

The last observation links directly to the new economic story that suddenly broke out in Britain this weekend - the fear of a "run on the pound". This sudden anxiety is a weirdly distorted echo of the great policy debate that raged in Britain throughout the postwar era until it was settled by the collapse of John Major's economic policy in 1992 and six years later by Gordon Brown's decision to keep Britain out of the euro. Since Black Wednesday, almost no British politician or economist has been silly enough to use the "weakness" or "strength" of sterling as a proxy for the state of the British economy, never mind to suggest that a fall in the exchange rate was a portent of economic doom.

In reverting to the economic fallacies of the Major period - which David Cameron was supposed to have put behind him when he left the side of Norman Lamont - the Tories have not only disqualified themselves from any serious role in dealing with the present financial crisis. They have also put themselves on the wrong side of history, alongside the most unexpected of allies - the few remaining euro-enthusiasts who believe that Britain should have joined the single currency and, failing that, should now behave like a shadow member, trying to stabilise its currency and not to deviate too much from eurozone monetary and fiscal policies.

This school of thought is articulated most persuasively by Willem Buiter, the former Monetary Policy Committee member who strongly advocated euro membership for Britain and is now a columnist on the Financial Times. According to Professor Buiter, last week's fall in sterling is symptomatic of a "triple crisis" - a simultaneous loss of confidence in the currency, in the banking system and in the Government's fiscal solvency - that could threaten Britain with an Icelandic-style collapse; this crisis is the price that Britain, like Iceland, is now paying for its stubborn refusal to join the eurozone. Professor Buiter's analysis is obviously more sophisticated than George Osborne's, but rests on the same fundamental arguments: first, that Britain, like Iceland, is a "small economy" that does not have the privilege of using a "reserve currency", such as the dollar and the euro. Secondly, that Britain's banking sector, like Iceland's, is so big that government banking guarantees endanger the country's long-term fiscal solvency.

I see these arguments as fallacious - and, much more importantly, so do the Government and present members of the MPC. There are many objections to the Buiter argument, but the main one is simply that in the modern world of paper money and floating exchange rates, there is no such thing as a "reserve currency" - only different currencies that are traded and used as stores of value in the same way as other as assets. Investors cannot sell one currency, such as sterling, without buying another, be it the dollar, euro, yen or Swiss franc. The attractiveness of these alternative currencies depends on a host of factors, above all the return on assets in the country concerned, the inflation outlook, the degree of protection for property rights and the tax and legal systems. The level of government borrowing is only one consideration in investment judgments about a currency - and a very minor one, as evidenced by the strength of the yen despite the Japanese Government's enormous debts. The size of the banking system relative to national income is even less important, as demonstrated by the strength of the swiss franc.

The upshot is that, far from being feared as a "punishment" for Britain's monetary independence or long-term fiscal profligacy, the present fall in the pound should be seen as part of the solution to Britain's economic problems. As Mervyn King noted at his press conference last week, the UK needs to revive economic activity and avert deflation, but also to restructure its economy to reduce dependence on consumer spending and housing. It would also be helpful to reduce the country's reliance on foreign capital inflows. What all these requirements mean, as a matter of simple arithmetic, is that the structure of Britain's trade must shift substantially, to the point where exports either exceed imports or the remaining trade deficit is matched by inflows of capital from foreigners investing in UK property, businesses and other assets, in the expectation of better returns than they can earn elsewhere, either from higher return on capital or a future rise in sterling.

The textbook way to achieve such a shift in foreign trade and capital inflows is to combine bold cuts in interest rates, which lead to a sharp, though usually temporary, currency devaluation, with a squeeze on consumer demand. This was precisely the combination that worked so well for Britain in the 1990s after the Treasury's age-old fixation with trying to stabilise or manage sterling was abandoned once and for all.

Britain's aggressive use of monetary policy leads to two obvious conclusions - and one less clear. The first obvious conclusion is that the "collapse" of sterling will not discourage the MPC from continuing to cut interest rates. Most MPC members see sterling's decline as a welcome side-effect of lower rates and a helpful transmission mechanism from monetary easing to the real economy at a time when credit markets remain paralysed. Mr King has now publicly confirmed what I said here last month - that bank rate could easily fall to previously unthinkable levels as low as 1 per cent. The second obvious conclusion is that the present currency weakness, far from reopening a debate in Britain about joining the euro, should be seen as a vindication of the decision to keep an independent monetary policy and a floating currency.

The less obvious issue is whether the pound will continue to weaken against the euro, as the MPC moves farther ahead of the ECB in the cycle of monetary easing and the Government stimulates the economy by cutting taxes. With Euroland now in deep recession and the pound back to the low that triggered a strong economic rebound in 1995, market sentiment may well swing against the euro and in favour of sterling as investors conclude that eurozone policymakers are doing too little, too late, while Mr Brown and the MPC are laying the foundations for economic recovery in Britain.

COPYRIGHT - THE TIMES, LONDON

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