The fall in sterling has been substantial in recent months. A pound bought 1.51 Euros in January 2007, 1.34 Euros in January 2008 and only 1.26 Euros in May 2008, a drop of 16.5% over the last 17 months. It is also beginning to weaken against the dollar after a long period of strength, falling from more than $2 to the pound in 2007 to $1.95.
Why is this happening?
There are the first indications that after a long period of US neglect of their currency they are now trying to stabilise it. The authorities seemed to favour a lower dollar in recent years to price US products back into the overseas market. Now they think the decline has gone far enough, and maybe they will now tighten their money stance which has been loose to deal with the Credit Crunch.(The publication of poor unemployment figures and a surge in the oil price led to a further dollar fall shortly after this was written, but that fact does not necessarily mean the sentiment of this paragraph is wrong)
In Euroland the Bank is firmly in inflation fighting mode, and has kept interest rates up at a time when the UK has lowered rates a bit to deal with the problems in financial markets. Markets are now more concerned about the impact this policy is having on the fragile economies of Euroland. Italian industry is being badly damaged by a Euro which is too strong for their exporters, whilst in Iberia a property crash is exacerbated by a monetary policy that has not suited local conditions, being too loose on the way up and now too tight on the way down. Markets think the next move in Euro interest rates will be down, although not any time soon. They think the Euro is quite high enough. Recently the EC Bank has sown doubt about this, suggesting rates have to stay up or even go up to control prices. This may just work for the stronger German economy, but will cause further trouble for the weaker peripheral economies of the Union. Markets are not sure which way the Euro will go for a bit.
The UK has experienced a move from boom to bust in credit markets. The money supply has been expanded quite considerably, first to fuel a boom on the basis that Asian competition would take care of price increases, and then to make markets more liquid to mitigate the crash. The volatility of sterling against both dollar and Euro shows the need for floating rates here in the UK, because the economy is not harmonised with either that of the US or Euroland. It remains stubbornly mid-Atlantic, and will need to become more Pacific oriented as the rise of India and China continues apace.
What does it mean?
The fall in sterling means higher inflation. We have relied for a long time on ever keener prices from Asia to curb inflation. We now have to look forward to dearer goods from Asia, both because inflation has taken off in India and China, and because the Chinese currency is likely to appreciate further.
We should also be able to enjoy greater growth of our exports, as they will be that much more competitive given the fall in the currency. There should also be more scope for import substitution from home production.
As people’s incomes are squeezed, so they will be able to afford even fewer of the imported goods whose prices are going up thanks to cheaper sterling. Manufacturers will be able to sell more abroad at keener prices, and will also probably increase their profit margins at the same time. This is a slowdown where the corporate and government sectors do not intend to suffer much, intensifying the squeeze on individuals.
Should we join the Euro?
Twice this week in meetings with seemingly intelligent business people I have been told we ought to be thinking of joining the Euro, as it is now a stronger currency and becoming an important reserve currency for the world. Why can’t these people grasp the enormous damage sterling’s entry into the Euro would do both for the Euro and for us? Don’t they see the volatility of the pound against the Euro tells us the UK economy is different from that of Euroland and would destablise the Euro area if joined? Can’t they see it is better if some of the adjustment is made by changing the currency rates, rather than all the adjustment having to be made by fewer jobs and lower wages here in the UK?
And why do they always suggest the Euro and not the dollar? If it really were the case that we could benefit from belonging to a bigger world currency with an important role in financing world trade, would not the dollar be a more natural choice? We are mid-Atlantic, but closer in important ways to the US cycle and experience than to the French and German.