Anybody venturing overseas, particularly to European destinations, will know the symptoms: the too frequent visits to cash machines, the yearning for the free museums and galleries we enjoy in Britain, the cup of coffee that costs “How Much?”
If you have been around long enough all this is familiar. I have no personal recollection of the £50 limit for British tourists travelling abroad in the 1960s, though I remember when Britain was the poor man of Europe after sterling was forced out of the European exchange rate mechanism (ERM) in September 1992.
Periods of sterling strength, as in the early 1980s (which considerably damaged industry), or the long period from 1996 to 2007, have been all too rare. Mostly the pound gets sand kicked in its face.
Many will see this, like the severe squeeze on household incomes, as the natural consequence of Britain’s necessary economic adjustment. The pound had to fall to rebalance the economy in favour of exports and against imports.
In balance of payments terms, a holiday abroad is as much of an import as a new Audi or BMW. And, while it can be hard to find domestic alternatives for some imported goods, that is not the case for holidays, as the tourist boards will tell you.
Pricing at least some British people out of foreign holidays is economically the same as getting them to spend less on imports and that has to be a good thing.
Not only that but exports are one of the few bright spots of the economy at the moment. They made a significant contribution to the first quarter rise in gross domestic product and, according to the latest purchasing managers’ index for manufacturing provided the spur to growth – admittedly within a decelerating growth rate – against the backdrop of depressed domestic demand.
So, you might say, we should grin and bear it, because the last thing Britain needs at this juncture is a stronger pound. It is, however, a question of degree. Sterling’s average value is around 25% lower than immediately prior to the onset of the global financial crisis in the summer of 2007.
Before he left the Bank of England’s monetary policy committee (MPC) last week, Andrew Sentance pointed out that a depreciation on this scale is much bigger than in previous episodes.
The successful if unintentional post-ERM depreciation of the 1990s, for example, was closer to 15% (and was reversed by the end of the decade), while the the original Harold Wilson “pound in your pocket” devaluation of 1967 was 14%.
The only comparable sterling fall was from 1972 to 1977, a period which included Britain’s IMF (International Monetary Fund) crisis, hardly an example to follow.
Currency markets overshoot. The surprise was not that the pound fell when the global crisis hit in 2007, reflecting Britain’s vulnerability, but that it has stayed down. All sterling depreciations have been followed by significant rebounds.
This one has not, and it is easy to see why. Sterling and monetary policy are intimately connected. Every time the pound threatens a recovery, it is knocked back by the MPC reinforcing its commitment to ultra low interest rates, or by hints it is contemplating more quantitative easing. At a time when other central banks are hiking rates, not just in Europe, sterling is about as attractive as a wet Wednesday in Wigan.
What I think it also does is delay the adjustment to the pound’s lower level. Such adjustments take time. Exporters have to make up their mind whether to enter new markets, which can be risky and expensive. Companies have to decide whether to relocate production and other activity to Britain: the Bank’s regional agents’ survey of why imports had stayed so strong found that UK supply capacity for many components no longer existed.
Such decisions need exchange-rate clarity. And before anybody says such clarity would be provided by euro membership, yes it might, but at a far greater cost to both the euro and to Britain.
The point is that businesses need to know where the pound will settle. Its current level against the dollar, around the mid-$1.60s, is fine; close to the average of the past 30 years. Its level against other currencies, particularly the euro, is wrong.
Against sterling, the euro has ranged from 1.02 to 1.75, and is now in the 1.10-1.15 range. Fair value is considerably higher, probably 1.30-1.35. The pound is struggling against a very troubled euro. Until firms know how that struggle will end – how far the pound will bounce – they will hold off making decisions.
The main reason Britain needs a stronger pound, of course, is that it would help control inflation and limit the extent that interest rates will need to rise to do so.
The weakness of household spending and confidence, attributable to falling real incomes, is very much on the minds of the MPC. Paul Fisher, the Bank’s executive director for markets and an MPC member, cites it as the main factor holding him back from hiking rates. He also said he would contemplate further quantitative easing.
This is where policy risks getting dangerously circular. The low pound will maintain the squeeze on household incomes until fully passed through to inflationt. But as long as the MPC signals it will hold off from hiking rates, sterling will not recover, and could go lower, adding to that squeeze.
Wishing for a stronger exchange rate and achieving it are, of course, two different things. I do not think, however, it is that difficult. Instead of a very soft stance on interest rates, the Bank has to start talking tougher.
It does not have to match the Institute of Economic Affairs’ shadow MPC, which this week votes 6-3 for an immediate rate hike, with five wanting a half-point hike and one a full-point rise to 1.5%.
It does need to recognise the advantages of a higher exchange rate in easing the squeeze on domestic demand (by reducing import prices) and allowing the economy to properly adjust. Neglecting the pound, as the Bank is doing, does nobody any good.
My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.
This post originally appeared at David Smith’s EconomicsUK and is reproduced here with permission.