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Fall from grace? The Pound’s plunge is hurting, but pain is part of the remedy. After a decade in which it rode high on the foreign exchanges, sterling has been plumbing new depths. Predictably, this has rekindled the acrimonious debate over whether Britain should join the euro. In fact, the Pound’s recent weakness has reinforced the economic case for staying out. Since its latest peak in July 2007, sterling’s trade-weighted value has sunk by a quarter. The fall, which exceeds the depreciation after Britain was turfed out of the European exchange-rate mechanism in 1992, has passed through three main stages. First the Pound weakened against the Euro in late 2007 and early 2008. Then this summer it started a steep drop against the dollar. In November sterling’s decline against the Euro resumed, falling below €1.10 in December. The Pound’s slide has aroused understandable anxiety. Currencies are national virility symbols and sterling is sagging. Britain’s postwar history was punctuated by currency crises, which devalued governments as well as the Pound. Sterling looks especially vulnerable in the new world that dawned after the credit crisis.

One worry is that the public finances are in a mess, which might undermine confidence among foreign investors who hold a third of all gilts. Another is that Britain, with its big financial-services sector, is Iceland writ large. There is something in both concerns, but not much. The Treasury’s recent forecasts for the budget deficit, due to rise next year to 8% of GDP, were dismal. Yet Britain’s public debt compares favourably with that of other large economies; indeed, its gross government debt as a share of GDP is the lowest among the G7 countries. Although there are worries about underlying obligations that are not counted, such as unfunded public-service pensions, these do not enjoy the same degree of formal government backing as gilts. As for the notion that Britain is a bigger Iceland, whose currency crashed along with its banks, this misses several points. For one thing, size matters. Iceland has a population of 300,000 compared with Britain’s 60m; its national output and fiscal resources are commensurately smaller. More important, Iceland’s banking liabilities in mid-2008 were almost ten times the size of its GDP, according to the OECD. Britain’s were 4.7 times output, higher than the Euro area (3.5) but lower than Switzerland (6.8).

Britain’s highish ratio reflects the City’s longstanding role as an international financial centre. The foreign banks that cluster there account for over half of all banking liabilities in Britain and two-thirds of those in foreign currencies. By contrast, Iceland’s own banks accounted for all its banking liabilities, and most of these were in foreign currency. Britain is far less exposed to a run on its banks by foreign depositors than Iceland was, says Ben Broadbent, an economist at Goldman Sachs. The fall in the Pound may have been disconcertingly large but it marks an overdue adjustment after a long period in which sterling was overpriced. A measure of the sustainable value of a currency is the exchange rate that would equalise the prices of goods and services in two countries. According to the OECD, sterling’s purchasing-power parities against the dollar and the Euro are $1.50 and around €1.30 respectively. This suggests that the Pound is now close to its underlying value against the dollar and about 15% below its long-term value against the euro.

Sterling’s slide has been greeted with dismay by British tourists, accustomed to the heft a strong Pound gave their wallets when holidaying abroad. But their pain is part of the remedy for Britain’s economic ailments. A weaker Pound will encourage more of them to holiday at home, and will attract more foreign tourists to Britain. The Pound’s fall is similarly benefiting British exporters. As long as their overseas markets are also suffering from the global downturn, the Pound’s fall is not enough to make up for weakening foreign demand. But it does make the exports they can sell more profitable and encourages them to build up their presence abroad. Advocates of British membership of the Euro found it difficult to make their case while sterling was thriving. Now the Pound is being pounded they are finding a readier audience. Yet monetary sovereignty is all the more crucial when the economy is in trouble. The Bank of England has been able to cut interest rates below those in the Euro area for the first time since the single currency started.

That in turn has pushed sterling down, a stimulus all the more welcome since monetary policy is less effective than usual because banks are reluctant to lend. The need for such a boost was underlined this week by figures showing that the number of people claiming unemployment benefit increased by 75,700 between October and November, taking the total above 1m. The weaker Pound will help not just to soften the blow of recession but also to create a basis for a subsequent recovery that will be necessarily less reliant on consumers. The inflationary impact of sterling’s slide will be countered by the collapse in commodity prices and the contraction in economic activity. In a recent letter, Mervyn King, governor of the Bank of England, said that consumer-price inflation, currently 4.1%, was likely to be below its 2% target during much of 2009. Sterling is now in the stocks. But that is the way with currencies; the euro, now the strongman, was once dubbed a “toilet currency”. The economic case for Britain to keep the Pound remains a strong one.

Dit artikel verscheen oorspronkelijk in het weekblad The Economist.

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3 Reacties:

At 11:10 Larry Hayes said...

The case made here for Britain to stay out of the Euro could have applied to any of the Euro's current members (at least the large ones). I would have liked to read what makes Britain different... The article should also have examined the potential benefits of adopting the Euro, if only to reject them as insufficient to outweigh the costs. I oppose the introduction of the Euro in Britain on both, 'political' and 'economic' grounds, while The Economist here is putting way too much emphasis on the 'political' angle of the debate.

At 13:26 Anoniem said...

I don't completely understand the economics involved in the single currency, the pros and the cons, other than the rather simplistic notion that it allows the UK to control its economic policy through interest rates as if this were all that mattered.

Certainly, the nationalistic arguments of wanting ones own currency, on a par with the Queen and the Tower of London is at least a hundred years out of date, and certainly belongs to the realms of intellectual drivel. What does concern me is how this problem affects the economy: Gone are the days of economic sovereignty where a nation was pretty much a self-sufficient economic unit.

One of the greatest weaknesses of the British economies, and a major cause of Sterlings plunge is its the dependence on the financial industry, which I seem to remember accounts for over 30% of GDP, and more of its growth. That's an awful lot of eggs in one basket, especially one that produces no real wealth. On the other hand, this is just an illustration of the reality of globalisation: No one in their right mind would say that it is madness for the financial industry to be based in London rather than spread out through every town and city in the UK, as this would make London particularly sensitive to a downturn in the financial industry. Size and specialization matters, and the UK is now the financial center of Europe.

It is the best at this, whereas Germany has taken over as the industrial center, having a bigger trade surplus with its eighty-something million people than China with its 1.3 billion (a fact no-one seems to mention as a threat to world trade and stability, by the way!!!). This just means that economically, Europe has become one vast country, or rather, one vast economic system (vs. the US as another with its own financial and manufacturing hubs, and the Far East is gradually coallescing into a third, witness the meeting of China, Japan and South Korea in recent days to discuss inter-regional financial policy, with the explicit statement that the region needs to coordinate to defend themselves against the global financial crisis with policies separate to those of America, as the region has similar financial and social characteristics which are different from those of the West.

The long and the short of it is, with an economy which is no longer sovereign, but just a segment of the European economy, ie. its financial arm, can it afford to maintain a separate currency that can then be attacked, as someone mentioned, by hedge funds and financiers like Soros. The UK is not strong enough financially to withstand such an attack, as has been shown in the past, and a precipitate plunge in the currency would be devastating.

The Euro is more resistant to such short term manipulation simply because of its size. The US$ is still the major reserve currency, and as such, has an insurance policy whereby countries which told hundreds of billions of dollars of its bonds do not really want it to depreciate too much. China has 2 trillion dollars worth of reserves to defend any attack, plus, it has wisely refrained from floating it currency while its economy is still third world in parts. What defence does the UK have for the pound?

At 16:10 Aloys said...

The Economist really needs to see a psychiatric specialist to treat its compulsive anti European stance on almost any issue. You will turn any situation inside out to give a negative European message.

The Euro is a solid currency because it is backed by fundamentally solid financials both internally and externally (not universal among the members but globally sound) as well as reasonably strong financial discipline mechanisms (again by no means perfect but there are rules and supervision mechanisms).

The failure of small islander nationalism and so called "sovereignty" issues in justification of maintaining sterling as an independent currency (whilst at the same time running continuing signficant external and internal deficits) and in not joining the Euro at the appropriate time (nor having had any politician with the guts to take a stance on this issue) is the price that sterling is now paying for being "alone" and outside of the protective barrier of the Euro.

Devaluations are not really a solution in this globalised world and you are misleading the readers when you highlight the so called "positives" of a collapsed currency. The fact is all Britians are much poorer today relative to the rest of Europe and the world at large than they would otherwise have been as Members of the Eurozone!! When will you learn on which side your bread is buttered!!


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