Crunch for Sterling

It is increasingly apparent that the emperors of UK economic policy have no clothes. The commitment to keep sterling within an exchange rate mechanism (ERM) band centred on DM2.95 to the pound is unsustainable. The UK joined the ERM at a rate which observers at the Bundesbank at the time regarded as over-valued by between 10 and 15 per cent. They were right.

There are at least four arguments for sterling's realignment.

• Various indices of competitiveness suggest the pound is overvalued;
• The traded goods sector's reduced capacity;
• The trade deficit;
• And depleted net foreign assets.

On measures of manufacturing competitiveness, the graph shows UK relative producer prices from 1964 to 1991; the comparison with Italy is pertinent because the lira is widely seen as overvalued. Some observers ignore the evidence for the period before 1980 to argue that the UK was more competitive in 1991 than in 1981. In fact, since 1979 (apart from a brief episode in 1986-87), UK competitiveness has been substantially worse than in the previous 15 years.

The second argument concerns production capacity. Here the comparison with Italy is instructive. Compared with the UK, Italy enjoyed a relatively stable and favourable competitive position between 1977 and 1988. The effect of improved competitiveness on output and capacity in Italy is illustrated by the 37 per cent rise in manufacturing output in 1979-89; in Britain manufacturing output rose by 11 per cent over the same period.

The loss of capacity and job skills which is now occurring will raise inflation when demand eventually improves. Econometric models, including the Treasury's, omit this effect. Thus, such models take no account of the ways a devaluation could in current circumstances raise output permanently and cut inflation in the long run.

The third argument is that in spite of weak domestic demand stemming from the consumer "debt trap", the highest real interest rates on record and falling real income and wealth, Britain imports more than it can sell abroad.

Fourth, half a decade of trade deficits have run down Britain's international wealth and its ability to finance further deficits.

The competitiveness of the UK in 1991 was about 20 per cent worse than the 1964-79 average. However, this does not imply that a 20 per cent fall in the sterling index is required.

This is because, first, the temporary undervaluation of the dollar will begin to correct itself when European interest rates fall; and second, because the UK now has bigger net exports of oil and gas than it had in 1964-79, though levels are now declining compared with the 1980s.

On balance, sterling needs to fall to between DM2.4 and DM2.5 - the bigger realignment in ERM history. Three years on, this is likely to leave UK prices 2½ to 3 per cent higher than they would have been. This, in turn, would add less than 2 per cent to inflation in any year which, given the declining trend in inflation, is tolerable.

The credibility of the UK government demands that any sterling realignment be large enough to make negligible the risk of a further early devaluation of the pound. My proposal for sterling's realignment meets this requirement. The government's credibility is likely to be enhanced by moving to the narrow band at the new exchange rate. Other steps such as increasing the independence of the Bank of England and not extending mortgage interest tax relief would also help.

The Italian lira also needs to fall against the D-Mark. Italy is not far behind the UK in breaking the inflationary round but needs more teeth in the emergency powers its new government is seeking to make a devaluation successful.

For both the UK and Italy, a realignment within the ERM is safer than floating their currencies, as the recent Scandinavian experience shows.
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