Sterling's splendid isolation
Tim Congdon
Three years ago the pound was collapsing on the foreign exchanges. As some wiseacres projected that it would drop to $1, newspapers became alarmed. Quite apart from what would happen to the economy, headline-writers despaired of finding new phrases on the theme of 'sterling crisis' and 'the pound at all-time low'. But to judge from the latest newspaper reports there is only one thing worse than a falling pound — and that is a rising pound. Since the beginning of 1979 it has been revalued against other currencies by about 15 per cent. Instead of this being greeted With enthusiasm, industry has objected that export orders are toeing lost, import competition is intensifying and profitability is being eroded. Big companies, basing theif case, on the latest Confederation of British Industry trends survey, have begun to organise a lobby for a weak pound, while a gang of prodevaluation economists is rumoured to be about to engage in polemical fisticuffs with the international monetarists'.
It is the international monetarists, led by the London Business School and several City commentators, who have been the most consistent advocates of the course now being pursued by the Government. They deserve the blame — or the credit — for what IS taking place. For them money supply targets are the centrepiece of economic Policy. In the eight months to mid-June, sterling M3 was rising at an annual rate of about 102 per cent, compared to a target of 8 to 12 per cent for the twelve months to mid-October. The Bank of England's manageMent of interest rates and the exchange rate must therefore try to bring the money suPply back within target. Domestically. that has required Minimum Lending Rate at at per cent to curb the recent surge of at* credit to the private sector. ExternallY. it has meant no intervention to repress the pound on the foreign exchanges. ,,,,r The Problem with intervention is that :en the Bank of England sells pounds in the the exchange market to keep the rate down they have to be replaced by pounds from somewhere else to finance the overnment's deficit, The obvious a lterna!ve source is the banking system. But when ii!le Government borrows from the banks Lew bank deposits are created and the iii_oney supply rises, If the Bank had tried to LTA /eat sterling revaluation, money supply F (NO would have been running at a much _rasoter rate than 1.3, per cent a year. The m ney s lainable.uPPIY target would by now be _1st can be argued against this that currenc,aies_ are su t bject to fashions; and, as with all .x hions, they are difficult to predict, plain or justify. There seems little in Britain's economic prospects, apart from North Sea oil, to warrant an upward movement in the pound as large as that seen so far this year. It follows that the pound's buoyancy reflects the whims of a few misinformed currency operators and will soon come to an end. On this view, it would be more sensible to give priority to exchange rate stability rather than money supply targets.
Such thinking has recently taken hold in leading central banks in other countries, notably the American Federal Reserve and the German Bundesbank. There seems to be an understanding between them that the dollar should not be allowed to fall beneath the 1.80 deutschemark level. The Bundesbank has an obligation to intervene in support of the dollar once that level, is tested. This approach is a new departure for the German authorities who, in the last few years. had become noted for their toughness in pursuing independent money supply objectives. By accepting an exchange rate agreement with the Federal Reserve, their independence has been compromised.
This would not interfere with Germany's traditional goal of minimising inflation if American monetary policy were sufficiently restrictive. However, that condition is not satisfied at present. Commercial and industrial bank loans in the US have risen by 16 per cent in the last 12 months, while the issue of commercial paper has increased by a startling 50 per cent. The latest data show that the broader, more meaningful monetary aggregates have been growing at about 15 per cent a year.By pegging its currency to the dollar, the Bundesbank has become exposed to the virus of inflationary American credit. Only central banks which allow their currencies to float freely can avoid contamination.
Because the European Monetary System is (as yet) an area of fixed exchange rates, the Bundesbank's decisions apply in effect to all the member central banks; and, for reasons best known to themselves, the Swiss National Bank and the Bank oi Japan have also stepped in to keep the dollar up. The Bank of England is left, in splendid isolation, as the only major central bank to stay out of what is almost an international dollar rescue consortium. It is using interest rates solely to regulate domestic credit, while the pound finds its own level on the foreign exchanges. The Bank's stand has been tough, unbending and. as a contribution to anti-inflationary economic policy, very appropriate. Sterling's advance has no doubt been exaggerated, and a downward reaction, perhaps of as much as 5 to 10 per cent, may soon occur. But the firmness of the British currency is not merely a fashion. It is instead the reward for the strict monetary policies which the Government has adopted.
Industrialists may deplore the impact on profitability. But they have been complaining about low profits throughout the Seventies and, for most of the decade, the pound has been losing value against other currencies. The evidence from Germany and Japan is that exchange rate movements have no long-run effects on profits, output or employment, but only on the rate of inflation. Certainly there will be adjustment problems for major exporters if the pound stays at over $2.30, but, however awkward, they are temporary. The benefit of a lower price level, on the other hand, is Permanent.
The Bank of England has done an excellent job in controlling the money supply in recent months. It has faced problems from all quarters. The Budget deficit has been large; surprisingly vigorous loan demand from the private sector has persisted; and capital inflows from overseas have been strong. But the 8 to 12 per cent money supply target may still be achieved. The new respect given to the pound on the foreign exchange is the symbol of the Bank's success. British tourists abroad, who to their surprise have received more pesetas. bras and drachmae for their pounds this year, can be forgiven for feeling, if not national pride, a certain chauvinistic conceit. It is. after all, quite a change from 1976.
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