The Mighty Pound
For the most of the past 50 years, the story of the pound sterling has been a sad affair. In the 1950s, sterling was worth a proud $2.80, DM11.70 or Y 1,000. Ever
since, it has suffered from continual droop, punctuated by the occasional outright collapse. The exchange rates of half a century ago are a dim memory. Yet in the past three years or so, sterling has recovered a little of its old vim. At one point this week, at 60.66 pence to the euro, it bought the equivalent of nearly DM3.23. its highest rate against the D-mark since February 1989. In trade weighted terms, it was worth more than at any time since January 1986. For at least two years, sterling's upward path has puzzled most economists, including those at the Bank of England. The experts were predicting sterling's demise three months ago, and a year ago, and a year before that; yet the pound has carried on climbing regardless. Since the turn of the year, sterling has gained more than 3% against the euro and has risen a little against the dollar. Convincing explanations of this latest burst of vigour are hard to find. It is true that the British economy has continued to look strong, cementing economists' convictions that the Bank will keep increasing interest rates in order to curb inflation. Even if the pound has further to rise in the short run, its current rate is almost certainly unsustainable. It ought to fall eventually. But how far? On a few occasions in 1995, the pound dipped below DM2.20. At that rate, it was obviously undervalued. According to a recent study by economists at the International Monetary Fund, sterling's equilibrium value at the end of 1998 (when it actually bought DM2.77) was around DM2.45. That also looks too low. Even last year, most city economists would have thought DM2.60-2.70 was nearer the mark. But could Britain live with something stronger still? After all, the pound has spent the past ten months above its old central rate in the European exchange-rate mechanism of DM2.95. For more than two and a half years it has been above DM2.77, the floor of its ERM range. In 1992, even the lower of these rate proved far too tough. But in the past couple of years, exporters have made a good fist of coping with a stronger exchange rate. The current-account deficit last year was probably around 1.5% of GDP. According to the euro-weakness theory, the single currency might fall against sterling because euro-zone economists grew disappointingly slowly, and euro-zone politicians looked like they were backsliding on reform. Once the euro-zone perks up, investors will pile in and the single currency will recover. And if the euro-zone countries adopt a more Anglo-Saxon way of running their economies, the euro's resurgence will be stronger still. Although there is something to this, the pound's strength cannot be expected to vanish so easily. Economic reform still has far to go in many continental European economies. A fuller explanation of the pound's strength is that Britain grew faster than almost anyone expected. In Britain, where recession looked on the cards, GDP grew by 1.8% or so. In addition, a rash of mergers boosted the British stockmarket and attracted foreign capital, giving the pound an extra, albeit temporary, fillip. In the past, a strong pound has caused almost as many crises as weak one. In 1980s, a high exchange rate, the product of tight fiscal policy and tight money, was the agent of recession and unemployment. In the early 1990s, Britain's attempts to sustain an overvalued pound in the ERM also hurt the economy. This time, things look different. Exporters have had to cope with a strong pound for a while, and have learned to live with it. Anyway, exporters often say that they are irked as much by the instability of the pound against the euro as by its level. For this reason many of them would like to join the single currency. However, the pound's very instability is an obstacle to membership. From the Economist
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