Sunday, January 25, 2004
The knock-on effects of currency turbulence
Posted by David Smith at 06:00 PM
Category: David Smith's other articles

Why would anybody troop all the way up into the Swiss mountains, and risk having his ears frozen off, just to hear some talking heads sound off on the economic and business issues of the day?

It is a good question, and some people have provided their own answers. For them, the World Economic Forum at Davos, which ends today, has become easy to skip. Gordon Brown, who was due to attend, has instead assembled his own mini Davos at home. Tomorrow in London he will host his summit on how Europe can learn enterprise lessons from America. Beijing’s usually large delegation also stayed at home because of the Chinese new year.

Even so, you do learn something. One of this year’s lessons is on the key economic story of the moment: the state of the dollar. Europe and America are about as far apart as is possible on both the causes of the greenback’s weakness — indeed whether it even is weak — and the need for solutions to it.

The US currency’s volatility represents a huge turnround. Paul O’Neill, the deposed US treasury secretary who has been causing President George Bush some embarrassment, could during his time in office talk about a strong dollar policy with a reasonably straight face. John Snow, his successor, dare not try.

The effect has been most dramatic on the euro. In just five years of existence the single currency has given a fair impression of a Swiss ski jump. Launched at $1.16 at the start of 1999, it slid almost from day one to a low of $0.83. Now it is in the upper half of the $1.20s, a rise of 50%. Think about the impact of that kind of shift on any business.

Sterling’s rise has been less dramatic but is important nonetheless. To find a time when the pound was decisively above $2 for any length of time, you have to go back to the early 1980s. The Thatcher government’s determination to hit its monetary targets led to 17% interest rates and a $2.40 pound. The squeeze, particularly on industry, was savage.

Since then the pound has been extremely volatile, sliding to within a whisker of parity with the dollar in the mid-1980s (a sterling crisis that led directly to the Tory government joining the European exchange-rate mechanism), before climbing to touch $2 again in 1990. In recent years, however, sterling has been mostly within an acceptable $1.40 to $1.60 range, and reasonably steady.

Until now. Sterling’s rise is, of course, a direct reflection of the dollar’s fall. Before the euro was launched, some economists warned that the pound would be caught between the two huge forces of the US dollar and the single currency. That is happening, although it is interesting that staying out has given Britain less currency volatility than would have occurred with membership.

An exchange rate above $1.80, while not punishing for exporters, is uncomfortable. A $2 pound, which many forecasters predict, would hurt a lot. Traditionally, the ideal combination for the UK economy was a strong pound against the dollar and a somewhat weaker one against the euro and its predecessors.

With oil and other commodities denominated in dollars, sterling’s strength against the dollar would keep down import costs. Its weakness against the euro would boost exports to countries that, collectively, make up Britain’s biggest export market.

Unfortunately, the current situation is slightly different. America is where the action is, with the economy likely to grow by at least 4.5% this year. Euroland, by contrast, is struggling, and may not even manage 2% growth. A weaker sterling against the euro does not help much when export markets are dead.

The divergence between American and European growth has been the central issue at Davos. And if the chancellor, in his summit tomorrow, can get Europe to learn lessons from the United States, he will have accomplished a minor miracle.

The superior growth figures have brought back American arrogance. Don Evans, the US commerce secretary, told a seminar that the world needed to learn from all aspects of American economic policy, including fiscal policy. That’s the same fiscal policy that has given America a budget deficit that makes Britain’s black hole look like a minor blemish. As for the current-account deficit, Washington’s view is that it is the consequence of economic leadership. America is dragging the world economy along again so a current-account deficit, even one of $600 billion, is the natural consequence.

America’s view of Europe, meanwhile, is that it is hopelessly unreformed and unwilling to embrace the obvious solutions. One of those solutions, lower interest rates, is being vigorously opposed by the European Central Bank.

The European view, unsurprisingly, is rather different. Many continental policymakers see America achieving economic growth on a “live now, pay later” diet of debt and deficits. The unspoken belief is that it will all end in tears, but probably not until Bush is safely back in the White House. To them, the American economy is flattering to deceive, as much as the technology bubble was a few years ago.

This is not just a European view. Stephen Roach, Morgan Stanley’s chief economist, also believes that there are serious “bubble” dangers for the US economy.

That view, in turn, provides further incentives for sellers of the dollar. If they believe, not only that America needs a weak dollar for election reasons, but will need one even more in the future to keep growth going and narrow the current-account deficit, the greenback has further to fall. If, on the other hand, a prolonged and strong US recovery was guaranteed, the arguments for a weaker dollar would be limited, a powerful upturn compensating for the deficit and the White House’s current “soft dollar” policy.

That is where the debate stands. It means that the Group of Seven is unlikely to act to curb the dollar at its next meeting in Boca Raton, Florida, on February 6-7. One of the discussions in Davos was: “What would happen if the dollar fell another 20%?” The verdict was that it would be disastrous for Europe and, by extension, not too good for Britain.

Whether it goes that far, dollar volatility looks to be with us for some time. And that can’t be good news.

PS: Mervyn King’s revelation last week that the great Lord Keynes once enjoyed the exertions of 22 strapping young men in shorts — a football match between Aston Villa and Blackburn — brought to mind some of the unexplored connections between economics and football.

When Keynes watched his only football match between two of the giants of the English game in 1913, all those giants came from the country’s industrial heartlands. Now most of the top teams are from London.

What about Manchester, I hear you say. Well, our northern metropolis long since ceased to be an industrial centre. The workers who once trudged to those dark satanic mills have been replaced by loft-living urbanites sipping cappuccino rather than supping Boddington’s. Some might even say it has become rather effete. Only when a team from the West Midlands wins the championship again will we be able to say with confidence that industry has made a comeback.

And if you want further proof of the link, look at the state of Scottish football, whose sad decline is a fair reflection of the economy’s performance since devolution.

From The Sunday Times, January 25 2004