The cure for an overmighty pound

On the face of it the British economy is having a good year. Its size has surpassed the high point reached before the crisis, in total if not per head, and unemployment has continued to fall. Low and stable inflation has also meant the Bank of England can take its time about raising interest rates.

Yet a rather less welcome development has worried economists and prompted complaints from UK exporters. The pound has risen against a range of currencies - about 10 per cent against the dollar over the past year - threatening to worsen an already serious current account deficit.

It would be folly for British policy makers to take their eyes off the twin targets of price and financial stability, and start trying to juggle a third in the form of the exchange rate - especially as the appreciation has no obvious cause. The strength of the pound does highlight one of the crucial weaknesses in the UK economy, but it also underlines the need to try to address it through more fundamental means.

Complaints about the rise in sterling are heading towards a chorus. Both Rolls-Royce and BAE Systems warned this week that the strong pound was cutting into their earnings. The International Monetary Fund, opening a new bout in its intermittent sparring with the UK Treasury, said that the pound was 5-10 per cent overvalued in real terms and was preventing the UK recovery from rebalancing away from domestic spending towards exports.

Some rebalancing would most certainly be welcome. Last year's current account deficit of 4.4 per cent of gross domestic product was Britain's second worst in 70 years. While the underlying trade balance was little changed on the previous year, net income received from investments abroad fell sharply, underlining the UK's reliance on earnings from overseas assets making up for weak exports.

Yet while the problem is evident, the causes of the appreciation, particularly against the dollar, are less so. Relative long-term interest rates in the US and UK have remained broadly stable over the past year. With this in mind, it would be foolish for the Treasury or the Bank of England to try to affect the level of sterling directly. Delaying interest rate rises, for example, to try to coax down the currency makes no more sense than setting monetary policy to target house prices.

In any case, the idea that a fall in the nominal exchange rate would by and of itself sort out Britain's current account is not borne out by recent experience. As the global financial crisis struck, the pound depreciated by nearly 25 per cent between 2007 and 2009. Yet the competitiveness gain was largely wasted: the trade deficit as a share of GDP stayed stubbornly high, not helped by productivity remaining strikingly weak. As the IMF pointed out, the rise of 16 per cent in UK unit labour costs since 2007 is the highest of the big G7 economies.

Productivity is too feeble for Britain's economic recovery to be based on net exports rather than on consumption. Fixed investment as a share of GDP has fallen to a 60-year low, and the combination of domestic demographics and a self-destructive turn against immigration has reduced the relative size of the working-age population. Together with fiscal discipline in the medium term, the UK needs higher investment and a more flexible economy to tackle its current account problem, not manipulations of the currency.

The rise in the pound is welcome for almost no one except British tourists departing for holidays abroad. But the strength of sterling underlines the UK's problems rather than being their main cause. The British economy struggles to pay its way abroad. It will require more than good luck in the casino of the foreign exchange markets to fix that.

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