Gareth Morgan, Director of Gareth Morgan Investments
The humiliating currency experience for the British over recent weeks illustrates the folly of weak commitment to price stability.
The British failed to defend their currency within its EMS band by not resorting to higher interest rates to ward off speculative selling. Instead they relied upon the collective obligations of the EMS central banks to buy pounds to defend the rate. But that activity necessitates increasing the supply of other currencies as the pounds are bought. For the Germans in particular, the obligation to raise the supply of DM given the already rapid growth in their monetary aggregates, was not appealing. There was clearly a conflict for the Bundesbank between its obligation to defend weaker EMS currencies and its obligation to curb German inflation. Indeed a rising DM is quite an ally in their inflation battle but dictates that other EMS countries need to raise interest rates if they are not to experience a weakening against the DM.
The British, while not wanting to devalue stefling, clearly were not prepared to raise interest rates to the extent necessary to dampen the speculative selling of the pound. Despite being in their third year of recession this remains the price of the pound earning its stripes as a hard core Euro currency. The British naively expected other European banks to defend the value of their currency by buying it. Yelping at the Germans over their ultimate refusal to keep buying pounds and the German declaration that the pound was overvalued, seems a bit rich given British unwillingness to earn senior ERM status by defending their currency themselves. British pusillanimity contrasted with Swedish determination. The Swedes are not even members of the EMS yet but are tying the krona to the ECU anyway to earn strong currency status before formal entry. When put under currency pressure, the Swedes were quite willing to raise short rates to over 500% in order to maintain their currency’s value.
So where to now for the cowering British bulldog? Now they’re out of the EMS there’s unlikely to be any respite until they indicate what their new inflation policy is. Markets will quickly question British post-EMS intentions by betting that the British government still has no steel to defend the pound and really yearn for the old days of inflationary growth. Over coming weeks this bet will thrust the pound into another crisis until eventually it has to be saved by higher interest rates – exactly what the British should have done instaed of inviting ignominious ejection from the ERM.
In the interim British economic policy will lose so much credibility that finally they’ll have a weaker pound but interest rates substantially higher than they’d have needed to be if only British inflation resolve hadn’t been so pathetic. The market’s suspicion about British commitment to low inflation will have proven correct and for their feebleness the British will be rewarded by an even deeper recession – economic benefits of a weaker pound unlikely to offset the punishment of higher real interest rates.