It’s already a theme of 2008, picked up by the FT’s Short View column on Thursday. After a decidedly gloomy start to the year, is the pound set to emulate the dollar’s dive?
Yes, answers Martin Wolf. And it should be welcomed. This is why we stayed out of the eurozone.
In some respects, the UK position is worse than that of the US, he reasons, with a larger run up in house prices and household indebtedness and a larger current account deficit, at 5.7 per cent of GDP in the third quarter – even that may have been an underestimate, with exaggerated net investment income.
But until recently sterling was a very strong currency. Even last December, the trade-weighted real exchange rate calculated by JPMorgan was 7 per cent above its average since 1970. A year ago it was almost 14 per cent above that average.
Such high valuations were unlikely to last and have not done so. The strength was driven by the country’s stable economy, open capital markets and the highest nominal interest rates in the Group of Seven leading high-income countries. But now growth seems likely to slow sharply, short-term interest rates are set to fall and capital markets are suffering credit-crunch blues.
Definitely do not worry, advises Wolf. Those seeking cheapie holidays will be unhappy – but these were in effect finance on credit and that could not last. Consumption looks set to weaken sharply this year, with the credit squeeze and associated housing correction.
The UK must now shift to an economy with lower real house prices, higher savings, a smaller current account deficit and a weaker real exchange rate. This adjustment is far better achieved through a decline in the nominal exchange rate than through the years of “competitive disinflation” that Spain, to take one example, is likely to suffer.
British policymakers must focus only on preserving credibly low inflation. That is essential if a sterling retreat is not to become a rout. The external adjustment is most unlikely to be big enough or fast enough to offset the slowdown in domestic demand, particularly given the constraints on fiscal action. So be it: unbalanced growth cannot last forever. The UK must simply keep its nerve while the economy and currency come down to earth. So, too, should the government.