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Pound strong, Euro foolish

The pound has appreciated in a way that five years ago no one predicted. Today it stands at 110 on its index against a basket of other main currencies, compared with 100 in 1990 when we were being readied for the exchange rate mechanism and about 85 from when we left it late in 1992 until the end of 1996. By contrast the Deutschemark (since January 1999 the same as the euro) has fallen in a way few predicted. In early 1995 there were 1.40 DM per $; now there are 2.05, a fall of about a third. Even compared with its average from 1990 to 1994, about 1.60, it is a fall of a fifth. Just to complete the picture, the pound -paradoxically you might think- has not moved much against the dollar since we left the ERM; then it fell to around 1.50 $ per £ since when it has almost invariably moved in the range of 1.45-1.65.

What do we make of it all? These recent exchange rate movements cannot have a great deal to do with inflation. Inflation is low everywhere; one can make out a case that the prospects for inflation differ in the euro-zone, the USA or the UK; but when the central banks of each have shown that their main aim is to keep inflation down, it is not an easy case to make and most market opinion currently would be sceptical. So currencies have moved on expectations about the relative prices that each currency region can charge when converted into a common currency; this is the 'real exchange rate' or 'competitiveness'. For example goods made in Germany now cost around a third less in world markets than they did in 1995; by the same token wages paid to German workers are now worth a third less in terms of dollar purchasing power. Market opinion therefore must be that this is where that country's goods can realistically be priced.

This market view looks defensible after the latest collapse of wage demands in Germany- the strongest union, the Metalworkers' (IG Metall), settled for 3%, having forcibly demanded over 5. Germany has very high unemployment-  10% officially but if you add in those who in the USA or here would be offering themselves for work and are not in Germany you reach a truer figure of 'non-employment' of around 20%. In order to bring down unemployment Germany must sell more- whether to foreigners or home consumers. That means lower prices of German goods. That in turn means lower costs of production and so wages, since the cost of capital is fixed in world markets.

One way to achieve this lowering is a fall in the exchange rate; another would be a fall in wages but that would require a large and politically unlikely deflation. However there is an obvious catch about using the exchange rate to devalue wages by stealth. Workers and their unions will resist and restore the cut in wage purchasing power (their 'real wage') with higher wages- as they do so costs of domestic goods too rise and once the 'wage spiral' has worked itself out, all prices and wages have risen by the devaluation, leaving competitiveness the same as before.

This catch would not apply if before or during the devaluation unions and workers have changed their view of the real wage they want. This may well have happened in Germany: the slow poison of high unemployment, the fear of competition from low-wage countries and the computer, and government pressure in Germany's consensual world may have done the trick that caused IG Metall to climb down after decades of militance. The huge German devaluation may therefore 'stick'.

This implies a continuance of a low euro and so a high pound. But why does the pound not drop too? There was a time when it would have. Think of 1986 when unemployment was still over 3 million. Or 1992 when the severe ERM recession had pushed unemployment back up to 3 million (10%). At those times the pound fell to help the necessary supply-side policies (union laws, tougher conditions on unemployment benefit and so on) slow down real wage growth.
But those times may well have gone, as that supply-side medicine has worked deeper into the body economic. For the past decade and a half we have witnessed a surge in business creation in the 'new service industries'- since 1984 some four million new jobs. These new industries have on average a degree of monopoly power that is higher than the old manufacturing ones- basically because they are new and the competition has not yet properly developed. That means they can charge higher prices on world markets- and the exchange rate rises to deliver them in a mirror image of what is happening in Germany.

You then get the familiar sequence; the currency rises, the new traded services have higher relative prices but still sell well, the cheapening of imports raises living standards, other non-traded prices in the economy rise because they share in the general prosperity, and money flows in from abroad to finance the current account deficit because there are strong returns on the stock market with that prosperity. In the process the old industries contract, making way for the new.

It will not go on for ever. As soon as other countries get the hang of the new industries competition from them will sharpen: our prices will fall, theirs will rise. That will mean a stronger euro, and a weaker pound and dollar. The question is when. The Lisbon Summit notwithstanding, there is little sign of deregulation in Germany; true there is some overdue corporate tax-cutting but in the crucial labour market there is nothing except talks with the union 'social partner'. Alas, the new industries can only be stalled by such partnership.  It took the UK two decades to reform via the Thatcher  revolution- the big three continental countries have barely started, while proclaiming 'no Thatcherism  here'. What price results by 2030?

So the euro weakness, the pound and dollar strength look as permanent as the absence of reform in central Europe. And that may be as permanent as it gets.

Patrick Minford is professor of economics at Cardiff Business School  

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