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Fixed exchange rates and the lessons of history
By Douglas Jay, FT 90-10-10

The author is a former Labour MP, financial secretary to the Treasury and president of the Board of Trade.

Debate on the UK's adherence to the ERM has been conducted far too much in terms of economic and political doctrine. A hard look at the actual economic experience of recent years may therefore be useful. Such a look prompts the conclusion that if UK adherence means a fixed sterling exchange rate with the D-Mark, the effect would be highly damaging to this country. And if It does not, nothing will have been gained by joining. In any case, fixity with the EC currencies will still mean floating with the currencies of the rest of the world, with whom we do half our trade.

The exchange rate is a price like any other, which brings different economies into some sort of balance. If you fix it, you will just as certainly generate imbalance elsewhere as iIf you permanently fixed the price of oil or rate of income tax.

Unfortunately public opinion swings every 20 years or so between demanding floating rates when they are fixed, and fixed rates when they are floating.

History shows, first, that exchange rate levels are more important than ever, and second that the UK is particularly sensitive to them. Between mid-1979 and November 1980 the sterling rate against the dollar rose from $2 to $2.45. There followed the sharpest fall in UK real output in a three-year period since 1850.

Real manufacturing output fell 20 per cent In three years. Unemployment rose 60 per cent 4n the 18 months up to January 1981, and for the only time in UK history the rise continued for seven years.

- Then, sterling fell 30 per cent against the D-mark between July 1985 and February 1987, - with dramatic results. In 1986, unemployment started to drop for the first time for seven years. Nigel Lawson discovered that he had performed, though unintentionally, an economic miracle. Meanwhile in France and Italy, which had joined the ERM, unemployment was steadily rising and is today well above UK levels. France's total unemployed doubled in the years between entry to the ERM and 1989.

All the arguments used for joining the ERM were used from 1920 to 1925 for fixing the dollar-sterling rate of exchange at the historic $4.86. This would, we were assured, achieve "stability", and a "strong currency". For a few months in 1925 the fixed rate was greeted with euphoria. But by the end of that year the economics of the coal industry collapsed, and 1926 brought not stability, but a six-month coal strike, the General Strike, long-drawn-out unemployment and an irresistible run on sterling in 1931.

Keynes had estimated the over-valuation in 1925 as 10 per cent, much less than it is today.

In the U K after the 1931 depreciation,, a remarkable recovery occurred. The freeing of the exchange rate enabled interest rates to be reduced. The Bank rate dropped to 2 per cent at the time of the June 1932 War Loan conversion and stayed there for 20 years.

UK unemployment steadily fell. Manufacturing output rose 58 per cent (in real terms) between 1932 and 1937. Yet in these same years after 1931, France, Belgium, Holland, Switzerland and Poland formed the "Gold Bloc", an almost exact prototype of the ERM. Gold parities, and therefore mutual exchange rates, were fixed, and central banks worked together. From 1931 to 1935-36 all these countries suffered deepening depression and unemployment until Belgium broke ranks and devalued in 1935, followed by France in 1936; when recovery began.

After the 1939-45 war the UK devaluation of 1949 was an adjustment to the economic facts of the postwar world; and was followed by a UK balance of payments surplus in 1950 and throughout most of the 1950s. In the view of Sir Alec Calrncross ("Sterling in Decline") that devaluation restored balance between the whole sterling and dollar worlds.

The 1967 depreciation gave us nearly Liba in payments surpluses in 1970 and 1971, with low unemployment and without oil. Similarly, the German economic miracle of the 1950s was very greatly helped by a much undervalued DM, which was shrewdly devalued with sterling in 1949.

The right exchange rate for any economy is that which will enable it to use its full capacity and achieve a sustainable balance of payments. Sterling is therefore demonstrably overvalued today, probably by 15-20 per cent in the view of Professor Wynne Godley and fellow authors ("Britain's Economic Problems and Policies in the 1990s" IPPR).

Those who now believe that the "discipline" of a high exchange rate would somehow restrain further rises in pay rates and prices are, I fear, misleading themselves. First, because most pay negotiators are not themselves unemployed, and second because exorbitant salaries earned in the City have made any patriotic or moral appeal for moderation useless. In these circumstances, big and small companies, squeezed between weak demand and rising pay rates, would more often be disciplined into liquidation. But the greater error of believers in this discipline is to forget that any rise in prices due to a lower exchange rate, needed to correct overseas deficit, is simply the real premium which a nation charging too much for its goods has to pay for getting back into balance.

Britain has now deprived itself of import controls, exchange control, incomes policies, low-cost food imports, and credit controls. The only instrument left for curing our huge balance of payments deficit is, therefore, the exchange rate. To give it away seems to me a strange decision. And the most probable outcome must be erpected to be a few months, perhaps weeks, of euphoria, followed, as in former years, by a worsening payments deficit, a weakening pound, higher interest rates, loss of reserves, and rising unemployment.

Moreover, in the case of a persistently weak exporter like the UK the rate which is right one year will be wrong two or three years later. Until the fundamental weaknesses and handicaps hampering our economy are remedied, the need is for prudence and not gratuitous adventure.

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