The pound's value affects not just our holiday money and investments but the entire economy. Jeremy Warner on what the future holds for sterling.
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Why is the pound falling like it is? Isn't it the euro which is supposed to be in crisis?
The euro was in crisis, which is why until about six months ago the pound had been doing relatively well. With the single currency apparently on its death bed, sterling assets became a "safe haven" for eurozone investors wanting to protect themselves against a break-up. But action by the European Central Bank has succeeded in calming the sovereign debt and banking crises, so now funds are flowing back the other way.
With the eurozone crisis abating, the spotlight has swung back to underlying weaknesses in the British economy, including a still-crippling fiscal deficit, rising public indebtedness, poor levels of productivity, stagnant output and a badly impaired banking system.
Are we heading for a full-blown sterling crisis?
This seems unlikely. The pound barely moved when Britain lost its AAA credit rating, and there is no sign yet of catastrophic loss of confidence in sterling assets. Compared with some eurozone economies, the UK still looks a decent bet. Though the immediate existential threat to the euro has been removed, the economic crisis in a number of its member states persists, with political instability piling in on top of an already deep depression.
Doubts about the future of the Coalition are growing, and with them concern about the possibility of a Labour government less committed to fiscal consolidation than the present administration. Even so, the UK is still generally regarded as a relatively good credit risk.
How does this compare with past devaluations?
This is certainly a biggie bigger, for instance, than much more famous devaluations such as Britain's departure from the gold standard in 1931, Harold Wilson's famous "pound in your pocket" devaluation in 1967, and the UK's ignominious exit from the European Exchange Rate Mechanism in 1992. On a trade-weighted basis, the pound is down by around 25pc since the beginning of the crisis in 2007.
So how much lower can it go?
Well, it has actually been lower than it is now, against both the euro and the dollar. In the depths of the banking crisis, the pound fell to virtual parity with the euro, and back in the mid-Eighties, it also fell to parity against the dollar. It's possible that these milestones could be reached again if the economy continues to underperform.
What does it mean for inflation?
Since the crisis began, Britain has experienced relatively high inflation compared with both Europe and the US, and a substantial part of this is down to the higher import costs associated with a falling pound. This has raised energy and raw material costs, so even British producers have had to raise prices to maintain their margins. Wages, on the other hand, have remained largely stagnant, resulting in a sustained squeeze in disposable incomes.
In that case, why are policymakers deliberately pursuing devaluation?
They hope that a lower pound will make British exports more competitive, and will thereby help "rebalance" the UK economy away from undue, and unsustainable, reliance on debt-fuelled government and household consumption to net trade and investment. As a nation, Britain is still spending more than it earns. Devaluation should in time help correct this affliction, though there is little evidence of it so far.
So is this all the fault of quantitative easing?
Absolutely. By operating a "zero interest rate" policy, the Bank of England deliberately tries to make sterling assets as unattractive as possible to overseas investors. Market interest rates are further depressed by printing new money to buy UK government bonds, or gilts so called "quantitative easing". This generates what is in effect a negative real rate of interest rate (a yield on bonds which is lower than the rate of inflation), making the UK a relatively unattractive place for foreign money. Debasement of the coinage in this manner presses down on the value of the pound, which makes British goods and services relatively cheaper, and therefore, in theory at least, boosts domestic and overseas demand for them.
What does devaluation mean for living standards?
Because of its effect on inflation, it has so far proved quite bad for living standards. The cost of living has increased sharply at a time when wages are not rising to match. As a nation, we are poorer than we were, a fact we are made acutely aware of when we go abroad. Our pounds no longer buy as much as they used to.
What does it mean for those who live abroad or have second homes abroad?
For those living on a British pension or sterling income, it is little short of disastrous. Like the tourist, your pounds no longer buy what they used to. For second home owners, it's a two-way street. The sterling costs of maintaining the property, or any euro mortgage, will have gone up markedly, but the sterling value of the property will have improved too, all other things being equal.
Trouble is that all other things are not equal. In most cases the local currency value of the property will have declined significantly. In Spain, for instance, property prices are off by up to 50 per cent, more than outweighing any gains you might have experienced on euro appreciation against the pound.
What is more, a weak pound acts as a big deterrent for potential sterling purchasers, making it more difficult to sell the property. For a UK resident, this may or may not be a good time to sell, but it is certainly a bad time to buy. So on balance, this is not good news for second home owners. For them, it would be much better if the euro broke up, since the countries in which Britons tend to own properties are the ones likely to devalue the most if they returned to former currencies.
Will the pound ever get back to where it was?
There is no reason to think it won't. In the past 30 years, the pound has been up and down like a yo-yo, but against the dollar it has broadly conformed to a $1 to $2 range. Much the same is true of the euro and its predecessor countries. There has been no definitive lurch to lower ground in the same way as there was in the post-war era. On the other hand, it may be many years before sterling returns to the top of these ranges again.
Policy is going be kept exceptionally loose until the UK economy adequately rebalances, and that's going to take a long time.
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