Britain faces an economic policy dilemma. The housing market is booming and interest rates may need to go higher to hold back domestic demand. Those higher rates may push up the pound. Yet the pound is already at an 11-year high against euro currencies, and if we want the option of Emu entry, we need a lower pound soon, followed by a period of stability.
The orthodox answer is to tighten fiscal policy (raise taxes or cut spending) to restrain demand, in the hope that interest rates, and the pound, will fall. But Labour is committed to higher health spending, without raising tax. And with a budget surplus, fiscal tightening is hard to sell politically.
There is, however, something rather simple which the government can do to bring significant downward pressure on the pound and benefit its own revenues. The government's 20-year bonds now yield less than 5 per cent, nearly one percentage point below their equivalents in Germany and more than a point below France and Italy. The government could issue long-dated gilts, say ?20 billion for a start, and reinvest the proceeds in our neighbours' bonds. If the pound stays where it is, this would yield a net revenue of ?200m a year for 20 years.
Moreover, in buying the euros to invest, the government would be applying the required downward pressure on the pound. The scheme is thus a fail-safe. In the unlikely event of it not succeeding in depressing the pound, the government picks up the running yield of 1 per cent and waits. The odds are very good that at some point in the next five years the pound will fall 10 or 20 per cent. The government can then unwind its position for a profit. Fifteen per cent of ?20 billion is ?3 billion. That is a lot of hospitals.
If the policy is such a good one, why has it not been undertaken? There are two reasons, neither respectable. First, the policy is perceived as too risky by politicians and bureaucrats. They have been trying to persuade the public that the exchange rate is a market price outside their responsibility. If they intervene, they admit responsibility. And if they fail-owing to an unforeseeable event-they will catch a lot of political flak. The political cost-benefit calculation is not as good as the economic one.
Second, their caution draws some support from economic theory. The textbook says that purchase of foreign currency financed by issuing bonds, rather than printing money, is "sterilised intervention" which has no necessary effect on the exchange rate. Issuing all that debt tends to raise yields, encouraging a capital inflow and counteracting the effect on the currency of the government's purchases of euros.
Yet this theory depends on assumptions that do not hold. British financial institutions will swallow the extra gilts with little effect on yields, and capital inflows into Britain are not very sensitive to small fluctuations in yields; if they were, sterling would not be so high in the face of such low yields.
The political fashion is to limit state intervention in the economy. In such a climate, the most obvious measures can seem risqu?. Yet it has been shown repeatedly that currencies can depart from their sustainable level under the pressure of cyclically divergent short-term interest rates and can stay over-or undervalued for long periods. The government cannot control exchange rates but there are extremes of misalignment it need not tolerate. When it faces a clear overvaluation it can issue liabilities in its own currency and trade them for foreign currency assets. Moreover, when it gets a return from doing so, the operation becomes, in market parlance, a no brainer.
