–Vincent Cable is Deputy Leader of Britain’s Liberal Democrats. He is a former economist who is also the party’s spokesman on economics and finance. The views expressed are his own. –

Most of Britain’s moments of high economic drama in the 20th century centred on sterling: the Gold Standard in the inter war period; the various balance of payments crises of 1949 and 1967; Black Monday and the ERM.  It is perhaps understandable that commentators should reach for these folk memories and attach the word “crisis” to the current fall of sterling against the main trading currencies particularly the Euro.  Understandable; but wrong.

Britain certainly faces very deep and painful economic problems  which may prove as serious as any since the second world war: a sharp contraction in output; high unemployment; perhaps, for the first time since the 1930’s, sustained price deflation; serious depressed asset markets, as for equities and housing; and, not least, a virtual collapse of the banking system.

It may well be that the sharp fall in sterling reflects market perceptions that Britain is exceptionally vulnerable even in a major global recession because of its exposure to financial shocks through the City and an extreme ‘bubble’ in house prices and personal debt preceding the crisis.  Markets can clearly see that the Bank of England has been forced to cut interest rates more aggressively than the Eurozone.  Sterling’s fall is a symptom of this vulnerability rather than a problem in itself.

Since the ejection of Sterling from the ERM, Sterling has been allowed to float.  When the independence of the Bank of England was institutionalised in 1997, with the Monetary Policy Committee setting interest rates, it was made explicit that the exchange rate was not a policy objective.  Interest rates were to be used to meet the inflation target, not an exchange rate objective.

For most of the last decade the consequence of monetary policy has been a strong exchange rate in real effective terms – that is taking account of relative inflation and the exchange rates of different trading partners.  One (apparent) benefit was lower inflation, in sterling for imported goods, enabling the Bank of England to cut interest rates (but helping to fuel the disastrous bubble in house prices).  The cost was a severe squeeze on manufacturing industry which suffered a major loss of competitiveness and shed one and a half million jobs in 10 years.

The sharp fall in the exchange rate has reversed the costs and benefits.  Imports cost more in sterling terms, oil for example. And that is potentially inflationary except for the fact that this is a deflationary environment and the Bank of England is cutting, not raising, interest rates.

A more competitive currency should, by contrast, help traded activities like manufacturing – exports and import competing – tourism – including British people taking holidays at home – farming or universities seeking to attract foreign students.  In a contracting world market the benefits to exports are less apparent but experience suggests – from the mid 1990’s for example – that, after a time lag, the fall in sterling will provide a powerful stimulus.  An additional stimulus comes from the fact that a cheap currency increases the attraction to foreign investors of acquiring UK assets denominated in sterling.  It is not unreasonable to argue that weak sterling is one of the few potential sources of growth and opportunity in the stricken British economy and a long overdue and necessary adjustment.

Such a relaxed view of the exchange rate is far from universally shared.  The British Conservatives have portrayed the recent fall in sterling as a national disaster.  Their motives are transparently political.  Embarrassment over the ERM fiasco is still there and it would be enormously helpful to them if the Labour government could be blamed for making the same mistakes.  They may succeed politically.  But in reality the two situations are totally different.  John Major and Norman Lamont were trying to defend a fixed exchange rate with high interest rates – which reached 15% – but failed.  Speculators were offered a one-way bet on the currency.  None of those conditions apply today. Perhaps a closer analogy is to the 1975 balance of payments problem when a 30% fall in the value of sterling preceded the crisis and helped to precipitate it, a problem resolved only by securing an IMF loan.

The other source of criticism has come from the UK’s trading partners, notably France, arguing that devaluation is ‘unfair’.  There is some legitimate concern over the use of exchange rates as a beggar-my-neighbour weapon.  Conflict with China is building over this issue.  But it is misplaced in the UK context.  There is no suggestion that the UK authorities are deliberately forcing down the rate.  Moreover for a decade or more sterling was ‘over valued’ from the point of view of trade competitiveness.  The French did not complain then.

There is one significant worry about Sterling nonetheless.  Floating exchange rates tend to overshoot especially in times of uncertainty and panic.  The government may start to have difficulty selling government bonds in international markets to finance the large budget deficit if foreign investors worry that the exchange rate could plunge much further.  The UK no longer has the luxury, like the USA, of an international reserve currency, able to borrow internationally in its own money.  Were markets to worry about the UK’s vulnerability the cost of government borrowing could rise sharply.  There is little sign of that happening, however, and Britain is very far from the extreme situation of Iceland, portrayed as ‘national bankruptcy’.

One indirect consequence of the revival of currency politics may be to resurrect the Euro debate.  Although there are advantages in exchange rate flexibility and monetary independence, as described above, these can be overstated especially in a context where the currency lurches from significant overvaluation to undervaluation and where the monetary authorities lose credibility.  An argument is gathering strength that in order to avoid an Icelandic fate, a consequence of over dependence on financial services and the City, the currency should be locked into the Euro zone.

That is of course only one argument for membership among others for and against it. Moreover it remains to be seen if the Euro zone does any better in this crisis.  Its more vulnerable members have the opposite problem to the UK: they cannot use monetary independence and a floating exchange rate to adjust.  The Euro zone may or may not survive the strains being put on it.  If it does, and if it recovers from the crisis more quickly than the UK, Euro zone membership will be back on the UK political agenda.

The financial crisis has rallied support for euro adoption in many European countries outside the currency bloc, yet in Britain the discussion is so far confined to a few voices among the policy elite.

The politics of the issue remain as fraught as ever, and Britons appear no more willing to lose monetary sovereignty in a recession than they were in the boom years.

For most of the last decade, as the flexible, finance-driven British economy was roaring ahead of its sluggish continental cousins, the economic and political case for joining the single European currency was hard to make.

A Eurosceptical tabloid press helped scare former Prime Minister Tony Blair out of his initial intention to lead Britain into the euro. The 2003 Iraq war drained the political capital he would have needed to win public support.

But now that Britain faces the deepest recession of any major economy next year, arguments for keeping the pound have become harder to defend.

“The crisis has taken the hubris out of the debate. It’s now possible to mention the euro again in British politics without getting a complete ‘No’,” said Lord Wallace of Saltire, European affairs spokesman of the pro-EU Liberal Democrats.

The City of London financial district has been humbled by bank crashes, government bail-outs and a vicious credit squeeze. The housing market is collapsing and the pound has fallen 21 percent against a basket of currencies in 15 months.

“PRAGMATIC SELF-INTEREST”

The establishment think-tank Chatham House was first to call for a rethink in a September report entitled: “A British agenda for Europe; designing our own future.”

A panel of policy wonks stopped short of urging London to join the currency but said: “The extension of euro membership to the vast majority of EU member states in future years will mean Britain is excluded in practice from deeper intra-EU economic consultation and coordination, including in areas of significant national interest such as financial market regulation.”

While London should not join just to avoid losing influence in Europe, “under future national or global economic conditions, the government may need to appeal to the pragmatic self-interest of the British electorate over giving up the pound”, it said.

Denmark, which voted against the euro in 2000, is feeling the political and economic cost of having opted out and weighing a referendum on joining. If it does, Sweden may well follow.

Central European governments led by Poland were quick to conclude they could no longer afford to question the merits of euro adoption, and are now racing to meet the criteria for joining the currency bloc as soon as possible.

The euro zone may not be perfect, but it’s warmer inside.

Will Hutton, director of the left-leaning Work Foundation, argued this month that Britain now resembles a gigantic hedge fund and sterling’s sharp fall could turn into a rout.

“Suddenly membership of the euro — politically toxic — is beginning to look a very attractive escape route,” he wrote in the Observer newspaper.

Joining the euro at the current devalued exchange rate would make British exports competitive, enable reindustrialisation and underwrite the City’s huge borrowing needs, Hutton argued.

COMPETITIVE DEVALUATION

Opponents of euro membership say a floating currency has enabled Britain to avoid painful adjustments in wage costs by depreciation, first when sterling was ejected from the European Exchange Rate Mechanism in 1992 and again this year.

“What is the point of enduring the years of economic weakness needed to achieve the 15 per cent improvement in competitiveness against the euro zone secured, painlessly, in the past year?” economic columnist Martin Wolf asked in the Financial Times.

Yet the idea that Britain can get away with a competitive devaluation every 15 years to wipe the slate clean from the excesses of its bubble economy sits uncomfortably with traditional notions of fiscal rectitude.

It also suggests that British membership might be more of a threat to the stability of the euro zone than joining the euro would be to Britain’s monetary sovereignty.

Prime Minister Gordon Brown, who faces a general election within 18 months, has sought to avoid a public debate on the euro. As finance minister for a decade, he had a hand in blocking Blair’s ambition for euro membership by devising five economic tests that were never met to his satisfaction.

Opposition foreign affairs spokesman William Hague said in an interview that the national sovereignty argument against the single currency remained stronger than any short-term expediency case for joining in a crisis.

Things may have to get still worse before the British conclude they would be better sharing monetary sovereignty with France and Germany than risking the fate of Iceland or Hungary.