Rates uncertainty takes its pound of flesh

The worst may be over as far as the over-valuation of the pound is concerned; but the problem for industry is that no one knows how far it will fall - or how long it will stay there. It is not just periodic over-valuation, but the instability of sterling that plagues industry. When exchange rates are so uncertain, it is difficult for firms to make sales plans or determine labour requirements even a few months ahead, let alone make decisions to invest in new capacity which may take years to come to fruition.

This is not just a British problem. As firms increasingly function on an international scale, the need for exchange rate stability becomes greater if they are to invest and operate effectively. The recent difficulties in the motor industry are just one example.

While floating rates have become excessively volatile, a return to the post-war Bretton Woods system of so-called 'fixed' rates is not the answer. Exchange rates need to be adjusted with changing circumstances, not left until weaker countries eventually become forced to devalue in crisis conditions. 'Pegging' currencies to a major currency, such as the dollar, raises similar problems. Currency unions, such as Emu, avoid this difficulty, but they are only a workable solution for groups of countries already integrated.

The answer is to look for ways of managing exchange rates in a flexible manner. This must be done on a two-tier basis, regionally and globally - since it is only practical to operate such arrangements between a limited number of countries.

There are lessons to be learnt from experience with the exchange rate mechanism (ERM). The first is the need to adjust rates relatively frequently and by small amounts, rather than waiting to make major adjustments when they have become well out of line. For example, in an ERM-type system with +/-2.5 per cent bands, parities might be reviewed monthly and changes made in steps of say, 1 per cent. The new parity would then still be within the old band, and the changes in spot rates following the monthly review would not provide scope for the sort of major speculative gains associated with sterling's exit from the ERM in 1992.

The second lesson is the need to build in arrangements for automatic intervention if the agreed bands are threatened. This should be the responsibility of a special fund with borrowing powers, rather than left to central banks with limited resources.

Such an arrangement would be a particularly appropriate means of managing the relation between sterling (and the currencies of other EU members outside Emu) and the euro. It would leave open the question of whether we eventually joined, but stabilise the sterling-euro relationship in the interim. To benefit British industry, however, it would be essential to agree a competitive rate for the pound. But with the Emu authorities worried about the weakness of the euro, this could be a good moment to negotiate a mutually beneficial deal which would lower the pound and strengthen the euro.

Such a new-style ERM should go hand in hand with arrangements to manage the rate between the euro and the dollar. This is particularly important for the UK. We should not want greater stability against the euro to be purchased at the cost of continuing instability against the dollar and other currencies. Such a limited arrangement should be expanded as soon as possible into a tripolar system involving the yen. This should evolve into a formal system under the IMF, with stated parities and bands, and effective intervention arrangements. We should see the development of regional currency arrangements in the western hemisphere and Asia based on the dollar and the yen.

One corollary of exchange rate stability would be that countries would no longer be free to use monetary policy as the sole instrument of demand management. Interest rates in different countries would have to remain broadly in line (after allowing for differences in inflation) and their level would reflect the general state of the world economy. Countries would then have to make more active use of budgetary policy to dampen or stimulate demand. This is the situation in Emu today, although the European Central Bank and governments have been slow to recognise it.

Gordon Brown may have thought that leaving demand management to the Monetary Policy Committee, and exchange rates to the workings of the market, would absolve him from the political crises that beset his predecessors. But it is clear that the electorate still blames the Government for crises in industry as it suffers from over-valuation. Perhaps he will now be more eager to put the question of stabilising exchange rates on the agenda for discussion of the new 'global financial architecture'. So far it has been conspicuous by its absence.

John Grieve Smith is the author of a forthcoming Fabian pamphlet 'Reforming the Global Financial System'.