Bill Emmott - International Author & Adviser


The pound will rise as the euro heads south
The Times - March 8th 2010

Political uncertainty is holding back sterling. But it’s a sure thing that the eurozone has a rough time ahead

The time to be greedy, the Sage of Omaha says, is when others are fearful, and the time to be fearful is when others are greedy. Warren Buffett has for years delighted in reusing old investment sayings, and they don’t seem to have done the world’s most famous investor much harm. Right now, that saying looks especially valid for anyone feeling nervous about their holdings of sterling. It is time to get greedy instead.

Such thinking may sound merely wishful after the wailing and gnashing last week about hung parliaments, eternal fiscal deficits and credit downgradings. For sure, currency forecasting is a mug’s game, given the complexity of factors involved and given that all exchange rates are seesaws rather than absolute values, with one currency’s fall always involving others’ rise. Yet with the euro being one of the main currencies at the other end of the pound’s seesaw, this looks a pretty good bet to take.

The British economy’s woes and weaknesses are news to no one. It has been plain at least since 2007 that we need higher exports and lower consumer debt, and plain for the past year that the huge rise in public borrowing can only be an interim solution. But that is why sterling has already fallen by more than 25 per cent since mid-2007, reversing the roughly 25 per cent rise that had occurred since the late 1990s.

Could it fall another 25 per cent? Well, it has fallen 4 per cent in the past month, and could, of course, in theory fall even further if investors came to think of other currencies and economies as a better bet. In practice, though, there is a good case that we are now somewhere near the bottom.

Economic recovery has begun, albeit inevitably shrouded with uncertainty about quite how strong and durable it is going to be. The big issue is not economic but political: Britain is in a state of paralysis while Gordon Brown waits and waits and waits to hold the general election, the never-ending campaign for which must be making many voters, viewers and investors lose the will to live. But an election will be held, a government will be formed after it, and the one thing the new Prime Minister will know, however weak he may be, is that he cannot afford to have no plan for dealing with the budget deficit.

Now look across the Channel. There, a form of clarity is emerging, and in the long term it is likely to be good for the survival of the euro.

But it is not likely to be good for the short or medium-term recovery of the eurozone economies, nor quite possibly for the political stability of some of them. The clarity is that the euro is going to work according to German principles, chief among which is that there will be no bailouts for countries that break the currency’s rules.

The meeting on Friday in Berlin between the German Chancellor, Angela Merkel, and the Greek Prime Minister, George Papandreou, made this clear once and for all. Any sense that some typical European fudge would emerge to rescue Greece, dressed up by French ideas about enhancing “economic governance”, or even of starting a new push towards political union, can be forgotten. Greece is getting just political support, Chancellor Merkel emphasised, while it slashes its budget deeper and deeper.

Perhaps, once Greece’s own austerity packages have become well entrenched, some loans will be made from European Union funds to help it to roll over its debts. But the key point is that the adjustment must be Greece’s to make, just as it has been for Ireland and is going to be for Spain.

This is exactly the right approach for Germany to take in its own interests. Germany is probably the only country that would actually be praised by investors if it were to quit the euro, for its monetary and fiscal policies would be expected to be even more orthodox and anti-inflationary outside than in. That, combined with strong public sentiment against bailing out undisciplined free-riders in southern Europe, makes an insistence on strict adherence to the rules of the euro’s founding Maastricht Treaty eminently sensible, even praiseworthy. But it does have consequences.

Chief among those is likely to be deflation. The European Central Bank will hold fast to its highly restrictive inflation target of 0-2 per cent. This means that countries with big debts and deficits, and where unit labour costs have risen far above Germany’s, will have to cut debts, deficits, wages and prices to bring themselves into some sort of competitive line again. That means all the southern Europeans — including not just troubled Greece, Spain and Portugal but also stagnant Italy.

When the euro was founded in 1999, the hope was that it would force member countries to deregulate their economies, making them better able to cope with loss of the ability to devalue their currencies. This never happened, partly because easy money and a healthy world economy made it seem unnecessary, which is always a good excuse for politicians, who enjoyed the chance to have faster inflation than the Germans without any penalties. Now the excuses have gone, and the pain is starting.

With Germany forcing deflation on southern Europe, and with political and social pressures liable to keep boiling up in those countries, will the euro be weaker or stronger? It could be either, actually, just as Japan’s long period of deflation has encompassed weak periods for the yen and now a strong one. But unless Germany and other northern European economies pull off a surprisingly strong rebound in their own consumption and corporate investment, dragging up the rest of the eurozone with them, the outcome is likely to be a pretty dismal few years for overall euro-area growth.

Compared with that, even the British recovery, and adjustment process, is likely to look stronger, not to mention the more rapid revival in America. Eurozone stagnation is not good for Britain, as so much of our trade is with Europe, but our devalued currency makes it probable that British exporters will still gain market share there. For that reason, anyone wondering now whether to bet on sterling, the dollar or the euro ought to be wondering whether what has already gone down so far could well be destined to go up. Such is the nature of seesaws.


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