A stronger pound will keep Britain ticking over

There’s not much about the British economy to give anyone cheer at the moment. But there is one positive sign: the pound is getting stronger. And with a stronger pound, says Matthew Lynn, we might just pull through.

There's not a great deal about the British economy to make anyone cheerful at the moment. It has slipped into a double-dip recession. The downturn that began in 2008 is now the longest of the last 100 years. Unemployment is still rising and the government's finances remain a mess. The eurozone, our largest trading partner, looks set for another chaotic summer of summits, arguments and bail-outs.

There is one positive sign, however. The pound is getting stronger. For the last few years the British have had to get used to wincing every time they ordered a cup of coffee in France or Italy or any of the other European countries they might visit over the summer. This year they should be able to buy a meal without having to put in a call to their mortgage broker first.

That's a relief for holidaymakers but it might well be a relief for the Bank of England and British economy too. A stronger pound will do three things that have yet to make their way into most mainstream forecasts. It will bring inflation down. It will allow the government to keep borrowing at very low rates. And it will allow the Bank to press the button on more quantitative easing (QE), supporting flagging stockmarkets and keeping the property market alive. All three will just about keep the British economy ticking over.

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In the wake of the credit crunch, sterling fell off a cliff. It had been up as high as €1.50 against the euro, and above $2 against the US dollar. As our banking system fell apart and the government embarked on a series of expensive bail-outs that sent the deficit soaring, investors took fright and started dumping sterling as fast as they ditched the Icelandic krona. The pound fell to near-parity with the euro and $1.40 against the dollar. Exporters might have celebrated. But for everyone else, it compounded the misery of a deep recession. Holidays cost more. Inflation started to rise steadily.

But this year, sterling has begun to strengthen again. The pound is up to €1.24 against the euro, and above $1.60 against the dollar. The gain against the euro is particularly important, because the eurozone is our key trading partner. For much of the past two years the single currency has stayed remarkably strong, despite the region's debt crisis.

Now, with Germany and France at loggerheads over austerity plans, Spain in deep recession and Greece on the edge of withdrawal, that confidence has cracked. It's unlikely to return soon. Britain has plenty of problems but compared with the eurozone, it looks like an oasis of stability and growth. No one should expect the pound to hit the levels reached in 2006 and 2007. But neither is this a blip. It can get stronger still and remain strong.

For a small, open economy like Britain, which both imports and exports much of what it consumes and makes, the exchange rate is crucial. Stronger sterling will shift the policy options for the Bank of England. To start with, it will bring inflation under control.

The Bank has missed its inflation target more often than Greece has missed its deficit-reduction plans. But the line between a higher pound and lower prices in the shops is a straight one. The cost of petrol will fall, making an immediate difference to the headline inflation rate as well as to hard-pressed motorists.

Everything we import will start to get slightly cheaper from clothes, to food, to electronics. Lower inflation will ease the pressure on consumers. With wages largely static, the only way families could cope with higher prices was to spend less. If prices come down, they will spend more and that may get the high street moving again.

Next, it will make Britain's vast budget deficit easier to fund. The government is still borrowing an extraordinary 10% of GDP, around a third of which comes from abroad. Perhaps surprisingly, it can still do so at very low rates. But an attack by the bond vigilantes remains the single greatest threat to Britain.

If we suddenly had to pay 6% for our money, like the Spanish or Italians, we'd be broke. But a stronger pound makes it easier to sell all those gilts for European, American or Asian investors it automatically raises returns measured in their own currency. As sterling strengthens, the day of reckoning with the bond markets can be postponed yet again.

Lastly, by easing inflation and keeping the gilts markets healthy, it will allow the Bank to push through more QE. With a flat economy, the only thing holding the Monetary Policy Committee back from reactivating the printing presses was the threat of higher prices and a collapse of confidence in gilts. With that lifted, they can let rip. More QE will drive share prices higher. It will mean interest rates remain at record lows for longer which will help keep the property market alive, even if it won't revive it.

True, a stronger pound might not be what Britain needs in the medium-term. It won't help the economy rebalance (although there was little sign of this even after sterling's fall). But it will help Britain get through a tough year, which might be the best we can hope for right now. And at least you'll be able to afford a coffee or a glass of wine on holiday this year.

Matthew Lynn

Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years. 

He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.