Give inflation currency in euro debate

THE EURO debate is beginning to shed some light on the issues, rather than generate name calling between the contestants. Eurosceptics are now seldom accused of xenophobia, and euro lemmings less often called traitors. This is welcome, but we still have a long way to go before the real issues are faced.

The Treasury's five economic tests are irrelevant. The key is the real exchange rate. There are two theories as to why this was not mentioned in the tests. One is that they were designed to confuse. The other is that Chancellor Gordon Brown and his chief adviser Ed Balls suffer from jet lag in taxis.

Happily, the penny, though not yet the pound, has now dropped. While sterling is correctly given centre stage, there are two points not yet fully appreciated. The first is that the pound must not be overvalued, not just against the euro but all currencies. The second is that it is the real exchange rate, not the nominal rate, that matters.

Even if we join at a fair rate, we will still suffer badly if the euro then rises against other currencies. We will suffer more than the rest of Europe because we do more trade with the rest of the world. We will also suffer with Europe, which will itself have a hard time if the single currency strengthens. So we must not join the euro while it is undervalued, unless sterling is equally so.

The difference between the real and nominal rates is even trickier. In nominal terms, the US dollar has risen from $4.80 to the pound to $1.40 since 1945. In real terms, it is more or less unchanged. The difference lies in inflation.

Not only must sterling fall a lot before we can join, it must fall in real terms. When it does, this must not be offset by higher inflation. Over the past decade, sterling has been rising. This has pushed down the price of manufactured goods, through competition with imports. Those services which cannot be imported have risen in price. The combined effect has been to keep inflation under control.

This has had a disastrous impact on manufacturing profits. Profitability in British manufacturing is now only one-third of that in services. This shows how much sterling is overvalued. Getting it down in real terms will have the opposite impact. Manufacturing profits will recover, but the price of goods will rise. So, to avoid inflation, service prices must fall. This will be tricky without a recession and a large rise in taxes.

Another problem is that the adjustment to euro entry will take time. Prices do not respond immediately to a fall in exchange rates. To join at the right rate we need a weaker pound. But that is not enough. We will then need at least two years to make sure the fall is real and cannot be undone by inflation.

www.smithers.co.uk