Time to still siren song on sterling

The manufacturing lobby is in full voice. The theme of its siren song is that if only the Bank of England would stop raising interest rates the pound would drop, exports and investment would pick up, and balance and harmony would be restored to the economy. The descant to this chorus is the line that the Chancellor of the Exchequer would have made it a lot easier if he had raised consumer taxes in the Budget, with yesterday's retail sales figures confirming the scale of the windfall-fuelled spending spree.

All kinds of apparently sensible people have accepted this nonsensical reasoning. It has three main flaws. The first is to conclude that because manufacturing is flat and industry's export orders starting to decline, the economy cannot be overheating. The second mistake is to argue that it is better to use taxes than interest rates to manage the economy in the short term. The third is the belief the Bank of England can easily manipulate the level of the pound by adjusting interest rates.

Take the first point. It is perfectly possible for manufacturing to be depressed while the rest of the economy remains buoyant. Manufacturing makes up only 23 per cent of national output, little more than finance and business services at 19 per cent. As a recent circular by Peter Warbuton at investment bank Flemings points out, there could scarcely have been a greater contrast between the performance of these two sectors during the 1990s.

Although growth in manufacturing started picking up in late 1991 (the trough of the recession preceded Black Wednesday in September 1992, contrary to popular myth), the recovery in business and financial services and telecommunications has been much sharper. They are currently expanding at an annual rate of nearly 10 per cent in real terms, compared to flat manufacturing output.

Mr Warbuton argues that this divergence between sectors reveals the "madness" of setting policy according to aggregate figures on the economy. He writes: "Hi-tech business services, financial and telecommunications services are not subject to the same output constraints as blast furnaces and assembly lines."

This is highly debatable - that bottlenecks are less tangible in services does not mean they do not exist. They instead take the form of labour shortages or congestion. But skip over this. He could also make a similar argument about the divergence between regions, with the fortunes of London in sharp contrast to Crewe, say. The London and south-eastern labour market will hit skills shortages well before the rest of the country.

The trouble is economic policy has to be set according to some kind of aggregate measure rather than one sector of the economy. Whether it should be industry or financial services depends on your assessment of the balance of risks.

This is something about which there is obviously profound disagreement at present. Some economists reckon there is a strong parallel between the late 1990s and the late 1980s. Many of the same indicators are flashing red or amber, but now as then the delays in the inflation process mislead many commentators into thinking there is no danger in this. Suggestions that the economy's trend growth rate had increased permanently or that flexibility in the jobs market meant unemployment could fall further without triggering wage inflation were two-a-penny a decade ago. They have resurfaced with a vengeance recently.

Other experts say there might be a closer parallel with the early 1980s, when a tough Budget, high interest rates and strong pound plunged Britain into a scarring recession. Growth had been picking up through 1979, and rising oil prices made the inflation penalty pretty immediate.

Perhaps I am inclined to put more weight on the boom theory simply because I live in London, just as industrialists put more weight on the gloom theory because they don't. But it is worth pointing out that policy in this country has hardly ever erred on the side of being too cautious. Typical British mistakes have been giving in to the complaints from industry that the cost of borrowing is too high, the pound too strong or the tax breaks too miserly.

The good thing about relying on small changes in interest rates to adjust policy over the cycle, however, is that if this view turns out to be too tough, the Bank of England can easily reverse it. Suppose the members of the Monetary Policy Committee decide to raise rates by another quarter point next month, as they should if tomorrow's figure for second-quarter GDP is as robust as yesterday's retail sales figures. Suppose August and September then bring news of a drop in export volumes and a slowdown in the spending of the consumer windfalls, and the flash estimate of third- quarter GDP the following month is weak. The Bank could then revise its inflation forecast and cut interest rates. Three months with rates at 7 per cent rather than 6.75 per cent would not be catastrophic.

This is why the Chancellor is right to argue that Budgets should set taxes for the medium term, not for fine-tuning over the economic cycle. Although he actually raised taxes on companies rather than consumers, despite his claims to the contrary, this is an unhelpful mix rather than a terrible error of judgement. After all, he could hardly have come back with another Budget in November to cut taxes again if the economy does turn out to be weakening.

And, as Gavyn Davies has pointed out in his column in The Independent, fiscal policy is very tough indeed. Mr Brown is planning no real-terms increase in the public spending total. If any single part of the economy is bearing the burden of austere policies, it is public services rather than manufacturing.

The final point to make about industry's special pleading is that the Bank of England cannot necessarily make the pound fall by cutting interest rates. If it did so at a time when the economic indicators were still warning of inflationary risks - as they are - the foreign exchange markets would simply look forward to an even bigger rise in interest rates later. It would be a postponement of the inevitable. The last government unleashed faster growth than the economy can sustain and it will sooner or later have to be brought back under control. What's more, the bigger the boom, the bigger the bust.

There is nothing to be done about the fact the British economy is further advanced in its cycle than the rest of Europe, or about the uncertainties over EMU that are depressing the continental currencies. All the special pleading in the world cannot bring the pound down. This is something that time, rather than the Bank of England, will have to set to rights.