John Grieve Smith: Unless we manage the pound, we will lose manufacturing forever

'The Chancellor can no longer shrug off the strong pound by arguing that rates are market-determined'

British industry now faces twin threats from the global economic slowdown and the continued overvaluation of the pound. The National Institute's latest review typifies the growing pessimism among forecasters: "Any lingering hopes that the economy might be immune to the global downturn have been dispelled by the recent plunge in manufacturing output which fell by almost 2 per cent from March to May." The Item forecasting group (which uses the Treasury model) is also predicting a further slowdown. The outlook is particularly serious for manufacturing industries, such as steel and motors, which have already been hit by the strength of the pound.

We are now in danger of facing an irreversible loss of manufacturing capacity – as we did in the 1980s. The Chancellor can no longer shrug off the effects of the strong pound on industry by taking the line that rates are determined by markets over which the Government has no control. The irony is that it should have been easy enough for a Labour Chancellor to "talk the pound down" – any little slip to the left might have done the trick! One obvious ploy would have been for the Government to make it clear much earlier that we would only join the euro at a lower rate for the pound. It beggars belief that when the markets were recently beginning to take this on board, the Treasury should start trying to talk up the pound.

The Treasury's reluctance to see the pound fall would only make sense if the inflation target of 2.5 per cent a year was the sole objective, not just of monetary policy, but of economic policy as a whole; and a fall in sterling might jeopardise that. But if sterling remains at present levels, the balance of payments will continue to worsen, and may well reach a point that a sudden lack of confidence could precipitate an excessive fall in sterling – just the sort of crisis the Chancellor is trying to avoid. Meanwhile closures and lay-offs, and lower investment from abroad will erode our manufacturing base; and worsen the problem of regional unemployment.

Both to encourage a fall in the pound and to put any negotiations to enter the euro on a realistic basis, the Government should now give a clear indication that we would only join the euro at a competitive rate. Such a move might not get the pound down far enough in the present climate, given that any referendum seems unlikely for at least two or three years; but it would at least get it moving in the right direction. In the current deflationary atmosphere, it might not cause more than a slight blip, if any, in the rate of inflation – a small price to pay for preserving our manufacturing base.

But while the Treasury could at least be leaning in the right direction, it would be wrong to think that any one country can be master of its own exchange rate in a world of volatile financial markets. The basic problem of misaligned and unstable exchange rates can only be solved by international co-operation. The fundamental need at the moment is for an appreciation of the euro – something the UK cannot conjure up on its own.

The best solution would be for the US, Japan and the EU to get together to manage the rates between the dollar, the yen, and the euro. This could be done, as in the past, on an informal, ad hoc basis. The immediate difficulty would be to agree on the new exchange rate objectives. While it is fairly clear that the euro needs to appreciate, the dollar/yen relation is more difficult. In the longer run the dollar needs to come down to reduce the US balance of payments deficit and the yen to go up to reduce the Japanese surplus. But in the short run any appreciation of the yen could accentuate the threat of a Japanese depression; and a sudden loss of confidence in the dollar could precipitate a slump on Wall Street. The current yen/dollar relation should therefore be left broadly where it is for the immediate future.

Exchange rate management has gone out of fashion in recent years. But the instability of the current system of floating rates is causing worldwide problems for industry and must be tackled one way or another. Currency unions such as the EMU are one solution, but only practicable where there is a high degree of convergence and integration. The general need is to achieve greater stability while leaving some room for adjustment as costs get out of line or circumstances change.

Ad hoc management of three major currencies would make a start. But currency management also needs to be tackled on a regional basis. Europe is well ahead as far as the euro members are concerned. The next step should be to set up a new ERM style system to manage the rates between the euro and the pound and other EU currencies outside the euro. This would create greater stability while leaving open the question of eventual membership. It is quite wrong to suggest, as the Government has done, that we either have to join outright or continue the present unstable float.

In Asia, the currency swap arrangements agreed between 13 countries under the Chiang Mai Initiative are a start. For their part, Latin American countries have long been trying to work out the best way of achieving a reasonably stable relationship with the dollar. Such regional arrangements can, and should, differ. But the road we should be treading is to evolve a series of regional currency schemes and then manage the relations between them globally.

The idea that exchange rates will find some sort of "right" level if left to the markets is well wide of the mark. Currency markets are dominated by speculative movements in short-term capital, not by trade. This leaves them subject to marked fluctuations and liable to remain out of line with comparative costs. With industry increasingly operating on a global scale, this makes planning output and sales even for a few months ahead difficult – let alone investing in new capacity that will not be operative for three or four years. It is high time we put exchange rate management back on the international economic agenda.

In the meantime, the Chancellor would be well advised to sit back and let the pound go down. This might not please the City, but industry would be mightily relieved.

John Grieve Smith is the author of the Fabian pamphlet 'Closing the Casino: Reform of the Global Financial System'