Vericool Finance

Trust the Germans to set the cat among the pigeons. The last time a senior German official publicly criticised Britain’s economic policy, in 1992, the spat eventually sent the pound crashing out of the European exchange rate mechanism.

This recent attack by German finance minister Peer Steinbrück’s remarks about Gordon Brown’s conversion to “crass Keynesianism” threatened to send it through the floor.

The outburst was a gift for headline writers: “Don’t mention the economy,” sniggered the Daily Mail. But is was also seized upon by the Tories as further weight for their argument that Brown’s decision to borrow heavily, in an attempt to prevent recession from turning into a slump, is a potentially ruinous gamble.

The markets have given their verdict on the Government’s recklessness with a vote of no confidence in our currency. It was a pivotal psychological moment when sterling’s value fell to near-parity with the euro.

Investors, bluntly, are fleeing the prospect of a bankruptcy scenario. The Government is expected to borrow at least £70bn this year to add to the £640bn it already owes. Throw in the hundreds of billions it has made available to banks, and suddenly the prospect of a £1trn national debt does not seem so distant.

Sterling devaluations are a touchy issue for Labour: they crippled every government from Ramsey MacDonald to Jim Callaghan. But the pound had to fall: it was over-inflated for years by speculative cash. This devaluation could prove as good for Britain’s economy as our ejection from the ERM in 1992.

There’s not much sign of an upside yet. The much-vaunted benefit to exporters hasn’t materialised, and the weak pound is damaging both our national self-esteem and our buying power overseas. But that doesn’t mean that Steinbrück is right to dismiss Brown’s stimulus policy as crass.

Ultimately this debate boils down to who is right: the mega stimulators – Gordon Brown and Barack Obama – or the steady-as-she-goes brigade. History may offer the best guide. What did the Weimar equivalent of Peer Steinbrück do? He stuck to sound money and fiscal rectitude – with eventually fire consequences. FDR, by contrast, opened the spigots.

As the world faces another terrifying nosedive, history supports the theory of economic intervention.

It was asking for trouble to take one of modern history’s most resonant names and put a II after it. And the recent emergency economic summit was certainly no Bretton Woods – the 1944 summit that led to the creation of the IMF and the World Bank.

There were two main items on the agenda: to stop the world sliding into depression, and to discuss the reform of the global financial system. But for most Americans – and probably many participants – there was a key missing ingredient that rendered the meeting meaningless: the summit without Barack Obama was Hamlet without the prince.

The G20 leaders made a point of blaming banks and poor regulation for the recent financial turmoil, but that conveniently overlooks their own sloppy policies – and this search for scapegoats poses long-term dangers. The 1929 stock market crash was blamed for the Great Depression (until a similar crash in 1987 failed to set off a repeat performance), while more important contributory factors – such as the US Federal Reserve’s overly tight monetary policy and import tariffs – were largely ignored.

The result was years of unnecessarily heavy financial regulation. Similarly, the G20 leaders now seem bent on ignoring the role played by their over-expansive monetary policy, which produced an environment of cheap money and rising assets that encouraged speculation.

Governments are right to examine the activities of banks, but they should inspect their own records, too. Acting on an inadequate assessment of the causes of the financial crisis invites bad policy or, worse, a repetition.

The most valuable outcome of the summit was probably the geopolitical point it made – that this was a meeting of the G20, as opposed to the G7 or G8, meaning that important economies such as China, India and Brazil were at last included. In fact, it would be a fitting legacy of the meeting if it proved to be the old G7’s death certificate.

The rejection of protectionism, and the resolution not to erect any new trade barriers for a year, were also welcome. But in practice, what do they mean?

The next US administration isn’t bound by the promise: indeed, the proposed bailout of the Big Three car makers in Detroit would already appear to violate the spirit, if not the letter, of the agreement. And however desirable it might be, in principle, to create some kind of supernational financial regulator, no US administration would ever seriously contemplate anything that might be seen as a surrender of sovereignty.

Down the years economic summits have been a waste of time for a reason, and some things even Barack Obama cannot change.

No British recession would be complete without a good old-fashioned run on the pound… The pound has been slipping against the dollar for weeks, but it slumped to its lowest level for five years after the Bank of England governor gave it a good kicking with his unremittingly gloomy speech about the economy’s long march back to boredom.

By the time official figures, showing that the economy had contracted 0.5% in the last quarter, were released, sterling was in freefall on fears that the recession would be deep and long. It plunged more than 10% in a week to a low of $1.53. Given that the pound was trading at $2 at the start of the year, that’s quite some shift.

Sterling isn’t just falling because of Britain’s weak economy – though with markets now factoring in an interest rate fall from 4.5% now to 2.5% by this time next year, that is certainly a factor.

It’s also due to a spectacular dollar rebound. For six years, the world has been borrowing cheaply in dollars and yen to bet on property, oil, metals and every bubble in every corner of the globe. In an unwinding crescendo, that huge carry trade is now reversing. There is a perception among international investors that buying dollars is once again a safe option.

Troubles in eastern Europe are undermining the euro, and money managers increasingly feel they know what they’re getting from the US Federal Reserve, which has already cut back rates hard. The idea is also gaining ground that the US, being first into the downturn, will be the first out.

Such a large and sudden fall in sterling can be extremely damaging – especially if you’re an importer buying in dollars and selling in pounds. But it brings benefits too. The plunge comes at a good time for manufacturers, particularly small- to medium-sized firms, and could make a big difference to survival in the tough couple of years ahead.

As the ejection of sterling from the exchange-rate mechanism in 1992 showed, such sharp devaluations can give the economy a shot in the arm, but with overseas markets slowing rapidly, the low pound is hardly going to be a bonanza for exporters. It doesn’t do much for national morale either.

The fall in sterling means that our economy is now significantly smaller than France in dollar terms and could soon be taken over by Italy.

The credit crunch has humbled London, and when the dust finally settles, the City that emerges will be a very different place to the freewheeling money-machine that helped Britain enjoy a record 16-year spell of unbroken economic growth.

Britain faces dark days ahead, but you might not guess as much from the renewed vigour of Gordon Brown, who is building on the international triumph of the “Brown plan” to push forward his ideas for rewriting the rules of the global economy.

Declaring that the last big shake-up of the financial system – the 1944 Breton Woods accord – was designed for a world of national markets that no longer exists, he is calling for a new international financial architecture.

Brown doesn’t intend to muck around. He is challenging the world’s finance ministers to implement complex proposals by Christmas – surely a dangerously arbitrary deadline – and is urging national regulators to place each of the world’s top 30 banks under co-ordinated supervision. That might play better with the crowd if Britain’s own regulatory body, the FSA, hadn’t been such a woeful failure.

Brown has also called for a global early-warning system to identify future risks. But we already have one: institutions like the IMF have been issuing earnest warnings of the risks posed by the credit boom for years.

The problem was that few governments, including our own, wanted to listen. Rather than grandstanding at the IMF, Brown should have spent the past ten years listening to what they said. He’s on the wrong tack again: overcoming financial fears has more to do with psychology than fact. Instead of crowning himself Savour of the Free World, he should be concentrating on sorting out the policy nitty-gritty at home.

Brown might easily argue that he has a talented new lieutenant in place to do the job for him. Certainly, the new chairman of the FSA, Adair Turner, seems determined to enter the stage with a bang. The era of “light regulation” is over, he trumpets. “There will be more people asking more questions” and “there is no doubt the touch will be heavier”.

Lord Turner intends to improve City policing by recruiting more regulators and paying them more competitively, but while the City certainly needs more effective regulation, it’s doubtful whether bigger regulation will help much: there is a danger of throwing out the baby with the bathwater.

There is one consolation, perhaps. Worried about losing your job in banking? No matter. There are lots of them to be had in financial regulation.

A little-known fact about the Chancellor is that he attended the same Scottish public school as one of his predecessors, Norman Lamont. Who knows what they put in the water at Loretto, but somehow they’ve contrived to produce not just two of the last four British chancellors, but the pair who drove the nation’s economy into recession.

Alistair Darling may claim we’re not there yet (the technical definition is two successive quarters of negative growth), but the evidence is there to certify that the boom is officially over.

After 16 years of uninterrupted growth (63 quarters in all), the economy spluttered to a halt in the second quarter of this year. GDP figures – which were expected to show an etiolated 0.2% growth rate – instead registered precisely zero.

Does this really matter to anyone but statisticians? The answer depends on whether we’re looking at a hiccup, or the beginning of a recession lasting well into next year – and everything a recession brings: sharp rises in unemployment and business bankruptcies, sinking government finances, a plunging pound, and years of depressed conditions in the equity and housing markets.

Almost everyone agrees with the latter prognosis, but it is quite possible that Britain’s real economy will turn out to be less sensitive to housing and credit problems than the financial markets assume.

Many of the statistics regarding Britain’s consumers and manufacturers are by no means catastrophic, and ours is hardly the worst placed economy. We still have the highest interest rates of any G7 country, giving the bank plenty of scope to cut on evidence of prolonged weakness. Britain is highly unlikely to become the sick man of Europe.

But we must be cautious. Watching Britain and America slide into economic mayhem has been like observing a group of heavy smokers insisting that fears about lung disease are overdone. There is a dangerous lag between inhaling and infection. Our debt-ridden economies and consumers have had it coming.

The shocks now impinging on the economy are at least as challenging as back in the 1970s, and the final piece in the jigsaw of gloom – unemployment – is about to drop into place. Britain should count itself lucky if it escapes with only two quarters of negative growth, though there’s a danger that continuous pessimism will feed on itself to make a bad situation worse.

The bank should act now. The excuses for not cutting interest rates immediately are wearing thin.

The unmistakable message from the recent inflation figures is that it’s going to get worse before it gets better. Soaring food prices took inflation, measured on the consumer price index, to a 16-year high of 4.4% – more than double the Bank of England’s 2% target. With swingeing increases in gas and electricity bills still to feed through, there’s every likelihood the upward charge could hit a startling 5.5% in September.

The figures are nothing less than shocking and the Bank’s quarterly inflation forecast – in which governor Mervyn King delivered his gloomiest assessment of prospects yet – will make uncomfortable reading in Downing Street. King forecast that UK growth would be broadly flat with a possibility of “a quarter or two of negative growth”. We should steel ourselves, he said, for “a difficult and painful adjustment”.

The figures are merely telling us what we already know – we are still in a jam. In fact, to many Britons suffering double-digit price rises in basic foodstuffs and fuel, the official figure probably feels too low. But this latest price rise will badly hit Government finances. Public pensions and state benefits will be indexed upwards, pushing spending way above expectations. Result: yet higher borrowing.

Meanwhile, the Bank’s interest rate dilemma is intensifying. The Monetary Policy Committee is performing a bold hope trick by taking no action on rates, while insisting it remains committed to its 2% inflation target. The hope is that a combination of slowing economic growth and falling commodity prices will bring down inflation without the need for a painful hike in interest rates.

Certainly, the Bank cannot risk a cut in rates until the back-end of the year at least – even if that means a deeper and longer economic slowdown.

Yet there is room for optimism. The fall in oil and commodity prices seems to be accelerating. The Russia-Georgia conflict should have sent the price of oil soaring, but it remained below $115 a barrel. Classic investment theory has it that when a price fails to react to bullish news, it’s a sure indication that the next big move is down.

Certainly, stock markets – which have done well recently despite the gloomy economic news – seem to smell a change of mood. In addition, when inflation does start falling, it is likely to come down fast – increasing the scope for rate cuts. So watch the oil price and keep the fingers crossed.