Tel. +44 (0)20 7287 4414
Tel. +44 (0)20 7287 4414
The Bruges Group spearheaded the intellectual battle to win a vote to leave the European Union and, above all, against the emergence of a centralised EU state.
The Bruges Group spearheaded the intellectual battle to win a vote to leave the European Union and, above all, against the emergence of a centralised EU state.

"No such thing as the right exchange rate"

Bernard Connolly

On Wednesday September 16, 1992, with the economy on its knees, the then-president of the CBI delivered himself of the remarkable judgment that "we need 15 per cent base rates like we need a hole in the head. But if it is a choice between that and devaluation then I suppose it will have to be." Fortunately for his members, there was another way out - floating the currency.

Five years ago, CBI advice was simply stupid and self-destructive. Today, the organisation's advice is self-serving but destructive for the rest of us. For the CBI, like the rest of the latterday Bourbons who clamoured for ERM entry, now favours tax increases as the way to "deal with" an exuberant economy and rapidly falling unemployment.

Even accepting that the economy needs to be reined back to keep inflation low (a judgment that the most supply-side-minded economists contest), why on earth should economic success be rewarded with tax increases?

Taxes are an economic evil, necessary to provide genuine public goods and to provide for the genuinely poor - they should never be used to keep the private sector on a leash. The alternative prescription involves higher interest rates and a climbing pound, the hallmarks of a successful capitalist economy in a period of strong growth. Sadly, however, mercantilism still reigns in many dark corners of the British economic nomenclatura. And while the economy may be delivering the goods metaphorically, it is not doing so literally - services, not manufacturing, are booming.

To a certain cast of mind, this is doubly distressing. First, services are often regarded as the province of the true entrepreneur: the man or woman who takes risks to make profits, rather than of those "captains of industry" (or their supposed representatives) who too often seek an assured return - a rent - through cosying up to the Government. Second, the service sector is more "disorderly", almost anarchic. Its success depends much on the mood of the private sector, not on the will of the authorities. That is not pleasing to the great and good who feel that when they push a button or pull a lever the economy ought to respond obediently and predictably to their command.

In short, the British economy is showing all the characteristics of a truly capitalist system. That is the result of Thatcherism, and in no small measure of the abolition of capital controls in 1979. That was a decision that transferred power from the State to the private sector - far more momentous than Gordon Brown's transferring power over interest rates from one part of the State to another.

Once capital could flow freely, the expected rate of return on capital was restored to its rightful place as the keystone of the economy - the variable that runs everything else. If a truly capitalist economy is to survive and prosper, its government must put in place structural policies (not least low taxes) that generate bullish private sector expectations of the rate of return.

But, as Knut Wicksell, the great Swedish economist, pointed out a century ago, if the anticipated rate of return goes up, the real rate of interest must also go up. If it does not, there will be a cumulative process of rising asset prices (equities and property in particular), overinvestment and unwise lending by banks until an overextended boom goes bust.

In our world of integrated capital markets, the real rate of interest in a successful economy can rise above the world rate only if that economy's real exchange rate is expected to depreciate. For that to happen, the real exchange rate must first rise above its notional long-run equilibrium level.

In other words, losing "competitiveness" in the upswing is absolutely essential in a capitalist economy such as Britain's. Some manufacturers will have their rents reduced in the process; that is capitalism's "gale of creative destruction", the genius of a system that in 200 years transformed, hugely for the better, the everyday life of ordinary people after centuries in which aristocracy - whether titled or not - corporatism and mercantilism (a good description of the governing principles to which Macmillan, Heath, Wilson and Callaghan disastrously returned) preserved the privileges of the few at the expense of misery for the many.

Capitalism, benign though it is, is a cyclical system. Jumps in "animal spirits" produce jumps in spending on houses, consumer durables and business investment. But the frenetic rate of spending will not (unless spurred on by overlax monetary policies) last for ever. When it falls away, interest rates must fall with it, and so must the currency. "Competitiveness" must improve again. New Labour is right to want to avoid a permanently high level of sterling; but even more right to eschew ERM re-entry. In a dynamic capitalist economy, there is simply no such thing as the "right" exchange rate for more than an instant.

If Tony Blair means what he says about embracing capitalism, he must at the same time renounce corporatism. If he wants to fulfil his aim of improving the quality of public goods and of provision for the poor, he must keep taxes as low as possible. If he wants to improve the private opportunities available to the many he has to accept the "permanent revolution" stigmatised by that most patrician of corporatists, Douglas Hurd. And all that means that he - and the CBI - will have to learn to live with a yo-yoing pound.

Bernard Connolly is Managing Director, International Economics, at AIG International.

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Founder President :
The Rt Hon. the Baroness Thatcher of Kesteven LG, OM, FRS 
Vice-President : The Rt Hon. the Lord Lamont of Lerwick,
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Director : Robert Oulds MA, FRSA
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