Mind you, there are those who say the euro is the currency that is about to suffer. Parity with the dollar is on the cards.

Here is a question for you. If the pound eventually falls to parity with the euro, as some predict, and the euro falls to parity with the dollar, what will the dollar–pound exchange rate be?

Ummm, well, you don’t need to be brain of Britain to work that one out.

So let’s start with what the trade figures say.

Well, they were pretty awful. The UK’s seasonally adjusted deficit on trade in goods and services was £3.8 billion in January, compared with the deficit of £2.6 billion in December. More to the point, it was the biggest monthly deficit for some time. Exports are supposed to be going up, but they are not. January saw exports come in at thirty-two and a half billion. That’s lower than the figures for October, November and December.

Okay, we know there is a time lag between a fall in a currency and improvement in trade. In fact, economic theory says that in the short run, the balance of trade may get worse, as sales may be fixed, but the cost of importing will rise. But once the economy adjusts, we should import less and export more, so things should improve. In fact, the curve plotting the trajectory of our trade balance following a depreciation is said to be “J”-shaped. Hence economists have coined the phrase “J-curve” to describe what happens to trade following a fall in a currency’s value.

But surely we should be past the dip in the “J” by now.

At least we can take comfort from the fact that the latest survey of manufacturing from CIPS/Markit, albeit relating to February, had exporting booming. Maybe we just have to wait a tad longer.

Meanwhile, Erik F. Nielsen, Goldman Sachs Chief European Economist told Bloomberg: “People are very bearish on the U.K., probably more than they should be…The euro is clearly in its biggest crisis since it started, so it’s kind of strange that it’s overvalued.”

He went on to say: “There is a permanently higher risk premium on investments in the euro-zone and on the euro.” He predicted euro parity with the dollar at some point over the next few years.

But if the euro is set to reach parity with the dollar, what does this say about the pound? Well, Mr Nielsen has some reassuring words: “We think the U.K. will outperform the euro-zone in growth terms…We have a constructive forecast for sterling.”

The real snag at the moment is that just about every country in the world is hoping to recover by exporting. This just can not happen.

If every country tries to keep imports down and pushes for more exports, the ultimate result will be global recession.

Because the UK is not in the euro, we have a slight advantage, and Britain may eventually prove to be one of the few countries to pull the export trick off.

But the wait for the export-led recovery just seems to be going on and on.

The pound is now down by around 30 per cent from peak, and arguably that is the stuff crashes are made of. But then again, before we get carried away, sterling was grossly overpriced at peak, which in turn had a calamitous effect on our exporters.

But now, the latest falls in the pound have had the panic bells ringing out in a deafening cadence that no one can ignore.

So is that it then? Is this the great sterling crisis we have been warned to expect?

 The recent run on the pound is worse than that seen in 1967, or 1992, at least it is if you look at the data from certain perspectives. Short-sellers have built up massive bets in anticipation of further falls. Within the cacophony of screaming hysteria, a few calm voices say things like “The UK isn’t Greece,” “The budget deficit is affordable,” but their voices are like a whisper amongst a forest of wailing mourners.

So, are we in for a sterling rout? And if the pound does collapse, will this be the disaster we are told it will be, or could it be good? But first, what happened? And what were the causes of yesterday’s sell off?

At the time of writing there are 1.49 dollars and 1.10 euros to the pound. To put this in some kind of context, just six weeks ago there were 1.62 dollars to the pound. Just over a fortnight ago, there were 1.15 euros to the pound. So we have seen quite a sell off.

Yesterday’s falls were sparked off in part by the announcement from the Prudential that it is to buy the Asian assets of AIG, the giant US insurer that was bailed out by US authorities at the height of the banking crisis. In all, the Pru is forking out £35 billion in cash, and that means an awful lot of pounds will have to be sold to expedite the bid.

Markets didn’t like the sound of that.

Also, the trickle of news out of the EU that Greece will somehow be rescued by its fellow eurozone partners, meant markets were able to focus their zeal on the UK.

But the key factor seems to have been news from the opinion polls.

Horror of horrors, we may yet face a hung parliament, and that had the markets pressing the panic alarm and trying to make the resulting sound form the notes of Elgar’s funeral march.

UK gilts shot up in price, with the spread against the German Bund widening, while the spread between Greek one-year gilts and the Bund narrowed. (Although yields on Greek five-year gilts remain almost half as much again greater than yields on the UK equivalent.)

The notes of barely disguised hysteria rang out from newspaper-land. Writing in The Times, David Wighton said: “It says something about your currency when foreign exchange dealers are even prepared to swap it for the Zimbabwean dollar. Yet this was the pitiful fate of sterling yesterday as it suffered its biggest rout on the currency markets for more than a year.

“Apart from the pastings received at the hands of the US dollar and the euro, sterling also fell by more than 1.7 per cent against Zimbabwe’s much-mocked paper, completing a decline of more than 7 per cent since the end of January.”

Meanwhile, writing in the FT, Willem Buiter said: “There are good reasons for the weakness and volatility of sterling. Among industrial countries, Britain’s economic fundamentals are uniquely awful. As regards public debt and deficits, Britain’s true fiscal circumstances are about as bad as Greece’s reported situation, once we allow for the understatement of UK public debt through the off-balance-sheet accounting tricks of the past decade (the private finance initiative, unfunded public sector pensions, student loans and other Enron-like constructs).”

Those who fear the effects of a hung parliament look back to the sterling crisis under Mrs Thatcher. You may recall, this was the era when Mrs T. and her economic adviser Alan Walters seemed at loggerheads with her very own chancellor, Sir Nigel Lawson. George Soros saw the political crisis, and bet against the Bank of England, famously winning.

Of course there was no hung parliament, but the government was split. Therefore, reasoned the markets, think how bad it will be if the government is hung.

But wait a moment. As the fingers on the panic button ring out that high-pitched whistle, the sound softens. The whistle changes, it becomes tuneful and starts playing the sound of Greensleeves.

For one thing, the comparison with Zimbabwe is daft. See it in football terms; imagine Manchester United get beaten by Chelsea, and on the same day Accrington Stanley beat, say, Chester. How would we react if a journalist said of Manchester United: “It says something about the once great football team, when it secures fewer points than Accrington Stanley.” Well, we would not be impressed with the line of logic, and neither should we be impressed with the logic that compares sterling’s recent falls with the Zimbabwean currency.

And so what if we get a hung parliament. As has been explained here, half the economists in the world seemed to think that if we cut the budget deficit too fast this will be calamitous; the other half say the opposite. There is no reason to think a hung parliament, one that may perhaps mean Vince Cable becomes a cabinet minister, will be less anxious to cut the deficit than a government made up of a party of waverers.

The truth is that sterling was grossly overpriced against both the dollar and the euro for a very long time. A couple of years ago the dollar sterling exchange rate went to $2.10. At that level the UK GDP per capita was actually higher than US GDP per capita. Against the eurozone, our lack of competitiveness was destroying the economy. We had become too reliant on the City, which seemed to be just about the only UK sector which could still compete.

This situation resembles what became known as the Dutch disease, after North Sea oil pushed up the price of the guilder and made the Dutch economy uncompetitive.

For the UK, the City’s strength pushed up the pound, hitting our exporters.

The general consensus seems to be that for purchasing power parity, the dollar–pound exchange rate should be about $1.60. For the euro it should be mid 1.20s. So, okay, at current prices the pound is cheap. But not that cheap.

But after years of battling against cheap currencies, the pendulum has now swung in favour of our exporters. They deserve this help.

In recent weeks, the crisis in the eurozone with the so-called PIIGS – Portugal, Ireland, Italy, Greece and Spain – had raised the alarming spectre of a crash in the euro. There seemed to be a real risk that sterling would appreciate, killing off exporters’ newly-found advantage.

The current crisis should help cement the great export-led recovery.

That is not to say there aren’t risks.

Should the pound fall much further, then things will start looking nasty.

But those who knock the UK seem to overlook one fundamental truth. The real snag today is not just with the UK, it is global.

Globally, demand is not matching supply. Globally, savings are too great. Globally, the boom saw the build up of massive imbalances. And too many economies are trying to recover via exporting.

The dollar remains too expensive. So the fundamental imbalance remains in place. But a fall in sterling was always going to be a vital part of the global readjustment. The UK economy actually did quite well during the 1930s, thanks to our exit from the gold standard.

The real nagging worry, however, is not with sterling, it is with the dollar. To correct global imbalances, the dollar needs to fall too.

But Uncle Sam’s creditors don’t want that to happen.

George Osborne finally starts putting some meat on his plans to slash spending, and yet the IMF comes out in support of maintaining spending for a while longer. Meanwhile, a currency trader has said if the fiscal debt is cut too soon, the pound will crash.

Georgy boy chose the occasion of the 2010 Mais Lecture yesterday to start putting some detail on how the government debt will be managed under the Tories. He wants to freeze wages for public sector staff, make changes in public sector pensions, and cut some benefits, especially those to the better off.

Meanwhile, the IMF has produced a reporting saying: “In general, fiscal and monetary stimulus may need to be maintained well into 2010 for a majority of the world’s economies, including several of the largest, although the timing of the exit is likely to differ substantially across countries.”

You will recall former stalking horse, not to mention Mr Spock look-alike, John Redwood, reckons that unless government spending is cut, the pound will fall off the edge of a cliff.

And yet a report from UBS has warned that if government spending is cut too rapidly, sterling could be savaged. George Magnus, a UBS economist and regular on BBC2’s Newsnight, co-wrote the report. It said that if government cuts were too great this will “endanger tax revenues, Britain’s sovereign rating, the recovery of the banking sector and the UK labour market.”

UBS is right, but so is George Osborne. The two Georges disagree, but they are both right.

Government spending has got to be cut. But if it is cut too quickly, the result could be a deepening recession. But then again, it is difficult to envisage circumstances in which cutting government expenditure would be good timing. Those who argue in favour of fiscal stimulus say, sure, we have got to stop borrowing eventually, but not now.

Okay, so when? The exit strategy is non existent, or if it does exist it is built on a wing and a prayer.

In other words, we are stuck between a rock a hard place.

The only possible solution would be for the government to carry on spending, like the IMF and George Magnus suggest, but to channel the money into areas that will create wealth for the future. See: Economist wars for a more detailed analysis

Let’s start with the China crisis and then finish with what really is an absolutely fascinating point about why the appreciation of the Chinese currency will not solve all the world’s problems as some politicians think. Rather, it will create a new set of problems.

Kenneth Rogoff belongs to that elite group of economists who called the economic crisis. He is a former chief economist at the IMF, a professor at Harvard, and co-wrote one of the better economic books that have been published recently – This time it is different. And right now, our Ken is in Japan hobnobbing it at an IMF conference.

He said people say that China “won’t have a financial crisis because there’s central planning, because there’s a high savings rate, because there’s a large pool of labor, blah blah.” But this time, he suggested, it won’t be any different.

The real crisis in the making in China is the asset and investment bubble.

As you know, China reacted to the economic slowdown by massive increases in government spending. But, said the famous economist: “Their response to the latest financial crisis clearly raised the risk that they have a debt-fueled bubble in the economy.” He went on to talk about a bubble in real estate in Shanghai and Beijing which has “taken a departure from reality”, and warned that such a crisis in China will be horrible for Latin America, where many countries export their commodities to the other side of the Great Wall.

There is one drawback to the good professor’s prediction. Let’s tell you about one particular sentence he uttered: “You’re not going to go a decade without having a bump in the business cycle.”

Umm, so he is actually saying China will see growth fall drastically at some point this decade. But it won’t be like Japan’s lost decade, he said, rather the China slowdown will be a bump in the economic cycle.

So it’s a bit like going to a séance, and the mystic saying: “Do we have anyone in this room called John?” So yes, China will see growth stumble at some point in the next ten years.

Investment and Business News is good at making predictions, too. We can now exclusively reveal that it will snow in the UK, at least once more, at some point during this decade.

It seems that a good economic forecaster gets his predictions right, just like a good astrologer, by making them as imprecise as possible.

What Kenneth was really saying is that China is no different from the rest of us, and that maybe the world has become over reliant on China.

Maybe more telling was his comment that when China stumbles it will not be like the Japanese lost decade. In this sense he is dead right.

Did you know that according to the Chinese Academy of Social Sciences, the average Chinese will produce $4,000 worth of goods and services during 2010, compared to just $3,500 odd in 2009.

Aspects of China’s growth story may have a hint of a bubble about it.

But the real story of China is that productivity is surging. There is nothing illusionary about this. It is not a case of the emperor has no clothes. The Chinese emperor is well and truly clothed.

And if you want to know what has really caused today’s economic crisis, a factor is surely that a fifth of the world’s population is industrialising so fast that this is creating imbalances.

Whenever a new superpower emerges, the result is upheaval. This does not have to be a bad thing, but that there will be negative consequences at some stages during the process is inevitable.

And that brings us on to the good article. Writing in the FT, Geoff Dyer points something out that few people in America seem willing to contemplate.

As you know, US politicians, and some European ones, blame the cheap yuan, or renminbi, as the cause of all the world’s ills. There seems to be this view that the Chinese currency needs to appreciate by about 40 per cent against the dollar.

But consider what this would entail. China’s GDP measured in dollars would rise by 40 per cent, meaning  all of a sudden the Chinese economy will be around half the size of the US economy.

Now call the author of this article disingenuous if you like, but US politicians won’t like that.

As Mr Dyer points out, they won’t like it either when the capitalisation of Chinese companies such as ICBC, which is already the world’s largest bank, sees its value shoot up. They won’t like it when firms such as PetroChina become one-a-half-times bigger than ExxonMobil.

But what they really won’t like is when these giant Chinese firms look for American firms to buy out, or when the Chinese defence budget rockets with the appreciating yuan.

The argument that a higher yuan will solve the world’s problems is simplistic nonsense.

The truth is that in developing economies the currency is always cheap. It was thus when the US was a developing economy. The big difference this time is that there are two developing economies, India and China, which between them make up between a third to half of the world’s population and which greatly outnumber, in terms of population, the developed world.

And of course this creates problems, just as it creates opportunity.

And that, more than bankers’ greed and debt bubbles, is surely the real explanation of what’s going on in the world today.

For more on China, the yuan versus dollar, and sino versus western culture see
The Great Bubble of China
China and the West: the lesson of history
Truth or myth, free trading yuan is answer to our ills
Will the emergence of China mean more unemployment in the West?
Why China’s real opportunity gets overlooked: the parallel with Japan
What went wrong with China and what went right?
China and the West – The difference is cultural
China in our hands and the currency row
China solves economic crisis, with cunning plan
China heading for recession, and the yuan myth
The great imponderable
China: the government is not omnipotent – it is impotent; and that’s where the West has got it wrong

Mr O’Neill reckons China has simply got to move on the currency, in order to dampen burgeoning Chinese inflation.

As you no doubt are aware, there is a stream of politicians from Washington to Brussels who believe that the cheap yuan is the cause of all the world’s ills. A 5 per cent appreciation won’t change the world, but it will help.

For more on this see yesterday’s lead story:

But while the world waits to see what China will do next, hardly anyone noticed that something almost as significant, but for the opposite reason, happened in Japan. Japan expanded by an impressive 1.1 per cent in the final quarter. On an annual basis, growth is now running at minus 0.4 per cent, compared to minus 8.8 per cent at the beginning of 2009. Consumer spending rose 0.7 per cent, after a 0.6 per cent jump last quarter. That is encouraging, but the biggest boost came from exports, up 5 per cent.

If you sign up to the school of thought that says global imbalances are the root cause of the global economy’s problems, then what is quite encouraging about the Japanese recovery is that imports have now increased for two successive quarters. But the increase in exports is much, much greater. And for as long as Japanese exports rise faster than imports, the fix to the problem of global imbalances remains elusive.

Meanwhile, in Europe, France expanded by an impressive 0.6 per cent in the final quarter. Germany, by contrast, saw zero growth. Italy and Spain contracted – although in the case of Spain only just – output was down 0.1 per cent.

You probably won’t be surprised to learn that Greece was the worst performing of the Eurozone economies, with its economy contracting by 0.8 per cent in the final quarter.