Q&A: Devaluing the pound

The Item Club, an influential forecasting group, says the Bank of England should strive to weaken the pound in order to stimulate British industry. This view has proved controversial, despite the chorus of corporate complaint about strong sterling. BBC News Online looks at the pros and cons of devaluation.

Is the devaluation idea going to be put into practice?

Probably not: the Item Club is an independent group of forecasters, with influence but no actual power.

Their suggestion on devaluation is simply a further step in an ongoing debate on how best to kick-start the UK economy.

For the policy to be put into practice, the Item Club and its many supporters would need to win over the Bank of England and the Treasury.

Neither of these two are likely to be won over easily.

What are the advantages of devaluation?

If the pound were to fall, British exporters would - in theory - become more competitive on the export market.

Because one euro or dollar would buy more pounds, they would earn more sterling simply by continuing to export the same amount of goods for the same price.

Alternatively, they could boost their global market share by cutting their export prices, without harming their sterling revenues.

Many countries have seen a weak or falling currency as a convenient way out of an economic crisis, or even as a long-term policy.

A weak yen helped Japanese exporters carve out global dominance in electronics and cars during the 1970s and 1980s, and the Japanese government is now keen to prevent the yen strengthening.

Countries as diverse as Argentina, Russia, Turkey and Indonesia have - either deliberately or under market pressure - allowed their currencies to fall in recent years.

Russia's economy, for example, has bounced out of crisis since it allowed the rouble to fall by 75% in August 1998.

And Argentina is hoping that its recent 40% devaluation of the peso will lift it out of its four year recession.

What are the disadvantages?

Devaluation only really helps exporters.

If an economy is heavily export-dependent, then devaluation arguably does provide a healthy stimulus.

But in a more balanced economy, the disadvantages can outweigh the advantages.

Imports become more expensive, which can lead to a surge in inflation.

Inflation can also be produced if the economy is over-stimulated by the earnings of export-oriented firms.

More fundamentally, financial markets don't like devaluation.

It smacks of panic, and is usually taken as a sign that the economy really is in crisis.

It is no coincidence that those countries that use devaluation as a tool tend to be counted as emerging markets.

Rich Western countries such as Britain tend to grin and bear strong currencies, fearful of losing the respectability that goes with a steady and predictable exchange rate.

Are we really being hurt by the strong pound?

Manufacturers say so, and continually urge the Bank of England to cut interest rates - a move that would cause the pound to drop.

But the Item club now says that the Bank of England should deliberately weaken the pound, rather than just relying on the effects of lower interest rates.

The British manufacturing industry has been in decline since the middle of last year, and last month suffered its sharpest fall since 1996.

And there are already some signs that the recession in the manufacturing sector is starting to spread to the services sector.

Some argue that a strong pound is bad for Britain's tourism industry, scaring off foreign tourists, and encouraging Britons to holiday abroad.

What chance is there of the policy being adopted?

Very little.

Whatever the merits of devaluation, it is certainly almost never seen as "prudent".

Chancellor Gordon Brown and his New Labour colleagues have based their economic policies on caution and stability; devaluation would be an uncomfortable reminder of the panicky economic policies of the 1970s.

Although the Bank of England used to see the value of the pound as its primary economic tool, it now focuses on inflation, allowing the pound to find its own level.

There is also the danger that an attempted devaluation would fail, as the markets spot an opportunity to embarrass the Bank of England.

Concerted interventions by central banks are notoriously prone to failure, as markets do not like being manipulated.

For some months now, the consensus among economists has been that the pound will eventually weaken under its own steam.

Although this hasn't happened yet, Mr Brown is unlikely to want to tinker with market forces.