If imbalances between a buoyant service sector and weak manufacturing intensify, current policy will be unsustainable

If there is one lesson to be drawn from changing fashions in economic policy, it is that pursuing any single objective to the exclusion of everything else leads to big trouble sooner or later. That is true whether the target is price stability, exchange rate stability or real growth.

The official line is that nothing can be done about the high sterling exchange rate, and we must live with it for the sake of longer-term stability. But we have heard this argument before. There comes a point at which no government can withstand the pressures of the business lobby supported by the unions against what they see as an overvalued pound.

The decision of the Bank of England's monetary policy committee last week to leave interest rates unchanged has only bought a little time. Despite weakness in one or two indicators, it is likely that the next assessment will show domestic demand continuing to shoot ahead, while the internationally exposed sectors suffer ever more losses and closures.

It does not make much difference to the harassed trader whether sterling is regarded as too strong or the euro as too weak. Roger Bootle of Capital Economics may have a point when he says that the 70 per cent weight of European Union currencies in the sterling index, which is based on manufacturing, is too big. But many services - most obviously tourism - are also sensitive to the exchange rate, as is some inward investment.

It is true that the sterling-dollar rate has been relatively stable and that the dollar may have been been suffering from over-valuation. Indeed the symptoms are very similar in both the US and the UK: a large current payments deficit and weak savings covered by heavy capital inflows; and nominal and real interest rates well above those prevailing in the euro-zone. But there are crucial differences. The most important is that the US has had clear evidence of a rapid productivity take-off in the last few years, which is not apparent today in the UK.

What then are the options if the present British course becomes politically untenable? There is a clamour among City economists for a tighter fiscal policy, and there was indeed some loosening in the Budget of the fiscal stance, which had become much tighter than intended. Yet net government borrowing is still expected to be negative in both this and the next financial year.

The chancellor should heed the warning of David Walton of Goldman Sachs about the dangers of frequent upward revisions in supposedly firm public spending plans. But he does not need to go further than ensuring that the medium-term guidelines are met in fact as well as on paper. A fiscal tightening of at least 4 percentage points of gross domestic product in the last three years has not prevented a large sterling appreciation. Would bigger doses of the same medicine do the trick?

What are the other options? One is to leave it to the MPC. The argument here is that if sterling is too high, this will produce recessionary pressures, which will reduce inflation below the 2 per cent target and thus cause the MPC to reverse course and reduce interest rates.

The trouble is that when inflation is very low, the short-term movement of the chosen indicator, RPIX, is at the mercy of chance events such as changes in indirect taxation, oil price rises and similar modest shocks. Of course, the target could be redefined either in terms of some core index such as the European harmonised inflation index. On the latter basis, British inflation is 1 per cent or among the lowest in Europe, and below the rate at which the Bank governor is required to write a letter to the chancellor explaining the undershoot. Such an adjustment is worth making, but could still run up against Goodhart's law that any indicator is liable to become distorted once it becomes a policy target.

In fact the MPC has chosen to base its action not on current inflation but on forecast inflation two years ahead. But since the most important influence on whether that forecast overshoots or undershoots the government's 2.5 per cent target is the exchange rate, on which the uncertainty rests, this only takes us round in a circle.

What else is left? We can wait for the dollar to crash, which on past form would take sterling with it and cause both Anglo-Saxon currencies to depreciate against the euro. But is it realistic to base British policy on the chance of such a crash, which may not happen for quite a time, and which would have plenty of other unpleasant consequences?

We are then left with more fundamental changes. Market intervention by one country on its own, and in the absence of monetary policy changes, achieves little. The most far-reaching change would be to revise the terms of reference of the MPC to allow it to take explicit account of sterling.

It is difficult to believe that a more stable exchange rate against the three main currency blocks - the euro, the dollar and the yen - could ultimately be inflationary, as long as these three areas were themselves enjoying near-stable prices. It could mean, however, going back to a 19th century concept of price stability, when prices might move up or down by a few per cent in any one year, but displayed no longer-term trend.

I have to admit that, if made now, such a change would only increase the impression that the British adopt a bewildering succession of monetary objectives, only to drop them when the going gets rough.

The government's policy is to join the euro as soon as some ill-defined convergence conditions are achieved and the prime minister can drum up enough public support. Why not gain some benefit from this approach?

Contrary to popular impression, there is no reason why the entry rate should be at anything like the prevailing market exchange rate. For joining economic and monetary union is not like joining the exchange rate mechanism, which depended on market confidence that a particular rate could be held. It would in fact be abolishing sterling altogether. The analogy is more with German monetary unification in 1990, which involved setting a conversion rate for switching eastern marks into D-Marks. An entry rate would in the end have to be negotiated and not fixed unilaterally.

Why should not the chancellor announce a range of what on present evidence seem to him acceptable rates for joining Emu, and see what effect it has on the foreign exchange market? Membership in any case requires two prior years of stability against the euro, which might be achieved if the market reaction took sterling down to a more realistic level. A range of, say, DM2.6 to DM2.9 would be well above the estimates of most economists and the International Monetary Fund, despite being well below the current market rate. This course seems worth trying and may well be the least bad option.