Britain could be developing imbalances similar to those in the US, but it is not so well equipped to deal with them

Discussion is often at its most frantic when a problem is beginning to go away or even being succeeded by its opposite. When the US began to worry about an excessively high dollar in 1985 and intervened with other countries through the Plaza Accord, the dollar was already falling. There is still no consensus on whether the Plaza agreement made any difference.

Similarly, discussion of the overvalued pound has reached a climax at a time when the trade-weighted sterling index has already fallen well below the level of 108.9 forecast by the Bank of England in its May Inflation Report for two years ahead. Some of this depreciation reflects a modest recovery of the euro, but most of it is due to the dollar's rise.

Whatever its composition, the sterling depreciation has not come a second too early. There may be room for discussion on whether demand in Britain is rising too fast or not. But there is almost unanimous agreement that too much of this demand has been generated domestically and not enough by the external traded sector.

For a graphic illustration one has to go no further than the economic prospects table that appears in the Budget Red Book. The first-quarter national income and trade figures are pretty well in line with these projections. These showed a growth in gross domestic product at constant prices of 3 per cent in 2000 - taking the middle of the range offered. This is a good half a percentage point faster than most estimates of the growth of capacity.

Labour productivity Average annual % increase
		US	UK	Difference
1973-95	Whole economy	1.4	2.1	-0.7
1995-99	Whole economy	2.4	1.3	1.1
	of which:
	use of IT	0.6	0.3	0.3
	production of IT	0.6	0.2	0.4
	measurement	-	-0.2	0.2
	other	1.2	1.0	0.2
Sources: Primark Datastream; Goldman Sachs

The more serious problem relates to the composition of this growth. Total final expenditure is expected to rise by nearly 4-1/2 per cent. But some of this extra spending is expected to be siphoned off into a growth of imports of 8 per cent - well exceeding that of exports.

The official projections suggest that this all comes right by next year. Domestic demand is expected to slow down, together with import growth. And the growth of GDP itself is scheduled to decline to the postulated 2-1/2 per cent safe rate.

But there is little room for error. A faster than expected growth in domestic spending or a disappointing export performance would lead to a much higher current balance of payments deficit, which is already estimated at £20bn or 2-1/4 per cent of GDP.

Does this really matter? The US is running a current deficit of about 4 per cent of GDP and the dollar seems to stride ever higher. The crude doctrine that a balance of payments deficit is an evil in itself has gradually been supplanted by the slightly more sophisticated doctrine that it may not matter if the extra resources made available are used to finance investment. But UK investment does not seem to be growing any faster than expenditure as a whole.

The details of the capital account are not particularly reassuring either. There obviously has to be a net overseas inflow to finance the deficit. But if one examines the gross investment inflows, they are of a liquid and volatile kind, above all portfolio investment. On the other hand, UK investment overseas has mostly been direct. The UK overseas balance sheet has deteriorated for several years and net liabilities amount to about 15 per cent of GDP. Thus while officials say that sterling is too high, they may well worry more about the chances of a plunging pound.

The basic policies required are clear enough. There has to be some brake on domestic demand, and a diversion of output overseas. Recent increases in base rates may be enough to restrain domestic demand; but if not, they will have to rise further. According to an old rule of thumb, a 4 per cent fall in the exchange rate, once it has fed through to activity and prices, is enough to undo the effect of a full percentage point of base rate increases.

If sterling continues to fall, the diversionary part of the exercise should be achievable. Exporters do worry lest the pound should start rising again; and some of them would like the government to harden its stance in favour of the euro to safeguard themselves against currency swings.

But faithful readers may remember that I suggested something much more moderate on the basis of existing government policy, which is to join the euro when the conditions are right and after a referendum. What I proposed was that the chancellor should start thinking aloud about the range of rates at which he might be prepared to negotiate entry when he believes the conditions are fulfilled. Contrary to much superstition, when one currency is being merged with a larger one, there is no need to join at the prevailing market rate. Sterling's entry into the euro would be a conversion operation, much more like German currency unification than joining the exchange rate mechanism.

Inevitable difficulties in managing short-term prospects should not blind us to one important sign of progress. That is the big improvement in the underlying rate of unemployment at which the economy can operate without running into accelerating inflation. The two EU countries that have shown the biggest improvement have been the Netherlands and the UK. According to Steven Nickell, the labour economist who is the newest member of the Bank of England's monetary policy committee, the principal contributor to the fall in unemployment between the early 1980s and the mid-1990s in both countries was "changes in wage bargaining" (Centre Piece, Centre for Economic Performance, Spring 2000, written with Jan van Ours).

The Dutch changes reflected a shift to moderation by unions in the context of the Wassenaar agreement between employers, unions and government. The UK changes reflected "Mrs Thatcher's tough new legislation to reduce union bargaining power and a decline in union representation in the private sector". Labour's Welfare to Work policies came too late to be reflected in the estimates.

It is no paradox that the UK measured productivity performance appears to have deteriorated as job prospects have improved. A large increase in the employed labour force, combined with a more slowly changing stock of capital, is bound to run into diminishing returns. This is quite apart from the possibility that, as unemployment falls, the extra workers taken on are of lower quality than those already in jobs.

But it is relevant that the US, which has seen a similar improvement in the labour market has experienced a far bigger rise in measured productivity. For this reason alone, the UK might not be able to tolerate external or internal imbalances on an American scale. And even in the US, it is worth noting that Wall Street averages - and not only high-technology stocks - have come off the boil since the beginning of the year.