Ambrose Evans Pritchard: 'Dutch disease' could shake the pound

By Ambrose Evans-Pritchard
The Telegraph, London
Friday, July 20, 2007

http://www.telegraph.co.uk/opinion/main.jhtml?xml=/opinion/2007/07/20/do...

Don't be fooled by the surge in sterling to a 16-year high of $2.05 against the dollar. We have not become the planet's uber-rich, nor have we stumbled upon the secret of perpetual wealth.

The pound is no higher against the euro or Canada's loonie than it was three years ago. It has fallen against India's rupee, the Philippine peso, Poland's zloty, Romania's leu, Chile's peso, and the Aussie and Kiwi dollars. Brazil's real has been the strongest currency in the world for a couple of years.

This is a global dollar slide, the long-deferred consequence of America's monetary misrule. At least at first sight.

Look closer at the world currency system and you see a shift in spending power from Atlantic civilisation to the rest of the world, one of those rare realignments that occurs every century or so. The euro and sterling will follow the dollar down soon enough against the new boys.

For now, China is refusing to play its proper role in the emerging order, causing ructions for everybody else. It is holding down the yuan against the dollar by political intervention -- in the process flooding the world with some $1.2 trillion in liquidity, and driving up the prices of London houses, premier cru Bordeaux, Monet landscapes, and gold.

By default, much of the dollar exodus is ending up in Europe, even though an ageing, hidebound continent with unfunded pensions is no place to put money.

The euro has reached a record $1.38, leading to this week's pitched battle between France and Germany for control over the European Central Bank. As Airbus chief Louis Gallois said last week, if the euro stays above $1.35 for any time, aircraft production in Europe is finished.

Fund managers may suspect -- many do -- that the euro's moment of glory merely brings forward the day when the two-speed currency union finally cracks up. That does not stop them buying euros. There will be plenty of warning signals before that happens.

So they watch with a jaundiced eye as the Teutonic and Latin blocs drift ever further apart (Germany has a current-account surplus above five per cent of GDP after its decade-long wage squeeze; Spain, Greece and Portugal all have deficits of 10 per cent after their credit bubbles). For now the ECB is still raising rates, so up the euro goes.

Against this stateless currency, sterling looks rock solid. It has a viable nation state to back it up in a crisis. The Bank of England has regained the prestige it last enjoyed in the halcyon days of late empire. We offer interest rates of 5.75 per cent and yields on 10-year Gilts of 5.45 per cent, the best terms on offer from a big G7 player.

The Banca d'Italia has placed 26.5 per cent of its foreign reserves in sterling. The Swiss, Swedes, and oil-rich Russia (world's No. 3 in reserves with $405 billion) have all put 10 per cent in pounds.

Foreign governments love our money, for now, and we love their money. As Peter Mandelson put it: "We are intensely relaxed about people getting filthy rich."

But has Britain itself metamorphosed into little more than a bank, just as Iceland has become a hedge fund? IMF data show that -- on paper -- the UK is now the world biggest "creditor" with claims of $7.05 trillion.

This is not because we have any savings to lend out. Household debt is running at £1,300 billion, or 165 per cent of disposable income -- worse than America. No, this is the world's money, courtesy of the global credit bubble. Hats off to the City for netting these flows.

If you step back, however, is it not obvious that Britain has succumbed to a mutant strain of the Dutch Disease, the fate that befell Holland after it briefly struck rich on North Sea natural gas in the 1960s?

Countless countries have been through versions of this boom-bust saga: 19th-century Brazil with rubber, or 1970s Norway with oil, or imperial Spain with metals. The currency rises too far, warping the economy. The underlying commodity crashes.

Our disease is the great nexus of banks, hedge funds and private-equity firms stretching from Mayfair to Canary Wharf, collectively known as "Richistan" and so flush it could afford to pay £1 million or more in bonuses to 4,000 of its own last year.

Add the attendants -- accountants, florists, lawyers, chefs, estate agents and nannies -- who live off the machine and it becomes big enough to push the economy off kilter.

Richistan is the clearing house for globalisation, but aren't Dubai, Mumbai, Shanghai and a revived Tokyo all trying to create their rival cities to bag regional business? And what happens if the global mood changes?

The EU has just eliminated "free and unfair" competition from its list of core treaty objectives, but has kept Maastricht Article 59 giving EU ministers the power to impose exchange controls by majority vote.

On Capitol Hill, the all-powerful Democrats are turning market shy. If Hillary Clinton takes the White House, protectionists will have a duopoly in Washington.

In any case, the "price" of finance has surely been inflated just as extravagantly as oil or rubber in their day. The world's central banks held interest rates too low from 2003 to 2006, driving down the cost of credit to levels that encouraged reckless use of debt. They have belatedly slammed on the brakes.

With the usual time-lag, we are now starting to see the denouement. The issuance of new-fangled CDOs (collateralised debt obligations), CLOs (collateralised loan obligations) and other exotica that make up the $2.5 trillion world of structured finance has come close to freezing since two Bear Stearns hedge funds blew up on US property bets.

While the epicentre of this credit crunch is America, the tremors are hitting Europe. Hardly any junk bonds have been issued for three weeks. Traders are on the sidelines, holding their breath.

When the liquidity tide does recede, and beaches the British economy, we will find out what the Brown legacy really is: a bloated state sector that has risen from 37 per cent to 45 per cent of GDP in a decade (on OECD data) with taxes to match, and that is now higher than Germany's; a budget deficit of three per cent of GDP at the top of the cycle, worse than America or Italy; a current-account deficit of 3.4 per cent of GDP; and of course our own version of America's subprime debacle -- yet to hit, although arrears are already shocking.

Soon enough the British housing boom will cool, knocking away the interest-rate prop that has held up sterling. Global markets will then make a harsher judgment on Brownism.

The pound will not look so pretty, and perhaps that will help cure us of our Dutch Disease. As Churchill mused regretfully in the late 1920s after restoring Britain to the gold standard at a punishing exchange rate to please the City: "I would rather see finance less proud, and industry more contented."

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