The Ernst & Young organised ITEM club, who use the Treasury model to make economic forecasts have again accused the chancellor of overdoing forecasts for the UK economy. The difference this time is only 0.2% for 2002 but this was enough to make Sunday paper business section headlines again.

As with our previous analysis of the ITEM club, their insistance that the UK economy needs devaluation is wrong. The Uk economy is in a fair structural balance and that includes exchange rates by definition. William Keegan in the Observer last Sunday reported and rubbished Purchasing Power Parity (PPP) calculations that suggested that sterling was currently 30% overvalued.

Without going into the usual reason that international trade measures are inaccurate measures of relative buying power I have a slightly simpler explanation. It is no coincidence that the countries who appear to be the most overvalued (UK, US & Switzerland) have the largest currency and equity markets and are among the more stable economies in the world. Relative levels of international currency flows will impact on the exchange rate and may make maunufactured goods look comparatively expensive. This affects the smaller UK economy much more than the US due to economies of scale. Stability of economy will inflate an exchange rate due to the lower risk associated with it (resulting in lower interest rates). In the long run these factors will even themselves out as manufacturing firms have access to cheaper money for investment. US industry has benefited from this for many years. Only time will tell whether UK manufacturing and its historically low level of capital investment will benefit to the same extent.