For currencies, this looks like becoming the year of living dangerously. We have already had more than a touch of the jitters. The collapse of the Mexican peso at the turn of the year reminded investors that the fact that economies were closely li nked -Mexico and the US are, of course, members of Nafta - did not stop their currencies diverging.
There is nothing like losing a quarter of your money by being in the wrong currency to concentrate the mind. Investors bruised by this experience cast their eyes around the rest of the world to see which other candidates there might be for membership of the devaluation club. So Canada, the third member of Nafta, was pilloried for high budget deficits.
In Europe, three countries with very high fiscal deficits found their currencies (and their government debt) falling. Sweden, whose government last Tuesday announced a less than convincing budget, has had the further indignity of seeing its public debt downgraded by the rating agencies. Italy, where political uncertainty has compounded the problem of fiscal indiscipline, saw its currency fall to an all-time low. And Spain, slightly unfairly lumped into the "fiscally challenged, politically
unstable" basket, experienced a run on the peseta, which also pushed it to all-time lows.
At least there is a solid case for concern in all these countries: all have high public-sector deficits and weak governments. Unflatteringly, France also found itself the target for attack. The argument here is that though its fiscal position is under reasonable control and, notwithstanding the forthcoming presidential election, it has solid government, its unemployment levels are so high that it will be unable to match the expected rises in interest rates in Germany later this year. Result: the franc at a 13-month low against the mark.
What's up? Anyone who remembers the turmoil of the currency markets in the 1970s and early 1980s, or the way in which they broke up the ERM, might think that the markets had simply reverted to their normal bad behaviour. But is that right? During the 1970s and 1980s they had the excuse that they had to adjust exchange rates to allow for high and different rates of inflation. At the time of the break-up of the ERM, although inflation had fallen somewhat, exchange rates had been pegged at levels that did not fully reflect past inflation, so the markets had the excuse that they were merely correcting the mistakes of politicians who had fixed the wrong rates. Now, since differences of inflation through most of the developed world are so small as hardly to matter, there ought to be much less of a need for currencies to shift, and accordingly much less of an excuse for the sort of currency volatility of the last two or three weeks.
Part of the explanation must lie in the habitual cussedness of financial markets: if there is nothing to worry about they will think of something fast. But the more substantial part of the explanation, perhaps, is that the markets are not worrying so much about different inflation rates as about different levels of public debt. The main criterion for financial respectability for the past few years has been low inflation; provided they could achieve that, governments could borrow more or less as much as they wanted.
Look at the ease with which we were able to finance a Public Sector Borrowing Requirement that peaked at pounds 50bn. But now that low inflation has, more or less, been achieved, lenders are asking the direct question: are we going to get our money back?
If countries cannot reduce the real burden of debt by inflating, they either have to repay it . . . or default. It is the spectre of default that is now spooking the markets. This helps to explain why currencies have diverged so far from their purchasingpower parities. In the long run the exchanges will adjust for differences of purchasing power, but the long run could be 20 years. …