So the pound is just falling to 'fair value'. What if it can't stop?

Sterling crises have come and gone in the past 40 years. Simon Evans asks if Gordon Brown can learn any lessons from Harold Wilson and Norman Lamont

When the price of insurance against the Government defaulting on its bonds becomes more expensive than the equivalent cover for McDonald's, either the markets are getting it horribly wrong or there is something distinctly rotten with the state of UK plc.

Certainly the market's ability to price risk accurately has been called into question over the past few years. In banking, retailing and oil, for example, the markets haven't always got the valuations right.

But the problems facing Britain go beyond market failure. Our economy is in a deep recession and faces the prospect of continued negative growth and rapidly rising unemployment. We also boast one of the biggest budget deficits in the world, which has swelled as Gordon Brown has sought to pour a fiscal stimulus of giant proportions into the economic engine. Britain's debt is projected to climb to £1 trillion by 2012.

Germany's minister of finance, Peer Steinbruck, broke diplomatic ranks last week by calling Mr Brown's fiscal medicine a return to "crass Keynesianism". His blunt broadside seems to have drawn considerable support.

Evidence of that support has come from the foreign exchange arena, with sterling plunging in value.

Just over a year ago, newspapers were full of stories on how to spend your spare cash abroad, as sterling rocketed in value against the US dollar and the euro. Last November, £1 could buy you $2.10. Today you'd be lucky to get $1.49. The fall of sterling has been even more marked against the euro. Today, £1 will get you around €1.131. Parity, something that seemed inconceivable a few years ago, could be around the corner.

Nick Fullerton, from broker FC Exchange, says: "Sterling has already moved significantly and there has been a great deal of damage over recent months. After further rate cuts, sterling could reach the €1.10 level. Parity is fairly far away in my opinion due to the extent of movement already. If it did start to breach the €1.10 territory, we would see a lot of speculative movement and technical barriers – where large institutions programme trades to buy – would be hit. €1.1086 is the important figure where everyone is expecting support to come. If this is breached, then who knows where it could go."

Sterling has long been due a fall, having been hugely overvalued in the past few years. But now this longstanding anomaly has been rectified, it is the extent of further weakening that is vexing City minds. And many think sterling's downward journey has further to go in 2009.

"I think sterling will go beyond parity against the euro," says Stuart Thomson, chief economist at Ignis Asset Management. "It has always been the most vulnerable to the credit crunch because of our reliance on financial services and the current account deficit. Sterling has been overvalued in recent times because of the relative strength of these sectors, but I think those days are over now."

Mr Thomson believes the pound is likely to settle at a longer-term equilibrium of around $1.40, but could, in the short term, spike as high as $1.70.

Against the euro, he thinks sterling could perch itself just above parity in the longer term. At the euro's launch in 1999, £1 could buy you €1.40.

"We are looking at UK growth based on productivity gains more akin to 1970s levels in the coming years," adds Mr Thomson. "What we have at the moment isn't, in my opinion, a sterling crisis. We are moving towards fair value quickly, but there is a very real chance we could hit the crisis point next year."

Horizons in the Square Mile typically span days rather than years, but it is instructive to look back at the recent history of financial crises.

In the late 1960s, under the old fixed, but adjustable, sterling-dollar exchange rate, the pound was devalued by 14 per cent. Harold Wilson, then Prime Minister, famously sought to reassure a sceptical nation when he stated: "It does not mean that the pound here in Britain, in your pocket or purse or in your bank, has been devalued." His promise rang hollow, as inflation spiralled out of control.

During the 1976 sterling crisis, the Chancellor, Denis Healey, was forced to go cap in hand to the International Monetary Fund (IMF) to ask for £2.3bn of bailout cash, as Britain was in effect exposed as bust.

Back then, the Government's solution was to instigate a sweeping package of public expenditure cuts and tax rises – precisely the opposite to what was implemented by Alistair Darling in thepre-Budget report.

But sterling crises haven't been the sole preserve of Labour administrations. In 1992 the value of the pound vacillated as Conservative Chancellor Norman Lamont pulled the levers of monetary policy to little effect – and Britain was forced to abandon its plans to join the euro as it quit the exchange rate mechanism (ERM).

George Soros, the Hungarian hedge-fund trader, famously pocketed more than $1bn worth of profit betting against Mr Lamont's interest rate shifts.

Of these three crises, Wilson's in 1967 probably resonates most today. Then, too, Britain was coming to the end of a boom period and sterling had been overvalued for a long time.

Though the ERM crisis was different in nature from today's problem, William Buiter, a former member of the Bank of England's Monetary Policy Committee, suggests that joining the euro is one way for Mr Brown to escape from the looming currency mess.

Britain would first peg sterling to the euro as a precursor to full membership – a move that would stabilise Britain's macroeconomic and financial situation. Then, if interest rate hikes proved necessary to stabilise the exchange rate, argues Mr Buiter, they would come with much greater credibility than during the 1992 run on the pound. Back in 1992, the Government controlled monetary policy. Now, in theory at least, the Bank of England is totally independent.

But last week Mr Brown ruled out joining the euro, "'this year, next year and beyond".

The depreciation of sterling makes our exports to other countries much cheaper for foreigners. Unfortunately, any kicker from the tumbling pound hasn't filtered through yet. Last week, figures from the CBI showed exports among its members were 45 per cent down, in spite of sterling's fall. Our goods may be cheaper, but other countries don't have the cash to buy them.

Sterling's depreciation also raises the spectre of galloping inflation as we import relatively more expensive goods from abroad.

Back in 1967, Harold Wilson said the 14 per cent depreciation of sterling would enable Britain to "break out from the straitjacket" of boom-and-bust economics. However, Britain's economy then declined into a period of discontent.

Although the medicine administered by Mr Brown today is very different from that prescribed by Wilson, an alternative outcome doesn't appear to be on the cards. The pound seems set on a very rocky road in 2009.