Here is a graph of how the pound has behaved relative to the euro over the last 5 years (source: FT).
You can see the pound lost nearly 10% in 2007 and over 20% in 2008. Arguably it has recovered a bit but four years ago the pound was over €1.50 and now it is about €1.15. Will it bounce back? Is it at an artificially low level now? Or was it at an artificially high level before?
One way of valuing a currency was discovered after the massive German inflation of 1923. They made a new currency, the Reichsmark, based roughly on what the things in the economy were worth: the land, the buildings etc. It did all right. When they made the euro in 1999 (bank deposits only for the first two years) they added up the money supplies of the individual nations. Did they get it right? Almost immediately the euro fell 20% and then clawed that back, so that the first entry you see on the graph, for 2006, was roughly the level (against the pound) that it was launched at seven years earlier.
Another way of valuing a currency is called Purchasing Power Parity: that is to say a currency should be valued at what you can buy for it. If a Korean family of four spends $1,000 a month on property, food and fuel then a British family should spend the same. The problem is fundamental differences: Korea might not have easy access to fuel; Koreans might eat less than the British (from my experience their diet consists largely of kimchi, pickled cabbage, and you don’t want too much of that, you really don’t).Closer to home, Italy’s GDP or national income is given as $31,320 whereas the purchasing power parity is $30,910, suggesting the euro in Italy is overvalued against the dollar by 1.3% . The comparable figure for Germany is an overvaluation of around 5%.
A simple way of getting round these PPP differences is to choose a product which is identical in every country. The Economist publishes the Big Mac Index
Thus what costs $3.71 in America costs no less than $6.78 in Switzerland and only $2.18 in China, suggesting that the Swiss Franc is overvalued by 80% and the Chinese yuan is undervalued by 40%. The euro area looks overvalued by nearly 30%, against 1.3% in Italy and around 5% in Germany on the traditional basis.
So what do they want, these countries? A currency that is artificially low will make that country’s exports cheaper (this is what the Chinese have been up to) but it will tend to be inflationary, because it makes imports more expensive. Coming out of a recession all countries want to stimulate their export businesses so to an extent it is a race to the bottom, keeping your currency as low as possible, although Britain and to a lesser extent the Eurozone is worrying about inflation. If interest rates go up in Britain before they go up in Europe, the pound will rise against the euro, for the simple reason that you get more money on your £ deposits.
The other thing which affects currency value and particularly in difficult times like now, is trust.
The Americans hope the markets will trust them because it is, well, America, strong, purposeful, invincible. Against that they have a nasty habit of printing more dollars, making them worth less.
The British are hoping the markets trust its austerity measures. So far this looks to be working but there are tough times ahead.
The Japanese hope the markets will trust Japan’s ability to pull itself out of recession and get its people spending.
In the Eurozone they are hoping that the markets believe Germany will remain strong and that the strongest will bail out the weakest. The markets have believed this so far. If Greece defaults and investors actually lose money, rather than see the economy bailed out with more loans, things might get ugly. Germany would like a weaker euro (good for the exports); the weaker countries would suffer.
Sorry, I don't have an answer. Keep an eye on Greece, is my advice.
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