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The pound is dead

December 05, 2001

WAKE up Britain-you`re already in the euro. A new analysis of data from foreign exchange markets shows that the pound sterling and the euro have always behaved as if they are the same currency.
        Surprisingly, these revelations are not the work of economists or bankers. They come from a pair of physicists who analysed fluctuations in exchange rates using a technique usually employed to spot patterns in DNA sequences and climate records.
        The physicists` analysis reveals that the exchange rates of sterling and the euro-and before that the Deutschmark and the French franc-have been locked together for years. This follows an announcement by the Organization for Economic Cooperation and Development (OECD) last week that the British economy is already performing as if it were close to the heart of the euro zone, and removes a key economic argument for Britain staying out of the single currency.
        Next month euro coins and notes will start circulating in the 12 countries that adopted the euro in 1999 and 2000. Britain has kept its own currency, and if it decides to join will have to satisfy the entry criteria set out in the 1992 Maastricht treaty. These include specified levels for borrowing, debt-to-income ratios and inflation. The only criterion the British economy was thought not to have met yet is establishing a stable exchange rate against the euro. But it now appears that it has already done so. Marcel Ausloos of the University of Liege, Belgium, and Kristinka Ivanova of Pennsylvania State University have found that the fluctuations in sterling`s exchange rate mimic fluctuations in the euro-and before that fluctuations in Europe`s strongest national currencies.
        This can only have happened if Britain is so strongly tied to the European economy that currency traders are already treating the currencies as indistinguishable. "Our study shows the GBP is already part of the EUR," the researchers say in a report to be presented this week at a London conference on the application of physics in financial analysis.
        Ausloos and Ivanova obtained their data from a set of nearly 2000 European currency exchange rates that appeared on the international markets between 1 January 1993 and 30 June 2000. They then created a "false euro", composed of a weighted sum of the exchange rates of 11 European currencies before the euro was created in 1999. Economists routinely create a false euro. It was also used to set individual currencies` final values against the euro when they joined.
        Even so, a straightforward examination of the foreign exchange data masks important underlying relationships between the currencies. To get at the fundamental pattern behind the data the researchers used a technique called detrended fluctuation analysis. DFA looks at the way a signal, such as a climate record or exchange rate, fluctuates over time, and provides a way to log the changes between subsequent data points so that they can be compared with the rest of the changes in the sample.
        Applied to a currency`s exchange rate, this produces a daily correlation coefficient that reflects how the rate for that day compares with the figure for every other day for the following two years. Plotting the coefficient day by day gives a curve that reveals the underlying behaviour of the economy.
        Before 1999, the pound fluctuated against the Deutschmark, French franc, Finnish mark, Dutch guilder and Austrian schilling in the same way as it fluctuated against the false euro-and later against the euro itself. Against the Italian lira, Belgian franc and Irish pound it moved differently. The researchers also found that the correlation coefficients of the pound, Deutschmark and French franc shared the same character as the euro. Other individual currencies, notably the lira, followed a different pattern.
        The researchers say this shows that the euro and pound have effectively been behaving in the same way, despite daily changes in their respective exchange rates (see Graphic). The finding surprises economist Andrew Hughes Hallett of Strathclyde University in Glasgow. He says he would not have expected there to be a strong correlation between the pound and the euro. The conventional view is that the pound is more closely linked with the dollar.
        But Peter Richmond of Trinity College, Dublin, who also borrows techniques from physics to understand economics, says Ausloos and Ivanova`s work stands up to scrutiny. He believes their findings show the emergence of the euro as a major trading currency.
        The researchers also found that fluctuations between the pound and the euro followed a "Brownian distribution" that would be expected in a system undisturbed by external influences such as currency speculators (see lower Diagram). The close ties between sterling and the euro seems to have stymied efforts to speculate and profit from fluctuations in their exchange rates.
        So what does this mean for Britain`s decision whether to join the single currency?
        The British government has set out five economic tests that it will use to decide. They relate to factors such as unemployment levels and the impact on companies` investment in Britain. Critics say these tests, which will be assessed by June 2003, are so open to interpretation as to be meaningless.
        Many economists believe that the exchange rate directly reflects the overall state of a nation`s economic health-and the British Treasury echoed this view in a statement this year. So Ausloos and Ivanova`s findings not only show that the exchange rates of the pound and the euro are already aligned with each other, it also shows that the economies of Britain and the euro zone are fundamentally on the same track.
        In the end, though, the decision will be a political one-while the British and euro zone economies may be in similar shape overall, the detailed changes involved in joining the euro will be good for some and bad for others. Low interest rates, for example, benefit borrowers but not savers, and high interest rates the reverse. "The thing is entirely political," says Hallett. "There are economic arguments for and against, but when you come to sum up the costs and benefits they`re not terribly large either way."
        Ivanova believes the study will support those in Britain who wish to join the euro, and make those who wish to stay out change their minds. Nick Canning of Britain in Europe, an organisation dedicated to getting Britain to join the single currency, believes the study gives a further reason for Britain to join the euro as soon as possible. "The pound is currently dominated by the movements of the euro yet has no say over how that currency area is managed," he says.
        Ausloos prefers to remain objective. "I`ve nothing to say about British politics." Nonetheless, he believes the data does indicate that, in terms of fluctuations of exchange rates, there would be no difference if Britain joined the single currency tomorrow. In fact, he adds, the pound should be more stable inside the euro.

AUTHOR: Michael Brooks

New Scientist