Given last Thursday's 25 basis-point rate cut by the Bank of England, a cut not matched by the European Central Bank (whose motto is "If we can do it wrong, we will"), a brief history lesson is offered. Germany's 1991 reunification involved exchanging the virtually worthless ostmarks of the former East Germany for West German deutsche marks on a one-for-one basis.

This expanded the German money supply by the quantity of ostmarks exchanged, and it triggered a round of rate increases by the Bundesbank, Germany's central bank, to forestall inflation. Other European countries were compelled to follow suit in order to keep their currencies in a tight band against the mark within the European Monetary System. George Soros and others bet that the Bank of England, the Swedish Riksbank, etc., would have to relent eventually. They did, and their currencies promptly collapsed.

Did this produce a massive capital outflow? Hardly. The U.K.'s FTSE index started to rally out of a bear market shortly before the pound collapsed. In the early fall of 1992, the further the pound fell, the more the FTSE rallied. The key, of course, was lower, more rational, interest rates.

The Importance of Proper Currency Valuation In 1992, the Footsie rallied while the pound sank

Source: Bloomberg

... Have a Chance to Learn Something

The British rate cut, which was announced at 7 a.m. EDT, ignited a rally in the S&P 500 futures before Thursday's open. But this rally was dashed at 7:45 a.m. EDT when the ECB announced it was standing pat. The S&P 500 futures never traded higher than that point on either Thursday or Friday, as seen in the tick chart below. You have to wonder why the antiglobalization protesters never turn their attention to the world's central banks: These guys can destroy a planet faster than anything this side of the Death Star.

The Rally That Didn't Last The S&P futures reacted briefly to the British rate cut

Source: Bloomberg

Will the British markets be rewarded for their foresight? If we regard the pound/euro cross-rate (EUBP) weakening as a measure of success, the process has begun already. The EUBP fell from 1.74 in October 2000 to 1.552 at the start of 2001. It has encountered stiff resistance at 1.677, and it's about to break horizontal support at 1.617. As was the case in 1992, the weaker pound seems like a catalyst for higher equity valuations in London. We can compare the relative performance of the FTSE and the Morgan Stanley Euro Index (MS-Euro) from Oct. 23, 2000, to the EUBP and get a very clear picture of the currency-equity relationship in Europe.

History Repeats Itself As pound and euro dip, equity valuations rise

Source: Bloomberg

Don't construe this as an argument for competitive devaluation as the pathway to prosperity. It's not the absolute level of any currency -- the dollar included that's important to stock and bond markets. It's the sense that the currency's level is proper. If the Bank of England and the Chancellor of the Exchequer (is that a cool title or what?) decided to weaken the pound to enhance the competitive position of British exporters, the markets would react negatively. More important, it would recall the competitive raising of tariffs in the 1930s, which served to deepen and prolong the Great Depression.

The Bank of England isn't doing anything heroic as much as the ECB is continuing to disappoint those hoping for a dollop of common sense for once. The forward curve in euro money markets is inverted, which is prima facie evidence of a tight monetary policy. ECB President Wim Duisenberg, this century's candidate for the Sphinx-Without-a-Riddle award, must be ignoring what everyone else sees, and that is recessionary pressure in the eurozone. Why Prime Minister Tony Blair would want the U.K. to abandon the pound in favor of this buffoonery is quite a mystery.

Recommendation for U.S. Policy

The U.S. dollar has weakened quickly over the past month, dropping from 120.9 July 5 to 116.14 Aug. 3. While nothing is certain, the fall appears likely to continue for some time to come. What should our policymakers do? The answer, pure and simple, is keep their mouths tightly closed. The notion that we're actively debauching the dollar will unsettle markets, and the notion that we would "defend" it via higher interest rates would be unwelcome as well. Stocks frequently have rallied in the face of a weaker dollar; this was true in 1986-87 and again in 1995. Above all, silence is golden.