Weaker pound is welcome but no panacea The challenge is to connect monetary and fiscal policy to promote demand while enhancing supply Sterling is falling. Hurrah! The needed rebalancing of the UK economy calls for a further depreciation of the real exchange rate. If the call by Sir Mervyn King, governor of the Bank of England, for £25bn in asset purchases at the February meeting of the Monetary Policy Committee delivers a significant decline in sterling, he has delivered a lucky policy strike, despite being outvoted. Sir Mervyn laid out requirements for a durable economic recovery in his presentation of the inflation report earlier this month: "We must focus our efforts in two areas. The first is to put in place measures aimed at boosting the supply capacity of our economy . . . The second is to find ways of boosting overseas demand for our products in order to bring about the rebalancing that the UK economy needs to see. Data suggest UK manufacturing remains uncompetitive relative to services, which are less open to trade. The net rate of return on capital in manufacturing was 4.7 per cent in the third quarter of 2012, against 16.9 per cent in services. The argument that the real exchange rate is overvalued looks overwhelming. With demand abroad weak, exporters will need all the help they can get. Could one have too much of this good thing? But broad trade-weighted nominal and real indices show that sterling is still well within the ranges established since the huge financial crisis in the autumn of 2008. I would be happy to see sterling lower. So, I suspect, would Sir Mervyn. This is a relatively attractive way to deliver monetary loosening. Indeed, it would make sense for the BoE to buy foreign currency rather than yet more gilts. The bigger point is that a country with a floating currency is likely to see adjustment to shifts in portfolio preferences come via movements in the exchange rate rather than in the prices of bonds. If the exchange rate had been fixed, yields on longer-term gilts would almost certainly have risen more than they have. As it is, they remain at historically low levels. Data on conventional and index-linked gilts suggest a modest worsening of inflation expectations, though not one sufficient to justify a tightening. But this fact, combined with sterling's weakening, supports the case for the majority's caution on further large asset purchases. As Sir Mervyn recommends, another part of a sensible strategy consists of measures aimed at boosting supply. The response must focus on expanding investment. The government's unforgivable mistake is to ignore the signals given by the very markets in which it is supposed to believe so strongly; with index-linked gilts showing real yields of zero, or even less, savers are in effect screaming: borrow and spend. Two interesting recent reports shed additional light on how to meet this fundamental challenge. In Investing for Prosperity, the LSE Growth Commission argues for radical institutional changes, to promote both more and more efficient public (and private) investment. The proposals are technocratic: an infrastructure strategy board, an infrastructure planning commission and an infrastructure bank. A good additional proposal is to raise compensation for those adversely affected by the projects. A crucial benefit of a better system for evaluating and implementing investments would be a vastly superior allocation of resources. Making such changes work would surely be hard. But the provision of infrastructure has not worked well in the UK. This is partly because it is so politicised. It is also because capital spending is the first thing to be savaged in a crisis. That has been true this time. In the 2010 emergency Budget, net public investment for 2015-16 was cut to just 1.1 per cent of gross domestic product from 3.5 per cent in 2009-10. Yet one should not forget the potential contribution of investment to demand. In a contribution for Lombard Street Research, Christopher Smallwood lays out the Keynesian case for higher investment. In order to make this more palatable to the markets, he suggests that the government would continue with its deficit-cutting programme for the current budget, while additional borrowing would be tied directly to specific investment projects and programmes. The UK economy looks a mess: inflation stubbornly high, output level and fiscal deficits large. Despite austerity, underlying borrowing is stagnating at very high levels. What, then, is to be done? The BoE is right to accept the inflation overshoot, so long as cost pressures at home remain subdued. The fall in sterling could be economically helpful, though it suggests caution on further large-scale asset buying. The big challenge, however, is to connect monetary and fiscal policy more closely, in an effort to promote demand, while enhancing underlying supply. This cannot be done without a rethink of policy towards public investment at a time of historically low real interest rates. The onus is on the government. It must act soon.