The pound weakened further yesterday against the dollar and the euro, even though data showed that retail sales had been unexpectedly resilient in October. Sterling now trades at $1.47. Since July, when it traded at more than $2, sterling has lost more than a quarter of its value against the dollar. Investors are alarmed at the weakness of the UK economy. The slowdown is accompanied by a sharp deceleration in the rate of inflation. Traders are assuming that the Bank of England will continue to cut interest rates as the economy plunges into recession.

On the face of it, there are reasons to welcome the depreciation of sterling. The economy is at serious risk of something much worse than a normal cyclical downturn. With the freezing of credit markets, the collapse of asset prices in both the financial and the housing sectors, and confidence among manufacturers at its lowest level for 30 years, sober commentators are talking seriously of a depression on the scale of the 1930s. Against this background, a weaker pound provides a minor respite.

Though holidaymakers to the United States will find their purchasing power suddenly diminished, manufacturers can expect their exports to be more competitive in world markets. The benefit should not be overstated. The global economy is in recession, and there is no possibility that the UK will avoid this through export-led growth. But the customary risk of currency depreciation - a pick-up in inflation as import prices increase, and nominal wages rise in order to keep pace with the cost of living - is largely absent.

The more serious risk for policymakers is that inflation will undershoot the Government's target and even turn negative. If prices fell for a sustained period, the economic pain would be intense: the inflation-adjusted value of household debt would increase, and consumption would be reined back still further. The Government cannot formally welcome a lower level for sterling; but it will regard this outcome as a minor support to stabilising the economy.

Unfortunately that is not the end of the story. There are serious potential costs to a precipitate decline in the value of the currency. Because of the collapse of consumption in the global economy - and particularly the US - policymakers need to take action directly to stimulate demand. They can do this by boosting public spending, cutting taxes and cutting interest rates. But the risk of a large fiscal expansion is that investors will take fright at the prospect of wide budget deficits. Globalised financial markets allow governments, businesses and consumers to borrow more efficiently and cheaply; but they also have the potential to destabilise economies that run up large sovereign debt, by exposing them to the demands of foreign investors.

David Cameron was right to caution last week that the Government could not borrow without limit. Numerous emerging economies have suffered a collapse of investor confidence when trying to manage competing objectives of stimulating growth through public spending and the exchange rate, and moderating the debt burden. The UK is a developed economy, but sterling is not a major international reserve currency comparable to the dollar or the euro. Policymakers do not know the point at which currency weakness might escalate into currency crisis. And the lesson of recent international currency crises is that they easily translate into banking crises.

The Government was right to recapitalise the banks. But the taxpayer's exposure to the banking sector makes it all the more important that international investors retain confidence in the currency. Stimulative policy is urgently needed; but a cycle of financial uncertainty would be the worst possible outcome.