As chaos reigned in the European markets, the US Treasury Secretary, Nicholas Brady, admitted that governments and central banks may no longer be able to control their currencies in the face of massive speculative flows on the foreign exchanges.
The German and French central banks made a determined effort to defend the franc, but analysts feared that their efforts would prove futile unless the Bundesbank cut interest rates.
The breaking of the link between the franc and German mark would effectively spell the collapse of the ERM and severely damage the link between Bonn and Paris, the axis of European integration.
The Bundesbank, the Banque de France and the French and German finance ministries declared jointly as the markets opened that they had no intention of devaluing the franc.
The Banque de France backed up the statement with a massive support-buying operation for the franc and a sharp rise in a key French interest rate from 10.5 to 13 per cent. The Bundesbank also bought francs while the currency was above its floor in the system.
The support-buying of the franc inflicted losses on dealers who had gambled on an imminent devaluation. 'During the (French) revolution, such people were known as agioteurs and they were beheaded. Today we have more civilised customs . . . When you raise overnight interest rates you hit them where it hurts - in their wallet,' said Michel Sapin, the French Finance Minister.
The Banque de France has run support-buying operations for five successive days, and currency analysts believe France may almost have exhausted its foreign currency reserves. 'Everyone wants to sell the franc and the only buyer is the Banque de France,' said Steve Barrow, of Chemical Bank.
The banks' efforts helped lift the franc four centimes above its floor during the morning, but it slipped again to close less than two centimes from the floor.
'The only escape route for the franc is a reduction in German official interest rates,' said Avinash Persaud, of UBS Phillips and Drew. Although the Bundesbank did not cut its official interest rates, it did edge down money market rates by not draining away all the marks which had returned to Frankfurt after being used to buy weak currencies.
Gerald Holtham, of Shearson Lehman Brothers, said that if the Bundesbank continued this policy, it was essentially printing the marks the markets wanted and could hold the line. 'These are pathological market conditions and the central banks need to give the markets a bloody nose.'
The financial crisis is entwined with a collapse of political confidence which officials fear jeopardises international co-operation in a wide range of areas, including trade.
Mr Brady said the Group of Seven leading industrial nations would have to consider proposals to control the markets. In a speech to the International Monetary Fund in Washington, he called for a new study of global capital flows and their impact on the world monetary system.
'Capital markets have grown dramatically in size and complexity. Daily transactions in the foreign exchange market are approaching dollars 1 trillion. This is roughly double the total reserves of the major industrial countries and well beyond the resources governments can bring to bear in the markets,' he said.
The Spanish central bank succeeded in relieving pressure on the peseta by reimposing capital controls eight months after lifting them. Spanish currency speculators now have to lend the government, interest-free, an equivalent amount of pesetas to any sales for foreign currency.
Europe's plan for a single internal market requires that capital, goods, services and people can move freely between members of the EC, but the experience of the past few months shows how destabilising that can be to government policy.
Some bankers and politicians are calling for more rapid movement towards a single currency in Europe. Karl-Otto Pohl, former president of the Bundesbank, said yesterday he favoured abandoning the Maastricht plan for monetary union. Instead, 'those countries which are willing and able to establish a currency union with a common central bank and single currency should do so, not in 1997 or 1999 but in the near future,' he told the Swiss weekly Weltwoche. This could include France, Belgium, the Netherlands and Germany.
Plans to push forward with integration of the Twelve through the Maastricht treaty on European Union are stalled, with politicans using the Brussels-based European Commission as a scapegoat for popular opposition to the treaty.
But Commission officials are furious that they are being blamed for what they see as the inadequacies of national governments. 'I get the impression we are the bogey-man in German fairy tales,' said Martin Bangemann, the EC Internal Market Commissioner.
The treaty has yet to be ratified in Britain, and opposition in both main parties is increasing. Yesterday the Labour leadership defeated calls for a referendum on the treaty, as the Shadow Cabinet and national executive reaffirmed the party's commitment 'to closer economic and political cooperation', a single currency in the long run, and 'a managed system of fixed but adjustable exchange rates'.
European crisis, pages 6 and 7
Leading article; letters, page 28
Lawrence Freedman, page 29
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