Comment: Another flight, another humbling

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The Independent Online
WASHINGTON - It feels like 1976 all over again - Britain being humbled by the foreign exchanges just before an annual meeting of the International Monetary Fund and World Bank.

Then Denis Healey turned back at Heathrow on the way to Manila and Britain asked the IMF for a loan. Now Norman Lamont reaches Washington but heads back early, leaving a hapless Robin Leigh-Pemberton to read a speech for him today.

Again the British team is in a state of humiliation and shock, and is treated with a mixture of pity and contempt by other nations. But there are differences. The fundamental position is not so serious: the payments deficit more manageable, inflation under control. The events of 1976 led to a complete change of policy with Britain using monetary targets to put discipline into its finances. They also led to the election of Margaret Thatcher.

The 1992 debacle does not feel quite like that. The humiliation is there: the Danes putting the pound into a third tier f currencies, along with the lira and the drachma; Spain suggesting that the pound will not be allowed back into the exchange rate mechanism until the Maastricht treaty gets through Parliament and Germany saying that if Britain reapplies there will have to be a vote on it. But there is also a sense of liberation. Mr Lamont looks as though a great weight has been lifted from him; he is out of the dreadful ERM.

That is technically correct in the sense that the pound is no longer anchored by the Bundesbank. But intellectually and practically there is still the problem - what is policy?

The Chancellor and his officials do not know. There was clearly no contingency plan for the events of last week. It never occurred to them that anything like that could happen and they cannot quite believe that it has. This explains the confusing signals that are being given to the financial markets. There was a little statement to the IMF on Sunday, quite a clever attempt to put the best face on the whole business. By the time of the Autumn Statement in November, maybe the Mansion House speech next month, this statement will have to be developed into a policy.

But there is a big problem. Is it just a stop-gap? If it is, then no one will have any faith in it. But if it is more permanent policy, does this mean that going back into the ERM is postponed indefinitely?

Essentially we are back to the mid-1980s but trying to learn from those mistakes. Thus there will be the published target for narrow money, M0; and there will be new targets (which in practice will have to be published) for broad money, M4.

In addition the Government will take into account movements in other asset prices, in particular house prices. So a sharp rise in house prices would lead directly to higher interest rates. Had that policy been in place in 1987-8 it would have been unpopular, for it would have choked off the house-price boom. But it would have saved a lot of misery now.

And then there is the exchange rate. Mr Lamont says he does not believe in it but in practice there is a rough relationship between changes in the exchange rate and interest rates: a 4 per cent change in the value of the pound is roughly equivalent to a 1 per cent change in base rates. So the fall that took place over the past two weeks is equivalent to a fall of 2 per cent in base rates - this probably accounts for the confusion about the Government's intentions on interest rates in the weekend press.

But changes in the exchange rate and in interest rates have a different effect: one helps exporters, the other companies and individuals that have borrowed money. The pound is also a practical determinant of interest rate policies, for the Government cannot let it fall too far without importing inflation.

Mr Lamont has been going on about the need to keep bearing down on inflation, but this will have little credibility if the pound plunges further. It is understood that yesterday's fall in the pound has put on hold any substantial fall in interest rates for the time being. Sterling needs to find some sort of floor before there can be more than a token cut in base rates. So it is gradually dawning that freedom from the ERM is not a true liberation at all.

Mr Lamont suggested to journalists here in Washington that the DM2.95 rate was a reasonable one and that the problem had really been with the pound at dollars 2. There is a lot to be said for that view. But it is not credible to defend the old ERM rate and then allow the pound to fall to, say, DM2.50 or below, particularly since in practice there are no reserves to defend it.

So policy has to be cautious; the Government has to hope that the markets will switch to other targets; it will have to try to make monetary targets a credible policy that avoids the mistakes of the 1980s; and it will have to be humble.

That last bit will be easy. Whenever the Bundesbank or German Finance Ministry officials say anything there is an immediate cluster of people around to learn what they are saying. When Mr Leigh-Pemberton left the IMF yesterday no one bothered to ask him the time of day.