Comment: Britain will be judged by results

Click to follow
British economic policy will, for the time being, remain sub-contracted to the financial markets. If the financial markets indicate that there can be a base rate fall, expect one to follow; if they warn against, expect no change.

That is the only sensible conclusion to draw from the debate yesterday on the economy. The markets must now assume that the pound will not re-enter the exchange rate mechanism for many months, maybe never. Not only will we not want to rejoin, for there is little chance of it being modified on the lines that Britain is seeking; we may well not be allowed to rejoin except on terms that we would find humiliating and at a rate that even the sterling bears would admit was unnecessarily low. So we stay out.

For 95 per cent of the movers and shakers in the financial markets this would probably suggest that Britain will slither slowly on down the path of currency depreciation. Maybe the pace will not be the helter-skelter plunge of the past, but sterling will remain a weakish currency, with relatively high interest rates and relatively high inflation by the standards of the industrial world. This shows in the markets now: much has been made of the fact that at the very short end of the money markets we have lower interest rates than Germany. But at three months - the main operative rate for commercial borrowers and depositors - sterling interest rates are nearly 1 percentage point higher than for the DM.

The remaining 5 per cent would argue that at some stage in the next 18 months we will see the pound back at DM2.95. That is such an unfashionable view at the moment that it might seem almost ridiculous to acknowledge it, but were the UK economy to recover ahead of the German, were the inflationary implications of the present devaluation not followed through in wage rises, and were the dollar to recover, it is just conceivable that the case for sterling's old ERM rate could be validated again by the markets.

Alternative anchor

Meanwhile, an alternative anchor for monetary policy will have to be constructed, and there will have to be a tightening of fiscal policy. The anchor will have to be explicit. It will not be credible to say that the authorities are looking at a range of indicators and will make a judgement: the 'trust us' line won't wash. So there will have to be published targets for narrow and broad money supply, and ideally some numbers for the price of financial assets and the exchange rate.

That is not to say that house prices should have a target: you could hardly have the Government cutting interest rates because house prices were rising below projections. But there could be an informal broad target range for the currency, perhaps between 80 and 95 on the sterling index.

Fiscal policy will have to be tightened as soon as is practicable. The enormous surge in the deficit this year was justified as a counterbalance against an extremely tight monetary policy. Leaving the ERM loosens that policy, so no counterbalance is now needed. The deficit must be cut.

The common point here is that something needs to be done to replace the discipline of the ERM. All the post-war experience shows how dangerous it is in Britain not to have some anchor for policy. The ERM anchor did bring about an extraordinary change in assumptions about the likely trend of inflation. That ground has not yet been lost, but if it is, the Government will be repeating the mistake of the middle 1980s when it threw away the progress on cutting inflation in the runaway boom.

There is a further reason for wanting to see a new anti-inflation policy in place: it looks very much as though the core of the EC will race on in the coming months towards monetary union.

It is surmise at this stage, but yesterday the Continent was swirling with rumours that France and Germany would try to move towards such a union even more quickly than the Maastricht treaty laid down.

The turmoil surrounding the franc has demonstrated the unsatisfactory nature of the ERM as at present constituted. Even if the Bundesbank wins and manages to save the present franc parity, the costs will have been so high in terms of the excess money it has needed to create that it will hardly want to do so again.

Currency union

There is no reason why the Bundesbank and the Banque de France could not set up a joint monetary committee, aimed at co-ordinating policy in the run-up to currency union. In a way this would merely be making more formal the very close co-operation that has taken place in the past few days. It would cement the special relationship between the two countries. Arguably even if the Bundesbank loses and either exchange rates are changed, or more probably, the Bundesbank is forced to drop its interest rates, there is a case for more explicit co- operation on these lines.

Of course the whole move to monetary union may fail. But if it does proceed the heat will be on the other EC members to line themselves up for subsequent entry. Italy can be expected to do so by rejoining the EC within the next two or three months; Britain has to have some alternative policy in place.

Yesterday, the Prime Minister had to talk to the UK political constituency. He had to put the best face on the defeat of the past few days: this required a measure of criticism of the way the EC has handled its affairs. But viewed from anywhere outside Britain the idea that British criticism of the ERM has any credibility would be absurd. From the point of view of the Bundesbank, a recent member of an established club failed to follow the advice of the club's elders, both at the time of entry and over the weekend when the lira devalued. As a result it was booted out. Intellectually Britain may have a good case; but in the real world no one is going to take it seriously.

The only way to rebuild credibility will be to show that the alternative policy will provide an equally strong anchor. The judges - the markets - will not be very interested in what British politicians say in the coming months, but they will be interested in what they do.

There is a parallel here with the US. It too has made policy errors, and as a result no one takes seriously its ideas about world monetary reform. But if the US economy performs better the world will sit up and take notice. The same applies to Britain: we will be judged by results.