Comment : Clarke engineers scepticism in the markets

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The best inflation outlook since the late 1960s combined with the best growth outlook since the late 1980s; Kenneth Clarke could not have asked for a better economic background for the election campaign if he had engineered it himself. Come to think of it, is that not precisely what he has done?

The Chancellor is still chanting the old mantra - that good economics is good politics - but most of us have come round to a more cynical view. It is both that a good old fashioned pre-election boom has indeed been put in train regardless of its long-term consequences, and that booms of this type do help unpopular Governments win elections. That view has rather been backed by John Major's unfortunate letter to disaffected voters. He writes at least in hope of the feel-good factor, even if it lasts only as long as it takes for him to get re-elected.

Financial markets never believed the rhetoric and it looks increasingly as if they were right. The high long-term interest rates demanded of the UK government by the markets are a resounding vote of no confidence in its monetary policy. The markets believe that inflation near the 2.5 per cent target will be a brief interlude.

Mr Clarke can repeat that his is the best inflation record in a generation until his face is as blue as his campaign rosette. It will cut no ice with markets that know that inflation is a backward-looking indicator. The signs of higher inflation in the future are clear in all those "highest since 1989" indicators such as narrow money, house prices, record consumer credit and buoyant surveys. Even clearer are the signs that the Budget at the end of November will bring tax cuts on at least the same scale as last year. They will take place against a background of consumer windfalls from building society flotations.

As for interest rates, if Mr Clarke does hold off reducing them again, it will be an electoral first. In 1987 there were four base rate cuts in the three months before the election, bringing the level from 11 per cent to 9 per cent. There were two reductions in the seven months before the last election. The last Chancellor to raise interest rates in the run-up to an election was Denis Healey in 1979. It is hard to see Mr Clarke seeking any parallel with the late 1970s.

Morgan Grenfell has the backing to survive

Week two of the Morgan Grenfell debacle and the numbers involved seem to grow ever larger. From the basic cash injection of pounds 185m which Deutsche Bank was originally forced to provide, the German parent could now find itself liable for very substantial compensation on top. Deutsche is at this stage denying any further monetary responsibility, but this hardly seems a sustainable position long term. A reasonable starting point would be that investors should at least be returned to the position they were in before the irregularities began. The more extreme case would have investors compensated from that point even if they had since made a profit. Depending on when the irregularities began, this could lay Deutsche open to compensation claims of hundreds of millions of pounds.

It hardly needs saying that if Morgan Grenfell was still an independent investment bank, it might have been wiped out by such an outcome. Fortunately it has a deep-pocketed German bank as its parent. For the dwindling band of British merchant banks that have chosen to remain independent, the implications of this latest disaster could hardly be more uncomfortable. Since acquiring Morgan Grenfell, the Germans have positively gone out of their way not to interfere; the bank has carried on as if it were still independent. In these circumstances it might be possible to draw the link between independently run British investment banks and a propensity to fall victim to calamitous fraud.

Certainly that is what many American investment bankers argue - that old-style City merchant banks lack the size, discipline, controls and knowledge to cope in fast-moving financial markets. The evidence for this is ambiguous. True, before Morgan Grenfell there was Barings. And Robert Fleming was perhaps lucky to escape from its recent problems in Hong Kong with damage of just pounds 12m in compensation and fines.

On the other hand, even the big players have not been immune to scandals of this sort. Deutsche has had its own derivatives debacle. But even accepting that scandal of this sort is random in the way it strikes, that there is little you can do to stop the determined fraudulent trader, the point is still the same. Big players with lots of capital survive such traumas, and so do clients disadvantaged by them; smaller ones do not. The implications of this sorry story for the small clutch of independents still holding out in the hills - Schroders, Robert Fleming, Hambros, NM Rothschild, and yes, even Cazenove - however switched on, and however good their internal controls, are not good, not good at all.

Codes have changed the way people think

Directors of some of our largest companies have been complaining about the burden of complying with the Cadbury and Greenbury rules on corporate governance. They would say that, wouldn't they, given that the rules are designed to set limits to their powers.

But while these attitudes have been common currency in the boardroom, they have found few public echoes among the big investing institutions that control half the shares in British public companies, at least in their public utterances. The Cadbury and Greenbury codes are, after all, meant to make companies more open and accountable to these shareholders, and it would seem churlish to complain. Now Britain's biggest pension fund manager, Mercury Asset Management, has said what many institutions have been saying in private for a long time, which is that an over-zealous application of the Cadbury and Greenbury rules is not going to work.

As we reported yesterday, MAM has sent a statement of its principles of corporate governance to more than 1,100 clients, making clear it is not prepared to let the codes override its better judgement about what is or is not in the economic interests of shareholders. The codes were never meant to be legal documents, and they are full of let-outs and loopholes, which remain even where chunks have been incorporated in the Stock Exchange rulebook. Common sense says that where there are uncertainties about the application of the rules, the best guide is usually to choose the course of action that most benefits shareholders.

These codes have had their effect, and though they no doubt have many faults, it is important not to allow them to be dismissed as worthless. At the very least the constant airing of corporate governance issues has made MAM's pension fund clients anxious to see their fund managers exercise voting rights more often. The fact that MAM has decided to compile a public statement of corporate governance principles is itself very good evidence that the Cadbury and Greenbury committees have changed the framework in which people think.