There was talk at the weekend's Group of Seven discussions of a possible German interest rate cut on Thursday, but maybe it was naive to expect more comfort for those who would like the ERM to continue in its present form: there is no general interest among the G7 in sustaining European currency stability, particularly if it has increased the average level of EC interest rates.
Looking ahead, the balance of probability must be that there will be a further rebalancing of ERM parities in the next two or three months. The Danish krone and the Spanish peseta both look over- valued at current levels; the first because of the revaluation that in effect has taken place against the other Nordic currencies; the second because despite the devaluation of last autumn it looks at least 10 per cent overvalued on a purchasing power parity basis. And then there is the French franc.
The cases for and against a franc devaluation have been widely debated. But the academic arguments do not really matter very much if either the markets, or the centre-right coalition that will form the new government, perceive that France needs a devaluation. It is odds-on that the present franc/German mark parity will be broken before the summer is out. Considering the political commitment by France and Germany to that rate, the ERM in its present form will finally have died.
But only in its present form. There are at least three powerful reasons to be confident that some form of ERM will continue. Most important is the fact that the Continental European countries have run some form of currency union for most of the post-war period. After the Bretton Woods fixed exchange rate system finally broke down in 1972 there was a brief period of floating rates, but quite quickly the main EC currencies linked themselves together in the 'snake'. By the end of the decade, this had developed into the ERM. Continental Europe likes currencies to be anchored.
Second, considering the degree of integration of the EC economies, there is a practical reason for trying to do so. For a small EC country close to Germany -
Belgium or the Netherlands - to sell any product to a customer more than 150 miles away will involve a foreign currency transaction. It is as though London was a foreign market to a Manchester-based producer. So the proportion of GDP exported by, say, the Netherlands, is vastly higher than that of France, Germany or Britain, simply because of distances.
Third, whatever happens on the exchanges, the ERM technically continues and, under the Maastricht treaty, develops at the end of this year into stage two of monetary union. The European Monetary Institute, the precursor of a European system of central banks, will be operational. Whether or not one believes that stage three, the move to the single currency, will ever happen, the fact remains that the institution designed to pave the way for a single currency will exist. This is less than a year away.
Let's assume then that the ERM does indeed break up in its present form: what then is likely to happen? In the short run, the existing arrangements of the ERM will continue; the French franc will get a new parity; perhaps the Italian lira will rejoin; and the smaller currencies will be reshuffled. It is just conceivable that sterling will rejoin, though few people expect it. The result will be a new set of ERM parities, which should be credible to the foreign exchanges for some time - 18 months at least.
This calm will give the European Monetary Institute a breathing space to build its influence. It will be helped by the low level of inflation throughout the industrial world, for both the cyclical and the underlying trend of inflation will be firmly downwards for at least three years. The institute's principal mission is to promote price stability, something that is easier to do when price rises seem to be subsiding anyway.
The institute will also be helped by the memory of ERM tensions. If the franc is devalued, that will weaken the influence of the Bank of France and the Bundesbank, just as the devaluation of sterling has weakened the influence of the Bank of England and the Treasury. It is hard to guess at the power of a body that does not yet exist, but if the new institute developed a reputation for being right, it could become very powerful. Something of the Bundesbank's role as custodian of European monetary order could pass to it. It has, under the Maastricht treaty, some technical powers in administering the ERM. By astute public relations, it could develop considerable authority.
It is important to remember that a year from now the European economic scene will look very different. Germany will have just finished a year of recession; France may well have seen recession and certainly will have experienced very little growth.
By contrast, the UK economy will have had a year of reasonable progress, perhaps becoming the fastest-growing of the European countries. If this can be achieved without serious inflationary pressures, it ought to give Britain rather more influence in the new institute than it has at present at EC finance ministers' meetings.
So there will not only be a new power- centre in the EC; it will be one where the influence will be better balanced than it is now in Brussels. The European Monetary Institute may find that it does not take on the task of building a common European currency, because that will become politically unacceptable. But it may prosper in its interim role as manager of a European currency zone. The lower world inflation, (and hence world interest rates) the easier it will be to manage a semi-fixed exchange rate system, for exchange rate changes are largely needed because of differential inflation rates.
It often happens that institutions formed for one purpose end up taking on another. The Bank for International Settlements, in Basle, was originally set up to handle German war debts after the First World War. The Gatt secretariat in Geneva was an interim body, which was supposed to develop into an international trade organisation alongside the IMF and World Bank.
And so it may be with the European Monetary Institute: it may become a much more important body than envisaged. But meanwhile, whatever happens to the ERM in the coming months, European currency links will continue in some form or other. Do not write off the ERM.