Conditional plan to save the ERM
Monetary union first. France and the Benelux countries want it and in some sense qualify for it. They would be ready to dash for it, leaving the fringe countries to follow later. Germany is the stumbling block. The Kohl-Genscher generation of German politicians wants European monetary union as part of a European political union, which was also favoured by a majority of their electorate, although people were uneasy about giving up the German mark. The experience and expense of German unification have soured that electorate to the idea of big expensive unions, however. The Kohl generation of politicians is passing from the scene (next year's elections could finish the job) and it is not clear that their successors will want to push European political and monetary union at the expense of their own popularity.
The Maastricht treaty already postpones monetary union into the remote future, largely at German insistence. There is little sign that German political dynamics will permit acceleration.
What about collapse? Some people argue that the single market and the drive to develop the ERM into a more rigid system were products of the late 1980s boom. Recession and slow growth in the 1990s will see increased introspection, nationalism, protectionism and the freezing of the whole European programme. In a world without capital controls and where progress towards union is incredible, it is said, a fixed exchange rate system cannot survive.
That argument ignores that while the single market was promoted in the late 1980s boom, it was intellectually the product of the early 1980s period of stagnation and the diagnosis of 'Eurosclerosis'. European growth after the early 1980s recession was miserably slow for a number of years and unemployment kept rising - until 1986 in the UK, until 1988 in France, for example. The popular diagnosis was too much welfare and government spending, and efforts were made to cut budgets and 'make labour markets work better' by reducing access to social security. That was the new right agenda, which took Thatcherite form in this country. The only other programme with any following was the Delors one of reanimating the European Community and hoping that would impart some dynamism to sclerotic economies.
Now after a boom and slump we are heading back into the same position. It is predictable that Europe will grow painfully slowly over the next couple of years and unemployment will rise. The UK will not escape. Still the only solutions on offer are the new right's hair shirt - more austerity, low inflation and trust to the market - and EC initiatives. Keynesianism in one country is a lame duck, in spite of Brian Gould's effort at resurrection. Beggar-my-neighbour efforts at competitive devaluation are all too obviously a dead end. So as unemployment, racism and political extremism grow, and the promises of the Lamonts, Portillos or Balladurs of a free market heaven after just one more spending cut wear thin, the dynamism and hope offered by by the Delors programme will seem attractive.
But if you can have a single market without a common currency you surely cannot have one with exchange rates floating about all over the place. Therefore Europe is condemned to make some form of ERM work.
What about the argument that it is an impossible task; the market can deploy more funds than any central banks can possibly match - billions of dollars an hour? It sounds plausible but it is a mistake. If the market is selling one currency it must be buying another. And the monetary authority supplying the currency in demand cannot run out, because it manufactures the stuff. Everyone can run out of marks, for example, except the Bundesbank. All that is needed for the stability of any fixed exchange rate system is the firm belief that the monetary authority supplying the currency most in demand at any time is ready to intervene in the market and supply it without stint at the advertised exchange rate. The Bundesbank did that when the French franc was under pressure. The franc survived. The Bundesbank made its reservations known in other cases; the currencies fell.
The Bundesbank, of course, does not like the commitment to intervene to support ERM parities because that conflicts with its control of its own money supply. If it is forced to supply lots of marks to the foreign exchange market, that money will find its way back into German banks and mess up the M3 target. The market knows that, which is why the ERM is unstable. None the less the poor old Bundesbank is stuck; its constitutional obligations at home are in conflict with the international treaties setting up the ERM signed by the German government.
Here is my proposal. Abolish the unconditional commitment to intervene to support ERM currencies at the margin. Replace it with a conditional commitment. Any currency hitting its floor must be in good order to qualify for unlimited support. That means meeting a list of conditions to be negotiated, agreed and published by the European monetary authorities. The conditions would include monetary indicators, like money supply, but also some 'real' indicators such as the current account.
In return for this restriction of the obligation to intervene, the strong-currency authority (the Bundesbank in practice) would intervene without reserve when conditions were met. After all, if the conditions were met, the central bank should have confidence that the speculation, not the parity, is unsustainable so any loss of control of its money supply is temporary. Anyway, under fixed exchange rates it is the aggregate money supply of the system, not that in a single country, that matters. The conditions would mean that the Bundesbank was in effect taking account of monetary conditions in partner countries.
This system would greatly reduce, perhaps eliminate, speculation against currencies in good order. And the others? They would simply realign from time to time as was common in the ERM up to 1987. The conditions would prevent political ambition running ahead of economic reality and destabilising the whole system. This simply codifies and institutionalises a situation that is already emerging, painfully, from recent events.
The author is chief economist at Lehman Brothers International and affiliated professor at London Business School
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