Consequences of the last awful recession are still with us

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The Independent Online
All recessions are awful, but the recession of 1990 to 1992 and the ejection of the pound from the European Exchange Rate Mechanism (ERM) were particularly traumatic for Britain. They gave a boost to British Euroscepticism, and ensured that Britain now looks more isolated than at any time since we joined the European Union.

To understand why that period had such a far-reaching impact, it is important to look beyond the macro-economic figures. Below the surface, this was an unusual recession. It was the first downturn since 1929-31 that affected large parts of middle-class, Middle England. It thus struck at the heart of Conservative support. Since it was politically impossible to admit that the recession was the result largely of domestic policy failings, our ERM membership became the whipping boy for the Thatcherite right.

In reality, the recession was a product of the excesses of the Thatcher- Lawson boom from 1987 to 1989. That boom was fuelled - like those in much of Scandinavia, Japan and the United States - by financial liberalisation and competition. The easy availability of credit pushed up asset prices - most importantly house prices - and made credit even easier to obtain. Rising consumer spending fuelled higher imports and mounting inflation, which exceeded 10 per cent in 1990.

When interest rates began to rise in 1988 to choke off demand, heavily indebted house-buyers bore the brunt of the tightening. Negative equity and repossessions became the bywords of the recession. Consumer spending dipped. The South-east was among the hardest hit regions: unemployment rose sharply even in traditionally middle-class occupations and areas. London, long sheltered from the full force of business cycles, suffered an unemployment rate higher than the national average.

And the newspaper proprietors hated the pattern of the recession too, which is why the attacks on the Government from the newspapers owned by Rupert Murdoch and Conrad Black had such an edge: advertising revenue is particularly important to broadsheet newspapers, and real revenue plunged, whereas it had gone on rising during the 1979-81 recession, which had affected mainly the manufacturing centres of the Midlands and North and hence the Labour-supporting heartlands.

Ironically, John Major's decision to put the pound into the ERM in October 1990 probably helped at first to moderate the recession. Interest rates had come down from 15 per cent just before we joined to just 10.5 per cent in September 1991 without the exchange rate tremors that usually accompany such a decline. But with rates only 1.25 percentage points higher than Germany's, the question then became whether we could go any lower - or whether we would have to keep rates higher than Germany as a risk premium, since sterlingwas seen as more inflationary and prone to devaluation.

The French provided the answer in November, when they were forced to raise interest rates to defend their parity despite a better anti-inflationary track record than Britain.

The official line, as stated by the newly promoted Treasury permanent secretary, Sir Terry Burns, on the anniversary of joining, was that there might be a conflict between the interest rates necessary to maintain the exchange rate band and the interest rates needed to conduct monetary policy in a more general sense. But he added: "Experience suggests that does not last for very long typically, nor is it very predictable."

We disagreed: "Ironically, the best news for Europe would now be a sharp slowdown in Germany because the boost from the likely fall in interest rates would outweigh the direct loss of markets. But that does not look likely. The second year of ERM membership may prove less accommodating than the first."

From then on, the pressures for domestic relaxation mounted as house prices fell and commentators played ''spot the upturn'': CBI surveys came and went. Hopes rose, and hopes were dashed. I put my head on the block by predicting that output would bottom out in the second half of 1991, but the economic indicators showed continued stagnation well into 1992. (This is an object lesson in knowing whether you are forecasting the economy or the official figures: the GDP figures now show that the bottom of the recession was in the first quarter of 1992, and output began to recover in the second quarter despite high interest rates.)

But Germany was still suffering from the after-effects of the reunification boom, and the independent Bundesbank - led by the arch-conservative president, Helmut Schlesinger - was reluctant to cut rates. The rest is history and humiliation.

On 2 June 1992 the Danes voted against Maastricht and the markets' belief that we were on track for monetary union began to crumble. It was not an original thought - the EU Commission had made the point many times - but we warned that it was not obvious that the ERM could survive in its present form unless there was a clear commitment to monetary union:

"Either Maastricht is put back on the road, or the ERM will have to change. Secondly, the resolution of that question spells trouble for the Chancellor in the markets. If there is no hard evidence of lift-off in the autumn, the Chancellor will face renewed pressures for devaluation or even a free- floating pound outside the ERM." One worrying sign was that the yields on gilts were picking up. On 26 August, Norman Lamont popped out of the Treasury - "with all the decorum of a cuckoo clock" - to say that he would not devalue or leave the ERM. The heavy selling began in earnest.

On 3 September, the Government borrowed pounds 7.2bn in foreign currencies to bolster the reserves and buy sterling, but 10 days later the Italian lira succumbed with a devaluation of 3.5 per cent, and the magical belief that the ERM parities were immutable was gone.

The academic and unworldly Mr Schlesinger then committed the unpardonable indiscretion of telling a senior journalist that the Italian realignment would not be the last. The markets knew the British government had not consulted its partners about the appropriate rate for sterling when it joined, and Mr Schlesinger's remarks were the signal for a rout. On White, Black or Grey Wednesday - depending on your taste - the pound was out of the system despite a 2 per cent rise in base rates, and the announcement of three points more.

And so, by accident rather than design, Britain arrived at a macro-economic policy which is arguably its best for years: an inflation target buttressed by a Bank of England governor with a licence to ring alarm bells; publication of monthly monetary committee minutes and the Bank's inflation report. As the Government cut interest rates and sterling sank, the recovery gathered force.

However, there has been a high cost. Europe has become a dirty word and Britain looks peculiarly isolated: the other Europeans concluded from currency volatility that monetary union was more important, not less.

After the ERM debacle, the focus turned to fiscal policy. Before the election in June 1992, the Independent performed a minor public service in a study with Coopers & Lybrand by pointing out that sky-high budget deficits meant taxes were going up whoever won.

In March 1993, the last spring Budget, Mr Lamont duly put VAT on fuel, cut mortgage interest relief and increased excises, proving the old adage that there is no better diet for a politician than a meal of their own words. Gallup reported that Mr Lamont was the most unpopular Chancellor since the Second World War.

The period was not entirely dominated by macro-economics: one of the sports of the time was to predict which of the stock market stars of the Eighties would fall to earth. Victims included Alan Bond, Asil Nadir, Robert Maxwell, Robert Holmes a Court, George Walker and more. BCCI collapsed and kept official committees going for months. The Lloyd's saga revealed ever more stunning losses.

Gerald Ratner told the Albert Hall that one of the products his shops sold was crap, and the company had to cut 1,000 jobs. His was one of them. Salomon Bros, one of the top houses of the Eighties, was found to have rigged the US bond market. Peter Clowes was sentenced to 10 years on 18 counts of fraud.

Having made their provisions on Third World debt, the clearing banks found a new way to lose money. Barclays revealed the first loss in its history thanks to lending on property. One of those responsible became chairman.

But these were lagging indicators. There were signs of better times to come. Argentina adopted a currency board system, and crushed its hyperinflation. The Brady debt plan cleared the way for renewed growth in middle-income countries.

Russia emerged slowly from its Communist hibernation, a giant economy of the future. And China estimated its 1993 growth rate at 13.5 per cent, a figure only slightly less impressive for being published in December, before the year ended. The world was on the mend.

Christopher Huhne is now the managing director of IBCA Sovereign Ratings.

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