Economic Commentary: Bundesbank comes to Major's aid

Perhaps John Major knew that a cut in Bundesbank interest rates was about to come to his aid when he made his uncompromising speech about devaluation last Thursday, but he has still dug himself into an entrenched position that no true pragmatist would ever have contemplated. No-one can be sure how far German and other European interest rates will now fall, but it seems unlikely to be fast enough to restore much or any economic growth to the UK next year. Furthermore, sterling will remain fundamentally weak until the British economy mounts a decisive recovery, and yesterday's lira devaluation show that the markets can, under some circumstances, make governments eat their words. Although the financial markets will probably be euphoric this morning, rejoicing may well prove premature.

Number 10 essentially sees itself in a repeat performance of Margaret Thatcher's 'lady's not for turning' performance of 1981. But in fact there are more differences than similarities with 1981. Then, there was a clear reason why the pain of the recession might be necessary. After the continuous inflationary crises of the 1970s, the electorate seemed to have instinctively realised that something urgently needed to be done to curb the power of the trade unions, to change the attitudes of British management and to bring public debt under control.

In the Britain of 1992, the case for ploughing ahead - even after the Bundesbank move - is much harder to sell within the Conservative Party than it was in 1981. There is now no urgent need to reduce the power of labour, no compelling requirement to curtail the scope of the public debt. All that John Major can promise, if the policy succeeds, is the lowest rate of inflation in recent British history. This, it might be thought, should be enough to assuage a party that was elected 13 years ago to control inflation, and that until now has not quite managed to achieve its goal. But Conservative thinking so far has been remarkably unimpressed by the belated fulfilment of a central objective.

Among Conservative politicians, a promise to reduce inflation further is increasingly being equated with a threat to create more bankruptcies and weaken the housing market. Meanwhile, from Conservative economists, who in the early 1980s argued that a free market economy would be self-righting without intervention from the public sector, there is now a unanimous chorus of abuse aimed at the Prime Minister.

In a reversal of roles that is quite hard to explain, it is the Keynesian-leaning economists who are now more likely to support the government, despite the fact that it was they who correctly warned a decade ago that a 'short-term' recession would produce a permanent rise in chronic unemployment.

None of this means that there is no case for the current strategy. On the contrary, there is a strong case, but it is subtle, long-term, and difficult to sell to a political audience, particularly to a Tory political audience. If the Prime Minister says that the strategy will bring low inflation, his audience replies that we already have too much of that. If he says it will bring recovery (which he noticeably did not in Scotland last week), his audience says we have heard it all before. If he says that it it is necessary for the UK to be 'at the heart of Europe', his audience says they would much rather be somewhere else.

As a result of all this, the bunker in Number 10 is much more isolated from its natural allies within its own party than it was in 1981. Yet John Major does have two compelling points in his favour which Lady Thatcher did not.

First, this crisis is brewing two years earlier in the political cycle, so the party will be much more inclined to be patient with a policy it dislikes. Second, while Lady Thatcher was not isolated from her party in 1981, she was almost totally isolated from her Cabinet, which continued to be dominated by the likes of Whitelaw, Prior, Gilmour and other 'wets'.

In the early Thatcher years, there was always a chance that the Cabinet would stand up and say 'enough is enough', as they eventually did in November 1990. The fact that they did not do so much earlier in her term was mainly due to the fact that she thinned their numbers with selective purging before they were able to coalesce against her.

This time, there is no obvious group of Cabinet dissenters from the strategy that Prime Minister and Chancellor wish to pursue. There is plenty of background rumbling, but no alternative strategy on which any sizeable group of ministers can agree. Furthermore, the one or two remaining Thatcherites in the Cabinet realise that it would be political suicide to express dissent in public. Even if they believe that, on a free vote among Conservative backbenchers, there would currently be a majority for devaluing sterling or leaving the ERM, they know that no such vote will ever take place.

Short of a leadership election (and with the possible exception of the Maastricht ratification bill, which could cause serious problems), there is simply no forum for backbench discontent on economic strategy to bring itself to bear on the Prime Minister. The idea, which is quite prevalent in the financial markets, that the House of Commons will defeat the Government on an important issue of economic policy is quite frankly absurd.

And the thought of another 'stalking horse' leadership contest has little appeal for the right of the Tory Party. Even if they were able to humiliate or defeat John Major, they have no crown prince of their own. Still worse, they might hand the chalice to none other than Michael Heseltine, a fate they would wish to avoid at all costs.

So for quite a while longer, if the Prime Minister and Chancellor wish to continue with the present strategy - which they assuredly do - it is difficult to see anything in the political firmament that can stop them. Until now, for all the media talk of a 'foreign exchange crisis', sterling has not actually come under heavy attack in the markets. The graph shows what has happened to one-month interest rates in the two countries, Italy and Sweden, where speculation has been heavy, and contrasts this with the relatively placid behaviour of UK interest rates during the summer.

The Bundesbank decision to cut rates, if it is more than just a temporary ploy to assist the French government ahead of Sunday's referendum, will undoubtedly help the UK a great deal, but even so a 'no' vote in France on Sunday could yet unleash a serious speculative attack on sterling. The same could happen if the domestic economy weakens further in the next few months.

Faced with such an eventuality, everything the Prime Minister has recently said suggests that he would prefer to raise interest rates, perhaps substantially, rather than meekly accept a sterling devaluation. Those who believe that the Prime Minister may soon be following the Italian example - devaluing immediately after saying such a course was inconceivable - have not correctly assessed their man.

(Graph omitted)