Before the fateful date of 16 September 1992, a whole raft of senior figures were apparently willing to stake their reputations on sustaining sterling's position in the mechanism, come hell or high water. Now there is nothing but relief that the UK is on the outside, and not the remotest intention at the highest level of government of taking us back in.
The graph makes it easy to understand the British attitude. It shows the behaviour of three-month interest rates, less price inflation, in the continental European countries, and in the developed world as a whole. In both, real rates fluctuated around the historically high level of about 4.5 per cent in the second half of the 1980s.
Then, as the world recession started to bite in 1990, global real rates subsided, and they are now hovering at a more normal 2.5 to 3 per cent. This decline reflected the far-sighted easing of monetary policy by the Federal Reserve starting in 1989, and the more belated, but still important, easing by the Bank of Japan over the past two years.
These enlightened actions in the US and Japan have probably saved the world from its worst recession since the 1930s. Meanwhile, examine what has happened in Europe. Not only have real short-term interest rates failed to decline, they have perversely risen sharply as the recent
slowdown in activity has started to take hold. Although the Bundesbank has relaxed monetary policy on three separate occasions in the past few months, substantial increases in nominal interest rates have been necessary elsewhere in Europe to hold the ERM together. This, together with a moderate decline in inflation, resulted in a 2 per cent average rise in real rates on the Continent last year.
It is all very well for real interest rates to be very high when policy is straining to control surging credit demand as an economic boom gathers momentum. At that stage of the cycle, the direction of causation runs from the economy to the level of real interest rates, not the other way round. The expectation of future profits growth is strong, so the private sector is willing to pay high rates of interest on the money needed to acquire both physical and financial assets.
For these reasons, there was no cause for concern about the strong up-trend in European real rates from 1983 to 1990. But there comes a moment in each economic cycle when credit demand finally breaks, and when the natural market pressures on interest rates turn strongly downwards. In a flexible exchange rate system, this is, incidentally, the moment when the currency starts to fall. If the
central bank resists these natural downward pressures on interest rates, for reasons related to the exchange rate or anything else, the direction of causation starts to reverse. High real rates kill economic activity.
The situation in Europe is now one of extreme danger, somewhat akin to the position in which Britain found itself in early 1990, when real interest rates shot up to about 10 per cent just at the moment when the boom was finally starting to crack. We all remember what happened next over here. Central bankers in the rest of Europe often tell themselves that the depth of the UK recession was just another manifestation of the long- term structural weakness of the British economy, and that it could not happen to the 'stronger' economies on the Continent. This is simply not true.
Although most parts of Europe (especially Germany) are less exposed to excessive debt than the UK, and therefore less susceptible to a sudden monetary implosion, no economy yet invented can withstand the degree of monetary tightness now in place in Europe.
Furthermore, not only is this undermining the long-term financial health of the private sector in many economies, especially the banks and the commercial property companies, it is also contributing to a further sharp deterioration in the public finances. Government deficits are rising for two reasons: the loss of tax receipts as economic growth withers away, and the increase in debt servicing as a result of high real interest rates.
For Europe as a whole, the ratio of government debt to GDP is rapidly moving above the 60 per cent limit imposed in the Maastricht treaty. For at least two countries - Italy and Sweden - interest rates remain so high that the impact of draconian programmes to reduce public spending is being swamped by the explosion of debt servicing costs.
The central banks of both these countries have been extremely reluctant to reduce short-term rates following the fracturing of their ERM links. Yet both the lira and the Swedish krona have recently been subject to heavy selling because the markets have taken the view that, sooner or later, much higher inflation will be necessary to erode the build-up of public debt.
Ironically, the longer the authorities in these countries maintain their monetary squeeze, the more convinced the markets will become of this necessity, and the more difficult it will be to control the
public debt without a burst of inflation. Many other countries, including Spain, are grappling with similar problems, though they are not yet quite as intense. So high interest rates across Europe are actually making it harder for governments to respond to recessionary forces by easing their budgetary stance. Throughout the Continent (though here France is now an honourable exception, since fiscal policy is modestly expansionary), both arms of macro-economic policy are simultaneously contractionary.
The governments that are imposing these policies on Europe are all doing so for what seem to be over-riding strategic reasons. In Italy and Sweden, tight monetary policies, and even tighter budgetary squeezes, are seen as necessary signals of a fundamental break with the politics of the past. In the one case, it is a break with ungovernability, in the other a break with Social Democracy, but both go right to the roots of the political system.
In Spain, ERM membership is a cornerstone of 'Europeanisation', a process still thought to be fragile in a country so recently under Franco's rule. In France, the link between the franc and the mark has as much to do with President Francois Mitterrand's laudable aim of keeping Germany facing West as with
anything else. In Ireland, the ERM has become a symbol of a nation's emergence from British economic dominance.
All of these objectives are highly understandable; indeed, most of them transcend the mundane matter of how to set monetary policy in the early stages of an economic downswing. It is easy to see how they have come to dominate government thinking. But unless governments bend very soon before the serious recessionary forces they are facing, the current thrust of policy will have precisely the opposite effect to that intended.
Not all the electorates of Western Europe have a reputation for accepting economic hard times with the resigned phlegm traditionally shown by the British. Unless there is a sea change in policy soon - and I mean a cut in interest rates of several percentage points, preferably led by the Bundesbank - the electorates of Europe may show a growing tendency to throw out some babies with the bathwater.Reuse content