Economic Commentary: How France and Germany could fix it

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The Independent Online
While Britain, with its irredeemable penchant for navel-gazing, has once again been wondering whether Parliament will ratify the Maastricht treaty, a move is afoot elsewhere in the European Community to change the rules of the game. Last week, the French opposition parties, which will be elected to government in late March, embarked on a vital new tack. If they succeed they will transform the Community, since they are, in effect, calling for swift monetary union between a core group of countries, built around the pillar of a permanently fixed franc/mark exchange rate.

Both the parties that will form the new French government (Valery Giscard d'Estaing's centre-right UDF and Jacques Chirac's Gaullist RPR) are committed to using 'all necessary means to maintain the value of the currency'. Those right- wing politicians who have previously favoured floating the franc (such as Alain Madelin) have, for the moment, admitted defeat. All now say they are willing to give existing parities a try.

This means that the new French government will probably behave as follows. On taking office, it will initially reaffirm its support for the current exchange rate mechanism parities, in the hope that this will be enough to allow interest rates in France (currently at almost 12 per cent) to subside substantially. If this works, then all well and good. If, however, it does not, then a new initiative will quite quickly be needed to get interest rates down. With a presidential election looming in two years, no one on the right has any desire to take political ownership of prolonged recession. So if interest rates do remain sticky, as I fully expect them to, the new government will launch a concerted drive to persuade the Germans to speed up the process of monetary union.

What precisely would this involve? Ideally, the French might like to go the whole hog immediately, and introduce a genuine single currency in Germany and France this year. But on serious consideration this turns out to be wholly impractical. It would involve a time-consuming and hugely contentious constitutional change in Germany, and it surely could not be implemented in France without a referendum. Furthermore, it would take the two countries entirely outside the Maastricht process, leaving the rest of the Community in the lurch. No one appears ready to cross this formidable series of barriers.

HIGHLY COMPETITIVE

A lesser, but more workable, alternative would be to announce that the franc/mark exchange rate would henceforward be permanently fixed at a specific level, say 3.40. This would have a reasonable chance of sticking in the market place. It is close to the average rate at which the currency has been trading in recent months and, as the graph shows, it would leave the franc highly competitive against the mark.

This would probably be an advantage, since it would reduce the chances of speculation against the franc, which the market would no doubt still see as potentially the weaker of the twin sisters. A problem for both countries would be that the new double-currency would remain markedly uncompetitive against the US and Japan (not to mention the UK). But this would not be a new problem, and it could be solved by a subsequent strengthening in the dollar and the yen.

Furthermore, there would be no analytical reason to focus on the uncompetitiveness of the franc under such circumstances; indeed, the focus should really be on the mark, which would be much the more uncompetitive of the twin sisters.

All this could, in theory at least, be implemented without constitutional changes in the framework of central banking in either country.

Furthermore, since it would simply involve a bilateral agreement between two central banks (or a multilateral agreement between several central banks), it would not necessarily scupper the Maastricht treaty. Indeed, it would almost certainly be described as a temporary step on the way to a single European currency in 1997 or earlier.

In order to guarantee that this arrangement would work, the Bundesbank and the Bank of France would need to give an open-ended commitment to buy and sell the currency of the other country at this fixed rate forever.

Some economists have argued that this would be no different from the arrangements in operation in the ERM - or, indeed, those in the Bretton Woods system up to 1971. But there would be two crucial differences, making this an entirely new departure.

First, there would be no 'fluctuation bands' for the franc/mark rate, so there would be no uncertainty whatever about the exchange rate for as long as the bilateral agreeement was in place. This would encourage the interchangeable use of the two currencies in both countries (though the niceties of legal tender laws would still stand in the way of perfect substitutability).

STRICT LIMITS

Second, the nature of the commitment given by both central banks to underwrite the deal would be entirely new. Under all previous fixed exchange rate systems, there have been strict limits, in time and quantity, on the amount of intervention any central bank is forced to make in support of another currency. This essentially means that the markets have known that such agreements can always be blown apart if there is enough private sector selling of a weakening currency. Therefore, such systems have lacked ultimate credibility.

If, tucked away in any new Franco-German agreement, there are limits on the amount of intervention the Bundesbank would be forced to undertake in support of a weakening franc, the same would apply again. But if there were no such limits, the system would carry great credibility. Imagine what would happen if the private sector started to sell francs in these circumstances. The Bundesbank would simply buy them in exchange for marks, and would not sterilise the effects of its actions in the domestic money markets.

The supply of marks would therefore increase while the supply of francs would shrink, leading to a fall in German interest rates relative to those in France. Provided that the entire system remained politically credible, the private sector would soon start to buy francs because of the interest rate advantage over marks.

Technically, there is no reason why such an agreement should not succeed. The two central banks would need to work in concert to set the level of interest rates in the entire currency area.

Reserve asset ratios, and monetary targets, would need to be the same in the two countries. And, to prevent long-term problems from developing, there would have to be convergence in fiscal policy as well.

It is easy to see why the French might prefer such a development to the complete break-up of the ERM. But what about the Germans? The Bundesbank has already made it clear that it would consider the loss of its monetary sovereignty under such a deal to be an unacceptable price to pay for saving the ERM, and it can be expected to remain implacably opposed to a currency fix of this sort.

But Chancellor Helmut Kohl has overruled the Bundesbank before. If - and only if - he is ready to do so again, then this deal could fly.

(Graph omitted)

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