Sterling surely cannot be held within its ERM bands if Britain cuts interest rates substantially, especially if Germany's go up. How is this circle to be squared? Neil Kinnock, in a letter to the Financial Times last week, suggested that the Government should be lobbying hard for an upward revaluation of the mark against all other ERM currencies. That, he argued, would enable the UK to reduce its interest rates without the taint of unilateral devaluation. There has been mounting speculation that the strain of high German interest rates on a stagnant European economy would force the first general realignment of currencies since 1987.
In my view, this escape route is a mirage. The general realignment is most unlikely to happen. The key is France. The current French government and particularly the prime minister, Pierre Beregovoy, are closely identified with a 'franc fort' policy. They have set their faces against the franc depreciating vis-a-vis the mark. Two other countries, the Netherlands and Belgium, already peg their currencies more closely to the mark than required by ERM rules. If the mark realigns against the ecu but the Netherlands, Belgium and France all follow, the system will be dividing into two tiers, the sheep and the goats, the saved and the damned. Countries such as Denmark and Ireland would decide they had better be with the sheep and hey presto, the German revaluation becomes patently a devaluation of just a few ERM currencies. The Government would want Britain to be one of the sheep too.
Only if the French agreed to let the mark revalue against them might revaluation succeed. So those hoping for or expecting a realignment pin their hopes on two events: the French referendum on the Maastricht treaty on 20 September; and the French Parliamentary elections, currently scheduled for March 1993.
If the French vote against Maastricht, progress to European monetary union will receive a severe, probably fatal, check. There would be considerable political uncertainty in France. Early elections would be probable and President Mitterand might go. The most likely outcome would be a right-wing coalition government, despite its massive split over the Maastricht treaty and European policy. Unemployment in France has just reached 10 per cent and growth, while positive, is below trend. So many believe the new government would accept realignment. It would not be as associated with the 'franc fort' as Mr Beregovoy.
A 'no' vote does not look likely at present. Party loyalties suggest that 60 per cent of the French electorate should be in favour of the Maastricht treaty. Even so, the French government could lose office at the subsequent elections. What chance a realignment in any case, then?
In one word, lousy. The French establishment does not want to emulate Germany, it wants to be Germany, the cornerstone European economy. They believe they have tried the devaluation option - three times under Mitterand in the early 1980s - and that it did not stop unemployment rising. Their current 'franc fort' policy has had much success after some difficult years. Inflation is down 3 per cent and has been below the German rate for a couple of years - France is gaining in competitiveness, even at a fixed exchange rate. Now the French trade balance has moved into trade surplus, with exports gaining market share. The hope is that the gain in competitiveness will slowly but surely be reflected in a fall of unemployment.
Against that, the attractions of devaluation look feeble. No one has explained how devaluing within a fixed exchange rate system actually reduces interest rates. A commitment to a new, albeit lower, parity means that interest rates have to remain close to their German counterparts. Only a floating exchange rate permits interest rates to diverge substantially, and the French will certainly not abandon the ERM.
Some argue that if the mark were allowed to appreciate inflationary pressures in Germany would be reduced and the Germans could reduce interest rates. But German inflation is heading down now, and it is unclear how much faster it would decline given a moderate revaluation of the mark.
There is, finally, a substantial difference at present between France and most other European countries that makes it much less prone to the temptations of devaluation. The French are currently not in breach of the Maastricht conditions for a monetary union. In particular, their budget deficit is below the target of 3 per cent of GDP, despite the growth recession they have been experiencing. None of the other large countries can say as much (see charts). There is no particular pressure on the French to tighten fiscal policy by cutting government spending. Whereas the UK, with a deficit of over 4 per cent of GDP, the Italians, and the Germans themselves, will be tightening fiscal policy, putting a further brake on the growth of demand and output, the French need not. That is one reason why most forecasters expect France to top the European growth league in 1992 and 1993.
Why, you may ask, when the ERM is already condemning them to too-tight monetary policy, do countries want to compound their problems by tightening fiscal policy too? It is a very good question that highlights one of the flaws of the Maastricht treaty - its attempt to design a monetary union without reforming fiscal responsibilities.
Be that as it may, the relative position of a right-wing French government (assuming there is one after the election) would be even stronger. Whereas the current Socialist government has a modest privatisation programme, the right would sell off some FFr300bn ( pounds 31bn) of state assets over the next few years. French Privatizations, a study by colleagues of mine at Lehman Brothers shows this is quite possible without touching any of the major state utilities such as power or the railways.
That sell-off would transform the French budgetary situation, just as Nigel Lawson's did in the UK in the 1980s. The French government could actually expand fiscal policy to tackle unemployment and still show smaller budget deficits. The situation is clear. The Socialists won't realign and the right won't need to.
Britain is faced with slogging down the same road that the French followed for nine difficult years. Either that or quitting on our own. France will not provide a figleaf.
Gerald Holtham is an executive director of Lehman Brothers International and Economics Fellow of Magdalen College, Oxford
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