Economics: Germans to the rescue of sterling

Click to follow
THIS has been a most important week for Britain's economic policy. The Chancellor and the Prime Minister will not have enjoyed the experience of the first few days, when they discovered the hard way exactly how far they were able to cut interest rates below German levels before they precipitated a free fall in sterling. The last interest rate cut, the panicky manner of which implied still more cuts to come, was too far.

By the end of the week, they had been saved from the consequences of their own confusion by a lucky accident. The Bundesbank, quite contrary to its previous protestations, cut its interest rates. The cut was a tiny quarter percentage point on the discount rate - the official rate that sets a floor to money market rates and therefore is the key rate when monetary policy is easing. But it stopped the plunge in sterling.

It also relieved, at least temporarily, the pressures on what remains of the exchange rate mechanism. The Danish krone bounced back, and the French franc looked stronger. But it would be a brave person who would bet that the franc will survive at its present parity until the election, let alone after it.

In Britain, the cut put the Bundesbank back on the front pages. Despite the claims of those who thought that our exit from the exchange rate mechanism unshackled us entirely from German interest rates, much still depends on Bundesbank policy. The quicker the Buba council cuts rates, the safer it will be for the Chancellor to deliver another British interest rate cut.

The drop in the pound between our interest rate cut and the German one was 4.4 per cent on the trade- weighted index, which is some going for a mere eight trading days. Even with a 1 per cent rebound on Thursday and Friday, the total devaluation since sterling's ejection from the ERM is 14 1/2 per cent. This is raising import prices and will raise other UK prices. But the depth of the recession and the debt burdens of British people and companies mean that the once-off rise in the price level will not necessarily lead to a permanent rise in the inflation rate.

The key factor is wage bargains, and the news is still good. The CBI says that average manufacturing settlements were 2.8 per cent in the final quarter of last year. There is therefore a fair chance that the gains in competitiveness brought about by the fall in sterling will be maintained. In short, the devaluation could be a real devaluation (after allowing for offsetting inflation).

But there are limits. Our balance of payments problems may mean that a further gain in price competitiveness - whether through a fall in sterling or slower inflation than our trading rivals - is eventually necessary. But it would be tempting fate to allow sterling to fall sharply again now. There are limits to the capacity of any economy to adapt to changes. A sharp further fall in the pound could reignite inflation and prove counter-productive.

The key is that the markets should not believe that the Government is so scared about the continuing slump that it is prepared to run risks with inflation. Last week's problem was that the Sunday Times story (suggesting that the Prime Minister had assumed personal control over economic policy) implied that caution was being thrown to the winds.

This debacle does not rule out another interest rate cut, but it means that the Government has to tread warily. The best course, although a politically unpalatable one, would be for the Chancellor to say clearly that Britain's interest rate cuts are an advance payment on German ones, and that he anticipates they will rise once again when the recovery is under way. He needs to show awareness that the differential between British and German interest rates matters.

Mr Lamont also needs to sing this ditty not just solo in his bath, but backed by a harmonious chorus of both the Prime Minister and the Governor of the Bank of England. The markets can sniff out division and weakness, and there were many City people last week who smelt a stench coming from Whitehall.

If the Bundesbank eases again soon, Mr Lamont's difficulties will be eased. It is possible that there will be another cut before the French elections, not least because the public sector unions agreed a low and pace-setting 3 per cent wage deal just after the Buba rate cut.

But the odds are that the Buba will continue to dispense rate cuts grudgingly and in penny packets. The Bundesbank president Helmut Schlesinger is stubborn, insensitive, dogmatic and blinkered in the pursuit of low inflation. This is what he is paid for. Mr Schlesinger also hates criticism for being too lax, yet German commentators rightly pointed out on Friday that inflation has hit a new high of 4.4 per cent and money supply is overshooting strongly.

The plunge in the pound may have made British ministers more wary about interest rate cuts, but it may also have strengthened the hand of those in the Bank and the Treasury arguing for a Budget rise in taxes. It would nevertheless be a grave mistake to tighten fiscal policy before the recovery is clearly under way, a view reinforced by arguments in the latest circular from Christopher Dow, the former economics director at the Bank of England.

I recently reread Mr Dow's commentaries (from Leopold Joseph & Sons) and concluded that no one else had so consistently judged this recession correctly. Most monetarists failed to spot the recession coming, and most Keynesians expected a recovery too soon. I regret to report that Mr Dow is now even gloomier than I have been recently.

He argues that the burden of debt on companies and people is so unprecedentedly high and so intractable that it 'seems capable at least of holding back any spontaneous revival for years'. With our European markets turning down, he does not rule out renewed recession.

The Chancellor should particularly take to heart Mr Dow's conclusion on fiscal policy: 'Anyone with the job of financing a huge deficit must lie awake wondering just how it can possibly be done. But the historical fact is that there have been deficits relatively much larger still which each year - when the end of the year comes - are seen to have been financed. It is a necessary identity that if one person or sector is spending more than his or its income, there is another spending less.

'It is therefore not impossible for the first to borrow from the second, either directly or through intermediaries. Indeed, if that does not happen, the deficits and surpluses cannot happen as planned . . .

'A government that cuts spending or raises taxes in a recession makes the recession worse. Philip Snowden in 1930 has been reviled by history ever since for doing that, thus further deepening the deepest recession in history. Tragically, that folly seems now about to be repeated.' I hope that Mr Dow is wrong for once.

A Budget that allows borrowing to rise may imply higher long-term interest rates, but it would emphatically not be inflationary. Indeed, a rise in taxes could be inflationary in two ways. Indirect tax increases would put up retail prices, and any tax rise might also force the currency markets to conclude that interest rates would have to be lower to get the recovery going. A tighter fiscal policy now - before the recovery is clearly under way - could push down the pound.