Economics: How Europe was undone by fixed rates

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The Independent Online
GREAT events can have small beginnings. On Thursday, in a nondescript modern building in Frankfurt, a group of German bankers effectively killed off not only the ERM but perhaps the Maastricht treaty as well, with Heaven knows what consequences for Europe's future. And all this by not cutting the German discount rate as the market expected. That the franc clung on (just) during Friday did not matter a jot. The Banque de France put up a good a performance as King Canute. But the system's fate had been sealed by the Bundesbank's inaction.

Many will berate the 'speculators' for ending the European dream. In fact, we should thank them for ending the European nightmare. But in reality the speculators are mere agents of change. The system that they have helped to destroy was deeply flawed from the start.

That is not to say that a fixed or semi-fixed exchange rate system never had a role or can never work, at least for a time. Rather, the ERM changed its character markedly over its short life. It began in 1979 with the rather modest aim of reducing uncertainty in currency markets by limiting the size of variation around agreed central parities, but the parities themselves could be changed, and frequently were.

From 1987 until last September, however, there had been no realignments. Two developments brought about this change. First, Europe as a whole, following a worldwide trend, put the conquest of inflation at the top of its economic agenda and chose to pursue this by maintaining a rigid exchange rate link with the most anti-inflationary of its members, Germany. This would be painful and might require tough policies, including high interest rates, but as long as Germany controlled inflation and they maintained the link, their inflation rates would fall sharply.

The second development was political. The view gained ground that Europe should press on to closer union, with monetary union at the leading edge. In a monetary union, the countries of Europe would have no independent monetary policies; there would be only one interest rate and no possibility of exchange rate changes. Accordingly, why use exchange rate changes in the years running up to monetary union? Rather, the intention was to hang on to the existing structure of exchange rates as the forcing house of monetary and economic union. The need to hold that combination of rates would bring economic reality into line across Europe.

In any case, what was the point of exchange rate changes? The European economies were now so integrated that all behaved more or less similarly, and even if they did not, exchange rate depreciation was no answer for the weaker countries because it merely caused higher inflation. This view betrayed both an extraordinary arrogance towards financial markets in general and a misunderstanding of the role of exchange markets in particular.

For exchange rate changes act as a sort of safety valve when two countries are in some way out of kilter. The divergence may be in trading performance or inflation rates or the relative attraction of assets.

Having an exchange rate to take the strain helps in two ways. First, the rate change may itself alter the relative performance between the two areas. Second, it permits interest rates to be different. As asset markets have become more important and capital movements have been liberalised, so this second factor has become of increased importance.

Far from being a period when differential shocks disappeared from Europe, the early 1990s have witnessed one of the greatest shocks since the war - German reunification. This was bound to lead to faster growth and inflationary pressures in Germany, but the German government's decision (if that is what it was) to let its budget deficit balloon to finance it made matters worse. This effectively obliged the independent Bundesbank to raise German interest rates and keep them high. The obvious solution for Europe (including Germany) was to allow the mark to float up and for the Germans to operate higher interest rates than a number of other European countries. But instead, the ERM imposed this same level of rates (plus a margin) on the whole of Europe. It was at precisely this point, of course, that the UK chose to join the system.

What has made the plight of the system worse is that at just the time the Germans were losing their anti-inflationary halo, other countries' inflation performance was starting to improve. The agony has been particularly acute for France. As the first chart shows, French inflation has reached very low levels but French interest rates, though lower than they were, have remained at ludicrously high levels and in the recent crisis money market rates have headed back up to 10 per cent. Borrowers in France now face real rates close to 10 per cent.

What will happen now? On the economic front, there is little doubt. One way or another, European interest rates are set to plunge to very low levels. Either this will happen within the current system because the Germans buckle and cut rates, to be followed by other members of the ERM (perhaps associated with some sort of realignment), or it will happen outside as the system itself collapses. But happen it will.

This will put added pressure on British base rates and they may well fall to 4 per cent, or even lower, by the year end. These are not startling numbers; the US and Japan already have interest rates at this level. As the second chart shows, since Black Wednesday the UK has chosen an intermediate path between high European and low American rates. What Europe (and the world) needs now is a policy of 3-4 per cent interest rates everywhere, sustained for a long period. After recent events, that may be exactly what transpires.

The political fallout is harder to read. It is possible to see the collapse of the ERM as a mere technical difficulty. All the key aspects of the Maastricht treaty could continue as before. But is this likely? The plans for monetary union are built on the foundations of the ERM. Moreover, how will relations stand between Germany and France after the French are forced to abandon their treasured fixed link with the mark?

At a deeper level, the collapse of the ERM will serve as a symbol of the failure of a general approach to economic policy. Pan-European economic policy-making is characterised by price fixing - fixing the price of labour, of butter and of French francs. In every respect this policy is an unmitigated disaster. Can it survive the collapse of the ERM?

For too long now the Euro steamroller has trundled on, apparently oblivious to the wishes of people and the functioning of markets. Politicians have burbled on, increasingly out of touch with reality, as though living on the Planet Zog. They now owe it to the European peoples to save the worthwhile and important objectives - the single market, and economic and political co-operation - from the ruins of the fantasy world of rigidly fixed exchange rates.

Roger Bootle is chief economist of Midland Global Markets.

Christopher Huhne is on holiday