This week has been billed as 'make or break' for the exchange rate mechanism. If the French franc is devalued against the German mark, the argument runs, the ERM is finished. If, on the other hand, thanks to a cut in German interest rates, the franc-DM relationship is maintained, the ERM is saved.
It is always attractive to see things in these stark terms, and of course on a six-month view it matters a great deal whether the franc-DM rate holds or not. (It also matters to British holidaymakers in France. They would be well advised to put as many bills as possible on their credit cards, for there is always a chance that the franc might be devalued before the bill reaches their account and is converted into sterling.)
But when the history of the ERM is written 10 years from now this week will rank no more than a paragraph. The ERM has already changed irrevocably over the past year and will continue to change in the next whatever happens this week. Because everyone has focused on the battle to 'save' the franc the scale of this change has received relatively little attention.
In the space of a few months the European currency zone has gone back to the levels of disorder that ruled in the early 1980s. A core of currencies, representing substantially less than half of Western Europe's GDP, are still operating nominally with the ERM as a discipline but actually as part of the DM bloc.
For the moment the franc is within that bloc, but French membership does not make the bloc 'European', or even Franco-German. The mark is still the dominant currency. If it were not the Bundesbank's decision on the scale of the cut in German interest rates would not be so crucial to the franc.
Meanwhile, the whole of the rest of Europe, whether formally still in the ERM or not, is in practice floating. Not only sterling and the lira are doing so.
Consider the peseta. Formally it is still part of the ERM, but in practice it is floating, because every time there is a determined speculative attack it finds itself devalued. At some stage in the months ahead there is no reason why a speculative attack in the other direction will not cause it to be revalued, if that is what the markets deem necessary.
For such currencies membership of the ERM may have some influence on the timing of exchange rate adjustments, but that is all.
Reduced to its simplest, then, the ERM is now explicitly a German currency bloc, run by the Bundesbank, and the rest of Europe is running a floating rate system. The experiment of the late 1980s and early 1990s of using the ERM to glue currencies together has failed.
Yet the need to give some discipline to European exchange rates should hardly be in dispute. It is not just that markets make mistakes, pushing currencies hither and thither in response to little more than fashion. Given the integration of the Western European economy, there is a powerful case for trying to insert a little glue into the system.
This happened quite successfully for world currencies for four years after the Louvre accord in 1987, which established target zones for the dollar, yen and DM. It is difficult to hold together the currencies of such diverse economies as Japan, the US and Germany. It should be rather easier for the integrated economies of Western Europe.
And that is the way the development of the ERM will go in the coming months. At the end of the year, under the Maastricht treaty, Europe will set up a new European Monetary Institute, the purpose of which is to prepare the way for a European central banking system.
If the battle to 'save' the franc is lost this week, the EC central bank governors can press ahead with the creation of the institute but give it the explicit task of drawing up revised rules for a new-style ERM.
If, on the other hand, the franc is 'saved' and the tensions continue, as they will, the job of the institute will be more difficult. It will have to manage a dual role - giving order to a rump ERM that will be repeatedly attacked by the markets, and setting up a system to reduce the scale of the fluctuations of the other Western European currencies. But in the end the second function will be the more important, for it affects a larger economic area.
If the European Monetary Institute does its job well it will lead not so much to a common European currency but to a Europe where it does not really matter whether there is a common currency or not. If it is to be a success, the institute will have to encourage common financial policies - low public sector deficits, low inflation - and, if it succeeds there, the various European countries will achieve low interest rates and their currencies will have much greater stability than they have today.
Ten years from now the break-up of the ERM, which took place over a 12- or 18-month period starting in September 1992, will be seen as a prelude to the new set of common rules for managing European currencies that will be established in the second half of the 1990s. If the DM-franc rate is broken this week, Europe can make a slightly earlier start on those rules.Reuse content