How the ERM disaster turned into a triumph

BLACK WEDNESDAY. Or maybe White Wednesday. In political terms it was certainly a disaster, for there is no debate about the damage that sterling expulsion from the ERM in 1992 did to the reputation of the Tories for economic competence. But in economic terms it proved to be a triumph, for two reasons.

First, it allowed a sharp - though as it turned out, temporary - fall in sterling that gave a direct boost to the economy without generating any significant inflation. And second, leaving the ERM forced the Treasury to find a new framework for maintaining fiscal and monetary stability. That framework, modified by giving the Bank of England the power to set short-term interest rates, has been the basis for the subsequent long boom.

We know all that now. But there are still huge questions about the whole experience, and depending on the answer to those questions, different lessons for the future. Two main questions stand out.

One is, what matters more: exchange rates or interest rates? The conventional wisdom of the time was, and probably still is, that sterling entered the ERM at too high a rate and that became the root of the problem. Interest rates had to be increased to protect the pound and these made the early Nineties recession deeper than it otherwise would have been.

There is a counter view, however, which runs like this. The problem was not too high an exchange rate but too high interest rates - too high even before they had to be increased to protect the pound. The most convincing reason for buying this view is that by 1997 sterling rebounded back to an even higher level than it was when it was in the ERM (see first graph). Yet growth continued without any unacceptable deterioration in the current account. The current account did move from being in rough balance in 1997 to a deficit of about 2 per cent of GDP, but it has not deteriorated further since then (next graph). Further minor corroboration comes from the earlier years. As you can see, the deficit had already narrowed by 1992 from 5 per cent of GDP at the end of the Eighties. So the ERM level was consistent with a narrowing of the deficit, not a widening.

By contrast, interest rates in double digits were clearly wrong. The UK is particularly sensitive to changes in short-term interest rates because most mortgages are still linked to short-term interest rates - an even higher proportion was linked in the early Nineties European interest rates had to be set high enough to cope with the German boom that followed reunification. But the UK needed rates that were low enough to help it out of recession, for the bottom of the UK economic cycle was 18 months ahead of the German one.

The result of too-high rates in the UK was a slump in house prices, a squeeze on personal disposable income and a cut in domestic consumption. You can see the sudden decline in interest rates in 1992 in the next graph, together with the fact that the markets consistently expected higher interest rates than they actually got. (The little stubby lines show what the markets expected to happen to rates at the start of each year: they are consistently higher than the out-turn.)

So under the new framework - and under Tories and Labour - the country got not only low interest rates but lower ones than it expected. How so? Well, the final graph shows the surge in growth that started in 1993, growth that has been maintained right through to now, together with low inflation as measured by the consumer price index. Key point: there was no surge in inflation from 1993 onwards despite the fall in the pound. Low inflation validated low interest rates.

That leads to the second big question: why did inflation remain so low? There are three answers here. One is to say that the fall in inflation was part of a worldwide shift and we were just part of it. A second is to say that initially rapid growth took place against a background of some distress - negative equity squeezing individuals, a gradual rise in demand helping companies but against a background of earlier pain. By the time companies had experienced three or four years of solid demand, sterling rose and put a squeeze on their exports. As a result workers were in no mood to bid up their wages, nor companies their prices. And the third? Well, it would be to say that the new monetary framework did indeed work.

There is truth in all of these, of course, but my instinct would be that the first two have been more important than the final one. That is not to denigrate the idea of inflation targets, nor the work of the Bank of England's Monetary Policy Committee. I just suspect that for reasons that are still not fully understood, inflation at a consumer level stopped being a global issue during the Nineties.

If the answers to these two questions are more or less right, there are some pretty important implications for the future. One would be that the tensions in the eurozone are less the result of countries going in at the wrong level but having to put up with the one-size-fits-all interest rate. For Germany that is both encouraging and discouraging. It is encouraging in that German companies will be able to prosper despite the mark's euro entry level, which many people now think was too high. It is discouraging because the country is liable to have too high interest rates for a considerable period.

Another would be that exchange rates are in general less important than they used to be. Thus a further fall in the dollar would not do much to help correct the current account deficit but it also would not do as much damage to US inflation as many people fear. Further, the UK seems to be managing all right with its present high rate against the dollar.

On the other hand, it suggest that getting interest rates right does matter enormously. That leads to a question about US policy of holding short-term rates below inflation for more than three years. Only now are real rates becoming positive again. That has not had much cost in terms of higher domestic inflation. But it has created a global asset boom in property and some securities, the long-term costs of which are still to show through.

The good news is that, since the authorities can control interest rates and cannot control exchange rates, it is very helpful in that interest rates matter more. The bad news is that if they get interest rates wrong, they can do a lot of damage.

PROMOTED VIDEO
Arts and Entertainment
Standing the test of time: Michael J Fox and Christopher Lloyd in 'Back to the Future'
filmReview: A week late, Secret Cinema arrives as interactive screening goes Back to the Future
Travel
travel
Arts and Entertainment
Sydney and Melbourne are locked in a row over giant milk crates
artCultural relations between Sydney and Melbourne soured by row over milk crate art instillation
Arts and Entertainment
Adèle Exarchopoulos and Léa Seydoux play teeneage lovers in the French erotic drama 'Blue Is The Warmest Colour' - The survey found four times as many women admitting to same-sex experiences than 20 years ago
filmBlue Is The Warmest Colour, Bojack Horseman and Hobbit on the way
Arts and Entertainment
Preparations begin for Edinburgh Festival 2014
Edinburgh festivalAll the best shows to see at Edinburgh this year
News
Two giraffes pictured on Garsfontein Road, Centurion, South Africa.
i100
News
ebookA unique anthology of reporting and analysis of a crucial period of history
News
Kenny Ireland, pictured in 2010.
peopleBenidorm, actor was just 68
Environment
View from the Llanberis Track to the mountain lake Llyn
Du’r Arddu
environmentA large chunk of Mount Snowdon, in north Wales, is up for sale
News
i100
Arts and Entertainment
arts + ents
News
Morrissey pictured in 2013
people
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Regulatory Reporting-MI-Bank-Cardiff-£300/day

£200 - £500 per day + competitive: Orgtel: I am currently working on a large p...

Trainee Recruitment Consultant - Birmingham - Real Staffing

£18000 - £23000 per annum + Commission: SThree: Real Staffing are currently lo...

Training Programme Manager (Learning and Development)-London

£28000 - £32000 per annum + benefits: Ashdown Group: Training Programme Manage...

1st Line Support Technician / Application Support

£20000 - £24000 per annum: Harrington Starr: A leading provider of web based m...

Day In a Page

Dress the Gaza situation up all you like, but the truth hurts

Robert Fisk on Gaza conflict

Dress the situation up all you like, but the truth hurts
Save the tiger: Tiger, tiger burning less brightly as numbers plummet

Tiger, tiger burning less brightly

When William Blake wrote his famous poem there were probably more than 100,000 tigers in the wild. These days they probably number around 3,200
5 News's Andy Bell retraces his grandfather's steps on the First World War battlefields

In grandfather's footsteps

5 News's political editor Andy Bell only knows his grandfather from the compelling diary he kept during WWI. But when he returned to the killing fields where Edwin Vaughan suffered so much, his ancestor came to life
Lifestyle guru Martha Stewart reveals she has flying robot ... to take photos of her farm

Martha Stewart has flying robot

The lifestyle guru used the drone to get a bird's eye view her 153-acre farm in Bedford, New York
Former Labour minister Meg Hillier has demanded 'pootling lanes' for women cyclists

Do women cyclists need 'pootling lanes'?

Simon Usborne (who's more of a hurtler) explains why winning the space race is key to happy riding
A tale of two presidents: George W Bush downs his paintbrush to pen father’s life story

A tale of two presidents

George W Bush downs his paintbrush to pen father’s life story
Restaurateur Mitch Tonks has given the Great Western Pullman dining car a makeover

The dining car makes a comeback

Restaurateur Mitch Tonks has given the Great Western Pullman dining car a makeover
Gallery rage: How are institutions tackling the discomfort of overcrowding this summer?

Gallery rage

How are institutions tackling the discomfort of overcrowding this summer?
Louis van Gaal has £500,000 video surveillance system installed to monitor Manchester United players

Eye on the prize

Louis van Gaal has £500,000 video surveillance system installed to monitor Manchester United players
Women's rugby: Tamara Taylor adds fuel to the ire in quest to land World Cup

Women's rugby

Tamara Taylor adds fuel to the ire in quest to land World Cup
Save the tiger: The day America’s love of backyard tigers led to a horrific bloodbath

The day America’s love of backyard tigers led to a horrific bloodbath

With only six per cent of the US population of these amazing big cats held in zoos, the Zanesville incident in 2011 was inevitable
Samuel Beckett's biographer reveals secrets of the writer's time as a French Resistance spy

How Samuel Beckett became a French Resistance spy

As this year's Samuel Beckett festival opens in Enniskillen, James Knowlson, recalls how the Irish writer risked his life for liberty and narrowly escaped capture by the Gestapo
We will remember them: relatives still honour those who fought in the Great War

We will remember them

Relatives still honour those who fought in the Great War
Star Wars Episode VII is being shot on film - and now Kodak is launching a last-ditch bid to keep celluloid alive

Kodak's last-ditch bid to keep celluloid alive

Director J J Abrams and a few digital refuseniks shoot movies on film. Simon Usborne wonders what the fuss is about
Once stilted and melodramatic, Hollywood is giving acting in video games a makeover

Acting in video games gets a makeover

David Crookes meets two of the genre's most popular voices