Rebuilding currency relationships

The idea, suggested here some months ago, that sterling might eventually climb back to its old European exchange rate mechanism range of DM2.95 seems a little less absurd now than it did then. Sterling is enjoying a rerating on the exchanges while the mark is at last responding forcibly to the weakness in the German economy.

Of course there is a long way to go: at DM2.54 yesterday, it was at the highest level since the immediate aftermath of Black Wednesday, but the rerating at present being talked about on the exchanges stops way short of the DM2.90 region.

All this says is that the exchanges are as prone to fashions as any other market, and that once the collective nervous breakdown associated with the dismemberment of most of the ERM was past, the economic fundamentals would reassert themselves. On purchasing power parity, sterling ought to be about DM2.80, and it will eventually go there - but it will probably also overshoot.

What happens to the ERM (and former ERM) currencies has great political implications for Europe, for obvious reasons. But it is something of a sideshow to the bigger issue of world currency stabilisation: the relationship between the dollar, the yen and the European currencies.

Everyone is talking about the ERM: what a mess it is in, does this mean Maastricht is truly dead, how might a revised ERM work, and so on. But the bigger issue is the future development of the world floating rate system, and in particular the question of when we will return to a more managed float.

The formal position is that the Louvre Accord is still in place. The Group of Seven governments still operate under a general understanding that they will not allow wild swings on the exchanges, and that currencies should reflect economic fundamentals. But the key operative part of the Louvre Accord - that the dollar, the yen and the mark should be held in unpublished bands - has fallen into disuse. The bands may still exist in the bottom drawer of the central banks' filing cabinets, but such intervention as takes place is on an ad hoc basis.

The reason these bands are no longer observed is that the various finance ministers and central bankers cannot agree what they should be. The perceived identity of interest that led first to the Plaza Agreement and then to Louvre no longer exists. In particular, there is little common ground between the US and Japan on the crucial dollar/yen rate. It is worth just sketching the two positions, for these may well change.

Seen from the US, Japan's predatory trade practices require that the yen should rise further against the dollar: the Japanese should permit more imports and abandon overly aggressive exporting, thereby eliminating their current account surplus. If they fail, they will just have to put up with a higher and higher yen until they price their exports out of world markets. If that means a collapse of the Japanese economy, that's their tough luck.

Seen from Japan's perspective, this is wholly unreasonable. Except in one or two special cases such as rice, Japan has an open door policy on imports. It does not import as much as it exports because its consumers do not want to buy foreign goods. Where foreign goods are of the highest quality, Japanese consumers buy: the crown prince uses a Rolls-Royce.

These two positions cannot be reconciled. But the Japanese position may be about to change. Behind Japan's current account surpluses has been a sense of insecurity. The old guard of the LDP, who have run Japan since the 1950s, had their early years shaped by post-war austerity. They have felt that Japan has to be a successful exporter because it is so vulnerable: without imported food and fuel Japan would starve and freeze. Even the export success is vulnerable, for it has been built on a narrow range of products. The recent surpluses are may seem large, but they could be quickly reversed.

But Japanese politics are changing. The conventional wisdom is that the next government will be weak. Either it will be a much-weakened LDP, or more probably a weak coalition of opposition parties. That judgement ignores the fact that a new generation of politicans will be in much more powerful positions, whoever forms the government: that the generational change is more important than the party change, if it takes place.

This younger generation no longer see Japan as fundamentally weak. They may well recognise that it is not in Japan's longer-term interest to run up huge external surpluses, which go into US securities or office property, which promptly becomes worth much less than the price paid.

They may also recognise that it is not in Japan's long-term self-interest to antagonise the most important market for its exports and the guarantor of its external security.

There will be no change at next week's economic summit in Tokyo, but once a new government is installed there may once again be a coincidence of interest between Japan and the US: it may actually suit Japan to find ways of cutting its trade surplus. Once that is accepted, it begins to become possible to rebuild the Louvre Accord.

Meanwhile the rise of the dollar against the mark will put the dollar back into a reasonable relationship with the European currencies. Six or nine months from now the three currency blocs could be back into a reasonable relationship with each other. If the currencies are deemed to be in the right range, it becomes much easier to agree to hold them there.

If this were to happen it would be a really important step forward. Big swings in currencies may be good for George Soros, but they do weaken the glue that holds the world's liberal trading system together. In a dangerous world, that is very bad news indeed.