The game is not over yet: Gaffes by the US Treasury and the Bundesbank brought Lamont's plan to save sterling within a whisker of failure

THE CHANCELLOR is bloodied but unbowed. He has survived the ultimate test of any finance minister's mettle - the ability to ride out a speculative attack against his currency. But it has been tough. 'The game is not over yet,' one official said.

Mr Lamont's plans had been drawn up in advance, but could not foresee mistakes. Beset by gaffes by the US Treasury Secretary and one of the Bundesbank's senior members, last week's attempt to save the pound without a damaging interest rate rise came a hair's breadth away from failure.

The crisis began in earnest on Friday 21 August. Money flooded out of New York into Frankfurt, pushing up the German mark so strongly that other European currencies floundered. By dusk, dealers found themselves in a full-blown dollar crisis.

Tension had built up all week. The dollar sagged as long-term investors, such as pension funds, moved out of the currency. International banks and professional traders were closely watching their charts. The dollar was edging towards its all-time low of DM1.4430, a crisis point at which a fall could turn into a rout. That morning, the key support level was breached.

The Bank of England watched with alarm. The poor economic outlook and the fear that the mark might break away from the exchange rate mechanism if the French vote against the Maastricht treaty on 20 September unsettled the pound; the market interest rates paid by the banks were beginning to edge up in anticipation that the Chancellor would have to raise rates to keep the pound above its ERM floor of DM2.7780.

In a desperate bid to support the dollar, 18 central banks decided that they had to intervene near the new low or the markets would believe that they no longer cared about the US unit. The central banks spent more than dollars 1.5bn, and failed completely.

To the intense irritation of the Bank of England and several other European central banks, which had been enthusiastic for dollar support as a way of easing the ERM tensions, the US Treasury Secretary, Nicholas Brady, said that there was plenty of room for US interest rates to fall again.

With the markets looking closely at the near 7 per cent gap between US money and German interest rates, Brady touched the dollar's rawest nerve. The effect of the intervention washed out in minutes.

For sterling, the situation was desperate. If intervention did not work there were only two alternatives. One - devaluation within the ERM - had already been ruled out by the Government. The other - a rise in interest rates of at least 1 percentage point - would cause a howl of protest from industry and could devastate business confidence.

Norman Lamont, staying in Lord Wyatt's villa in Tuscany, was kept in touch by the small team of officials at the Treasury. They decided that intervention would hold the line on Monday but Mr Lamont agreed to come home - a day after the Prime Minister to show there was no panic - and reconsider whether interest rates should rise.

When the European markets opened, there were another two waves of heavy central bank support. Again, the intervention proved futile, with sterling rising briefly above dollars 2 and falling further against the German mark. But the Bank of England signalled clearly that it wanted to keep interest rates down - for the moment.

The Chancellor arrived back at the Treasury at 6pm, and immediately went into meetings of the key Treasury advisers still in London - Sir Terence Burns, Permanent Secretary, Nigel Wicks, Andrew Turnbull and Paul Gray. Eddie George, the Bank of England deputy governor, had a long telephone conversation in which he brought Mr Lamont up to date on the day's trading.

That Tuesday morning Mr Lamont had his only face-to- face meeting with the Prime Minister, going next door to Number 10 for a working breakfast at 8am. The occasion, described as a strategy meeting, reaffirmed the direction of government economic policy.

Unfortunately for sterling, however, new polls suggested that the French might reject the Maastricht treaty next month. A new wave of panic hit the market and sterling plunged steeply to within one pfennig of its floor against the mark.

But it was not until a crucial point on Tuesday evening at the Treasury that the decision was taken to make the controversial restatement of policy on the steps on the Treasury.

Mr Lamont decided that the markets needed reassurance from the Chancellor's lips - something denied them because of his holiday. The newspapers and broadcasters were alerted. The Chancellor's minders left little to chance, even polishing the brass plate outside the Treasury. At 8.20, just before the opening of the markets, Mr Lamont appeared for his 'controlled soundbite'.

But when the markets opened, they gave a resounding thumbs down to his remarks because he said nothing new. He would do 'whatever was necessary' to meet our ERM obligations.

The Bank then adopted the unusual tactic of standing openly in the market buying up pounds. It spent almost dollars 1bn of Britain's reserves of foreign currency. The overt intervention, the first of its kind since the IMF crisis in 1976-7, succeeded in hoisting the pound briefly above DM2.800.

It stayed there for less than an hour. The effort at intervention was abruptly undermined by another gaffe, this time from the German authorities. Halfway through the morning an advance copy of a speech by Professor Reimut Jochimsen, a member of the German Bundesbank council, was released saying that a realignment in the ERM was possible.

Foreign exchange dealers interpreted this to mean that sterling might be devalued after all. The pound slumped back below DM2.7900 despite the Bundesbank's denials of possible realignments.

By Thursday, however, the Government's attempt to bluff the markets without raising interest rates appeared to be succeeding. Even though sterling continued to fluctuate close to its ERM floor, interbank interest rates eased back, and were once again consistent with 10 per cent base rates.

The phone lines between the Treasury and European capitals were kept busy, particularly with the Chancellor preparing for this week's informal Ecofin meeting in Bath. On Friday, his consultation with every European finance minister paid off with more support for the pound: a joint statement that ruled out a realignment.

Europe's central bankers were also preparing to throw unprecedented sums at the markets. By activating the 1987 Balse-Nyborg agreement on credit lines, there is now a presumption that the Bundesbank will provide the central banks of weaker currencies with all the German marks they need for intervention. The big guns are being rolled into place.

(Photograph omitted)