Germany's monetary leadership has been based on the inflation-fighting reputation of the Bundesbank. Investors insisted on a premium over German interest rates if they were to hold other currencies in the system, because of the perceived risk of higher inflation and devaluation. The high German interest rates needed to quell the inflationary impact of reunification were the main problem for Britain's membership of the system. Britain was forced to adopt inappropriately high interest rates that merely helped to deepen the recession.
The new ability of the hard-currency core of the exchange rate mechanism to cut short rates below Germany's - Germany's call money was at 7.35 per cent last night against 7 per cent in France and 6.6 per cent in the Netherlands - is a useful element of flexibility. But it does not necessarily mean that France will inherit the Bundesbank's mantle. The markets believe that German interest rates are heading down, and are prepared to let franc rates anticipate the decline. That process has been made easier by the flight of capital from Frankfurt to New York, which has driven down the mark against its European partners as well as the dollar.
The acid test for Europe's monetary leadership will be what happens as the recovery begins. When France begins to raise interest rates - a while off yet - will the Germans have to raise their rates to maintain the mark against the franc? This would occur only if the markets believed that the franc was likely to prove less inflationary in the long run than the mark.
However, the markets are so far suggesting that any such bouleversement is unlikely. Although France's short-term interest rates are now below German ones, long-term interest rates (implied by yields on bonds with maturities of five years and more) are still higher. The Bundesbank has not lost its reputation yet.