Lira pulls down pound: Italian state of emergency and fears of Maastricht failure send shivers through financial markets

TURMOIL on the financial markets yesterday forced Italy's government to demand emergency economic powers and brought the pound to its lowest level in the European exchange rate mechanism (ERM) since its entry.

The measures to defend the lira marked the latest crisis to afflict Europe's currencies as investors and politicians take fright at the costs of German unification and the possible failure of the Maastricht treaty.

With investors piling in to sell the lira, the Italian government yesterday said it wanted emergency powers for three years to fight the crisis. 'We feel the measures adopted today are sufficient to calm (market) operators who were worried about the stability of the lira due to internal problems,' said Giuliano Amato, the Prime Minister.

The proposed powers would allow the government to act immediately on state spending, borrowing or tax regulations in order to tackle the fiscal deficit, running at more than 10 per cent of economic output. The government has already been forced to push interest rates up to 15 per cent.

The pound, just behind the lira as the main target for the financial markets, closed only a fraction above its permitted floor in the ERM in London last night. Yesterday a rumour that the German central bank wanted a realignment, with the pound devalued - hotly denied by the Bundesbank and the Treasury - led to fresh pressure. At one stage the pound traded at DM2.7812, its weakest since joining the system in 1990.

Countries with currencies fixed to those within the European Monetary System but are not full members are taking the full force of speculative selling. Sweden was forced to raise its key interest rate to 75 per cent yesterday, its government and central bank saying they were determined not to devalue. On Tuesday, Finland decided it could no longer bear the pressure of capital outflows and let its currency float.

Germany is at the root of the European problem. It is facing serious economic and political problems, as the wealthy west Germans digest the costs of unification, impoverished east Germans face unemployment, and racist thugs mount attacks on asylum-seekers. The weakness of the US economy and the dollar and the large gap between low US and high German interest rates, has undermined all other currencies.

Yesterday Helmut Kohl, the German Chancellor, lashed out at his critics, saying of his decade as Chancellor: 'They were 10 years, and especially the last two years, in which we were able to achieve a lot, didn't achieve some things, in which we did a lot right and some things wrong.' There have been rumours that his Christian Democrat party was ganging up on him, and preparing for a pact with the opposition.

But Mr Kohl failed to address the issue of how Germany will finance the costs of unification. He said only that the west must transfer DM150bn a year to the east 'for a long time' and added that: 'With the current levels of financial support for East Germany, I think we have finally reached the end of our economic possibilities.'

DIW, an influential German research institute, said that tax rises were unavoidable. 'If one looks beyond the short term, the government will ultimately hardly be able to avoid further increases in taxes and duties,' it added.

Fears that the Maastricht treaty will not be ratified have only added to the pressure. The latest French poll shows support for the agreement on European economic and political union has dropped to 51 per cent of decided voters, placing the possibility of defeat within the pollsters' margin of error. Pierre Beregovoy, France's Prime Minister, yesterday made an economic argument for the treaty. 'The recovery is economic but also psychological. A 'Yes' to Maastricht will reassure companies and give them an incentive to go forward,' he told a newspaper.

However, under the terms of the agreement on economic and monetary union, all participating countries would have to stick to tough targets for government borrowing and inflation. With financial markets fearing that these targets would not be kept to if the treaty failed, Italy's move was intended to provide reassurance.

But the markets also fear the longer-term effect of Maastricht's failure may be to weaken European unity, as nationalism mounts and states disintegrate under the pressure.