The ERM Crisis: Doomed by arrogance and complacency

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The Independent Online
THE EUROPEAN exchange rate mechanism, at least in its present form, is doomed. On past form, the people who will get the blame for its demise will be, first, the evil foreign exchange speculators and, second, the backwoodsmen of the Bundesbank council who vetoed the expected cut in Germany's key discount rate on Thursday. Both helped to deliver the coup de grace, but both were also playing no more than their appointed roles - the purpose of markets is to seek profit and the purpose of the Bundesbank is to put the conquest of inflation in Germany above all else.

The real culprits are Europe's political elite, who are guilty of arrogance, complacency and cowardice, in that order.

Their arrogance dictated that the ERM be converted from a perfectly viable system of fixed but adjustable exchange rates into what was, for all practical purposes, a fatally flawed, fully fixed rate system - the glidepath into European monetary union.

It is just possible that the gamble might have worked had it not been for German unification and the utterly complacent reaction to that great historic event.

Predictably, the costs of unification delivered a severe and continuing shock to the system's anchor currency. In economics, as in the physical world, some flexibility is required to absorb shocks.

The way for the ERM to absorb the shock of unification was to permit the mark to revalue against the other member countries. The French refused to countenance anything which would weaken the precious franc-mark link. Thus the die was cast in the form of an unnecessarily savage European recession and the slow collapse of the ERM as successive member currencies were picked off.

What we are now witnessing, as the ERM finally succumbs to its own contradictions, is the ultimate cowardice of Europe's leaders. Faced with the disintegration of their grand design for economic and monetary union, still mouthing words of determination and purpose which no longer convey any meaning, they seem incapable of response.

Although the collapse of the old, flawed ERM may be good news for the European economy in the short- term - interest rates should now be able to fall, paving the way for recovery as happened in Britain when the pound was ejected from the system - the longer term consequences, if nothing is done, are potentially


Europe vitally needs a degree of exchange rate stability if its highly integrated economy is to operate efficiently. Given the tendency of unmanaged exchange rates to overshoot wildly, the risks and the transaction costs of doing business within Europe would rise substantially. It is also inconceivable that the single market would survive for long if Europe's currencies embarked upon a spate of competitive devaluations. And without the single market to hold some of the more reluctant of Europe's free traders in line, what price a Gatt deal? Apart from the economic damage which would be the price of failing to resurrect a reformed ERM, the political damage would be incalculable. The two motors of the European Community have been an appreciation of the benefits of deepening economic integration and the enduring strength of the Franco-German relationship. The latter is already under huge strain, but if economic co-operation starts to come apart at the seams, the EC itself could begin to unravel.

Such an outcome is unthinkable. But it will require a degree of common sense and steadfastness if it is to be avoided. What is now needed is a less ambitious and more flexible ERM which restores some stability to Europe's currencies without imposing inappropriate policies on member countries in the name of forcing the pace of economic convergence.

Monetary union is not dead, but it is for another day (or decade). Strangely enough, the country which has some sensible ideas and which now might be listened to is bystander Britain. Whether our embattled Prime Minister is capable of seizing the opportunity is another matter.