The Sterling Crisis: Fundamental causes lie in world economy

The immediate cause of yesterday's crisis was the remarks made by Helmut Schlesinger, Bundesbank president. By telling the German business paper Handelsblatt that last weekend's realignment was not enough, he suggested that the pound should be devalued too. Even though his office then denied his remarks, the damage was done. The pound plummeted.

But the indiscretions of one person, however powerful, are not enough in themselves to dislodge a system of fixed exchange rates that had been stable for more than five years. The fundamental causes are deeper. One problem was the way in which the German government handled reunification with the east.

By agreeing to subsidise the east Germans at generous levels, the federal government pumped cash into its own economy. As industry proved incapable of supplying the rising demand, prices gradually accelerated. Inflation, which had been as low as 1.3 per cent in 1988, crept upwards to reach 4.8 per cent last March. That is not a lot by British standards, but it is shocking by German ones. The independent Bundesbank is charged with 'safeguarding' the currency and is fiercely proud of its inflation-fighting reputation; interest rates went up and up, peaking this summer at 9.75 per cent in an attempt to rein back growth and control inflation. Because the German mark has never devalued, investors usually prefer to hold it than less solid currencies. So other European countries have to keep their interest rates at least as high as German ones - and usually higher - to induce investors to hold their currencies.

That in itself would not have created such strains within the system had the US economy not been so sluggish. But the United States has stubbornly refused to pick up, causing the Federal Reserve, the US central bank, to cut its interest rates down to just a little over 3 per cent. With an unprecedented gap of nearly 7 percentage points between German and US interest rates, money flooded from New York to Frankfurt. As the Americans bought marks, the mark surged.

The European currencies linked to the mark - not just those in the exchange rate mechanism but satellites like the Swedish krona as well - found it hard to keep up. The difficulty was made all the worse by the prospect of the French referendum on the Maastricht treaty this Sunday. For several years, the markets had come to believe that European exchange rates would remain fixed until a single currency was adopted. With the Danes rejecting a single currency on 2 June, the markets could not be so sure.

The French referendum was designed in part by President Mitterrand to placate these fears and put the single currency back on track, but the closeness of the opinion polls has meant that the Elysee's gamble has gone disastrously wrong. Instead of feeling sure that the European currencies would stay together, the markets increasingly believed that some would fall. It became more and more difficult for the lira and sterling to keep up with the rising mark.

The crisis began in earnest on 21 August when the foreign exchange markets scored their first victory in the war with the politicians. Eighteen central banks tried to prop up the dollar with support-buying - intervention - but failed. The mark continued to be strong.

The markets then picked off the weakest of the currencies linked to the mark - the Italian lira. For two weeks, the Italians threw everything they had at the markets, buying up lire with marks and raising interest rates to stop it falling out of the system. But even purchases of pounds 15bn worth of lire in a fortnight were not enough. By last weekend, the Italian authorities were ready to concede a 7 per cent devaluation in exchange for Germany's quarter percentage point off the key Lombard interest rate.

The financial markets were initially impressed, but soon had second thoughts. The German rate cut was not large, and the German press was highly critical of even such a small concession. Moreover, the first devaluation for five years meant that other currencies could also be devalued; the credibility of the system was suddenly and perhaps fatally weakened.

Sterling was the next candidate for devaluation in the market's eyes. Clearly, Britain's economic and financial position is far stronger than Italy's. Inflation, debt and the budget deficit are all lower. But there are serious chinks in the economy's armour.

The fundamental reason for market scepticism about the pound was that most economic analysis suggests that the old rate was slightly overvalued: if Britain's prices and costs were compared with those overseas at the old ERM rate, we tended to be about 10 per cent higher. Another tell-tale sign of overvaluation was that we are still importing more than we export, even though spending in the shops is so depressed. It is obvious, the City sceptics say, that imports will boom when spending picks up.

In principle, there is no reason why a small overvaluation cannot be cured by making sure that our prices rise less rapidly than those overseas. But that takes time which the markets were not prepared to give the Government. They are also well aware of the criticism within the Conservative Party about current economic policy, and that Britain is near the pain threshold.

High interest rates hurt Britain more than they hurt other European countries because we have much higher debts. Interest payments as a proportion of households' incomes are twice as high as in France, and five times as high as in Germany.

In common with other Anglo-Saxon countries, Britain liberalised the financial system during the Eighties, making it much easing to borrow (and spend) money. The hangover from that debt build-up is the prime reason for our recession, but Germany and Europe's high interest rates have made it no easier to survive.

The markets have been aiming at Britain's Achilles heel. Yesterday, they struck home.

Start your day with The Independent, sign up for daily news emails
Have you tried new the Independent Digital Edition apps?
ebooks
ebooksA special investigation by Andy McSmith
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs General

Ashdown Group: Front-End UI Application Developer

£30000 - £40000 per annum + Benefits: Ashdown Group: Front-End UI Application ...

Recruitment Genius: Digital Account Executive

£18000 - £26000 per annum: Recruitment Genius: They work with major vehicle ma...

Recruitment Genius: Service Engineers - Doncaster / Hull

£27000 per annum: Recruitment Genius: Domestic Service Only Engineers are requ...

Recruitment Genius: Employability / Recruitment Adviser

£23600 - £27500 per annum: Recruitment Genius: The Employability Service withi...

Day In a Page

Where the spooks get their coffee fix: The busiest Starbucks in the US is also the most secretive

The secret CIA Starbucks

The coffee shop is deep inside the agency's forested Virginia compound
Revealed: How the Establishment closed ranks over fallout from Loch Ness Monster 'sighting'

How the Establishment closed ranks over fallout from Nessie 'sighting'

The Natural History Museum's chief scientist was dismissed for declaring he had found the monster
One million Britons using food banks, according to Trussell Trust

One million Britons using food banks

Huge surge in number of families dependent on emergency food aid
Excavation at Italian cafe to fix rising damp unearths 2,500 years of history in 3,000 amazing objects

2,500 years of history in 3,000 amazing objects

Excavation at Italian cafe to fix rising damp unearths trove
The Hubble Space Telescope's amazing journey, 25 years on

The Hubble Space Telescope's amazing journey 25 years on

The space telescope was seen as a costly flop on its first release
Did Conservative peer Lord Ashcroft quit the House of Lords to become a non-dom?

Did Lord Ashcroft quit the House of Lords to become a non-dom?

A document seen by The Independent shows that a week after he resigned from the Lords he sold 350,000 shares in an American company - netting him $11.2m
Apple's ethnic emojis are being used to make racist comments on social media

Ethnic emojis used in racist comments

They were intended to promote harmony, but have achieved the opposite
Sir Kenneth Branagh interview: 'My bones are in the theatre'

Sir Kenneth Branagh: 'My bones are in the theatre'

The actor-turned-director’s new company will stage five plays from October – including works by Shakespeare and John Osborne
The sloth is now the face (and furry body) of three big advertising campaigns

The sloth is the face of three ad campaigns

Priya Elan discovers why slow and sleepy wins the race for brands in need of a new image
How to run a restaurant: As two newbies discovered, there's more to it than good food

How to run a restaurant

As two newbies discovered, there's more to it than good food
Record Store Day: Remembering an era when buying and selling discs were labours of love

Record Store Day: The vinyl countdown

For Lois Pryce, working in a record shop was a dream job - until the bean counters ruined it
Usher, Mary J Blige and Will.i.am to give free concert as part of the Global Poverty Project

Mary J Blige and Will.i.am to give free concert

The concert in Washington is part of the Global Citizen project, which aims to encourage young people to donate to charity
10 best tote bags

Accessorise with a stylish shopper this spring: 10 best tote bags

We find carriers with room for all your essentials (and a bit more)
Paul Scholes column: I hear Manchester City are closing on Pep Guardiola for next summer – but I'd also love to see Jürgen Klopp managing in England

Paul Scholes column

I hear Manchester City are closing on Pep Guardiola for next summer – but I'd also love to see Jürgen Klopp managing in England
Jessica Ennis-Hill: 'I just want to give it my best shot'

Jessica Ennis-Hill: 'I just want to give it my best shot'

The heptathlete has gone from the toast of the nation to being a sleep-deprived mum - but she’s ready to compete again. She just doesn't know how well she'll do...