As the Chancellor reminded us only weeks ago, the EMS was the 'cornerstone' of our policy. He would do whatever was necessary to defend the pound, because therein lay the guarantee of low inflation. Therein also lay the passport to any monetary union with the French and the Germans, a premier league from which it was vital not to be relegated.
But this underestimates the importance of the EMS, which successive Chancellors had been trying to join since Margaret Thatcher's first veto in 1985. Unlike other EC countries, which founded the system in 1979 as a means of limiting volatile exchange rate movements, British policy-makers looked to the EMS as a last resort after trying and failing almost every other type of economic policy on our own.
By linking ourselves to the rest of the Continent, we had hoped to avoid the cycles of boom and bust that have plagued Britain since the breakdown of the dollar-based exchange rate system in 1971. The Barber boom, the Healey incomes policy, the Thatcher experiment with raw monetarism and the 'Trust me, I'm clever' phase under Nigel Lawson had all ended in tears.
Let us begin with the golden age. When the pound was pegged against the dollar within the Bretton Woods system in the post-war years, Britain enjoyed an average annual growth rate of 2.8 per cent, which has never been matched before or since. Inflation was usually below 5 per cent, although creeping upwards. Unemployment was less than 3 per cent. But policy-makers were dissatisfied because living standards were growing less rapidly than our rivals.
After Bretton Woods broke down in 1971, we used our new-found freedom from the constraints of a fixed exchange rate to deliver a Keynesian boost to the economy. A falling pound, easy interest rates, more public spending and tax cuts sent the economy into overdrive: even with real growth of 7.4 per cent in 1973, supply could not keep up with demand.
The Labour government elected in 1974 then aggravated its inheritance by attempting to expand the economy in the teeth of the world-wide recession brought on by the first OPEC oil shock. Eventually, it decided to try incomes policy as a way of controlling inflation and allowing some growth. But that died during the winter of discontent in 1978-79.
After two episodes in which the Keynesian orthodoxy was tried and found wanting, the new Conservative government embarked on wholesale change. We tried monetarism: the attempt to control the growth of the money supply (notes, coin and bank accounts) so that inflation is kept low. The high priest of the monetarist revival, Milton Friedman, came and blessed our efforts.
The result, so conveniently forgotten today by advocates of monetary targeting, was as much an ignominious failure as Wednesday's. The chosen money measure - sterling M3 - gave consistently misleading signals, expanding rapidly even when inflation was plunging and the economy was mired in recession. In 1979 bank base rates went to 17 per cent. Two million people lost their jobs, and manufacturing output fell by a fifth, three times as much as the drop during this downturn.
Nor is this merely a matter of choosing the 'wrong' measure of money, as some monetarists argue. The narrow measures (which include only notes and coin) gave a better guide to the tightness of policy during 1979-81, but were wholly misleading during the early Seventies. A speedometer that is only reliable some of the time - and unpredictably at that - is useless.
The denouement was less dramatic than this week's events, but no less profound. In 1980, the Government committed itself to maintaining 'a progressive reduction in monetary growth'. Although interest rates and taxes might have to change, 'there would be no question of departing from the money supply policy, which is essential to the success of the anti-inflationary strategy'. In 1982, the M3 targets were raised sharply, and shortly after were abandoned.
The Treasury's disillusion soon led it to admire the successful experiment of the European Monetary System, not least because of Nigel Lawson's searing experience in the sterling crisis of January 1985, when the pound plunged and interest rates hit 14 per cent. But Mrs Thatcher and the Conservative right would not allow our early entry. As a result, policy was left to the discretion of Mr Lawson. By taking into account all monetary indicators, including the exchange rate, he was able to justify whatever hunch happened to suit his catholic tastes.
The result was a triumph of optimism over common sense. The liberalisation of the financial system allowed people to borrow on easier terms than ever before, boosting the average house price from pounds 30,000 in 1984 to pounds 60,000 five years later. We allowed the pound to fall in 1986. We then cut interest rates in an attempt to hold the pound down in 1987, and injected pounds 6bn of tax cuts into the economy in the 1988 budget, further feeding the boom.
The disastrous results of that mismanagement have been haunting us ever since, and were the reason why John Major was so determined to put the pound into the EMS at the earliest convenient opportunity. We had fouled up Keynesianism, monetarism and 'discretion'. We needed the Teutonic respectability of a marriage with the German mark. At least the Bundesbank knew how to organise non-inflationary growth. As we now know, German unification was to make the mark an altogether less steady partner than we had hoped.
If the French vote for Maastricht on Sunday, Paris may try to arrange a monetary union with Germany and the Benelux countries quickly. If that is the case, it is unlikely that the fundamental objectives of British policy will change. The pound may rejoin a diminished EMS at a lower rate. The transition to low inflation may take longer. We will be in the slow lane of a two-speed Europe, but still heading in the same direction.
If the French vote against Maastricht, the options for British policy widen. A period of 'discretion' seems inevitable, with the Government possibly deciding to sacrifice some of its hopes for low inflation in favour of a more rapid recovery. The pound and interest rates could be lower.
The fundamental economic consensus, though, is unlikely to change even then. Economists have become much more pessimistic about the ability to trade a little inflation for some more growth. In these circumstances, it makes sense to keep inflation as low as possible. The best means of doing so is to make the Bank of England as independent as the Bundesbank. Independent central banks will always be more credible guardians of the currency than politicians with an eye on their own re-election.
The role for politicians should then be simple. They should start addressing the problem that they have avoided in each generation since the debate about national efficiency began at the time of the Boer war: how to make British managers and their workforces better educated, trained, adaptable and responsive to what customers want than their rivals. There is no other way to success.Reuse content