Leading Article: A dead ERM is no panacea

IN FAILING to deliver the expected cuts in its key Lombard and discount rates, Germany's Bundesbank has again put its own domestic responsibilities above the wishes of its EC partners - and rightly so (though whether it is correct in its judgement on the needs of the German economy is more questionable). The German central bank is constitutionally obliged to give priority to its role as guardian of the currency. With inflation remaining obstinately high and monetary growth excessive, there was no clear justification yesterday for a cut. Any such move risked being seen as overtly political, and thus damaging to the bank's credibility.

It is not the fault of the men in Frankfurt that other EC currencies are tied to the German mark within the European exchange rate mechanism (ERM), and that its own moves largely dictate actions in other capitals. As a result, yesterday's negative decision aroused deep disappointment across the recession-bound Continent, and especially in France. The French franc, and other currencies recently targeted by dealers, came under fresh pressure. There was speculation about enforced departures from the ERM, as suffered by the pound and lira last September. Sterling, then quickly devalued and since floating, meanwhile resumed its steady rise.

The big question now is whether the French government will cling, against all the odds, to its cherished policy of a franc fort, or recognise that the price is becoming excessive. The high interest rates required to sustain the franc's value are seriously aggravating the recession in which France's economy is gripped. Those rates are also adding to a level of unemployment, now nearing 12 per cent, that dominated the dramatic general elections in March and could soon strain the country's social fabric.

The main motives behind the strong franc policy have been political: the intended message is that France is an equal partner of Germany in leading the EC towards monetary union. For all the many strengths of the French economy, and the growing realisation that Germany's is beset by weaknesses additional to those created by unification, the currency markets refuse to accept France's pretensions.

The choices seem clear. Either - as recommended in yesterday's Financial Times by six leading economists from the Massachusetts Institute of Technology - the French should slash their interest rates and let the franc float free; or the ERM should revert fully to its more flexible pre-1987 form, in which smallish exchange rate adjustments were made relatively frequently. Temporary suspension is also possible. The notion of accelerating monetary union, if only among the strongest currencies, now looks utopian.

Britain's chief short-term interest is in an early economic recovery in its important EC export markets. That would be hastened by the collapse of the ERM. But the outcome would not be all gain. Without the disciplines and stability that the ERM provides, widely fluctuating currencies and competitive devaluations would revive all the old uncertainties of earlier eras. There could even come a time when the ERM is looked back to with nostalgia.