Major's risk in following Germany's path of virtue

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The Independent Online
LAST weekend, the Sunday Times carried a remarkable piece of propaganda about what happened in Germany in the Forties. I refer to its interview with John Major, and his explanation of his present policy towards the pound.

He told Michael Jones, the paper's political editor, that he wanted to give savers and investors confidence in the value of their currency. Mr Jones's report continued: 'The Germans had done it from a standing start, said Major, by keeping their currency strong and their inflation under rigorous control.'

It is easy to see why Germany's economic miracle shines so brightly in the Prime Minister's mind - not least in a week when Britain's interest-rate policy has been reduced to a neurotic wait for yesterday's meeting of the Bundesbank. During the Fifties, the value of the Deutschmark held constant, and prices barely moved. Output more than doubled; unemployment disappeared; exports outstripped imports. By the end of the decade, the Federal Republic of Germany had overtaken us in its share of world trade.

Clearly, if Mr Major could emulate that record, he would be granted the accolade of national saviour. But there are three reasons why the lessons of Germany's post-war recovery help his cause rather less than he seems to think.

The first is that Germany did not prosper through monetary policy alone. It imposed high personal taxes to maintain fiscal discipline. It encouraged strong unions to foster social cohesion. It offered large tax incentives for investment in housing and basic industries. It welcomed massive immigration from eastern Germany and southern Europe to stop the labour market suffering inflationary bottlenecks. It adopted proportional representation and a federal system of government. These policies contrast markedly with today's Majorism: low taxes, weak unions, fiscal neutrality, strict immigration controls, first-past-the-post elections and centralised executive power.

Second, the story of Germany's 'standing start' gives scant comfort to those who would battle today to defend an overvalued pound. By common consent, Germany's post-war recovery was born on 20 June 1948, with the implementation of Operation Bird Dog. Overnight, old Reichsmarks were replaced with new Deutschmarks. Each German could buy up to DM40 at a rate of DM1 to RM10.

Linked to the currency reform was a series of measures of economic liberalisation, such as an end to rationing. The first 18 months were rocky: hardship for many, erratic price rises and a sharp climb in unemployment. But from 1950 onwards the new strategy underpinned the country's remarkable growth. As far as Britain's economy today is concerned, however, the key point is that Operation Bird Dog involved a seismic shock to Germany's financial system in order to create an internationally competitive currency. Only after the trauma, and in many ways because of it, did Germany achieve the stability that Mr Major envies.

The third defect in Mr Major's argument concerns his use of the word 'strong'. The German mark has been regarded as a strong currency for the past 44 years because of its buoyancy. Throughout the Fifties it was worth 8 1/2 p. Then, from 1961, its value started to rise: by 1970 it was worth 11p, by 1980, 25p, and today 35p.

As with share prices or any other financial asset, the German mark's strength has flowed from its gradient, not its level. Imagine a stockbroker looking at two companies. He or she judges that in a year's time both will be worth 70p a share. The computer screen shows that company A is currently trading at 60p, up from 50p a year ago, while company B's share price is 80p, down from 90p since last summer. The stockbroker's advice is obvious: sell B, buy A.

In that example, A is the cheaper, but stronger share; company B is dearer, but weaker. The general point is that a 'strong' asset is one that is cheaper than its prospective medium-term price. That has been the story of the German mark: for most of the past 44 years it has been undervalued. Each revaluation has involved a recognition that it was too cheap.

If Mr Major wants the markets to treat sterling with equal respect, he must abandon his equation of 'strong' with 'dear'. At the very least, a mild, British version of Operation Bird Dog would involve a sharp devaluation - say, by 20 per cent. The Government's objective would be to make the pound so cheap that its next expected movement would be upwards.

Can devaluation be reconciled with Mr Major's target of zero inflation? Not easily: many prices would be bound to rise at first, even though the depth of our recession should prevent a wages explosion.

Again, Germany's experience suggests some useful, if painful, lessons. Draconian monetary and fiscal policies were crucial to the success of Operation Bird Dog. One option open to Mr Major is to mix the same ingredients into a devaluation cocktail, and accept a year of economic - and political - hell before taking Britain into the virtuous circle of a strong pound, zero inflation and rapid growth.

I am not arguing here that all these measures are wise, even less that they would add in the short term to the sum of British happiness. Nor am I at all sure that they would be sufficient to achieve long-term prosperity: Britain also needs to study the supply-side lessons of Germany's post-war recovery.

The point, rather, is that if the Prime Minister seriously wants to kill inflation without killing recovery, something has to give. That something includes the exchange rate - and probably much else besides. He is right to invoke the record of Germany, but wrong to imagine that it can be copied without intense initial pain, and hence enormous political risk.

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