More a mark crisis than a sterling crisis

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The Independent Online
THERE is a real whiff of fear in the air. Manufacturing output is about to plunge after the little upward blip recorded in the second quarter, house building - a key leading indicator of economic activity - is lurching downwards again, the Conservative Party treasurer in the run-up to the election, Lord Beaverbrook, has just announced that he is broke following the repossession of his BMW car. On all sides, economists are downgrading their forecasts.

At best, it seems that the recession will just carry on. At worst, it may be about to intensify. From a policy perspective the Government's problems have also become more stark. The Bundesbank's decision to raise the discount rate in July was hardly helpful, but since then the weakness of the dollar (and consequent strength of the mark) combined with anxious uncertainty ahead of the French referendum on Maastricht has produced a quite new and very frightening species of sterling crisis.

Until the French vote on 20 September, there appears to be virtually nothing the Government can do beyond trusting to concerted central bank intervention to hold back the tide of speculation against the dollar and the weaker exchange rate mechanism (ERM) currencies.

Nor can the Government be especially sanguine about the probable course of events after 20 September. If the French vote 'yes', the immediate crisis will probably ease, but the underlying strains within the ERM and the policy dilemmas they present for the British government will not have diminished. Indeed, they are likely to worsen rapidly as the markets become ever more convinced that the depressed state of the UK economy will eventually force the Government into unilateral action of some kind. In those circumstances a 1 or 2 per cent increase in base rates might do little more than provoke a feeding frenzy.

If the French vote 'no', at least something will happen quickly. The immense speculative pressures unleashed would almost certainly prompt a realignment within the ERM. The extent of the currency chaos will depend upon whether the European finance ministers meeting in Bath this weekend will commit themselves in advance to an immediate realignment in the event of a French 'no'. Any delay, in which a mix of intervention and raised interest rates was tried, would be both expensive and futile.

The second danger for Britain would be that a forced general realignment might result in an unwelcome and unnecessary devaluation of sterling in which the pound would be bracketed with weak ERM currencies such as the lira. If the Bank of France decided to revalue with the mark in a fit of misguided machismo, the conditions would have been laid for precisely the two-speed Europe which it is the object of British policy to prevent. To make the political humiliation all the more painful, nothing much would have been gained on the interest rate front.

Before suggesting a way out, it is worth making the following points. The first is that Britain is suffering from an interest rate problem rather than an exchange rate problem. It is not the competitiveness of the currency that is holding back the economy, it is real interest rates of 7 per cent. The object of policy is not to devalue but to get lower interest rates. Second, the crisis in the ERM is not a sterling crisis but a mark crisis, which has been exacerbated by a dollar crisis.

The way the ERM operates is for one 'anchor' central bank to set interest rates while the other members target exchange rates. The cause of the ERM crisis is German unification. Since 1989, the German government deficit has risen from from 1 per cent of GDP to 7 per cent, while the large structural current account surplus has disappeared. When President Ronald Reagan embarked upon his monster fiscal binge, the dollar rose by more than 30 per cent as resources were switched from the traded-goods sector to government consumption.

However, under the ERM the mark has only been able to appreciate by 5 per cent in the last three years. Because the Bundesbank has properly refused to accommodate inflation and because of the semi-fixed exchange rate system, the consequence of the massive fiscal shock of unification has been a steep rise in German real interest rates.

In other words, the anchor bank of the ERM has set its interest rates entirely according to pressures in Germany which do not prevail anywhere else in the ERM area. The unintended result is that the rest of Europe is suffering under a monetary regime which is strangling the possibility of recovery from recession. In recent weeks, the system has come under further pressure from the weakness of the dollar. As anchor currency, the mark has attracted the bulk of the money flowing out of the dollar, thus leaving other ERM members, above all sterling, weaker.

The answer to these problems is blindingly simple. What is needed is a substantial revaluation of the mark - 15 per cent would be about right - leaving the other currencies at their existing central rates, with the exception of the Dutch guilder (which would probably go up with the mark) and the lira (which might devalue by 5 per cent). Not only would the immediate interest pressure be relieved, a higher exchange rate would give the German authorities the monetary tightening they need to combat inflation, thus allowing them to begin a series of phased interest rate reductions, which other member central banks would then follow.

If it were up to the Bundesbank, all this would probably have happened some time ago. Unfortunately, while the Bundesbank controls interest rates, it is the German government that takes decisions on the exchange rate. Even more unfortunately, the French have until now resisted every suggestion of a mark revaluation which would break the current link with the franc. At one time, the intransigence of the French had a certain logic to it. The political elite is committed to a European monetary union that would restrain German power and lead to a shared monetary sovereignty, and it sees dogged attachment to the mark as the only way to bring this goal about. But that goal is a great deal more distant than it seemed a year ago, whether or not the French political establishment gets the result it wants on 20 September.

Securing a mark revaluation should now be the most vital objective of the British Presidency. Unfortunately for a government that would love to be seen to be doing something, whatever persuasion and arm-twisting there is will be behind tightly closed doors.