Paying for monetary freedom: The exchange rate mechanism may be in crisis, but managing Europe's currencies remains preferable to floating them, says Christopher Huhne

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The Independent Online
THE LATEST crisis in Europe's exchange rate mechanism is its most profound. The Maastricht road to European monetary union (EMU), always suspect but increasingly implausible since last autumn, is now blocked. When the smoke of the battlefield clears, Europe's governments will face a stark choice - either to proceed almost instantly to a single currency for those who are willing, or to retreat permanently to a more flexible system of linking their exchange rates.

The crisis does not, however, mean that the objective of a single currency is futile or impossible. Indeed, it could be part of the solution to the problem of wild speculative flows. Nor does it mean, as Sir Alan Walters, Lady Thatcher's former adviser, has argued, that fixed exchange rate systems are doomed because you 'cannot buck the markets'.

Monetary history is marked by similar episodes in which over-ambitious policy-makers have come a cropper. Currency crises no more undermine the case for pegged exchange rates than the occasional tragedy invalidates the case for vaccinating children. Anybody who begins to talk about economic policy as if it does not involve a balance of costs and benefits is behaving like an ideologue.

For most of monetary history - through the pre- First World War gold standard and then under the Bretton Woods system from 1945 to 1971 - the major currencies have been linked together. Such currency links have generally made the world more predictable for business people, who have one less risk to worry about. When governments persuade themselves that the burdens of fixed systems are intolerable, a short period of freely floating exchange rates usually disabuses them.

After all, the currency turmoil of the Thirties played a large part in creating a political constituency for the Bretton Woods system after the Second World War. 'Beggar-my-neighbour' devaluations merely fostered protectionism and deepened recession. Wild gyrations in exchange rates that give some countries a competitive advantage are usually followed by an outbreak of restrictions on trade: just look at the rash of import barriers erected by the US as the Japanese yen fell against the dollar during the Reagan years.

Indeed, the period of floating since 1971 has been characterised by three cases of wildly misaligned exchange rates that inflicted lasting damage on economies, including the overvaluation of the pound between 1979 and 1981. Britain's manufacturing output fell by a fifth at that time, and left us with a shrivelled trading sector that remains one of our principal structural obstacles. Floating is not a free lunch.

The impulsion to managed exchange rates is particularly strong in Europe, because Europe's economies are smaller and hence more interdependent than the Japanese or United States economies. Even a big European economy such as Britain's exports more than a fifth of everything it makes, whereas the US exports just 7.3 per cent and Japan 9.8 per cent. After the breakdown of the worldwide Bretton Woods in 1971, Europe tried its own version, the 'snake'. When that broke apart, the Community launched the exchange rate mechanism in 1979.

The early period of the ERM was generally regarded as a success. Policy-makers did not succumb to hubris. They moved their official exchange rates down when a country suffered more inflation than its partners, providing a crucial element of flexibility, but ensuring that the markets could not harmfully overvalue currencies (causing recession) or undervalue them (causing inflation).

But the ERM gradually became more rigid. From 1987 until last autumn, there was no change in the permitted floor for any participating currency. Yet the politicians also removed the last controls on free flows of capital, making their task of currency fixing more difficult. This trick was only sustainable while the markets remained convinced that the main currencies were on track to adopt a single currency - exchanging their currencies at their current exchange rates.

Two events undermined that assumption, and with it the ERM. The first was the first Danish 'no' to Maastricht, followed by a narrow French 'yes', revealing doubts that existed about the plan. The second event was German reunification. The vast subsidies to east Germany stimulated spending throughout the economy, and forced the Bundesbank to keep interest rates high to control inflation.

Because investors like the German mark's longstanding reputation as a store of value, other ERM members had to pay at least the same level of interest rates as Germany. So the ERM transferred the high interest rates that were appropriate for an inflation- hit Germany across Europe, even though they were inappropriate to other recession-hit economies.

In the short term, the greater flexibility agreed in Brussels was inevitable. With luck, wider 15 per cent bands linking the mark and the franc will also prove to be the trigger for a Europe-wide economic recovery. They may allow the interest rate cuts that France badly needs. If the British government follows suit with further rate cuts, Britain should benefit from most of the gains in price competitiveness from the devaluation since last October and from recovering continental markets.

Politically, however, the crisis raises questions about the future of monetary union. The Maastricht stages assumed that the ERM would become more and more rigid until, in 1997 or 1999, governments would simply announce that they were locking their exchange rates together at a single, fixed rate. Each currency would then be replaced by a new ecu. This gradual process bowed to Germany's insistence that the new currency be as solid as the mark, and therefore should be introduced only when other countries had proved their willingness to undergo the same disciplines.

However, gradualism in monetary matters is not always sensible, particularly when the Maastricht process involves paying considerable costs now in exchange for benefits that arrive only when the single currency is adopted. It makes more sense to concertina the process, enjoying the benefits at the same time as paying any costs.

Just as crucially, the key institution of the Maastricht transition was to be the Bundesbank, because it effectively set the floor to interest rates for all ERM members. Yet the Bundesbank is also the single European institution that stands to lose most from the success of any transition to a single currency. Monetary union would replace the Bundesbank with a European central bank. Turkeys do not vote for Christmas, and the Bundesbank hates the idea of a single European currency.

Not surprisingly, the Bundesbank has proved thoroughly unhelpful to the ERM through most of the past year. Helmut Schlesinger, its president, dished sterling by letting it be known that he thought it overvalued, and his failure to cut German rates on Thursday showed that the bank did not value its international obligations at all. As the international financier George Soros said: 'I think for France to stay (in the ERM) after the Bundesbank action would be like for a battered wife to go back from the hospital to her husband.'

There are two remaining big questions: about France and about Germany. First, will the French continue to want monetary union with Germany, or will they be scalded by this experience? My guess is that they will eventually persist, mainly because of the belief of many leading French policy-makers that economic integration is the only way to lay the ghosts of three German invasions since 1870.

Second, will the Germans be prepared to give the French what they want, as they did with the ERM in 1978 and with Maastricht in 1990? The odds again are that they will, but that the means of arriving at monetary union will have to be very different. The old European Community assumption that everyone or no one should participate - a condition insisted upon by the Italians and other weaker members - will have to go.

If there is ever to be a European monetary union, it will have to begin speedily for a few - perhaps at first only Germany, France and the Benelux - with others preserving the option to join later. Despite all the blood and tears involved in its ratification, Maastricht's transition to a single currency is dead.

(Photograph omitted)