If the Chancellor and the Prime Minister stick to their guns, they will endure an extremely uncomfortable year on the horns of this dilemma. But their reward will eventually come, for two reasons. The first is simply that the international environment will improve. As German interest rates begin to fall, rates across the Continent will come down. The principal markets for British exports will revive. Recessions never last for ever.
At the same time, British business is well placed to take advantage of that revival. The 'Thatcher miracle' was always a silly mirage, but there were improvements in the underlying performance of the British economy during the Eighties, particularly in manufacturing. Entrepreneurship is respected - and rewarded. Companies are much more tautly managed than they were 10 years ago, in part because the crisis of 1979-81 heaved out an older, more staid generation. British companies are also enjoying the benefits of the expansion of higher education in the Sixties.
Quality has improved, as have delivery times and responsiveness to markets. Costs are under better control, and the relationship between managers and employees is infinitely healthier. One test is foreign investment, where Britain continues to be attractive. In the latest fiscal year, Britain received more than half of all Japanese direct investment in the European Community.
Another test is pay, where the trade union reforms are showing their worth. Pay settlements have been much quicker to respond to recession and falling inflation than they were at the beginning of the Eighties. With low pay awards and productivity growth far higher than during the beleaguered Seventies, wage costs per unit of output are also rising less rapidly than Germany's, a phenomenon that would have been regarded as extraordinary 10 years ago.
Eventually, that process of pricing ourselves into continental markets by means of low inflation will lead to a slow but steady recovery. It will not be spectacular, but it will be more solidly based and more sustainable than most British post-war upturns - unless we throw it all away.
The alternative course of action - devaluing or leaving the ERM - offers all the illusions of the soft option. Britain's most serious problems arise from the mismanagement of the economy during the late Eighties, when many of the people who now complain about our ERM membership conspicuously failed to warn against the build-up of indebtedness in the economy. Indeed, they regarded the liberalisation of the financial system as one of the triumphs of Mrs Thatcher's term of office. Yet the new ease of borrowing in the mortgage market led directly to the housing and consumer boom of 1987-89. Debt-to-income ratios are now twice as high as they were at the beginning of the Eighties, and the desire to repay high debt is the main reason for the current recession.
The more subtle argument is that ERM membership may not be to blame, but it is making a cure more difficult. Sir Alan Walters, Mrs Thatcher's economic adviser, has argued that we should leave the ERM and cut interest rates. But this, too, is to paint too rosy a view of the alternative. There is every likelihood that we would suffer as much of a sterling crisis outside the ERM as in it. No government has ever been able to ignore the value of the pound because we are a medium-sized economy importing nearly a third of everything we buy.
A rule of thumb is that a 10 per cent fall in the pound adds 10 per cent to import prices and 3 per cent to overall prices. Even when we were floating the exchange rate, and were beholden to no fixed system, Mrs Thatcher was forced to raise interest rates as high as 14 per cent in January 1985 to stop an inflationary run on sterling. At the time, the economy was growing slowly and unemployment was also rising by nearly 30,000 a month. There was a similar episode at the end of 1986. Inside or outside the ERM, the foreign exchange market is a fickle mistress.
People who argue that, outside the ERM, we could and should cut interest rates as low as those in the United States - a little over 3 per cent on the money markets - are living in a different world. After all, the cuts in US interest rates have led to the mother and father of all dollar crises: the US currency has slumped to a new low against the mark and the pound, and is now a fifth below its level of last summer. Any British government suffering a 20 per cent fall in the pound would face an inflation rate leaping by as much as 6 percentage points: with an underlying inflation rate still at 4.4 per cent, inflation could be back to double digits.
The argument that inflation would not rise because the money supply is under control flies in the face of our experience in the Eighties. Not a single measure of the money supply has given consistent and reliable advance indications of inflation over the past 15 years. Nor is there much consolation in the view that the spare capacity in the economy would minimise any direct impact of a devaluation. Look, say those who urge a fall in the pound, at what happened when sterling fell by 15 per cent between 1981 and 1984: inflation went on falling and output picked up. British companies would expand their output and push their competitors out of the home market.
But that argument conveniently ignores the rise in the pound of 18 per cent between 1978 and 1981. Importers could hardly believe their luck. As the pound rose, they did not pass on their falling costs to consumers in lower prices because they thought the rise was only temporary. They pocketed higher profits instead. When the pound subsequently fell, importers absorbed much of the cost by cutting their profit margins. Prices did not go up. It is therefore wishful thinking to suppose that a similar fall in sterling today would fail to boost inflation. The impact on prices would be much more rapid.
This, though, is surely the secret agenda of those who press for a change of policy: deep down, the critics of the present policy want another burst of good, old-fashioned British inflation. What could be more pleasant for all our debtors? Their incomes would go on rising a little ahead of prices, while their debts would be eroded by inflation. The housing market might even refloat. Come on, Norman] Be a sport]
Fortunately, the Chancellor will remember that we have been here before in the Seventies. He will also remember the consequences. Managers spend their time worrying about contracts that fail to make due allowance for rising prices. Companies suffer cash-flow crises and plead for tax relief. Industrial strife increases. Political pressure steadily mounts from savers and others to get inflation under control. And the way of doing that? We squeeze demand for goods and services. We put up interest rates. We cut public spending. We have another recession. The cycle turns again.
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