Hamish McRae: How the ERM disaster turned into a triumph

Black Wednesday. Or maybe White Wednesday. In political terms it was certainly a disaster, for there is no debate about the damage that sterling expulsion from the ERM in 1992 did to the reputation of the Tories for economic competence. But in economic terms it proved to be a triumph, for two reasons.

First, it allowed a sharp - though as it turned out, temporary - fall in sterling that gave a direct boost to the economy without generating any significant inflation. And second, leaving the ERM forced the Treasury to find a new framework for maintaining fiscal and monetary stability. That framework, modified by giving the Bank of England the power to set short-term interest rates, has been the basis for the subsequent long boom.

We know all that now. But there are still huge questions about the whole experience, and depending on the answer to those questions, different lessons for the future. Two main questions stand out.

One is, what matters more: exchange rates or interest rates? The conventional wisdom of the time was, and probably still is, that sterling entered the ERM at too high a rate and that became the root of the problem. Interest rates had to be increased to protect the pound and these made the early Nineties recession deeper than it otherwise would have been.

There is a counter view, however, which runs like this. The problem was not too high an exchange rate but too high interest rates - too high even before they had to be increased to protect the pound. The most convincing reason for buying this view is that by 1997 sterling rebounded back to an even higher level than it was when it was in the ERM (see first graph). Yet growth continued without any unacceptable deterioration in the current account. The current account did move from being in rough balance in 1997 to a deficit of about 2 per cent of GDP, but it has not deteriorated further since then (next graph). Further minor corroboration comes from the earlier years. As you can see, the deficit had already narrowed by 1992 from 5 per cent of GDP at the end of the Eighties. So the ERM level was consistent with a narrowing of the deficit, not a widening.

By contrast, interest rates in double digits were clearly wrong. The UK is particularly sensitive to changes in short-term interest rates because most mortgages are still linked to short-term interest rates - an even higher proportion was linked in the early Nineties European interest rates had to be set high enough to cope with the German boom that followed reunification. But the UK needed rates that were low enough to help it out of recession, for the bottom of the UK economic cycle was 18 months ahead of the German one.

The result of too-high rates in the UK was a slump in house prices, a squeeze on personal disposable income and a cut in domestic consumption. You can see the sudden decline in interest rates in 1992 in the next graph, together with the fact that the markets consistently expected higher interest rates than they actually got. (The little stubby lines show what the markets expected to happen to rates at the start of each year: they are consistently higher than the out-turn.)

So under the new framework - and under Tories and Labour - the country got not only low interest rates but lower ones than it expected. How so? Well, the final graph shows the surge in growth that started in 1993, growth that has been maintained right through to now, together with low inflation as measured by the consumer price index. Key point: there was no surge in inflation from 1993 onwards despite the fall in the pound. Low inflation validated low interest rates.

That leads to the second big question: why did inflation remain so low? There are three answers here. One is to say that the fall in inflation was part of a worldwide shift and we were just part of it. A second is to say that initially rapid growth took place against a background of some distress - negative equity squeezing individuals, a gradual rise in demand helping companies but against a background of earlier pain. By the time companies had experienced three or four years of solid demand, sterling rose and put a squeeze on their exports. As a result workers were in no mood to bid up their wages, nor companies their prices. And the third? Well, it would be to say that the new monetary framework did indeed work.

There is truth in all of these, of course, but my instinct would be that the first two have been more important than the final one. That is not to denigrate the idea of inflation targets, nor the work of the Bank of England's Monetary Policy Committee. I just suspect that for reasons that are still not fully understood, inflation at a consumer level stopped being a global issue during the Nineties.

If the answers to these two questions are more or less right, there are some pretty important implications for the future. One would be that the tensions in the eurozone are less the result of countries going in at the wrong level but having to put up with the one-size-fits-all interest rate. For Germany that is both encouraging and discouraging. It is encouraging in that German companies will be able to prosper despite the mark's euro entry level, which many people now think was too high. It is discouraging because the country is liable to have too high interest rates for a considerable period.

Another would be that exchange rates are in general less important than they used to be. Thus a further fall in the dollar would not do much to help correct the current account deficit but it also would not do as much damage to US inflation as many people fear. Further, the UK seems to be managing all right with its present high rate against the dollar.

On the other hand, it suggest that getting interest rates right does matter enormously. That leads to a question about US policy of holding short-term rates below inflation for more than three years. Only now are real rates becoming positive again. That has not had much cost in terms of higher domestic inflation. But it has created a global asset boom in property and some securities, the long-term costs of which are still to show through.

The good news is that, since the authorities can control interest rates and cannot control exchange rates, it is very helpful in that interest rates matter more. The bad news is that if they get interest rates wrong, they can do a lot of damage.