Economic Commentary: Dangers of life outside the ERM

It is already obvious that the Government is in danger of embarking on one of the great lurches in economic policy that have so plagued the performance of the British economy in the post-war years.

The humiliation suffered at the hands of the currency markets last Wednesday will now lead the body politic - which in our democracy seems doomed to operate in a twilight zone between serious thinking and tabloid hysteria - to draw several conclusions: that the whole idea of the exchange rate mechanism was always a disaster, that it was solely responsible for the recession, that European integration is a highly suspect cause and that the best thing to do now is to move as fast as possible in the opposite direction.

These are the big issues raised by last week's events, but first a word or two about the immediate circumstances of the debacle. It is important to recognise that there was not one ounce of governmental discretion involved in the decision to float sterling last week. In the Chancellor's words, this was entirely a case of force majeure (overcoming, he might have added, force Major).

Quite simply, by early Wednesday morning the Bank of England was the only buyer of sterling in the foreign exchange markets. And to blame yuppie speculators in red braces is an absurdity. The selling came from all quarters, especially from blue chip companies and from august long-term investing institutions. No one wanted to be left holding a depreciating asset - and that, understandably, included the Bundesbank.

It is possible that if the Government had acted sooner, raising interest rates when sterling first started to slide in the summer, there might have been a different outcome. But I doubt it.

In hindsight, the sterling parity was almost certainly doomed from the moment that the brief post-election rally in economic activity petered out. From then on the markets concluded that any interest rate increases were unsustainable.

In fact, the UK was caught in a trap not dissimilar to that of Italy. The Italian government has found that high interest rates have had little effect on the lira because the markets have deemed them to be unsustainable, given the extra debt

servicing charges they would involve for a government already facing severe solvency problems. In Britain's case the Government is not facing a 'debt trap', but some parts of the private sector clearly are, and the markets have therefore concluded that higher base rates could not possibly be sustained for long.

If we accept that nothing much could have been done to hold the parity following the renewal of recession this summer, do we conclude that the whole ERM experiment - and I think it right to put it in the past tense - was a disaster?

Not necessarily. Looking back over several years, it is clear that a huge policy mistake was made by keeping base rates so high for so long prior to ERM entry in the autumn of 1990. This set in train the recessionary forces that are still with us.

In fact, from October 1990 to October 1991 the ERM definitely contributed to base rates falling considerably faster than would have occurred outside the system, which in retrospect seems to have been an important blessing. It is only since the turn of this year, and then not by very much, that the ERM has definitely caused the policy stance to be tighter.

What about the idea that the UK joined the system at too high a rate, or at the wrong time? I suspect that the entry rate made little difference. The problem was that interest rates were too high, and they would not have fallen any further with a lower central parity.

And the timing? Yes, we did join at the wrong time. The right time was in the autumn of 1985, when Margaret Thatcher first vetoed entry. If sterling had entered then there would have been no boom in the late 1980s and no bust in the early 1990s. That was the crucial mistake.

Total discretion

Now for the future. Those who have already concluded that the ERM was the sole cause of our present difficulties now think it logical to adopt precisely the opposite strategy, targeting an extremely low level of interest rates and forgetting about the exchange rate altogether.

(The low level of interest rates may be justified by reference to a new set of domestic monetary targets, but the latter would just be fig-leaves for a policy of leaving total discretion on the setting of base rates in the hands of the politicians.)

I would caution those who think in this way with the following observations.

First, the one definite lesson of the past decade is that large swings in monetary policy have massive economic effects, but they accumulate over a period of several years. It might now look very convenient

to reduce base rates to 6 per cent or less, but this could lead to a sizeable build-up in inflationary pressures just in time for the next election. And relying on money supply targets will not prevent this any more than it did in the 1980s.

Second, it is dangerous to turn a blind eye to the exchange rate. Calculations suggest that sterling is now slightly undervalued on a purchasing power basis against the average of European currencies. This might be taken to mean that sterling would not collapse if interest rates were reduced considerably further.

However, this would be the wrong conclusion. We know from experience that currencies subjected to substantial interest rate shocks are likely to overshoot their equilibrium values in the foreign exchange markets.

I doubt if base rates of 6 per cent would be consistent with a DM-pounds rate much above 2.20-2.30. And a devaluation of 20 per cent or more would, if sustained, almost certainly have a large inflationary effect sooner or later.

Indeed, model simulations do not suggest that devaluation is at all a good bargain. For a 10 per cent devaluation (shown in the graph) the models tend to suggest that there would be a modest pick-up in growth of about 0.7 per cent for two years, followed by lower growth in the long term.

On prices, the models say that inflation rises by about 2.5 per cent per annum for several years following the devaluation, though by less in the first year.

Given the depth of the current recession this inflationary effect would probably take a long time to emerge, since importers might initially absorb some of the devaluation effects in their margins and workers might allow real wages to be temporarily squeezed. But these effects could not be expected to last for ever.

And the third word of caution is this. Given the degree of economic integration that now exists between European countries, other EC countries will quickly attempt to stitch back together some form of monetary integration - even if the entire ERM blows up in the next few days or weeks, which it might.

The Government must not conclude from last week's bitter reversal that it should remain aloof from this process.