Economic Commentary: Double or quits for Lamont on ERM

Just before being suspended from the ankles in a huge tank of water, Harry Houdini would stop the show. Handcuffs, chains round the legs, ropes enveloping the body were simply not enough. Why not have himself placed in a massive leather straight-jacket, just for good measure? That would impress the fans.

Norman Lamont's remarkable speech on the exchange rate mechanism last Friday was intended to have the same effect. Already severely constrained on virtually every side, the Chancellor went out of his way to spell out in detail each of the policy alternatives to sticking with the ERM at a central parity of DM2.95. He then went on not just to reject them after calm consideration, but to rubbish them in such lurid language that it is hard to see how he could in future adopt any of them and survive.

Cut interest rates? Lamont believes this to be 'theoretically ingenious but wholly unrealistic'. A German realignment? 'No country in the ERM is looking in that direction. The issue is simply not on the agenda.' Devaluation within the ERM? 'It is patently absurd to suggest this would allow interest rate cuts.' Leave the ERM and cut interest rates? 'It's the cut-and-run option. The credibility of our anti-inflationary strategy would be in tatters. We would have surrendered.' Leave the ERM and set interest rates according to domestic monetary targets? 'It is the responsibility of government not to debauch the currency. It is the ERM that is most likely to deliver price stability in Britain.'

This is not the language of a routine political speech. It is the language of someone who has decided he would rather go down in flames than to accept policy adjustments of a type that previous Chancellors have frequently been forced to pursue. It is double or quits on the ERM.

Why has the Chancellor chosen this moment to deliver such a speech? One obvious economic reason is that talk of an impending devaluation had heavily undermined the strength of sterling in the previous week, and it needed to be scotched if the risk of a rise in UK base rates was to be avoided.

A routine speech would simply have been shrugged off by the financial markets. It needed something special to make the markets sit up and pay attention.

But the Chancellor would not have risked making such a speech just for the purposes of short-term market management. His remarks not only spelt out current government policy to market participants in as clear and uncompromising a way as possible. They also had a crucial political purpose.

Mr Lamont is saying to his natural allies on the Thatcherite wing of the Tory party: 'Not only do you not have my support, I am your most implacable opponent. Your ideas are not just wrong, they are intellectually disreputable and inflationist. If you insist on calling for devaluation, or quitting the ERM, you will bring down the Chancellor, and quite possibly the Prime Minister as well.'

The Prime Minister's position is possibly the most interesting of all. He could have chosen to leave the 'technicalities' of the ERM to his Chancellor, just in case at any point in the future both might need to be jettisoned together. But within the usual limits of 'Prime Minister speak', he has chosen the opposite course.

Admittedly, much of his interview in yesterday's Sunday Times was hard to fathom. He is, for one thing, greatly over-estimating the importance of reaching a Gatt agreement for getting the world economy out of recession. This is nothing more than a side-show at present, compared with the problem of debt and asset deflation in several economies.

Furthermore, he persists in arguing, to a much greater extent than Mr Lamont, that there might be scope to reduce UK interest rates to below those in Germany. But none of this matters very much in comparison with the general political support the Prime Minister is willing to give to his Chancellor, which is considerable. He has ruled out devaluation, or quitting the ERM, in equally clear language as Mr Lamont, and is digging himself in for a long, hard battle.

This is a brave strategy, and one which will be seen as admirable if it works. It is probably the right thing to do in the long term, but it will involve a great deal of agony for the foreseeable future. And as a result the Government will find itself very short of allies in the next few months. The bandwagon of economists in favour of the ERM has clearly stopped rolling. The Opposition is showing clear signs of losing enthusiasm for the current parity.

Far more important, Tory backbenchers who are not hard-core Thatcherites have started calling for devaluation, apparently in blissful ignorance of the obvious fact that a sterling devaluation (as opposed to leaving the ERM altogether, or inducing the Germans to revalue the mark, after which they might cut their rates) would not bring base rates down. This is the stuff of which real political crisis might be made.

The next stumbling block will come on Thursday, when there is a very real chance that the Bundesbank might tighten German monetary policy yet again. This may seem startling in view of the fact that much of the talk at last week's G7 summit was of lower worldwide interest rates. But the Bundesbank has frequently thumbed its nose at the G7 in the past, and would secretly enjoy doing so again this week.

As the graph shows, German M3 has been growing much faster than is permitted under the Bundesbank's target range for many months now, and the central council seems to be moving towards a consensus that something needs to be done to retain its legendary credibility as an inflation fighter.

There are basically three options, in ascending order of monetary stringency:

Raise the discount rate. This would gain the most attention, and act as a clear warning shot to the German government about the need to control public deficits, but it would not do much to change money market interest rates, since the discount rate (at 8 per cent) is so far below those rates at present.

Raise the Lombard rate. This would be more significant, since the Lombard rate (currently 9.75 per cent) effectively sets the ceiling for money market rates. Any rise would be automatically reflected in German rates, and would probably be quickly followed by several other ERM members. But it would probably be only a quarter or (at most) a half-point move.

Restrict the availability of Lombard credit. By restricting the amount of Lombard credit available to the banks, this would effectively enable money market rates to trade above the Lombard rate, potentially by a large amount. Although it may not appear on the day to involve a monetary tightening as severe as the first two options, it would entirely remove the Lombard ceiling, and might result in a much larger rise in rates over the next few months.

Whichever option is chosen, a signal will probably emerge from Frankfurt on Thursday that international calls for Bundesbank moderation have been ignored. The Government can expect the next stage of its ERM adventure trip to be even more hazardous than it has been so far.

(Graph omitted)