Unstoppable myths of ERM and recession

One of the disappointing features of macro- economics - critics might say that it renders the pursuit entirely useless - is that there is almost no proposition which the subject clearly demonstrates to be true or untrue. Will inflation rise as unemployment begins to fall? Does the trade deficit matter? Should taxes rise further? To all of these questions, macro-economics replies with a thundering 'perhaps'.

And disputes such as these are not only empirical in origin. Competent theoreticians are easily capable of constructing apparently sound cases on both sides of each question. Indeed, I would challenge readers to think of any important proposition that macro-economics has demonstrated, beyond any reasonable doubt, to be untrue.

I very much doubt whether the same question can be asked of the natural sciences, though this admittedly depends on how one defines the word 'true'. Newtonian physics was thought to be both a true and complete explanation of the laws of motion until Einstein came along and showed it to be not so much untrue as a special case. 'Truth' is therefore time-dependent. But in the natural sciences there are at any given moment a huge number of propositions that virtually all practising scientists would agree to be valid. Even more propositions have been shown, to the satisfaction of practically everyone, to be invalid.

Therefore there is a 'state of the art' that is commonly accepted by all but a few fringe practitioners in the subject. Disputes between natural scientists are, of course, frequent and extraordinarily bitter, but after a time they tend to be settled, and the subject then moves on to a new area of controversy. The difference in economics is that disputes are never settled. They simply lie dormant for a while, only to crop up again later.

One dispute that will run forever is the role of the exchange rate mechanism in causing the recession. Because the economy started to demonstrate obvious signs of recovery shortly after sterling's departure from the system, there is a bandwagon rolling which seeks to blame the entire recession on the ERM. This bandwagon is not divorced from political motivation. It is being propelled mainly by those on the Thatcherite wing of the Tory party who are desperate to taint the Maastricht treaty with the brush of recession, and to discredit the Major administration into the bargain. A new and discreditable development is to hide this direct political attack on the Government behind the veil of an assault on the officials in the Treasury and the Bank of England who are said to have supported the ERM in the first place.

The linkage between the ERM and recession will obviously be one of those myths that has a sufficient kernel of truth at its heart to have unstoppable momentum. Certainly, the intrusion of a few awkward facts into the process will not deflect its progress by more than an inch or two. But the opposite case should not be allowed to go entirely by default, so here goes.

There are three issues to consider: the onset of recession in 1990/91, its prolongation in 1992, and the recovery in 1993. As the graphs show, it is very difficult indeed to blame the ERM for the onset of a recession which started several months before sterling joined the system, and which (by chance) was already beginning to flatten out a little when ERM membership was announced in October 1990.

The genesis of recession was quite clearly the lengthy period of extremely tight monetary policy from mid-1988 to mid-1990, the need for which can be traced back to the failure to control the boom in the previous three years. Perhaps there are some zealots who would argue that the 1988- 90 phase of tight policy can be blamed on the need to prepare sterling for ERM membership, since the Government had decided in advance to enter only when the real exchange rate was sufficiently firm. But this is far-fetched. The only way in which the ERM can be sensibly brought into this part of the story is to join Lord Lawson in arguing that the failure to join the system in 1985 was a key element in allowing an uncontrolled boom to develop in the first place.

Turning to the prolongation of the recession, the evidence is mixed. For the first 12 months of sterling's ERM membership, there is very little doubt that the confidence effects generated in the markets allowed base rates to drop considerably more rapidly than would otherwise have been the case.

In fact, base rates fell from 15 per cent to 10 per cent during this period, and real interest rates were far lower than they had been for most of the previous decade. This easing in monetary policy, which critics now forget happened because of the ERM, prepared the ground for the recovery in activity to start in early 1992.

However, from that point on, the critics of the ERM begin to have a point. It is quite clear that base rates would have dropped to their present level of 6 per cent much more rapidly if sterling had been outside the mechanism.

It is also clear that real interest rates had risen to inappropriate levels last September (about 6 per cent), and that the real exchange rate was by then too high, especially against the dollar and yen. This could well have slowed the recovery during 1993, and by last autumn the tightness of the policy mix was threatening to turn the economy down again, possibly quite sharply.

This raises the last question, which is what would have happened if sterling had remained inside the ERM until now. This question is almost impossible to address, since there was probably no policy the Government could have followed to achieve this result. But let us stretch a point and imagine that sterling could have been defended by a combination of high, French-style interest rates (12 per cent or more) and an implausibly large amount of Bundesbank financial assistance.

It is simply unknowable whether this would have resulted in an outright slump. There is no question that business and consumer confidence would have been severely impaired. But there is equally no doubt that the earlier easing in monetary policy was by then working with the usual long lags to support recovery.

What is perfectly certain is that the political situation in the UK last November and December would not have permitted the Prime Minister and Chancellor to have stayed within the ERM under those conditions. Although in September an 'orderly withdrawal' from the ERM would have split the Cabinet, with resignations from the Euro-enthusiasts, the political mood was changing extremely fast when Black Wednesday struck.

Furthermore, if the markets had not had their earthquake, there would quite soon have been mounting pressure from Treasury officials to suspend membership.

I shall not forget an extremely senior official telling me last July that it might make sense for a few weeks to defend sterling's parity by increasing interest rates sharply, but that if this did not work quickly, then the parity would have to be jettisoned. The idea that Treasury and Bank officials were so blind that they would have defended the ERM commitment at the expense of a domestic slump is quite simply wrong and offensive.