Comment: A lesson for Europe's governments

This is a victory for the financial markets. For some months now the markets have been convinced both that the lira needed to be devalued and that the Bundesbank's high interest rate policy was damaging the world economic recovery. But, for a combination of political (in the broadest sense) reasons, the authorities chose to resist them. The politicans - and indeed the Bundesbank - now look rather silly.

The financial markets had no direct way of forcing the Bundesbank to cut interest rates, but by escalating a guerrilla war on the lira to a frontal assault they not only forced the devaluation, they also forced the Bundesbank to change course. The scale of intervention that the Bundesbank had to undertake last week was so undermining Germany's tight monetary policy that the lira devaluation had to be made more credible.

Peer pressure by other central bankers will have had some impact on the Bundesbank's view of the world, but it was the currency inflows into the mark that ultimately caused it to make a 180-degree turn. Seen from Frankfurt, the cut in rates was a small price to pay to stop a flood of unwanted money into marks.

What else have the events of the weekend, and the market reaction to them, taught us? Take the cut in German rates and the devaluation of the lira separately, and take first the practical implications.

The fundamental new information for the markets yesterday was that German rates will not go higher this cycle. Carping about the size of the cut misses this point. They may stay where they are for some time, but the next movement will be down.

This has a number of implications. Provided the French vote 'yes' (and quite possibly even if they don't) this coming weekend, the path of European interest rates will also be down. In the case of sterling the next cut will have to wait until the pound climbs off the floor of the ERM grid. The authorities, knowing how fragile the pound has been, will be anxious not to try to grab the cut in rates before the pound has climbed back into its narrow bands at least.

Turning point

The cut in German rates has also turned the dollar. For some days now the markets have been looking for reasons to call the turning point.

It was suggested here last week that the bottom for the dollar was in sight, though it was probably too early to expect it now. That judgement has been both vindicated and overtaken by events.

One can say now that the dollar has almost certainly passed its cyclical bottom against the mark, perhaps a couple of months before the turn might otherwise have been expected. That, of course, is good for the British economy. Sterling's problem has been that it has been overvalued against the dollar, not against the mark.

Together, the fall in European interest rates and the turn of the dollar will help to convince bond markets around the world, and particularly in Europe, that they are cheap. It is easy to make an intellectual case for investing in fixed-interest securities against a background of a falling secular trend of inflation. But high short-term rates in Europe held the markets back. The jump in gilts yesterday showed that the fundamental demand for fixed-interest securities is high provided there is some prospect of falling short-term rates.

Now the practical impact of the fall in the lira. It tells the world that the ERM cannot lock currencies together for ever if the economic fundamentals point the other way. Sensible people knew that all along, but even a week ago the EC finance ministers were saying the contrary. They now look stupid, and jolly well ought to feel stupid too.

But admitting that ERM rates can be changed might, under the wrong circumstances, encourage the markets to celebrate their victory over the lira by taking a pot shot at the next weakest currency in the ERM, the pound. The evidence of yesterday is that this will not happen, and that if the markets did they could be repelled. (The Swedish experience helps, for it looks as though the Swedes may beat off calls for devaluation.) The lesson seems to be that one can acknowledge that there will be realignments in the ERM without leading to a domino-like collapse of its weaker members.

Good news

The final practical effect of the weekend's events will be to tell markets that the European monetary authorities, like the Americans and the Japanese, are prepared to take action when faced with serious market pressure. The US has been moving for many months. The big Japanese package came earlier this month. Now there is some movement in Europe too. So all the three big trading and currency blocs are easing policy by varying degrees. This is new, and it is good news.

Now for the longer-term implications. These mostly concern the path of European monetary integration. Assume a 'yes' vote in France - if it is 'no' the whole idea disappears.

The fact that the German central bank is the de facto central bank of Europe is now plain to see. The fact that the ERM will have to be patched together for several years is also plain. Europe as a whole, and Germany in particular, therefore need a commitment to making the ERM work. This in turn requires the Bundesbank to accept its EC responsibilities. Rejecting them leads to the 180-degree turn of the weekend.

But it also requires EC governments to put in place financial and monetary policies that lead to economic convergence. It is no good pretending that the ERM on its own will force governments to follow sensible policies. It has not worked in the case of Italy, for when push became shove the exchange rate gave, not the fiscal policy.

This is a very important lesson for EC governments. There has been a back-about-face element to the whole Maastricht debate, the assumption that the move towards a common currency would force governments to bring in the common policies needed to make the currency union work. But, of course, the common policies have to come first.

Setting the goal of EMU has public relations value, but not much more. Wrong-headed policies will be punished by the markets. They are worth changing for their own sake, not just because they break the Maastricht club rules.