Economic Commentary: Fault lines that cannot be repaired

In his parliamentary speech last Thursday, the Chancellor made the following remark about the ejection of sterling from the exchange rate mechanism. 'Although this was not the outcome I sought, the events of last week have, in some ways, presented us with an opportunity . . . We have over the past months been forced to pursue a policy that was tighter than required to get inflation down in Britain. The Government was prepared to accept that while sterling remained within the ERM, because of the long-term gains that we wanted to get from low inflation, but now that sterling is floating I have been able to make a prudent reduction in interest rates which is wholly appropriate to Britain's own domestic situation.'

Examine these words closely. Policy has apparently been 'tighter than required to get inflation down'. Does not that imply that at least some part of the recession was unnecessary? And if so, why did the Government not take steps to ease policy earlier? Surely no mere foreign exchange mechanism could be important enough to justify an unnecessary recession.

The Chancellor's reply to this is that he wanted to stay in the system because of 'the long- term gains . . . from low inflation'. But now that sterling is outside the ERM, policy can apparently be eased. Does that not imply that Norman Lamont is less concerned to attain the long- term gains from low inflation than he was before? And what could that mean other than that government policy is now aimed more at regenerating economic activity than at combating inflation? A sensible objective, perhaps, but one that is entirely at odds with the central tenet of economic strategy since 1979, which has that macro-economic policy should be aimed solely at low inflation, with output and employment being left to be solved by micro-economic measures.

I make these points not in a spirit of animosity (since it would be unreasonable to expect a fully coherent government line to have been developed so soon after a cataclysm like Black Wednesday), but simply to emphasise that policy is currently adrift from any reliable anchor. Of course it is technically feasible to operate a monetary policy based on a mix of domestic objectives such as M0, M4 and asset prices, while also giving some weight to the exchange rate in the formulation of interest rate decisions. But our previous experience with such a mix (from 1983-90) was not a happy one, permitting an inflationary boom to build up, and creating much confusion in the markets.

Put simply, it left far too much discretion in the hands of politicians in the setting of monetary policy, and all of our post-war history suggests that such discretion will sooner or later be abused. That, indeed, was the central reason for joining the ERM in the first place. If we are to stay outside the system on a semi- permanent basis, then the case for making the Bank of England more independent of Whitehall will simply not go away, however much the Government would like it to.

The alternative, of course, would be to re-join the ERM after a fairly short interregnum. But this is looking ever more difficult as the Government plays up the ERM 'fault lines' that will need to be repaired before sterling could go back in. Virtually everyone in the Cabinet has been banging on about these fault lines, but most have been very coy about what precisely they involve. All the Chancellor has said is that a review is needed of 'the ERM intervention rules, the co-operation procedures and the obligations that it places upon those countries at the top and bottom of the bands'. These, then, are presumably the fault lines the Government wants to repair.

Exchange loss

Some chance. Let us consider what the UK is really asking of the Germans. The current rules of the ERM force the Bundesbank to join with the Bank of England in buying sterling in unlimited quantities when it reaches the limits of its band against the mark. However, the Bundesbank has the right to return any sterling purchased to the Bank of England three months later in exchange for marks, with the UK suffering any exchange loss that occurs through devaluation in the meantime. Furthermore, the Bundesbank can 'sterilise' the initial issuance of marks by draining the German money markets of an equivalent amount of liquidity, thus leaving interest rates unchanged.

As argued in this column several times in the past few months, this intervention arrangement is in effect an elaborate bluff, which the markets have now called. Since the Bank of England knows that it is forced within three months to reimburse the Bundesbank in marks for any intervention the latter undertakes, it knows that it cannot allow such intervention to exceed the UK's foreign exchange reserves, from which the reimbursement needs to be drawn. The extent of the UK's reserves therefore remains the effective constraint on the amount of joint intervention that can take place, and this is a drop in the bucket compared with the size of today's foreign exchange markets.

How could this 'fault line' be repaired? The Bundesbank could be forced to lend for longer periods or (more important) asked not to sterilise the original issuance of marks, in which case German interest rates would automatically fall whenever sterling came under attack. To some extent, the Bundesbank has shown itself willing to do this for the French (flooding the Euromark markets with liquidity last week, thus drastically cutting the overnight rates to be earned on mark deposits outside Germany). But it cannot keep this up for very long without it leading to reductions in domestic German interest rates, which it would be unwilling to countenance. And it would never be willing to do it automatically for sterling or the lira.

The only major concession the Germans have been willing to make when these issues have been raised in the past has been to allow (from 1979 onwards, as an improvement to the original 'snake' mechanism in the 1970s) the calculation of currency 'divergence indicators', which are intended to show which country should take monetary policy action when the parity grid is under strain. The aim is to make the ERM more symmetrical, rather than having the onus of adjustment always falling on weak currencies.

Red signal

But this is potentially a serious embarrassment for Britain's analysis of the fault lines. As the graph shows, when the ERM came under increasing strain in the weeks before the bust-up, the mark's divergence indicator never went above its upper limit, so there was never even a theoretical onus on the Bundesbank to ease policy. Meanwhile, sterling's divergence indicator went through its lower limit in late August, a flashing red signal that was repeatedly ignored by the British government in the weeks before Black Wednesday.

This awkward fact is hardly likely to help Britain's case (which was anyway pretty hopeless) for reforming the ERM. If the Government really wishes to press this case in a serious fashion, then it must know that it is deliberately erecting a hurdle to sterling's re-entry that can simply not be overcome. Fudges are always possible, but at present the Government's ERM conditions look like conditions for staying out, not for getting back in.