Economic Commentary: Radical rethink needed on ERM

A German monetary easing on Thursday might enable the remaining members of the exchange rate mechanism to continue pretending for a while longer that the events of the last few months have been just a temporary inconvenience. In their eagerness to castigate the 'speculators', it seems barely to have crossed their minds to ask whether the recent market disruption is sending a more profound message about the feasibility of maintaining the ERM in its present form. Nor are they willing to address the question of whether a system that was a great success for all its members in the 1980s remains desirable in the 1990s. These questions, though, will not go away.

The ERM was until recently a success because it directly addressed the central problem of its time, the control of inflation. Throughout Europe, there was a revulsion against the high inflation rates of the 1970s, so governments were willing to hitch their currencies to the standard of the German mark, thus voluntarily accepting a tough external restraint on monetary policy.

The result was declining inflation in several economies, including Italy and France, which had previously endured rapidly rising prices and periodic devaluations.

Later, economic growth began to recover, but unemployment never fell back to the levels that had been in place a decade before. What the ERM did was provide an external discipline to toughen the backbone of governments that had previously been unable to maintain an internal political consensus for the control of inflation. Even in the case of Britain's brief sojourn in the system from 1990 to 1992, it played a useful role in this respect.

However, what the ERM did not do was reduce the costs of disinflation in terms of lost output and jobs; it simply made it politically feasible for governments to stick to a low inflation route, at the cost of permanently higher unemployment, and that left the system vulnerable to a renewed dose of recession in the 1990s.

FISCAL MANAGEMENT

There were in fact four developments in the last few years that crucially undermined the system.

First, governments became overenthusiastic in their rejection of the Keynesian practices of earlier decades, and chose not only to jettison domestic monetary sovereignty, but also to turn their backs on active fiscal management. It was all very well to attempt to reduce the size of the budget deficit on average in the course of an economic cycle. That much was needed. But to refuse to employ budgetary means to dampen the cycle meant that there was no macroeconomic policy weapon available to combat recessionary forces when they arrived. Two-club golfing was replaced by no-club golfing.

Second, many countries have for the first time in many decades abolished controls over capital movements as part of the 1992 single market programme. Therefore the ERM became the first monetary arrangement since the Gold Standard to combine fixed exchange rates with completely free capital movements. Many academic economists conjectured that the potential size of the capital flows now could make this combination unfeasible, and so it has proved.

Third, the economic boom of the 1980s began to subside, first in the Anglo Saxon countries and Japan, and latterly in Continental Europe. This was extremely damaging to a system that had been built on the need to reduce inflation, and that had encouraged the progressive dismantling of any policy weapon that might combat recession. Surprisingly, most political parties throughout Europe have so far remained committed to the principle of the ERM despite the recession. But it should be recognised that the recession is only just beginning on the Continent, and political support for the ERM will drop as fast as unemployment will increase throughout Europe next year.

Fourth, German unification desynchronised the European economies. The appropriate response to this huge shock was a rise in German real interest rates and a temporary, but quite large, jump in the real value of the German mark. The ERM prevented the latter from occurring, and thus suppressed a key channel for absorbing the unification shock. By foolishly turning their backs on a mark revaluation in 1989, governments increased the chances of the entire system breaking up in disorderly fashion in 1992.

Although the last of these problems should soon begin to ease as the German recession deepens, it is now questionable whether this has come in time to rescue the ERM. If recessionary forces are thought by the markets to be gathering momentum at a time when the Bundesbank simply drags its heels over interest rate cuts, the instability that has so far plagued only the peripheral currencies of the ERM could easily spread into the core.

Recent exchange rate turbulence has in no way been connected to traditional 'fundamentals' such as trade, inflation, budget deficits, and purchasing power parity, so core currencies such as the French and Belgian francs need not necessarily be protected by their undoubtedly strong 'fundamentals'. The partial break-up of the ERM has so far been caused by one 'fundamental' only - the need to accelerate reductions in real interest rates in countries suffering recessions. And no country is necessarily immune to this force.

POLICY CREDIBILITY

Faced with these intractable problems, it is difficult to thump the table and say that the present arrangements must be defended at all costs. There is now no question that the defence of the ERM is leading to higher interest rates than would otherwise be necessary in several European economies, so the system is directly causing output and employment losses. Offsetting these losses are the gains in policy credibility that the ERM confers on countries such as France.

These credibility gains are long-term, and have a direct beneficial effect on holding down interest rates on average over a period of years, and perhaps in reducing the long-term equilibrium unemployment rate that is consistent with stable inflation. But as the immediate losses appear larger and more permanent, and as the long-term gains appear more nebulous, it is rational even for long-standing friends of the ERM (such as myself) to ask whether a temporary suspension of the entire system, pending a permanent solution to the problems listed above, might not be a good idea. This would be an over-reaction only if the Bundesbank is ready to make a large and immediate reduction in German interest rates for its own domestic reasons.

In the longer term, some form of monetary integration will remain an essential part of the single market programme, without which the European Community has no purpose. Therefore a permanent solution will emerge, probably based on full monetary union between a small core group of countries, which may or may not include France. Britain must as an absolute priority work towards an ever-closer relationship with this core - we have no viable future otherwise.

But it will take a long time to stitch together such an agreement, since the Maastricht treaty (increasingly looking like a beached whale) is not the appropriate vehicle for such a reform. And the suggested narrowing of the present ERM bands for the frank/mark exchange rate would be a political gesture doing nothing to address any of the problems noted above.

The ERM was a system well suited to solve the inflationary problems of the 1970s in an environment of strict controls over international capital movements. Something radically different may now be the order of the day.