Economics: Eerie calm after the ERM storm

THE most curious feature of the past week on the foreign exchanges has been the odd calm that has descended on previously crisis-hit currencies. A fortnight ago, the markets were selling the franc for all it was worth, as we now know from the reserve figures of the Banque de France. France's official holdings of foreign currency, available to support the franc, plummeted by pounds 11bn.

Yet last week, with the bands of the exchange rate mechanism widened from 2.25 per cent to a positively liberal 15 per cent, the franc fell by only 3 per cent below its old floor even at its lowest point. After the rebound on Thursday, the Friday close was about 1.5 per cent down. Such a modest reaction, after all the sound and fury, prompts the question of whether the European central banks misjudged the real force of speculation against the system.

This is not to argue that they should have continued to resist at the old official exchange rates. A rise of the mark against all other currencies has been desirable for more than a year, and had it been allowed last summer much pain would have been avoided in London, Rome and Paris. (Norman Lamont's reputation, for one, would not have undergone the collapse from which it must now recover.) More flexibility in Europe's currency grid was necessary to absorb the greater-than-expected shock from German reunification.

However, there is also a question of tactics. It would have made sense to concede a relaxation in the franc-mark link after beating the speculators, even at the cost of borrowing foreign currency. By failing to choose their own time, the central banks have undermined their reputation for winning, making it harder to curb future speculation.

This matters because Europe is still far too interdependent for its currencies to be allowed to fluctuate as freely as the yen or dollar. Exports and imports are at least double and sometimes as much as seven times American or Japanese levels, as a share of output. To have currencies gyrating as much as the yen and dollar would sharply increase uncertainty for many businesses.

Although the way in which the exchange rate mechanism has been run since 1989 has served to spread recession through Europe, that was a specific fault of the failure to realign the mark. It is not a general criticism of managed exchange rates, the alternative to which is usually worse. Even in the period of dirty floating since 1971, there have been three examples of grotesquely distorted currency values.

The overvaluation of sterling between 1979 and 1981 led to a loss of competitiveness of more than 50 per cent and to a fall in manufacturing output of a fifth. This unnecessary squeeze on the tradeable sector is one of the reasons why we are running an unprecedented balance of payments deficit even at the bottom of a recession.

The overvaluation of the Swiss franc under floating rates led to one of the slowest periods of Swiss economic growth in its history, while the overshooting of the dollar under Ronald Reagan bequeathed the United States an enormous and long-lasting payments deficit, which turned the world's largest creditor into the world's largest debtor in just a decade.

The foreign exchange markets are notoriously short-sighted and unstable. After all, the markets that speculated against the franc a fortnight ago were the same markets that, only weeks before, had pushed the franc up within its bands, allowing the French to preen themselves on their success in cutting interest rates below Germany's.

Nor is it an accident that the United States erected import barriers against Japanese goods through the 1980s. The pressure for protection rises in proportion to the overvaluation of the exchange rate, and to the handicaps thereby imposed on a country's traders. There is an exact parallel with the period of beggar-my-neighbour devaluations and protection in the 1930s. Most European governments are well aware of these considerations, which is why Europe is the last to abandon fixed exchange rates and the first to reinstitute them. The rigid ERM as it has operated since 1987, with no realignments of any currency's floor until last autumn, is thankfully dead. But 15 per cent bands are too flexible for most European currencies (although maybe not, in the short-term, for the mark).

For the time being, the best model may well be the operation of the ERM between 1979 and 1983. During that period, there were frequent realignments of official target parities to take account of differing rates of inflation: high-inflation countries devalued more often, preserving constant price competitiveness for their trading sectors.

This type of crawling peg system helps to avoid the costly misalignments that have been a feature of free floating. It does not, though, provide any anti- inflationary discipline. That would either have to be generated at home by setting an inflation target (as with Britain's 2 per cent objective) or by hardening the system gently, as happened between 1983 and 1987. During this period, ERM members with high inflation rates devalued their official target exchange rates by about half their loss of price competitiveness.

Such a system nevertheless requires an anchor currency against which to assess performance, and it should clearly not be any currency susceptible to, or suffering from, serious inflationary shocks (such as the mark today). The anchor could be a franco-mark, a currency used by a mini-monetary union. Or it could be a revamped ecu based not on fixed shares of other participating currencies but on having its own monetary policy and interest rates. It could be akin to the British government's hard ecu proposal, revived on Friday in a paper from the Institute of Directors.

However, the hard ecu has one feature that would be a serious weakness in present circumstances, because it carries a guarantee never to devalue its official rate against other European currencies. Given that the mark needs to revalue to help Germany control inflation, the hard ecu would be driven up as well. It would be just as hard a taskmaster as the mark has been, exporting similarly inappropriate policies. The preferable alternative would be an independently run ecu whose value would be kept constant in terms of European goods and services, a version of the proposal by Jacques Riboud.

In the short-term, though, European governments should exploit a little of their new-found freedom. There seems no point in France hesitating to cut its interest rates, particularly since the factor undermining the franc and other weak ERM currencies has been domestic recession. As soon as the continental recovery begins, the franc may find itself not far away from its old central rate against the mark. Last week's calm suggests that Europe's exchange rates are more aligned with the fundamentals than some people in the markets thought. The hard ERM is dead. Long live stable currencies.