Economics: France pins its colours to the ERM

THE French election opens a new phase in the battle to keep the franc within its bands in the exchange rate mechanism, and to keep Europe on track for a single currency. If the new government faces down the financial markets, it will have relaunched the Maastricht treaty more convincingly than any positive vote in the House of Commons.

If the franc's link with the mark holds, it will not be long before France, Germany and the Benelux countries proceed to monetary union inside or outside the Maastricht framework, whatever everyone else does. And it will probably not be long before all those British industrialists (you know who you are, Sir Denys Henderson) who hailed our ERM membership in 1990 and hailed our exit in 1992 are once again appealing for us to rejoin.

But the war is not over yet. Although the Banque de France has not had to weather renewed speculative attacks on the franc's parity, France's high interest rates are an equally telling indication that the financial markets are not yet convinced that the franc-mark link is solid. France is paying a premium of about 2 per cent a year (on deposits of cash) to stop money flowing out of francs and into marks. Before the ERM crisis in September, the premium was as low as half a point.

The unfairness of this premium is shown by the second graph. France's inflation is now just half of Germany's rate at 2.1 per cent. This means that France's real interest rate (after allowing for inflation) is a crushing 8 per cent. Given that a typical historical figure is more like 2.5 per cent, it is not surprising that industrial output is falling nearly as sharply in France as in Germany.

France could opt out of the ERM and cut interest rates, just as Britain did. Edouard Balladur, the new Prime Minister, promised that there would be no devaluation before he became finance minister in 1986, and then promptly devalued. But the signals he is now sending out, notably with the appointment of Edmond Alphandery as economics minister, are quite different.

Mr Alphandery is a minister in the mould of Raymond Barre; he is another economics professor with a long-standing record of support for both sound money (usually defined in France as a stable foreign exchange rate) and economic liberalism. He comes from the centrist - UDF - wing of the French centre- right coalition, rather than from the nationalist - RPR - wing.

Lest anybody doubt his backing for the franc fort, this is what he said last week: 'As for applying in France the policy John Major has followed in Britain, that is to say decoupling the franc from the mark and playing around with interest rates, I hope that the disastrous effects of the policy followed on the other side of the Channel will open the eyes of those who might be tempted by such siren songs.'

Even allowing for the predilection of politicians to eat their own words, this is the sort of statement that should rule out a devaluation for a few months at least. The Right's manifesto commitment to early independence for the Banque de France, as a way of strengthening the franc's link with the mark, looks more than cosmetic.

The most important French motive for hanging on to their mark parity is simply that relief could well be in sight. Having invested so much, is it really worth throwing in the towel just as German interest rates may fall sharply?

The French can argue that they will receive a double benefit. Not only will the fall in German rates allow a parallel cut in French rates, but the decline will make the franc-mark link more credible. In those circumstances, the French will also be able to cut their risk premium. A three- point cut in German interest rates could lead to a four-and-a-half-point cut in French rates.

There are three strands to French thinking. The first is the intellectual conviction shared by most European economists that devaluation no longer buys more than a temporary gain in price competitiveness, because European economies import so much from each other that higher import prices rapidly stoke inflation. A higher domestic price and wage level soon cancels out the benefit of a declining exchange rate. (There may be exceptions to this doctrine in a severe recession such as Britain's, when the inflationary impact is more muted.)

The second French motivation is political. Having accepted the case for an exchange rate system, the French find it galling that they effectively have to accept monetary policy decisions taken in Frankfurt. They want to regain control over their own monetary policy. This is only likely to happen in a monetary union where a European central bank with French representatives takes account of French as well as German monetary conditions when setting interest rates for the whole area.

The third motivation is a long- standing, Ridleyesque mistrust of the Germans, which spilled out into the open during the French referendum campaign. Maastricht and a single currency are seen as another stage in the attempt, which began with the European Coal and Steel Community in 1952, to bind the Germany economy so closely into the rest of western Europe that it no longer has an independent capacity to make war. That consideration seems far-fetched only to the ahistorical. France has been invaded by Germany three times since 1870.

The French will therefore want to persist, and the usual post-election honeymoon period means that they are unlikely to have reached their pain threshold yet. The big question then remains how quickly German rates will come down.

The cut in German rates since the September ERM crisis has been horribly grudging, given the travails of Germany's monetary partners and the decline in the German economy. Money rates are down by less than 2 points from their peak, even though industrial production has been falling for a year and unemployment has been rising since the beginning of 1992.

The main stumbling block has been the recalcitrance of Germany's 4.2 per cent inflation, caused in part by indirect tax increases feeding into prices. The money supply, much venerated by the Bundesbank, has also been stubbornly high, probably distorted by special factors such as eastern European demand for cash.

But even the Bundesbank cannot afford to ignore output and jobs with impunity. Inflation, after all, tends to lag behind what is happening in the economy. There may be another rate cut within a month, and the replacement of Helmut Schlesinger as Bundesbank President by Hans Tietmayer this summer should help to speed up the process. German money rates could be down to 6 per cent by year end.

Any renewed attack on the franc would probably be met by even faster cuts, not least because a sharp rise in the mark against the franc could turn Germany's expected GDP decline of 1.5 to 2 per cent this year into a collapse of 2.5 to 3 per cent. Reports of the demise of the exchange rate mechanism may yet prove to have been exaggerated.