View from City Road: Common sense versus the French for debacle

The Bundesbank appears to have left the French government with two practical options: a worsening domestic recession because of high interest rates, which amounts to continuing flagellation for the sake of a principle; or departure from the exchange rate mechanism, accompanied by lower interest rates and an early revival of the economy, which to just about everybody but the French government now seems the only common-sense way to proceed.

But despite close parallels, it is wrong to see this as a simple rerun of Britain's debacle last September, with the markets entirely in control. Then, the sheer weight of speculative money forced the pound out against the will of the Government. There was no choice in the matter.

One important difference is that the pound had long been seen as over-valued. It was only as the crisis developed that the damaging effect of continuing high interest rates on Britain's prospects for recovery became a serious factor in the speculative attack on the currency.

But the franc is not seriously over-valued. This is largely an interest-rate crisis forced on the French government by its own decision to gear domestic monetary policy to Germany's counter-inflation campaign, which is managed by the Bundesbank, the anchor of the ERM. Germany, of course, is at an earlier stage of the campaign than France, largely because of reunification, and will not lower its rates to suit the French.

To a certain extent a British-style vicious circle has begun to develop, in that the franc becomes less attractive as unemployment rises and output falls. But even now it is the peseta rather than the franc that looks the likeliest candidate for immediate departure from the ERM. As yet the Bundesbank and the French government have managed - at high cost - to stop the markets going out of control.

Indeed, high French rates and determined intervention could still keep the franc struggling on within the system for a while longer, despite the scepticism of the markets.

Devaluation might give a breathing space, but a new parity a few per cent lower would immediately have to be defended by the same high level of interest rates, gaining little. So why bother?

Thus if France does leave the ERM in the near future there is a reasonable prospect that it will be voluntarily, an overt political decision all the harder for the fact that there is a genuine choice, unlike that which faced Britain 10 months ago.

Common sense says the French should withdraw now, to prevent such a situation developing. But as long as some freedom of action remains, politicians may regard a decision delayed as a decision made.

As for the UK, the Bundesbank's snub to the French makes it much more likely that the Government will eventually be able to cut base rates. Disarray in the ERM threatens to make sterling too strong for British exporters. But it would pay to wait, to see how the crisis is resolved.