Why Britain cannot turn from Europe

THE MORE I see of British reactions to the mugging of the pound, the more worried I become about the future course of Britain's economic and European policy.

Helmut Schlesinger, the Bundesbank president, was guilty of carelessness but he does not deserve vilification. Nor does his mistake justify a rash of anti-German sentiment that could properly be the subject of complaints to the Race Relations Board.

There has long been a case for a general realignment within the exchange rate mechanism. This would have involved the upward valuation of the German mark. A rise in the mark cuts German import prices and inflation and hence allows lower German interest rates. Interest rates throughout Europe could fall.

But the problem has been France, not Germany. The French saw no reason why they should break a mark link unchanged since 1987 when their trade is in surplus, their inflation is lower than Germany's, and they are gaining competitiveness through lower price rises rather than a devaluation. They wanted the ERM to be the glidepath to monetary union with the mark.

Nor is the British government blameless. We joined the ERM in October 1990 at what officials conceded was an ambitious rate of DM2.95. Underlying inflation was at 7.9 per cent. John Major, then Chancellor, had failed to take his officials' advice either to raise interest rates or taxes. Instead, he spent 1990 talking the pound up as a third-best way of tightening policy.

We were also careless when we joined, merely telling our partners an hour before the close of trading what we intended. We did not consult about the appropriate exchange rate, presenting our partners with a fait accompli. The Bundesbank always thought the pound was too high.

This is the main reason why the French, despite their smaller foreign currency reserves, have been able to fight off the speculators when the British could not.

True, the rise in French interest rates was more credible than Britain's, because the French are so much less indebted. High rates thus cause less pain. But interest rates are not in any case the key weapon, because such large annual rates are required to compensate investors for the risk of even a small but imminent devaluation.

The key to the defence of a weak currency is the attitude of the authorities of the strong currency against which it is falling. If the Germans are prepared to print marks, they can stop its rate from rising. In 1978, the Bundesbank allowed the money supply to expand by more than 20 per cent to stop the fall in the dollar.

The Bundesbank last week performed a similar trick for the franc. It stated clearly that it thinks there is no case for a franc devaluation, and it intervened actively. The Franco-German relationship is also the bedrock of both countries' foreign policies and would have suffered grievously from a French humiliation.

An important lesson of the pound's ejection from the ERM, therefore, is that we should have consulted our partners over the appropriate sterling rate, putting them under a greater obligation to help in its defence. This common interest could, in principle, now be reinforced by some risk-sharing, such as a pooling of reserves for use in the event of a speculative attack.

But it would be wrong to insist on a long list of preconditions before rejoining the ERM at a lower rate. It is in our own interests to do so, not least because of the difficulty of withstanding political pressures to cut interest rates and let the pound slide too enthusiastically. In a nation of debtors, there is little more popular than a burst of inflation to erode debt and push up money incomes.

The idea that devaluation can buy a stronger recovery without causing higher inflation is wishful thinking. I do not know whether inflation will merely stop falling, or will actually reverse. But a rise in import prices is inevitable when the pound is now 9.4 per cent below last year's level (taking the trade-weighted index against all our partners). Since a third of all we buy comes from abroad, overall prices will be some 3 per cent higher than otherwise over a few years.

Less favourable scenarios are only too plausible. The National Institute of Economic and Social Research believes that wage bargainers will see that the devaluation will raise inflation, and will react quickly. Its briefing note last week suggested that a 10 per cent devaluation and 1 point off bank base rates - roughly the situation - would add 3.8 percentage points to inflation next year ('The aftermath of Black Wednesday', NIESR, pounds 1.50.). (Growth would be up by 1.4 per cent next year, and 0.5 points in 1994.)

The competitiveness gains would be temporary: within four years, higher inflation would have cancelled out the initial benefit. If devaluation were an easy recipe for success, the British economy's performance would be miraculous.

In 1960, the pound bought 11.7 marks. Since then, the external value of the pound against the mark has fallen by 78 per cent, but any advantage has been eroded by rising domestic prices. Over that period, the arguments against devaluation have become stronger as imports have grown as a share of spending. Devaluation's impact on inflation is more rapid.

Ministers might also consider what the current policy mix is likely to do for the economic outlook at the time of the next election, in 1996-7. Economies turn around slowly. Our present problems of debt and recession built up from 1987-9 and wrecked the Conservatives' electoral-economic cycle. A sharp relaxation of policy and higher inflation could do the same again.

Then there is the impact of recent events on the rest of Europe, and hence our relations with it. The prospect of monetary union has been the glue holding together the ERM's parities for five years. The belief that the parities would remain fixed made it easier to defend them: the limits acted like reverse magnets repelling speculators. As the prospect of monetary union faded, so did the glue.

That was the main reason why I predicted, after the Danish 'no' in June, that it would be difficult to hold the line on the pound: 'If there is no hard evidence of lift-off in the autumn, the Chancellor will face renewed pressures for devaluation or even a free-floating pound outside the ERM.'

It is also the reason why many policy makers have concluded from the experience of the past three weeks that the 'hard' ERM is an unstable point between the more flexible system of 1979 to 1987 and a full-scale monetary union.

The instability arises because it is impossible for countries to combine free capital flows, a fixed exchange rate and an independent monetary policy. If your interest rates drop out of line with another country in a fixed exchange rate system, money flows to the other country until the fixed link is broken, or capital flows are blocked, or interest rates are brought back into line.

Bretton Woods survived as a fixed-rate system with different interest rates because of capital controls. Thanks to free flows, the ERM's fixed rates could only survive if the markets believed monetary policy would effectively be run in common. But the markets, faced with the Danish 'no' and a French 'maybe', could believe no such thing, at least for the weak currencies.

Wholly predictably, the reaction of the countries on the periphery of the ERM has been either to let the exchange rate float (in the case of Britain and Italy) or to reimpose exchange controls on capital (in the case of Spain and Ireland last week). The currency turmoil is a threat to an efficient capital market, and could soon be a threat to trade as well.

Equally predictably, the reaction of the core ERM countries - Germany, France and Benelux - is to move more quickly to a single currency, the ultimate speculator-proof fixed-rate system. Last week, the Belgian central bank president, Alfons Verplaetse, said that a five-nation union could go ahead immediately. The German finance minister, Theo Waigel, and France's Europe minister, Elisabeth Guigou, were reported to have made similar remarks.

This, from the viewpoint of British foreign policy, is the nightmare scenario. Once again, Britain would have excluded itself from mainstream European developments by virtue of economic weakness and iridescent nationalism.

From an economic viewpoint, too, there are dangers. All those companies that have been busy marketing themselves as European will find it more difficult to do so. The City's position in investment banking, consultancy and insurance will be weaker. Most dangerous of all, Britain's 51 per cent share of Japanese direct investment in the European Community last year would be under threat.

The feelings of British policy makers have been badly hurt, but the buffeting of the past few weeks has changed neither the world of ideas nor Britain's fundamental economic or political interests. The sooner British heads begin to rule hearts, the better.