The Sterling Crisis: Very bloody, but surprisingly unbowed

NOTHING has changed. The pound has not been devalued, the Government's commitment to the ERM is undiminished, the pursuit of permanently low inflation will be unswerving and, for good measure, there is no intention of vacating our proper place 'at the heart of Europe'. A period of unprecedented turbulence in the currency markets, caused by essentially short-term factors beyond our control, left the Chancellor with no choice other than temporarily to suspend sterling from the ERM. The pound will return to the ERM 'as soon as conditions allow'. Nothing has changed.

It is easy to scoff. What could be more typical of traumatised politicians than to shelter pathetically behind the wreckage of burnt-out policies? These are men in shock. Maybe, but is it really such a bad way of responding to what has happened?

The truth is that the Government really has no alternative other than to rededicate itself to its existing policies. On Wednesday night, after a day none of the players would wish to live through again, there was bitterness about the Bundesbank and ambivalence as to whether the ERM would ever be worth rejoining.

In the cold light of yesterday morning, things looked rather different. In the first place, it is easier to acknowledge a temporary setback than be forced to abandon everything you have held most dear. Stripped of its economic and European policies, the Major government would have nothing to call its own beyond the Citizen's Charter. Secondly, and more importantly, when the Government thought about the non- ERM options, they all looked distinctly unappealing.

For the Treasury, the issue is quite simple. There has to be some kind of monetary anchor or policy will be run on hunch and expediency with the usual inflationary consequences. Over the years, in its search for a 'rule', the Treasury has concluded that there is probably nothing better than targeting the exchange rate. And as the countries with which you do most of your trading happen to operate a system of exchange rate targeting, it makes more sense to be in that system than out of it.

For the Foreign Office, there is an equally straightforward issue - how do you secure for Britain the maximum international influence and degree of control over its own affairs. The answer, whenever the question has been asked over the past 30 years, is by playing the fullest role in Europe. Whatever the stresses and strains in Europe today there can be no sensible argument about where our destiny lies. A permanent retreat from the ERM would make infinitely less likely the development of the kind of Europe it is in Britain's interests to see.

By the time the Cabinet met yesterday, there were no longer any doubts about the desirability of returning to the ERM as soon as is practicable.

Precisely what this means, however, is inevitably less certain than the intention. To begin with, nobody has any idea how the French will vote on Sunday. For what it is worth, the Government continues to hope for a 'yes' vote and has every intention of securing ratification at Westminster in that event, whether or not we are back in the ERM by then. (It is suggested that Mr Major might actually find it easier to get the Bill through Parliament because of the Government's difficulties.) It is highly unlikely, however, that the pound will speedily rejoin the mechanism unless there is a substantial realignment, including an upwards revaluation of the mark, which would allow interest rates within the ERM to fall.

In the slightly more probable event of no further realignment for the time being, the Government will want to wait until German interest rates have fallen significantly before getting back in. In that case, it could be six months before 'conditions allow'. In the interim, it should be possible to reduce interest rates by a little more than would otherwise have been the case - perhaps down to 8.5 per cent by the end of the year if sterling is looking strong enough. What the Government will not do is to abandon its fight against inflation. Calls for a US-style interest rate crash will go unheeded.

Of course, the Government has experienced a bitter defeat this week, but it does not accept that its policies were wrong. It intends to pick itself up, dust itself down and press on. The Prime Minister is not yet for turning.