Euromoney collapse hangs on knife-edge: Andrew Marshall and Julian Nundy look at the implications of Europe's currency crisis and the deep anger it has stirred

THE MOOD in Europe's capitals on Friday was subdued as politicians tried to play down the crisis in the European Monetary System. 'The EMS has its own rules and these rules must be and have been respected,' said Jean-Luc Dehaene, the Belgian Prime Minister. 'There are rules and these rules are working well,' said Edouard Balladur, France's Prime Minister, in Paris. Yet each was watching the collapse of the central pillar of his economic strategy.

To anybody who followed the British Cabinet through its own crisis last September, it was a familiar sight: politicians denying reality. But that is not the universal view of the crisis in Europe. The EMS has become a battleground, not only between politics and economics, but also between two different views of how states should pursue their interests.

The EMS was conceived as a 'zone of monetary stability' when the collapse of American financial hegemony and the rise in oil prices had convulsed the world economy. It was to handle currency tensions through frequent realignments, with intervention, co-ordinated interest rate policy and other tools to manage floating exchange rates.

But the pragmatism of its earlier years was allowed to slip away. It became one of the central economic instruments in many EC countries, the means of targeting inflation. And as the EC drew up plans for economic and monetary union, the Exchange Rate Mechanism came to be regarded by many states as the test-bed for a single currency.

In the last year, the credibility of that vision has been tested to destruction on the foreign exchange markets. Those markets are concentrated in London; the dealers and analysts there and in New York clearly do not believe a single currency can happen.

High German interest rates have imposed enormous pressures on countries with successful anti-inflation records. The markets do not believe that these states wish to keep up the struggle, and are betting they will not.

Belgium and France, two of the 'hard-core' states, have pinned their credibility on staying in the ERM at present exchange rates. Nor is it certain, said French economists last week, that they will be able to bring down interest rates, even if they follow Britain's flight of last September.

For the EC and advocates of monetary union, the present crisis has created a fortress mentality. 'I have only one thing to tell you - France will not allow anything to be imposed on it,' Mr Balladur said on Friday night.

The Bonn-Paris axis could be perhaps the biggest casualty if the French franc is devalued. Set in place by Charles de Gaulle in 1963, this cornerstone of European construction has been under strain for months. Germany's commitment to support the franc had seemed its only strong remaining point - and with the Bundesbank's refusal to lower its discount rate on Thursday, that also went.

Even before March's French elections, some conservative politicians were predicting that relations with Germany would worsen in the new government's early days.

The first sign that things were going badly came in late June when Theo Waigel, the German finance minister, cancelled a trip to Paris after Edmond Alphandery, his French counterpart, issued an invitation to discuss lowering interest rates in terms that sounded like a summons. As a result, an expected rate cut was delayed several days. France, with a strong franc, could talk to Germany as 'an equal', Mr Alphandery had said.

The Bundesbank did weigh in massively to shore up the franc during last September's crisis. But French conservatives predict that the monetary issue - its most crucial component - will eventually undo the alliance, already under strain from a number of other policy differences, notably over former Yugoslavia and the GATT talks. One Gaullist said the EMS had worked while Germany was 'virtuous, but when they are no longer virtuous . . .'

All this has created a climate ripe for conspiracy theorists, who noted that the key players were out there on Friday, talking away Europe. The Financial Times, which destroyed Jacques Attali, was now advancing on the EMS. Six economists from the Massachusetts Institute of Technology, argued that something had to give. Reuters had an analysts' poll saying the system would break; and George Soros, the quintessential player of global markets, said it was time to launch the final assault. 'I do not expect the ERM to continue functioning. I do not expect the present arrangement to be operative on Monday morning,' he told them.

The damage done by this crisis to co-operation in Europe will be severe. There has already been talk in Brussels about the wisdom of dropping capital controls over the last few years, and there are hints that the European Commission may take a sanguine view if some states choose to re-adopt them. Attempts to re-inject some vitality into the EC with a joint package of economic measures may come to nothing.

To the opponents of the EMS, all this may look like history in the making, as the EC drops an unrealistic vision and embraces reality. In Brussels, it looks more like history in reverse.

Leading article, page 20