Makings of the money crisis: It's simple really. The money markets trust the Bundesbank more than the British. Hamish McRae analyses Europe's economic crisis

What is going on? Britain is suffering the longest recession since the war, and the next move in interest rates may well be up rather than down.

The most recent turmoil on the exchanges has, apparently, been caused by the float of the Finnish markka and the introduction of a 75 per cent short-term interest rate in Sweden. The lowest interest rates for 30 years have failed to boost the United States economy, which may be heading for a third dip. The European exchange rate mechanism, which sterling joined as a haven of currency stability, seems to be the centre of the storm. And John Major says that there can be no change in policy.

Either the world's financial markets are absurd, or much deeper forces are at work.

Assume, for the moment, that the second proposition is the more correct one. It is possible to explain much of the turmoil on the exchanges, the threat that this poses to the world economy, and the difficulty governments are having in responding to it. What is tougher is persuading electorates that governments are as prescient as they pretend to be.

Currency crises do not come out of the blue; they happen when several conditions combine in a destructive way. There are now at least three separate forces - perhaps three-and-a-half - that happen to have coincided in recent months, each of which would have been bound to cause tensions.

The first is the cyclical recession in the world economy. The graph (top left) shows the British version of the three recessions since 1970, which, assuming we pull back into growth by the end of the year, all look broadly similar (though the 1974/75 one had a double bottom). The picture for the US is much the same as Britain's, though it is a little ahead of us in the cycle and seems to have clambered back into growth. Germany and Japan, by contrast, are running behind the US and UK, and have yet to move into recession.

The shapes vary somewhat, and sometimes a country can avoid an actual contraction, as Japan did in the early Eighties, but all countries are to some extent prisoners. This stage in the cycle is one of maximum strain, partly because it is towards the end of a recession that companies find they have used up their fat, and this is when people lose their jobs. But it is also a time of strain on the currency markets because countries move into recession at different times.

The countries which go in early tend to have policies designed to pull them out: larger budget deficits, lower interest rates. Whether these policies work is another matter: what is beyond dispute is that they put strains on the foreign exchanges, the mechanism that links different

economies.

The second force is the process of disinflation which has been evident in the world economy since about 1980. The graph (top centre) shows the twin peaks of British inflation between 1974 and 1980 at that time, followed by the much smaller peak two years ago. Again, the pictures for the other main economies would vary in detail, but the message is remarkably similar.

For some reason, which is not easy to explain, the world is set on a course towards price stability; each peak in the inflation cycle seems to be lower than the last. This has created a particular problem for countries, companies and individuals who over-borrowed in the Eighties. In any earlier cycle, they would have been bailed out by inflation; this time they got it wrong. The evidence in Britain is vividly portrayed by the housing market, by the Canary Wharf debacle and in the daily squeals from company chairmen who borrowed to expand at the wrong time.

But this is not just a British problem. Losses on the Japanese equity market are far worse than anything here, and in Tokyo it looks as though bank losses will in part be met from public funds. The bailing-out of the US savings and loans industry - the equivalent of our building societies - is costing the taxpayer several hundreds of billions of dollars. And the Scandinavian banking crisis is far worse than the relatively modest losses by UK banks.

There are, of course, gainers from falling inflation: the elderly in every country, who tend to be the main savers; and companies that have relied on reinvested profits to finance their expansion.

But the fact that there are costs has led to suggestions that the shift towards low inflation is a misguided policy, imposed by central banks for ideological reasons (with the Bundesbank and the Bank of Japan catching most of the flak).

Maybe. But it is not just the central banks, for in truth, just as we do not really know why the world has to have recessions, we do not really know why this process of disinflation is taking place. It has something to do with the growing power of financial markets which can shift funds from one continent to another in an instant, and which take their money and run at the threat of inflation. But that is hardly a complete answer.

In the meantime, partly because the debt burden varies and partly because some countries are faster at reducing inflation than others, the process puts pressure on currencies and economies.

The third force is the process of financial integration within Europe. Recession and disinflation affect the whole world, but the EC countries have stirred in a third source of tension by trying to force integration of their economic policies through the ERM.

Until 1987 it was a loose club that allowed currencies to devalue if they wanted to: the French and the Italians periodically did so. Since then, it has officially been a precursor of some form of common currency, and therefore in theory at least it locked currencies together. By locking currencies you would, it was argued, force economic policies and inflation rates to come together, too.

To some extent that has happened: crudely, the French have brought their policies in line, but the Italians have not. In any case, shortly after the German mark became the anchor for the other ERM currencies, it also became the currency of the enlarged Germany. This led to new strains on Germany's finances, which - thanks to the mark's position as the core EC currency - have spread across the whole of the EC. The whole of Europe has to pay interest rates appropriate to finance the reconstruction of eastern Germany.

Those are three reasons; for the rest, look at Finland. Anyone familiar with chaos theory will appreciate that a small event in one corner of the globe is liable to start a chain reaction that creates a catastrophe in another. The small event was Finland's loss of the Soviet export market. This led first to a devaluation of the markka (which had been shadowing the mark), then to pressure on the other Nordic currencies, and most recently to a full float of the markka and that 75 per cent interest rate in Sweden.

This process is not yet finished. If Sweden cannot hold its rate against the mark, the markets will question whether Italy or Spain can. If not Italy and Spain, what about Britain?

And that gives a rationale to the robust inaction of Mr Major. He is not doing anything because there is nothing much he can do. The Government has to support the Maastricht treaty because, if Maastricht goes, the financial markets would expect Germany - and perhaps the Netherlands - to remain the only custodians of monetary virtue. That would be where they would put their money.

The graph (top right) shows why: sterling has had a bumpy ride against the dollar, but its trend against the mark has been pretty consistently south. That, perhaps, is the key to understanding the pressures on world currencies and the prison that the markets create for governments.

Electorates vote in governments, which they hope will deliver economic prosperity, and they feel disgrunted if they fail. But while governments have the power to make mistakes - the US by allowing a vast fiscal deficit, Germany by not raising taxes to pay for unification, Britain and Japan by allowing the late Eighties boom to get out of hand - they are at the mercy of the international markets.

Why is sterling under pressure while the mark, despite the German crisis, goes from strength to strength? And why cannot Mr Major do anything about it? Because the markets trust the Bundesbank more than Britain's tarnished monetary authorities.

(Photograph and Graphs omitted)