Patching up the European currencies quilt

Although there was an eerie calm in the foreign exchange markets for most of last week, the dramatic events of the previous weekend will leave an indelible legacy on the future of the European exchange rate mechanism. I stubbornly believe that the system, or something like it, has a future, despite the criticism heaped upon it in the last two years.

It is striking that, no matter how long a system of managed exchange rates lasts, and no matter how successful its operation, it is deemed to be an abject failure simply because it does not last forever. The Bretton Woods system, which collapsed in the early 1970s, is often castigated for the failings of its last few years, a period in which the world economy was severely distorted by the Vietnam war. The considerable contribution of the system to the previous two decades of low inflation and unparalleled economic growth somehow seems to be overlooked.

So it is with the ERM. We speak in Britain as if the system were only invented in 1990, when we deigned to join it. But in Continental Europe, its achievements and failings are assessed over a longer period. The fact is that the system succeeded in its main aim, which was to prevent the huge misalignments of real exchange rates that have generally characterised floating rate regimes. If we compare the stable behaviour of real exchange rates inside Continental Europe since 1979 with the wild fluctuations of those outside, it is like comparing chalk and cheese.

For the first half of its life, the ERM was not seen as a precursor of full monetary union, nor even a means of exporting low German inflation to the rest of the Community. Instead, it was accorded the more humble tasks of dampening down short-term fluctuations in nominal exchange rates, and of adjusting these rates in orderly fashion once or twice a year. At each realignment, the exchange rate changes approximately compensated for inflation differentials, so real exchange rates did not become misaligned. The exporting sectors of France, Italy and Germany were therefore spared the bouts of chronic currency overvaluation that hit the UK and US during the 1980s.

INCREASING FRUSTRATION

The disadvantage of this approach, though, was that it permitted large differentials in inflation rates between EC countries to persist. This was a source of increasing frustration in several member states. Whether consciously or sub-consciously, they doubted whether they could reduce inflation to the German level without imposing on themselves some form of external constraint to ensure that monetary discipline was maintained in the face of domestic political attack. Just as the British Labour government used the International Monetary Fund to discipline its wilder elements in 1976, so the governments of several European countries used the ERM in the late 1980s.

This, too, worked - or at least up to a point. Inflation rates did converge on the German standard, and real exchange rates remained free from major misalignments. So successful did this achievement appear from the outside that even Margaret Thatcher felt unable to veto British membership of the system in 1990. And so successful did it appear from the inside that member states pressed ahead with ambitious plans for full monetary union.

The disinflation that occurred during this phase could probably not have been achieved without the ERM, but the unemployment costs of lower inflation proved high and long- lasting. Indeed, these costs are generally estimated to have been no lower inside the ERM than they were elsewhere. Meanwhile, against the advice of most independent economists, the Maastricht treaty envisaged a prolonged period of virtually fixed exchange rates, for the first time wholly unprotected by capital controls in the member states, and buffeted by the shock of German unification. No one could say for sure whether the ERM's reputation for stability would permit its core to survive these forces in an unchanged form. It came close, but it did not quite make it.

Several countries have emerged from the latest crisis saying that the old ERM can be reconstituted fairly soon, perhaps by the end of the year. But this probably under-estimates the effects of widening the bands on market psychology.

MAGICAL BELIEF

In its heydey a couple of years ago, the ERM benefited from what economists call 'stabilising speculation'. (As explained last week, I dislike using the term 'speculation' for the action of pension fund managers, corporate treasurers and holidaymakers, among others, but it will do for now).

Whenever one of the weak currencies approached the bottom end of its band against the mark, 'speculators' saw little prospect of further depreciation, since they believed the band would remain in place. For as long as this belief held, the ERM was automatically 'policed' by the markets, with speculators in effect conducting foreign exhange intervention on behalf of the central banks.

But once this magical belief in the bands has been punctured, speculation becomes destabilising. As a weak currency approaches its lower limits, the market believes devaluation is likely, and sells the weakening currency. When this psychology takes hold, the costs to governments of defending the bands - either in the form of central bank intervention or in higher interest rates - become vastly greater.

This quite quickly became apparent to the UK government in the aftermath of Black Wednesday. More interestingly, in view of their deep commitment to European integration, it has also become apparent to the Italians, who showed no interest in diving back into the new 15 per cent bands last week. The Danes and the Belgians, who have expressed a strong desire to reconstitute the old narrow bands as soon as possible (perhaps via bilateral arrangements with the Germans) could soon discover how difficult this will be.

The markets are simply not going to be persuaded that the old bands will prove durable until the fundamental reasons for last week's crisis have passed into history. This means an end to the European recession, closer synchronisation between the output cycles in different economies (as well as continuing inflation convergence), and some reason to believe that Germany has fully absorbed its unification shock. All this could take time, perhaps several years.

Until then, European exchange rates will be virtually floating, but this does not mean that wild fluctuations are inevitable. The remaining central rates within the ERM are not obviously misaligned relative to purchasing power parity. In fact, as the graph shows, it is the mark that is expensive in these terms, not the franc.

The markets are perfectly well aware of this, which is one reason why the franc weakened so little when the bands were widened last week. It also implies that the French authorities will eventually be able to reduce their interest rates very substantially without risking a sustained devaluation of the franc.

Admittedly, there could be some initial 'overshooting' by the franc as interest rates drop, and it is understandable that the Bank of France should want to tread softly while the markets are in their current nervous state. But the irony is that in the new wider bands, the French could soon have the powerful forces of stabilising speculation operating on their side, instead of against them.

(Graph omitted)