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A Comment on "Black Wednesday" Samuel Brittan on Wincott Lecture by Sir Alan Budd, 05/10/04 Norman Lamont once remarked that membership of the the ERM in 1990-92 was beneficial in bringing down rapidly the British inflation rate but that exit from the system was also beneficial in promoting recovery from recession. This is more or less the line taken by Sir Alan Budd now; and I agree with them. What I would like to do in this Comment is say a little about the European and British political background and then go on to a few implications of Sir Alan’s analysis. A common fault among both proponents and opponents of ERM membership was to see the system purely in terms of the British debate and not to examine how the ERM participants - the core members of the EU - themselves saw it. The exchange rate anchor "Fixed but adjustable" exchange rates prevailed under Bretton Woods system after World War Two, with the emphasis shifting to "reluctant adjustment”. They were seen as a way of bringing order into international monetary relationships without the straitjacket of the old Gold Standard. The system worked with the dollar as the "anchor currency" against which other currencies were fixed. In the European Exchange Rate Mechanism the D-mark became the anchor for member countries. By the 1980s many economists and commentators had begun to see such systems as a backdoor method of achieving and maintaining low inflation. The idea was that if a country had a stable exchange rate against a low inflation country it could in a sense "borrow" that country’s credibility. It was even sometimes described as "monetarism by the backdoor". A D-Mark anchor was however far from the intention of the Founding Fathers of the System, which was a result of the initiative of the French and German leaders, Valery Giscard-D’Estaing and Helmut Schmidt in the late 1970s (in the wake of earlier prodding by Roy Jenkins during his period as president of the Brussels Commission). A large part of their objective was to combat the domination of the dollar. As far as they thought out what they meant by this, it was the ability of the United States to absorb resources from the rest of the world by running a large payments deficit financed by other countries accumulating dollar assets. (Yet 25 years later, with European Monetary Union up and running, the United States is doing exactly the same on a larger scale.) The ERM became a D-Mark anchor system largely as a result of the actions of the Bundesbank which continued to operate German monetary policy in what it regarded as German interests. For a large part of the 1980s French interest rates could be above German ones because of the risks of downward realignment. This was the system which most of the advocates of British membership - apart from the out and out European federalists - wished to join and which Margaret Thatcher and Alan Walters so vehemently opposed. But even as the battle lines were being drawn up in the UK the Europeans had, as so often, moved the goalposts. Realising that the ERM had not worked out as intended they set up the Delors Committee to work out plans for a genuine monetary union. That committee seized the bull by the horns and declared that it would mean a single currency. After the Committee reported in 1989 the aim was to make realignments small and rare to provide a glide path to monetary union. By the time the British had plucked up their courage and embraced membership in 1990 the ERM was transforming itself into something very different. In 1993 the Delors plan threatened to blow apart in a wave of currency storms (following the 1992 wave which had forced the UK outside). But European finance ministers decided rather than to abandon the ERM altogether to widen the margins of fluctuation to 15 per cent on either side. The characteristic British reaction was to regard this as just a fig leaf. Kenneth Clarke (who ironically was the originator of the 15 per cent suggestion) had no intention of fighting a domestic political battle to return to what had then become an extremely unpopular system. But as so often in the past the core EU members took seriously commitments and timetables and eventually reduced to a very small margin currency fluctuations against the Mark, leading to the formal establishment of EMU in 1999 and domestic circulation of euros in 2002. British Political Implications The ERM has had a longer history in British domestic politics than generally realised. Well before the 1979 election, when Labour was still in power a Treasury official gave a strongly worded but unattributable brief criticising the ERM and say why it was not in British interest to join. The Prime Minister Jim Callaghan had apparently decided from the beginning that the Labour party would not countenance British membership. At the time Labour was more sceptical of the EU than the Conservatives and the currency project appeared to those who thought about it at all as a bankers’ ramp to impose deflation on the UK. Nigel Lawson makes it very clear in his memoirs (The View from No. 11.1993) that his initial impetus to join the ERM came from observing that the very same ministers - the so called ’wets’ - who were most opposed to domestic counterinflationary stringency were also enthusiastic supporters of projects associated with European Union. This element persisted right through to the end in that notorious 1992 ministerial meeting when exit from the ERM was delayed by a crucial few hours and the reserve losses mounted, while pro-European ministers fought against the odds to save British membership. It is impossible to overestimate the political fallout from the forced departure from the ERM. Although few voters would have remembered the precise details, it destroyed the Conservative reputation for economic competence. The repercussions extended to the Labour Party as well. The former Labour leader John Smith was an enthusiast for the ERM. precisely because he believed that it provided an alternative to the party’s previous painful attempts to obtain pay restraint from the unions directly. Gordon Brown was Labour’s economic spokesman at the time; and it was in the post-ERM period that Tony Blair moved ahead of him in party popularity. Stakes. Of course there were larger elements involved; but the ERM episode helped give a jolt to the comparative reputations of the two men at a crucial moment. The Key British Error Could the UK have stayed in the ERM? I believe many mistakes were made in defence of the ERM parity (some of them are detailed in the books by Stephens - Politics and the Pound,1998- and Lawson) but the one I felt about most strongly was the surprise expressed by the British authorities with the size of the speculative movement against the pound. If there is one lesson to be learned from attempts to defend parities, it was that the movement of speculative funds was likely to be many times greater than anything to be expected from last time round. But I do not want to dwell on this aspect here. A more successful defence would have meant higher interest rates for longer. Even if the British government had been prepared to entertain this, the markets would not have believed that it would have stayed the course in the face of soaring unemployment and falling output. The big error surrounding the eventual entry into the ERM in 1990 concerned European politics. From the time that the Berlin Wall fell in November 1989 and German unity loomed, the Mark was no longer suitable as an anchor currency. That should certainly have been apparent by October 1990 when the UK joined. Unfortunately nearly all the politicians, officials and commentators who had previously urged ERM membership continued to do so despite the way German unification was being handled. And I include myself. Our minds operated in two parts: cheering on German political reunification, while continuing to view British problems in our usual insular way. After Membership Alan Budd is quite right to say that experience in the ERM brought inflation down with a rapidity and to a level which would have been extremely difficult to achieve by domestic means. In the highbrow literature there is I believe an expression known as "opportunistic disinflation”. This means that the authorities in high inflation countries will not deliberately impose a sufficiently fierce domestic squeeze to bring inflation down from, say double digits, to 2 or 3 per cent. But they will take advantage of any outside events - as Gordon Brown might put it to "lock in" the lower rate of inflation thus achieved. Could disinflation in Britain could have been achieved more slowly and less painfully without the 1990-92 episode. There is a sporting chance that it might have been if the first attempt at membership had not been vetoed by Margaret Thatcher in November 1985 when German unification was still a distant dream. The model that many ERM supporters then had in mind was France. That country was prepared to make downward realignments within the ERM but reluctantly, treating it as a sort of mini Bretton Woods. For such a policy to have had a chance of success in Britain, sterling would have had to realign with the franc in 1986 (as Lawson concedes in his memoirs) without undermining policy credibility. Whether that would have been possible, given the hysteria which has so often surrounded discussion of the exchange rate in Britain, I do not know. How inflation target was prepared One favourable surprise after Black Wednesday was the speed with which an alternative policy was put together. Nearly all the key characteristics of the present - and so far successful - stable monetary regime were announced within a few weeks of the exit from the ERM. These included the inflation target, the Bank of England’s quarterly inflation report. the formal monthly meetings, followed when Kenneth Clarke became chancellor in 1993 by publication of the minutes of these meetings. These paved the way for operational independence for the Bank and the establishment of the MPC. Many of these policies were first contained in embryonic form in a letter dated October 8, 1992, from Norman Lamont to the Conservative chairman of the Treasury and Civil Service committee. They apparently emerged from a meeting between the Prime Minister, Chancellor, and senior Treasury officials in Brighton, on the fringes of the Conservative party conference. (Stephens, pp.266-7). It is difficult however to see how such a comprehensive framework could have emerged so quickly after Black Wednesday unless at least a few people had been thinking about policy in a non-ERM world well before the UK was forced to leave. I am reminded of the period up to the 1967 sterling devaluation when the subject was treated as "the great unmentionable", but a few people had obviously thought about it to be prepared for the day when it happened. One question raised by Alan Budd is whether Britain as a country could have adopted an inflation target earlier. He quotes Peter Middleton as saying that there was some kind of inflation target several years before. But that target belonged to a different era when incomes policy was still seen as the main way of tackling inflation and the target was set in that context. It was both a guiding light for pay settlements and held out - rather dangerously - as a reward for the unions if they stuck with the policy. Inflation targets, in relation to a monetary approach to inflation, were hardly known until about 1990 when New Zealand was the first country to experiment. And I must admit that if I had been asked at any time in the 1980s about such a target I would have said "How do you enforce it? You are describing only the goal and not the means.” Even if it had been advocated in conjunction with an independent Bank of England, I would still have asked: "How does the Bank go about it?" EMU Lessons I would like to elaborate on why the ERM episode holds almost no lessons for the desirability or otherwise of Britain joining the euro. This is because despite superficial similarities they are two entirely different systems. The ERM was an exchange rate system rather like Bretton Woods; and monetary discipline came from the exchange rate constraint. There is no such constraint within the European Monetary Union for the very simple reason that there are no exchange rates between the euro countries. Their separate currencies have been abolished (and there has been rightly no attempt to use the euro dollar rate or the euro yen rate as a counter-inflationary constraint). The euro system is in fact very similar to the present British system with an independent central bank and a low inflation target. Leaving aside the rather political emotions on either side the economic question is whether we would do better to have this system operated by the Bank of England’s Monetary Policy Committee or by the ECB. It is a question of trading off the advantages of ending exchange rate fluctuations against countries accounting for a good half of our overseas trade against the disadvantages of a one-size-fits-all monetary policy adapted to average conditions in the euro area rather than those in any particular country. Until a couple of years ago I would have said that it was six of one and half a dozen of the other. But today I would be more inclined to say it is seven in favour of the MPC system and only five in favour of joining the ECB. Adjustable pegs There is a final and more general question. The almost universal fashion today is to believe that a country must make a choice between a floating exchange rate and merging its currency with that of a wider area. Even the halfway house of a Currency Board has been out of favour since the Argentinian collapse. Economic fashions change rapidly and unpredictably. Even so I do not see an early return to Bretton Woods-type systems or even G7-type currency range targets. Such a shift could come about of course if globalisation were to collapse and we went back to tight exchange control and restricted capital movements, which would be technically very difficult - but not impossible in the face of strong populist political reaction. In that case far more would be at stake than the curency regime.
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