It may seem a strange thing that a mere ratio-the rate at which the British pound exchanges against other currencies-should have become a symbol of political failure for so many British governments. But it has. Harold Wilson never recovered from the devaluation of 1967, which he had spent three years trying to avoid. The next Labour administration never recovered from Denis Healey's turnaround at London airport on the way to the 1976 IMF meeting to attend to a sterling crisis at home. It has been said that when Margaret Thatcher is dead the three letters "ERM" (exchange rate mechanism) will be found written on her heart. John Major's enforced departure from that mechanism on Black Wednesday, 16th September 1992, broke the back of his administration. Never again would it be glad confident morning for him.
And yet, this sad tale is not entirely unjust. The exchange rate for sterling must, in the end, reflect the spending power of the pound compared with other currencies. For two, three or even more years, inflation and the exchange rate can move in opposite directions. But over longer periods there is an inexorable link. As Philip Stephens remarks: "Since 1964, the pound has lost over 80 per cent of its purchasing power against the Deutschmark. Its purchasing power in Sainsbury's has fallen by 90 per cent." His own book deals authoritatively with one slice of that decline under the Thatcher and Major governments-the period since 1979.
The record is pretty dispiriting. Under the free floating regime, the pound first shot up, imposing a much bigger squeeze on industry and employment than the government ever intended. Then there was a more erratic drop associated with the resurgence of inflation in the late 1980s. John Major's attempt to hold a pegged rate in 1990-92 via the ERM was an ignominious failure. The devaluation which followed has so far not prevented a fall in inflation to the lowest rate in three decades and a fitful economic recovery.
The sequence can be looked at in another way. Margaret Thatcher vetoed all attempts to join the ERM in the mid-1980s when the system had not yet frozen into rigidity and would have imposed a valuable check both on runaway external movements of the pound and on domestic monetary policy. She eventually gave in to pressure in her last few weeks as prime minister and joined at the wrong time, and at the wrong rate. By 1990 German unification, financed from red ink, was making high interest rates necessary in that country. These were inappropriate for the rest of Europe.
In his conclusion, Stephens confines himself to the folly of "dogma." He believes that it is hazardous both to ignore the external value of the currency and to make a fetish of any particular exchange rate. One might go further. There was no inherent reason why compromise systems such as Bretton Woods (under which currencies were tied to the dollar until 1971), or the ERM (under which currencies were effectively pegged to the DM) should not have persisted longer if they had been better managed. But given human fallibility, it was inevitable that sooner or later speculative forces would push aside exchange rate pegs. This has now happened so frequently that there is no possibility of reinstating them for the main currencies. If national economies are not to be disrupted by violent currency fluctuations, the only remaining recourse is to try a truly international currency.
Alas, a full world currency is not on offer. This is all the more reason to go ahead with the proposed Euro, which would cover over half of the trade of the countries involved. To do so would not require a European federal government, huge fiscal transfers or any of the horrors that Euroenthusiasts and Europhobes combine to conjure up. On the contrary, such a currency mainly requires that governments should refrain from tampering with the proposed European Central Bank, in the same way that they accepted the verdict of the gold standard in the last great phase of globalised markets in the 40 years before 1914.
Not everyone will have drawn the same moral from Politics and the Pound. The book is more concerned to establish what happened and to provide enough background for readers to draw their own conclusions. Its emphasis is not on the international monetary system but on sterling policy. From this point of view, the more important revelations concern the period since John Major became prime minister in 1990. The pi?ce de r?sistance is the account of the events leading up to Black Wednesday, including an hour by hour account of events that day. The earlier Thatcher-Lawson battles over currency policy have been too well documented to add very much more. Moreover, the author is obviously more comfortable with self-styled pragmatists-such as John Major, Douglas Hurd or Kenneth Clarke-who dominated the scene from 1990 onwards, than he is with the figures of the earlier years, when Margaret Thatcher, Nigel Lawson and (in his quieter way) Geoffrey Howe made the very necessary effort to change the thinking behind policy.
Perhaps I have the advantage of having been at Cambridge when there were still academics who resisted the mainstream postwar interpretation of Keynes and still saw inflation in monetary terms. Stephens and the officials he cites find it hard to take on board the distinction between first order principles of policy (in this case a monetary approach to inflation) and second order questions about the means to implement them, the answer to which will vary with time and place. The various measures tried or suggested, such as targets for alternative definitions of money, exchange rate objectives, and an independent Bank of England, were alternative means to the same end, and not a series of disconnected brainwaves by Chancellor Lawson, as they are presented here.
Peter Middleton and Terry Burns, who were the official leaders of the Treasury in the Lawson period, may now disclaim any interest in rules and frameworks because they want to place all the responsibility on the elected politicians. But I remember many discussions with them on just these topics. In any case, rules have not been banished under the present regime. There is now another set based on an inflation target of "below 2.5 per cent" and (more dubiously) of forecasts for this variable two years ahead.
Many of the quotes in the first 100 pages consist of the riposte of Treasury officials to Lawson's book, The View from No. 11. The last two thirds of the book cover the Major years, when officials were back in charge providing all the analysis. They first persuaded John Major (as chancellor) to join the ERM and then to stick to the DM2.95 entry rate through thick and thin, despite all the changes brought about by the way German re-unification was financed. Then they failed to realise the extent (originally even the existence) of the 1990-92 recession. Later, they refused either to recommend a temporary departure from the ERM (although Burns toyed with the idea after picking it up from the Lawson book) or to press for a realignment, unless France was willing to do the same.
It is worth examining the famous piece of Treasury analysis from which the conclusion came that devaluation, inside or outside the ERM, would be hopeless. It was embodied in the speech of the then chancellor, Norman Lamont (no enthusiast for the ERM), at the European Policy Forum on 10th July 1992. He went through the options, ruling them all out as incapable of lowering interest rates, or giving the UK a competitive advantage. He did not rule out a general realignment, but said that it was not on the agenda. As for leaving the ERM, combined with large cuts in interest rates, "the result would be a fall in the pound probably unprecedented in the last 40 years."
The original paper had been written by Alan Budd, the Treasury's chief economic adviser, and endorsed by Terry Burns. It had argued that any theoretical benefit in terms of international competitiveness from a lower pound would be quickly eroded. The paper did admit that a fall in the exchange rate which was very large-say 15 or 20 per cent-might induce the financial markets to expect that the next move in the pound would be upwards; and this would make a UK interest rate cut possible. But the authors of the paper believed that such a drastic move would be ruled out by European partners and would, in any case, re-ignite inflation. The analysis was quickly endorsed by Major, who staked his reputation on it.
Honesty compels me to admit that I had been arguing on the same lines and endorsed the Lamont speech in the Financial Times and elsewhere. I still believe that this Treasury analysis is right about the long term effects of repeated devaluations-or of one very large one. The mistake the pro-ERM side made in those last months was to assume that the long term adverse effects of devaluation would emerge much more quickly than they did. In fact, a recession-ridden British economy became very resistant to a pass-through of higher import costs; and the UK did experience a real devaluation. But I would not count on it lasting.
However many of us made the same mistake, the fact remains that the Treasury paper was wrong and gave bad guidance over the period to which it is related. As for the Bank of England's "war plans" for defending sterling against speculative waves, the less said the better.
Not one person in 100 had much idea of what was really at stake in the ERM decisions. But the public did sense that John Major had made ERM membership the centrepiece of his economic policy-"not an optional extra," as he once put it. But instead of admitting defeat or apologising, he chose to proclaim the glories of the so-called "competitive pound" which he had previously done so much to avoid. Henceforth, hanging on to office became an end in itself. There must be a better way.
Politics and the pound
Philip Stephens
Macmillan ?20
