Today's date:
Winter 1993

Is Monetary Union a German Racket?

Nicholas Ridley - So outspoken was he against consigning British sovereignty to the Bundesbank during the reign of Margaret Thatcher that Nicholas Ridley was forced to resign as Minister of Trade and Industry on July 14, 1990. He said then that the Exchange Rate Mechanism was a "German racket" aimed at dominating Europe.

World observers must have been perplexed by the storm that struck the European Community currencies in mid-September. The pound sterling, the Italian lira and the Spanish peseta went spinning out of the Exchange Rate Mechanism (ERM). The French franc and the Irish punt very nearly did, too. The Deutschemark climbed to new peaks, not only against all the European currencies, but against the U.S. dollar.

Those who have known fixed exchange rates, imposed on their currencies in the past, find these events depressingly familiar. The dollar, the yen, and many other currencies wisely float free in the market. No such traumas can happen to them.

Attempts to fix currency exchange rates are, alas, depressingly frequent in Europe. Their breakdown is equally frequent. There have been 10 "revaluations" within the ERM over its 13 years of existence, culminating in the mega revaluation of September. Still they won't learn the lesson and stop doing it.

The reason for failure is obvious. If an exchange rate is fixed between two currencies and the market finds it at some stage unrealistic, the market will shift the rate. The market is composed of real traders exchanging currencies as part of the world's commerce. If a price is too high, buyers withdraw; if it is too low, sellers withdraw, until the price is right. Dealers adjust prices to ensure that transactions take place. What was wrong with European fixed parities in September was that the Deutschemark was worth more in relation to the other currencies in the ERM. Its value went up, and the others didn't. Indeed, the pound sterling subsequently went down in value, while others settled somewhere in between. The DM is now the world's strongest currency.

Why is this so, and why do dealers in foreign exchange think it right to adjust these parities? There are two reasons. First, the German economic record is particularly good. Low inflation, steady and continuing economic growth, and a healthy balance of trade have characterized the German economy for decades. It seems like a safe haven for money. Second, the Germans are paying high interest rates - 9.75 percent - for international money. Together, the twin advantages of security and a high return are irresistible, and so all the money goes there.

The Germans are offering such good terms for international because they need to finance a huge government deficit. They are spending DM 170 billion a year reconstructing eastern Germany. In addition, billions of DM are pouring into Eastern Europe and Russia - mostly in loans and credits they will never see again. Then there is the European community itself. Germany pays the lion's share of the costs, and even paid huge sums in a vain intervention to save the other currencies in the September crisis.

At the same time, German taxes are woefully inadequate to cover the government's expenditure. Government borrowing has become massive. Yet the government is also determined not to have high inflation. It has an independent Central Bank charged to avoid inflation in managing the interest rate policy.

A high interest rate in Germany thus serves two purposes. First, it finances the huge deficit by attracting international money. Second, it curbs domestic inflation (which is on the increase) by reducing the German money supply, and slowing economic activity a little. Economic activity has been too high in Germany because of the immense expenditure by the government on roads, schools, houses, factories and the environment in the east. For those responsible for managing the German currency, this is a sensible policy.

But is it selfish? There are two issues to address. First, it could be described as selfish to leave German taxes too low, and to seek to borrow a high proportion of the world's savings at high rates of reward to cover this large spending. It is at least arguable that an internationally well intentioned neighbor would keep out of the market to a greater extent.

Britain, the United States and many other countries are also borrowing heavily. I fear that the rest of us don't have any better intentions. I have seen no sense of guilt or remorse in Britain or the US for the high proportion of the world's savings we both seek to borrow. So why turn on the Germans?

Second, this German policy did indeed cause the currency crisis last fall. A strong economy, with a high reward for lenders, has forced up the value of the DM, and had the effects mentioned earlier of "knocking" all the other European currencies. Is that selfish? That is what the British, rather petulantly, argued at the time of the crisis. On this count, too, I exonerate the Germans.

It is membership in the Exchange Rate Mechanism that has caused the crisis. If it had not existed, the DM could have floated upward, and the rest of us downward, without any embarrassment. So the fault is with the rest of us for joining this fruitless mechanism, which was the real cause of the panic and distress.

Where is all of this leading?

As a result of what has happened. Germany's position is getting even more difficult. The high DM value will make its exports less competitive and its trade balance will continue to worsen. Germany's high interest rates are already beginning to slow in economy - activity has at last begun to slacken. These interest rates will have to come down in the medium term, and, as they come down, the DM may look less attractive. The current situation cannot long endure.

It is also possible that Germany will have to move quickly to further support the French franc, which is also ailing. That would be very expensive.

The conclusion must be that Germany is overextended, and that the DM may peak quite soon. The European currency crisis is not yet over?

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