ERM: the true stories

John Major, Norman Lamont and myself were wrong about the ERM
December 20, 1999

16th september 1992-the date Britain was ignominiously forced out of the European Exchange Rate Mechanism-is etched into the memory of the economic policy-making class. The government tried to pretend that nothing much had happened-except the exposure of mythical "structural faults" in the ERM. And few members of the public were turned on by the esoteric arguments about monetary regimes. Even among businessmen, the day was remembered mostly for the shock when interest rates were briefly raised to 15 per cent in an attempt to stop the rout. Nevertheless, the main pillar of economic policy had collapsed; and a sense of this did percolate through to the electorate. It could never be glad confident morning again for John Major's government.

The ERM story is one of the main points of overlap between the John Major and Norman Lamont books, which are otherwise quite different. Lamont's is an insider's story of some crucial years in economic policy. Major's is a much more extensive personal and political autobiography.

Lamont is convincing that he was the first to realise that Britain might have to leave the ERM. Major's efforts were devoted to a series of sad notes to Helmut Kohl, pleading with him to lean on the Bundesbank to change policy to help Britain. Kohl was out of his depth and not even sympathetic.

The speeches of the prime minister and his chancellor before 16th September went much further than the ritual "no devaluation" protestations required by a fixed exchange rate regime. It is normal in such circumstances for the chancellor to resign, if only to take another post. But in this case the ERM policy was first and foremost Major's. As he remarked when Lamont offered to resign, his chancellor was his "lightning conductor." When Lamont had served that purpose, and the press turned him into a scapegoat for slow economic recovery, he was sacked. If the chancellor had gone in September 1992, the prime minister might have had to go, too; and the reputation of both men would now be higher.

No one comes out of this episode with credit. Ministers such as Kenneth Clarke and Michael Heseltine were called in on the fatal day by Major to protect his flank. They just added to the reserve loss by insisting on holding out a few hours longer out of misplaced European sentiment.

But why did Major make the original decisions to take Britain into the ERM in 1990, with such ill-fated political results? We need to go back some way to understand. The postwar orthodoxy stated that full employment and growth could be secured by high spending. It was called "Keynesian"-although whether Keynes, who died in 1946, would have approved is another question. Under this doctrine, inflation could only be controlled by tackling wages, through exhortation, a pact with the unions, or legislation, or some mix of all three.

That was the principle. In practice, the link with the dollar, which was then a stable currency, ensured a low rate of inflation. It was, if you like, monetarism by proxy. But by the 1970s this approach was in a shambles, even before the fivefold increase in the price of oil.

Meanwhile, Milton Friedman had shown that there was no long-term choice between inflation and unemployment; and that inflation had to be tackled by monetary means. Under the influence of his then son-in-law, Peter Jay, Prime Minister Jim Callaghan bravely embraced the Friedman doctrine at the Labour Conference of 1976. How far he meant it, no one knows. But for Chancellor Denis Healey and his permanent secretary, the Keynesian Douglas Wass, the new doctrines were mainly hot air for the financial markets. Harold Lever called it "unbelieving monetarism."

When Margaret Thatcher came to office, believing monetarists took over from unbelieving ones. The question still remained: how was monetary policy to be guided to achieve the new aim of low inflation? Under the last years of Denis Healey and the early ones of Geoffrey Howe (chancellor after 1979), the answer was monetary targets.

The early 1980s witnessed a paradox. Conservative policy had over-succeeded if inflation was to be regarded as the judge and jury. The economy had been tightly squeezed, sterling had shot up, unemployment soared and inflation plummeted. Yet the professed monetary targets had been overshot and changed many times.

Meanwhile a more theoretically minded chancellor, Nigel Lawson, arrived in 1983. He had been impressed by the way in which countries which had linked themselves to the German mark-then the currency of a very sound money country-had reduced their inflation rates gradually but dramatically. This was a form of monetarism by proxy, linked to the mark, just as Bretton Woods had been one linked to the dollar.

Many readers will be familiar with the struggles between Lawson, who wanted the ERM discipline for Britain, and Thatcher, who hated the idea of British policy being run by what she sometimes called "Belgium." The faute de mieux policy of "taking everything into account" which guided events in the second half of the 1980s, did not convince anyone. By 1990 Lawson and Thatcher had fought each other to a standstill. The former resigned in 1989, followed a year later by the Iron Lady herself.

Major, who became chancellor after Lawson, inherited the problem of how to set monetary policy. He also inherited a resurgence of inflation (exaggerated by absurd price indices) due to an unforeseen surge of bank lending and a property boom. As Major puts it, this was a boom about which everyone was wise after the event.

The unpopular 15 per cent base rate which Lawson had left behind was in fact squeezing out inflation pretty effectively. But how was the new chancellor to convince the markets that sound money was here to stay? He saw no alternative to taking up Lawson's policy of joining the ERM. He succeeded in getting membership past a by-then demoralised Mrs Thatcher, six weeks before she left office herself; and it became the flagship of his economic policy for the next two years.

What else could he have done? There are a few technical monetarists who still believe that all that was necessary was to reaffirm monetary targets. But as their professed allegiance was to different measures of the money supply which moved in dazzlingly different directions, they were easily-perhaps too easily-brushed aside.

Why were inflation targets-which stated a clear goal but left the authorities with discretion on technical means-not considered? The short answer is that they were not yet fashionable. Moreover, many Treasury officials argued that an inflation target could only be credible once inflation was already in low single figures.

Lamont, who had run Major's campaign for the Tory leadership and then became chancellor, had a different attitude. Al-though he had spent much of his ministerial career in the Treasury, he had not been involved in the exchange rate battles; and he writes that he himself would not have taken the decision to join the ERM. But once chancellor, he came to see the ERM's value as an anti-inflationary constraint. In 1991, the first full year of membership, it helped to bring down inflation, allowing interest rates to be cut. By 1992 the situation had changed. The earlier high interest rate policy had begun to work with a vengeance and the economy was in recession. Lamont had no doubt that on domestic grounds, base rates needed to be reduced far lower. He began to see the ERM as an unwelcome constraint-probably well before Major did.

The fundamental reason why the ERM policy failed so dismally lay in the way in which Germany handled the economics of reunification. Just as the US could no longer be the anchor for a world system of semi-fixed exchange rates after the inflationary financing of the Vietnam war, so Germany could not be such an anchor in the years following the fall of the Berlin wall.

This should have been obvious not merely by 1992, but by 1990. In the summer of that year, well before Britain entered the ERM, the East and West German marks were unified at the ludicrous rate of one for one. Worse still, East German wages and benefits were leveraged up to West German levels, way ahead of any conceivable reduction in the productivity gap. To cap it all, Chancellor Kohl insisted that the costs of unification could be met without any substantial rise in taxes or cuts in West German spending.

The Berlin wall came down a fortnight after Lawson had resigned; and the currency unification announcement was made three months before Britain's entry into the ERM. With hindsight, all of us who urged entry, not as a step towards some federalist goal but as a practical monetary arrangement, should have seen the writing on the wall and shelved the idea. This applies to Major, Lawson and, I must add, myself, as I became a staunch adherent of sticking to ERM membership at the initial entry rate. My main reason was similar to that of Terry Burns, chief government economic adviser: what would it say for the determination of the government, if after less than two years of a policy about which it had argued for ten years, it just abandoned it?

By 1992, there was no strategy which could have kept Britain in the ERM without prolonging recession, which-because it hit the southeast harder than its predecessors-provoked fury. German interest rates had risen sharply in response to the manner of financing reunification, and that worsened Britain's recession.

Lamont's view in retrospect was that the combination of two years inside the ERM, followed by departure, was beneficial. Inflation would not have come down so far without the period in the ERM; but recovery from recession was earlier and more vigorous in Britain than in the countries which remained inside the system. The combination of entry, followed by forced exit, was nevertheless politically disastrous.

The former chancellor should be given more credit than he usually receives for announcing an alternative within weeks of Black Wednesday. Indeed, most of the key features providing for transparency and accountability-of which Gordon Brown now boasts-were put in place by Lamont. It was he who installed the inflation target and the quarterly Bank of England inflation report, which lie at the heart of present policy. He would have gone the whole hog towards Bank of England operational independence-like Lawson before him-if the prime minister had allowed him to do so. The contribution of his successor, Kenneth Clarke, was mainly to publish the minutes of the Bank-Treasury meetings.

Unfortunately the story cannot end there. A failing of both books is that they are too reticent (and kind) about the official advice that their authors received. This is explained (not justified) by their need for help in gaining access to documents after they left office. Is it unfair to expose the advice of officials who cannot answer back? Can't they just? Much economic commentary consists of unattributed comments by officials on the politicians whom they are supposed to serve.

In some instances a franker account would have been to the credit of official economists. The switch to an inflation target could not have come so quickly after the ERM departure unless officials had been thinking about it beforehand. And for all Gordon Brown's bluster to the contrary, the present inflation target of 2.5 per cent, with a permissible range of one percentage point either side, is as near as makes no difference to the original Lamont target of 1 to 4 per cent.

Other episodes show officials in a less favourable light. If there is one matter on which tactics are suggested by officials rather than by politicians, it is contingency plans for a run on the currency. The excuse for the panic departure from the ERM was that the selling pressure on sterling took everyone by surprise. Surely, if there is one lesson that should have been learned from past crises, it is that the selling pressure when a fixed parity comes under strain is always many times higher than any advance estimate. At the time, the public remarks of the Bundesbank president, Helmut Schlesinger, about the need for realignment, were more than a bit gauche and were blamed for the d?bâcle. But the British had no excuse for being surprised. In all my own contacts with the Bundesbank, long before Black Wednesday, the pressure for realignment was made quite clear.

It is likely that the best of tactics could not have prevented sterling's forced departure. But at the very least, wiser officials could have insisted that the only way of staying inside the system was to raise interest rates much earlier.

The biggest official deficiency of all was in the reliance on forecasts. Repeatedly in the two years up to Black Wednesday an upturn was predicted but never materialised. Output stagnated in 1990, fell in 1991, and stagnated again in 1992. The "green shoots of recovery" for which Lamont was mercilessly castigated did not really appear until 1993, about the time he was sacked.

This over-reliance on short-term forecasts has been the bane of policy for getting on for 55 post-war years. The usual defence of these forecasting fiascos is to say that forecasts are inevitable in human affairs. But if I have to make a plan for a holiday in February, it would be best to assume that the weather will be cold, with a wide range of variation; I should prepare for this variation by taking a range of clothing, rather than relying on long-range weather forecasts. Living with uncertainty is both an art and a science which needs to be developed much more.

When I wrote my first book on the Treasury, several decades ago, I was taken to task for commenting on "advice given by officials to ministers," as if I were revealing the secrets of the confessional. Supposed measures to make government more transparent, under both main parties, have been careful to protect the secrecy of such advice. The Whitehall establishment has always wanted to maintain power without responsibility. While this attitude persists it is difficult to weep too many tears about complaints that the civil service is being politicised.

l Samuel Brittan's website is