EC: Economics - Dealing with that all-dominant Deutschmark.

EC: Economics - Dealing with that all-dominant Deutschmark. - Markets shouldn't believe that Germany must set the floor for rates.

by David Smith, economics editor of The Sunday Times.
Last Updated: 31 Aug 2010

Markets shouldn't believe that Germany must set the floor for rates.

On 1 July, 1992, a glorious day dawned. The bells of the City rang out as Britain assumed the six-month presidency of the European Community. Somehow, it doesn't quite have the ring of Samuel Pepys about it. Perhaps that is part of the problem about British attitudes to Europe. Unless something has been around for a very long time we don't take it seriously enough. The European Community has been with us for only 36 years, and Britain has been a member for barely more than half that time.

This means that European initiatives are treated with a healthy scepticism in Britain, though as in the case of the long delay in entering the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS), this scepticism can be overdone. Now, however, British-style scepticism appears to be the order of the day and most dramatically so in the case of Denmark's referendum "no" vote in June. Scarcely was the ink dry on last December's Maastricht treaty changes on European monetary union (Emu) than doubts emerged around Europe. In Germany, in particular, realisation that Emu will mean the eventual abandonment of the Deutschmark came late, but has created powerful anti-union emotions. Put simply, if countries such as Italy and France see Emu as diluting the power and influence of Germany, it is easy to explain lukewarm attitudes within Germany.

Outside Europe, the US Administration has begun to express fears about the anti-growth bias of a Europe determined to achieve monetary union. The concern is that, far from diluting German domination of Europe, Emu will be the embodiment of German-style policies.

Staying with Germany, there has also been a growing awareness among other European countries that the actions taken by one key player in the Community can have a dramatic impact on the rest. German unification has given Germany a serious, if not insoluble, budget deficit problem. It has also, by imposing relatively high interest rates on others through the Exchange Rate Mechanism, had a damaging impact on growth in Europe. Germany's European partners are apparently, in a no-win situation. When Germany is performing well, they struggle to compete with what has traditionally been a low-inflation, successful exporting economy. But when Germany goes off the rails, even a little, it is difficult for them to capitalise, because the Bundesbank's hand is on the European monetary tiller.

One central problem for Europe is, therefore, excessive economic dominance by Germany. Old habits dies hard. France's determined pursuit of low inflation, and the achievement of sub-German rates over a sustained period, has not received its just reward in the form of, for example, the Banque de France's ability to set interest rates at levels well below those of the Bundesbank. The effect is to weaken enthusiasm for the European Monetary System and, more generally, for the whole idea of Europe.

Britain has been in a slightly different position. Having joined the ERM less than two years ago, when base rates stood at 15%, interest rates have moved in the right direction. So, thanks to the severity of the recession, has the process of convergence with European inflation. Suppose, however, that the achievement of German-style (ie normal German-style) inflation standards merely locks Britain, and the rest of Europe, into a period of disturbingly low growth, because of the monetary policy constraints imposed by the Bundesbank.

The first priority of the next six months is, therefore, to be less concerned with the long-term ambitions of closer union in Europe, but to escape from the present impasse. Germany needs high interest rates, and will continue to do so, to cope with the monetary fall-out of unification. Other countries, in the main, do not. How then to weaken the German grip on European interest rates?

A general realignment of ERM parities, which has been suggested as a way out of the present situation, would not, I think, do the trick. A Deutschmark revaluation, or a mass devaluation by the other member countries, would merely reinforce the foreign exchange markets' belief in the hegemony of the Germany currency. The devaluing countries would achieve one-off gains in competitiveness, but these would be dissipated in higher inflation. Any reduction in the general level of European interest rates below those of Germany, would, therefore, be temporary. Sooner or later the markets would look for the next realignment. The solution, then, has to be to stick with the existing parities but for all the ERM members - with the exception of Germany - to cut their interest rates in a co-ordinated move, while at the same time declaring their intention not to contemplate a devaluation. But if these currencies offered interest rates below those obtainable on the Deutschmark, wouldn't it lead to panic selling, and the break-up of the ERM?

There is no reason why it should. The dollar has performed well against the Deutschmark despite the fat that in recent months money market interest rates in New York have been six percentage points below those in Frankfurt. Currency movements occur for a wide variety of factors, and not just because one country's short-term interest rates are higher or lower than another's. The time has come to jolt the markets out of their belief that Germany sets the interest-rate floor for Europe. In the case of Britain, the return of a stable, right-of-centre government, and low company and individual taxation provide powerful incentives for inward investment.

Breaking Germany's grip on European interest rates would do a power of good. But there should be other key requirements of the UK presidency. The final run-in to the completion of the single market on 31 December 1992 should be just that. The single market has been hyped mercilessly over the past few years. The great danger is that we will get to 1 January 1993 and find that nothing has changed. It may already be too late, but a drive to ensure that remaining restrictions are weeded out is paramount.

Finally, what shape should the European Community be as we move into the next century? Should it be a tighter grouping of the existing 12, or a more accommodating arrangement welcoming members from a wider Europe, including the old Eastern bloc economies? The more that Europe is "integrated" in the sense of umbrella policies such as the Common Agricultural Policy, the more difficult and expensive it becomes to let in new members, not least by increasing the costs faced by the existing ones.

A wider, and less rigid Europe? Or a Europe of ever closer links between a relatively small number of members? It is a choice that has to be made, and soon.

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