The financial markets are often berated for the destabilising impact they can have but, argues David Smith, businesses will have learn to live with them, and use them to their advantage.
It is fair to say that for many businessmen the people who run the international financial markets vie for unpopularity alongside journalists and politicians. The markets are responsible for damaging currency instability, bring pressure on governments to raise base rates when it is not in the country's interest to do so, and force short-termist strategies on managers.
When non-financial businesses try to take on the markets at their own game and beat them, they can get badly burnt. Witness the tribulations last year of Metallgesellschaft, the German industrial giant, when it speculated heavily in oil futures and lost. The increasingly complex derivatives markets appear to have acquired a life of their own, far-removed from the underlying financial assets from which they are derived.
Concern over the adverse impact of the financial markets is not new. It harks back to past battles between the City and industry. And while it is more than two years since the markets imposed themselves on British economic policy in a spectacular way (by forcing sterling out of the European exchange-rate mechanism on 16 September 1992), the debate remains a live one. The current issue of the left-of-centre journal New Economy is devoted to the issue, with its main article concentrating on how a future Labour government should respond to the 'inevitable' sterling crisis that would occur when it took office.
The two most workable solutions offered, assuming a Labour government was committed to maintaining low inflation, are for the adoption of an interest-rate rule (raising interest rates by 1.1 percentage points for every one percentage point that inflation rises above a pre-determined target range) or handing over monetary policy to a fully independent Bank of England. Neither would sit easily alongside Labour's objectives for economic growth.
More popular left-wing proposals include introducing a new turnover tax on foreign exchange transactions to discourage the speculators, and adopting a dual exchange rate, with one rate for trade transactions (which the Government would seek to control) and another for purely financial purposes, which could go where it will.
Aside from the question of whether any of these proposals would work, are they aimed at the right target? Do the markets need to be fettered?
Britain's 23-month spell in the ERM is a case in point. We know that, throughout the period of membership, the markets were suspicious of whether the Government could stick to its guns. Interest rates did fall while sterling was in the system, from 14% to 10%, but they remained too high to allow the economy to escape easily from recession. Thus, the Government's external objective - a stable exchange rate around a central rate against the German mark of DM2.95 - was at odds with the internal objective of securing recovery.
And while the defeat of the British bruised plenty of reputations, and left John Major's Government tottering on the brink of collapse, could anyone blame the markets? The inconsistency of the policy was plain for months before the September 1992 high noon. Without the markets, the subsequent economic story would have been very different. Indeed, had policy been planned in this way (two years of hard cost adjustment to cope with an over-strong exchange rate, followed by a substantial devaluation bonus for exporting businesses) people would have credited the ministers responsible with a stroke of genius.
The rush to blame the markets for the shortcomings of policy is understandable. When the ERM faced a wider crisis in the summer of 1993, which was only resolved by the adoption of very wide (15%) currency bands, the word from Paris and Brussels was that 'Anglo-Saxon speculators' were to blame. The two ERM episodes were, however, instructive in another way, because they demonstrated that speculators do not have a monopoly of wisdom. George Soros made millions by correctly betting against the ability of the UK authorities to maintain sterling's value. But he lost money when, less than a year later, he took the view that France would be successful in defending the franc.
This does not mean that the markets do no harm. Traders make money when currencies or interest rates are moving, not in an environment of rock-solid stability. It is in their interest to have movement, and movement can degenerate into wild, destabilising swings. This is where policymakers should act, but not by imposing turnover taxes or exchange controls. Rather, they should ensure that the movements of their currencies do not become, for the markets, a one-way bet. They should keep dealers guessing about the timing, magnitude and direction of interest-rate changes, and they should be prepared to intervene, when appropriate, to blow away speculative froth.
Most intelligent observers would accept that it is not possible to recreate the postwar Bretton Woods system of fixed exchange rates. Similarly, it is not possible to turn the clock back to the pre-1979 days when Britain had a system of exchange controls. Financial derivatives cannot be uninvented.
Any attempt to do so, or to impose new taxes on the financial markets, would rebound on the country that did it. And, as the chart shows, thanks to London's important position as an international financial centre, Britain has more to lose than most.
Businesses have to learn to live with the markets, and use them to their advantage. Derivative markets are all about controlling financial risk, or hedging against unexpected outcomes. Few would deny that international business is easier to trans-act in an era of liberalised markets and greater global liquidity. That there is occasionally a downside in greater financial turbulence than is warranted has to be accepted as a fact of life.