City: Economy escapes from madness

IT TOOK the Government a long time and a great deal of unnecessary pain to get there. Eventually ministers did the right thing however, if only because they had no option. They should have done it ages ago. That much is now blindingly obvious. But the Government got itself so tangled up in its own flawed arguments and desire to be seen as a committed part of a united Europe that it became incapable of backing away from a policy which has brought ruin and now humiliation on the country.

Indeed, up until 7.30pm on Wednesday, when the pound was withdrawn from the ERM, the sterling crisis was so spectacularly mismanaged that you begin to wonder whether the whole thing was not part of some grand design to help the Government execute its U-turn under the guise of force majeure.

There was massive intervention in the currency markets (well over half Britain's foreign exchange reserves appear to have been used), a 5 per cent hike in interest rates and any number of statements by ministers that under no circumstances would they devalue. But this did nothing to stop the run on the pound. Any government with even a modicum of feel for the markets would have realised the futility of such efforts in the face of a major onslaught. But the experience none the less enabled Norman Lamont to claim with that much more credence (if he is now capable of saying anything with credence): 'The world's finally gone mad. There was nothing we could do about it. We were faced with a wholly exceptional set of circumstances the like of which we haven't seen for 20 years or more. What we did was simple common sense in the face of a whirlwind.'

Absurd though this nice little conspiracy theory is, it's almost believable. Certainly, anything seems possible set against the improbable nature of last week's events and the Government's astonishingly inept handling of them. It is, however, undoubtedly wrong. To suggest that the bungled attempt to defend the pound was a carefully stage-managed way of bringing about an effective devaluation with a minimum of political fall-out, as some of the market's more lateral thinkers are (tongue in cheek, of course), would be to credit ministers with too much good sense.

By my calculation, the Government has lost pounds 1.5bn in its fruitless attempt to prop up the pound. That's enough to pay for quite a few hospitals. If the Cabinet were the board of a major public company, John Major and his Chancellor would be out on their ear for that alone. Never mind the other costs of an economic policy which now lies in tatters. As it is, the lack of any credible alternative to Mr Major, plus the fact that the Cabinet was apparently united behind his ERM folly, means he will survive, though with his credibility shot to bits. The Chancellor is a different matter. His is in a deeply unfortunate position. Privately, he was never whole-heartedly behind Britain's membership of the ERM, but once committed, he pursued the Government's chosen policy with a vigour that makes his position now look untenable. The markets will never believe a word he says again. You can't have a Chancellor whom no one believes.

BY CHANCE, rather than design, ministers have finally managed to get themselves off the hook of their own high fixed exchange rate policy. Whatever the long-term consequences for inflation, competitiveness and growth, it needed to happen. The old policy was slowly killing us. The stock market is usually a pretty good judge of these things, and its response was unequivocal. Since Wednesday lunchtime, the FT-SE 100 index has risen the best part of 300 points. The Government's underlying economic message over the last couple of years - we know it's going to be horrible for all of you, we know that half our industry is going to be wiped out, we know unemployment will continue to soar, we know that recession is in danger of turning into slump, but keep on taking the tablets and in the long run it will do you good - had lost all credibility long before last week's sterling crisis. In the end, the markets had their way, and it's a brighter, kinder and more forgiving world into which we have emerged. With interest rates back to 10 per cent and likely to fall over the next six months, and the pound no more than 6 per cent off against the German mark, you begin to wonder what the last two years of torment was all about. It seems that we were locked into something that was neither desirable nor necessary. Publicly, the Government still insists that it will re-enter the ERM when things settle down, but privately, a large part of the Cabinet must be praying that a French 'no' vote in today's referendum on Maastricht will bury the damn thing for good. With bitter recriminations now reverberating around Europe over the immediate causes of Britain's woes, re-entry may in any case be ruled out for the foreseeable future.

But perhaps the most unseemly aspect of this affair is the Government's determination to blame everyone but itself for the collapse of its policy. Ministers have attempted to use two obvious and high-profile scapegoats: the speculators and the nasty foreigners - German ones at that.

First the speculators. The idea that Essex barrow boys in red braces, together with their overseas counterparts, were the villains, as ministers seem to imply, is about as ridiculous as it is unlikely. Currency dealers, speculators - call them what you will - are there to make money, sure. But their actions also reflect underlying market forces. The view of the market, as well as the pundits that guide it, was that sterling was fundamentally overvalued. If the Government had understood this better, it might not have blown so much of our foreign reserves in a futile effort to defend the pound. But ministers seemed determined to ignore realities. Having joined the ERM at a rate that looked far too high even at the time, they were unprepared to live with its high interest rate, recessionary consequences. As European interest rates, particularly German ones, rose, Britain seemed only intent on cutting its rates, in its desperation to feed the green shoots of economic recovery. As a result, the exchange rate became increasingly unsustainable. But ministers seemed to believe they could walk on water and ignore this unpalatable truth.

Second, the nasty foreigners. It has long been known that the Bundesbank privately held the view that sterling was overvalued. Confirmation by Helmut Schlesinger, its president, in an interview with the German newspaper Handelsblatt was certainly a stupid thing for him to have done, but it was no more than a statement of the obvious. The run on sterling was a crisis waiting to happen. To blame Mr Schlesinger is like saying a shot in Sarajevo caused the First World War - true, but an explanation of events so simplistic that it would barely warrant a pass in GCSE history.

For the time being at least, the stock market's view is that things could scarcely have turned out better. With no ERM parity to sustain, interest rates should now begin to fall steadily, allowing Britain to pull out of recession a good sight quicker than it would otherwise have done. The political fall-out from the crisis also seems to have been far less severe than it might have been. At worst, the Government is going to lose a Chancellor. As far as the stock market is concerned, there are now plenty of reasons for being mildly bullish, but before you get carried away by it all, don't forget that the recession wasn't caused by ERM membership alone. Nor will it be cured by withdrawal alone.