Comment: US holds key to world currency link

Yesterday saw a resumption of hostilities on the foreign exchanges, after the Christmas truce, with a modest attack on the French franc . . . and a dismissal by most City pundits of the idea floated over the weekend by the Prime Minister of a more general link between the pound, the ERM currencies, the dollar and the yen. But actually a few turbulent months on the exchanges might be just the sort of thing to convince the financial establishment that there should be some effort made to stabilise currency movements.

It is fairly easy to see what will happen to the exchange rate mechanism over the next year, but rather more interesting to gauge what will happen to the world currency system over the next five years. As far as the ERM is concerned, some further readjustment of parities will take place during the first half of this year. Looked at in the big, we are half-way through a protracted ERM realignment. By mid-year this should be complete, with a modest devaluation of the French franc signalling this, and the path therefore clear for the Italian lira to rejoin.

The realignment, and in particular the fact that it has been carried through in such a messy way, will change the nature of the ERM itself. It will be accepted that the only way for the ERM to continue will be as a system of fixed but flexible parities. In theory there is no reason why Britain should not rejoin towards the end of this year. In practice that has now been ruled out by John Major, who is seeking some wider international currency agreement. That is not going to happen in 1993.

FIXED RATES

If, however, one is looking towards the back end of this century, it is possible to chart a path towards greater currency stability - not a return to anything like the Bretton Woods system of fixed exchange rates, but to a more explicitly and aggressively managed floating rate system.

To see how such a currency agreement might develop, look at the Plaza and Louvre accords of 1985 and 1987. Plaza helped cut the value of the dollar, which had risen sharply since the early 1980s, and was theatening to set off a trade war between the US and Japan. Louvre stopped the fall of the dollar and established a set of bands linking the dollar, the mark and the yen. These bands were not published, and the exchanges were left to work them out for themselves by seeing where and when the central banks intervened.

Since the late 1980s the Louvre accord has rather fallen into abeyance. It still notionally exists, but the central bankers and finance ministers do not now talk about currency bands at their various meetings. There is a wide band for the dollar/mark, which guides Bundesbank intervention - a dollar floor of about DM1.45 and a ceiling perhaps of DM1.75 - but there will need to be a new political impetus if what remains of this system of unpublished bands is to be revived.

That political impetus cannot come from Britain. The harsh truth is that at the moment what Britain says carries no weight. (In a year or so, when UK economic performance is relatively better, maybe it will carry a little more credibility). Nor will the political impetus come from Germany or Japan. The Bundesbank has always been cautious about any international agreement that might tie its hands, and currency bands, even unpublished ones, tended to narrow its scope. Japan, for its part, has a single interest: maintaining an exchange rate that will bear down on inflation but also be sufficiently competitive to enable Japanese industry to continue exporting to the vital US market. The impetus will have, therefore, to come from the States.

We know little about the Clinton administration's view on international monetary matters. Indeed the safe working assumption is that it does not have a view at the moment, but that its policy will be pragmatic and will be shaped by whatever US industry and commerce say to it in the coming months. If - and this seems quite likely - the dollar spends much of 1993 climbing on the exchanges, then there could well be pressure to cap the rise before it does serious damage to US exporters. Couple that with a desire for currency stability for its own sake, and it would be quite consistent to have a US administration calling for a rebuilding of the Louvre accord within the next 18 months.

In the world of currencies it takes three to make an agreement. Whether Germany and Japan will buy a new Louvre is another matter. But remember that American economic prestige will tend to rise over the next few months vis-a-vis that of Germany and Japan, as the US recovery becomes more secure and the German and Japanese economies remain depressed. If the US wants to take the initiative, it has a window of opportunity to do so.

CREDIBLE PATH

A new Louvre is a long way from a new Bretton Woods. But fixed exchange rates do become a more practical possibility as world inflation rates come down. (Maybe the point is more forceful put the other way round: fixed exchange rates are an absolute impossibility if there are high and differential rates of inflation around the world). One could therefore chart a credible path back towards a fair degree of fixity in exchange rates, provided that the trend towards lower inflation worldwide is sustained.

This path would start with a rebuilding of the Louvre in its original form. After a couple of years the unpublished currency bands (which could be quite wide) would be published. There would then be a suck- it-and-see period, when the central banks would seek to assert their authority in defending the bands, but - and this would be crucial if the whole system was to be credible - the bands would be changed as need arose. By the end of the century a global system of loosely fixed, but adjustable, exchange rates would be in place. This would in practice be something akin to the global ERM mooted by Mr Major.

From the big historical viewpoint, something like this would make sense. It is hard to see a global currency within a generation at least. But the proliferation of currencies, with every tiny country thinking it has to have its own, is unsatisfactory too. The experience of the 1970s and 1980s of floating rates is hardly encouraging either. The world cannot go back to the gold standard or to Bretton Woods, but it can have a system that reflects the reality that the most powerful nations economically will run the most important currencies. If the three biggest have a broad agreement that currency stability is a useful aim, then they can achieve it - if.