Economic Commentary: The Chancellor's nuclear weapon

Last week, I commented that the Chancellor was like a military commander who had only one big decision to make - when, if at all, to use the nuclear bomb. By this I meant that without devaluing sterling, or leaving the European exchange rate mechanism altogether, the Government's room for policy manoeuvre was almost non-existent. I have not yet made up my mind that the nuclear bomb will ever be the right solution. It goes without saying that it should be used only if the Government believes itself to be in 'last chance saloon', which is certainly some distance off, and may well never be reached. But I am increasingly convinced that any policy change short of that is just fiddling around at the margins.

The authorities look as if they may shortly engage in a bout of such fiddling. On Friday morning, the Bank of England excited the financial markets by cutting its money market dealing rates on longer dated bills by 1 32 , thus encouraging speculation that base rates might come down this week. Although the unofficial guidance from those 'in the know' was that this move was entirely technical, this claim is wholly disingenuous.

The last base-rate cut was signalled well in advance by precisely the same move in the money markets, and the Bank must have known that any cut in its intervention rate, coming immediately before this week's world economic summit, would inevitably cause intense speculation that base rates might come down. This was precisely the effect that the authorities must have intended. They are clearly putting their toes in the water to see whether the temperature is right for UK interest rates to drop below rates in Germany.

There is a strong suspicion that the main impetus for this move stems from the office of the Prime Minister, who is beginning to feel, on this subject as well as on the linked question of Maastricht, some real pressure from the right of his party to shake free of the constraints imposed by Europe. The right is now able to link three issues: the Chancellor's inability to respond to recession by cutting interest rates, thanks to the ERM; the de- bauching of fiscal policy that has occurred as a result; and the further loss of monetary sovereignty that ratifying Maastricht would imply. This is a dangerous brew for John Major. With recession, sovereignty and high public debt bubbling together in the same pot, the chances of a really serious Tory rebellion on Maastricht ratification are increasing.

POLITICAL PROBLEM

It is therefore obvious that a period of inactivity is highly problematic from a political point of view. And the economy is doing the Government no favours. Recent evidence from the housing market and the High Street suggests that economic forecasters have still not downgraded their growth projections far enough. A drop of around 0.5 per cent in GDP this calendar year now looks likely, followed by growth of only about 1.5 per cent next year. Even that requires making the assumption - it is in fact little more than an act of faith - that a reasonable cyclical recovery will start before the year end.

Hence the Prime Minister's desire to be seen to be taking some action in the face of a deteriorating situation. But he is playing with fire. Since the Danish rejection of Maastricht, the markets have been in no mood to take the stability of the ERM on trust. The Italians have already faced a severe speculative attack on the lira, and those who think the same could not happen here should pay attention to the following - sterling has been the only currency that has actually been trading below the lira in the ERM grid during the past few weeks.

The graph shows the expected profile for ERM interest rates that is built into the money markets for the next two years. At no point do the markets believe that British interest rates will drop below those in Germany. If the UK authorities attempt to make this happen, they will be delivering a shock to market sentiment that could severely unsettle sterling.

Admittedly, if this happened, interest rates could be raised again. Before the election, the possibility of such a reversal was seen as potentially disastrous, for obvious political reasons. Now there is a willingness to contemplate it with greater equanimity. But is this wise? A cut in interest rates, followed by a swift reversal, could leave consumer confidence at a lower ebb than simply leaving base rates at 10 per cent. Furthermore, how would the Tory right respond if the ERM actually forced an increase in base rates just as the recession was taking a turn for the worse? Could this not be too much of a red rag to the Tory bull?

Faced with these unappealing options, it is natural that the markets should be buzzing with speculation that, sooner or later, devaluation will be the only way out of the mess. The Government itself must of course deny the possibility of devaluation with the utmost vigour, but one of the pleasures of being outside Whitehall is that this self-denying ordinance does not apply. Already, economists at the London Business School - usually described as close in thinking to the Burns/Budd/Robinson nexus at the Treasury - have suggested that a devaluation, linked to a budgetary retrenchment and a move to make the Bank of England independent, might be a good idea.

'LAST CHANCE SALOON'

This suggestion needs serious analysis at a later date. But I would like to end this week by making a few points on devaluation that have been widely misunderstood. First, if we ever reach 'last chance saloon', it will be because a combination of high real interest rates and high consumer debt is preventing a recovery in demand and undermining the housing market. Usually, the case for devaluation is that greater competitiveness is needed to help the supply side of the economy, which is why a downward movement in the exchange rate is often linked to fiscal retrenchment. But the purpose of a 1993 devaluation would be different - it would be to enable real interest rates to drop and (perhaps) to raise inflation so that debt can be more rapidly eroded.

This is an unusual state of affairs, and it leads to a second point, which is that there is no sense in opting for a form of devaluation that fails to get real interest rates down. A small devaluation, while remaining in the ERM, would almost certainly fail to affect interest rates, except possibly to put them up. A very large devaluation within the ERM (15-20 per cent) might work, but probably could not be negotiated with our European partners. So the logic suggests that the only course would be to slash interest rates and simultaneously float the currency, at least for a while, outside the ERM. And where would the Prime Minister's commitment to Maastricht be then?

The economic equivalent of the nuclear weapon turns out to be a device so explosive that it could only be used by the desperate or the suicidal. For quite a while longer, the Government must sit there and hope that something - preferably the economy - turns up.

(Graph omitted)