A little less interest, a little more hope

YESTERDAY Europe's finance ministers and central bankers showed that they had some human compassion for the disasters of the European economies and currencies. Some, but not much. The move they made was timid, if in the right direction - perhaps a good beginning, but certainly no more than that.

The small general revaluation of the exchange rate mechanism, together with a small devaluation of the Italian lira and a reduction in German interest rates, is intended to save the European Monetary System, and incidentally to help the 'Yes' vote in the French referendum. On the face of it, the pound should benefit from the reduction in German interest rates and the consequent fall to be expected in the European currencies against the dollar and yen.

For the present the intolerable tensions inside the ERM should be eased. The absolutely necessary European devaluation against the yen and the dollar will be achieved without a sterling devaluation inside the ERM. Britain may well be unable to reduce interest rates, unless the Bundesbank cut is larger than expected, but will not have to raise them.

The market will decide in the longer term whether this modest rearrangement is sufficient. Exchange dealers will now know that the ERM can still make changes when the pressure is great enough, even changes in German interest rates. The system is the better for having regained some flexibility, but it will be also more open to pressure in the future. The devaluation of the lira looks to be on the low side. The Italian debt problem remains unmanageable, the Italian government remains very weak, and a combined lira devaluation of 7 per cent is far from decisive. A renewed market attack on the lira is certainly possible inside a few weeks or months. That issue has not been settled.

The position of sterling, which is only somewhat over-valued inside the ERM but is much more seriously over-valued as a member of the ERM against the dollar and yen, will depend on the scale of the German interest rate reduction. On the assumption that our interest rates remain higher than the German, the exchange market may well feel more relaxed about the pound, at least for the present.

The British economy will benefit in so far as there is a general European devaluation against the dollar and the yen, and will benefit again when German interest rates fall to the point at which significant UK interest rate cuts become possible. For the present these effects will be modest or some way off. The recession will continue, but the pressure to make it worse will be reduced. Policy may be inadequate but will be less perverse in its effects.

The recession in the British housing market will only turn round when there are quite big cuts in mortgage rates. However, the present ERM adjustments may prevent British mortgage rates actually having to rise, and the removal of that fear will help to restore some confidence.

The rise in the dollar which started on Friday is likely to continue, as will the rise in the yen. The exceptionally large gap between American, Japanese and German interest rates will be reduced, and the over- valuation of the ERM currencies will be reduced with it. This trend is likely to last for some time. The German recession is serious, and German interest rates are likely to have to fall for the next year or 18 months.

Whether the impact of this minor Italian devaluation and the German interest rate reduction will be sufficient to change the minds of the French is unknowable. The damage done by high ERM interest rates has played a larger part in the British debate over Maastricht than it has in France. Nevertheless the balance of the French vote seems to be very close, and so far as these measures affect it, they should be favourable to the 'Yes' vote. At least they show that Europe is capable of some degree of economic co-operation in a crisis, even if the co-operation has been limited and comes very late.

So long as the exchange market is satisfied with sterling, the political impact in Britain will be helpful to the Prime Minister. The objective of his critics, which was to reduce the over-valuation of the pound relative to the non-European currencies, will have been achieved without devaluation inside the ERM or leaving the system. That is at least a neat manoeuvre. He will have the benefits of a devaluation and will call it a revaluation.

Yet the pressure of recession and rising unemployment will continue, and they are the forces that are making the Government unpopular. This adjustment is not big enough to turn them around, and will not become so until Germany has gone further down the road of interest rate reduction. If this adjustment does tip France into a narrow 'Yes' vote on Maastricht, that will bring Maastricht back on to the British political agenda. There the crucial question is whether there will have to be a British referendum.

The news is therefore modestly encouraging for Britain, but only modestly; mildly helpful to the pro-Maastricht vote in France, but only mildly; and doubtfully sufficient for Italy. What about Germany? There surely is the greatest difficulty. The German economy is labouring under the burden of former East Germany. The Bundesbank had to raise interest rates, if only because the West Germans did not want to meet the cost from taxation. The result has been an enormous increase in Germany's debt, with east Germany already absorbing DM350bn without showing real signs of recovery.

The weakness of the German economy and the need to raise interest rates for the mark destabilised the ERM and created work in a paradoxical way. A small reduction in German interest rates will not solve the burden of the new debt, unemployment in east Germany, recession in west Germany, or Germany's disturbing loss of competitiveness in export markets. The ERM crisis has been largely a crisis of the German economy, and yesterday's measures will do little to help that.

The rest of the world is also in economic difficulty. The recovery in the United States shows no vigour; there is mass unemployment at the managerial level; the August US employment figures are only one sign that the recession has still not been brought to an end. Despite the recovery in the Japanese stockmarket, the fall in Japan's asset values is still a threat. World confidence remains feeble and uncertain. What happened yesterday was that Europe stopped making the European aspect of the crisis still worse. The exchange market has enforced a little sanity, but so far that falls short of what will be needed.

The next weeks will therefore be spent in an urgent atmosphere of 'what next?' There are two possibilities. The negative one is that this represents the best compromise that could now be reached, and will not be followed at all quickly by any adequate further action. In that case the mood of European depression will quickly return and the slide of the European governments into deserved unpopularity will continue.

The positive hope it that this is just the start of a progressive reduction of European interest rates, and an attack on the still growing threat of the European recession and high European unemployment. The European system has to prove that cooperation to restore prosperity and reduce unemployment is still possible. In itself yesterday's move was disappointingly small and markets may put on pressure for more. But as a beginning - even a late beginning - it offers a glint of hope.