Leading Article: Tories in a trap

The government must convince two audiences this week that its economic policy is back on track. One is the Conservative Party, assembled amid the encircling gloom in Brighton for the annual party conference. The other is the world money markets, whose exploitation of sterling's vulnerability brought both the pound and the Government low. Both audiences urgently require an early signal that the Government has a credible policy and intends to implement it. The finer points will take a little longer to evolve, and a party conference is not the best place for them to be expounded.

In Brighton ministers should make three things clear. The first should please both the money markets and the Prime Minister's critics on the party's right wing: namely, that government spending is being brought back under control. Fears that the public spending borrowing requirement (PSBR) was spiralling upwards to pounds 40bn have contributed to sterling's fall. The pound would benefit if the Government indicated an absolute limit for next year's PSBR. An announcement is anyway due in next month's autumn statement. To advance it would steady nerves all round.

The second necessary, but more controversial, announcement is that negotiations for the pound to re-enter the exchange rate mechanism will begin once the Maastricht treaty has been ratified. When he was Chancellor of the Exchequer, John Major used the expectation of entry to talk up the pound and thus bear down on inflation. With hindsight he is felt to have pushed the level too high. By contrast, the present relationship with the German mark looks significantly too low if the inflationary cycle sparked by a weakened currency and more expensive imports is to be avoided.

Third, the Government should indicate its intention to exercise discipline over the money supply both before and after re-entry to the ERM. This will require targets for broad money as well as the narrow money at present targeted. However, since these conventional measures have been found to be flawed, the Treasury should consider targeting a further definition of money, the 'Divisia' formula, named after a French economist. This takes into account all forms of money, but in particular it gives greatest weight to narrow money (for example, in current accounts), which is most likely to be spent.

With the downward floating of the pound threatening to produce a delayed inflationary effect, the Government faces the possibility of having to restore the 1 per cent cut in interest rates unwisely announced immediately after sterling's withdrawal from the ERM. That might steady the pound, but it would reduce business, public and Tory morale still further. An increase in indirect taxes would also be damaging, especially at this juncture. Norman Lamont's message is likely to be that such unpalatable medicine may be necessary if public spending is not controlled.

By way of a sweetener, he is expected to announce some belated help for the depressed housing market, targeted at those caught in the 'negative equity trap' created when a home is worth less than the mortgage which it secures. The Government itself might be said to have fallen into a 'negative policy trap', in which the value of its promises has fallen steeply since voters bought them in April.