Schlesinger: a banker's guilt: The president of the Bundesbank has been woefully indiscreet. But the Chancellor, too, is a diminished figure, says Christopher Huhne

Both the Government and the German Bundesbank have realised that their row has reached the stage when neither side can hope to benefit. The Bundesbank has been wounded by the episode, which calls into question both the competence of its president and its loyalty to the European goals of the Bonn government.

But the Chancellor of the Exchequer, too, is a diminished figure. Whatever the rights and wrongs of his complaint about the Bundesbank's behaviour during the defence of the pound, his angry riposte to the German central bank's briefing note served to undermine the Prime Minister's and the Foreign Secretary's attempts to rebuild their European policy.

If both sides are now damaged, both sides must also take some of the blame for the denouement of 'Black Wednesday', when sterling was forcibly ejected from the exchange rate mechanism (ERM). The British government made several important errors, but the first and most crucial was the high-handed way in which it announced that it would put the pound into the ERM at a rate of DM2.95 on 5 October 1990.

That fait accompli flew in the face of all the co-operative traditions of the European Monetary System, whereby any realignment of a target 'central rate' is a matter for negotiation. The Bundesbank made clear at the time that it thought the pound was too high. As a result, it was less committed to defending the rate than it should have been.

The choice of a high rate was entirely that of John Major, the then Chancellor. Britain's underlying inflation rate had reached 7.9 per cent, and he wanted a strong pound so that imports would remain cheap. This would in turn keep up the pressure on British companies to curb price rises. Having failed to take the Treasury's advice either to raise interest rates or taxes early in 1990, Mr Major instead talked up the pound by teasing the markets about our ERM entry. Sterling rose by 6 per cent during 1990, and was then locked into the ERM.

At the time, the intention of senior Treasury mandarins was that the rate would hold for a year or more before some devaluation. But the reason for a devaluation - to avert any 'Black Wednesday' - always seemed less pressing than the reasons to avoid one. A devaluation within the ERM would not necessarily have allowed Britain lower interest rates, because investors might require a higher interest rate to compensate for the possibility of another drop in value. It would also have undermined the possibility of joining Germany and France at the top table of monetary union.

So we struggled on, with ministers lashing themselves ever more publicly to the mast. John Major told the Scottish CBI on Thursday 10 October - just six days before nemesis - that devaluation was 'fool's gold'.

However, the Bundesbank's view about sterling's overvaluation had not changed, as anyone who knew its senior officials could testify. This was to be a fatal weakness in the battle for the pound.

Ultimately, there are only feeble weapons with which to defend weak currencies in a fixed exchange rate system. Finance ministers and central banks can buy up their currency, but only to the extent that they have reserves of foreign currency with which to do so. For example, Britain had some dollars 44bn, not much beside the dollars 303bn turnover of the foreign exchange market in London every day.

The second line of defence for a beleaguered currency is a rise in interest rates to increase the rewards for people holding it. But the scale of the interest rate rise needed to compensate an investor who is betting on a 10 per cent devaluation of the currency tomorrow is 10 per cent each day, not each year.

Since this is unrealistic, the key to the successful defence of a currency grid is the willingness of the authorities of the strong currency to print more of it: by pumping marks into the market, the Bundesbank can hold the exchange rate of the mark down (and the pound or the franc up). But if the Bundesbank implies that it is not prepared to do so, it can trigger a wave of selling of the weak currency.

This essentially is the charge that the Chancellor has levelled against the Bundesbank president, Helmut Schlesinger: whatever his private views about sterling, he and his fellow Bundesbank officials failed to maintain the discretion expected of central bankers attempting to defend a partner currency. On this charge, Mr Schlesinger is guilty.

The Bundesbank has committed so many gaffes that some British observers seriously questioned its good faith in operating the system. After all, the Bundesbank stands to lose most from the creation of a single European currency with its own Euro-central bank. Was its heart really in Europe's new monetary arrangements?

On 25 August, for example, Reimut Jochimsen, a Bundesbank council member, issued a speech saying that there was potential for realignment within the ERM. Sterling weakened. On 10 September, an unnamed Bundesbank official was quoted as saying that a devaluation of sterling was inevitable. The pound fell.

But the coup de grace was delivered the day before 'Black Wednesday' by Mr Schlesinger. Sterling was struggling to stay within its prescribed bands on Tuesday 15 September, when the news shot across the wires that the Bundesbank president had given an interview to the German financial paper Handelsblatt and the Wall Street Journal in which he cast doubt on the ability of the ERM to hold together.

The report said: 'The President of the Bundesbank, Professor Helmut Schlesinger, does not rule out the possibility that, even after the realignment and the cut in German interest rates, one or two currencies could come under pressure before the referendum in France. He conceded in an interview that the problems are of course not solved completely by the measures taken.'

The effect was devastating. The report of Mr Schlesinger's remarks turned the selling of sterling into an irresistible flood. 'This generation at the Bank (of England) had never seen anything like it. It was as if an avalanche was coming at us,' one official said.

Mr Schlesinger's leaked memo now attempts to rebut the charges by saying that he cannot be held responsible for the misunderstanding of journalists, and that he had excluded sterling from those currencies which he said were in danger. It is also true that the full interview, when it appeared in Handelsblatt on 17 September, did not support the early reports.

However, Mr Schlesinger's memory may be defective. Werner Berkhoff, the journalist who conducted the interview, is a respected, accurate and senior specialist. The interview was on the record, but with the unusual caveat, unique to Mr Schlesinger, that direct quotations had to be approved before publication.

Since Mr Berkhoff realised that he had a good story, he published a report using indirect speech in the issue of 16 September, releasing it to the news wires the night before, as is the German custom with scoops. He had no doubt about what Mr Schlesinger said to him, but he excised the quotations to which Mr Schlesinger objected in the version of 17 September because he wanted to maintain his relationship with the central bank.

When the Bank of England asked the Bundesbank to issue a retraction on Tuesday night, it stated: 'The text was not authorised. He did not say that, and it was not what he intended to say.' But the markets were not convinced, precisely because of the previous history of the Bundesbank's views. The skids were under sterling.

The truth of the matter is ultimately opaque, since we must believe either Mr Berkhoff or Mr Schlesinger. For what it is worth, my money is on Mr Berkhoff. Mr Schlesinger is a courteous, old world academic who has never been confident in his own articulacy. The curious arrangement of having his quotations 'authorised' was unknown to his predecessor Karl-Otto Pohl, a former journalist who understood the power of his own words.

Mr Schlesinger was for many years Mr Pohl's No 2, and would probably never have attained the top position without the Bundesbank's need for a stopgap. Mr Schlesinger's designated successor and deputy, Hans Tietmeyer, spent some time advising Chancellor Kohl, and it was felt that he could not take over immediately because he needed a period in which to re-establish his political independence.

Mr Schlesinger should therefore be acquitted of knavery, but he is properly accused of incompetence and over-promotion. The fact that the Bundesbank abided by its legal obligation to buy sterling in the marketplace is neither here nor there: what is at issue is the corrosive nature of the remarks made repeatedly by Bundesbank officials and devastatingly by Mr Schlesinger.

There was a chance, but perhaps not a large one, that sterling could have survived within the system. British policy-makers certainly made mistakes. But once Mr Schlesinger had talked to Handelsblatt, the game was up. And the moral? Central bankers should not tell lies, but, equally, they are under no obligation to tell the whole truth.

(Photographs omitted)