The system self-destructs: Another devaluation, another crisis. Unless the mark can rise, the ERM may die, says Christopher Huhne

Five of the 11 currencies in the exchange rate mechanism at the beginning of September have devalued or been suspended from the system. The Italian lira was the first to go, followed in short order by sterling. The Spanish peseta, the Portuguese escudo and now the punt have been forced to devalue.

Moreover, the system's travails are not over yet. As the anguished reaction of the French finance ministry to the news of the Irish devaluation shows, the markets' sighting shots are moving closer to the heart of the system: the link between the French franc and the mark. If that relationship breaks down, the ERM will be dead.

The consequences for European politics and economics will be profound. The British government had invested only two years in the system, but its credibility was left in tatters by 'Black Wednesday'. By contrast, an ejection of the franc will write off a decade of French monetary policy. The hopes for a 'zone of monetary stability', as the ERM's founding fathers, Roy Jenkins, Helmut Schmidt and Valery Giscard d'Estaing, called it in 1979, will have been destroyed in the firestorm of speculation.

Even if the franc survives, the strains which the system is now imposing on French policy will probably lead to a radical review by any new right-wing government. The front-runner for the finance ministry after the March elections is Edouard Balladur, who was there between 1986 and 1988. Despite his protestations that he will never devalue, market participants with long memories will remember that he has said the same before, and nevertheless devalued. For that very reason, the devaluation may even come before the election. The price of defending the franc - 13 per cent interest rates against a 2 per cent inflation rate - looks ever more absurd.

The sad truth is that the ERM, far from being an element of stability in Europe, has become an engine of destruction. What were once beneficent disciplines have become manacles binding European governments into economic policies that are wholly inappropriate to their circumstances. As recession sweeps across Europe and unemployment soars, interest rates ought to be tumbling down. Instead they are held in the vice-like grip of French, Belgian, Dutch and Iberian commitments to a parity with the German mark.

The essential problem is that investors prefer to hold marks rather than any other currency within the system because of the Germans' record for sustaining their currency's value. Other currencies in a fixed relationship with the mark thus have to pay interest rates higher than Germany's to attract investors. (Outside the system, currencies can fall to such a low level that the markets are prepared to hold them, even if their interest rates are lower than German ones).

In former times, this mattered little. Germany had a reputation for sound money which other countries were happy to borrow. But German reunification in 1990 dramatically changed the conditions of the German economy. High public spending on benefits, roads, railways and public buildings put money into people's pockets, so that demand outstripped even Germany's legendary supply capacity. The trade surplus vanished. Prices began to rise and the Bundesbank reacted with the highest interest rates for 30 years.

The solution to this problem should have been easy: let the mark rise sharply, which would reduce German import prices and inflation, and encourage the Bundesbank to cut interest rates. In the more flexible early years of the ERM, there would have been no hesitation. But this was not a solution the French could any longer accept.

Ever since Francois Mitterrand's U-turn in 1983, the policy of the franc fort has become holy writ. The French persuaded themselves, like most other continental Europeans, that devaluation would so raise import prices and inflation as to offset any temporary benefit to their competitiveness. They were also playing for higher stakes: a monetary union with Germany which would give them a real influence over their own interest rates, and which they believed would be imperilled by a devaluation.

Once the French ruled out any realignment against the mark, it became politically more difficult to arrange any devaluation for the British or Italians. Like the Bretton Woods exchange-rate system before it, the ERM began to fray because pride stood in the way of change. Inflexibility meant the system did not bend. It snapped.

There is, though, an irony which the French are the first to point out. The perceived need for a rise in the German mark does not come about because Germany is competitive, or running a trade surplus, or has low inflation. Ironically, the perceived need for a higher mark arises because Germany's fundamentals are bad, not good: high inflation requires a tight money policy which attracts capital flows and raises the mark.

When Germany's inflation is licked, its interest rates will subside, and so will its currency. German reunification ideally requires the ERM to have the flexibility to allow the mark to rise and then fall back. But this is precisely what the ERM's narrow 2.25 per cent bands do not allow.

A new element of flexibility is probably now the only hope of saving what remains of the system. One solution is for the Germans to adopt a wider fluctuation band - perhaps 10 per cent or more - allowing the mark to rise sharply. Other countries might be able to run lower interest rates than Germany's, because the wider band would allow the markets to believe that other currencies could eventually rise against the mark. Most importantly, the French could claim that there had been no change in parity, and no loss of face.

If the system does bust apart, it will have to be reinvented in some less ambitious form. Europe is simply too integrated an economy to allow its currencies to judder violently against each other. Even a big European economy such as Britain's exports a third of everything it produces, and we can ill afford the sort of currency overvaluation that we suffered under free-floating in 1979-81. Indeed, it is arguable that the price of free- floating and beggar-my-neighbour devaluations in Europe would soon be the unravelling of the single market.

If the exchange rate mechanism is reinvented, it must change its architecture. The Europeans made the same mistake in designing the ERM that the Bretton Woods conference made in 1944 when it designed the post-war monetary regime. They opted to put a single country's currency at the centre of the system - the dollar at Bretton Woods and the mark in the ERM. Instead, they should have established a new multilateral currency whose management would take account of inflationary trends in all the member countries. History suggests that betting on one key currency is likely to end in tears.

(Photograph omitted)