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A mark of the times

The Exchange Rate Mechanism is dead, and so is the old dream of European unity. But, says Helen Simons, the economic integration of a new Europe centred on Germany is only just beginning

When Europe's Exchange Rate Mechanism (ERM) finally cracked in July, it sent a wave of panic across the continent. After weeks of devaluation pressure centred on the French franc, Europe's financial chiefs tried to cobble together a deal to save the system. But when their only solution was to abandon the cherished notion of exchange rate stability and allow Europe's currencies to float within bands so wide as to be meaningless, it was clear to all that the old ERM was dead.

The crisis of the ERM has been accompanied by apocalyptic warnings about 'the end of Europe' and future instability. According to many pundits not only is the ERM finished, but Maastricht is dead and even the future of the EC itself is in question. European cooperation, they claim, is now set to be superseded by a return to the economic nationalism of the 1930s.

Certainly things have changed since the ERM debacle. The trouble is that any rational explanation for the monetary crisis has been obscured by the claims and counter-claims flying across the continent, as governments and economists blame each other for the chaos. As a result many experts have missed what is really happening within Europe, and the likely future of European relations.

The most ludicrous claims about the crisis came from the British government. The Tories watched the turmoil in Europe's currency markets with barely disguised glee. John Major's government had been humiliatingly forced out of the ERM last September. Now ministers claimed that the latest episode proved that the ERM rather than the British economy had been the problem, as there were fundamental 'fault-lines' within the system.

Major even seized the opportunity to relaunch his 'hard Ecu' plan which was laughed out of Europe two years ago. But while Tory ministers may relish the fact that their European partners have now run into problems, Europe is not about to take lessons in currency stability from British capitalism.

Britain was forced out of the ERM because its economy is the sick man of Europe. With most of British industry unable to compete in world markets, sterling could not maintain its parity with the deutschmark. Sterling collapsed not because of hidden fault-lines in the ERM, but because of the obvious fault-lines in the British economy. Far from vindicating its position, the Major government's reaction to the latest crisis only served to confirm Britain's isolation within Europe.

The French press argued that 'Anglo-Saxon financial speculators' were the villains of the piece. The right-wing paper Le Figaro claimed that these traders set out to break the franc because of their opposition to fixed exchange rates and their suspicion of France. Former French foreign minister Roland Dumas even suggested that 'the Anglo-Saxons' were determined 'to see European construction stopped'.

Meanwhile, French premier Edouard Balladur and many French officials blamed the Germans for holding Europe to ransom by refusing to cut interest rates. By putting German domestic fears of inflation ahead of Europe's need for interest rate cuts, the Bundesbank had thrown the continent into crisis. Since Germany was the problem, some French officials called for Germany to leave the ERM.

Unlike the British explanations, French claims do have a resonance within Europe. Journalists, analysts and politicians have targeted the speculators and many agree that France is paying the price for Germany's post-reunification problems. But these arguments cannot explain the currency chaos either.

Take the idea that speculators caused the crisis. Speculators, Anglo-Saxon or otherwise, are not aliens driven by strange and sinister motives. They are old-fashioned capitalists, motivated only by the drive for profits. Speculators make their money by anticipating price movements on the world currency markets. But they have no magical powers to move prices at will. Price fluctuations are a result of the workings of the entire market system.

Some commentators tried to suggest that the latest ERM crisis had partly been caused by arch-speculator George Soros 'playing up' the £1 billion he allegedly made from exploiting the pound's difficulties last year. But even if Soros had speculated every penny, it would make little overall difference to a currency market in which $300 billion is traded every day in London alone.

It also makes little sense to blame Germany's economic weakness for the crisis. Suggestions that the ills of the ERM could be solved by Germany leaving the system are farcical. A European monetary system would mean nothing without German involvement. The mark is the key currency because Germany is Europe's key economy.

Number one

Because Germany is the number one trading partner for all major European countries, they all seek currency stability with the mark. The fact that the ramifications of German interest rate policy are felt across the continent indicates the strength of the German economy rather than its weakness. The idea that this 'weak' economy should drop out of the system to ensure stability is, as BBC economics editor Peter Jay pointed out, a bit like telling the sun to quit the solar system.

At one point during the eleventh hour talks to save the ERM, Germany did agree to leave the system and let the rest sort things out. The response was instructive. First the Netherlands struck a secret deal to leave the system with the Germans. And then, like rats leaving a sinking ship, Belgium, Luxembourg and Denmark all declared that they would do the same. This would have left France in an ERM with Spain and Portugal.

Faced with the stark choice of sticking with the ERM or going with Germany, all the core economies in Europe wanted to go with the Germans. This demonstrates that European institutions are only meaningful today insofar as they reflect the real power relations between the nations of Europe. Instead of blaming the speculators, the Anglo-Saxons or the Germans for the ERM's downfall, it is more useful to look at those relations in order to explain why such an institution should fail.

Exchange rates between nations reflect the relative performance of economies at a moment in time. If an economy is strong with high productivity it will tend to be reflected in a strong currency. Investors are always on the look out for winners. Nations with the competitive advantage of high productivity and dynamic growth will tend to attract investors. Demand for that currency will increase and its value on the foreign exchange markets will rise.

The reverse applies to weaker nations. If productivity is low and economic activity is slow then there will be little to attract investors. Unless governments create attractive conditions for investors through incentives such as high interest rates, there will be little demand for the currency. The result will be a relatively low exchange rate on the money markets.

The ERM was designed to minimise shifts between Europe's currencies. This was achieved by setting a narrow target range for exchange rates and getting the monetary authorities to manipulate the foreign exchange markets, through controlled buying and selling of currencies by the central banks and careful manipulation of interest rates.

The ERM worked best in the boom years of the late eighties, when the pressures on the system were minimal. But when the slump caused tensions to rise within the system, the ERM was unable to buck the market. Last year the system could not hold either sterling or the Italian lire at their over-inflated prices. When it reached the point where the only thing preventing a sterling or lire crisis was massive buying in the market by the central banks, the mechanism gave way. The pound and the lire crashed and other peripheral currencies were soon forced to devalue.

This summer's ERM crisis was precipitated by the French government promoting the franc further than was justified by the strength of its economy. In May, one French minister demanded that the franc should become the ERM's anchor currency. The Balladur administration cut interest rates 10 times in as many weeks, while insisting that the French economy remained strong enough to support the franc. However, once French interest rates dipped significantly below German levels, the franc fort beloved of the Balladur government was vulnerable.

At first the French got away with their bravado in the exchange markets, as forecasters and investors became preoccupied with what they saw as the new problem facing Europe - the German recession. With all eyes focused on the problems of the German economy, French claims to economic strength seemed reasonable by comparison. Many investors moved out of the mark and put their money into gold, Japanese yen or even French francs. But the moment investors took a serious look at French and German future prospects, the hype surrounding French claims became transparent.

Premature obituaries

Whatever difficulties Germany faces in the short term, it remains Europe's strongest economy. German productivity is about 15 per cent above the average of Europe's other industrial nations. While France can also claim productivity levels above Europe's industrial average, in key sectors such as car production and metals Germany beats its French neighbour hands down. Wise investors will still choose marks over francs every time.

Once the bubble of hype about France's economic strength had been burst, the franc was left without support. The French government pushed through a last ditch interest rate hike, and spent all of its foreign currency reserves defending the franc fort, but in vain. By attempting to challenge Germany for the economic leadership of Europe, the French authorities had created the conditions for the franc's downfall.

The collapse of the ERM was a big blow to Franco-German relations. Since this axis has been the linchpin of the EC, it is not surprising that many commentators declared that the ERM crisis spelled the end for closer European cooperation and currency union. But such obituaries are premature.

It should certainly be clear to all by now that the dream of a harmonious, united Europe of equal partners is a non-starter; but then, in reality, it always was. On the other hand, the fall-out from the ERM crisis has accelerated the process of pulling Europe's core economies together under German leadership.

For a start, the summer's events revealed the close links between some of the core currencies of central Europe - those of Belgium, Luxembourg, Holland and Denmark - and the German mark. They all pledged allegiance to Germany rather than the ERM in the midst of the crisis. And within days of the adoption of wider ERM bands, proposals were being floated for a smaller and tighter ERM. This would be nearer to a fixed exchange rate - and hence to a single currency - than anything which Europe has seen so far.

Nor are the economies that are coming together at the centre of Europe restricted to existing members of the European Community. At the height of the crisis Hungary announced that in future it would denote its foreign trade in deutschmarks rather than Ecus. More significantly, the Austrian and Swiss currencies remained closely tied to the mark throughout the turmoil.

No other option

The restructuring of European economies under the pressures of the slump is also helping to pull Europe's most important markets and industries into closer proximity with one another. Mutual investment levels between France and Germany are now at an all-time high, as are inter-European mergers and acquisitions. Despite all the political rancour, the European economy is now more truly integrated than ever before.

The final factor is that none of the other European economies has any serious alternative to following the Germans. France is the best example. Recent events have shattered the dreams of French politicians about shaping Europe's future. No doubt many of them would love to tell the Germans what to do with their deutschmarks. But while French pride is at rock bottom, France has no serious foreign policy options other than to hold on to its German connection. In the end it will have to swallow its pride and be prepared to be humiliated every time it tries to outflank Germany.

Much has been said about the ERM debacle heralding the end of the old Europe. Yet few understand that it also symbolises what European capitalism is becoming. In the months ahead it should become clearer who are the winners and who are the losers in the new Europe. But there can now be no doubt that Europe is a German continent, in which the mark can buy and sell the rest.

Reproduced from Living Marxism issue 59, September 1993

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