Economic Commentary: Ambushed by the Frankfurt hawks

The general collapse in financial markets last Friday was no minor squall. European equity markets fell by over 2 per cent, Wall Street was down by 1 per cent and bond markets in many centres were down by about a point. Short-term interest rate futures became markedly more pessimistic throughout Europe, and speculation against the exchange rate mechanism parity grid, which had previously been confined to the Italian lira, became widespread, hitting the pound in particular.

All this stemmed from a generalised, if rather belated, realisation that the outlook for world activity this year is much less good than had been thought, and that there is a real chance that the Bundesbank will tighten the screw yet again before the end of the year.

The Bundesbank's recent behaviour has been a classic of its kind. No more than 10 days ago, the markets were entirely complacent about German interest rates, and the British Government had reduced its money market intervention rates in an extremely foolish, and extraordinarily badly timed, effort to steer UK base rates down.

Meanwhile, a group of hawks on the Bundesbank central council had clearly decided that it was time to rein back German monetary growth, which has been uncomfortably strong for over a year. They started informing the press that a tightening of policy would be needed if the Bundesbank were to retain its credibility as an inflation fighter.

This changed the public climate, making it difficult for the doves on the central council to argue that nothing should be done on Thursday, since this would now look weak. Hence the doves eventually agreed to a 'compromise' proposal to increase the discount rate by 0.75 per cent, hoping this would simply lead to an increase in bank lending rates inside Germany, leaving German money market rates (which have a crucial effect on rates throughout Europe) little changed.

UNPLEASANT TRUTH

At first, the markets seemed disposed to see this as a non-event but by Friday the unpleasant truth had dawned. The German discount rate is now only 1 per cent below the Lombard rate, which is the narrowest gap between the two rates for 13 years. This means that any further tightening in policy will almost certainly involve a rise in money market rates, either because the Lombard rate will have to rise, or because the availability of Lombard credit to the banking system will be restricted.

Furthermore, the likelihood of a tightening is enhanced by the decision of the central council to leave the target range for M3 unchanged at 3.5-5.5 per cent, despite the fact that the actual growth in the money stock so far this year has been 8.7 per cent. This was intended to convey to the markets the firm impression that the Bundesbank does not intend to latch on to any of the 'alibis' that have been suggested for excess money growth. (For example, the mark note issue has ballooned this year because the German currency has displaced the dollar as the transactions currency in use throughout Eastern Europe.)

By turning down this and other alibis, the central council has intentionally boxed itself in - either M3 growth must spontaneously slow down, or interest rates will rise. This was precisely the end point that the hawks had planned all along; for them, the exercise was coolly planned and clinically executed.

Britain is not the only country left in trouble by these developments, but it is probably the one in deepest trouble, since it needs a cut in interest rates more desperately than any other economy. The consensus of forecasters has been downgrading growth projections for the umpteenth time in the last month, but yet again it has failed to go far enough.

The decline in industrial production in May, taken together with the likely drop in retail sales in June to be reported this Wednesday, suggests that GDP fell for the eighth successive time in the second quarter. In the wake of these figures, a central projection for GDP this year would have to be that it will drop by more than 1 per cent, compared with the recent consensus estimate of zero. (Incidentally, I would like to know who told the Prime Minister a fortnight ago to say that positive GDP growth of 'up to 1 per cent' was likely this year. Whoever it was is inhabiting the wrong planet.)

The government remains entirely bereft of attractive options, but an interesting question for the next few weeks is how the new Opposition will respond. Neil Kinnock has already called for a revaluation of the mark against all other ERM currencies, his political instincts telling him that a continuation of blind support for the present ERM parities cannot be good politics for Labour. And at this stage of the electoral cycle, opposition should be about politics, not policy.

Yet the incoming economic leadership of the party (Smith and Brown) is acutely aware that Labour cannot win the next election if it is seen as the party of devaluation. Furthermore, to change tack so soon after giving copper-bottomed guarantees in the election campaign that sterling would not be devalued would leave the party with a permanent credibility problem. What is needed is something that takes account of new developments since polling day, yet stops a long way short of supporting a unilateral sterling devaluation.

How about the following? There have been three crucial developments since the election that justify a change of strategy, not just in the UK but throughout Europe. These are: the Danish vote on Maastricht, which makes an early move to full monetary union exceedingly improbable; the German interest rate rise; and the renewed slowdown in European activity, which has been partly triggered by the slump in the dollar.

NEW PACKAGE

Taken together, these developments mean that the previous strategy of sticking to the present ERM parities while waiting for the imminent arrival of EMU is no longer tenable. The Opposition could call for a new European package of measures with the following strands.

No sterling devaluation. Labour could enhance its credibility by emphasising that the problem is not with sterling's value against the European currencies (about which, please note, no prominent industrialist is complaining). The problem stems from high real interest rates, which would not be brought down be a unilateral sterling devaluation within the ERM. Leaving the system altogether, which would reduce interest rates, would be seen by the electorate as a return to Labour's bad old anti-European ways, and would surely be vetoed by John Smith. Hence, Labour should remain opposed to all these 'soft options'.

Revaluation of the mark. The same arguments do not apply to a DM revaluation against all other currencies. Since the problem originates in Germany, it should be solved by Germany. A mark revaluation could pave the way for lower German interest rates, helping all other European countries to bring rates down. Of course, the Prime Minister cannot breathe a word of support for this, in case it undermines sterling. But the Opposition can.

European fiscal policy. The Maastricht limits on budgetary policy are too strict in the short term, now that European activity has failed to recover. They should be temporarily relaxed. In the UK, Labour could argue for a package of emergency assistance for the housing market, including more generous tax relief on mortgage payments.

The dollar. All the European economies are suffering because the dollar is so weak. Labour could call for G7 action to change its direction.

This package would provide some product differentiation from the Government, without undermining Labour's long-term credibility. It would be a good start for the new Opposition.