British economist Jonathan Portes remembers the UK’s exit from the Exchange Rate Mechanism:
We argued that the fundamental problem was that we’d joined the ERM at the wrong rate; sterling was overvalued, meaning that we were stuck with a structural current account deficit. The only way to maintain the peg would be through what is now, in the eurozone context, referred to as “internal devaluation”; that is, real interest rates at a higher rate than dictated by internal conditions, and a long and grinding squeeze on wages and prices.
Our solution? We didn’t dare suggest complete abandonment of the ERM. One possibility was for sterling to “realign”, that is devalue, to a considerably lower rate, boosting exports and allowing interest rates to fall. Even better, politically and perhaps economically, would have been if the Germans could have been persuaded to realign upwards, so avoiding the perception that sterling was being singled out; but the French were resolutely opposed to any devaluation of the franc.
The fascinating thing here is, of course, that nothing has changed. In many ways, this is because the issues haven’t changed. Keynes said that the whole complex problem of European currencies and trade in the 1920s could be reduced to one question: how much of France’s war debts would be paid by workers and how much by savers, whether through taxation or through inflation. The answer would set the price level and hence the exchange rate, and how much of a trade surplus Germany could run, and therefore how much of Germany’s war debts could possibly be paid.
Similarly, in 1992 the questions was how the costs of German reunification would be split. Taxation was chosen over inflation, capital was privileged over income. Now, arguably, the question is how the cost of the Great Bubble will be split, and you guessed it. Portes is damning on the reasoning behind this:
The UK had long suffered from periodic cycles of boom and bust, most recently exemplified by the deep recession of the early 1980s and the unsustainable boom of the late 1980s. Monetarism – targeting various measures of the money supply – had failed miserably. The alternative was to “import” credibility from a country with a demonstrated record of maintaining low inflation while avoiding boom and bust – Germany, and we could do exactly that by tying our exchange rate and monetary policy to theirs…
But for me, the most important lesson was a more general one about “credibility”- a concept often used and abused by both politicians and economists. As with the ERM, the argument made by the current government and its supporters for sticking to its fiscal consolidation plan, despite its evident failure, is that the strategy has established “credibility”, especially with financial markets, which can only be preserved by sticking with it.
But of course this is not a justification, economic or otherwise, for the policy. Instead it is an argument for never changing policy at all…
The real hit to credibility comes from sticking to unsustainable policies; and economic success comes from abandoning them and doing something sensible instead. That is one lesson from Black Wednesday we could usefully remember.