Why We Should Leave the ERM

Abstract

The ‘liverpool Six’have called again on the government to leave the Exchange Rate Mechanism and return to monetarism with flexible exchange rates. Our reason is simple. Monetary conditions here have been tightened more than dangerously by the need to support the pound within the ERM, just as in late 1987 and early 1988 they were loosened excessively by the need to hold the pound down in the attempted ‘shadow’ phase of the ERM. The has repeatedly undermined monetary stability, and has caused first renewed inflation and now severe and protracted recession. It has also tended to produce sterling overvaluation and so chronic balance of payments difficulties; to correct these, recession will need to be prolonged. In the havoc it has wreaked, it risks fuelling demands for a return to the government intervention of he past. As a source of counter inflationary discipline it is therefore flawed. We advocate a return to monetary targeting under floating rates. This would in the short term permit interest rates to fall sharply to stimulate recovery in money supply growth and hence the economy; the exchange rate would fall to a properly valued level, removing the threat to our balance of payments. In the longer term this policy shift would recreate a framework of counter-inflation discipline in which there could still be reasonable domestic responses to cyclical and other UK shocks.