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By Root 2939 0

just one factor being taken into account in order to assess monetary conditions. It was the monetary aggregates which were crucial. The wider measure of money — £M3 — which we had originally chosen in the MTFS had become heavily distorted. A large proportion of it was in reality a form of savings, invested for the interest it earned. In Nigel’s first budget (1984) he set out different target ranges for narrow as well as broad money. The former — M0 — had been moving upward a good deal more slowly and this was taken into account in plotting the future course. But at this stage M3 and M0 were formally given equal importance in the conduct of policy. Other monetary indicators, including the exchange rate, were also taken into account. Our critics, who had until now denounced our policy as a rigid adherence to a statistical formula, began to denounce our rootless and arbitary pragmatism. And indeed, sensible as this change was, it was to mark the beginning of a process by which the clarity of the MTFS became muddied. This in turn, I suspect, caused Nigel, as the years went by, to search with increasing desperation for an alternative standard — reliable in itself, convincing to the markets — which he finally thought he had found in the exchange rate.

Events in January 1985 brought the ERM back into discussion. The dollar was soaring and there was intense pressure on sterling, in spite of the soundness of Britain’s finances. I agreed with Nigel that our interest rates should be raised sharply. I also agreed with Nigel’s view that there should be co-ordinated international intervention in the exchange rates to achieve greater stability, and I sent a message to this effect to President Reagan. This policy was formalized by Nigel and other Finance ministers under the so-called ‘Plaza Agreement’ in September. In retrospect, I believe that this was a mistake. As Alan Walters would always argue, if intervention is ‘sterilized’, that is to say not allowed to affect the money supply and short-term interest rates, it will have only a fleeting effect; on the other hand, if it does promote monetary growth then it will be inflationary. The Plaza Agreement gave Finance ministers — Nigel above all perhaps — the mistaken idea that they had it in their power to defy the markets indefinitely. This was to have serious consequences for all of us.

Sterling’s problems also prompted Nigel to raise with me in February the issue of the ERM. He said that in his view controlling inflation required acceptance of a financial discipline which could be provided either by monetary targets or by a fixed exchange rate. It was essentially a secondary matter which of these was chosen. But new factors, argued Nigel, favoured the ERM. First, it was proving difficult to get financial markets to understand what the Government’s policy towards the exchange rate really was: the ERM would provide much clearer rules of the game. There was also a political consideration. Many Conservative MPs were in favour of joining. In arguments about additional spending and borrowing it would, he thought, be helpful to be faced with a discipline which MPs themselves accepted. Entry into the ERM would also move the focus of attention away from the value of the pound against the dollar — where, of course, the problem at this particular moment lay. Finally, £M3 was becoming increasingly suspect as a monetary indicator because its control depended increasingly on ‘overfunding’, with the resulting rise in the so-called ‘bill mountain’.* I was not convinced on any of these counts, with the possible exception of the last. But I agreed that there should be a seminar involving the Treasury, the Bank of England and the Foreign Office to discuss it all.

Alan Walters could not attend the seminar and so he let me have his views separately. He put his finger on the key issue. Would membership of the ERM reduce the speculative pressure on sterling? In fact, it would probably make it worse. That was the lesson to be drawn from what had happened to other ERM currencies, like the franc. Moreover,