To Save the European Union Create New ERM, Minus Mark

A CASUAL observer, watching Europeans gear up for their month-long vacations would be hard pressed to imagine that the battle for a unified Europe had reached a climax not on the Bosnian battlefields but on the marbelized floors of the world's currency exchanges. Fortress Europe, which was to have been fortified by a single currency (the ECU), has been laid low by a horde of speculators and barbarians in red suspenders. When the German Bundesbank failed to cut interest rates last Thursday, the final batt le was joined, and the currency speculators began their charge. They would either overwhelm the teetering currency union, or retreat in ignominy.

Their adversaries, the political leaders of Europe, braced for the assault with only hollow statements that they would not surrender. The rest of Europe sat, mostly unawares.

The European Exchange Rate Mechanism (ERM) was supposed to end such tumult by smoothing the transition to a monetary union and anticipating political union. Italy, Spain, and Portugal - notorious debtors - would be given time to discover Teutonic virtue and economy. This would not be painless; but with the steady Germans manning the helm, the benefits would outweigh the costs. Price stability, low interest rates, and economic growth would turn unified Europe into the world's foremost economic power. Euro pe would be like America, with a single currency.

Until then Europe's currencies would be pegged to each other, some loosely, some less so, and allowed to float between a narrow ceiling (the strongest currency) and a floor (the weakest). Ruinous fluctuation would end, speculators would be emasculated.

But a funny thing happened on the way to paradise. The Berlin Wall collapsed, and the Germans began creatively financing public spending. As the German government turned spendthrift, the Bundesbank, never terribly impressed by politicians, dug in and raised interest rates to quell inflationary pressure. British, French, Italians, and Spaniards, all innocent, were forced to follow suit and defend their currencies with high rates.

Their economies were in no position to endure such heroism. Higher interest rates choked domestic investment and sent wobbly economies into recession. Unemployment skyrocketed, GDP plummeted, and opposition politicians scored big. At least the Germans, also in recession, got East Germany: The rest of Europe had no such prize. The rhetoric of monetary union rang hollow in the ears of unemployed workers.

Speculators bet against ERM. They sold the pound and lira mercilessly until in September, on "white Wednesday," the two currencies were ejected from the ERM. Governments and central banks put up a fight, spending billions to prop up the currencies; but they were no match for speculators who brought hundreds of billions to bear. Fortress Europe wobbled.

The story might have ended if Britain had paid a price for its apostasy. Those who stayed in the ERM told the world they were more committed to currency union than ever. France, which ratcheted its inflation rate below Germany's for the first time since anyone could remember, talked glowingly of its franc and claimed the mantle of ERM leadership. Spain and Portugal dutifully devalued.

But in recessionary Britain another funny thing was happening. The never-ending recession was ending. The British economy, freed from high interest rates, snapped back to life. Britain's ejection from the ERM proved a boon. By June, production and sales were up 4 percent. Unemployment and inflation fell. France could boast of its franc, but French output dropped 3 percent; unemployment hit 11 percent. When a French center-right government not enamored with ERM steamrolled the incumbent Socialists in May,

speculators paid attention.

The French government, they decided, would follow the lead of Britain and abandon the ERM. France's new prime minister, Edouard Balladur reaffirmed his commitment to the ERM many times - to no avail. The assault against the franc began.

By last week it reached fever pitch. Intense selling pushed the franc down to the ERM floor. The central banks counterattacked, spending $40 billion to support the franc.

But the Bundesbank, committed only to fighting inflation in Germany, sat on its hands waiting for local inflation figures. If too high, it would raise interest rates. This would be the end of ERM. If too low, it could cut rates and relieve the franc. The Bundesbank would decide the fate of European union.

THE inflation was lower than expected but the staid Bundesbank refused to cut its rate. It chose inflation-fighting over the ERM. Speculators hit soft currencies; the ERM's death knell was heard. After a 14-hour meeting, ministers only came up with stop-gap measures allowing currencies to float widely against each other. Redefining "ERM" as free-floating currencies means it - and a single market - now exist in name only. The ERM has collapsed and with it dreams of early European union. The single currenc y was to have been its breath of life. Short-sighted German politicians, stubborn and nationalistic German inflation-fighters, and ERM stalwarts who did not redesign a system full of flaws, undermined Europe's greatest achievement. Now Europe's economies will diverge; political union will fade.

Europe's leaders may yet save the union. A reconstituted ERM, with the French franc as anchor, and the German mark left floating would lay the groundwork for lasting monetary union. The French currency is fundamentally sound. Germany's economy is the one with structural difficulties requiring high interest rates. Germany and Germany alone should bear the indignities of temporary ejection from the ERM. A new ERM without Germany would be stable; Germany could join after taming its deficit.

Germany will have to let its cherished currency lose some luster. European union is the best bet for all of Europe's prosperity. A new ERM, minus the mark, must take the place of the old before the European dream fades.