The European Monetary System Crisis of 1992-1993

Shirley Law & Arnaldo Silvio Rabolini Salamanca

Outline

1. Historical context2. How the crisis unfolded3. Explanations – why?4. Possible policy responses5. Conclusion/discussion

The Snake (in the Tunnel)1971-1979

• First attempt at European monetary cooperation perceived as a neccessary after the collapse of the Bretton Woods’ fixed exchange rate system

• Fluctuation band with a maximum oscillation of 4.5% and with all the currencies moving together against the dollar

• External shocks (oil crisis and stagflation) undermined the stability of the system. One currency after another withdrew from the peg

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The European Monetary System

• Creation of the European Monetary Fund• Exchange Rate Mechanism (ERM):

currencies pegged within 2.25% bands and with the DM as the inflation anchor

• Two distinct phases: -from 1979 to 1987: a period of stability

with several realignments -from 1987 to 1992: the “hard” EMS

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Timeline of the Crisis1990

1991

1992

1993

1 July: Capital controls eliminatedAutumn/Winter: German reunification

2 June: Danish referendum13 Sept: Lira devalued. Realignment rejected16 Sept: Black Wednesday – UK leaves ERM17 Sept: Italy leaves ERM23 Sept: Speculative attack against French

franc. 80 billion francs in reserveslost, Bundesbank forced to intervene

Nov 1992 – Summer 1993: Speculative frenzycontinues. More devaluations

30 July: All ERM currencies except the guilder& punt quoted at the bottom of their bands

1 Aug: ERM bands widened from 4.5% to 30%

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Explanations for the Crisis

• Economic explanations: - First generation model - German reunification shock• Political explanations: - Second generation model (self-

fulfilling speculative attacks) - Policy coordination failure

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First generation model

• Weaknesses in macroeconomic fundamentals steadily exhaust foreign currency reserves

• A speculative attack abruptly depletes the foreign reserves the first moment where gains can be made

• Speculators do not trigger the crisis but only anticipate it

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Applicability of the first generation model

• Evidence shows that only Italy was experiencing macroecomic fundamental deficiencies (serious loss in competitiveness). Lira first currency to devalue and also first currency to come under intense speculative attack

• Although the UK and Spain had some problems, the evidence does not indicate that economic considerations triggered a speculative attack (i.e. forward exchange rate well within the bands until a few weeks before the start of the crisis)

• Other countries under attack, such as France, had healthy fundamentals

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The first generation model cannot explain the

extent of the crisis!!!

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German Reunification Shock

• Expansionary fiscal policy to fund the huge investments required in East Germany creates inflationary pressures

• Bundesbank raises interest rates to protect price stability

• Higher discount rates in Germany create deflationary tendencies in other countries (Mundell- Fleming model)

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German Reunification as an Explanation of the Crisis• The German reunification shock could have

created future economic problems that would have put currencies under pressure to devalue

• Moreover, the political cost linked to keeping high interest rates could become unbearable to policymakers who eventually would have opted to quit the peg

• Incentives to make profits trigger speculative attacks

• Again, available data does not sustain this position (forward exchange rates, reunification happened two years before and adjustment was under way)

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Second Generation Crisis

• Multiple equilibria: entirely different outcomes can occur depending on the agents’ expectations

• A sudden deterioration of investor confidence can lead to a policy response that validates the investors’ expectations (because they expect the policymakers’ optimal response to a macroeconomic shock)

• Speculative attacks can occur even when economic fundamentals are sound

• Depends on credibility of the monetary authorities

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Second Generation Crisis

• Higher interest rate to defend peg• However, higher interest rates also imply

higher unemployment, larger mortgage debts, etc

• Maastricht Treaty:– Convergence criteria: stable exchange rate

without any severe tensions for two years preceding entry into the EMU

– Once attacked, the country no longer qualifies = no incentive to maintain the peg

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Political Contagion

• Goal of pegged exchange rates is closer economic integration. Therefore, no incentive to maintain peg if integration jeopardised

• Maastricht Treaty requires unanimous approval. Doubts about it passing leads to greater likelihood of devaluation

• Crisis not start until Danish referendum• Convergence criteria: if one country

fails to qualify, lower utility for all

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Policy Coordination Failure

• Effects of depreciation in one country:– Demand shifts towards its goods– OR Demand for everyone’s goods increases– Which effect dominates?

• Cooperative response: small realignments by all countries

• Uncooperative response: huge devaluations by only a few

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Policy Responses - Them

• Devaluation of the franc• General realignment of ERM currencies• Floating the deutsche mark out of the

ERM• Imposing deposit requirements on

banks’ open positions in foreign currencies

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Policy Responses - Us

• Escape clauses in case of extreme shocks

• Capital controls– Currency transaction tax– Deposit requirements

• Enhancing policy coordination and cooperation

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Main Lessons

• More than just macroeconomics that caused the crisis

• Political considerations in a currency union: contagion, cooperation, reputation

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Questions?1

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