The European Monetary System Crisis of 1992-1993

1. The European Monetary System Crisis of 1992-1993 Shirley Law & Arnaldo Silvio Rabolini Salamanca

2. Outline • Historical context • How the crisis unfolded • Explanations – why? • Possible policy responses • Conclusion/discussion

3. ▶ 1 2 3 4 5 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

4. ▶ 1 2 3 4 5 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

5. 1 ▶2 3 4 5 Timeline of the Crisis 1 July: Capital controls eliminated Autumn/Winter: German reunification 1990 2 June: Danish referendum 13 Sept: Lira devalued. Realignment rejected 16 Sept: Black Wednesday – UK leaves ERM 17 Sept: Italy leaves ERM 23 Sept: Speculative attack against French franc. 80 billion francs in reserves lost, Bundesbank forced to intervene Nov 1992 – Summer 1993: Speculative frenzy continues. More devaluations 1991 1992 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% 1993

6. 1 2 ▶3 4 5 Explanations for the Crisis • Economic explanations: - First generation model - German reunification shock • Political explanations: - Second generation model (self- fulfilling speculative attacks) - Policy coordination failure

7. 1 2 ▶3 4 5 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

8. 1 2 ▶3 4 5 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

12. 1 2 ▶3 4 5 The first generation model cannot explain the extent of the crisis!!!

13. 1 2 ▶3 4 5 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)

14. 1 2 ▶3 4 5 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)

15. 1 2 ▶3 4 5 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

16. 1 2 ▶3 4 5 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

17. 1 2 ▶3 4 5 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

18. 1 2 ▶3 4 5 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

19. 1 2 3 ▶4 5 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

20. 1 2 3 ▶4 5 Policy Responses - Us • Escape clauses in case of extreme shocks • Capital controls • Currency transaction tax • Deposit requirements • Enhancing policy coordination and cooperation

21. 1 2 3 4 ▶5 Main Lessons • More than just macroeconomics that caused the crisis • Political considerations in a currency union: contagion, cooperation, reputation

22. 1 2 3 4 ▶5 Questions?