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

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

The Snake (in the Tunnel) 1971-1979 ▶ 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

The European Monetary System ▶ 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

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

Explanations for the Crisis 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

First generation model 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

Applicability of the first generation model 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

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

German Reunification Shock 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)

German Reunification as an Explanation of the Crisis 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)

Second Generation Crisis 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

Second Generation Crisis 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

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

Policy Coordination Failure 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

Policy Responses - Them 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

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

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

1 2 3 4 ▶ 5 Questions?