ARTICLE:
The European Currencies in Turmoil

Article Synopsis: An examination of the series of crises in the European Monetary System in 1992, 1993

Relevant Chapters: 30, 31

Topics Covered: Monetary policy, monetary independence, fixed exchange rate system, European Monetary System

Focus Questions:

1. Why does a fixed exchange rate system entail a loss of international monetary independence?
2. Using a diagram, illustrate the loss of international monetary independence in the European Monetary System (EMS).
3. Why did Germany raise interest rates between 1990 and 1992?
4. How were the crises of 1992 and 1993 in the EMS related to loss of international monetary independence?
5. How were the crises of 1992 and 1993 resolved?

The European Currencies in Turmoil

source: "The European Currencies in Turmoil" by The United States Government Printing Office. Economic Report of the President, Washington: 1994, pp. 244-245.

The EMS [European Monetary System] has experienced a series of crises since the summer of 1992. Germany adopted tight monetary policies in response to inflationary pressures that arose following German reunification in 1990. As a result, German short-term interest rates, which had been rising since 1988, continued to rise, reaching nearly 10 percent by the summer of 1992.

German policy, in turn, created a dilemma for other ERM [exchange rate mechanism] participants. Maintaining fixed parities with the deutsche mark them to tighten monetary policy despite stagnating or declining output, rising unemployment, and low rates of inflation.

When investors are free to choose among assets denominated in different currencies, the rates of return they expect to receive for comparable degrees of risk cannot vary too far from one currency to another. Expected exchange-rate changes are important in determining expected rates of return on assets denominated in different currencies. If, for example, investors expect the French franc to depreciate relative to the deutsche mark, they will move funds from French franc deposits into deutsche mark deposits unless they are compensated by a higher franc interest rate. Thus interest rates on franc-denominated assets would have to rise above the interest rate on deutsche mark assets to prevent sustained flows of capital out of franc assets and into deutsche mark assets.

Speculative pressures motivated by the possibility of a change in parities precipitated a crisis in September 1992. In the United Kingdom, where output had declined by more than 4 percent from its previous peak and the unemployment rate had topped 10 percent, pressure increased to realign or to drop out of the EMS so that interest rates could be lowered. Finland and Sweden, although not formal participants in the ERM, had been unilaterally maintaining pegged exchange rates, and so faced similar dilemmas as their economies went through deep and prolonged recessions. In September 1992, Finland, the United Kingdom, and Italy decided to allow their currencies to float, with the last two effectively leaving the ERM. Sweden followed in November. Spain, Portugal, and Ireland all devalued within the ERM between September 1992 and January 1993.

A second crisis erupted in mid-July 1993, following additional signs of growing slack in the European economies. Massive speculative capital flows occurred. Belgium, Denmark, France, and Portugal all raised interest rates and intervened heavily to defend their currencies. Nonetheless, the Belgian franc, the French franc, and the Danish krone dropped through their ERM floors. Selling pressures on these currencies continued, and on August 2, 1993, the countries participating in the ERM decided to widen the bands around the (unchanged) central parities to ±15 percent. (A separate agreement maintains bands of ±2.25 percent for the deutsche mark and the Dutch guilder.) Since all currencies were well within the wider bands, central banks were not obliged to intervene and the speculative crisis stopped.

The wider bands allow the participating countries much greater latitude to change interest rates independently. For the most part, however, the authorities have not used this ability to push interest rates down. Instead, they have sought to maintain relatively stable exchange rates with the deutsche mark and have cut interest rates only in parallel with Germany. By the end of 1993 the Belgian, Danish, France, Portuguese, and Spanish currencies were within or near the old ERM limits relative to the deutsche mark. The United Kingdom aggressively cut interest rates after leaving the ERM in September 1992.