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October 17, 2011

Back to the Future: Revisiting the European Crisis

Paolo Pesenti

Recent financial developments are calling into question the future of regional economic integration. Market confidence deteriorates across countries in a contagious way. The place is Europe, the time is . . . now? Or twenty years ago? In fact, in the early 1990s Europe went through a systemic crisis that displays remarkable similarities to today’s events. In this post, we go back to those momentous times and briefly recall how the last Europe-wide crisis started, unfolded, and concluded. The 1992 crisis was eventually resolved, suggesting that there may be some light at the end of the current tunnel as well.

    Two points are worth emphasizing from the very beginning, as they may help to highlight the links between past and present. (Readers interested in a more detailed account of events and debates at the time are referred to my work with Willem H. Buiter and Giancarlo Corsetti, Financial Markets and European Monetary Cooperation: The Lessons of the 1992-93 Exchange Rate Mechanism Crisis, Cambridge University Press, 1997.)

    First, in 1992-93, and arguably today as well, the speculative attacks that made the headlines were the tail, not the dog, of the story. The financial crises represented the rational responses of markets to the realization that cooperation among European members was fatally weak. The system came under attack as the European countries could not agree on a joint policy strategy to deal with the imbalances, relying instead on uncoordinated adjustment by the individual member states.

    Second, the crisis ended with the emergence of a new policy framework better suited to deal with the systemic implications of European trade and financial interdependence. From the markets’ vantage point, what brought about an effective resolution of uncertainty was not the reiteration of the commitment to shaky institutional arrangements (in that case, the mechanism of narrow exchange rate bands), but rather the rejection of the arrangements in favor of policy options that paved the way for more effective integration (in that case, the roadmap to the Eurosystem).

The “Hard ERM” and German Reunification
Twenty years ago, the monetary landscape for many countries in Europe was centered on the exchange rate mechanism (ERM), a complex system of narrow bands of fluctuation among the pre-euro national currencies. In practice, each country pegged its currency against Germany’s Deutsche mark at some level (“central parity”), intervening in the currency market when the exchange rate became too weak within the small band around central parity. The ERM allowed for sporadic realignments of the weak currencies’ central parities, that is, occasional exchange rate devaluations. But over time, the frequency of these adjustments had declined and by the early 1990s the system had evolved into a “Hard ERM,” with stable bands, highly correlated interest rates, and very limited exchange rate flexibility. In December 1991, the Treaty of Maastricht was supposed to clear the way to Economic and Monetary Union (EMU) precisely through the consolidation of the “Hard ERM.”

    At the same time, the Berlin Wall had fallen and the reunification of East and West Germany was proceeding fast, accompanied by an investment boom and massive transfer payments to the former East Germany. In response to the fundamental imbalances stemming from German reunification, the Bundesbank was pursuing the goal of price stability through a tight monetary stance. From October 1990—the date of reunification—until the signing of the Maastricht Treaty in December 1991, German key interest rates were gradually raised in several steps. The higher German interest rates were exported to the other European countries through the exchange rate mechanism. But most ERM members would not accept the increased unemployment and excess capacity associated with higher rates and a tighter monetary stance. Policymakers in the “periphery” countries of Europe kept expecting, and pressuring for, cuts in German interest rates.

    A real appreciation of the mark against Germany’s trading partners would have also helped to cool down the overheated German economy. At the same time, it would have helped improve cost-competitiveness in several peripheral countries. With a fixed nominal exchange rate in place, this real appreciation could only be brought about by a higher German rate of inflation or a lower rate of inflation in the rest of Europe. But this adjustment channel was not feasible in the short term. Alternatively, real appreciation could occur through an exchange rate devaluation of the periphery currencies against the mark, which would require abandonment of the “Hard ERM” era. However, this option was deemed unacceptable and counterproductive by the periphery governments, as it would involve high political costs and loss of reputation, undermine hard-earned anti-inflationary gains, and represent a relaxation of the external constraint on domestic fiscal policy.

    In a nutshell, there was a conflict related not only to the modalities of adjustment, but more broadly to how the adjustment burden—both economic and political—would be shared between center and periphery countries. Once this conflict became unsustainable, turmoil erupted.

From the Danish Referendum to Black Wednesday
In June 1992, Danish voters unexpectedly rejected the Maastricht Treaty in a national referendum. The Danish results signaled a widespread erosion of social consensus regarding the Maastricht agenda and the fixed exchange rate policies in Europe. Shrinking political support for Maastricht was confirmed later in the summer by public opinion polls in France and elsewhere.

    At this point, an orderly realignment, involving on average rather modest devaluations of all non-Deutsche-mark-zone currencies against the mark, could have brought the currency grid back in line with fundamentals. And a significantly greater availability of credit lines or swaps to boost the international reserves of currencies under pressure might have reduced speculation.

    As it was, no general realignment did go through. On September 13, 1992, only Italy devalued, by 7 percent, providing the clearest possible signal to the markets that intra-ERM cooperation had failed. The response of the markets was swift and hard. Less than twenty-four hours later, the lira reached the bottom of its new band, this time joined by the British pound and, to a lesser extent, the Spanish peseta.

    September 16, 1992, was nicknamed Black Wednesday in England. In the morning, the Bank of England raised the minimum lending rate from 10 to 12 percent. A few hours later, a new increase, to 15 percent, was announced but never implemented. Large amounts of reserves were lost, to no avail. In the evening, the Bank of England announced the withdrawal of sterling from the ERM. Italy followed suit.

Rebuilding Credibility
In the months since Black Wednesday, Europe was shaken by waves of speculation on most currencies, irrespective of the strength of national macroeconomic fundamentals. To make a long story short, we can jump to July 30, 1993, when almost all remaining ERM currencies were quoted at the bottom of their bands against the mark. After an emergency weekend meeting of the finance ministers in Brussels, a thorough revamping of the ERM was announced on August 1. Most of the surviving “Hard ERM” was replaced by a much weaker scheme, almost indistinguishable from a free float: the ERM bands around central exchange rate parities were widened up to 15 percent in either direction.

    Far from representing the last nail in the coffin of European monetary stability, the capitulation of the ERM finally put an end to the crisis. The long-established policy belief that monetary stability required exchange rate targeting was abandoned. In terms of the intellectual and policy tenets in 1990s Europe, this was close to a Copernican revolution, as the previously unthinkable scenarios had become institutional reality.

    From the summer of 1993 on, building domestic credibility meant, in addition to fiscal rectitude, a reform of monetary policy to signal some radical break with the past. For instance, the Bank of England and the Bank of Sweden adopted inflation targeting
as a new comprehensive strategy to stabilize prices. For other countries, the credibility-building strategy was to develop a stronger domestic political consensus to participate in EMU, and therefore to fulfill all the formal prerequisites established in the Maastricht Treaty in terms of inflation, fiscal stance, and interest rates.

    In 1993, national commitments to fiscal discipline and price stability under the systemic umbrella of the nascent Eurosystem were credible enough to convince markets and halt the long wave of speculative frenzy. In retrospect, this was far from the definitive solution to the problems of financial and economic cohabitation in Europe. While exchange rate volatility disappeared forever from the list of policy concerns in Europe, fiscal spillovers and cross-country financial vulnerabilities remained at the very top. But the attempt to find systemic solutions to systemic problems was an important step in the right direction. Twenty years later, current market events seem to be calling for a renewed, and deeper, assimilation of this key lesson from the 1992-93 events.

The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

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