Learning from the past is often the best way to prevent future tragedies but the similarities between the EMS crisis of the early 1990s and the current Euro zone crisis is uncanny. I think there are certainly lessons that should have been learnt from that episode that should have reduced some of the damage the Euro zone is facing today. This is part one of a two part special on the lessons the EU should have learnt from the EMS crisis.
The fundamental aim of the European Monetary System (EMS) was to consolidate the process of monetary integration amongst member states through monetary stability. Increased economic stability would ensure relatively smooth movement of capital, goods and services that would lead to increased intra-national trade. Additionally, the EMS was devised in order to establish a coherent system in which exchange-rate fluctuations were centralized and reduced in order to promote and maintain stability within the European Union. EU members were advocating for a system of governance that would establish economic cohesion, minimalize exchange-rate uncertainty and safeguard themselves from external shocks. The EMS system could be seen because of the failure of the Bretton Woods system that left many European nations somewhat disillusioned with a scheme that placed international monetary fundamentals in the direct control of the United States.
The EMS comprised of two main mechanisms, firstly there was the creation of an artificial unit of account named the European Currency unit (ECU) and a fixed exchange-rate system named the Exchange Rate Mechanism (ERM). The ECU was a unit of account rather than a medium of exchange, although, it shared the similarities of a common currency, no coins or notes were issued. In effect, it was an accounting unit, which all member currencies were expressed. Nations were allowed to fluctuate within the specific limits of ±2.25%. Additional features of the EMS included the Divergence Indicator and The System of available Credit Facilities. The Divergence indicator was measured in terms of ECU to enhance economic coordination. Hence, it measured the divergence of a nation’s given market rate with the central rate. Despite the system of available credit never coming to fruition, the ECU, ERM and the divergence indicator were mechanisms designed to enhance economic integration and more specifically exchange-rate stability amongst member states.
The importance of the ERM cannot be understated because the very nature of the EMS was to strengthen monetary integration by enhancing stability for member nations. Thus, the systemic failure of the mechanism is arguably the most significant factor contributing to the EMS crisis. The ERM adopted an asymmetrical system in which the Deutsche Mark became the reserve currency, in effect, the members of the ERM handed substantial monetary control to the German monetary authorities. Germany assumed a role similar to that of the United States in the Bretton Woods arrangement. Because monetary authority was effectively concentrated with Germany, when its own domestic interests conflicted with that of other ERM members, it caused severe economic shocks. Both Jones (2001) and Copeland (2005) concur to the suggestion that the domestic economic issues in Germany caused the greatest threat to ERM stability and thus the EMS came under severe threat.
“Because the DM was the linchpin of the system, the fate of the ERM was greatly influenced by developments in the German economy.” (Jones 2001, 56)
The reunification of both German states had severe economic consequences on the ERM members. Firstly, the amalgamation of a large and wealthy nation with a small and less economically developed one had an impact on West German current account. In order to make the transition function, the West German government transferred savings revenue to the East, and the government budget deficit rose from 5% to 13.2%. (Weerapana 2004, 4). This reduction in economic power as a result of the increased structural deficit forced the Bundesbank to increase interest rates in order to reduce inflationary pressure. Unemployment in the UK in 1990 (the year in which they joined the ERM) was 7.1% (Eurostat 1990). Because the UK had effectively handed monetary control to the German authorities in the sense that exchange-rates were determined by the ERM as oppose to the UK government, there was very little in terms of expansionary monetary policies that the UK could adopt.
Moreover, it is likely that the Conservative government at the time would have opted to devalue the Sterling in order to stimulate export demand, which would have increased economic growth through high levels of investment and thus job creation. However, this was not the case and it highlights one of the main problems with the ERM, conflicting monetary interests from nations with contrasting monetary agendas. The dominant German authorities had no incentive to reduce interest rates; the reunification process meant that saving revenue had to be released in order to bring the East German economy to a competitive level, hence high interest rates in order to reduce the internal government deficit. Furthermore, this is a clear example of one of the mechanism’s fundamental macroeconomic failures; it was created in order to establish economic cohesion through marginalizing exchange-rate fluctuations but it left the UK facing high levels of unemployment and high interest rates, due to the lack of economic stability because of a conflict in economic agendas.
On Wednesday 16 September 1992 the UK was forced to withdraw it’s currency from the ERM. Not only did this event drive market confidence extremely low, mainly because of the interest rate fluctuations, which in turn lead to speculative attacks on the currency, it also had severe economic consequences for the domestic economy. McDonald and Dearden suggest the UK currency was increasingly vulnerable to speculative attacks:
”For the UK, international investors watched as growing political pressure to address the recession forced the Government into a series of interest-rate cuts between October 1990 and September 1992.” (McDonald and Dearden 2005, 90)
There are various similarities with the present crisis. If Greece were to leave the Eurozone and affectively the EU, the costs of such a decision may be politically detrimental, but economically beneficial. When the UK left the ERM the decision damaged their economy in the short-run, unemployment levels were high and investment confidence was low, the years following however, saw the economy recover rapidly. Figure1.1 displays the steady fall in unemployment after 1992.
Monetary integration had always been an objective for European nations. In order to establish and maintain economic stability within Europe and particularly the EMS zone, domestic nations had to merge monetary policies in order for their goals to be achieved. Hitiris suggests that four fundamental principles were adopted in order for this process to occur; “free trade in goods and services and free mobility of capital and labour.” (Hitiris 2003, 128) Domestic currencies could therefore be viewed as a barrier to achieving these economic goals. The realization of an economic monetary union was perhaps best formulated in Jacques Delors report of 1989. The report made several recommendations to improve the efficiency of European monetary affairs through the convergence of macroeconomic affairs. The general theme of the Delors report was clear, the extension of a united economic European union, with little or no barriers preventing the flow of capital between member states.
 The most famous example of an individual profiting on short-sell Sterling was George Soros who profited just over $1billion on ‘Black Wednesday.
 Jacques Delors was the President of the European Commission from 1985-1995. It was under his premiership that a proposal for a common European
currency and more importantly, a European monetary union was to established. He was the first President to serve three terms.
4 thoughts on “How can the EMS crisis of 1992-93 crisis help the Eurozone today?”
I would say that semi-pegs like the ERM only work for strong currencies. China can keep a lid on yuan appreciation by monetary expansion and buying dollars. Likewise Switzerland has a massive forex pile at the moment, as they printed money and sold CHF to keep their currency from becoming ridiculously high (the price of a coffee in Zurich is already about the highest anywhere).
But defending a weak currency in a peg is only possible until forex reserves run out. That is happening in Egypt at the moment. The UK got this when they were forced out of the ERM, because of weakness not strength.
The next couple of years will be extremely interesting in southern Europe as industrious Germany strains the ties with poorly competitive Spain et al. Will the euro break like Argentina’s hard peg? Even George Soros is now saying Germany should leave the euro – or fund the south via eurobonds, which I suspect is politically impossible.
Hi Bruce, some very good and interesting points made. I was unaware of the currency crisis in Egypt. The ERM was also not strong enough because there were too many structural imbalances in Europe at the time (sound familiar?) and what strikes me is the apparent level of incompetence European bureaucrats have when they cannot draw similarities from this crisis and the 1992-93 crisis. They are not identical, but there are certainly lessons that should have been learnt. I’ll be posting part 2 of this piece in the next coming days so stay tuned and let me know what you think.
I should have said your ERM post is very good! I’m entirely an amateur economic person (my 9-5 work is in chemistry) so you can take this with plenty of salt. This article in the Economist was what I had in mind about the Egyptian forex situation. This one seems pretty good also. She says Egypt “now has only $13.5-billion left in its coffers”, but that number has been floating around since late last year as I recall, so it may well be lower now.
So heavily subsidising diesel is a real problem since if they let the currency fall against the dollar the subsidy cost rises. And the bread subsidy is so dangerous since so many people rely on it to survive. I don’t know how they can square the circle.
Thanks for the complement Bruce, I’m glad you enjoyed it. Its a shame what is happening in Egypt. I do think it needs stability and I think it could attract more foreign investment in the form of new business as well as tourists. This should boost their current account (relationship between imports and exports) and provide sufficient reserves to be able to subsidise both the bread and diesel allowance. Obviously this is hypothetically speaking and does require real long term stability, but it is certainly plausible.