16 September 2022 was the thirtieth anniversary of the Exchange Rate Mechanism (ERM) crisis. To mark this occasion, CEPR, the Pierre Werner Chair Programme at the European University Institute and the Center for Analytical Finance at the UC Santa Cruz organised two webinars to reflect on the potential lessons from the early crisis, for policy reforms in the euro area and in the EU today.
This was an opportunity to revisit the conditions and circumstances that generated currency crisis and instability in the early 1990s relative to today’s circumstances, and to compare the nature of the currency crises to more recent crises and turmoil in the European monetary area. The webinars highlighted differences and similarities and assessed the efficacy of the policy responses and the fragility/efficacy of cross-border cooperation in the face of large shocks.
The webinar offered a narrative of the ERM crisis as a watershed in the process of monetary and economic integration in Europe. Key participant in the webinars, Professor Richard Portes said that while the ERM crisis did not derail the plan for monetary unification altogether, it did undermine the architecture of the Maastricht plan for a smooth transition to the common currency, as the end-point of a process of progressive solidification of fixed exchange rate parities. In this respect, the crisis indeed highlighted the “destabilising role of fixed rules with escape clauses”. Most crucially, it led to risk polarisation across national boundaries and regions.
The ERM was at that time characterised by Dollar-Deutschmark polarisation. When funds flowed out of the dollar, because the US economy was doing poorly, they flowed into the Deutschmark, which was the closest substitute for the US currency. The appreciation of the Deutschmark put pressure on other ERM currencies.
This is precisely what happened in the aftermath of German reunification in 1990. The federal government in Bonn implemented an expansionary fiscal policy to support the integration of the territories of the former communist German Democratic Republic. This fostered higher inflation, which increased from 2.7% in 1990 to over 5% in 1992, to which the Deutsche Bundesbank responded with higher rates. Additionally, higher investment at home erased Germany’s current account surplus, which also put upward pressure on the Deutschmark.
Interviewed by Central Banking, ERM’s 1992 crisis offers lessons for today, academics say (28 October 2022), LBS’s Richard Portes said: “In 1990, it became clear to many of us that the economic impact of German reunification would require a real appreciation of the Deutschmark.”
The article goes on to point out that the ERM also confronted policy-makers with what economists call the ‘international finance trilemma’. This argues that a country can only have, at most, two of fixed exchange rates, free movement of capital and an independent monetary policy. In 1992 the Maastricht Treaty approved the creation of the modern European Union and the single market. It meant the removal of almost all of Europe’s significant capital controls. This set the stage for the intrinsic fragility of currency pegs in a setting of high capital mobility. Very few countries have been able to maintain currency pegs in such an environment.
The trade-offs involving capital movements across countries, currency pegs, and monetary policy was not fully grasped by EU national governments, added Portes. “By limiting the range of short-term speculative capital flows, controls had permitted orderly realignments before 1987,” he pointed out.
“Officials seemed to have believed that a policy of no [exchange rate] realignments would be safe, even without capital controls,” Portes said. “If they simply told the markets, there would henceforth by no parity changes.”
In Portes views that sense of security grew as time passed, as controls were removed, as the ERM structure seemed to become universally accepted. “Self-fulfilling expectations were supporting that path, but a shock that would disturb those expectations would remove the support,” he said.
Although major economies like the UK and Italy had important macroeconomic imbalances, most academics agree national economic fundamentals were not the source of the crisis.
Instead, the combined effects of the new single market and German reunification has rendered the system obsolete. “Permanently fixed exchange rates, that’s an oxymoron, there is no point in having an exchange rate except to change it,” said Portes. “In that sense, fixed exchange rates are closer to floating rates than to monetary union.”
“What we had was a self-fulfilling equilibrium,” said Portes. “We were told you can defend against a speculative attack by raising enough overnight interest rates. And that was technically correct. But, you know, it’s not very helpful if it raises the question, which falls first, the currency or the government?”
Observing the status quo of semi-pegged exchange rates could be successfully challenged, hedge fund managers attacked some of the ERM’s currencies. The ERM’s rates might have been defensible in the absence of the attack, but collapsed in its presence.
A case in point is when financier George Soros attacked the pound, forcing the Bank of England to raise interest rates which in turn hit British homeowners in the pocket, causing the bank to reverse course and sterling to collapse.
The UK eventually crashed out of the ERM on Black Wednesday, 16 September 1992.
An accident waiting to happen, and back to the future
In Portes’ view, it was an “accident waiting to happen”. The system was held together by expectations that were ready to be destabilised. A realignment of the Deutschmark was overdue and economically necessary, but the consequent real interest rates were unsustainable outside Germany.
“Financial systems couldn’t take the strain,” added Portes. “In the UK, variable rate mortgages were a key factor. We couldn’t have coped with the kind of overnight rates that Sweden imposed in November 1992.”
The vulnerability of the UK’s mortgage financing to higher interest rates became apparent again in September, following the mini-Budget presented by Liz Truss’s government.
Italy’s Achilles heel was, and remains, high public debt. It stood at 112 per cent of GDP in 1992, and is now 147 per cent. This was a challenge at the time, and it will be a challenge going forward as interest rates rise. Some of the national vulnerabilities that forced the UK and Italy out of the ERM persist in both economies. The UK is still highly affected by changes in variable mortgage rates, while Italy’s public debt has risen.