The Exchange Rate Mechanism Crisis
After the collapse of Bretton Woods agreement, there was
a tendency to move to flexible exchange rates globally except for Europe. They
were trying to limit the fluctuation of the exchange rates. The European
Monetary System was consisted of two components, the European Currency Unit and
the Exchange Rate Mechanism. After the collapse of Bretton Woods the European
nations lost confidence in the US to manage the monetary policy and the
European Monetary System was their window to get more control on their monetary
policy. The goal of the European countries was to manage the obstacle of
exchange rate uncertainty and have a fixed exchange rate between the countries
in the union to have a more efficient trade between them. The Exchange rate
Mechanism (ERM) was a managed float exchange rate regime with prespecified
bands. The bands were specified for each currency accordingly for example most
currencies were allowed to fluctuate 2.25% from the central rate whereas
Portuguese escudo and Spanish peseta were aloud to to fluctuate at a broader
band of 6%. The central rate for the union was the German Mark, so it acted as
the US in Bretton Woods. Germany had the most control over the monetary policy
and whatever change Germany does will affect all of the other countries. Most
of the countries were benefitting from the Union because its main goal was to
fight inflation and Germany were the best in fighting inflation because they
lived it between the World Wars. Problem rise as the ERM continues to be tested
because it helped in political cooperation between the European Union but it
affected them negatively in economic cooperation since they were speculating in
each other currencies to maintain between the bands.
How did the crisis start?
The main reason for the ERM was the unification of
Germany where the set a single currency for East and West Germany. The rate was
set for old East German Mark as 1.8 to 1 Deutsche Mark. It was a huge problem
because the West of high standard of living and the East had a very small
economy. While all the other European countries were dependent on Germany and
Germany has entered into inflation. All the countries were buying their
currencies from the market by selling the DM which wiped out their DM reserve
to just stay in between the bands. The economy in Germany was in expansionary
fiscal policy and contractionary monetary policy which led to a dramatic rise
in their interest rates. By Germany having higher interest rates than the other
currencies they witnessed a hug inflow of cash and a huge sell in the other
currencies like the GBP. By having this scenario it was clear that all the
currencies would lose value against the DM especially the GBP since it was the
most traded currency at that time. The British Central Bank lost most of it
reserves by trying to defend its currency till it dried up from the reserves it
had in DM and withdrew from the EMS. During that time, George Soros who is a
currency investor was betting against having an ERM from the beginning made
around billion dollars as it was stated by the economist Paul Krugman.
After the withdraw of Great Britain, the attacks on the
EU countries in the Forex market continued and they just got out from a managed
float to a free floating currencies such as France.
Weerapan, A. (February, 2004). Lecture 15: The ERM crisis
1992. Retrieved from http://www.wellesley.edu/Economics/weerapana/econ213/econ213pdf/lect213-15.pdf
Ahmed Alsayyah
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