The Prodigal Greek

The Greek crisis through a different prism

You can’t know where you are going, until you know where you’ve been

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The Exchange Rate Mechanism (ERM) was initiated in 1979. It was an exchange rate system based on fixed parities with fluctuation bands. Each member had to maintain its exchange rate within narrow fluctuations of all the other countries that were part of the scheme. The first years were rocky with many exchange rate realignments but after 1987 only two realignments took place. There was such a sense of stability in the system that member states began discussing tightening the bands further and moving to the next stage, the adoption of a common currency, with 1997 being the target year.

Under any exchange rate regime the interest parity condition must hold. The interest rate parity condition gives the relation between the domestic nominal interest rate, the foreign nominal interest rate and the expected rate of appreciation of the domestic currency.

it = i*t – [(Eet+1 – Et)/Et]

Under a fixed exchange rate regime where exchange rate fluctuations happen within very narrow bands, the interest parity condition requires that the domestic nominal interest rate is very close or equal to the foreign nominal interest rate. For a mechanism with various member countries like the ERM, coordination between the members is required for the adjustment of their interest rates or one country could take the lead and the others would follow.

During the 1980’s, European central banks had similar objectives and there was no objection to the Bundesbank taking the lead in setting interest rates. The situation was to change dramatically after 1990. The re-unification of Germany led to large German budget deficits, transfer payments from West to East Germany which, combined with an investment boom, sharply increased domestic demand. The German central bank feared that this overheating of the economy would put upward pressure on prices and increase inflation and its response was a restrictive monetary policy and an increase in interest rates.

This policy mix may have been the appropriate response for the macroeconomic conditions that Germany faced but not for the other members of the ERM, which were not experiencing the same increase in demand. However, to stay in the ERM they had to follow Germany and match its interest rates based on the interest parity condition. The result as expected was a sharp fall in demand and output in other ERM member countries.

France found itself in a situation that needed even higher nominal interest rates than Germany to convince investors of its conviction to maintain the parity between the Franc and the Deutsche Mark.

The impact was even more severe when looked at in real terms. Although countries had to match the nominal interest rates of Germany, they did not face the same pressure on prices as Germany. High nominal rates and low inflation led to much higher real interest rates than Germany. With high real interest rates the 1990-1992 period was characterized by a slowdown of growth and higher unemployment. French unemployment in 1992 was circa 10.5% from 9% in 1990 and in Belgium approaching 12% from 8.7% in 1990.

A similar story was unfolding in other ERM countries. Average unemployment in the EU reached 10.3% in 1992, compared to 8.7% in 1990. The effects of high real interest rates on the economies outside Germany were prominent.

By 1992, the defense of the ERM parity became attainable for a number of countries. Worried about the risk of devaluations, markets started asking for higher interest rates from countries that they considered the most probable candidates to break the peg. The result was two major exchange rate crises, one in fall of 1992 and the other in the summer of 1993 and the eventual departure of the UK and Italy from the ERM.

In early September 1992, the belief that a number of countries would need to devalue their currencies to maintain their peg with Germany led to speculative attacks on a number of currencies, sold in anticipation of a coming devaluation.

Interest rates were increased to prevent capital outflows and large losses of foreign exchange reserves by central banks that had to defend their currencies. Sweden offered an annualized 500% on overnight deposits.

At that point, a number of counties took different paths. Spain devalued, Italy and the UK exited the ERM, and France kept rates high and decided to tough out the storm. Despite the different courses of action, the underlying problem remained, German interest rates remained high.

In November 1992 further speculation forced the devaluation of the peseta, the escudo and the Swedish krona. The peseta and the escudo where further devalued in May 1993.

By July 1993, after yet another speculative attack, the ERM countries decided to adopt much larger fluctuation bands of +/-15% around the central parities. which effectively allowed very large exchange rate movements. This system held until the euro was introduced in 1999.

Coming back to the present day, many of the factors that led to the collapse of ERM are still present. The introduction of a single currency has not eliminated the diversity of the European economies, the different macroeconomic shocks and needs for fiscal and monetary responses. If anything, the eurozone seems to be adopting even more “one size fit all” policies with the Fiscal Pact, in spite of the fact that the dichotomy of the economies between the core and the periphery is staggering.

Although Mario Draghi said that people underestimate the amount of political capital that has been invested in the euro, the future of the common currency may not be that much different than that of its predecessor in the recent past. The biggest peace project that the European continent has ever seen deserves better than being jeopardised from a currency that increasingly resembles a straitjacket.


* Most of the ERM history information is coming from the Macroeconomics book of Olivier Blanchard


Written by Yiannis Mouzakis

April 25, 2013 at 11:08 am

One Response

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  1. Having started as an FX forecaster, I find it impossible to discuss exchange rates and the Single Currency without first looking at the trade balance, the CAP current account balance and the overall balance of payments.
    Since the exchange rate is a critical external adjustment tool, giving it up to join a Single Currency implies the need to maintain low CAB balances, small deficits AND small surpluses.
    And yet, Germany is setting record trade surpluses and the Eurozone continues to test the limits of trade divergence, with countries like Greece and Spain reaching unemployment of 27%.
    twenty seven per cent!
    So, when you look back, study the intra-Eurozone trade patterns, that’s what will tell us whether the Euro can become sustainable.
    See the blog PPP Lusofonia

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