and the Setting up of the Snake
4. The Crisis of 1992
At its establishment several scholars were skeptical regarding the long-term viability of the EMS�25 This viability was severly undermined by institutional developments that came in after 1986 and mainly by the liberalization of capital movements and the decision not to proceed further realignments of exchange rates�
The approval of the Single Market Agreement in 1986 was a step to build a single European capital market� That agreement provided, among other things, the removal of controls on capital movements� Because of that, realignments of exchange rates became problematic� In fact, as soon as a rumor was leaked that authorities of member countries were negotiating an adjustment of parities, a speculative attack on the weak currencies would have developed�
It is primarily for this reason that between January 1987 and August 1992 there were no realignments� By contrast, between January 1979 and December 1986 there were eleven realignments� These two different periods of the EMS, therefore, have been defined “soft” and “hard” EMS�26
The first turbulences within the EMS came out in June 1992, when Denmark in a referendum decided not to join the EMU project� The outcome of this referendum induced a public perception that the project to complete the monetary union of Europe would have been stranded�
The exchange rate of the currencies of the weaker countries of EMS,27 in primis the Italian lira, reached the lower limit of the oscillation band�
Currency tensions increased as a result of the uncertain outcome of the French referendum on the Maastricht Treaty, established on September 20�
An Ecofin meeting was held in Bath in early September to give a coordinated response to these tensions� The outcome of this meeting was, however, a failure, since, during the meeting, it emerged that member countries had very different positions�
25 See De Grauwe and Peeters (1979), Vaubel (1979) and Cohen (1981)�
26 See Giavazzi and Spaventa (1990)�
27 That is the Italian lira, sterling, the peseta and the escudo�
In particular, Germany refused to reduce its domestic interest rate, raised after 1989 to counter the inflation rate acceleration due to unification� In most other countries, given the economic slowdown, an adjustment of the interest rate to the German one became unsustainable�
This stalemate of the negotiations, together with the event just described, led to a change in investor expectations�
In the presence of large outflows of currency induced by this change of expectations and the deregulation of capital movements, the exchange rates of the weaker countries were pushed to the relevant intervention margins� The authorities of these countries decided to counter speculative attacks bringing interest rates to unusual levels (Figure 1)�28
Figure 1 – Money market interest rates – 1992
0 2 4 6 8 10 12 14 16 18
France Germany Italy UK
Source: Banca d’Italia (1993)�
This rise in interest rates had limited effects� On September 13 the German and Italian authorities proposed a realignment of parities� The Bundesbank undertook to simultaneusly reduce domestic interest rates�
None of the other countries participating in the EMS accepted the proposal�
Despite on September 14 the German Central Bank reduced the official interest rate, the weaker countries of the system, in particular UK and Italy, were affected by large capital outflows�
28 For a narration of the 1992 crisis see Eichengreen (2000)�
Two days after UK decided to abandon the exchange rate arrangement�
Following this decision, Italy decided to suspend interventions to defend the lira� Such interventions, since the beginning of the crisis, had cost to our country the depletion of 29 billion liras of foreign reserves�
On August 2, 1993, the countries still part of the EMS decided to widen the allowed fluctuation range of the exchange rate from ± 2�25 to
±15 per cent, leaving central parities unchanged� To this date can be traced the effective conclusion of the experience of the EMS� Starting from January 1, 1994, began the second phase of the European Monetary process, as outlined in the Maastricht Treaty�
Prevailing interpretations of the 1992 EMS crisis are essentially two and make reference to the currency crisis models of first and second generation�29
As it is known, in the first generation of models, foreign exchange crisis are traced back to macroeconomic imbalances, in particular persistent current account deficits, generated by wrong policy choices�30
In the second generation models, currency crisis is attributed to self-fulfilling expectations:31 the expectation of the currency depreciation forces authorities to counter the outflow of capital and foreign reserves through a rise in the domestic interest rate� At some point, however, further increases in the interest rate become unviable given the economic and social costs that they entail�
Those who interpret the 1992 crisis on the basis of the first generation models, insist on the fact that several countries pursued through the EMS an exchange-rate stabilization process� In processes of this type, since the nominal exchange rate is fixed and the deceleration of inflation is slow, the real exchange rate tends to appreciate� Consequently, a country that pursues an exchange-rate based stabilization loses competitiveness: its trade balance goes in deficit�
Between 1987 and 1992 the real exchange rate32 of Italy appreciated by 8�5 per cent� An analogous appreciation happened in UK (8�1 per cent) (Table 7)�
29 A survey of these interpretations is in Eichengreen and Wyplosz (1993)�
30 See Krugman (1979)�
31 See Flood and Garber (1994) and Obstfeld (1986)�
32 Measured with respect to unit labor costs�
Table 7 – Real exchange rates(1)
France Germany Italy UK
1983 96�9 85�1 104�4 117�1
1984 98�0 83�8 102�4 112�1
1985 100�0 82�5 99�9 113�2
1986 101�0 89�6 101�2 103�7
1987 100�0 100�0 100�0 100�0
1988 95�3 100�3 99�3 106�4
1989 90�7 99�5 105�6 105�5
1990 92�8 103�3 110�0 109�5
1991 91�1 101�8 111�3 112�6
1992 92�2 105�5 108�5 108�1
(1) Based on unit labor costs�
Source: Banca d’Ialia (1993)�
Always between 1987 and 1992, Italy and UK had persistent and sizeable current account deficits (Table 8)�
Table 8 – Current account balances (billions of dollars) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992
France -5�2 -0�9 - 2�4 -4�4 -4�8 -5�6 -13�8 -6�1 2�4
Germany 5�4 9�6 17�0 40�1 46�3 50�6 57�6 46�3 -19�5 -25�1 Italy 1�5 -2�4 -3�4 2�8 -1�5 -5�9 -10�9 -14�4 -21�4 -25�4
UK 5�5 2�1 3�9 - -7�6 -28�8 -35�6 -29�4 -11�4 -20�9
Source: Banca d’Italia (1993)�
If it is true that both Italy and UK between 1987 and 1992 were affected by a significant appreciation of the real exchange rate, it is equally true that in other countries, then hit by the crisis, this phenomenon did not occur�
Uncertainties about the validity of the interpretations of the 1992 crisis based on first generation models led some economists to believe that this crisis can best be interpreted in the light of the second generation models�
In this perspective, they emphasize that, between 1987 and 1991, countries such as Italy and Spain, marked by an inflation rate higher than EMS countries’ average inflation, having higher nominal interest rates, were affected by strong capital inflows�
The negative outcome of the Danish referendum led to a change in expectations regaring the completion of monetary union� The weaker countries were affected first by a decline in capital inflows, and then by capital outflows�
Attempting to counter these outflows with increases in domestic interest rates proved, beyond a certain limit, impractical� The defence of the exchange rate would require interest rates so high as to compromise the solidity of the economy and social cohesion� This intolerable cost explains the collapse in 1992 of the EMS�
5. Conclusions
In the introduction it was said that this contribution is meant to answer two questions� At the first of these questions, namely whether the EMS has been a success, we are given a substantially positive answer�
The exchange rate arrangement, in fact, strenghtened the cohesion among member countries along two lines� On the one hand, providing for fixed, although adjustable, exchange rates, it encouraged a growth of within Europe trade and eliminated the risk of competitive devaluations and their negative impacts on the custom union�
On the other hand, the EMS fostered a process of convergence of inflation rates in member countries, facilitating the subsequent monetary integration�
To the second question, that is the causes of the 1992 crisis and the EMS collapse, we are given an answer within the first generation currency crisis models� In fact, the crisis of the pound, and especially that of the lira, seem to be mainly derived from macroeconomic imbalances, particularly by persistent current account deficits� This does not mean that the crisis of these currencies then resulted in a lack of confidence in the wholse system and in its collapse�
The 1992 crisis has clearly highlighted the limits of fixed exchange rate regimes� In particular, it showed that the policy of “tie one hands” by adopting a fixed exchange rate has short-run effects, since it constrains a country marked by high inflation to adopt the monetary policy of the virtuous country� This policy, however, is not able to promote appropriate convergence of the institutional structure and the “culture” of different countries�
Beyond the short term, the persistence of institutional and cultural differences between countries determines the emergence of real exchange rates different from the equilibrium ones and, consequently, current account imbalances� Therefore, as Loureiro (1996; p� 128) writes, in the medium-long period “the hope that pegging the exchange rate do makes good intentions credible remains an illusion”�
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