Macroeconomic stability can be viewed as a classic pure public (intermediate) good, both nonrival and nonexcludable Macro-economic stability boosts the quantity and quality of investment. In turn, productive investment is one of the key determinants of economic growth and rising living standards. The provision of macroeconomic stability is a natural responsibility of the government.

Macroeconomic instability often manifests itself through outright inflationary financing or else through a rising public debt- GDP ratio that is not matched by a rising capacity for generating future public (primary) budget surpluses necessary to repay that debt. There is a growing body of empirical evidence (and some recent theoretical research) on the existence of a close link between macroeconomic stability and economic growth (see, e.g., Fischer 1991, 1993; Barro 1995; Easterly 1996; and Bruno and Easterly 1996).

In the economies of Eastern Europe and the former Soviet Union (FSU), the swift and wide-ranging price liberalization measures with which transition was started and the initial monetary overhang inherited from the central-planning era caused an initial big spike in the rate of inflation. Some countries, like the former Czechoslovakia, Croatia, Hungary, Poland, Slovenia, and the Baltics were indeed able, through restrictive macroeconomic policies, to prevent what was fundamentally a one-off shock from turning into a process of high inflation. Others were less successful and perpetuated high inflation for several years. In the advanced countries, though, not everything was solved in one blow. Some of the countries successful in disinflation soon confronted unfolding disequilibria in the current account of the balance of payments that translated partly into buildup of private and/or public external debt.

Capital market liberalization and “convergence plays”

The goal of this chapter is to complement the narrative of the 1992–93 events by focusing on the behavior of international financial markets. The recent literature has devoted considerable efforts to analyzing determinants and dynamics of ERM credibility as perceived by market participants and reflected in movements in asset prices as well as in the composition of financial portfolios. Section 4.1 presents a few relevant stylized facts characterizing European capital flows. Section 4.2 reviews the most common measures of ERM credibility. After discussing the performance of those measures, Section 4.3 addresses to what extent financial markets were able to anticipate the 1992–93 crises.

In the policy and academic debate, the coexistence of exchange rate stability and free capital mobility in Europe has long been regarded as problematic, if not impossible. In the late 1980s, many analysts shared a deep skepticism regarding the medium-term stability of the ERM. The process of liberalization, as traced in the European Council Directives 86/566 and 88/361, was expected to increase the vulnerability of weak currency countries to rapid capital outflows, thus raising the probability of a crisis.

The emphasis on the disruptive potential of capital mobility is the straightforward corollary of the consensus view that attributed a key role to capital controls (most prominent in France and Italy) in maintaining exchange rate stability in Europe during the 1980s. The rationale for restricting capital mobility is often presented in terms of a simple application of a standard open-economy model à la Mundell-Fleming.

Exchange rate crises and speculative attacks

In the aftermath of the 1992–93 events, there has been a revival of academic interest in analyzing and modelling the timing and determinants of currency crises and speculative attacks on fixed exchange rate regimes. Many recent contributions offer valuable elements for an interpretation of the logic of the ERM crisis. Informed by the historical reconstruction presented in the previous chapters, we now provide a synthetic survey of the current literature. This also lays the groundwork for our own theoretical construction in Chapters 6, 7, and 8.

Exogenous and endogenous policies

There exist two approaches to modelling exchange rate crises. The first approach, pioneered by Krugman (1979), focuses on the timing and the mechanics of a speculative attack when national authorities pursue policies that are inconsistent with the indefinite defense of the exchange rate parity. The second approach looks at optimizing policymakers who are assumed to have good reasons to peg the currency – for example, because a peg is seen as a commitment technology for reducing the undesirable consequences of an inflationary bias – but not at any price. They may, therefore, find it optimal to abandon the exchange rate parity under certain circumstances. Throughout this chapter, we will label the two modelling strategies as, respectively, the “exogenous-policy” and the “endogenous-policy” approach.

In Krugman's model, domestic credit expansion persistently exceeds the growth of money demand at a fixed exchange rate.

Toward the crisis

German reunification

German reunification was an unprecedented economic and political event: the integration of two national economies that had undergone postwar reconstruction under two very different systems, ending up with a substantial gap in productive capacities and standards of living. It would have been a difficult enterprise at the best of times. It was turned into a textbook example of macroeconomic mismanagement, eventually resulting in the adoption of a monetary–fiscal policy mix that was undesirable even for Germany internally, let alone for the EC as a whole.

First, the German Chancellor kept his electoral promise not to finance the massive transfer of resources to the Eastern part of the country by asking Western Germans to pay additional taxes. Nor were there significant cuts in other spending items in the budget. In 1991, the net transfer of West German public funds to East Germany was as high as 139 billion D-mark. To get a sense of this magnitude, it can be compared to West German private saving for that year of 260 billion D-mark. This net transfer reached 180 billion D-mark the following year. The rate of growth of West German public sector indebtedness, which averaged around 5% in the second half of the Eighties, rose to 13.4% and 11.2% in 1990 and 1991, respectively.

Second, with the creation of a Monetary, Economic, and Social Union in May 1990, GDR marks could be converted into D-mark on a 1:1 or 2:1 basis.

Since 1979, the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) has represented the cornerstone of monetary policy strategies in Europe and the most ambitious experiment in international monetary and exchange rate cooperation of the post-Bretton Woods era. Over the past decade, the nature of the ERM has changed drastically, from a system of fixed but adjustable rates with limited international capital mobility – as originally intended – to the “hard” mechanism implicitly ratified by the Basle-Nyborg agreement in 1987, characterized by stable and narrow target zones and the removal of capital controls.

By the end of the 1980s, the prima facie satisfactory performance of the “hard” ERM enhanced the general appeal of a further transformation of the system toward complete monetary harmonization and eventual unification. The successful conclusion of this transition was heralded as the permanent solution to the problem of inconsistency among national monetary policy objectives under free mobility of commodities, persons, and capital.

Starting in early 1992, however, a sequence of adverse developments of increasing severity seemed to compromise past achievements, as well as to undermine the process towards European Monetary Union (EMU). The crisis and revamping of the ERM between 1992 and 1993 represent the key events in the recent monetary history of Europe. Their origins, consequences, and implications are at the core of the current academic and political debate, both in Europe and elsewhere.

From Bretton Woods to the Treaty of Maastricht

The Bretton Woods days

Throughout the history of the European Community, both the political and the intellectual leaders of the movement towards European integration have shared a pronounced aversion to exchange rate fluctuations. One after the other, the political initiatives undertaken to strengthen the process of European integration have led to attempts to lock European currencies into systems and mechanisms that limit the flexibility of their conversion rates. Even during periods when the tide of European integration was at a low ebb, the idea and ideal of exchange rate stability never completely disappeared from the institutional architecture of the Community.

In the first fifteen years after the Treaty of Rome created the European Economic Community (EEC) in 1958 (with the aim of developing a common market for goods, services, labor, and capital), it was the Bretton Woods system that provided the institutional framework for exchange rate stability. The Treaty of Rome did not go beyond characterizing exchange rates as a matter of common concern (Art. 107 of the Treaty). In pursuit of the common goals of external equilibrium, full employment, price stability, and confidence in members' currencies (Art. 104), individual countries were authorized to take appropriate actions whenever exchange rates appeared to be inconsistent with these overarching objectives (Art. 107).

No mention was made of the desirability, let alone the possibility, of a European monetary union, since within the framework of an Atlantic strategic alliance, no form of monetary cooperation independent of the United States dollar was considered feasible at the time.

Introduction

The goal of the next four chapters is to offer a systematic approach to the theory of currency crises in a multicountry setup. Chapter 6 introduces our analytical framework. Focusing on the strategic interactions between the private and public sectors in a representative country, as well as the mechanism of expectations formation, Chapter 7 presents the key results of the unilateral peg literature as special cases of our model. Chapter 8, instead, devotes particular attention to the role played by international policy spillovers in the demise of a fixed exchange rate system and explores in detail the systemic dimensions of the monetary policy game. Finally, Chapter 9 focuses on the implications of the systemic view for our reconstruction of the 1992–93 ERM events.

Following the recent literature, the modelling strategy we adopt here considers an exchange rate crisis primarily as the rational policy response to excessive welfare costs of defending a peg. As a result, our construction excludes a number of analytical elements that play a key role in the traditional theory of balance of payments crises (Krugman, 1979; Flood and Garber, 1983, 1984). For instance, in our model money demand is not assumed to be interest sensitive, whereas this assumption is a crucial building block in the exogenous-policy literature. By the same token, our model does not explicitly consider the role of international reserves, either as a constraint or as an objective.

Introduction

In the central chapters of this book, most of our analysis of the European currency crisis was centered on the standard paradigms of a credibility game between a national policy maker and the private sector, and of strategic interaction among policy makers of different countries. In particular, we have built a novel interpretation of the 1992–93 events by developing a multicountry model of output and inflation stabilization with short-run nominal rigidities. Besides its application to the fall of the ERM, however, our theoretical construction has a number of additional implications for the design of a monetary union that are bound to be increasingly important as the final collective and individual decisions on EMU approach.

Following our discussion of the quest for exchange rate stability in Europe and our historical and analytical evaluation of the causes of the breakdown of the ERM in 1992–93, we now devote the final chapter of this book to the analysis of some key economic issues that have, so far, been only implicitly treated in our work. This involves a reexamination of the considerations that should guide the design of monetary, exchange rate, and fiscal policy by a group of nations considering monetary union and a brief discussion of a few issues in the transition to monetary unification. Much of it is a review of the theory of optimal currency areas, one of the murkiest and most unsatisfactory areas of macroeconomic and monetary theory.

Building blocks of a systemic theory

By focusing the analysis on the role of international spillovers and policy games, Chapter 8 has concluded our journey through the conceptual and analytical dimensions of the literature on currency crises. The goal of Chapter 9 is to assess the ERM crisis from the perspective of our Center–Periphery model. We start in this section by reviewing our analysis of the role of policy coordination in a currency crisis. In Section 9.2, we provide a detailed reinterpretation of the 1992–1993 events in the light of our results. While the formal analysis in Chapters 6 through 8 will instruct our reading of the crisis, in what follows we will widen the scope of the discussion beyond the strict boundaries of our model and consider additional elements that, for the sake of analytical tractability, were not incorporated into our formal analysis.

It may be helpful to restate the main features of our theoretical framework. Our construction conforms to the traditional view of the ERM as a way of borrowing or importing anti-inflationary credibility from Germany (the consensus view at the time of the crisis). Since individual Periphery countries are affected by an inflationary bias, they agree on the desirability of limiting exchange rate flexibility. The international exchange rate agreement provides the commitment technology that policy makers cannot find at home, although such a commitment is known to be less than perfect and market participants perceive the abandonment of the peg as a possible policy option in the presence of domestic or external shocks.

Introduction

In our view, most readings of the 1992–93 events miss the following crucial element: the ERM crackup has been the crisis of an exchange rate system, rather than the collapse of a collection of unilateral pegs individually pursued by a number of countries. The thesis we develop in this chapter is that the conclusions reached within the conceptual framework of the “unilateral peg” may be incomplete or misleading, since they both ignore the key role played by structural policy spillovers among European countries and overlook the effects of coordination (or lack thereof) of monetary and exchange rate policies within the system.

In this chapter and the next we argue that, while domestic private–public sector interactions are certainly an important part of the process that brought down the ERM, the 1992–93 crisis was in the first instance a conflict among monetary authorities and a failure of the European system as a policy coordination mechanism. In contrast to an approach that focuses exclusively on country-specific issues, ultimately only a systemic view is able to provide a comprehensive reading of the ERM crisis.

Our analysis thus fits the category of “fundamental” explanations, provided the set of fundamentals is augmented to include the cooperative (or noncooperative) design of monetary and exchange rate policies in the system, that is, to include the “rules of the game” that characterize the behavior of the Periphery countries and the Center vis-à-vis each other.

Introduction: sense and nonsense in the Delors Report

The much increased likelihood of significant advances in European monetary integrations – and even of European monetary union in the mediumterm future – has not surprisingly shifted the spotlight onto the need for coordination of fiscal policies as a complement to monetary unification. The Delors Report (1989) made much of the fiscal implications of the movement towards a greater degree of rigidity of nominal exchange rates among participants in the exchange rate arrangements of the European Monetary System (EMS).

No deficits, please

There are frequent further references in the Delors Report to the need to control national public sector deficits and in a number of places the Report becomes rather specific about the constraints to be imposed on national budgetary policy.