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A Study of European Monetary System; Events and the Crisis

Leading to formation of Euro ―€‖

Europe –till 1999

8/4/2010

Indian and Global Economy

By:

Harsh Doshi (32119)

Alok Rajan (32134)

Nikita Tekriwal (32145)

Mansoor Khan (32172)

Arun Menon (32175)

Abhishek Jain (32167)

Amit Tarnekar (32198)

Vezoto Theluo (32300)

1

Table of Contents

I. Table of Contents .................................................................................................................................... 1

II. EUROPEAN HISTORY .......................................................................................................................... 2

III. Bretton Wood System ........................................................................................................................... 4

IV. The Snake in the Tunnel ...................................................................................................................... 14

V. Oil Shocks of 1973 and 1979............................................................................................................... 19

VI. Formation of EMS/EMU/EU ............................................................................................................. 23

VII. The fall of Berlin Wall and ERM Collapse .................................................................................... 28

VIII. The fall of the Central Bank of England ......................................................................................... 30

IX.. Crisis in Finland and Sweden ............................................................................................................ 32

X. Timeline Summary............................................................................................................................... 37

2

EUROPEAN HISTORY (1957-1999)

TREATIES OF ROME

The Treaties of Rome are the two treaties signed on 25 March 1957 by Belgium, France,

Italy, Luxemburg, Netherlands and West Germany.

First treaty - established European Atomic Energy Community (EAEC)

Second treaty - established European Economic Community (EEC)

Background

Treaty of Paris 1951

Created European Coal and Steel Community (ECSC)

Designed to help the economy of Europe and prevent future wars by integrating the

members

Merger Treaty 1967

Combined the EAEC and ECSC into EEC

Enlargement and Elections

1960s saw first attempts at enlargement. Denmark, Ireland, Norway, and UK applied

to join the three communities. However UK application was seen as a Trojan horse

for US influence and applications of all the countries were cancelled.

In 1967 the countries were granted membership when Georges Pompidou succeeded

Charles de Gaulle

A parliament was constituted for the EEC and proposed a flag

Greece, Portugal and Spain joined EEC in the 1980s

Aims and Achievements of EEC

To preserve peace and liberty and to lay the foundations of an ever closer union

among the peoples of Europe

The establishment of a customs union with a common external tariff

Common policies for agriculture, transport and trade

Enlargement of the EEC to the rest of Europe

3

The treaty provided for a 10% reduction in custom duties and up to 20% of global import

quotas.

The Members

Belgium Denmark France West Germany Greece

Ireland Norway Italy Luxemburg Netherlands

Portugal Spain United Kingdom

EEC evolved to the formation of European Union in 1993.

4

Bretton Woods System

The Bretton Woods system is commonly understood to refer to the international monetary

regime that prevailed from the end of World War II until the early 1970s. Taking its name

from the site of the 1944 conference that created the International Monetary Fund (IMF) and

World Bank, the Bretton Woods system was history's first example of a fully negotiated

monetary order intended to govern currency relations among sovereign states. In principle,

the regime was designed to combine binding legal obligations with multilateral decision-

making conducted through an international organization, the IMF, endowed with limited

supranational authority. In practice the initial scheme, as well as its subsequent development

and ultimate demise, were directly dependent on the preferences and policies of its most

powerful member, the United States.

Setting up a system of rules, institutions, and procedures to regulate the international

monetary system, the planners at Bretton Woods established the International Monetary Fund

(IMF) and the International Bank for Reconstruction and Development (IBRD), which today

is part of the World Bank Group.

Four points defined the Bretton Woods system:

1. The pegged rate currency regime, a compromise between freely floating and

irrevocably fixed exchange rates.

2. A system for ensuring an adequate supply of monetary reserves.

3. A ban on most discriminatory currency practices or exchange regulation, to avoid the

kind of economic warfare that had characterized the 1930s.

4. A forum for international cooperation on monetary matters.

Origins

The political basis for the Bretton Woods system was in the confluence of several key

conditions: the shared experiences of the Great Depression, the concentration of power in a

small number of states (further enhanced by the exclusion of a number of important nations

because of the war), and the presence of a dominant power willing and able to assume a

leadership role in global monetary affairs.

Great Depression

5

A high level of agreement among the powerful on the goals and means of international

economic management facilitated the decisions reached by the Bretton Woods Conference.

Its foundation was based on a shared belief in capitalism. Although the developed countries'

governments differed in the type of capitalism they preferred for their national economies

(France, for example, preferred greater planning and state intervention, whereas the United

States favoured relatively limited state intervention), all relied primarily on market

mechanisms and on private ownership.

Thus, it is their similarities rather than their differences that appear most striking. All the

participating governments at Bretton Woods agreed that the monetary chaos of the interwar

period had yielded several valuable lessons.

The experience of the Great Depression was fresh on the minds of public officials. The

planners at Bretton Woods hoped to avoid a repeat of the debacle of the 1930s, when

intransigent American insistence as a creditor nation on the repayment of Allied war debts,

combined with an inclination to isolationism, led to a breakdown of the international financial

system and a worldwide economic depression. The "beggar thy neighbour" policies of 1930s

governments—using currency devaluations to increase the competitiveness of a country's

export products to reduce balance of payments deficits—worsened national deflationary

spirals, which resulted in plummeting national incomes, shrinking demand, mass

unemployment, and an overall decline in world trade. Trade in the 1930s became largely

restricted to currency blocs (groups of nations that use an equivalent currency, such as the

"Sterling Area" of the British Empire). These blocs retarded the international flow of capital

and foreign investment opportunities. Although this strategy tended to increase government

revenues in the short run, it dramatically worsened the situation in the medium and longer

run.

Thus, for the international economy, planners at Bretton Woods all favoured a regulated

system, one that relied on a regulated market with tight controls on the value of currencies.

Although they disagreed on the specific implementation of this system, all agreed on the need

for tight controls.

Design

Free trade relied on the free convertibility of currencies. Negotiators at the Bretton Woods

conference, fresh from what they perceived as a disastrous experience with floating rates in

the 1930s, concluded that major monetary fluctuations could stall the free flow of trade.

6

The liberal economic system required an accepted vehicle for investment, trade, and

payments. Unlike national economies, however, the international economy lacks a central

government that can issue currency and manage its use. In the past this problem had been

solved through the gold standard, but the architects of Bretton Woods did not consider this

option feasible for the post-war political economy. Instead, they set up a system of fixed

exchange rates managed by a series of newly created international institutions using the U.S.

dollar (which was a gold standard currency for central banks) as a reserve currency.

Informal

Previous regimes

In the 19th and early 20th centuries gold played a key role in international monetary

transactions. The gold standard was used to back currencies; the international value of

currency was determined by its fixed relationship to gold; gold was used to settle

international accounts. The gold standard maintained fixed exchange rates that were seen as

desirable because they reduced the risk of trading with other countries.

Imbalances in international trade were theoretically rectified automatically by the gold

standard. A country with a deficit would have depleted gold reserves and would thus have to

reduce its money supply. The resulting fall in demand would reduce imports and the lowering

of prices would boost exports; thus the deficit would be rectified. Any country experiencing

inflation would lose gold and therefore would have a decrease in the amount of money

available to spend. This decrease in the amount of money would act to reduce the inflationary

pressure. Supplementing the use of gold in this period was the British pound. Based on the

dominant British economy, the pound became a reserve, transaction, and intervention

currency. But the pound was not up to the challenge of serving as the primary world

currency, given the weakness of the British economy after the Second World War.

The architects of Bretton Woods had conceived of a system wherein exchange rate stability

was a prime goal. Yet, in an era of more activist economic policy, governments did not

seriously consider permanently fixed rates on the model of the classical gold standard of the

nineteenth century. Gold production was not even sufficient to meet the demands of growing

international trade and investment. And a sizeable share of the world's known gold reserves

were located in the Soviet Union, which would later emerge as a Cold War rival to the United

States and Western Europe.

The only currency strong enough to meet the rising demands for international currency

transactions was the U.S. dollar. The strength of the U.S. economy, the fixed relationship of

7

the dollar to gold ($35 an ounce), and the commitment of the U.S. government to convert

dollars into gold at that price made the dollar as good as gold. In fact, the dollar was even

better than gold: it earned interest and it was more flexible than gold.

Another view is that in the time of discount banks, discount was the interest earned on gold,

and that the only way to repay interest on government bonds is by printing more dollars, thus

raising the price of gold. If gold is fixed at $35 then other countries will demand gold and not

accept dollars. The closing of the gold window in 1971 was the result.

Fixed exchange rates

The rules of Bretton Woods, set forth in the articles of agreement of the International

Monetary Fund (IMF) and the International Bank for Reconstruction and Development

(IBRD), provided for a system of fixed exchange rates. The rules further sought to encourage

an open system by committing members to the convertibility of their respective currencies

into other currencies and to free trade.

What emerged was the "pegged rate" currency regime. Members were required to establish a

parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates

within plus or minus 1% of parity (a "band") by intervening in their foreign exchange

markets (that is, buying or selling foreign money).

In theory the reserve currency would be the bancor (a World Currency Unit that was never

implemented), suggested by John Maynard Keynes; however, the United States objected and

their request was granted, making the "reserve currency" the U.S. dollar. This meant that

other countries would peg their currencies to the U.S. dollar, and—once convertibility was

restored—would buy and sell U.S. dollars to keep market exchange rates within plus or

minus 1% of parity. Thus, the U.S. dollar took over the role that gold had played under the

gold standard in the international financial system. (Rogue Nation, 2003, Clyde Prestowitz)

Meanwhile, to bolster faith in the dollar, the U.S. agreed separately to link the dollar to gold

at the rate of $35 per ounce of gold. At this rate, foreign governments and central banks were

able to exchange dollars for gold. Bretton Woods established a system of payments based on

the dollar, in which all currencies were defined in relation to the dollar, itself convertible into

gold, and above all, "as good as gold". The U.S. currency was now effectively the world

currency, the standard to which every other currency was pegged. As the world's key

currency, most international transactions were denominated in US dollars.

The U.S. dollar was the currency with the most purchasing power and it was the only

currency that was backed by gold. Additionally, all European nations that had been involved

8

in World War II were highly in debt and transferred large amounts of gold into the United

States, a fact that contributed to the supremacy of the United States. Thus, the U.S. dollar was

strongly appreciated in the rest of the world and therefore became the key currency of the

Bretton Woods system.

Member countries could only change their par value with IMF approval, which was

contingent on IMF determination that its balance of payments was in a "fundamental

disequilibrium".

Formal regimes

The Bretton Woods Conference led to the establishment of the IMF and the IBRD (now the

World Bank), which still remain powerful forces in the world economy.

As mentioned, a major point of common ground at the Conference was the goal to avoid a

recurrence of the closed markets and economic warfare that had characterized the 1930s.

Thus, negotiators at Bretton Woods also agreed that there was a need for an institutional

forum for international cooperation on monetary matters. Already in 1944 the British

economist John Maynard Keynes emphasized "the importance of rule-based regimes to

stabilize business expectations"—something he accepted in the Bretton Woods system of

fixed exchange rates. Currency troubles in the interwar years, it was felt, had been greatly

exacerbated by the absence of any established procedure or machinery for intergovernmental

consultation.

As a result of the establishment of agreed upon structures and rules of international economic

interaction, conflict over economic issues was minimized, and the significance of the

economic aspect of international relations seemed to recede.

International Monetary Fund

Officially established on December 27, 1945, when the 29 participating countries at the

conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the keeper

of the rules and the main instrument of public international management. The Fund

commenced its financial operations on March 1, 1947. IMF approval was necessary for any

change in exchange rates in excess of 1%. It advised countries on policies affecting the

monetary system.

9

International Bank for Reconstruction and Development

The agreement made no provisions for international creation of reserves. New gold

production was assumed to be sufficient. In the event of structural disequilibria, it was

expected that there would be national solutions, for example, an adjustment in the value of

the currency or an improvement by other means of a country's competitive position. The IMF

was left with few means, however, to encourage such national solutions.

It had been recognized in 1944 that the new system could only commence after a return to

normalcy following the disruption of World War II. It was expected that after a brief

transition period of no more than five years, the international economy would recover and the

system would enter into operation.

To promote the growth of world trade and to finance the post-war reconstruction of Europe,

the planners at Bretton Woods created another institution, the International Bank for

Reconstruction and Development (IBRD), now the most important agency of the World Bank

Group. The IBRD had an authorized capitalization of $10 billion and was expected to make

loans of its own funds to underwrite private loans and to issue securities to raise new funds to

make possible a speedy post-war recovery. The IBRD was to be a specialized agency of the

United Nations charged with making loans for economic development purposes.

Late Bretton Woods System

U.S. balance of payments crisis

After the end of World War II, the U.S. held $26 billion in gold reserves, of an estimated total

of $40 billion (approx 60%). As world trade increased rapidly through the 1950s, the size of

the gold base increased by only a few percent. In 1950, the U.S. balance of payments swung

negative. The first U.S. response to the crisis was in the late 1950s when the Eisenhower

administration placed import quotas on oil and other restrictions on trade outflows. More

drastic measures were proposed, but not acted upon. However, with a mounting recession that

began in 1958, this response alone was not sustainable. In 1960, with Kennedy's election, a

decade-long effort to maintain the Bretton Woods System at the $35/ounce price was begun.

The design of the Bretton Woods System was that nations could only enforce gold

convertibility on the anchor currency—the United States‘ dollar. Gold convertibility

enforcement was not required, but instead, allowed. Nations could forgo converting dollars to

gold, and instead hold dollars. Rather than full convertibility, it provided a fixed price for

sales between central banks. However, there was still an open gold market. For the Bretton

10

Woods system to remain workable, it would either have to alter the peg of the dollar to gold,

or it would have to maintain the free market price for gold near the $35 per ounce official

price. The greater the gap between free market gold prices and central bank gold prices, the

greater the temptation to deal with internal economic issues by buying gold at the Bretton

Woods price and selling it on the open market.

In 1960 Robert Triffin noticed that holding dollars was more valuable than gold because

constant U.S. balance of payments deficits helped to keep the system liquid and fuel

economic growth. What would later come to be known as Triffin's Dilemma was predicted

when Triffin noted that if the U.S. failed to keep running deficits the system would lose its

liquidity, not be able to keep up with the world's economic growth, and, thus, bring the

system to a halt. But incurring such payment deficits also meant that, over time, the deficits

would erode confidence in the dollar as the reserve currency created instability.

The first effort was the creation of the London Gold Pool on November 1 of 1961 between

eight nations. The theory behind the pool was that spikes in the free market price of gold, set

by the morning gold fix in London, could be controlled by having a pool of gold to sell on the

open market that would then be recovered when the price of gold dropped. Gold's price

spiked in response to events such as the Cuban Missile Crisis, and other smaller events, to as

high as $40/ounce. The Kennedy administration drafted a radical change of the tax system to

spur more production capacity and thus encourage exports. This culminated with the 1963 tax

cut program, designed to maintain the $35 peg.

In 1967, there was an attack on the pound and a run on gold in the sterling area, and on

November 18, 1967, the British government was forced to devalue the pound. U.S. President

Lyndon Baines Johnson was faced with a brutal choice, either institute protectionist

measures, including travel taxes, export subsidies and slashing the budget—or accept the risk

of a "run on gold" and the dollar. From Johnson's perspective: "The world supply of gold is

insufficient to make the present system workable—particularly as the use of the dollar as a

reserve currency is essential to create the required international liquidity to sustain world

trade and growth." He believed that the priorities of the United States were correct, and,

although there were internal tensions in the Western alliance, that turning away from open

trade would be more costly, economically and politically, than it was worth: "Our role of

world leadership in a political and military sense is the only reason for our current

embarrassment in an economic sense on the one hand and on the other the correction of the

economic embarrassment under present monetary systems will result in an untenable position

economically for our allies."

11

While West Germany agreed not to purchase gold from the U.S., and agreed to hold dollars

instead, the pressure on both the dollar and the pound sterling continued. In January 1968

Johnson imposed a series of measures designed to end gold outflow, and to increase U.S.

exports. This was unsuccessful, however, as in mid-March 1968 a run on gold ensued, the

London Gold Pool was dissolved, and a series of meetings attempted to rescue or reform the

existing system. But, as long as the U.S. commitments to foreign deployment continued,

particularly to Western Europe, there was little that could be done to maintain the gold peg.

All attempts to maintain the peg collapsed in November 1968, and a new policy program

attempted to convert the Bretton Woods system into an enforcement mechanism of floating

the gold peg, which would be set by either fiat policy or by a restriction to honour foreign

accounts. The collapse of the gold pool and the refusal of the pool members to trade gold

with private entities—on March 18, 1968 the Congress of the United States repealed the 25%

requirement of gold backing of the dollar—as well as the US pledge to suspend gold sales to

governments that trade in the private markets, led to the expansion of the private markets for

international gold trade, in which the price of gold rose much higher than the official dollar

price. The US gold reserves continued to be depleted due to the actions of some nations,

notably France, who continued to build up their gold reserves.

Structural changes underpinning the decline of international monetary management

Return to convertibility

In the 1960s and 70s, important structural changes eventually led to the breakdown of

international monetary management. One change was the development of a high level of

monetary interdependence. The stage was set for monetary interdependence by the return to

convertibility of the Western European currencies at the end of 1958 and of the Japanese yen

in 1964. Convertibility facilitated the vast expansion of international financial transactions,

which deepened monetary interdependence.

Growth of international currency markets

Another aspect of the internationalization of banking has been the emergence of international

banking consortia. Since 1964 various banks had formed international syndicates, and by

1971 over three quarters of the world's largest banks had become shareholders in such

syndicates. Multinational banks can and do make huge international transfers of capital not

12

only for investment purposes but also for hedging and speculating against exchange rate

fluctuations.

These new forms of monetary interdependence made possible huge capital flows. During the

Bretton Woods era countries were reluctant to alter exchange rates formally even in cases of

structural disequilibria. Because such changes had a direct impact on certain domestic

economic groups, they came to be seen as political risks for leaders. As a result official

exchange rates often became unrealistic in market terms, providing a virtually risk-free

temptation for speculators. They could move from a weak to a strong currency hoping to reap

profits when a revaluation occurred. If, however, monetary authorities managed to avoid

revaluation, they could return to other currencies with no loss. The combination of risk-free

speculation with the availability of huge sums was highly destabilizing.

Paralysis of international monetary management

Floating-rate Bretton Woods system 1968–1972

By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce, the policy of the

Eisenhower, Kennedy and Johnson administrations, had become increasingly untenable. Gold

outflows from the U.S. accelerated, and despite gaining assurances from Germany and other

nations to hold gold, the unbalanced fiscal spending of the Johnson administration had

transformed the dollar shortage of the 1940s and 1950s into a dollar glut by the 1960s. In

1967, the IMF agreed in Rio de Janeiro to replace the tranche division set up in 1946. Special

Drawing Rights were set as equal to one U.S. dollar, but were not usable for transactions

other than between banks and the IMF. Nations were required to accept holding Special

Drawing Rights (SDRs) equal to three times their allotment, and interest would be charged,

or credited, to each nation based on their SDR holding. The original interest rate was 1.5%.

The intent of the SDR system was to prevent nations from buying pegged gold and selling it

at the higher free market price, and give nations a reason to hold dollars by crediting interest,

at the same time setting a clear limit to the amount of dollars that could be held. The essential

conflict was that the American role as military defender of the capitalist world's economic

system was recognized, but not given a specific monetary value. In effect, other nations

"purchased" American defence policy by taking a loss in holding dollars. They were only

willing to do this as long as they supported U.S. military policy. Because of the Vietnam War

and other unpopular actions, the pro-U.S. consensus began to evaporate. The SDR agreement,

in effect, monetized the value of this relationship, but did not create a market for it.

13

The use of SDRs as paper gold seemed to offer a way to balance the system, turning the IMF,

rather than the U.S., into the world's central banker. The U.S. tightened controls over foreign

investment and currency, including mandatory investment controls in 1968. In 1970, U.S.

President Richard Nixon lifted import quotas on oil in an attempt to reduce energy costs;

instead, however, this exacerbated dollar flight, and created pressure from petro-dollars. Still,

the U.S. continued to draw down reserves. In 1971 it had a reserve deficit of $56 billion; as

well, it had depleted most of its non-gold reserves and had only 22% gold coverage of foreign

reserves. In short, the dollar was tremendously overvalued with respect to gold.

Smithsonian Agreement

The shock of August 15 was followed by efforts under U.S. leadership to develop a new

system of international monetary management. Throughout the fall of 1971, there was a

series of multilateral and bilateral negotiations of the Group of Ten seeking to develop a new

multilateral monetary system.

On December 17 and 18, 1971, the Group of Ten, meeting in the Smithsonian Institution in

Washington, created the Smithsonian Agreement, which devalued the dollar to $38/ounce,

with 2.25% trading bands, and attempted to balance the world financial system using SDRs

alone. It was criticized at the time, and was by design a "temporary" agreement. It failed to

impose discipline on the U.S. government, and with no other credibility mechanism in place,

the pressure against the dollar in gold continued. This resulted in gold becoming a floating

asset, and in 1971 it reached $44.20/ounce, in 1972 $70.30/ounce and still climbing. By 1972,

currencies began abandoning even this devalued peg against the dollar, though it took a

decade for all of the industrialized nations to do so. In February 1973 the Bretton Woods

currency exchange markets closed, after a last-gasp devaluation of the dollar to $44/ounce,

and reopened in March in a floating currency regime.

14

The Snake in the Tunnel

In 1944, the Bretton Woods Agreements introduced a gold standard system that transformed

the US dollar into an international reserve currency, the only one convertible to gold. In such

a system of exchange rate parities, the dollar fulfilled the de facto function of gold. The

currencies were allowed to fluctuate by 1 % either side of parity, which was set in relation to

gold or the dollar by the International Monetary Fund (IMF). The dollar immediately became

the international unit of account, to the great economic and political advantage of the United

States. Indirectly, this system provided European countries with monetary stability for nearly

thirty years. Since 1958, the European Monetary Agreement (EMA) had authorised the

partial or total convertibility of European currencies. Under that Agreement, the central banks

of the signatory countries undertook to exchange their currency for dollars at rates set below

the limits imposed by the IMF.

Speculation on the dollar exchange market, which pushed up the value of the German mark,

began in the spring of 1971 and intensified during the year.

The German Minister for Finance and Economic Affairs, Karl Schiller, was known for his

austere financial policy. He was unyielding in his bid to curb inflation and was steadfast in

his desire to maintain the stability of the German mark.

Karl Schiller wanted all the European currencies to float. But that step was sure to push up

the value of certain currencies, amongst them the French franc. The French President,

Georges Pompidou, and his Finance Minister, Valéry Giscard d'Estaing, opposed

Mr Schiller's proposal and preferred to fix parities via exchange rate controls. The Germans

rebuffed such an interventionist approach. France was above all trying to avoid an overvalued

franc, since that would harm French exports and might slow economic growth and even lead

to social unrest.

In December 1971, the French President, Georges Pompidou, and the German Chancellor,

Willy Brandt, found a monetary compromise that was readily approved by the US President,

Richard Nixon, and the Member States of the European Economic Community (EEC).

The monetary agreements that were signed in Washington on 18 December 1971 set new

parities in relation to the dollar, which was devalued by 7.89 % in relation to gold. At the

same time, a number of currencies were adjusted upwards in relation to the dollar: the Italian

15

lira by 7.5 %; the German mark by 13.5 %; the Dutch guilder by 11.6 %; the Belgian franc by

11.6 %; the French franc by 8.6 %; and the pound sterling by 8.6 %.

However, the French Government also had to agree to a fluctuation margin amongst the

currencies wider than that set by the Bretton Woods System. The band was increased from

1 % to 2.25 % on either side of the dollar rate. The maximum spread, from floor to ceiling,

between any two European currencies was consequently 4.5 %. That was the width of the

tunnel.

After a meeting in Basle on 10 April 1972, the Committee of Governors of the European

central banks introduced an additional mechanism to narrow exchange rate fluctuation.

Accordingly, the Basle Agreement set up the European currency snake in the tunnel. The

snake entered into force on 24 April 1972 and allowed central banks to buy and sell European

currencies provided that the exchange rate fluctuation margin of 2.25 %, corresponding to the

authorised margins between the dollar and the currencies of the Six, was not overstepped.

The snake was therefore reduced to half its size in relation to the width of the tunnel. While

the EEC accession procedure was under way, the pound sterling, the Irish punt and the

Danish crown joined the snake on 1 May 1972. But these three currencies, not unlike the

dollar, came under speculative attacks and were forced to leave the exchange-rate mechanism

a few weeks later.

To understand why fluctuation margin was supposed to be 2.25 %, we need to go back to

18 December 1971. On that day, the representatives of the major Western countries, meeting

at the Smithsonian Institute in Washington, sanctioned the devaluation of the dollar. At the

same time, they decided that the rates of Western currencies could not deviate by more than

2.25 % above or below parity with the American currency.

Technically, this means that differences in exchange rates between two Community

currencies may amount to 4.5 % but only 2.25 % with respect to the dollar alone. What is

more, these figures relate only to differentials qualified by the experts as ‗instantaneous‘, or

in other words, recorded at a clearly determined time. In practice, between two periods, the

differentials may amount to 9 % between Community currencies (twice the ‗instantaneous‘

differential), compared to 4.5 % between each of these currencies and the dollar. The

Community countries felt that this differential between the exchange rates of their currencies

was far too broad. It was feared at the time that it might jeopardise the operation of the

common agricultural policy and the customs union. This was why the Nine chose to restrict

16

the range of exchange-rate fluctuations between their currencies to 2.25 % (actually 4.5 %). It

should be noted that relations between the latter and the dollar were not changed in any way

by the Basle Agreement. Under the Smithsonian Agreement, the Community currencies

would vary in relation to the dollar within a foreign exchange band that was also restricted to

4.5 %. The ‗snake‘ therefore had its ‗tunnel‘.

Less than two years after it came into force the European exchange agreement had lost many

of its supporters in the community, although two countries not part of the Community,

Norway and Sweden, still played by the rules. Two basic causes of this problem can be

identified: the cost of the snake and the problem of gold.

Prior to the Basle Agreement, the principal concern of the monetary authorities was to respect

the conventional fluctuation bands (4.5 % from the time of the Smithsonian Agreement)

between the exchange rates of their currencies and the rate of the dollar. Any European

central bank, knowing that the rate of its currency was at its highest (+2.25 %) or lowest (–

2.25 %) in relation to the dollar, could therefore sell or purchase the American currency on

the foreign exchange markets. With each one independently monitoring exchange rates in this

way, the Community monetary authorities indirectly managed to restrict exchange rate

variations between their currencies. This was how the dollar came to be seen as the only

intervention currency. With the Basle Agreement, the central bankers, solely out of respect

for the European exchange-rate agreement, promoted the Community currencies to the rank

of intervention currencies. Let us assume that the German mark is the highest valued

currency in the ‗snake‘ and the French franc is the lowest, the differential between these two

currencies threatening to exceed 2.25 %. The Bundesbank would then purchase francs on the

Frankfurt market, which would allow the French currency to remain within the ‗snake‘. The

mechanism might appear insignificant if debts were reimbursed. Thirty days after the end of

the month, the Banque de France would actually have to repurchase the francs bought by the

Bundesbank. One such instance cost France $2 Billion. This particularly heavy bill had to be

settled after a bout of speculation against the franc that was sparked off by upward pressure

on the Dutch guilder. The example shows how pressure on currency rates may cause

significant outflows of foreign currency from certain Community Member States.

The ‗snake‘ was not spared these difficulties, which are basically connected to the weakness

of the dollar in conjunction with the strength of the German mark. Most currencies in the

17

‗snake‘ could not accompany the upward variations in the mark; otherwise their currencies

might appreciate too much against the dollar.

It nevertheless proved possible to ease the pressure exerted within the ‗snake‘, thanks to the

revaluation of the German mark (3 % on 14 March 1973 and 5.5 % on 29 June 1973) and the

Dutch guilder (5 % on 17 September). Well before this however, several Community States

had already declined to apply the European exchange-rate agreement — the United Kingdom

and Ireland from 23 June 1972, and Italy from 13 February 1973.

The Basle Agreement laid down that intervention in Community currencies is to be

reimbursed on the basis of the composition of monetary reserves. A distinction is accordingly

made between ‗hard‘ reserves (gold and assets tied to gold, such as Special Drawing Rights

— SDRs) and ‗weak‘ reserves (currencies, particularly the dollar). Reimbursement of the

‗weak‘ part posed no problem at all. The ‗hard‘ part, however was another matter altogether.

The central banks no longer wished to dispose of their gold at an ‗official‘ price

(42.22 dollars per ounce), deemed to be ridiculous compared to the free market rate (160 to

165 dollars per ounce in March 1975). Bypassing this difficulty, in a special case, France

reimbursed its debt to Germany by paying only ‗hard‘-reserve SDRs.

This special case in no way relieved the intensity of the problem of transfers in gold. The

central bankers of the Community quite logically came up with compromises to ensure that

the Basle Agreement continued to operate smoothly. One of these, a provisional one, allowed

Italy to pay off future debts from July to September 1972 completely in dollars. The other, in

force since 1 January 1973, offered countries that had disposed of gold at 42.22 dollars per

ounce the opportunity to repurchase it as soon as a solution and a definitive price had been

found for the problem of transfers of gold between Community central banks. This

compromise, however, seemed less and less acceptable to countries like France and Italy,

who made their reintegration into the ‗snake‘ conditional upon the finalization of a solution.

Between 1974 and 1976, the Italian, British, Irish and French currencies were undermined by

galloping inflation and balance of payment deficits. The weakness of their currencies

prompted them to leave the snake on several occasions. France left on 19 January 1974 and

rejoined on 10 July 1975. On 15 March 1976, France once again left the system. At the same

time, parities in the snake were being adjusted frequently. In September, Jean-Pierre

Fourcade, the French Minister for Finance and Economic Affairs, proposed that all nine

currencies of the EEC be allowed to float freely. His plan was to achieve greater coordination

between the currencies in the snake and those floating around the snake. He also called on the

18

EEC Member States to act together on the currency market and suggested that a new

European unit of account be adopted.

Ultimately, from January 1974 onwards, the snake was no longer contained within the tunnel,

and only the countries of the mark zone – Germany, Denmark and the three Benelux

countries – remained within the system.

The European snake had undoubtedly been very effective in preventing quite a few avoidable

disruptions, but on its own it could not overcome the problems caused by a lack of economic

policy coordination.

19

Oil Shocks of 1973 and 1979

Background: End of Bretton Woods

On August 15, 1971, the United States pulled out of the Bretton Woods Accord taking the US

off the Gold Exchange Standard (whereby only the value of the US dollar had been pegged to

the price of gold and all other currencies were pegged to the US dollar), allowing the dollar to

"float". Shortly thereafter, Britain followed, floating the pound sterling. The industrialized

nations followed suit with their respective currencies. In anticipation of the fluctuation of

currencies as they stabilized against each other, the industrialized nations also increased their

reserves (printing money) in amounts far greater than ever before. The result was

a depreciation of the value of the US dollar, as well as the other currencies of the world.

Because oil was priced in dollars, this meant that oil producers were receiving less real

income for the same price. The OPEC cartel issued a joint communique stating that forthwith

they would price a barrel of oil against gold.

This led to the "Oil Shock" of the mid-seventies. In the years after 1971, OPEC was slow to

readjust prices to reflect this depreciation. From 1947-1967 the price of oil in U.S. dollars had

risen by less than two percent per year. Until the Oil Shock, the price remained fairly stable

versus other currencies and commodities, but suddenly became extremely volatile thereafter.

OPEC ministers had not developed the institutional mechanisms to update prices rapidly

enough to keep up with changing market conditions, so their real incomes lagged for several

years. The substantial price increases of 1973-74 largely caught up their incomes to Bretton

Woods levels in terms of other commodities such as gold.

Yom Kippur War

On October 6, 1973, Syria and Egypt launched a pre-emptive strike on Israeli-occupied

territories captured in the 1967 Six Day War . This new round in the Arab-Israeli conflict

triggered a crisis already in the making; the price of oil was going to rise. The West could not

continue to increase its energy consumption 5% annually, while also paying low oil prices,

and selling inflation-priced goods to the petroleum producers in the developing Third World.

This was stressed by the Shah of Iran, whose nation was the world's second-largest exporter

of oil and the closest ally of the United States in the Middle East at the time.

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On October 12, 1973, President Richard Nixon authorized Operation Nickel Grass, an overt

strategic airlift to deliver weapons and supplies to Israel, after the Soviet Union began

sending arms to Syria and Egypt.

Imposition of the Embargo

On October 16, 1973, OPEC announced a decision to raise the posted price of oil by 70%, to

$5.11 a barrel. The following day, oil ministers agreed to the embargo, a cut in production by

five percent from September's output, and to continue to cut production over time in five

percent increments until their economic and political objectives were met. October 19, US

President Richard Nixon requested Congress to appropriate $2.2 billion in emergency aid to

Israel, including $1.5 billion in out-right grants. Libya announced it would embargo all oil

shipments to the United States. Saudi Arabia and the other OPEC states quickly followed

suit, joining the embargo on October 20, 1973. At their meeting in Kuwait the OPEC oil-

producing countries, proclaimed the oil boycott that provided for curbs on their oil exports to

various consumer countries and a total embargo on oil deliveries to the United States as a

―principal hostile country‖. The embargo was thus variously extended to Western Europe and

Japan.

Though United States was the initial target of the embargo, it was later expanded to

the Netherlands. Price increases were also imposed. Since oil demand falls little when the

price is raised, the prices had to be risen dramatically to reduce demand to the new lower

level of supply. Anticipating this, the market price for oil immediately rose substantially,

from $3 a barrel to $12. The world financial system, which was already under pressure from

the breakdown of the Bretton Woods agreement, was set on a path of recessions and

high inflation that persisted until the early 1980s, with oil prices continuing to rise until 1986.

The effects of the Arab Oil Embargo are clear—it effectively doubled the real price of crude

oil at the refinery level, and caused massive shortages in the U.S. Over the long term, the oil

embargo changed the nature of policy in the West towards increased exploration, energy

conservation, and more restrictive monetary policy to better fight inflation.

Economic Effects of the Embargo

The effects of the embargo were immediate. OPEC forced the oil companies to increase

payments drastically. The price of oil quadrupled by 1974 to nearly US$12 per barrel (75

US$/m3).

21

This increase in the price of oil had a dramatic effect on oil exporting nations, for the

countries of the Middle East who had long been dominated by the industrial powers were

seen to have acquired control of a vital commodity. The traditional flow of capital reversed as

the oil exporting nations accumulated vast wealth. Some of the income was dispensed in the

form of aid to other underdeveloped nations whose economies had been caught between

higher prices of oil and lower prices for their own export commodities and raw materials

amid shrinking Western demand for their goods. Much was absorbed in massive arms

purchases that exacerbated political tensions, particularly in the Middle East.

Europe

The embargo was not uniform across Europe. Of the nine members of the European

Economic Community (EEC), the Netherlands faced a complete embargo, the United

Kingdom and France received almost uninterrupted supplies (having refused to allow

America to use their airfields and embargoed arms and supplies to both the Arabs and the

Israelis), whilst the other six faced only partial cutbacks. The UK had traditionally been an

ally of Israel, and Harold Wilson's government had supported the Israelis during the Six Day

War, but his successor, Ted Heath, had reversed this policy in 1970, calling for Israel to

withdraw to its pre-1967 borders. The members of the EEC had been unable to achieve a

common policy during the first month of the Yom Kippur War. The Community finally

issued a statement on November 6, after the embargo and price rises had begun; widely seen

as pro-Arab, this statement supported the Franco-British line on the war, and OPEC duly

lifted its embargo from all members of the EEC. The price rises had a much greater impact in

Europe than the embargo, particularly in the UK (where they combined with strikes by coal

miners and railroad workers to cause an energy crisis over the winter of 1973-74, a major

factor in the change of government). The UK, Germany, Switzerland, and Norway banned

flying, driving and boating on Sundays. Sweden rationed gasoline and heating oil.

The Netherlands imposed prison sentences for those who used more than their given ration

of electricity. Ted Heath asked the British to heat only one room in their houses over the

winter.

A few months later, the crisis eased. The embargo was lifted in March 1974 after negotiations

at the Washington Oil Summit, but the effects of the energy crisis lingered on throughout the

1970s. The price of energy continued increasing in the following year, amid the weakening

competitive position of the dollar in world markets.

22

1979 Energy Crisis

The 1979 oil crisis in the United States occurred in the wake of the Iranian Revolution. Amid

massive protests, the Shah of Iran, Mohammad Reza Pahlavi, fled his country in early 1979

and the Ayatollah Khomeini soon became the new leader of Iran. Protests severely disrupted

the Iranian oil sector, with production being greatly curtailed and exports suspended. When

oil exports were later resumed under the new regime, they were inconsistent and at a lower

volume, which pushed prices up. Saudi Arabia and other OPEC nations, under the presidency

of Dr. Mana Alotaiba increased production to offset the decline, and the overall loss in

production was about 4 percent. However, a widespread panic resulted, driving the price far

higher than would be expected under normal circumstances.

In 1980, following the Iraqi invasion of Iran, oil production in Iran nearly stopped, and Iraq's

oil production was severely cut as well.

After 1980, oil prices began a six-year decline that culminated with a 46 percent price drop in

1986. This was due to reduced demand and over-production, which caused OPEC to lose its

unity. Oil exporters such as Mexico, Nigeria, and Venezuela expanded production. Ending of

price controls allowed the US and Europe to get more oil from Prudhoe Bay and the North

Sea.

23

Formation of EMS/EMU/EU

After the collapse of the Bretton Woods agreement there was a greater tendency to move

towards flexible exchange rates among the countries of the world. However, this was certainly

not true within the European countries: from the late 1970‘s they were trying to limit intra-

European exchange rate fluctuations.

The European Union (EU), or the European Community (EC) as it was then known began

with 6 member countries: France, Germany, Italy, the Netherlands, Belgium and Luxembourg

and has since added 9 more members: Spain, Portugal, the U.K., Ireland, Greece, Austria,

Denmark, Sweden and Finland.

From 1979 until the early 1990‘s the EU member countries formed a joint system for

coordination of monetary and exchange rate policies: the European Monetary System

(EMS).The EMS is the precursor to the more recent European Monetary Union (EMU).

The European Monetary System: A Broad Description

The EMS consisted of two major components: the creation of an artificial unit of account

named the European Currency Unit (ECU) and a fixed exchange rate system known as the

ERM (Exchange Rate Mechanism).

The ECU was only a unit of account and not a medium of exchange. That is to say that there

were no ECU notes or coins issued and used to conduct transactions. It was merely an

accounting unit, constructed as a fixed basket of European currencies.

There are 3 main goals that are usually attributed to the EMS.

1. Enhancing the importance of Europe in the global economy: With the collapse Bretton

Woods, European nations lost confidence in the ability of the U.S. to take the

monetary policy leadership. The EMS was a way for the EU nations to handle some of

their monetary concerns amongst themselves rather than relying on a worldwide

system.

2. To create a unified Europe: The goal was to eliminate all barriers to the movements of

trade and capital across the European countries. The Europeans believed that exchange

24

rate uncertainty remained a huge obstacle to intra-European trade and a system of

fixed exchange rates would facilitate the flow of goods and services across countries.

3. To improve the functioning of the Common Agricultural Policy (CAP) an elaborate

system of price supports for agricultural goods within the EU. Since 1979, the CAP

specified prices for agricultural goods in terms of the ECU. Suppose the price of milk

was set at 1 ECU per gallon. If the current exchange rates were 5 FF per ECU, and 2

DM per ECU then French dairy farmers would receive 5 FF per gallon of milk while

German dairy farmers received 2 DM per gallon. By keeping the FF and the DM fixed

against the ECU, exchange rate fluctuations wouldn‘t affect real incomes across ERM

countries.

The ERM was essentially a managed float exchange rate system where the currencies of

participating countries were allowed to fluctuate within pre-specified bands. Of the countries

that were members of the European Monetary System only those willing to commit to the

exchange rate bands were said to belong to the Exchange Rate Mechanism.

There were 8 original participants in the ERM: France, Germany, Italy, Belgium, Denmark,

Ireland, Luxembourg and the Netherlands. Other countries, Spain (1989), Britain (1990) and

Portugal (1992) joined at subsequent times.

Central exchange rates for each currency against the ECU were established. Initially, the plan

was to allow a fluctuation band of 2.25% for most currencies against this central rate. The

Portuguese escudo and the Spanish peseta were allowed to fluctuate around a broader band

6% while the Italian Lira has the broader band until 1990 at which point it switched over to

the narrower band.

Member countries had to intervene to make sure that their currencies stayed within the

prescribed band. So if the French Franc was reaching the top of the Franc/ECU band then the

French Central Bank had to intervene and buy Francs in order to make sure that it did not

move outside the band.

Since the ECU is a fictitious accounting unit, the system effectively turned into a system

where the bands were maintained with respect to the most stable currency of the group, the

German Mark. Effectively we can think of the ERM as being a system where the exchange

rates of all countries were allowed to fluctuate in a band around the mark.

25

The mark became the unofficial reserve currency so when the French government was

intervening

To buy francs it would effectively be selling marks in exchange for francs. The ERM also had

a built in lending mechanism to prevent crises from happening: the German. Bundesbank is

supposed to lend DM to France if France needed to shore up its currency.

The Dominant Role of Germany in the ERM

Effectively, the role of Germany within the ERM is similar to that of the U.S. within Bretton

Woods. Since there are only N-1 exchange rates among the N countries, Germany becomes

free to set monetary policy for itself while the other countries have reduced control over

monetary policy since they have to hold reserves and intervene when the exchange rate got

too close to the edge of the band.

One argument for why this system was chosen is the greater credibility of the German

Bundesbank.

Some European countries would actually benefit by ceding control of their monetary policy

since their Central Banks were not very good at keeping inflation under control. For example,

the Italian Central Bank would not do as good a job fighting inflation with an independent

monetary policy as Italy could achieve by fixing their exchange rate to the DM and allowing

the Bundesbank to dictate the monetary policy decisions.

The Bundesbank was so good at fighting inflation because of the hyperinflations that plagued

Germany between the World Wars. When the new central bank was established following the

war, it was given an explicit mandate to root out inflation as its primary goal.

So countries in which the mandate of the central bank is not so anti-inflationary or poorly

designed may then benefit by tying their fortunes to a central bank that is deeply committed to

rooting out inflation. This will also help in stamping out inflationary expectations in these

countries and enable people to make long-term decisions with considerably less uncertainty.

Pros and Cons of the ERM

Pros

1. Exchange Rate Stability - Theoretically, countries would have to minimize the size of

exchange rate fluctuation to be within a relatively narrow band which would reduce

uncertainty and facilitate trade.

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2. Better inflation performance from the increased credibility of tying monetary policy to

the Bundesbank.

3. A step along the way to full European Monetary Union, by reducing the fluctuations

of the currency and improving the coordination of monetary policy decisions among

the member countries.

Cons

1. Asymmetric system.

The enhanced role of Germany works well for reducing inflation until one of

two thingsccurs. a) The responsible central bank ceases to act responsibly (the

U.S. under Bretton Woods) or b) The policy interests of Germany and the rest

of Europe diverge dramatically. For example, if the German economy is

growing too fast while the rest of Europe is suffering through a recession,

decisions to cut back on German money supply will then put major pressure on

the other currencies.

In fact, the eventual demise of the ERM was related to a country specific shock

that highlighted the problems of this type of system: the reunification of

Germany. The fiscal and monetary policy decisions undertaken at the time by

Germany led to a rise in German interest rates and pushed the currencies of the

other member countries to the bottom of the fluctuations band.

2. Exchange rate uncertainty is enhanced rather than reduced by the ERM.

For example, suppose the Lira is allowed to fluctuate in a band of 2.25%.

Because the system was not a completely fixed exchange rate system,

countries had some freedom to conduct monetary policy. Suppose that the

Bank of Italy expanded the money supply and inflation in Italy started to rise.

This would lead to a fall in Italian interest rates and a depreciation of the lira

against the mark and other currencies. However at some point, the lira would

hit the band around which the Lira/Mark was allowed to fluctuate. At that

point, the Italian Central Bank has to keep the exchange rate fixed: by buying

27

Lira and selling Marks. This will cause the Italian Central Bank to run out of

DM reserves and it would have to either devalue the currency or get more

Marks from Germany.

If it chooses to devalue then a new central value for the currency is chosen and

the exchange rate band is adjusted accordingly. So we end up substituting

frequent, small movements for infrequent, large movements in the currency.

When these ―realignments‖ of the bands became likely, speculative activity

heightened because there was money to be made by borrowing lira and

exchanging them for Marks at the pre-alignment rate and paying back the lira

borrowing after the realignment.

3. While EMS may have helped advance the political cooperation between EU countries,

it may not have advanced the incentives for economic cooperation between countries.

The events leading up to the eventual demise of the ERM may have convinced

countries like the U.K about the inherent inequities of the asymmetric system

and helped convince them of the virtue of having an independent monetary

policy and a floating exchange rate.

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The fall of Berlin Wall and ERM Collapse

The catalyst for the ERM crisis was the reunification of Germany in 1990, an event

unprecedented in history for the amalgamation of a large, rich economy with a smaller

economy with a much lower standard of living.

The Berlin Wall was a barrier constructed by the German Democratic Republic (GDR, East

Germany) starting August 13, 1961, that completely cut off West Berlin from surrounding

East Germany and from East Berlin. The Wall served to prevent the massive emigration and

defection that marked Germany and the communist Eastern Bloc during the post-World War

II period.

In 1989, a radical series of Eastern Bloc political changes occurred associated with the

liberalization of the Eastern Bloc's authoritarian systems and the erosion of political power in

the pro-Soviet governments in nearby Poland and Hungary. The fall of the Berlin Wall paved

the way for German reunification, which was formally concluded on October 3, 1990

In order to make this assimilation work, the West German government spent an enormous

sum of money: almost half of all West German savings were transferred to the East and the

government budget deficit rose from 5% to 13.2%.

East German consumers largely spent the transfers on consumption; after all they had been

deprived of most of the perks of capitalism for many years. Furthermore, the old East German

Marks were converted to DM at a rate of roughly 1.8:1, far exceeding the value of the East

German Mark. This meant that East German business owners could not sell their goods nor

could they afford to pay their workers leading to a large scale economic shutdown in East

Germany.

29

Most of the demand for goods from the East Germans would therefore fall on West German

made goods and the inflationary pressures started to build in the economy.

Second, the growth of DM increased in 1990 as the central bank issued DM in exchange for

East German Marks. By 1991, the Bundesbank was becoming very nervous about the

prospects of high inflation in Germany and started pursuing contractionary monetary policy

very seriously.

The Bundesbank raised interest rates by almost 3% in the years 1991 and 1992. The

combination of expansionary fiscal and contractionary monetary policy caused German

interest rates to rise dramatically.

Since German interest rates are higher than in the rest of the world, there is an inflow of

money into the German economy. This inflow causes the DM to appreciate and NX to fall.

The critical feature is that interest rates rise both in Germany and in the Rest of the World,

Further more output in Germany falls

Impact on Rest of Europe

German and world interest rates rise following reunification. There is an outflow of money

from Europe and ERM currencies like the lira and the peseta towards the bottom of their

target zones.

It also affected countries like Sweden and Finland that had stayed outside the EMS but chosen

fix their exchange rates to the DM perhaps in search of the anti-inflation credibility from the

Bundesbank.

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The fall of the Central Bank of England

The German economy was affecting its ERM partners. At the time, the U.K was in the worst

recession since the end of WW II, with unemployment rates well in excess of 10%. In

isolation, the U.K would have resorted to expansionary monetary policy to get out of the

slump but they are handcuffed by the fixed exchange rate system.

While this loss of autonomous policy was stifling the UK economy, things became much

worse following the reunification process and the tightening of German monetary policy.

There are three impacts of the events in Germany on the United Kingdom. First, the fall in

output in Germany results in fewer imports being purchased from elsewhere in the ERM.

Second the appreciation of the mark vis-a-vis non ERM currencies implicitly makes the

pound appreciate against those currencies. Finally, the interest rates in Germany and the Rest

of the World increases.

Since the rate of return in Germany and the rest of the world are higher, there is a monetary

outflow from the U.K. Under a fixed exchange rate system, an outflow of money leads to a

monetary contraction as the central bank exchanges foreign currency for domestic currency.

The important thing to note is that the slump is worse under fixed exchange rates than it

would have been under flexible exchange rates. Under a flexible exchange rate system, the

outflow of money will lead to exchange rate depreciation. Thus output in the U.K. economy

will be higher under a flexible exchange rate system than under fixed exchange rates.

The above analysis indicates that the temptation to leave the ERM was high for the U.K. The

same held true for many other struggling European economies like Italy, Spain and Portugal

as well as for countries like Sweden and Finland to break off their fixed exchange rate system.

At this point, speculators figured that many European nations would be forced to leave the

ERM and devalue their currencies, and attacked the Finnish markka, the Swedish krona, the

British pound and the Italian lira by borrowing large sums of these currencies and selling

them for German marks.

Essentially, these speculators were betting that the pound would lose value and started selling

pounds in exchange for other foreign currencies, thus causing reserves at the Bank of England

to dry up and putting further devaluation pressure on the pound.

31

The British Central Bank, for example, lost a lot of reserves trying to defend the pound (i.e.

by selling D-Marks and buying pounds) and withdrew from the EMS; Paul Krugman writes

that George Soros made a billion dollars betting against the pound.

These attacks continued well into 1993 and several countries including the U.K left the EMS

and countries like France saw their currencies come under such heavy attack that the

exchange bands were widened so much that they were effectively floating currencies.

32

Crisis in Finland and Sweden (1990-93)

Both Finland and Sweden are commonly regarded as small and open economies. Given this

openness and thus the importance of international trade to the two economies, it should not

come as a surprise that the economic crises in Finland and Sweden occurred during periods of

international economic slowdown. In this section we are discussing the 1990s crisis of

Finland and Sweden and compare them with earlier crisis in Finland and Sweden in terms of

real economic loss.

The early 1990s were turbulent years. Soviet Union was the biggest importer and exporter for

both Finland and Sweden. With the iron curtain came down on cold war, the Soviet empire

imploded and the Gulf War erupted. The industrial world entered a recession, triggered by

rising oil prices and rising real interest rates in Europe due to the re-unification of Germany.

The Bundesbank responded to the expansionary fiscal policy in Germany by increasing its

interest rate. In autumn 1992 and summer 1993, the recession culminated in Europe with the

ERM crisis.

The Finnish economy grew throughout the 1980s after recovering from the OPEC crises of

the 1970s and early 1980s. However, signs of an overheated economy began to show in the

latter part of the 1980s when real income growth accelerated, asset prices rose rapidly and

inflation rates started to increase. The boom was fuelled by the deregulation of financial

markets. Bank credit rose sharply and Finland received large capital inflows. The terms of

trade increased owing to the fall of energy prices and the increase in prices in the forestry

sector, a most important Finnish export industry. Fiscal policies were expansionary as well,

thus contributing to the bubble.

The boom in Finland ended in 1990. A switch to tighter policies to defend the fixed exchange

rate of the markka along with rising international interest rates led to a sharp increase in the

real rate of interest. Asset prices plummeted and a period of debt deflation set in. A financial

crisis erupted. Exports weakened further as a result of the collapse of trade with the

imploding Soviet Union in 1991. The markka came under severe pressure as the depression

grew deeper. In November 1991, the government enforced a devaluation of the currency. In

September 1992, the peg became unsustainable and the Bank of Finland had to let the markka

float.

33

The depreciation of the Finnish currency started the turnaround in 1993. The recovery was

export-led while the domestic sector remained depressed for a few years longer. During the

remainder of the 1990s the economy grew rapidly and new industries emerged. The structure

of the economy changed fundamentally. The old forestry and engineering industries became

less important while high-tech sectors such as the mobile phones industry dominated the

recovery process.

The Finnish economy started to decline in 1990 and real income did not return to its pre-crisis

trend until 1994, with a cumulative loss of real income of 26.4 percentage points. Industrial

production was somewhat less affected by the crisis than the rest of the economy, with a loss

of 21.4 percentage points during 1990-92. Employment declined by the same proportion but

over a longer period. Between 1990 and 1994 the cumulative loss of employment was 24.0

percentage points.

The Swedish economy followed roughly the same path as the Finnish. In Sweden the credit

markka was deregulated in 1985, leading to a rapid increase in the demand for and supply of

credit. High inflation rates and inflationary expectations combined with the design of the tax

system gave rise to very low real interest rates, often negative ones. The result was a

―financial hothouse‖ with sharply increasing asset prices.

In 1990, the introduction of a tax reform combined with higher international interest rates and

falling inflation created a sharp and sudden increase in the real rate of interest, bursting the

bubble and setting off a process of balance sheet adjustment with strong signs of debt

deflation. The financial sector was put under severe stress and Sweden was soon plagued by a

banking crisis and a currency crisis at the same time. The depression led to a sharp increase in

unemployment. Government expenditures increased while tax revenues stagnated, leading to

huge budget deficits. The Riksbank was eventually forced to let the Krona float in November

1992. As a result of the consequent depreciation and lowering of interest rates, an export-led

recovery slowly took hold.

The Swedish economy was hard hit by the crisis of the 1990s. It was one of the most severe

downturns in the 20th

century. Still, Sweden was less affected than Finland by the real effects

of the crisis. Between 1990 and 1993 the loss of real income was 13.0 percentage points and

of industrial production 17.0. Employment continued to decline for a year longer than the two

other measures. Between 1990 and 1994 job losses totalled 16.6 percentage points.

34

35

36

37

Summary of Events leading to pre-eminence of euro as currency

Birth of the European Monetary System

It was the economic crisis of the 1970s that led to the first plans for a single currency. The

system of fixed exchange rates pegged to the US dollar was abandoned. European leaders

agreed to create a "currency snake", tying together European currencies. But the system

immediately came under pressure from the strong dollar, causing problems for some of the

weaker European economies.

Plaza Accord

In the 1980s the dollar strengthened dramatically. US interest rates were very high. The cause

was a dispute between the Reagan administration and the US central bank over the size of the

budget deficit. In 1986 the world's leading industrial countries agreed to act and lower the

value of the dollar. The successful deal was struck at New York's Plaza hotel.

Maastricht Treaty

In 1991 the 15 members of the European Union, meeting in the Dutch town of Maastricht,

agreed to set up a single currency as part of a drive towards Economic and Monetary Union.

There were strict criteria for joining, including targets for inflation, interest rates and budget

deficits. A European Central Bank was established to set interest rates. Britain and Denmark

opted out of these plans.

38

ERM crisis

The Exchange Rate Mechanism - established in 1979 - was used to keep the value of

European currencies stable. But fears that voters might reject the Maastricht treaty led

currency speculators to target the weaker currencies. In September 1992 the UK and other

EU countries were forced to devalue. Only the French franc was successfully defended

against the speculators.

Asian crisis

The turbulence in the Asian currency markets began in July 1997 in Thailand and quickly

spread throughout the main Asian economies, eventually reaching economies as far away as

Russia and Brazil. Foreign lenders withdrew their funds amid fears of a global financial

meltdown, and the dollar strengthened. Many EU countries were struggling to cut their

budget deficits to meet the criteria for euro membership.

Euro launch

the euro was launched on 1 January 1999 as an electronic currency used by banks, foreign

exchange dealers, big firms and stock markets. The new European Central Bank set interest

rates across the euro zone. But uncertainty about its policy and public disagreements among

member governments weakened the value of the euro on foreign exchange markets.

Central Bank intervention

After just 20 months the euro had lost nearly 30% in value against the dollar. The European

Central Bank and other central banks finally joined forces to boost its value. The move

helped put a floor under the euro - but it has still not recovered its value. A weak euro helped

European exports, but undermined the credibility of the currency and fuelled inflationary

pressures.

Terrorist Attack

The terrorist attack in New York, aimed at damaging the world's leading financial centre,

severely tested currency markets. Money flowed out of the dollar, to safe havens like the

Swiss franc and - for the first time - the euro. Central banks tried to calm the markets and cut

interest rates across the globe. Many observers believe it may have marked the coming of age

of the euro as an international currency.

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Euro becomes cash currency

On 1 January 2002 the euro became a reality for 300m citizens of the 12 countries in the euro

zone. The arrival of the euro as a cash currency may foster closer integration and greater

price competition within the euro zone. It may also help boost its international role, as the

doubts grow over the strength of the dollar as the US economy continued to slow.