The Role of Financial Markets in the EMS Crisis: Implications for the Process to EMU

Prof. Dr. Peter Bofinger *

I. Introduction

on paper the future of European Monetary Integration never looked more promising than now:

- The Maastricht Treaty has finally been ratified so that the aim of European Monetary Union (EMU) rests on a solid legal basis now.

- On January 1, 1994 the European Monetary Institute has started its operations with the aim of intensifying monetary coordination in Europe. In addition it will prepare the conceptual groundwork for the activities of the future European Central Bank (ECB).

In reality, however, the prospects of the achievement of EMU have markedly deteriorated in the course of 1993:

- With the de facto breakdown of the ERM - caused by the introduction of the ± 15 % margins - it is no longer clear how the transition to absolutely fixed exchange rates in Europe shall be managed. Unfortunately the authors of the Maastricht Treaty were so impressed by the artificial stability of the ERM parity structure at the beginning of the 1990s that they overlooked the necessity of safeguards in the treaty for that event .

- A second serious impediment for the achievement of EMU has been erected by the recent decision of the German constitutional court. The judges emphasised the mandatory character of the criteria of convergence and prescribed a very strict interpretation of the given reference values. With the present deterioration of the economic situation and rising unemployment rates in Europe, especially the criterion for the level of public sector debt will not easily be met by the majority of countries in 1997/99. Under de facto flexible exchange rates in Europe it will generally become more difficult to enhance convergence as exchange rate fluctuations by themselves are a possible source of divergent economic performance.

Thus, under present conditions the likelihood of a failure of the whole Maastricht Treaty is quite high. In fact this would be nothing new. The same happened to the ambitious blueprint of the Werner-Report in 1970 and also to the decision taken in 1978, where the establishment of the second stage of the EMS should be started already two years after the inception of the System in 1979.

For those, who always disliked the whole EMU project, the Status Quo is therefore not a bad solution. For the proponents of the European integration, however, such a "wait and see" attitude is a very risky strategy. Obviously something has to be done to give a new momentum to the integration process. There are mainly three options that could contribute to this aim in the foreseeable future:

- an early return to narrow margins,

- the imposition of some form of intra-European capital controls, and

- the creation of a monetary union for the core EU countries in the near future.

II. Return to the Narrow Band

At the moment there is not much enthusiasm to be found for an immediate return to narrow margins. Especially in the view of the Bundesbank such a step would above all require a considerable improvement in the degree of economic convergence.

But is this really the main precondition for more exchange rate stability in Europe? Of course, economic convergence is always a stabilising factor for exchange rate movements. But is it also a sufficient condition? Looking on the one side at the economic situation in Germany and in low inflation countries like France, the Benelux-countries and Denmark on the other side it is obvious that there was never as much convergence as in summer 1993. Of course, countries did not only achieve more convergence in terms of virtue (lower inflation rates) but also in terms of vice (higher deficits) - but it is convergence anyhow. So it is difficult to imagine what the Bundesbank has in mind while asking for more convergence. Does it mean that the French inflation rate has to be reduced to a level of zero? Or does it mean that "convergence" is reached when fiscal deficits in France are only a quarter of the German deficit levels?

Obviously convergence is not enough for stable exchange rates. In this respect if it is also important to recall the experience with ERM in its first years. Although the divergence in macroeconomic fundamen-tals was immense at that time, it was always possible to defend the ERM parity structure. Of course, recurrent substantial parity changes were indispensable. In order to identify the other preconditions for a return to "narrow margins" it is necessary to analyse the causes of the ERM crisis in more detail.

The causes of the ERM crisis

- Especially outside Germany, the Bundesbank's policy of high interest rates is regarded as a major destabilising factor. However, when the narrow margins were abandoned, German interest rates had already decreased considerably from their peak level reached in July 1992.

- According to some observers, the shock of German unification overburdened the capacities of the Exchange Rate Mechanism. Without going into details, one should put a big question mark behind this very popular argument. Because beside of its impact on interest rates which certainly made life for the other countries more difficult in the EMS, the unification shock also had strong stabilising effects: By increasing the German inflation rate, it reduced and later even eliminated the inflation differential between the D-Mark and most EU currencies. And by generating a strong German import surge, it helped to remove the bilateral current account imbalances that were regarded as a major problem for the stability of the ERM in 1989.

- Excluding the more popular explanations of the ERM crisis leads to a destabilising factor which is often overlooked, especially in official papers. There is no doubt that the behaviour of foreign exchange market participants has made it increasingly difficult to operate the ERM with narrow margins: difficulties started already in the end of the 1980s when international investors erroneously believed that ERM parities would remain stable until the final transition to EMU. As a consequence, in the years of the so-called "new-ERM" there were no speculative attacks on ERM countries with high inflation rates. The necessary adjustment process was delayed for too long so that it was obviously not possible to achieve an orderly realignment in September 1992. After that date the situation got even worse, when the market started to attack low-inflation ERM countries. This forced them to increase their interest rates above the already very high German interest level. Strong speculative attacks, which were completely unwarranted by the underlying macroeconomic fundamentals, considerably deterio-rated the economic situation in these countries. Because of unsustainable macroeconomic costs the narrow margins had to be abandoned.

The credibility problem created by the EMS crisis

In sum, the experience with free international capital movements in the ERM confirms what one has been already able to observe for flexible rate regimes since two decades: Macroeconomic fundamentals do not play a decisive role in the portfolio decisions of internationally active investors:

- In flexible rate regimes this fact has become manifest in considerable misalignments and a high degree of short-term volatily especially of the US-Dollar and the Japanese Yen.

- In fixed rate systems one can have one of the following situations; either too little pressure (as could be observed in 1991) or too much pressure (since September 1992) on specific currencies.

What does this imply for policy-makers? Obviously, foreign exchange markets need guidance by official exchange rate policy. In fact, this was the most important rationale of the "old EMS". However, an exchange rate system can only provide such a kind of guidance if it is credible in general. Unfortunately, the reaction of the central banks to the currency turmoil in September 1992 and July 1993 reduced this credibility to almost zero. In the September crisis the Lira's new parity was only defended for three days. This was a clear break with the past, where realigned parities could always be maintained for several months at least. Thus, it was not surprising that subsequently also all other parities were no longer regarded as credible. This created the tensions that were already mentioned. After the crises in July 1993 official parities have completely lost their guiding role for exchange markets.

The implications for a possible return to narrow margins are obvious: There are no reasons to expect that they should ever become more credible than they were last summer. Thus, a reestablishment of the "old EMS" could immediately cause strong speculative attacks - independent of macroeconomic fundamentals-. In other words, the Bundesbank's recipe for more exchange rate stability in Europe does not take into account the strong credibility problem which has been caused by the reaction of central banks to the currency turmoil.

From this analysis follows in my opinion that additional measures have to be taken if more exchange rate stability is to be reached in the nearer future in Europe.

III. Capital controls - a solution?

Compatible with the analysis provided here are proposals that aim at the reimposition of controls for international capital movements. Such proposals include taxes for short-term financial flows (Tobin-tax) or the requirement to hold non-interest bearing deposits for open foreign-exchange positions. The main flaws of such ideas are the following:

- Because of the high sophistication of financial markets such controls either would be easily circumvented or huge international control adminis-trations would be required for monitoring and registering all cross-country financial flows.

- There is always the risk that such measures do not only prohibit destabilising speculative transactions but also financial transactions that are associated with trade transactions or international portfolio investments unrelated to currency speculation.

In other words: capital controls, even in more refined forms, are difficult to reconcile with the overall spirit of the internal market and the final aim of a monetary union which is explicitly defined as a region without any restrictions on capital flows. Reestablishing narrow margins hand in hand with the introduction of capital controls is therefore not a positive contribution to European monetary integration.

IV. A monetary union for the stability core countries?

An alternative solution to the credibility problems created by the EMS crisis is an outright creation of a currency union for the EU core countries (Belgium, Denmark, France, Germany, Luxembourg, the Nederlands). Under economic aspects this solution provides many advantages and has almost no disadvantages.

Risks and advantages of a currency union for the EU core countries

- All six countries have very diversified production patterns. Thus, it does not seem likely that they might be affected by an asymmetrical real shock requiring nominal exchange rate flexibility. Therefore, even EMU critics have to admit that these countries would constitute an optimum currency area.

- The core countries have experienced rather low inflation rates for many years so one can argue that even from the German point of view their "stability culture" is sufficiently well developed.

- Income levels are rather similar throughout this area. Thus, a currency union could not result in an undue equalisation of wages as it happened in the case of German monetary union.

- As German interest rates have now decreased consi-derably, the other countries would no longer be burdened by the effects of German unification.

Compared with the very limited risks a core monetary union would provide substantial economic benefits:

- Transaction and information costs for all transactions between these countries would be lowered.

- Compared with a return to narrow margins the member countries could no longer be impaired by unwarranted speculative attacks. In terms of credibility, a monetary union would clearly be superior to the ERM.

- Compared with capital controls, a core monetary union would not prevent an efficient allocation of capital among its members. Nor would it require an international or European administration for the implementation of such controls.

- Compared with flexible rates, a monetary union would avoid the negative economic effects associated with possible misalignments of exchange rates. In the case of the dollar, the impact on the individual European economies was limited. But it is not difficult to predict that misalignments within the internal market would have more far-reaching implications.

- Finally, within an area like the EU where national borders do not play a role for financial activities anymore, the effectiveness of monetary policy can be improved when the range of a central bank is identical with the range of market participants.

Advantages for the perspective of European integration

From the perspective of European integration this approach would also have considerable advantages:

- By putting a monetary union into practice immediately and by concentrating on countries that are obviously qualified for this procedure there is the possibility of a real test for the final target of EMU.

- If this approach is successful, a solid base for a later membership of other countries is provided. It would allow them to join an arrangement which has already proven its credibility and stability orientation.

The only problem with the whole proposal is that it is very difficult to reconcile with whole spirit of the Maastricht Treaty:

- The Treaty not only excludes any monetary union that would start before 1997.

- It also requires the fulfilment of the criteria of convergence (even more so after the decision of the German constitutional court).

Nevertheless it should be possible to find an adequate legal framework for an arrangement that is in the best interest of all European countries. Of course, this would require some major effort by politicians in Europe. But if the final aim of EMU is to be safeguarded, it is simply not enough to wait and see.

But is it really important to stick to the target of a monetary union? After the experience of the last 15 month the answer to this question is easier than before. We have learnt that international capital movements can cause considerable tensions in any system of adjustable rates. If capital controls are to be excluded, a monetary union has the evident advantage of giving financial market unlimited room for manoeuvre. At the same time, by keeping exchange rates absolutely fixed, it avoids the negative macroeconomic effects that can always be associated with the huge size of these markets.