For European monetary affairs, 1992 was a watershed: In January, the European Monetary System (EMS) celebrated five years of stability; by November, it was all but falling apart. Two of its members had been driven from the system, two others had experienced steep and involuntary devaluations. The EMS was undergoing the worst crisis of its existence.
When analysing these events, they inevitably lead to the issue of financial liberalisation. If the argument that the lack of control over international capital flows is at the heart of such crises is true, their costs must be weighed against the benefits of the liberalisation process.
But can the use of capital controls be in any way compatible with the process of European financial integration? Does the idea not go against the entire philosophy embodied in the project of economic and monetary union (EMU)? Some authors argue that not only can capital controls be made compatible with the integration process but that they are in fact the only option available to safeguard any pegged exchange rate system against the excesses of occasionally irrational and overwhelmingly powerful financial markets.
The resulting question, though merely speculative in retrospect, is thus two-fold: Could capital controls have helped to prevent the 1992-crisis of the EMS and would it therefore have been beneficial to allow for this instrument afterwards, instead of widening the fluctuation bands to 30 per cent? And, resultingly, could capital controls exist within a fixed exchange rate system like the EMS then and the EMSII in the future?
I shall, as preliminaries, first briefly summarise the main arguments of the discussion on the desirability of capital controls. Subsequently, I shall discuss, whether capital controls can actually achieve what they were designed for. In the main section, I shall analyse what causes for the 1992-crisis seem probable, why the post-1992 re-constitution of the system took the form it actually did and whether capital controls could have been relevant in this context or will do so in the future.
Table of Contents
Introduction
1. What are capital controls?
1.1 Types of capital controls
1.1.1 Controls on capital outflows
1.1.2 Controls on capital inflows
1.2 Arguments for and against the imposition of capital controls
2. How effective are capital controls?
3. Capital controls and the crisis of the EMS
3.1 Conditions for the viability of a pegged exchange rate system
3.2 Causes of the crisis
3.2.1 Inevitable policy shifts
3.2.2 Multiple equilibria and self-fulfilling speculation
3.3 Implications
3.4 Solutions
3.5 The right choice?
Conclusion
Research Objectives and Core Themes
This essay explores the historical and theoretical role of capital controls in the context of the 1992 European Monetary System (EMS) crisis, investigating whether such instruments could have mitigated the crisis or provided necessary stability for fixed exchange rate regimes.
- Mechanisms and theoretical classifications of capital controls.
- Empirical evaluation of the effectiveness of capital controls in preventing financial crises.
- Analysis of the causes behind the 1992 EMS collapse, specifically focusing on policy shifts and self-fulfilling speculation.
- Evaluation of policy alternatives for the EMS and future exchange rate mechanisms.
Excerpt from the Book
1. What are capital controls?
Capital controls are mechanisms or instruments to consciously limit the amount of capital that is flowing in and/or out of a country. Usually administered by governments, they are sometimes seen as protectionism, a way of preventing domestic savings from being invested abroad. On the other side, capital controls are also employed as a way of dealing with destabilising currency speculation, and this is the context in which they will be important for the issue at hand. Modern analyses of currency markets identify important market failures which lead to occasionally destabilising speculation and justify some form of intervention: asymmetric information giving rise to herd behaviour, and multiple equilibria which make self-fulfilling crises possible. Capital controls are put forward as one way of keeping such speculation in check and retaining room to manoeuvre for national monetary policy by effectively breaking the link between domestic and international interest and inflation rates.
Summary of Chapters
Introduction: Provides a historical overview of the 1992 EMS crisis and outlines the central debate regarding the compatibility of capital controls with European financial integration.
1. What are capital controls?: Defines capital controls, distinguishes between inflow and outflow regulations, and discusses the theoretical arguments regarding their economic impact.
2. How effective are capital controls?: Reviews historical and empirical evidence concerning the success of capital controls in managing currency crises and limiting speculative flows.
3. Capital controls and the crisis of the EMS: Examines the causes of the 1992 EMS crisis, identifying policy inconsistencies, self-fulfilling speculation, and potential solutions like band expansion or tax-based controls.
Conclusion: Synthesizes findings, suggesting that limited capital controls could provide necessary breathing space during crises without violating the core principles of European integration.
Keywords
Capital controls, EMS crisis, European Monetary Union, currency speculation, exchange rate mechanism, financial liberalisation, pegged exchange rate, multiple equilibria, Maastricht Treaty, monetary policy, market failure, capital flows.
Frequently Asked Questions
What is the primary focus of this research paper?
The paper examines the relevance of capital controls in the context of the 1992 European Monetary System crisis and discusses whether these instruments could have prevented the collapse or supported the system's stability.
What are the core thematic fields covered?
The work covers monetary policy, international financial architecture, the dynamics of speculative attacks, the history of the EMS, and the political-economic debate surrounding capital account liberalization.
What is the central research question?
The central question is whether capital controls could have helped prevent the 1992 EMS crisis and if they are compatible with the goals of European economic and monetary integration.
Which scientific method is utilized?
The author uses a qualitative, analytical approach, synthesizing existing academic literature and empirical studies to evaluate the desirability and effectiveness of capital controls within a fixed exchange rate framework.
What does the main body of the text discuss?
It discusses the definitions of capital controls, historical evidence of their effectiveness, the specific causes of the 1992 EMS crisis—namely policy shifts and self-fulfilling speculation—and proposed solutions for future monetary arrangements.
Which keywords best characterize this research?
Key terms include capital controls, EMS crisis, exchange rate mechanisms, monetary policy, and speculative attacks.
How does the author define 'preventive' versus 'curative' capital controls?
Preventive controls are implemented when a country is not yet under pressure to prevent future crises, while curative controls are used during an ongoing currency crisis to provide time for economic restructuring.
What role did self-fulfilling speculation play in the 1992 crisis according to the text?
The author explains that self-fulfilling speculation occurs when market participants believe a policy shift is inevitable, prompting them to attack a currency, which in turn forces the authorities to adjust their policy, validating the market's initial speculation.
- Quote paper
- Ulrich Machold (Author), 2002, Capital Controls, EMU and the Crisis of the European Monetary System, Munich, GRIN Verlag, https://www.grin.com/document/9448
