The European Exchange Rate Mechanism (ERM) crisis of 1992 and the Pound Sterling Crisis


Seminar Paper, 2020

19 Pages, Grade: 1.7


Excerpt

II. Table of content

I. Abstract

II. Table of content

III. List of abbreviations

1. Introduction

2. Theories and fundamentals
2.1. Exchange rate theories / hypothesis
2.1.1. Purchasing power parity hypothesis
2.1.2. Interest rate parity theory
2.2. Optimal currency area theory
2.3. Formsofmonetaryintegration
2.4. The „impossible trinity“

3. European Monetary System
3.1. Historical development
3.2. The European Monetary Systems’ goals
3.3. Exchange Rate Mechanism

4. The “Black Wednesday” crisis of 1992
4.1. Timeline
4.2. The role of the German Bundesbank
4.3. Effects

5. ExchangeRateMechanism-II
5.1. Goals of the Exchange Rate Mechanism-II
5.2. The conception of the Exchange Rate Mechanism-II

6. Conclusion

7. References

I. Abstract

This short seminar paper introduces the theory and fundamentals as well as the history and mechanisms which led to the creation of the European Monetary System (EMS) and later the European Economic and Monetary Union (EMU). It also follows the events culminating into the EMS’ crisis in 1992 and the permanent departure of the United Kingdom from this system. With the introduction of the EMU and the expansion of the European Union (EU) in the early years of the new millennium, the question arises of whether it is advisable for the newer members to become part of the European Exchange Rate mechanism-II (ERM-II) which leads to the introduction of the Euro in the future. The scope of this work only allows for a very pinpoint answer for this very complex topic but is a first step into more comprehensive and detailed literature.

III. List of abbreviations

Deutsche Mark DM

European Currency Unit ECU

European Economic and Monetary Union EMU

European Exchange Rate Mechanism ERM

EuropeanMonetary System EMS

European Single Market ESM

European Union EU

International Monetary Fund IMF

Purchasing power parity hypothesis PPP

Optimal Currency Area theory OCA

United Kingdom UK

1. Introduction

In this seminar “Finanz- und Währungskrisen” in the winter semester of 2019 / 2020 we aim to analyse and understand a specific crisis, review the scientific literature, and write a short seminar paper which aims to present the findings to the other course participants.

The crisis we chose to work on in for this paper is the so-called “Black Wednesday” crisis of 1992, which forced the British Pound Sterling and the Italian Lira to leave the European Exchange Rate Mechanism (ERM) - a core component of the European Monetary System (EMS). Sixteen years later, in the aftermath of the 2008 global financial crisis, the European Union faced its very own (Euro) crisis which brought Eurozone’s faultlines to the fore. Even today, in the year 2020, when the public discussion is focused yet again on a new phase of European integration in the wake of the Corona-pandemic, it is important to look back and understand the design, ideas and flaws behind the economic aspects of the European Union (EU), the European Monetary Union (EMU) and its ERM-II as the EMS’ successor.

With all this in mind, the question we seek to answer is the following:

“Is the participation of further EU countries to the ERM-II reasonable from an economic perspective in view of earlier EMS experiences (The EMS / crisis of 1992)?”

To answer this question, we must first briefly cover some theoretical background, which we do in chapter 2. The long process of European economic and monetary integration will be summarily presented in chapter 3, and this includes the goals and institutional machinery of the EMS and ERM.

In chapter 4, the dynamics of the 1992 crisis and its problems will be analysed to be followed by chapter 5, in which the ERM-II will be explained. This chapter’s focus is in the lessons learned during the crisis and the shortcomings of the ERM it brought to light.

The groundwork is then laid for the abovementioned question to be answered and assessed by the author in chapter 6.

2. Theories and fundamentals

2.1. Exchange rate theories / hypothesis

This chapter shall give a very short and brief overview of some of the fundamental principles ofhow exchange rates are expected to develop over time.

2.1.1. Purchasing power parity hypothesis

The purchasing power parity hypothesis (PPP) is a very old and simple theory, tracing back to the 16th century. At its core it calls for an equilibrium between the aggregated price levels and nominal exchanges rates of two countries (Taylor & Taylor, 2004: 1).

A general difference is being made the relative and absolute PPP. The former describes changes in the price level and exchange rates with the latter making a comparison between the national price levels in two countries compared in a common currency (van Marrewijk, 2004: 43).

The hypothesis is based on the “Law of One Price” - any internationally traded good should have the same price given in a common currency. This is due to the possibility of people making arbitrage profits otherwise, which will then close the price gap (Taylor & Taylor, 2004: 3).

This means, that in the long run, exchange rate and inflation will adjust accordingly and converge.

While historic data shows that long-run relative PPP is pretty accurate, short-term relative PPP shows high deviations (van Marrewijk, 2004: 43). This is one major part of critics regarding this hypothesis.

Another one is the impossibility of a lot of goods being arbitraged easily internationally, for example service labor or real-estate (Taylor & Taylor, 2004: 3).

In addition, linear empirical models were only able to find very few evidences, pointing to a very slow rate ofPPP reversion of 3-5 years (Taylor & Taylor, 2004: 23).

Research regarding the case of Portugal and Spain vis-a-vis with Germany using a linear long-run relationship in the period of I960 - 1990 did not reject the PPP-hypothesis and showed that the weaker currencies, in this case the Portuguese Escudo, appreciated over time (Duarte, 2005).

A more recent study of two south African countries, Lesotho and Zambia, found that in the case of Lesotho the theory could be supported while in the case of Zambia the theory was rejected (lyke & Odhiambo, 2017).

2.1.2. Interest rate parity theory

The Interest rate parity theory links interest rates and prices based on the Fisher equation

Abbildung in dieser Leseprobe nicht enthalten

An interest rate parity for an investment in the same currency (i.e. euro as an European) which yields the same result as an investment in dollar after re-converting the investment into euro is called covered. Covered in this case means the investment is hedged, the future exchange rate is fixed as of today by buying a future contract (van Marrewijk, 2004: 73-75).

An uncovered interest rate parity on the other hand is given when an investment is not hedged. It is not possible to draw conclusions, because the future exchange rate is unknown today. It can only be expected (van Marrewijk, 2004: 81-82).

While covered interest rate parity can empirically be proven close to perfectly, uncovered cannot. This might be due to underlying assumption like rational expectations, risk neutrality (= efficient market hypothesis) as well as transaction costs and risk premia (van Marrewijk, 2004: 89).

The aforementioned Fisher equation calls for the need of high nominal interest rates to yield positive real interest rates when the inflation rate is high.

2.2. Optimal currency area theory

First developed by Robert A. Mundell in 1961, the Optimal Currency Area theory (OCA) outlines a model for globally free floating flexible exchange rates between currency areas, in which each currency area there is one currency. It also examines the optimal size of one such area. (Mundell, 1961).

This so-called “old” or “early” OCA has been developed further since and shall be presented in this chapter.

The general idea being that benefits of being a member of such an currency area should be higher than the costs. Its main goal is to reduce incidences of asymmetric shocks and to establish adequate adjustment mechanisms (Papazoglu, Sideris, & Tsagklas, 2016: 35).

To achieve sustainable macroeconomic balance through adhesion to a monetary union some criteria or properties must be fulfilled:

The flexibility of prices and wages within the participating countries, the mobility of production factors including labour, an integrated financial market, a high degree of economic openness which was later focused on by the research of an OCAs endogeneity, a diversified production and consumption portfolio within the currency area, similar inflation rates of the member countries and fiscal and political integration (Geza & Giurca Vasilescu, 2011:3; Mongelli, 2008: 2-3).

These criteria shall only be named at this place, because a detailed look into each one of them would go far beyond the scope of this paper. A detailed discussion can be found in the according literature named in the references chapter.

The same goes for the question, whether monetary policy is even an effective policy instrument to generate macroeconomic benefits in terms of unemployment or growth (Mongelli, 2008: 5).

In the two decades following the 1992 crisis, due to significant advancements in the field of econometrics as well as addressing the OCA theories weaknesses a “new OCA theory” emerged (Mongelli, 2008: 8).

Part of this “new OCA theory” is the assumption, that countries may apply to an OCA membership even before they fulfil the criteria ex-ante, as they will fulfil those criteria ex­post due to the very membership converging the economy to be in line with the needs of such a currency area (Frankel & Rose, 1998).

Empirical evidence shows that converging into one currency area is enhancing further economic and financial integration. Therefore, borders of currency areas can be planned with expansion in mind since integration and convergence will even amplify further once a single, shared currency is setup (Mongelli, 2008: 8).

2.3. Forms of monetary integration

To give a better understanding of different options to integrate a region monetarily, we will distinguish between three different forms of integration (Schinasi, 1989: 3-4):

The first possibility is to form a currency union; This includes monetary integration, involving fixed exchange rates and easing monetary and trade adjustments by financing common facilities.

Second is the option of financial integration. This includes the free movement of capital, a single market, and unified financial institutions.

Lastly, the formation of a monetary union with unified policies which can go beyond just monetary policies but do not have to.

The first two forms can be chosen independently from each other and do not require the other one to be achieved (Schinasi, 1989: 4).

2.4. The „impossible trinity“

The „impossible trinity“ refers to a term used to describe three impossible to reconcile goals of monetary policy. These goals are free trade and movement of capital, fixed exchange rates and an autonomous monetary policy on the national level (Handler, 2007: 6; Mongelli, 2008: 13).

The European economic and monetary integration process can be considered a solution to this impossibility trinity and its details will be laid out in the following chapters.

3. European Monetary System

3.1. Historical development

In general, the EMS is widely agreed on to be based on Mundells’ OCA theory (Aschinger, 1993; Geza & Giurca Vasilescu, 2011; Mongelli, 2002, 2008; Papazoglu et al., 2016). In fact, Mongelli calls the process of European monetary integration a “laboratory” for the OCA (Mongelli, 2002: 7).

The basic outline and foundation for an Economic and Monetary Union (EMU) were drafted in the coming decade (Thygesen, 2013: 14). The set-up of the Basle agreement in April 1972 created the “common margins arrangement” or better known as the European “Currency Snake” with a set maximum margin of 2,5 % fluctuation between the currencies of the member countries (Schinasi, 1989: 6).

The years following the dissolution of the Bretton woods system in 1973 meant years of economic instability and divergence between the European countries with average inflation rates of the United Kingdom (UK) and Italy rising up to the 20 - 25 % range and the need for the International Monetary Fund (IMF) to intervene (Thygesen, 2013: 21-23).

This led to the foundation of the EMS on the 5th December 1978 with its set start date on 1st January 1979 which only applied to the central banks. Its full scale start was scheduled for 13th March 1979 (Hallensleben, 2001: 3).

[...]

Excerpt out of 19 pages

Details

Title
The European Exchange Rate Mechanism (ERM) crisis of 1992 and the Pound Sterling Crisis
College
University of Hamburg  (Fakultät für Wirtschafts- und Sozialwissenschaften)
Course
Währungs- und Finanzkrisen
Grade
1.7
Author
Year
2020
Pages
19
Catalog Number
V974476
ISBN (eBook)
9783346322524
ISBN (Book)
9783346322531
Language
English
Tags
European Exchange Rate Mechanism (ERM), Pound Sterling Crisis, EWG, Monetary Policy, Currency Snake, European Union, Pound Sterling, Economic Crisis, Pfundkrise
Quote paper
Andre Korbas (Author), 2020, The European Exchange Rate Mechanism (ERM) crisis of 1992 and the Pound Sterling Crisis, Munich, GRIN Verlag, https://www.grin.com/document/974476

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