Financial Markets and European Monetary Cooperation: The Lessons of the 1992-93 Exchange Rate Mechanism Crisis.
This book is aimed at extending the theoretical framework to better explain the 1992-1993 crisis in the European Exchange Rate Mechanism (ERM). At the outset, the authors trace the history of the "quest"(1) for exchange rate stability in Europe. The Snake, which had its roots in the breakdown of the Bretton Woods system, was the first significant step in this direction. The Snake spelled out narrower bands than those implied by Bretton Woods. Exchange rate fluctuations between member states were to be confined within these bands. The Snake had distinct shortcomings in the form of limited financing arrangements and an asymmetry in the crisis management responsibility. This asymmetry confined the stabilizing role mainly to the central banks of the state with the currency under devaluation pressure. The Snake was propped up by widespread capital controls. Encouraged by the convergence in European inflation rates in the preceding years, the (new) European Monetary System (EMS) was launched in 1987 with augmented financing arrangements and greater symmetry in the support role to be played by member central banks. The degree of realignment flexibility in the target bands was reduced. Capital controls were largely done away with. The remarkable stability of the system in its initial years encouraged acceptance of the Delors report in 1989 and the signing of the Maastricht treaty in 1991. These steps were aimed at a phased movement toward complete monetary unification. These plans came under threat with the 1992-1993 crisis in the ERM, which is the subject of this book.
The authors briefly recount the economic and politico-economic arguments that have led to this long "quest" for exchange rate stability in Europe. The authors discuss the well-known explanations of this "quest" in terms of preserving economic integration, inducing macro policy coordination in the face of spillovers, reducing uncertainty, preventing misalignment in international relative prices (supposedly caused by unregulated financial markets), and needing to ensure the viability of the Common Agricultural Policy. The politico-economic reason, rather than efficiency justification, for eventual monetary union is apparent.
The factors that led to the 1992-1993 ERM crisis are classified into two categories. The first category includes macroeconomic and political factors. Foremost among these factors is the German unification shock. A tight monetary policy in the face of a very expansionary postunification fiscal stance pushed German interest rates up to unprecedented levels. Fearful of recession and unemployment, other European nations were largely unable to follow suit. Disruption of the ERM was the natural consequence. The other causal events in the macroeconomic and political category are incompatible macro policies and the consequent loss of competitiveness in some economies, liberalized capital flows after the Single Act, and weakened commitment after the Danish vote.
The second category of factors leading to the crisis involves the role of self-fulfilling speculative attacks in undermining the ERM. The behavior and role of financial markets during this period is examined at length. The authors observe that the removal of capital controls and other provisions of the 1987 EMS seemed to stabilize the ERM by creating the perception of a lower likelihood of realignment. To determine whether financial markets perceived the ERM as credible, the authors examine data on interest rate differentials between European states to see whether the implied expected devaluation rates are within permissible ERM limits. The findings point toward the credibility of the ERM. There is a high correlation in the bilateral interest rate as it spreads across member countries, pointing toward certain systematic common influences. The bilateral spreads (and the credibility) seem to be unrelated to present and past values of important macro variables. Inflation differentials have some influence. Given the forward-looking nature of the interest rate differentials, this does not surprise the authors. Perhaps the most interesting observation is the fact that financial markets largely failed to anticipate the 1992-1993 crisis. Credibility of the ERM prior to the crisis was only marginally diminished.
The authors briefly discuss the theoretical models hitherto used to examine the mechanism by which various factors caused the ERM crisis. These models include exogenous policy models, where the levels and time paths of policy variables are exogenously given (Krugman 1979), and endogenous policy models, where policy variables are endogenously determined as the result of an optimization exercise (Obstfeld 1994). In both types of models, self-fulfilling speculative attacks are explained by the existence of multiple equilibria with the same underlying fundamentals. Speculative attacks involve a sudden convergence of expectations away from the "good" equilibrium toward the "bad" equilibrium that has a high probability of realignment associated with it. These models fail to provide any endogenous logic for this sudden shift in expectations. Further, they treat the ERM as a collection of isolated unilateral pegs and largely ignore spillover effects across member states. The model of Gerlach and Smets (1994) is a rare exception that incorporates spillovers. None of these existing models incorporates strategic interaction amongst policy makers.
This book attempts to overcome these shortcomings by developing a systemic endogenous policy model incorporating spillovers and strategic interactions. The model generates a rationale for the switch in expectations that causes speculative attacks to become self-fulfilling. The model, essentially a modified Mundell-Fleming setup, has a core-periphery structure, in keeping with the empirical reality of Europe. The periphery accepts an exchange rate peg as a means to import credibility for a low inflation monetary policy from the core. The policy maker weighs the cost of preserving the peg in each period with the cost associated with a realignment. If the peg is retained, monetary policy remains consistent with the peg, and if members renege on the commitment, monetary policy is the outcome of an optimization exercise. The nature of the functional forms leads to the existence of multiple equilibria in the intermediate range for shocks. The good equilibrium has a higher threshold and leads to abandonment of the peg only for exogenous shocks of very high intensity. The bad equilibrium has a lower threshold and would result in abandonment of the peg even in the face of moderate shocks. In response to the shocks, and depending on the magnitude of the shocks, it might be optimal for the periphery to adopt a cooperative or noncooperative response to a shock. Both the absence of an enforcement mechanism for a cooperative agreement and the postulated principle of national horizontal equity of burden in cooperation influence this outcome. The cooperative outcome would require small devaluations on the part of a large number of periphery states and would preserve the peg, whereas the lack of cooperation would require a large devaluation by one or a few states and would put the peg under threat. Thus, expectations would respond to signals that indicate a lack of cooperation possibilities, and, in anticipation of large devaluations of certain currencies, expectations would converge in favor of the bad equilibrium. This would lead to a collapse of the peg with a higher degree of certainty, without any change in the fundamentals. The interactions amongst members of the ERM in the 1992-1993 period conveyed an impression of noncooperation. The solitary realignment of the lira on September 14, 1992, was one such indicator. Thus, the authors see the 1992-1993 crisis largely as the consequence of a successful self-fulfilling speculative attack, aided by the noncooperative positions assumed by ERM member states and, in great part, unrelated to the fundamentals. This contention is rigorously demonstrated within a very elegantly executed model. To the extent that cooperation is seen as a source of stability for Europe, the model is a recommendation for greater European integration. To that extent, the European Monetary Unification can be seen as a good step for enhancing and protecting economic integration, even though the efficiency logic for it is no longer seen as being very strong.
The merit of this book cannot be more aptly described than by using the words on its jacket: "No one interested in international monetary relations, European integration, or the theory of currency crises can afford to overlook this important book."(2)
1 Term used in Giavazzi and Giovannini (1989).
2 Comment by Maurice Obstfeld.
Krugman, Paul. 1979. A model of balance-of-payments crises. Journal of Money, Credit, and Banking 11:311-25.
Obstfeld, Maurice. 1994. The logic of currency crises. Cahiers Economiques et Monetaires 43:189-213.
Gerlach, Stefan, and Frank Smets. 1994. Contagious speculative attacks. Center for Economic Policy Research, Discussion Paper No. 1055.
Giavazzi, Francesco, and Alberto Giovannini. 1989. Limited exchange rate flexibility,: The European monetary system. Cambridge, MA: MIT Press.
Anup Wadhawan Pennsylvania State University
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|Publication:||Southern Economic Journal|
|Article Type:||Book Review|
|Date:||Jan 1, 1999|
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