In memory of Dr. Andreas Höfert

The 20th anniversary of the EMS crisis

Twenty years ago in September 1992, my diploma as an economist freshly in my pocket and just before starting my graduate studies, I decided to enjoy ten days of holiday in London. It was my first visit to this extraordinary city. I was completely overwhelmed. Intense museum hopping during the day (J.M.W. Turner remains even today my personal favorite painter) was followed by fierce pub crawling by night. Against the clichés, the weather was gorgeous – ten days of sun – and the food excellent.

Twenty years ago in September 1992, my diploma as an economist freshly in my pocket and just before starting my graduate studies, I decided to enjoy ten days of holiday in London. It was my first visit to this extraordinary city. I was completely overwhelmed. Intense museum hopping during the day (J.M.W. Turner remains even today my personal favorite painter) was followed by fierce pub crawling by night. Against the clichés, the weather was gorgeous – ten days of sun – and the food excellent.

There was just one issue. I had exchanged all my travel money before the holidays at roughly 2.5 Swiss francs to the pound. Then Black Wednesday came, and the pound dropped by almost 20% against the franc. I was pretty upset that my holidays were costing significantly more than if I had taken my Swiss francs with me. But this experience ignited the passion I still have today for everything related to currency markets. The European Monetary System crisis of fall 1992 remains one of the most spectacular currency crises.

It all started with the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s. European leaders, especially the French, and European exporters never really accepted it. A first attempt to manage the exchange rates of the members of the European Economic Community was the so-called “snake in the tunnel.” Currencies would float (hence the snake) against each other within a band (hence the tunnel) of +/–2.25%. However, this system was too informal, with countries leaving and then rejoining the snake. By the end of the 1970s, this system mutated into a Deutschmark zone, as the Benelux countries and Denmark pegged their currencies to that of Germany.

The European Monetary System

In 1979, the countries of the European Economic Community decided to replace the snake with a more formal structure, the European Monetary System (EMS). Three main elements characterized this system:

  • The currencies of the EMS members would fluctuate among themselves around a predetermined exchange rate within a band of +/–2.5% (+/–6.0% in the case of Italy). This was the so-called exchange rate mechanism (ERM). Whenever the exchange rate hit the predetermined upper or lower band, the central banks would have to intervene, or the predetermined exchange rate would have to be reset, devaluating one currency against the other one.
  • A new currency was created as a basket from the different currencies of the EEC member states, the so-called ECU (for European Currency Unit, the acronym also referring to an old French coin). It was not a currency per se, like the euro, but a unit of account for currency exchanges between the different central banks.
  • The long-term objective was set. The EMS should lead to a common currency of the EMS member states. This would ultimately result in the creation of the euro in 1999.

In its 20 years of existence, the ERM went through many significant adjustments of its exchange rate bands, especially in the early 1980s, and a number of severe crises, the most severe likely being that which occurred in the fall of 1992.

In 1979, eight of the nine members of the EEC, the United Kingdom being the exception, adopted the ERM. Spain would enter the ERM in July 1989, the UK in October 1990 and Portugal in April 1992. All three countries had higher intervention bands of +/–6.0%.

Setting the stage for the crisis

At the beginning of 1992, there were no visible heralds of the turmoil that fall would bring. In February, the Maastricht Treaty, which would ultimately lead to the adoption of the euro, was signed by all ERM countries but still needed to be ratified.

There was an itch, however: Following its reunification, Germany was struggling with rather high inflation. The Bundesbank, loyal to its hawkish tradition, fought this with hefty interest rates increases.

Unfortunately in a fixed exchange rate system – the ERM can be seen as such – the burden of high interest rates is shared by all countries that are part of this system. To avoid this high burden of interest rates, the only alternative the other countries in the ERM had was to devaluate their currencies.

The Bundesbank was under a lot of political pressure, but it argued that a Deutschmark corroded by inflation would jeopardize the whole ERM by weakening its anchor. However, devaluing was also out of question for the other ERM members, not least because of national pride.

Investors were unconcerned about the last point and thought, rightfully in hindsight, that many of the ERM members struggling with recessions could not afford such high interest rates and would at some stage devalue. Hence they borrowed the supposedly weak currencies to buy the Deutschmark. After the Danish population rejected the ratification of the Maastricht Treaty in a June referendum, the currency speculation accelerated during the summer. Not only the ERM currencies were attacked but also the Swedish krona and the Finnish mark, which were closely tied to the Deutschmark.

Black Wednesday

On 13 September, the Italian lira was devaluated by 7% against the Deutschmark. This was not enough to stop the speculation, which then also attacked the British pound. At first the UK Treasury tried to defend the pound, but it had to surrender after having spent 27 billion pounds in currency reserves. On 16 September, called “Black Wednesday” by the British media, both the UK and Italy were forced to leave the ERM.

Documents from the UK Treasury made accessible in 2005 revealed that Black Wednesday had cost the British taxpayer 3.3 billion pounds in currency reserve losses, or roughly 0.5% of British 1992 GDP.

Attacks then intensified against the Spanish peseta and the Irish punt. The peseta was devaluated by 5% within the ERM, while the Irish tried to defend the punt with massive interest rate increases. Then it was France’s turn. The currency reserves of the Banque de France were depleted by over 34 billion US dollars during the defense of the French franc after Black Wednesday.

Relief finally came on Sunday, 20 September, when the French population accepted the ratification of the Maastricht Treaty in a referendum with the very narrow margin of 51%. With this uncertainty removed, the speculative attacks abated, but did not stop completely. The Spanish peseta and the Portuguese escudo were devalued within the ERM again in November 1992 and in May 1993.

The 1993 aftershock

The biggest aftershock of the ERM crisis started at the end of June 1993 and lasted through July 1993. It was triggered by the French Minister of Economy, Edmond Alphandéry, who openly criticized the Bundesbank’s interest rate policy in a radio interview. Speculation against the French franc resumed, but now also supposedly strong currencies like the Belgian franc and the Austrian shilling came under attack. However, lessons were learned from the 1992 crisis. Instead of trying to defend the pegs by any means and hence deplete the currency reserves of the central banks, the leaders of the remaining EMS countries decided to increase the fluctuation bands of the ERM to a whopping +/–15%. This stopped the speculation immediately.

Interestingly enough, with these extremely wide bands, the currencies still in the ERM didn’t experience much more fluctuation. The Italian lira was reintroduced to the ERM in November 1996, and by 1999 fulfilled the Maastricht criteria “of being part of the ERM for at least the last two years before adopting the euro and having not experienced a devaluation within those two years” like all the eleven other euro founding countries.

Some lessons from the EMS crisis

In hindsight, the EMS crisis of twenty years ago looks rather mild compared to the turmoil the Eurozone is currently facing. Realigning mispriced currencies in exchange rate mechanisms is far less difficult to do than deepening fiscal integration or breaking up a common currency, the two stable, long-term solutions to end the current crisis. However, there are some lessons to be learned.

First, we need to go back to the causes of the EMS crisis. Politicians quickly blame speculation as the main cause. But it is very likely that George Soros, the man who broke the Bank of England, and his colleagues would never have attacked the British pound and the Italian lira without reason. In 1992 both currencies were significantly overvalued against their fundamental value as measured with unit labor costs. The French franc, successfully defended in 1992 to avoid devaluation, was actually at its fair value against the Deutschmark at the beginning of the crisis.

If the lira and the franc still existed today, they would be overvalued by 20% against the Deutschmark according to unit labor costs. This is certainly one of the root causes of the current crisis of the euro.

A second lesson can be found in the attitude of the Bundesbank in 1992. While under hefty pressure to intervene or to lower its interest rates, it stood steady, to the extent that erstwhile President Helmut Schlesinger earned the nickname “spiked helmet” from his French counterparts. In 2008, with the release of thirty years of archives of the Bundesbank, it was revealed that in the wake of the creation of the EMS in 1978, the German Central Bank managed to negotiate a near secret clause with the German government before approving the EMS: it would only intervene to stabilize the external value of the Deutschmark, if such an intervention would not jeopardize its internal value. Or put differently, the goal of maintaining the ERM was subordinated to the goal of fighting inflation.

The latest power struggle between the European Central Bank and the Bundesbank regarding a new bond buying program shows a historically consistent pattern, spanning from the early days of the ERM until today.

A final lesson can be drawn by looking at the fate of the countries ousted from the ERM in the aftermath of the 1992 crisis. It is worth noticing that the UK economy outperformed both Germany and France from a growth perspective by an astonishing cumulated 12% during the five years following the 1992 crisis. This suggests that in the end it was beneficial for the UK to leave the ERM.

But the outperformance of Italy against Germany and France during the same period was almost negligible. This suggests that the UK experience is not a rule. This should curb the enthusiasm of those who in today’s crisis propagate the quick solution “such and such country should leave the euro.” The story is far more complicated.