The European Currency Crisis

1992-1993Cynthia Diaz

Hazel GonzalezDaniel Monge

Introduction of European UnionIntroduction of European Union1970’s, Collapse of the Bretton Woods System

The European Economic Community (EEC)(Germany, Italy, France Netherlands,Belgium and Luxembourg)

European Union Added Portugal, Denmark, Spain, U.K., Finland Greece, Austria, Sweden, and Ireland,.

30 yr Transition : European Monetary System (EMS).

European Monetary SystemEuropean Monetary System

Exchange rate variability / Monetary stability

EMS: 1. European Currency Unit (ECU) 2. Exchange Rate Mechanism (ERM)

Floating the exchange rate.

What is the purpose for EMS?What is the purpose for EMS?Europe in the global economy.

Create Europe Bond

Common Agricultural Policy (CAP).

To control fluctuations of the currency and improve coordination of monetary policy decisions among countries apart of the union.

Effect of the EMSEffect of the EMSEstablishedCentral exchange rates for each currencyBrought responsibility of countries in the EU to stay with band rates.Stable currency of the group ‘German Mark’Unofficial reserve currency: The Deutsche Mark (DM)German Central Bank (Bundesbank)

Factors Behind the Crisis• Deutsche Mark became the anchor in the European

Monetary System (EMS) • Due to Germany's strong economy after the split of

East and West Germany• Deutsche Bundesbank had low inflation

Germany Gained Economic Strength ◦ Became free to set monetary policy for itself

Other countries had reduced control due to reserves needed to adjust to the edge band of the mark.

The CrisisReunification of Germany (East & West)

◦ Merged large rich economy of the West with poor smaller economy of East

West Germany transferred savings to the East ◦ Caused the government budget deficit to rise from 5%

to 13.2%

Government increased money supply and initiated many development projects to gain economic growth◦ German interest rates rose about 3% in 1991 and 1992

to try to ease inflation

Germany’s EffectsGermany’s high interest rates made European

countries worse◦ Britain, France, Italy and other countries were

restrained from taking corrective monetary policy actions.

Britain, France, & Italy economies suffered such high deficits that they were forced to adopt a low interest rate policy◦currency devaluation would help the devaluing

country by boosting exports, and allowing the country to regain the flexibility it needed to stimulate its economy through interest rate cuts

SpeculationAnalysts speculated that these countries might soon

give up their support for the ERM

Due to speculations and a weakening currency◦ September 16, 1992 : Black Wednesday

◦ UK’s prime minister and cabinet members tried all day to boost up the sinking pound and avoid withdrawal from the ERM

Black Wednesday OutcomeThe British government raised the interest rate

from 10% to 12% to try to get speculators to buy pounds ◦ Market knew that the government could not afford to

keep interest rates high for longInvestors kept selling the pounds and eventually

Britain was forced to withdraw from ERM

Britain Treasury spent approximately ₤27 billion of reserves in trying to defend the pound by selling Deutsche Mark and buying pounds.

http://www.youtube.com/watch?v=AHDsO7gvXHQ&playnext=1&list=PLCDCB8FC42E6B0E3E

Speculative Attacks Continue Speculative assaults

◦ helped traders make billions at the expense of European central banks

◦ caused Spain and Portugal devalue their currencies against the German Mark.

French Franc was a major target because they had high interest rate, slow growth, & rising

unemployment◦ political pressure before elections demanded a cut in

the French interest rates◦ speculators betted that France would devalue the franc

or withdraw from the ERM

The Fall of the French Franc (₣)Speculative attack against the Franc

◦ made the central banks of France and Germany intervened aggressively

◦ central banks tried to hold their exchange rate◦ central banks kept buying Francs and selling

Marks.

The countries succeeded momentarily but France’s foreign currency reserves were nearly depleted

The Fall of the French Franc (₣)Continued Speculative attacks continued to hit the Franc

◦ speculators knew France needed lower interest rates to help stimulate the economy and reduce unemployment.

France’s and Germany’s central bank continuedto intervene directly to support the Franc

◦ Interest rates were raised to defend the Franc

Germany and France gave up defending the exchange rate link.

After the FallSpeculators won

◦ They secured huge profits by buying back the devalued Franc

The EU finance ministers and central bankers◦ allowed the widening of the currency trading bands

to fluctuate within 15% around a central rateA total of about 60 billion Mark ($35 billion)

was spent by the German trying to prop up the French currency

Maastricht Treaty Signed on February 7, 1992 in Maastricht, Netherlands Set the convergence criteria for a country to qualify for

participation in EMU◦ Inflation within 1.5% of the best three of the European Union

for at least a year◦ Long-term interest rates must not be more than 2% points

higher than the lowest inflation member states◦ Being in the narrow band of the ERM ‘without tension’ and

without initiating a depreciation, for at least two years◦ Government deficit to GDP must not be more than 3% and a

government debt/GDP ratio of no more than 60% The treaty entered into force on November 1, 1993.

European Monetary Institute Established as the forerunner of the European Central Bank

◦ intended to strengthen monetary cooperation between the member states and their national banks

◦ supervise ECU banknotes. European Council

◦ adopts the Stability and Growth pact to ensure budgetary discipline◦ establishes a new Exchange Rate Mechanism (ERM II) to provide

stability with the Euro and other national currencies. European Central Bank (ECB) is created Conversion rates between the 11 participating national

currencies and the euro are established