What have we learned from the EMS crises?

NORTH- HOLLAND

What Have We Learned from the EMS Crises?

Peter B. Kenen, Princeton University

The present international monetary system is not optimal; it would be better to adopt a system of target zones for the currencies of the Group of Seven countries. But the world is not ready for reform. The economic obstacles can be adduced by examining the crises of the Bretton Woods system in 1971-73 and the crises of the European Monetary System in 1992-93. The EMS crises do not prove that exchange-rate targeting cannot succeed. They do prove that adjustability should not be sacrificed to credibility, that asymmetric systems are not always robust, and that we need more policy instruments to pursue more policy targets, such as exchange-rate stability.

1. INTRODUCTION

The crises of the European Monetary System (EMS) in September 1992 and July 1993 have been studied thoroughly by academics and officials. Most such studies, however, have focused on the implications,of the crises for the EMS itself and for European monetary union (EMU).I I focus here, by contrast, on the broader implications. What have we learned from the EMS crises about the viability of pegged exchange rates and the design of exchange-rate arrangements for the major industrial countries?

2. COMPARING TWO CRISES

Let me begin by comparing the EMS crises in 1992-93 with the crises of the Bretton Woods system in 1971-73. There is, of course, one big difference between them. In 1971-73, the key currency of the system came under attack, partly for reasons relating to the reserve-currency role of the dollar. In 1992-93, the key currency

Address correspondence to Prof. Peter B. Kenen, Department o f Economics, Princeton University, Princeton, NJ 08544.

Received December 1994; final draft accepted May 1995. ~On the crises themselves, see Eichengreen and Wyplosz (1993), Goldstein et al. (1993),

and International Monetary Fund (1993); on the implications for the EMS and monetary union, see Committee of Governors (1993) and Monetary Committee (1993), Eichengreen (1993), De Grauwe (1994), Thygesen (1994), and Kenen (1995).

Journal o f Policy Modeling 17(5):449-461 (1995) 0161-8938/95/$9.50 © Society for Policy Modeling, 1995 SSDI 0161-8938(95)00051-T

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of the EMS was not attacked; in fact, the crises involved speculation against most of the other EMS currencies. But there are striking similarities between the two episodes and lessons to be learned from them. 2

In both cases, the country at the center of the system experienced a large political shock, underestimated the fiscal implications, and declined to pay the political price of correcting its mistake. In the late 1960s, Lyndon Johnson had tried to finance the Vietnam War without raising taxes; he declined to sacrifice the Great Society to win congressional support for a tax increase. He was misled, moreover, by Pentagon forecasts that minimized the cost of the Vietnam buildup. In the early 1990s, Helmut Kohl tried to finance German unification without greatly raising taxes. And he was misled by optimistic forecasts about the speed at which East Germany could be transformed. The two fiscal-policy mistakes had different exchange-rate effects because of the different ways in which the two central banks responded. As the cost of the Vietnam War mounted, there was at first a tightening of monetary policy in the United States, which ran very large balance-of-payments surpluses in 1968- 69; but monetary policy was reversed thereafter, driving the balance of payments back into deficit. In Germany, the Bundesbank tight- ened monetary policy right after unification and did not cut its official interest rates until the eve of the 1992 EMS crisis.

In both cases, moreover, the game played between markets and governments had caused the exchange-rate regime to ossify, although the architects of both regimes had tried to combine short- term exchange-rate stability with longer-term flexibility. The quest for credibility, although differently framed in the two cases, led governments to deny the need for an exchange-rate realignment. At the start of the 1970s, it was the dollar price of gold that had to be defended in order to preserve American credibility. (But other countries, notably Britain, clung stubbornly to pegged exchange rates with the dollar in order to preserve their credibility.) At the start of the 1990s, it was the exchange rate between the deutsche mark and French franc that had to be defended in order to preserve French credibility.

The American defense of the gold price was motivated mainly by political concerns, notably concern about reneging on tacit commitments made to foreign governments that had, in turn, refrained

2The comparison that follows draws on Kenen (1995) but extends the analogy suggested there.

WHAT HAVE WE LEARNED FROM THE EMS CRISES? 451

from buying gold from the United States when they acquired dollars in the foreign-exchange market. The French defense of the deutsche mark-f ranc rate, by contrast, was motivated by economic concerns, primarily the belief that a monetary policy aimed at defending a pegged exchange rate is intrinsically more credible than a monetary policy aimed at some other intermediate target or a policy aimed directly at price stability itself.

For these and other reasons, it proved impossible for the center c o u n t r y - t h e United States in the one case and Germany in the o t h e r - t o arrange an orderly exchange-rate realignment, and both of them resorted to unneighborly tactics. The tactics were different, but the outcomes were similar. In 1971, Richard Nixon and John Connally acted provocatively by shutting the gold window and imposing an import tax. In 1992, Helmut Schlesinger and other Bundesbank officials acted subversively by expressing doubts about the outlook for certain EMS currencies and thus mobilizing market forces to put pressure on them.

Finally, there is a distressing similarity between the conclusions drawn by official bodies after the crises were over. In the wake of the 1971-73 crises, governments established the Committee of Twenty to design a system of"stable but adjustable" exchange rates. In the wake of the 1992-93 crises, the Monetary Committee and the Committee of Central Bank Governors issued reports that said that more "timely" exchange-rate realignments might ward off future crises.

The two EC reports were presumably influenced by the German view, reflected in all official accounts of the 1992 crisis, that the crisis was due to the weak competitive positions of countries such as Italy and Britain. But when you ask the authors of those reports whether their own currencies should have been devalued in, say, 1990 or 1991, they all answer no. The two reports, moreover, failed to explain how governments can contemplate more "timely" realignments without reinforcing the EMS against speculative attacks. More importantly, the two reports acknowledged that the 1992 crisis had exposed a gap in the defenses of the EMS.

The intervention rules and credit arrangements of the EMS had been designed to guarantee that the countries with weak and strong currencies would bear joint and symmetric responsibility for the defense of the system. Whenever a country's currency reached the edge of its band vis-a-vis one of its partners' currencies, the partner was supposed to intervene unstintingly to prevent the exchange rate from crossing the edge of the band (or lend the weak-currency

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country as much of the partner's currency as the weak-currency country needed to intervene on its own). 3 In effect, the EMS was designed to protect a weak-currency country from exhausting its reserves and being forced to devalue. In 1992, however, we became aware of a crucial qualification to the formal rules.

The Bundesbank has always been concerned about the risk of conflict between its mandate to maintain domestic price stability and the need to intervene on the foreign-exchange market to honor commitments made by the German government. It had faced one such conflict in the final days of the Bretton Woods system and resolved it by letting the deutsche mark float. When faced with the risk of future conflict under the EMS rules, the President of the Bundesbank, Otmar Emminger, sought and received assurances from the German government about the Bundesbank's obligations. In the event of any such conflict, the Bundesbank could call on the German government to initiate discussions aimed at achieving an exchange-rate realignment. Should that prove impossible, the government would then discharge the Bundesbank of its obligation to intervene on the foreign-exchange market?

This arrangement went largely unnoticed for many years, and the obligation to engage in open-ended intervention and short-term lending was commonly regarded as the unique feature of the EMS. s Even those who tell us now that the EMS rules were unrealistic did not say so before the 1992 crisis, which was in fact precipitated when the Bundesbank invoked the Emminger letter and asked the German government to negotiate a devaluation of the lira. 6

3 Under the 1987 Basle-Nyborg Agreement, moreover, a weak-currency country was enti- tled to expect that it could borrow from its partners for intramarginal intervention, not merely for mandatory intervention at the edge of the band, if it did not abuse the privilege. But it was expected to permit its currency to move freely through the band (i.e., to engage in less intramarginal intervention than had been the previous practice) and to rely more heavily on interest-rate changes for the defense of its currency.

4The Emminger letter is quoted by Eichengreen and Wyplosz (1993), who also quote a statement by the German Minister of Economics that the Bundesbank "has the option not to intervene if it is its opinion that it is not able to do so."

5In 1981, however, the German government (not the Bundesbank) threatened to halt intervention in support of the Belgian franc because the Belgian government was resisting a large devaluation; see Henning (1994). I was among those who attached great importance to the intervention rules of the EMS; see Kenen (1988). I acknowledged, however, that those rules could not be replicated at the global level, not even among the G-7 countries.

6The Bundesbank actually favored a wider exchange-rate realignment and was willing to calibrate its own interest-rate cut to the breadth of the realignment; see, e.g., Cameron (1994).

W H A T HAVE WE L E A R N E D FROM THE EMS CRISES? 453

The Monetary Committee and the Committee of Central Bank Governors did not mention the Emminger letter, but they came very close. Thus, the Governors warned that "there cannot be an automatic and mechanistic response to market tensions, involving symmetrical action on the part of the authorities of countries with weak and strong currencies." Voluntary action was possible, but it should not interfere with "control over domestic monetary conditions in the country issuing the intervention currency" and should be "consistent with the primary objective of achieving price stability in the Communi ty ."

3. LEARNING FROM THE CRISES

What can we learn from this long analogy between the crises of the early 1970s and those of the early 1990s? It teaches us several important lessons about the endogenous dynamics of pegged-rate regimes.

First, those regimes become asymmetric, even when they were supposed to be symmetric. We usually describe the Bretton Woods system as being dollar-based and have come to describe the EMS as being deutsche mark-based. The former w a s designed with the expectation that the United States would play a key role in the world economy. In fact, some features of the Bretton Woods system, including the scarce-currency clause, were meant to protect it against misbehavior by the U.S. economy. But the Articles of Agreement of the International Monetary Fund (IMF) did not clearly contemplate the emergence of a new gold exchange standard based on the dollar or the key currency role of the dollar in foreign- exchange markets. Those features of the system developed endoge- nously. Furthermore, the architects of the EMS had detested the asymmetric features of the Bretton Woods system and thus sought to build a more symmetric system for themselves; see Ludlow (1982) or Gros and Thygesen (1992). Models of the EMS as an asymmetric system, anchored on the Bundesbank's monetary policy, came along later, in the mid-1980s, after "credibility" and "precommit- ment" had invaded the economists' vocabulary. 7

7Giavazzi and Pagano (1988) are commonly cited as being the first to treat the EMS as a device for lending or exporting credibility from Germany to other EMS countries, but Fischer (1987) did so earlier.

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It is sometimes said that U.S. leadership of the Bretton Woods system was imposed by the unique economic and political conditions of the postwar period, whereas German leadership of the EMS was earned by the quality of German policy:

[T]he leadership issue arises in any monetary regime, because the overall stance of monetary policy has to be set by a policy centre. However, this kind of de facto asymmetry within a formally symmetric system, which does not determine a priori which country should be the anchor of the system, is very different from the structural asymmetry of for example the Bretton Woods system whose rules gave the leadership to a particular country indepen- dently of the quality of its policy. Moreover, it can be considered desirable that the operation of the system rewards performance by linking effective leadership to reputation (Commission, 1990, p. 195).

But American leadership was not built formally into the Bretton Woods system, any more than German leadership was built formally into the EMS.

More importantly, the crises of 1971-73 and 1992-93 demon- strate vividly the danger of relying on the leadership of a single country, even when the leader's policy preferences coincide very closely with those of its partners. In simple monetary models, a firm commitment to price stability is both necessary and sufficient for exchange-rate stability. Those simple models, however, neglect two possibilities: (1) exogenous shocks and policy mistakes, especially fiscal mistakes, which call for changes in real exchange rates, and (2) cyclical and other temporary shifts in aggregate demand or labor-market conditions that are not fully synchronized across countries and thus call for differentiated monetary policies.

Both sorts o f phenomena occurred in the early 1990s. German unification and the fiscal mistakes made in dealing with it required a real appreciation of the deutsche mark, and there were two ways of achieving it. But the Bundesbank sought to block one of them - an increase of German prices relative to other countries' p r i c e s - and Germany's EMS partners blocked the o t h e r - a realignment of nominal exchange rates. When inflation emerged in Germany, moreover, the second problem came to the fore. The Bundesbank had to raise German interest rates at a time when domestic conditions in most o f the other EMS countries called for interest-rate cuts. The cost of following the leader rose steeply and abruptly.

I have already mentioned another important lesson. Systems of pegged but adjustable exchange rates tend to ossify gradually because governments try to defend them by using words to combat


rumors. Those who view the world in game-theoretic terms may find merit in this method. It is, after all, a device for raising the political price of changing the exchange rate and thus reducing the probability that the rate will actually change. Too often, however, the effort is made when the price of no t changing the rate is already high or rising. Short of introducing capital punishment for failed finance ministers, it may then prove impossible to raise the political price of a devaluation by enough to ward off speculation. Over the long term, moreover, this strategy is bound to become very expensive. It can keep exchange rates from changing when changes are not needed. In the process, however, it keeps them from changing when they should be changed.

The growth of international capital mobility has raised the incen- tive for governments to play this game but has also reduced the chances of success. The effects of the increase in capital mobility are not always understood. Bankers and journalists are fond of comparing the huge daily turnover in foreign-exchange markets with the much smaller size of central-bank reserves. That comparison is nearly meaningless. The size of the turnover says little about the size of the net positions that market participants are willing to take when they expect an exchange-rate change. And though the net positions can themselves be very large, they do not tell the whole story.

Under the Bretton Woods system, when capital flows were rela- tively small, a country with a current-account deficit had usually to draw down its reserves, and a large loss of reserves was often the trigger for speculation against a currency. That indeed is how we modeled a balance-of-payments crisis; see, for example, Krugman (1979). Matters are different now. A current-account deficit is often financed by an ongoing capital inflow. At times, indeed, the deficit is the result of the inflow. In such cases, a mere reduction or cessa- tion of the inflow, rather than outright capital flight, can trigger a balance-of-payments crisis. Three consequences follow:

First, current-account adjustment has become more costly, because current-account deficits are bigger, relative to income or out- put. In 1964-67, the years just before (and including) the third devaluation of sterling under the Bretton Woods system, Britain's current-account deficit averaged one percent of GDP; in 1989-92, the years just before (and including) Britain's departure from the EMS, it averaged 2.3 percent of GDP.

Second, the sustainability of a country's external position and, therefore, its exchange rate has come to depend on all the conditions

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affecting investors' expectations, not just their views about the exchange rate itself. The Italian lira began to weaken in the summer of 1992 when foreign investors began to wonder whether Italy could deal with its fiscal problems. Italy's fiscal plight had not worsened appreciably, but its political situation had deteriorated sharply, s In a more recent case, the attack on the Mexican peso in December 1994 was not due to a sudden deterioration in economic conditions; foreign investors started to worry about the political stability of Mexico.

Third, the Italian experience of 1992 leads us to wonder whether economists promise too much when they claim that capital controls can prevent speculation against a currency. 9 The capital controls used by France and Italy in the early years of the EMS helped to keep those countries' residents from acquiring claims on foreigners. But they did not keep foreigners from acquiring claims on French and Italian residents. In other words, they restricted capital out- flows but did not restrict inflows. Therefore, the controls curtailed speculation against the franc and lira insofar as they kept French and Italian residents from swapping domestic for foreign assets or kept them from making loans to foreigners to finance an attack on the domestic currency. But they could not keep foreigners from liquidating long positions already built up in the domestic currency or, for that matter, deciding not to enlarge those positions and thus halting an ongoing capital inflow.

It is, I said, imprudent to rely on a single country and currency to anchor a pegged-rate system permanently. The policy appropriate to that single country's needs cannot be expected to meet its partners' needs forever. This warning by itself, however, does not dismiss the case for using a pegged exchange rate to reduce inflation. Something more must be said, because of the importance attached to the device, not just in the EMS countries but also in debates on stabilization in the former Soviet Union.

SThe French referendum on the Maastricht treaty also played a key role here. The risk that Italy would be excluded from EMU for falling to satisfy the fiscal requirements of the treaty was frequently cited in Italy as an urgent reason for deep cuts in Italy's budget deficit. Hence, forecasts that French voters would reject the treaty were readily translated into forecasts that Italy would fail to reduce its deficit. Rose and Svensson (1993) have shown that forward exchange rates for the lira did not begin to embody expectations of a devaluation until the publication of public-opinion polls showing that French voters might reject the treaty.

9See Eichengreen and Wyplosz (1993) and Eichengreen, Rose, and Wyplosz (1994).


It should by now be clear that exchange-rate pegging can merely reinforce the changes in monetary and fiscal policies usually required to reduce inflation. It cannot substitute for them. It cannot "coordinate" a change in expectations if there is no other reason for the change in expectations, and there can be no such reason if domestic policies are not adjusted decisively. Nor can it reduce the inflation rate directly, by anchoring the prices of imported goods, if the distributors of those goods can continue to raise their home- currency prices in line with the previous inflation rate, because the buyers of those goods expect inflation to continue. The distributors will earn larger profits and, therefore, attract competition, which will limit their price-raising power, but that cannot happen immedi- ately.

Finally, the use of an exchange-rate peg is a high-risk strategy. When a government ties down its exchange rate, it deprives itself of recourse to the most useful policy instrument for offsetting the effects of previous inflation and, more importantly, offsetting the additional increase in prices that often occurs before exchange-rate pegging can impart much credibility to monetary policy and thus help to stabilize the price level.

A government that uses exchange-rate pegging to "import" credibility must thus strive to "internalize" that credibility quickly. In- stead of bragging about its success in keeping the nominal exchange rate from changing, it must begin to brag about its success in keeping domestic inflation down. The French record on this score is strangely ambiguous. In 1990-92, the French opposed a realignment of EMS exchange rates because it might damage the credibility of French monetary policy. In 1993, however, they said that the franc was ready to become the anchor (or co-anchor) of the EMS because French inflation was lower than German inflation. Had they been more confident of their success in internalizing the "franc fort" policy, the French might have agreed to a realignment in 1991 or 1992, which might have prevented the 1992 crisis. Had they been less confident in 1993, at a time when markets were ready to challenge any intimation of self confidence, they might have avoided the attack on the franc that precipitated the 1993 crisis.

4. WHERE DO WE GO FROM HERE?

Economists rarely change their minds about the comparative merits of fixed and floating rates. But I have changed my mind. A few years ago, I wanted the G-7 countries to move from the

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Plaza and Louvre accords to a full-fledged target-zone system. My views were heavily influenced by the apparent success of the EMS in combining short-term stability with medium-term flexibility. I was, of course, concerned about the need for frequent realignments and the concomitant risk of speculative attacks. Therefore, I suggested that the G-7 target zone be wider than the one used by the EMS before 1993. I was also concerned about the need for large-scale intervention to defend the system, even with wide bands, which led me to propose that the G-7 countries adopt mutual credit arrangements more elastic than those of the Bretton Woods system, although less elastic than those of the EMS.I°

I still believe that large exchange-rate misalignments can be very costly, not only because of their adverse effects on the allocation and utilization of real resources, but also because they produce protectionist pressures. (That is why I was not surprised at the speed with which the U.S. Treasury came to the aid of the Mexican peso. NAFTA is not invulnerable.) Furthermore, I still believe that there will be too little coordination of macroeconomic policies among the major industrial countries unless they are committed to exchange-rate targets. 1~ But policy coordination is also a pre- requisite for exchange-rate stabilization at the G-7 level, because no single country, not Germany, Japan, or the United States, can serve by itself as an adequate anchor. The situation will get worse, moreover, if the European Union succeeds in forming a monetary union along lines defined by the Maastricht Treaty. It will be very hard for the EU countries to join with the other industrial countries in exchange-rate stabilization, and the European Central Bank is likely to be even more wary than the Bundesbank about making commitments that could force it to engage in large-scale intervention. 12

There is another problem. In a world of high capital mobility, official intervention by itself cannot stabilize exchange rates. It must be supported by monetary policy. Hence, countries that make exchange-rate commitments must have additional policy instruments available to manage their domestic economies. By implication, the

~°My proposals were set out in Kenen (1988) and were strongly influenced by the events of the early 1980s, especially the huge appreciation of the dollar. I was not alone; see, e.g., Krugman (1989).

i1 My views are developed fully in Kenen (1994a, 1994b); I draw on those papers in the paragraphs that follow.

12See Henning 0994) and Kenen 0995).


major industrial countries must improve their policy-making pro- cesses, as well as their actual policies, before they can pledge themselves to more intensive methods of exchange-rate management. To be specific, they must find ways to make their fiscal policies more flexible.

Let there be no mistake: Fiscal consolidation must come first, especially in the United States. No country can afford to pile cyclical deficits onto structural def ic i ts-and those will continue to grow, for demographic reasons, unless painful adjustments are made in the size and coverage of social-insurance programs. But consolidation must not be confused with rule-based rigidity. We must impart more flexibility to fiscal policies before we can prudently recom- mend that monetary policies by redeployed to achieve exchange- rate stability.

Where, then, do I wind up? The present regime is not op t ima l - far from it. But I am very pessimistic about the outlook for reform. In fact, I would counsel against any ambitious attempt at reform, because we are not ready. The EMS crises do not prove conclusively that exchange-rate targeting cannot succeed. They do prove, however, that adjustability must not be sacrificed to credibility, that asymmetric systems are not very robust, and that we must have more policy instruments to pursue more targets, such as exchange- rate stability.

Barry Eichengreen goes too far when he argues in his new book (Eichengreen, 1994) that governments must choose between full- fledged monetary unification on the one hand and loosely managed floating on the other. But we cannot hope to stand between them without making a stronger commitment to policy coordination among the major industrial countries. By the time we are ready for that, however, the relevant group of countries is likely to change. Brazil and China may be more important than Italy or Canada. Hence, policy coordination cannot be conducted by a self-selected group of countries. It must be orchestrated by the IMF. To that end, I have made some modest suggestions that would strengthen the role and influence of the IMF. Let me conclude by repeating them here:

1. Within the Fund itself, there must be close collaboration among the relevant area depar tments- those concerned with the major industrial count r ies -under the leadership of the research department. The research department, in turn, must be charged not merely with compiling the semiannual World

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Economic Outlook (WEO) but with tracking current develop- ments closely in the major countries and in foreign-exchange markets.

2. The Managing Director of the Fund must participate fully in the deliberations of the G-7 countries, which must be inte- grated fully with the Article IV consultations between the Fund and each G-7 government. Furthermore, the Managing Director should report to the Executive Board on the deliberations of the G-7 governments. It would be quite appropriate, moreover, for the Executive Board to ask that the Managing Director convey the Board's views to the G-7 governments.

3. The Fund should have its own Council of Economic Advisers. Its members should be appointed for fixed, nonrenewable terms, to protect their independence. It should advise the Managing Director and Executive Board on a continuing, confidential basis. It should also be responsible for preparing the WEO, and each issue of the WEO should begin with a new prescriptive chapter, in which the Council should make recommendations to individual governments, on its own responsibility. Finally, the chair of the council should serve ex officio as the Fund's Economic Counsellor and have broad responsibility for the work of the Fund's research department.

These are rather modest steps but are aimed at a larger, more distant objective: restoring the Fund to an influential role in managing economic relations among the major industrial countries and moving the world decisively, though gradually, toward greater exchange-rate stability.

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Commission of the European Communities (1990) One Market, One Money, European Economy 44.

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De Grauwe, P. (1994) Toward EMU Without the EMS, Economic Policy lS: 147-185. Eichengreen, B. (1993) The Crisis in the EMS and the Transition to EMU: An Interim

Assessment. In Economic Policy Issues in Financial Integration (S. Honkapohja, Ed.). Helsinki: Hakapaino Oy, pp. 15-72.

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Eichengreen, B. (1994)International Monetary Arrangements for the 21st Century. Wash- ington: The Brookings Institution.

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Fischer, S. (1987) British Monetary Policy. In The Performance of the British Economy (R. Dornbusch and R. Layard, Eds.). Oxford: Oxford University Press, pp. 6-28.

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Henning, C.R. (1994) Currencies and Politics in the United States, Germany, and Japan. Washington, DC: Institute for International Economics.

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Kenen, P.B. (1994a) Ways to Reform Exchange-Rate Arrangements. In Bretton Woods: Looking to the Future: Commission Report, Staff Review, and Background Papers. Washington, DC: Bretton Woods Commission, pp. C13-C20.

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Documents

What have we learned from the EMS crises?