Political Economy of the ERM Crisis

The Delors Report, written in 1989 (Committee for the Study of Economic and Monetary Union 1989), proposed a three- step process in moving toward a European monetary union. The first stage was undertaken in July 1990, and was to be implemented gradually. However, due to revolutions in Eastern Europe and the fall of the Berlin Wall, Germany’s Chancellor Helmut Kohl identified German reunification as part of a greater European union (Sevilla 1995). French President Francois Mitterand pushed forward the concept of a European monetary union, visiting 11 European capitals to discuss the issue. By the end of 1990, Germany was reunited and revisions to the original European Community treaty were under way.

The details of the Delors Report garnered some criticism, particularly for Stage II, which required there to be some transfer of monetary authority to a central institution. France and Italy wanted to move toward monetary convergence rapidly, and supported the proposition that a European Central Bank be set up in Stage II. Germany and the Netherlands emphasized the necessity of nominal and real convergence before making the transition to a monetary union. Britain also wished to draw out the first stage before committing to a deeper integration. The Maastricht Treaty was a compromise plan drawn up by French President Mitterand and Italian Prime Minister Giulio Andreotti, which proposed that the EMU would become obligatory in 1999 for all European Community countries that fulfilled the following conditions, put forth in a proposal drawn up by the Netherlands:

  • 1. Implementation of strong price stability measured with respect to the average inflation rate, over a period of one year prior to the examination.
  • 2. Maintenance of government debt at less than 60 percent of gross domestic product (GDP) and a budget deficit less than 3 percent of GDP.
  • 3. Adherence of the exchange rate to within the narrow ERM margins, with no devaluations for at least two years before the examination.
  • 4. Adherence to interest rates of no more than 2 percent higher than the three members with the lowest inflation, for one year prior to the examination (European Council and European Commission 1992).

President Mitterand was committed to maintaining the value of the franc under the “franc fort” policy, and this meant that he was required to impose economic austerity and market liberalization. Voter satisfaction dwindled by 1992, as slow economic growth and high unemployment resulted from the franc fort policies. The public endured an increase in short-term interest rates to 13 percent on September 23, 1992 to defend the franc (Sevilla 1995).

In the UK, Prime Minister Margaret Thatcher was a proponent of the Single European Act for the promotion of free markets, but not of ERM requirements of complex managed exchange rates. Chancellor of the Exchequer Nigel Lawson ordered the Treasury and the Bank of England to informally link the pound to the Deutschemark. Over time, Prime Minister Thatcher was pressured into joining the ERM during the first stage of implementation. Thatcher’s reluctance to join the ERM rendered the British commitment to the pact questionable and subject to speculation. Prime Minister John Major, Thatcher’s successor, viewed a single European currency as a long-term objective. Major lacked a domestic coalition that supported sterling’s position, since economic conditions were poor. Eventually, Britain could not defend its commitment to the ERM, and the pound was forced to withdraw from the ERM in September 1992.

September 1992 resulted in a number of troubles. European Ministers of Finance and central bank Governors failed to come to an agreement on realignment at a meeting in Bath (Sevilla 1995). Finland abandoned its peg to the ECU. The lira devalued by 7 percent, only to face further downward pressure and then be withdrawn from the ERM. The only highlight of the month was a successful defense of the franc by the Bundesbank and Banque de France. The former spent 160 billion francs to defend the currency, while the latter committed between 10 and 30 billion Marks. Ultimately, it was only the franc that was successfully defended against speculation. The crisis was finally resolved in 1993 with adherence to a softer peg, and commitment to the monetary union continued. We now turn to the crises in the Nordic countries of Norway, Sweden, and Finland.

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