Economics of the Forex - Essay Example

Economics of the Forex work Starting from the year 1979, the Exchange Rate Mechanism -- ERM of the European Monetary System -- EMS has played a vital role in developing the foundation of the Monetary policy strategies in Europe and it has been a very striving research in the international monetary and exchange rate cooperation of the post-Breton Woods times. There has been a radical change in the nature of ERM, which is from a very fixed exchange rate with a limited mobility of the international capital to the 'hard' exchange rate mechanism which was approved by the Basle-Nyborg agreement in 1987 (Financial Markets and European Monetary Cooperation: The Lessons of the 1992-1993 ERM Crisis) During the end of the 1980's the gratified performance of this 'hard' exchange rate mechanism earned the confidence and increased the general appeal of a more total transformation of the system which was expected to result in agreement and a happening of unification. However, during 1992 a downfall on the past achievements occurred and also undermined the process towards European Monetary Union. Thus an ERM crisis occurred between 1992 and 1993 are said to be the most historical events in the then monetary history of Europe. Thus their source, effects and inferences are one of the most important events in the current academic and political debates through out the world. (Financial Markets and European Monetary Cooperation: The Lessons of the 1992-1993 ERM Crisis) The European monetary system was formulated with two major components: namely the European Currency Unit and a fixed exchange rate system known as the Exchange Rate Mechanism. During this time only 11 countries out of 15 were under the exchange rate mechanism among the members of the European Union. There are three goals that are closely in association with the EMS. They are the increased importance of Europe in global economy, to remove all obstacles for free trade and capital across the European countries and finally to improve and increase the functioning of common agricultural policy. Thus the ERM was a way of following a managed float exchange rate system where the countries which are under the ERM can fluctuate on their rates. (Lecture 15: ERM Crisis of 1992) Many questions arose as to whether the 1992 Exchange Rate Mechanism crisis in UK occurred due to the European monetary system being predictable, or whether it was caused due to the rising of the international financial markets May be the answers for these questions are in relevance to debates about the international financial and economic policies through out the world. These answers could also reveal the overall economic policy and the exchange rate regimes and there role on the 1992 ERM crisis. Considering a bipolar array where the hard exchange regimes on one side which involved pegged exchange rates, currency boards, taking in of another country's currency are more demanding than the flexible rate regimes. Another major point is that there cannot be any regime that can predict and offer a complete solution to the financial and economic changes that the country will undergo. (Truman, 2002) The ERM crisis was the first of its kind in the current century in terms of both private and official monetary circulation both during the crisis and also before the crisis. It could also be said as the first kind of crisis that occurred in terms of market and financial securities, derivative instruments and the financial market dynamics in the wake of building up the crisis. In view of the ERM crisis the European exchange rate regimes continued strongly support the view of pegged exchange rate mechanism. During the crisis countries and its investors were bailed out with exceptional amounts of official financing. But after the crisis the European government followed a very stringer way of its official financial management in the years that followed. (Truman, 2002) There is always a tension that reflects in every ongoing debate on the relative roles of economic fundamentals and the behaviour of markets during such a crisis. There could not be a crisis predicted in the future as that of 1992-93. Thus were the interaction of economic and financial policies and exchange rate regimes during the crisis since the 16 September 1992, which was said to be the black Wednesday. The 1992 ERM crisis was not fully unanticipated; the US perspective of the crisis was an anticipated one. Its potential dangers were not taken into account seriously which was the case in most of times when such international financial occurs. (Truman, 2002) Membership of the European Exchange Rate Mechanism was the focus of the British government's economic policies during the beginning of 1990's. During the crisis there was an entire focus of the media and the other international financial markets on the exchange rate mechanism and the forced withdrawal from the ERM during September 1992. The thoughts on this issue focused on interrelated issues which are in terms of 'depoliticisation' of the crisis and the politics that probed into recession. The members of the exchange rate mechanism forced pressure on the employers to embark upon the workers and to attain a lower-level unit labour cost, on the midst of covering the consumer spending through high interest rates. (Bonefeld, 1996) As a consequence many employers and consumers found it as a very difficult task to maintain the regular flow of interest and could not pay the interests correctly and thus accumulating the debts. This resulted in the drastic bringing down of consumer credit on the wake of undermining credit-based property ownership. Another consequence of the ERM membership was that the government was made to stay off the results of being very severe and also forced to be off the international commitments. Thus the ERM membership moved the government from all political responsibilities on economic regulations. (Bonefeld, 1996) On looking on to the background of the ERM membership by 1985 where there was a great amount of pressure on the higher depreciation of sterling against dollar. Many advisers from the bank of England and other members in the cabinet saw the participation in the exchange rate mechanism as a means of enforcing and regaining a strong monetary policy. During the crisis when the causes were analysed it was seen that there was a faster growing gap between the weaker and lethargic industrial performance and the greater and swift expansion on a global scale. This gap indicated that there the increased gap between the monetary gain and the production, which could also be said as the gap between money and exploitaition, was becoming weaker and the consequences of which were a strong deep inflationary pressure and speculative runs on currency. (Bonefeld, 1996) The history of the pounds in the exchange rate mechanism from October 1990 to September 1992 was analysed and the sterling was pegged at a central rate of DM2.95 with a fluctuation rate of 6%. During the crisis period UK entered into a state of high inflation, increased balance of payment of debts which resulted in political uncertainty. Therefore at this time the membership in the ERM was found to be a counter-inflationary catch point which would impose a financial discipline on the social and economic relations from outside the government which made them achieve what the government had failed to perform inside the regime. There was a short period between 1990 and 1992 when the membership was visualized in protecting the pound against attacks, reduced inflation, depoliticising economic policy and an improvement in the economic adjustments. The life expectancy of a fixed rate regime could be followed by many policy measures. (Bonefeld, 1996) The 1992 ERM crisis left a list of questions as to whether the crisis was being predictable, whether the basics of the economic policies were being partly or wholly or not at the primary reason for the start of the crisis (Ozkan; Sutherland, 1995) After the crisis, it could be witnessed that the exchange rate mechanism has a very important part to decide about the vital British economic policy. This brought about the conditions of a stable flexible as well as low inflation economy. After the prevalence of the crisis, Britain was going on an in an indefinite way of the economy. But now the way of the economic policy which was being followed by UK makes the world to return and also to initiate to follow the economic policies. Now it is said by the several policy makers that the economy is being increasing at levels more than what was being expected on those nations which had a membership in the exchange rate mechanism. (Naughton, 2005) Following the crisis the exchange rate mechanism has a vital role in determining the British economic policy. This resulted in a stable flexible and low inflation economy. After the occurrence of the crisis Britain was going to an indefinite way of economy. But now the way of the economic policy followed by UK makes the world turn back and even to start following their policies. Now it is said by numerous number of policy makers that the economy is growing more than what was expected from the exchange rate mechanism. There was a great cost spent on the cause of the Black Wednesday the 16 September 1992, which forced pound to be removed from the exchange rate mechanism. On this day the England government spent 28 billion dollars to retain the sterling's in the exchange rate mechanism. But the efforts failed and sterling's were forced out of the exchange rate mechanism which resulted in floating rates and also was a stepping stone to the upliftment of the British governments economy and its economic competitiveness (Naughton, 2005) At this juncture the government as well as the monetary authorities embarked on a new policy framework which was by way of inflation and an interaction between the treasury as well as the bank of England. (Adam; Cobham; Girardin, 2001) This method of bringing out a new strategic policy was able to withstand the pressures for some time within England. But well after the crises the then government took new steps. These steps which were taken wherein the interest rates were not enhanced and a new government which came into authority after the elections brought about some small, yet important inflationary reflections. Britain joined the Exchange Rate Mechanism in the year 1990 whereby pegging sterling to European currencies, but it had to crash out in the next few years. During the year 1992 which was a witness to the formation of the exchange rate mechanism crisis, the euro was being forced into this ERM wherein both the exchange rate policy as well as the interest rate policies was made as the two sides of the same coin. One could not be altered without the due consideration of the other, that is the exchange rate policy and the interest rate policies were two types which were being dependent on one another. That is the interest rates could not be altered without involving the exchange rate regime. The central governmental goal was to avoid the probing of the interest rates into that of the exchange rate regime. The most basic problems during the period of 1992 crisis were being based on the various diverse needs of the UK economies. After that the UK government was being able to recover after minimizing the high interest rates and bettering the economic policies after the period of the exchange rate mechanism crisis. It was early before the initiation of the crisis the thoughts on the partial removal of the ERM had being started. Thus the incident that shook UK's economy on 16 September 1992, was called the Black Wednesday, in which is the exchange rate mechanism crisis throws an explicit impact on the whole of Europe and other nations. All the eyes of the policy makers and other participants of the market are still on to the crisis which made a way towards altering their economic policies. (Black Wednesday - The Controversy Continues) REFERENCES Adam, Christopher; Cobham, David; Girardin, Eric. (July 2001) "External Influences and institutional constraints on UK monetary policy, 1985-2000" No.0116 Discussion Papers Series. Department of Economics: St. Salvator's College. Bonefeld, Werner et al. (Autumn 1996) "Britain and the politics of the European exchange rate mechanism 1990-1992" Capital & Class. Vol: 60; No: 5; p. 38. Retrieved from http://libcom.org/library/britain-european-exchange-rate-mechanism Buiter, Willem H. Financial Markets and European Monetary Cooperation: The Lessons of the 1992-1993 Exchange Rate Mechanism Crisis (Japan-US Center Sanwa Monographs on International Financial Markets. Retrieved from http://www.amazon.com/gp/reader/0521794404/ref=sib_dp_top_ex/002-5013220-1253603%5Fencoding=UTF8&p=S00G#reader-page Accessed 15 March, 2006 Davis, Evan. "Lessons Learned on Black Wednesday" Retrieved from http://http://news.bbc.co.uk/1/hi/business/2259648.stm Accessed 15 March, 2006 Gordon, Robert J. (February, 1999) "The Aftermath of the 1992 ERM Breakup: Was There a Macroeconomic Free Lunch" NBER Working Paper No. 6964. Retrieved from http://papers.nber.org/papers/w6964.pdf Accessed 15 March, 2006 Lamont, Norman. "Black Wednesday the controversy continues" Retrieved from http://www.centralbanking.co.uk/pdfs/cbx4lamont.pdf#search='the%20black%20wednesday1992%20ERM%20crisisUK' Accessed 15 March, 2006 Naughton, Phillippe. (9 February, 2005) "Black Wednesday cost UK 3.3 billion, documents show" Retrieved from http://www.timesonline.co.uk/article/0,,2-1477089,00.html Accessed 15 March, 2006 Ozkan, Gulcin, F; Sutherland, Alan. (March, 1995) "Policy Measures to Avoid a Currency Crisis" Economic Journal. Vol: 105; No: 429; pp. 510-519. Paul Soderline. "Market Expectations in the UK Before and After the ERM Crisis" http://ideas.repec.org/p/hhs/hastef/0210.html Accessed 15 March, 2006 Truman, Edwin M. (September 16, 2002) "Economic Policy and Exchange Rate Regimes: What Have We Learned in The Ten Years Since Black Wednesday" Speech at the European Monetary Symposium: London School of Economics. London, England. Retrieved from http://www.iie.com/publications/papers/paper.cfmResearchID=477 Accessed 15 March, 2006 Weerapana, Akila. "The ERM Crisis of 1992, Overview, Lecture 15. Spring Semester '03-'04" Retrieved from http://www.wellesley.edu/Economics/weerapana/econ213/econ213pdf/lect213-15.pdf Accessed 15 March, 2006 Read More