The 1992 European Exchange Rate Mechanism Crisis - Case Study Example

Economics of the FOREX work: Introduction: The exchange rate regime led to the 1992 crises in the UK, the European exchange rate mechanism (ERM) was formed in 1979, it was introduced to reduce exchange rate variations and for the purpose of maintaining monetary stability in Europe, it was also intended to stimulate trade and investment among member countries. The UK entered the European rate mechanism in 1990 but was forced to exit on September 1992 after a crisis which was dubbed black Wednesday, according to the UK treasury the amount lost on that day was approximately 3.4 billion pounds.1 When the European exchange rate mechanism was formed the UK declined to join, the UK policy makers however admired the low inflation rates of Germany, therefore the UK treasury used to survey the German mark in their policy making concerning interest rates and liquidity levels and this was used as a basis of UK government policy making. The European exchange rate mechanism was a system intended to maintain fixed but adjustable exchange rates, this mechanism was also seen as a way that would stimulate trade and investment among member countries, countries prone to inflation considered the fixed exchange rates as a way forward to maintain price stability in their own countries. The European exchange rate mechanism members were to maintain a 2.25% fluctuation with reference to the central rates, however when the UK joined it was allowed a 6% fluctuation, the European exchange rate mechanism was not a fixed exchange rate system but an adjustable peg system and the exchange rates were determined by the European exchange rate mechanism through negotiations between the participating countries.2 The 1992 European exchange rate mechanism crisis: On 16th September 1992 the government announced a rise in the base interest rate from 10% to 12%, the reason for the rise was to tempt speculators to buy the pound, however speculators declined and instead sold the pound despite the UK government promise to raising the interest rates again, as a result of this there was a great loss of wealth by the government to the dealers and investment banks, the UK went to a recession and there was a market crash. On that same day the UK government announced that it had exited the European exchange rate mechanism and that interest rates would remain unchanged at 12%, Italy was also affected by the crises on that same day and exited from the European exchange rate mechanism although it rejoined the union some years later.3 The UK crises can be linked to the failure of the regime to establish a crisis prevention and management mechanism within the union, if there existed a crisis management mechanism within the union it would have prevented the occurrence of the financial loss by the UK. In the ERM the currencies were floated and the exchange rate was determined by the market, the market forces dictate that if a currency is highly demanded then the currency will revalue and on the other hand if a currency is less demanded the currency will devalue. The crises in the UK can be linked to this market forces that determine the exchange rate of a currency, the government strategy at the time was to create demand for the pound by raising interest rates but this turned fruitless because speculators and investment banks were already aware of the strategy behind such a decision, speculators and investment banks therefore sold the pound to hold other currencies and this led to crisis in the UK which saw the devaluation of the pound. An expansionary monetary policy by a member of the European exchange rate would result into low interest rates among the other member countries, this would lead to the appreciation of all the other currencies, therefore there was a need to coordinate the policies among the member countries of the European exchange rate mechanism, the optimal coordination response to an aggregate demand shock by a member country was a set of small devaluations by the other countries, however this was not the case in this regime due to less commitment by member countries. When countries commitment to the system weakened and countries were more concerned with policies that would maintain economic stability in their own country, speculators and investment banks got a clear indication of the weakening coordination of policies in the European exchange rate mechanism, this was evident in that some countries would devalue their currency while others would not, the market therefore got a clear understanding of strategies by individual countries and this resulted to recurring speculative attacks which led to great financial losses. The 1992 crises can also be attributed the pressure from Germany, at the time of the crises Germany was faced with fiscal deficits and as a result the interest rates went up, this forced the member countries to increase their interest rates, at this time the UK was recovering from a recession and it was reluctant to raise interest rates because the economy at the time required low interest rate to recover, this therefore led to doubt about the level of commitment among member countries which led to great speculative attack by investment banks and speculators. 4 Speculative attacks also increased after the signing of the treaty of Maastricht which saw the emergence of single currency the euro in 1999, this treaty created joint monetary and foreign policies among the member countries, this caused major conflicts among member countries where the UK and Denmark were notably reluctant to participate in some of the unification process.5 Policies by individual countries sometime were not in line with the required of the union, in a case where a country would be in depression and the union required member countries to raise their interest rate; this led to conflict among member countries due to conflicts on policy requirements for the economy and those requirements by the union. Countries were more concerned with their economic stability and not the stability of the other countries, this led to more and more conflict within the European exchange rate mechanism. Speculators and investment banks would gain from such crises within the European exchange rate mechanism because they were aware of the weakening commitments by member countries, speculators were also aware of the individual strategies put in place by each country and this increased the occurrence of speculative attacks.6 Despite the loss of funds in the UK on black Wednesday people now refer it as the white Wednesday, the reason for this is because interest rates from that day interest rates and policies were to be determined within the country without external pressure and the government adopted institutional changes that strengthened economic stability of UK. The Mundell Flemings model can also describe what happened during the crises, this model is based on the IS - LM model which describes the effects of increase or decrease in money supply, interest rates and government expenditure. In the case where there is an increase in local interest rates of one country the IS curve will shift to the left appreciating the local currency, however this did not happen in the case of the UK because the speculators were well aware of the reason why UK had raised its interest rates. We can conclude that the 1992 crises in the UK was as result of increased conflicts and lack of commitment among members of the European exchange rate mechanism this led to frequent speculative attacks where the speculators and investment banks were aware of the strategies of individual central banks this as a result led to great financial losses. The European exchange rate mechanism was initially formed to stimulate trade and investment among member countries of the union; it was also to be used as a tool that would help maintain a stable exchange rate among the currencies of member countries where countries were allowed a 2.25% fluctuation margin although some currencies were allowed a 6% fluctuation. However even after the great loss black Wednesday is termed as white Wednesday because it led to institutional changes and better policies by the UK government that has led to a stable and appreciation of the pound against all the euro zone currencies, interest rates and government policies were determined through market forces and were no longer influenced by external forces, this has led to a stable economy in the UK. In 1999 however the European exchange rate mechanism was replaced by European exchange rate mechanism 2, the new mechanism seem to be better than the original mechanism in that in this system currencies were allowed to float under a margin of 15% against the euro, this system is also better than the original European exchange rate mechanism in that it uses the euro as the central unit of determining exchange rates. The European exchange regime would have been beneficial to member countries only that there was an increase in the level of conflict and decrease in coordination of policies among its members, the regime led to great losses but was also beneficial in that it stimulated trade and investment among the member countries. References: Daniel G. and Neil T. (1992) European Monetary Integration, From the European Monetary System to European Monetary Union, Longman publishers, UK Matthew B. and D. Henderson (1991) Monetary Policy in Interdependent Economy, MIT press, UK Peterson Institute for International Economics (2007) Economic Policy and Exchange Rate Regimes: What Have We Learned in the Ten Years since Black Wednesday, retrieved on 21st February, available at www.petersoninstitute.com Wikipedia the Free Encyclopaedia (2006) The Mundell Fleming Model, retrieved on 6th April, available at http://en.wikipedia.org/wiki/Mundell-Fleming_model Willem H. Corset G. and Paolo A. (1996) Financial Markets and International Monetary Cooperation: the Lessons from the 92 European exchange rate mechanism Crises, Cambridge University press, UK Willem H. and Richard M. (1985) International Economic Policy Coordination, Cambridge University press, UK Read More