Download Background of European Union

The European Currency Crisis
1992-1993
Cynthia Diaz
Hazel Gonzalez
Daniel Monge
Introduction of European Union

1970’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 System
/ Monetary stability

Exchange rate variability

EMS:

Floating the exchange rate.
1. European Currency Unit (ECU)
2. Exchange Rate Mechanism (ERM)
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 EMS
EstablishedCentral exchange rates for each currency
 Brought 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 Crisis

Reunification 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 Effects

Germany’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
Speculation

Analysts 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 Outcome

The 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 long

Investors 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=AHDsO7gvX
HQ&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 continued
to 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 Fall

Speculators 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 rate

A 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
