Transcript Chapter 15: Financial Markets and Expectations

Special Topics in Economics
Econ. 491
Chapter 6:
Black Wednesday ( UK and
EMU)
I. Background
 Central exchange rates for each currency against the ECU were
established, allowing a fluctuation band of 2.25% for most
currencies against the central rate.
 Member countries are required to intervene to make sure that
their currencies stayed within the prescribed band.
 Since the ECU was an artificial accounting unit, the system
effectively turned into a system where the bands were
maintained with respect to the most stable currency of the
group, which was the ‘German Mark’.
 The Deutsche Mark (DM) became the unofficial reserve
currency, so the ERM had a built-in lending mechanism to
prevent crises from happening.
 The German Central Bank (Bundesbank) is supposed to lend
DM to the member country if the country needed support for its
currency.
II. Germany’s Role
 Germany becomes free to set monetary policy for itself while
the other countries have reduced control over monetary policy
since they have to hold reserves and intervene when the
exchange rate got too close to the edge of the band.
 It was believed that other Central Banks were not very good at
keeping inflation under control, which is why they chose
Germany because they have made explicit mandates to root out
inflation as its primary goal after the World Wars.
 This allowed people to make long-term decisions with more
certainty because the member countries fix their exchange
rates to the DM, which allows the Bundesbank to dictate the
monetary policy decisions.
The Reunification of East and West Germany:
 The catalyst for the ERM crisis was the reunification of
Germany in 1990 because the event was unprecedented in
history for the merging of a large and rich economy with a
smaller economy with a much lower standard of living.
 In order to make the assimilation work, the West German
government spend an enormous amount of money.
 Almost half of all West German savings were transferred to the
East and the government budget deficit rose from 5% to
13.2%.
Germany’s Accelerated Effects:
 By 1991, the Bundesbank was becoming very nervous about
the prospects of high inflation in Germany and started pursuing
contractionary monetary policy very seriously.
 The combination of expansionary fiscal and contractionary
monetary policy caused German interest rates to rise
dramatically.
 The average rate of short-term interest climbing from 7.1 % in
1989 to 8.5 % in 1990, to 9.2 % in 1991, and to 9.5 % in 1992.
 The high interest rates of Germany made the situation for
Britain, France, Italy, and other European countries worse
because they were restrained from taking corrective monetary
policy actions.
Initial Speculations
 As the other European economies continued to deteriorate and
struggle, there was increasing pressures for the politicians in
the elections for Britain, France, and Italy to offer some policy
solution.
 As a result, some analysts speculated that these countries might
soon give up their support for the exchange rate peg against the
German Mark.
 A currency devaluation would help the devaluing country
boost exports, and allow the country to regain the flexibility it
needed to stimulate its economy through interest rate cuts.
III. Black Wednesday & Speculative Attacks
 “Black Wednesday” refers to the events on September 16,
1992.
 Due to major speculations and a weakening currency, the UK’s
prime minister and cabinet members tried all day to prop up
the sinking pound and avoid withdrawal from the ERM.
 The British government raised the base interest rate from a
high 10% to 12% in order to tempt speculators to buy pounds.
 During that same day, it promised to re-raise the interest rates
to 15%, but investors kept selling the pounds.
 Even with the spending of billions of pounds to buy up the
sterling being frantically sold on the currency markets, Britain
was eventually forced to withdraw from the ERM because they
were unable to keep the sterling above its agreed lower limit.
Effect of Black Wednesday
 The UK Treasury spent approximately ₤27 billion of reserves
in trying to defend the pound by selling Deutsche Mark and
buying pounds.
 The market knew that the UK could not afford to keep interest
rates high for long.
 The UK was not prepared to lose all of its currency reserves to
simply stay in a seriously flawed ERM.
 One of the most high profile currency market investors,
George Sorros, made over $1 billion in profit by betting
against the pound.
Speculative Attacks Continue
 A similar situation took place with Italy, and eventually Italy
pulled the Italian Lira out of the European ERM.
 The next major target for speculative attacks was the French
Franc.
 Elections for France were coming soon, and political pressure
were mounting for a cut in the French interest rates.
 As with the other currencies, speculators were betting that
France would devaluate the franc or withdraw from the ERM
rather than maintain a high interest rate with slow growth and
rising unemployment.
 As the Franc came under speculative attack, the central banks
of France and Germany intervened aggressively to hold their
exchange rate link by buying Francs and selling Marks.
 Bank of France raised interest rates to defend the Franc, and
both France’s and Germany’s central bank continued to
intervene directly to support the Franc.
IV. Is the UK ready to enter the Eurozone?
 UK satisfies most convergence criteria
 Two economic sources of UK hesitation to join:
a) There is evidence that UK may not form an optimal
currency union with the rest of the EU
b) The pound may be overvalued relative to the Euro
Thus, if the UK enters the Eurozone at too high an
exchange rate it might be saddled with low
competitiveness for years to come, putting downward
pressure on economic growth in the UK
Figure : Euro–pound exchange rate
(1999–2011)