Making the eurozone fit for the challenges of the 1990s

British economist Jonathan Portes remembers the UK’s exit from the Exchange Rate Mechanism:

We argued that the fundamental problem was that we’d joined the ERM at the wrong rate; sterling was overvalued, meaning that we were stuck with a structural current account deficit. The only way to maintain the peg would be through what is now, in the eurozone context, referred to as “internal devaluation”; that is, real interest rates at a higher rate than dictated by internal conditions, and a long and grinding squeeze on wages and prices.

Our solution? We didn’t dare suggest complete abandonment of the ERM. One possibility was for sterling to “realign”, that is devalue, to a considerably lower rate, boosting exports and allowing interest rates to fall. Even better, politically and perhaps economically, would have been if the Germans could have been persuaded to realign upwards, so avoiding the perception that sterling was being singled out; but the French were resolutely opposed to any devaluation of the franc.

The fascinating thing here is, of course, that nothing has changed. In many ways, this is because the issues haven’t changed. Keynes said that the whole complex problem of European currencies and trade in the 1920s could be reduced to one question: how much of France’s war debts would be paid by workers and how much by savers, whether through taxation or through inflation. The answer would set the price level and hence the exchange rate, and how much of a trade surplus Germany could run, and therefore how much of Germany’s war debts could possibly be paid.

Similarly, in 1992 the questions was how the costs of German reunification would be split. Taxation was chosen over inflation, capital was privileged over income. Now, arguably, the question is how the cost of the Great Bubble will be split, and you guessed it. Portes is damning on the reasoning behind this:


The UK had long suffered from periodic cycles of boom and bust, most recently exemplified by the deep recession of the early 1980s and the unsustainable boom of the late 1980s. Monetarism – targeting various measures of the money supply – had failed miserably. The alternative was to “import” credibility from a country with a demonstrated record of maintaining low inflation while avoiding boom and bust – Germany, and we could do exactly that by tying our exchange rate and monetary policy to theirs…

But for me, the most important lesson was a more general one about “credibility”- a concept often used and abused by both politicians and economists. As with the ERM, the argument made by the current government and its supporters for sticking to its fiscal consolidation plan, despite its evident failure, is that the strategy has established “credibility”, especially with financial markets, which can only be preserved by sticking with it.

But of course this is not a justification, economic or otherwise, for the policy. Instead it is an argument for never changing policy at all…

The real hit to credibility comes from sticking to unsustainable policies; and economic success comes from abandoning them and doing something sensible instead. That is one lesson from Black Wednesday we could usefully remember.

Meanwhile, Migeru from the collectif antilibérale has an excellent column taking a sector-balance approach.

3 thoughts on “Making the eurozone fit for the challenges of the 1990s

  1. When a headline is about the euro, but the content of an article is about sterling and the ERM, one can be forgiven for wondering why.

    The first hint is the claim that Sterling entered the ERM “at the wrong rate”. In fact, it entered at the market rate, and at a reasonable cross-rate against the Dollar, but then in 1992 the discount rate in Germany rose from 3% to 8%, the DMark rose with it, and therefore the other currencies, including Sterling were dragged up with it, until the cross-rate against the Dollar became unsustainable. What had been the right rate for Sterling in the ERM *became* the wrong rate.

    And so Sterling crashed out of the ERM. Alone? No, in fact apart from the french Franc, every ERM currency either left the ERM or devaluaed within it, and the allowed exchange rate variations were widened to 15%, making the whole thing meaningless.

    So why the focus on Sterling alone? Simple really. If you recast the ERm crisis as a Sterling crisis, and Sterling alone, you can argue that ERM actually *worked* darn it, except for those pesky Brits and their darned Sterling.

    And why does a very partial and biased retelling of the story of 1992 get a headlilne referring to the euro? Same story. We’re in the midst of a Sterling crisis! If it weren’t for those Brits and their darned Sterling, the euro would be working just fine.

  2. Having read this blog for a long time i have always felt it was a little bit too biased to the pessimistic side regarding the future development of Euro periphery countries. Nevertheless it is always good to see the bad case for a certain situation being layed out thoughtfully and with detail. Clearly the situation in Europe is not rosy right now with unemployment at a record high and economies diverging more than ever. I m not sure though that it is really mostly the structural flaw of the Euro system that is the cause for the mess that currently can be seen. There is a relentless bashing of the Eurosystem in the Anglo-american blogosphere, academia, television and newspapers. Seeing CNN broadcasting several hours about hypothetical breakdown scenarios i cannot help to think that there is a political agenda behind this. Trust and confidence are crucial to a successful economic development and all this Euro-bashing is undermining just this. Supposedly “inefficient” bans on short-selling for European stocks have always been followed by big rises in stock prices which makes you wonder if there are some market participants trying to attack the Eurozone economy by pushing down crucial assets values that will be followed by forced selling of other securities by leveraged actors (banks). Having pushed down the prices to fire-sale level and forced enough banks to sell investors then slowly accumulate assets at bargain prices while maintaining a climate of depression. The American economy is strongly depended on the success of its financial sector which needs to generate currency gains that the diminished industry cannot deliver anymore. It can do this best in an environment of volatile and biased markets. The Eurozone as a whole has been a success in comparison to the US and Great Britain economies for the last 13 years. It is important to point that out sometimes. Why and how can be read here:http://makrointelligenz.blogspot.de/2012/11/is-euro-historic-mistake.html

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