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A Study of European Monetary System; Events and the Crisis Leading to formation of Euro ―€‖
Europe –till 1999
Indian and Global Economy
Harsh Doshi (32119) Alok Rajan (32134)
Nikita Tekriwal (32145)
Mansoor Khan (32172)
Arun Menon (32175)
Abhishek Jain (32167)
Amit Tarnekar (32198)
Vezoto Theluo (32300)
Table of Contents
I. II. III. IV. V. VI. VII. Table of Contents .................................................................................................................................... 1
EUROPEAN HISTORY .......................................................................................................................... 2
Bretton Wood System ........................................................................................................................... 4 The Snake in the Tunnel ...................................................................................................................... 14 Oil Shocks of 1973 and 1979............................................................................................................... 19 Formation of EMS/EMU/EU............................................................................................................. 23 The fall of Berlin Wall and ERM Collapse .................................................................................... 28
VIII. The fall of the Central Bank of England ......................................................................................... 30 IX.. X. Crisis in Finland and Sweden ............................................................................................................ 32 Timeline Summary............................................................................................................................... 37
EUROPEAN HISTORY (1957-1999)
TREATIES OF ROME The Treaties of Rome are the two treaties signed on 25 March 1957 by Belgium, France, Italy, Luxemburg, Netherlands and West Germany. First treaty - established European Atomic Energy Community (EAEC) Second treaty - established European Economic Community (EEC)
Treaty of Paris 1951 Created European Coal and Steel Community (ECSC) Designed to help the economy of Europe and prevent future wars by integrating the members
Merger Treaty 1967 Combined the EAEC and ECSC into EEC
Enlargement and Elections 1960s saw first attempts at enlargement. Denmark, Ireland, Norway, and UK applied to join the three communities. However UK application was seen as a Trojan horse for US influence and applications of all the countries were cancelled. In 1967 the countries were granted membership when Georges Pompidou succeeded Charles de Gaulle A parliament was constituted for the EEC and proposed a flag Greece, Portugal and Spain joined EEC in the 1980s
Aims and Achievements of EEC To preserve peace and liberty and to lay the foundations of an ever closer union among the peoples of Europe The establishment of a customs union with a common external tariff Common policies for agriculture, transport and trade Enlargement of the EEC to the rest of Europe
The treaty provided for a 10% reduction in custom duties and up to 20% of global import quotas.
Belgium Ireland Portugal
Denmark Norway Spain
West Germany Luxemburg
EEC evolved to the formation of European Union in 1993.
as well as its subsequent development and ultimate demise. were directly dependent on the preferences and policies of its most powerful member.Bretton Woods System The Bretton Woods system is commonly understood to refer to the international monetary regime that prevailed from the end of World War II until the early 1970s. and procedures to regulate the international monetary system. Setting up a system of rules. the concentration of power in a small number of states (further enhanced by the exclusion of a number of important nations because of the war). the planners at Bretton Woods established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). the Bretton Woods system was history's first example of a fully negotiated monetary order intended to govern currency relations among sovereign states. A ban on most discriminatory currency practices or exchange regulation. Taking its name from the site of the 1944 conference that created the International Monetary Fund (IMF) and World Bank. In principle. to avoid the kind of economic warfare that had characterized the 1930s. 2. The pegged rate currency regime. endowed with limited supranational authority. A system for ensuring an adequate supply of monetary reserves. institutions. A forum for international cooperation on monetary matters. In practice the initial scheme. Four points defined the Bretton Woods system: 1. which today is part of the World Bank Group. the regime was designed to combine binding legal obligations with multilateral decisionmaking conducted through an international organization. a compromise between freely floating and irrevocably fixed exchange rates. the United States. 4. the IMF. and the presence of a dominant power willing and able to assume a leadership role in global monetary affairs. Great Depression 4 . Origins The political basis for the Bretton Woods system was in the confluence of several key conditions: the shared experiences of the Great Depression. 3.
it is their similarities rather than their differences that appear most striking. led to a breakdown of the international financial system and a worldwide economic depression. it dramatically worsened the situation in the medium and longer run. The experience of the Great Depression was fresh on the minds of public officials. and an overall decline in world trade. These blocs retarded the international flow of capital and foreign investment opportunities. all agreed on the need for tight controls. shrinking demand. for the international economy. preferred greater planning and state intervention. planners at Bretton Woods all favoured a regulated system. whereas the United States favoured relatively limited state intervention). for example. Its foundation was based on a shared belief in capitalism. combined with an inclination to isolationism. Although this strategy tended to increase government revenues in the short run. 5 . All the participating governments at Bretton Woods agreed that the monetary chaos of the interwar period had yielded several valuable lessons. Although the developed countries' governments differed in the type of capitalism they preferred for their national economies (France. The "beggar thy neighbour" policies of 1930s governments—using currency devaluations to increase the competitiveness of a country's export products to reduce balance of payments deficits—worsened national deflationary spirals. Design Free trade relied on the free convertibility of currencies. all relied primarily on market mechanisms and on private ownership. concluded that major monetary fluctuations could stall the free flow of trade. one that relied on a regulated market with tight controls on the value of currencies.A high level of agreement among the powerful on the goals and means of international economic management facilitated the decisions reached by the Bretton Woods Conference. fresh from what they perceived as a disastrous experience with floating rates in the 1930s. Negotiators at the Bretton Woods conference. when intransigent American insistence as a creditor nation on the repayment of Allied war debts. Trade in the 1930s became largely restricted to currency blocs (groups of nations that use an equivalent currency. mass unemployment. Thus. Thus. The planners at Bretton Woods hoped to avoid a repeat of the debacle of the 1930s. such as the "Sterling Area" of the British Empire). Although they disagreed on the specific implementation of this system. which resulted in plummeting national incomes.
the international value of currency was determined by its fixed relationship to gold. trade. which would later emerge as a Cold War rival to the United States and Western Europe. But the pound was not up to the challenge of serving as the primary world currency. Unlike national economies. and payments.S. The resulting fall in demand would reduce imports and the lowering of prices would boost exports. dollar (which was a gold standard currency for central banks) as a reserve currency. the international economy lacks a central government that can issue currency and manage its use. In the past this problem had been solved through the gold standard. gold was used to settle international accounts. they set up a system of fixed exchange rates managed by a series of newly created international institutions using the U. thus the deficit would be rectified. The architects of Bretton Woods had conceived of a system wherein exchange rate stability was a prime goal.The liberal economic system required an accepted vehicle for investment. economy. dollar. Informal Previous regimes In the 19th and early 20th centuries gold played a key role in international monetary transactions. Instead. and intervention currency. The gold standard maintained fixed exchange rates that were seen as desirable because they reduced the risk of trading with other countries. transaction. however.S. the pound became a reserve. Yet. Any country experiencing inflation would lose gold and therefore would have a decrease in the amount of money available to spend. governments did not seriously consider permanently fixed rates on the model of the classical gold standard of the nineteenth century. Supplementing the use of gold in this period was the British pound. A country with a deficit would have depleted gold reserves and would thus have to reduce its money supply. And a sizeable share of the world's known gold reserves were located in the Soviet Union. in an era of more activist economic policy. The only currency strong enough to meet the rising demands for international currency transactions was the U. but the architects of Bretton Woods did not consider this option feasible for the post-war political economy. given the weakness of the British economy after the Second World War. Based on the dominant British economy.S. Gold production was not even sufficient to meet the demands of growing international trade and investment. The strength of the U. the fixed relationship of 6 . This decrease in the amount of money would act to reduce the inflationary pressure. Imbalances in international trade were theoretically rectified automatically by the gold standard. The gold standard was used to back currencies.
At this rate. itself convertible into gold. and—once convertibility was restored—would buy and sell U. buying or selling foreign money). dollar. the dollar was even better than gold: it earned interest and it was more flexible than gold. Members were required to establish a parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates within plus or minus 1% of parity (a "band") by intervening in their foreign exchange markets (that is. If gold is fixed at $35 then other countries will demand gold and not accept dollars. Fixed exchange rates The rules of Bretton Woods.S. The closing of the gold window in 1971 was the result. What emerged was the "pegged rate" currency regime. foreign governments and central banks were able to exchange dollars for gold. currency was now effectively the world currency. in which all currencies were defined in relation to the dollar. (Rogue Nation. the U.S. 2003. The U. In theory the reserve currency would be the bancor (a World Currency Unit that was never implemented).S. Bretton Woods established a system of payments based on the dollar. Another view is that in the time of discount banks. thus raising the price of gold. As the world's key currency. most international transactions were denominated in US dollars. "as good as gold". provided for a system of fixed exchange rates. however. the United States objected and their request was granted. dollars to keep market exchange rates within plus or minus 1% of parity. all European nations that had been involved 7 . dollar took over the role that gold had played under the gold standard in the international financial system.S. Additionally. dollar.S.the dollar to gold ($35 an ounce). and above all. In fact. dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. the U. Thus. discount was the interest earned on gold. to bolster faith in the dollar. government to convert dollars into gold at that price made the dollar as good as gold. The U. and that the only way to repay interest on government bonds is by printing more dollars. Clyde Prestowitz) Meanwhile. suggested by John Maynard Keynes. and the commitment of the U. making the "reserve currency" the U. set forth in the articles of agreement of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). agreed separately to link the dollar to gold at the rate of $35 per ounce of gold.S. the standard to which every other currency was pegged. This meant that other countries would peg their currencies to the U.S. The rules further sought to encourage an open system by committing members to the convertibility of their respective currencies into other currencies and to free trade.S.
had been greatly exacerbated by the absence of any established procedure or machinery for intergovernmental consultation. As a result of the establishment of agreed upon structures and rules of international economic interaction. a fact that contributed to the supremacy of the United States. 1945. Already in 1944 the British economist John Maynard Keynes emphasized "the importance of rule-based regimes to stabilize business expectations"—something he accepted in the Bretton Woods system of fixed exchange rates. Thus. dollar was strongly appreciated in the rest of the world and therefore became the key currency of the Bretton Woods system. IMF approval was necessary for any change in exchange rates in excess of 1%. The Fund commenced its financial operations on March 1. International Monetary Fund Officially established on December 27. 8 . the IMF was to be the keeper of the rules and the main instrument of public international management. it was felt.in World War II were highly in debt and transferred large amounts of gold into the United States. It advised countries on policies affecting the monetary system. Formal regimes The Bretton Woods Conference led to the establishment of the IMF and the IBRD (now the World Bank). Thus. 1947. conflict over economic issues was minimized. the U. when the 29 participating countries at the conference of Bretton Woods signed its Articles of Agreement. negotiators at Bretton Woods also agreed that there was a need for an institutional forum for international cooperation on monetary matters.S. As mentioned. which was contingent on IMF determination that its balance of payments was in a "fundamental disequilibrium". and the significance of the economic aspect of international relations seemed to recede. a major point of common ground at the Conference was the goal to avoid a recurrence of the closed markets and economic warfare that had characterized the 1930s. which still remain powerful forces in the world economy. Member countries could only change their par value with IMF approval. Currency troubles in the interwar years.
Gold convertibility enforcement was not required. the international economy would recover and the system would enter into operation. The IBRD was to be a specialized agency of the United Nations charged with making loans for economic development purposes. allowed. New gold production was assumed to be sufficient. the U.S. To promote the growth of world trade and to finance the post-war reconstruction of Europe. However. The IMF was left with few means. the International Bank for Reconstruction and Development (IBRD).S. However. It had been recognized in 1944 that the new system could only commence after a return to normalcy following the disruption of World War II. held $26 billion in gold reserves. For the Bretton 9 . for example. with a mounting recession that began in 1958. there was still an open gold market. an adjustment in the value of the currency or an improvement by other means of a country's competitive position. a decade-long effort to maintain the Bretton Woods System at the $35/ounce price was begun. but not acted upon. the planners at Bretton Woods created another institution. now the most important agency of the World Bank Group. Late Bretton Woods System U. however. with Kennedy's election. The IBRD had an authorized capitalization of $10 billion and was expected to make loans of its own funds to underwrite private loans and to issue securities to raise new funds to make possible a speedy post-war recovery. this response alone was not sustainable. and instead hold dollars. it was expected that there would be national solutions. More drastic measures were proposed.S. of an estimated total of $40 billion (approx 60%). The first U. It was expected that after a brief transition period of no more than five years. The design of the Bretton Woods System was that nations could only enforce gold convertibility on the anchor currency—the United States‘ dollar. the U. Rather than full convertibility. the size of the gold base increased by only a few percent. As world trade increased rapidly through the 1950s. In 1950. it provided a fixed price for sales between central banks.S. to encourage such national solutions. balance of payments crisis After the end of World War II. In the event of structural disequilibria.International Bank for Reconstruction and Development The agreement made no provisions for international creation of reserves. In 1960. balance of payments swung negative. Nations could forgo converting dollars to gold. response to the crisis was in the late 1950s when the Eisenhower administration placed import quotas on oil and other restrictions on trade outflows. but instead.
could be controlled by having a pool of gold to sell on the open market that would then be recovered when the price of gold dropped.S. The first effort was the creation of the London Gold Pool on November 1 of 1961 between eight nations. either institute protectionist measures. there was an attack on the pound and a run on gold in the sterling area." 10 . the deficits would erode confidence in the dollar as the reserve currency created instability. thus.S. that turning away from open trade would be more costly. it would either have to alter the peg of the dollar to gold. balance of payments deficits helped to keep the system liquid and fuel economic growth.S. although there were internal tensions in the Western alliance. 1967. and other smaller events. including travel taxes. over time. bring the system to a halt. The Kennedy administration drafted a radical change of the tax system to spur more production capacity and thus encourage exports. But incurring such payment deficits also meant that. What would later come to be known as Triffin's Dilemma was predicted when Triffin noted that if the U. to as high as $40/ounce. and on November 18. and. designed to maintain the $35 peg. export subsidies and slashing the budget—or accept the risk of a "run on gold" and the dollar.Woods system to remain workable. set by the morning gold fix in London. In 1967. From Johnson's perspective: "The world supply of gold is insufficient to make the present system workable—particularly as the use of the dollar as a reserve currency is essential to create the required international liquidity to sustain world trade and growth. President Lyndon Baines Johnson was faced with a brutal choice. failed to keep running deficits the system would lose its liquidity. Gold's price spiked in response to events such as the Cuban Missile Crisis." He believed that the priorities of the United States were correct. In 1960 Robert Triffin noticed that holding dollars was more valuable than gold because constant U. than it was worth: "Our role of world leadership in a political and military sense is the only reason for our current embarrassment in an economic sense on the one hand and on the other the correction of the economic embarrassment under present monetary systems will result in an untenable position economically for our allies. and. economically and politically. the British government was forced to devalue the pound. This culminated with the 1963 tax cut program. the greater the temptation to deal with internal economic issues by buying gold at the Bretton Woods price and selling it on the open market. U. not be able to keep up with the world's economic growth. or it would have to maintain the free market price for gold near the $35 per ounce official price. The theory behind the pool was that spikes in the free market price of gold. The greater the gap between free market gold prices and central bank gold prices.
S. All attempts to maintain the peg collapsed in November 1968. and a series of meetings attempted to rescue or reform the existing system. Multinational banks can and do make huge international transfers of capital not 11 . 1968 the Congress of the United States repealed the 25% requirement of gold backing of the dollar—as well as the US pledge to suspend gold sales to governments that trade in the private markets. the London Gold Pool was dissolved. as long as the U. who continued to build up their gold reserves. commitments to foreign deployment continued. particularly to Western Europe. and by 1971 over three quarters of the world's largest banks had become shareholders in such syndicates. there was little that could be done to maintain the gold peg. and agreed to hold dollars instead.. But. exports. Since 1964 various banks had formed international syndicates. led to the expansion of the private markets for international gold trade. The collapse of the gold pool and the refusal of the pool members to trade gold with private entities—on March 18. the pressure on both the dollar and the pound sterling continued. which deepened monetary interdependence. This was unsuccessful. The US gold reserves continued to be depleted due to the actions of some nations. notably France. One change was the development of a high level of monetary interdependence. and a new policy program attempted to convert the Bretton Woods system into an enforcement mechanism of floating the gold peg. important structural changes eventually led to the breakdown of international monetary management. Growth of international currency markets Another aspect of the internationalization of banking has been the emergence of international banking consortia.While West Germany agreed not to purchase gold from the U.S. however. The stage was set for monetary interdependence by the return to convertibility of the Western European currencies at the end of 1958 and of the Japanese yen in 1964. which would be set by either fiat policy or by a restriction to honour foreign accounts. Structural changes underpinning the decline of international monetary management Return to convertibility In the 1960s and 70s. Convertibility facilitated the vast expansion of international financial transactions. In January 1968 Johnson imposed a series of measures designed to end gold outflow. as in mid-March 1968 a run on gold ensued. in which the price of gold rose much higher than the official dollar price.S. and to increase U.
the policy of the Eisenhower. Special Drawing Rights were set as equal to one U. They could move from a weak to a strong currency hoping to reap profits when a revaluation occurred. in effect. The intent of the SDR system was to prevent nations from buying pegged gold and selling it at the higher free market price. they came to be seen as political risks for leaders. The original interest rate was 1. Paralysis of international monetary management Floating-rate Bretton Woods system 1968–1972 By 1968. however. at the same time setting a clear limit to the amount of dollars that could be held. to each nation based on their SDR holding. accelerated.S. Because of the Vietnam War and other unpopular actions. Gold outflows from the U. providing a virtually risk-free temptation for speculators. The essential conflict was that the American role as military defender of the capitalist world's economic system was recognized. monetary authorities managed to avoid revaluation. dollar. In effect. but were not usable for transactions other than between banks and the IMF.S. or credited. During the Bretton Woods era countries were reluctant to alter exchange rates formally even in cases of structural disequilibria. Kennedy and Johnson administrations. Because such changes had a direct impact on certain domestic economic groups. had become increasingly untenable. consensus began to evaporate. Nations were required to accept holding Special Drawing Rights (SDRs) equal to three times their allotment.S.only for investment purposes but also for hedging and speculating against exchange rate fluctuations. monetized the value of this relationship. They were only willing to do this as long as they supported U. The SDR agreement. the unbalanced fiscal spending of the Johnson administration had transformed the dollar shortage of the 1940s and 1950s into a dollar glut by the 1960s. As a result official exchange rates often became unrealistic in market terms.S. but did not create a market for it. the IMF agreed in Rio de Janeiro to replace the tranche division set up in 1946. 12 . the pro-U. These new forms of monetary interdependence made possible huge capital flows. they could return to other currencies with no loss. and give nations a reason to hold dollars by crediting interest. In 1967. and despite gaining assurances from Germany and other nations to hold gold. other nations "purchased" American defence policy by taking a loss in holding dollars. the attempt to defend the dollar at a fixed peg of $35/ounce. The combination of risk-free speculation with the availability of huge sums was highly destabilizing. If. but not given a specific monetary value. military policy.5%. and interest would be charged.
In 1971 it had a reserve deficit of $56 billion. created the Smithsonian Agreement. with 2. It was criticized at the time. rather than the U. and created pressure from petro-dollars. it had depleted most of its non-gold reserves and had only 22% gold coverage of foreign reserves. continued to draw down reserves. this exacerbated dollar flight. and with no other credibility mechanism in place. 13 . government.S. however. Still.25% trading bands. leadership to develop a new system of international monetary management. and reopened in March in a floating currency regime. meeting in the Smithsonian Institution in Washington. The U.S. and was by design a "temporary" agreement. In February 1973 the Bretton Woods currency exchange markets closed. there was a series of multilateral and bilateral negotiations of the Group of Ten seeking to develop a new multilateral monetary system. President Richard Nixon lifted import quotas on oil in an attempt to reduce energy costs. as well.S.30/ounce and still climbing. tightened controls over foreign investment and currency. By 1972.S. the Group of Ten.20/ounce.The use of SDRs as paper gold seemed to offer a way to balance the system. and in 1971 it reached $44. turning the IMF. Throughout the fall of 1971.S.S. in 1972 $70. In short. On December 17 and 18. including mandatory investment controls in 1968. the dollar was tremendously overvalued with respect to gold. into the world's central banker. though it took a decade for all of the industrialized nations to do so. U. In 1970. It failed to impose discipline on the U. 1971. and attempted to balance the world financial system using SDRs alone. currencies began abandoning even this devalued peg against the dollar. This resulted in gold becoming a floating asset. Smithsonian Agreement The shock of August 15 was followed by efforts under U.. the pressure against the dollar in gold continued. after a last-gasp devaluation of the dollar to $44/ounce. instead. which devalued the dollar to $38/ounce. the U.
found a monetary compromise that was readily approved by the US President. Speculation on the dollar exchange market. Richard Nixon. the European Monetary Agreement (EMA) had authorised the partial or total convertibility of European currencies. The German Minister for Finance and Economic Affairs. opposed Mr Schiller's proposal and preferred to fix parities via exchange rate controls. the Bretton Woods Agreements introduced a gold standard system that transformed the US dollar into an international reserve currency. In December 1971. Georges Pompidou. and the Member States of the European Economic Community (EEC). since that would harm French exports and might slow economic growth and even lead to social unrest. He was unyielding in his bid to curb inflation and was steadfast in his desire to maintain the stability of the German mark. began in the spring of 1971 and intensified during the year. to the great economic and political advantage of the United States.The Snake in the Tunnel In 1944. Under that Agreement. and the German Chancellor. Valéry Giscard d'Estaing. the central banks of the signatory countries undertook to exchange their currency for dollars at rates set below the limits imposed by the IMF. The currencies were allowed to fluctuate by 1 % either side of parity. and his Finance Minister. which pushed up the value of the German mark. The Germans rebuffed such an interventionist approach. In such a system of exchange rate parities. At the same time. Since 1958. the dollar fulfilled the de facto function of gold. Georges Pompidou. Indirectly. The dollar immediately became the international unit of account. amongst them the French franc. which was set in relation to gold or the dollar by the International Monetary Fund (IMF). The French President. Karl Schiller wanted all the European currencies to float.89 % in relation to gold. this system provided European countries with monetary stability for nearly thirty years. a number of currencies were adjusted upwards in relation to the dollar: the Italian 14 . But that step was sure to push up the value of certain currencies. The monetary agreements that were signed in Washington on 18 December 1971 set new parities in relation to the dollar. the French President. Karl Schiller. France was above all trying to avoid an overvalued franc. the only one convertible to gold. was known for his austere financial policy. Willy Brandt. which was devalued by 7.
between any two European currencies was consequently 4. That was the width of the tunnel.5 %.6 %. This was why the Nine chose to restrict 15 . from floor to ceiling. The snake entered into force on 24 April 1972 and allowed central banks to buy and sell European currencies provided that the exchange rate fluctuation margin of 2.25 %. At the same time.5 % but only 2. the Belgian franc by 11. However.5 %. the German mark by 13. sanctioned the devaluation of the dollar.25 % with respect to the dollar alone.6 %. Technically.25 % on either side of the dollar rate. The maximum spread. was not overstepped. The snake was therefore reduced to half its size in relation to the width of the tunnel. The band was increased from 1 % to 2. the Committee of Governors of the European central banks introduced an additional mechanism to narrow exchange rate fluctuation. To understand why fluctuation margin was supposed to be 2. While the EEC accession procedure was under way. The Community countries felt that this differential between the exchange rates of their currencies was far too broad. the Dutch guilder by 11. But these three currencies. meeting at the Smithsonian Institute in Washington. It was feared at the time that it might jeopardise the operation of the common agricultural policy and the customs union. we need to go back to 18 December 1971.5 %. they decided that the rates of Western currencies could not deviate by more than 2. What is more. this means that differences in exchange rates between two Community currencies may amount to 4.lira by 7. between two periods. the representatives of the major Western countries. After a meeting in Basle on 10 April 1972. the French franc by 8. corresponding to the authorised margins between the dollar and the currencies of the Six.6 %. In practice. these figures relate only to differentials qualified by the experts as ‗instantaneous‘. the Irish punt and the Danish crown joined the snake on 1 May 1972. the differentials may amount to 9 % between Community currencies (twice the ‗instantaneous‘ differential). the pound sterling. the French Government also had to agree to a fluctuation margin amongst the currencies wider than that set by the Bretton Woods System.25 %.5 % between each of these currencies and the dollar. On that day. Accordingly. and the pound sterling by 8. not unlike the dollar.6 %.25 % above or below parity with the American currency. compared to 4. came under speculative attacks and were forced to leave the exchange-rate mechanism a few weeks later. or in other words. the Basle Agreement set up the European currency snake in the tunnel. recorded at a clearly determined time.
could therefore sell or purchase the American currency on the foreign exchange markets. which would allow the French currency to remain within the ‗snake‘.5 %. Most currencies in the 16 .25 % (actually 4. The ‗snake‘ was not spared these difficulties. promoted the Community currencies to the rank of intervention currencies. The example shows how pressure on currency rates may cause significant outflows of foreign currency from certain Community Member States. It should be noted that relations between the latter and the dollar were not changed in any way by the Basle Agreement. With the Basle Agreement. The Bundesbank would then purchase francs on the Frankfurt market. The mechanism might appear insignificant if debts were reimbursed. still played by the rules. Less than two years after it came into force the European exchange agreement had lost many of its supporters in the community. Thirty days after the end of the month. Norway and Sweden.5 %). Prior to the Basle Agreement. which are basically connected to the weakness of the dollar in conjunction with the strength of the German mark. With each one independently monitoring exchange rates in this way. Any European central bank. Under the Smithsonian Agreement.25 %. the principal concern of the monetary authorities was to respect the conventional fluctuation bands (4. the central bankers.5 % from the time of the Smithsonian Agreement) between the exchange rates of their currencies and the rate of the dollar. knowing that the rate of its currency was at its highest (+2. the Community currencies would vary in relation to the dollar within a foreign exchange band that was also restricted to 4. This was how the dollar came to be seen as the only intervention currency. One such instance cost France $2 Billion. the Banque de France would actually have to repurchase the francs bought by the Bundesbank. although two countries not part of the Community. The ‗snake‘ therefore had its ‗tunnel‘.25 %) in relation to the dollar. This particularly heavy bill had to be settled after a bout of speculation against the franc that was sparked off by upward pressure on the Dutch guilder. solely out of respect for the European exchange-rate agreement. the differential between these two currencies threatening to exceed 2.the range of exchange-rate fluctuations between their currencies to 2. Let us assume that the German mark is the highest valued currency in the ‗snake‘ and the French franc is the lowest.25 %) or lowest (– 2. Two basic causes of this problem can be identified: the cost of the snake and the problem of gold. the Community monetary authorities indirectly managed to restrict exchange rate variations between their currencies.
One of these. The other. seemed less and less acceptable to countries like France and Italy. Bypassing this difficulty. He also called on the 17 .5 % on 29 June 1973) and the Dutch guilder (5 % on 17 September). who made their reintegration into the ‗snake‘ conditional upon the finalization of a solution. allowed Italy to pay off future debts from July to September 1972 completely in dollars. His plan was to achieve greater coordination between the currencies in the snake and those floating around the snake. and Italy from 13 February 1973. in a special case. the Italian. however. A distinction is accordingly made between ‗hard‘ reserves (gold and assets tied to gold. Irish and French currencies were undermined by galloping inflation and balance of payment deficits. The Basle Agreement laid down that intervention in Community currencies is to be reimbursed on the basis of the composition of monetary reserves. In September. On 15 March 1976. The central bankers of the Community quite logically came up with compromises to ensure that the Basle Agreement continued to operate smoothly. The central banks no longer wished to dispose of their gold at an ‗official‘ price (42.‗snake‘ could not accompany the upward variations in the mark.22 dollars per ounce the opportunity to repurchase it as soon as a solution and a definitive price had been found for the problem of transfers of gold between Community central banks. such as Special Drawing Rights — SDRs) and ‗weak‘ reserves (currencies. It nevertheless proved possible to ease the pressure exerted within the ‗snake‘. The weakness of their currencies prompted them to leave the snake on several occasions. Jean-Pierre Fourcade. At the same time. particularly the dollar). otherwise their currencies might appreciate too much against the dollar. deemed to be ridiculous compared to the free market rate (160 to 165 dollars per ounce in March 1975). proposed that all nine currencies of the EEC be allowed to float freely. Reimbursement of the ‗weak‘ part posed no problem at all. France once again left the system. Well before this however. several Community States had already declined to apply the European exchange-rate agreement — the United Kingdom and Ireland from 23 June 1972. thanks to the revaluation of the German mark (3 % on 14 March 1973 and 5. parities in the snake were being adjusted frequently. in force since 1 January 1973. Between 1974 and 1976. the French Minister for Finance and Economic Affairs. a provisional one. France reimbursed its debt to Germany by paying only ‗hard‘-reserve SDRs. however was another matter altogether.22 dollars per ounce). This special case in no way relieved the intensity of the problem of transfers in gold. British. France left on 19 January 1974 and rejoined on 10 July 1975. The ‗hard‘ part. offered countries that had disposed of gold at 42. This compromise.
the snake was no longer contained within the tunnel. but on its own it could not overcome the problems caused by a lack of economic policy coordination. Denmark and the three Benelux countries – remained within the system. 18 . from January 1974 onwards.EEC Member States to act together on the currency market and suggested that a new European unit of account be adopted. The European snake had undoubtedly been very effective in preventing quite a few avoidable disruptions. Ultimately. and only the countries of the mark zone – Germany.
allowing the dollar to "float". This led to the "Oil Shock" of the mid-seventies. and selling inflation-priced goods to the petroleum producers in the developing Third World. floating the pound sterling. while also paying low oil prices. the industrialized nations also increased their reserves (printing money) in amounts far greater than ever before. OPEC was slow to readjust prices to reflect this depreciation. Until the Oil Shock. This was stressed by the Shah of Iran. The result was a depreciation of the value of the US dollar. The OPEC cartel issued a joint communique stating that forthwith they would price a barrel of oil against gold. Because oil was priced in dollars. but suddenly became extremely volatile thereafter.Oil Shocks of 1973 and 1979 Background: End of Bretton Woods On August 15. From 1947-1967 the price of oil in U. whose nation was the world's second-largest exporter of oil and the closest ally of the United States in the Middle East at the time. 1971.S. The West could not continue to increase its energy consumption 5% annually. dollars had risen by less than two percent per year. Shortly thereafter. 19 . OPEC ministers had not developed the institutional mechanisms to update prices rapidly enough to keep up with changing market conditions. The industrialized nations followed suit with their respective currencies. In the years after 1971. 1973. Yom Kippur War On October 6. Syria and Egypt launched a pre-emptive strike on Israeli-occupied territories captured in the 1967 Six Day War . Britain followed. as well as the other currencies of the world. This new round in the Arab-Israeli conflict triggered a crisis already in the making. The substantial price increases of 1973-74 largely caught up their incomes to Bretton Woods levels in terms of other commodities such as gold. the price of oil was going to rise. the United States pulled out of the Bretton Woods Accord taking the US off the Gold Exchange Standard (whereby only the value of the US dollar had been pegged to the price of gold and all other currencies were pegged to the US dollar). this meant that oil producers were receiving less real income for the same price. the price remained fairly stable versus other currencies and commodities. so their real incomes lagged for several years. In anticipation of the fluctuation of currencies as they stabilized against each other.
11 a barrel. joining the embargo on October 20. which was already under pressure from the breakdown of the Bretton Woods agreement. Imposition of the Embargo On October 16. the oil embargo changed the nature of policy in the West towards increased exploration. the prices had to be risen dramatically to reduce demand to the new lower level of supply.On October 12. 1973. the market price for oil immediately rose substantially. energy conservation. Economic Effects of the Embargo The effects of the embargo were immediate. 1973. after the Soviet Union began sending arms to Syria and Egypt. Anticipating this. an overt strategic airlift to deliver weapons and supplies to Israel. and caused massive shortages in the U. OPEC forced the oil companies to increase payments drastically. 20 .2 billion in emergency aid to Israel. and to continue to cut production over time in five percent increments until their economic and political objectives were met. and more restrictive monetary policy to better fight inflation. Price increases were also imposed. The following day. 1973. it was later expanded to the Netherlands. The effects of the Arab Oil Embargo are clear—it effectively doubled the real price of crude oil at the refinery level. Though United States was the initial target of the embargo. October 19.5 billion in out-right grants. Since oil demand falls little when the price is raised. a cut in production by five percent from September's output. Libya announced it would embargo all oil shipments to the United States.S. with oil prices continuing to rise until 1986. The world financial system. OPEC announced a decision to raise the posted price of oil by 70%. from $3 a barrel to $12. The price of oil quadrupled by 1974 to nearly US$12 per barrel (75 US$/m3). The embargo was thus variously extended to Western Europe and Japan. including $1. was set on a path of recessions and high inflation that persisted until the early 1980s. Over the long term. to $5. oil ministers agreed to the embargo. Saudi Arabia and the other OPEC states quickly followed suit. At their meeting in Kuwait the OPEC oilproducing countries. US President Richard Nixon requested Congress to appropriate $2. proclaimed the oil boycott that provided for curbs on their oil exports to various consumer countries and a total embargo on oil deliveries to the United States as a ―principal hostile country‖. President Richard Nixon authorized Operation Nickel Grass.
particularly in the UK (where they combined with strikes by coal miners and railroad workers to cause an energy crisis over the winter of 1973-74. Ted Heath. but the effects of the energy crisis lingered on throughout the 1970s. for the countries of the Middle East who had long been dominated by the industrial powers were seen to have acquired control of a vital commodity. after the embargo and price rises had begun. Germany. Of the nine members of the European Economic Community (EEC). the crisis eased. Sweden rationed gasoline and heating oil. A few months later. and OPEC duly lifted its embargo from all members of the EEC. Switzerland. the United Kingdom and France received almost uninterrupted supplies (having refused to allow America to use their airfields and embargoed arms and supplies to both the Arabs and the Israelis). driving and boating on Sundays.This increase in the price of oil had a dramatic effect on oil exporting nations. had reversed this policy in 1970. The members of the EEC had been unable to achieve a common policy during the first month of the Yom Kippur War. The Netherlands imposed prison sentences for those who used more than their given ration of electricity. amid the weakening competitive position of the dollar in world markets. but his successor. The UK. a major factor in the change of government). Ted Heath asked the British to heat only one room in their houses over the winter. Some of the income was dispensed in the form of aid to other underdeveloped nations whose economies had been caught between higher prices of oil and lower prices for their own export commodities and raw materials amid shrinking Western demand for their goods. this statement supported the Franco-British line on the war. Europe The embargo was not uniform across Europe. Much was absorbed in massive arms purchases that exacerbated political tensions. 21 . calling for Israel to withdraw to its pre-1967 borders. The Community finally issued a statement on November 6. and Harold Wilson's government had supported the Israelis during the Six Day War. The UK had traditionally been an ally of Israel. widely seen as pro-Arab. The price of energy continued increasing in the following year. The embargo was lifted in March 1974 after negotiations at the Washington Oil Summit. particularly in the Middle East. The price rises had a much greater impact in Europe than the embargo. the Netherlands faced a complete embargo. whilst the other six faced only partial cutbacks. and Norway banned flying. The traditional flow of capital reversed as the oil exporting nations accumulated vast wealth.
driving the price far higher than would be expected under normal circumstances. with production being greatly curtailed and exports suspended. and Venezuela expanded production. which pushed prices up. following the Iraqi invasion of Iran. Mohammad Reza Pahlavi. After 1980. they were inconsistent and at a lower volume. However. under the presidency of Dr. In 1980. Oil exporters such as Mexico. Protests severely disrupted the Iranian oil sector. and Iraq's oil production was severely cut as well. Ending of price controls allowed the US and Europe to get more oil from Prudhoe Bay and the North Sea. This was due to reduced demand and over-production. When oil exports were later resumed under the new regime. Saudi Arabia and other OPEC nations.1979 Energy Crisis The 1979 oil crisis in the United States occurred in the wake of the Iranian Revolution. fled his country in early 1979 and the Ayatollah Khomeini soon became the new leader of Iran. 22 . oil production in Iran nearly stopped. oil prices began a six-year decline that culminated with a 46 percent price drop in 1986. which caused OPEC to lose its unity. Mana Alotaiba increased production to offset the decline. Amid massive protests. the Shah of Iran. a widespread panic resulted. and the overall loss in production was about 4 percent. Nigeria.
S.The EMS is the precursor to the more recent European Monetary Union (EMU). To create a unified Europe: The goal was to eliminate all barriers to the movements of trade and capital across the European countries. However. Portugal. 2. or the European Community (EC) as it was then known began with 6 member countries: France. the Netherlands. Sweden and Finland. the U. European nations lost confidence in the ability of the U. Belgium and Luxembourg and has since added 9 more members: Spain. That is to say that there were no ECU notes or coins issued and used to conduct transactions. The European Monetary System: A Broad Description The EMS consisted of two major components: the creation of an artificial unit of account named the European Currency Unit (ECU) and a fixed exchange rate system known as the ERM (Exchange Rate Mechanism).K. The Europeans believed that exchange 23 . constructed as a fixed basket of European currencies. Italy. this was certainly not true within the European countries: from the late 1970‘s they were trying to limit intraEuropean exchange rate fluctuations. Germany. Enhancing the importance of Europe in the global economy: With the collapse Bretton Woods. 1. Austria.Formation of EMS/EMU/EU After the collapse of the Bretton Woods agreement there was a greater tendency to move towards flexible exchange rates among the countries of the world. The European Union (EU). The ECU was only a unit of account and not a medium of exchange. Greece. The EMS was a way for the EU nations to handle some of their monetary concerns amongst themselves rather than relying on a worldwide system. Denmark. There are 3 main goals that are usually attributed to the EMS.. Ireland. to take the monetary policy leadership. From 1979 until the early 1990‘s the EU member countries formed a joint system for coordination of monetary and exchange rate policies: the European Monetary System (EMS). It was merely an accounting unit.
Britain (1990) and Portugal (1992) joined at subsequent times. Luxembourg and the Netherlands. There were 8 original participants in the ERM: France. Since 1979. Denmark. exchange rate fluctuations wouldn‘t affect real incomes across ERM countries. Other countries. The ERM was essentially a managed float exchange rate system where the currencies of participating countries were allowed to fluctuate within pre-specified bands. 3. Suppose the price of milk was set at 1 ECU per gallon. and 2 DM per ECU then French dairy farmers would receive 5 FF per gallon of milk while German dairy farmers received 2 DM per gallon. the plan was to allow a fluctuation band of 2.rate uncertainty remained a huge obstacle to intra-European trade and a system of fixed exchange rates would facilitate the flow of goods and services across countries. To improve the functioning of the Common Agricultural Policy (CAP) an elaborate system of price supports for agricultural goods within the EU. Of the countries that were members of the European Monetary System only those willing to commit to the exchange rate bands were said to belong to the Exchange Rate Mechanism. Effectively we can think of the ERM as being a system where the exchange rates of all countries were allowed to fluctuate in a band around the mark. By keeping the FF and the DM fixed against the ECU. Belgium. the German Mark. Ireland. If the current exchange rates were 5 FF per ECU. Member countries had to intervene to make sure that their currencies stayed within the prescribed band. Spain (1989). the system effectively turned into a system where the bands were maintained with respect to the most stable currency of the group. So if the French Franc was reaching the top of the Franc/ECU band then the French Central Bank had to intervene and buy Francs in order to make sure that it did not move outside the band. Italy. 24 . Initially. the CAP specified prices for agricultural goods in terms of the ECU. The Portuguese escudo and the Spanish peseta were allowed to fluctuate around a broader band 6% while the Italian Lira has the broader band until 1990 at which point it switched over to the narrower band. Germany. Central exchange rates for each currency against the ECU were established. Since the ECU is a fictitious accounting unit.25% for most currencies against this central rate.
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. The Dominant Role of Germany in the ERM Effectively. The Bundesbank was so good at fighting inflation because of the hyperinflations that plagued Germany between the World Wars. the Italian Central Bank would not do as good a job fighting inflation with an independent monetary policy as Italy could achieve by fixing their exchange rate to the DM and allowing the Bundesbank to dictate the monetary policy decisions. the role of Germany within the ERM is similar to that of the U. it was given an explicit mandate to root out inflation as its primary goal. This will also help in stamping out inflationary expectations in these countries and enable people to make long-term decisions with considerably less uncertainty.Theoretically. The ERM also had a built in lending mechanism to prevent crises from happening: the German. One argument for why this system was chosen is the greater credibility of the German Bundesbank. Pros and Cons of the ERM Pros 1. Bundesbank is supposed to lend DM to France if France needed to shore up its currency.S. So countries in which the mandate of the central bank is not so anti-inflationary or poorly designed may then benefit by tying their fortunes to a central bank that is deeply committed to rooting out inflation. Since there are only N-1 exchange rates among the N countries.The mark became the unofficial reserve currency so when the French government was intervening To buy francs it would effectively be selling marks in exchange for francs. countries would have to minimize the size of exchange rate fluctuation to be within a relatively narrow band which would reduce uncertainty and facilitate trade. For example. Some European countries would actually benefit by ceding control of their monetary policy since their Central Banks were not very good at keeping inflation under control. 25 . Exchange Rate Stability . When the new central bank was established following the war. within Bretton Woods.
the eventual demise of the ERM was related to a country specific shock that highlighted the problems of this type of system: the reunification of Germany.S. The fiscal and monetary policy decisions undertaken at the time by Germany led to a rise in German interest rates and pushed the currencies of the other member countries to the bottom of the fluctuations band. For example. a) The responsible central bank ceases to act responsibly (the U. Asymmetric system.25%. under Bretton Woods) or b) The policy interests of Germany and the rest of Europe diverge dramatically. decisions to cut back on German money supply will then put major pressure on the other currencies. At that point. However at some point. For example. Cons 1. suppose the Lira is allowed to fluctuate in a band of 2. 3. if the German economy is growing too fast while the rest of Europe is suffering through a recession. the lira would hit the band around which the Lira/Mark was allowed to fluctuate. by reducing the fluctuations of the currency and improving the coordination of monetary policy decisions among the member countries. In fact. Exchange rate uncertainty is enhanced rather than reduced by the ERM. countries had some freedom to conduct monetary policy. Suppose that the Bank of Italy expanded the money supply and inflation in Italy started to rise. A step along the way to full European Monetary Union.2. Because the system was not a completely fixed exchange rate system. 2. Better inflation performance from the increased credibility of tying monetary policy to the Bundesbank. the Italian Central Bank has to keep the exchange rate fixed: by buying 26 . The enhanced role of Germany works well for reducing inflation until one of two thingsccurs. This would lead to a fall in Italian interest rates and a depreciation of the lira against the mark and other currencies.
When these ―realignments‖ of the bands became likely. it may not have advanced the incentives for economic cooperation between countries.Lira and selling Marks.K about the inherent inequities of the asymmetric system and helped convince them of the virtue of having an independent monetary policy and a floating exchange rate. The events leading up to the eventual demise of the ERM may have convinced countries like the U. If it chooses to devalue then a new central value for the currency is chosen and the exchange rate band is adjusted accordingly. large movements in the currency. This will cause the Italian Central Bank to run out of DM reserves and it would have to either devalue the currency or get more Marks from Germany. 3. 27 . speculative activity heightened because there was money to be made by borrowing lira and exchanging them for Marks at the pre-alignment rate and paying back the lira borrowing after the realignment. While EMS may have helped advance the political cooperation between EU countries. small movements for infrequent. So we end up substituting frequent.
East Germany) starting August 13. 1990 In order to make this assimilation work. This meant that East German business owners could not sell their goods nor could they afford to pay their workers leading to a large scale economic shutdown in East Germany.The fall of Berlin Wall and ERM Collapse The catalyst for the ERM crisis was the reunification of Germany in 1990.2%. Furthermore. The Berlin Wall was a barrier constructed by the German Democratic Republic (GDR. after all they had been deprived of most of the perks of capitalism for many years. far exceeding the value of the East German Mark. the West German government spent an enormous sum of money: almost half of all West German savings were transferred to the East and the government budget deficit rose from 5% to 13. a radical series of Eastern Bloc political changes occurred associated with the liberalization of the Eastern Bloc's authoritarian systems and the erosion of political power in the pro-Soviet governments in nearby Poland and Hungary.8:1. rich economy with a smaller economy with a much lower standard of living. In 1989. East German consumers largely spent the transfers on consumption. which was formally concluded on October 3. The fall of the Berlin Wall paved the way for German reunification. the old East German Marks were converted to DM at a rate of roughly 1. that completely cut off West Berlin from surrounding East Germany and from East Berlin. an event unprecedented in history for the amalgamation of a large. 1961. The Wall served to prevent the massive emigration and defection that marked Germany and the communist Eastern Bloc during the post-World War II period. 28 .
Further more output in Germany falls Impact on Rest of Europe German and world interest rates rise following reunification. The combination of expansionary fiscal and contractionary monetary policy caused German interest rates to rise dramatically. There is an outflow of money from Europe and ERM currencies like the lira and the peseta towards the bottom of their target zones. Second. It also affected countries like Sweden and Finland that had stayed outside the EMS but chosen fix their exchange rates to the DM perhaps in search of the anti-inflation credibility from the Bundesbank. the growth of DM increased in 1990 as the central bank issued DM in exchange for East German Marks. Since German interest rates are higher than in the rest of the world. The Bundesbank raised interest rates by almost 3% in the years 1991 and 1992. By 1991. The critical feature is that interest rates rise both in Germany and in the Rest of the World. there is an inflow of money into the German economy.Most of the demand for goods from the East Germans would therefore fall on West German made goods and the inflationary pressures started to build in the economy. the Bundesbank was becoming very nervous about the prospects of high inflation in Germany and started pursuing contractionary monetary policy very seriously. This inflow causes the DM to appreciate and NX to fall. 29 .
an outflow of money leads to a monetary contraction as the central bank exchanges foreign currency for domestic currency. The above analysis indicates that the temptation to leave the ERM was high for the U. While this loss of autonomous policy was stifling the UK economy. The same held true for many other struggling European economies like Italy. the outflow of money will lead to exchange rate depreciation. the interest rates in Germany and the Rest of the World increases. things became much worse following the reunification process and the tightening of German monetary policy. 30 .K. First.K was in the worst recession since the end of WW II. thus causing reserves at the Bank of England to dry up and putting further devaluation pressure on the pound. the fall in output in Germany results in fewer imports being purchased from elsewhere in the ERM. In isolation. Since the rate of return in Germany and the rest of the world are higher. the Swedish krona.The fall of the Central Bank of England The German economy was affecting its ERM partners. with unemployment rates well in excess of 10%. Essentially.K. Under a fixed exchange rate system. the U. the British pound and the Italian lira by borrowing large sums of these currencies and selling them for German marks. there is a monetary outflow from the U. Spain and Portugal as well as for countries like Sweden and Finland to break off their fixed exchange rate system. the U. At the time. speculators figured that many European nations would be forced to leave the ERM and devalue their currencies. At this point. The important thing to note is that the slump is worse under fixed exchange rates than it would have been under flexible exchange rates. Second the appreciation of the mark vis-a-vis non ERM currencies implicitly makes the pound appreciate against those currencies. Thus output in the U. Under a flexible exchange rate system. economy will be higher under a flexible exchange rate system than under fixed exchange rates. these speculators were betting that the pound would lose value and started selling pounds in exchange for other foreign currencies. and attacked the Finnish markka. Finally.K would have resorted to expansionary monetary policy to get out of the slump but they are handcuffed by the fixed exchange rate system. There are three impacts of the events in Germany on the United Kingdom.K.
e.K left the EMS and countries like France saw their currencies come under such heavy attack that the exchange bands were widened so much that they were effectively floating currencies. lost a lot of reserves trying to defend the pound (i. These attacks continued well into 1993 and several countries including the U. Paul Krugman writes that George Soros made a billion dollars betting against the pound.The British Central Bank. for example. by selling D-Marks and buying pounds) and withdrew from the EMS. 31 .
A financial crisis erupted. Soviet Union was the biggest importer and exporter for both Finland and Sweden. the recession culminated in Europe with the ERM crisis. The Finnish economy grew throughout the 1980s after recovering from the OPEC crises of the 1970s and early 1980s. In autumn 1992 and summer 1993. triggered by rising oil prices and rising real interest rates in Europe due to the re-unification of Germany. the peg became unsustainable and the Bank of Finland had to let the markka float. Exports weakened further as a result of the collapse of trade with the imploding Soviet Union in 1991. The Bundesbank responded to the expansionary fiscal policy in Germany by increasing its interest rate. Given this openness and thus the importance of international trade to the two economies. In this section we are discussing the 1990s crisis of Finland and Sweden and compare them with earlier crisis in Finland and Sweden in terms of real economic loss. Fiscal policies were expansionary as well. Asset prices plummeted and a period of debt deflation set in. Bank credit rose sharply and Finland received large capital inflows. signs of an overheated economy began to show in the latter part of the 1980s when real income growth accelerated. A switch to tighter policies to defend the fixed exchange rate of the markka along with rising international interest rates led to a sharp increase in the real rate of interest. The boom in Finland ended in 1990. In September 1992. thus contributing to the bubble. a most important Finnish export industry. The terms of trade increased owing to the fall of energy prices and the increase in prices in the forestry sector. the Soviet empire imploded and the Gulf War erupted. With the iron curtain came down on cold war. the government enforced a devaluation of the currency. asset prices rose rapidly and inflation rates started to increase. The markka came under severe pressure as the depression grew deeper. The early 1990s were turbulent years. The boom was fuelled by the deregulation of financial markets.Crisis in Finland and Sweden (1990-93) Both Finland and Sweden are commonly regarded as small and open economies. However. The industrial world entered a recession. 32 . it should not come as a surprise that the economic crises in Finland and Sweden occurred during periods of international economic slowdown. In November 1991.
0 percentage points. The depression led to a sharp increase in unemployment. Employment declined by the same proportion but over a longer period. Between 1990 and 1994 job losses totalled 16.The depreciation of the Finnish currency started the turnaround in 1993. Employment continued to decline for a year longer than the two other measures. The Swedish economy followed roughly the same path as the Finnish. The financial sector was put under severe stress and Sweden was soon plagued by a banking crisis and a currency crisis at the same time. leading to a rapid increase in the demand for and supply of credit. Sweden was less affected than Finland by the real effects of the crisis. often negative ones. the introduction of a tax reform combined with higher international interest rates and falling inflation created a sharp and sudden increase in the real rate of interest. The old forestry and engineering industries became less important while high-tech sectors such as the mobile phones industry dominated the recovery process.4 percentage points. In 1990. Between 1990 and 1993 the loss of real income was 13.0 percentage points and of industrial production 17. In Sweden the credit markka was deregulated in 1985. Still. with a loss of 21. High inflation rates and inflationary expectations combined with the design of the tax system gave rise to very low real interest rates.0. 33 . with a cumulative loss of real income of 26. The result was a ―financial hothouse‖ with sharply increasing asset prices. The Swedish economy was hard hit by the crisis of the 1990s. bursting the bubble and setting off a process of balance sheet adjustment with strong signs of debt deflation. During the remainder of the 1990s the economy grew rapidly and new industries emerged. Between 1990 and 1994 the cumulative loss of employment was 24. As a result of the consequent depreciation and lowering of interest rates. leading to huge budget deficits. an export-led recovery slowly took hold. The structure of the economy changed fundamentally. The Riksbank was eventually forced to let the Krona float in November 1992. It was one of the most severe downturns in the 20th century. Government expenditures increased while tax revenues stagnated.4 percentage points during 1990-92.6 percentage points. The Finnish economy started to decline in 1990 and real income did not return to its pre-crisis trend until 1994. The recovery was export-led while the domestic sector remained depressed for a few years longer. Industrial production was somewhat less affected by the crisis than the rest of the economy.
US interest rates were very high. meeting in the Dutch town of Maastricht. The cause was a dispute between the Reagan administration and the US central bank over the size of the budget deficit. But the system immediately came under pressure from the strong dollar. The system of fixed exchange rates pegged to the US dollar was abandoned. A European Central Bank was established to set interest rates.Summary of Events leading to pre-eminence of euro as currency Birth of the European Monetary System It was the economic crisis of the 1970s that led to the first plans for a single currency. Britain and Denmark opted out of these plans. agreed to set up a single currency as part of a drive towards Economic and Monetary Union. In 1986 the world's leading industrial countries agreed to act and lower the value of the dollar. interest rates and budget deficits. Maastricht Treaty In 1991 the 15 members of the European Union. including targets for inflation. tying together European currencies. 37 . European leaders agreed to create a "currency snake". Plaza Accord In the 1980s the dollar strengthened dramatically. The successful deal was struck at New York's Plaza hotel. causing problems for some of the weaker European economies. There were strict criteria for joining.
and the dollar strengthened. Euro launch the euro was launched on 1 January 1999 as an electronic currency used by banks. Central Bank intervention After just 20 months the euro had lost nearly 30% in value against the dollar. But uncertainty about its policy and public disagreements among member governments weakened the value of the euro on foreign exchange markets.was used to keep the value of European currencies stable. Terrorist Attack The terrorist attack in New York. aimed at damaging the world's leading financial centre. Money flowed out of the dollar. to safe havens like the Swiss franc and . Only the French franc was successfully defended against the speculators. Many observers believe it may have marked the coming of age of the euro as an international currency.ERM crisis The Exchange Rate Mechanism . In September 1992 the UK and other EU countries were forced to devalue.for the first time . Many EU countries were struggling to cut their budget deficits to meet the criteria for euro membership.but it has still not recovered its value. But fears that voters might reject the Maastricht treaty led currency speculators to target the weaker currencies. big firms and stock markets. eventually reaching economies as far away as Russia and Brazil. The new European Central Bank set interest rates across the euro zone.the euro. The move helped put a floor under the euro . The European Central Bank and other central banks finally joined forces to boost its value. Central banks tried to calm the markets and cut interest rates across the globe. 38 . Asian crisis The turbulence in the Asian currency markets began in July 1997 in Thailand and quickly spread throughout the main Asian economies.established in 1979 . foreign exchange dealers. severely tested currency markets. A weak euro helped European exports. Foreign lenders withdrew their funds amid fears of a global financial meltdown. but undermined the credibility of the currency and fuelled inflationary pressures.
The arrival of the euro as a cash currency may foster closer integration and greater price competition within the euro zone. 39 . as the doubts grow over the strength of the dollar as the US economy continued to slow. It may also help boost its international role.Euro becomes cash currency On 1 January 2002 the euro became a reality for 300m citizens of the 12 countries in the euro zone.
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