The ERM Crisis and Fixed Exchange Rate Systems


The problems that led to the ERM chaos on 'Black Wednesday'1) stem from the concepts of exchange rate economics and parity conditions. Fluctuating exchange rates directly affect all economic participants. The impact upon profits from changes in foreign currency is obvious, but fluctuations will also have a significant bearing on an ability to sell goods and services overseas and compete on imports. The principle of comparative advantage, a foundation of international trade, is entwined with the concept of variations in the pattern of relative prices across countries. Exchange rates may bring the trade between nations and segmented markets to levels on which imports and exports are in equilibrium in the currency of a particular country. This balancing of elasticities is also sensitive to short and long term capital flows associated with borrowing and lending activity, differences across domestic economic development levels and changes in relative development levels of industries within a national economy. The exchange rate will therefore impact upon all other economic variables including levels of inflation, unemployment and domestic growth. This causal chain does not appear to have been well heeded within the early euro zone as the member states looked to establish a pre-determined exchange rate system.

In principle, restoring the equilibrium of any international imbalances should arguably be achievable via those means of correction. This imbalance was informally acknowledged by the European Economic Community (EEC) in April 1972 where a joint currency float, a pegged exchange rate mechanism, was adopted as the exchange adjustment mechanism. Members hoped to establish a system whereby their currencies would be maintained within established limits of each other. By October 1992 however, the descendant of this heralded panacea had experienced severe problems including the suspension of participation by the United Kingdom and Italian governments. In order to uphold the mechanism, the participants seem to have assumed that largely homogeneous conditions and similar economic goals could be maintained by Europe’s multifarious members. With significant structural changes to the global economy and accelerating economic globalisation2) occurring since the early 1970's, this belief was likely to hit upon significant hurdles. The fixed currency exchange regime agreed at Bretton Woods in 19443) to manage global trade had collapsed. This international monetary system had contributed to a quarter century of largely steady global economic growth.

For the five years until March 1979, the members struggled with the realities of market pressures. Some pre-established currency limits broke down, and the initial 'snake' arrangement was dropped in favour of the formalised European Monetary System (EMS). Some lessons had been learnt as the concept was subtly different, with exchange rates not only tied to each other but also to the ECU4). Representing a basket of the participants' currencies plus the United Kingdom, its value was determined as a weighted average of the participating exchange rates. The weights were themselves derived from the assumed solid foundations of relative Gross National Product (GNP) and intra-European trade activity levels. The intention was to limit all currency fluctuations and prevent any recurrences of the initially unsustainable arrangement, after which several currencies had been realigned. This Exchange Rate Mechanism (ERM) set mutually pegged boundaries from a central par value within which member governments were expected to actively ensure all remained, with upper and lower bands for all currencies against all others. Although the need for revaluations of relative currency values was acknowledged, intervention was to be through the foreign exchange markets except where market pressures grew too strong. If one upper band was breached by a fellow member, the reasoning followed that the breacher would supply their currency in exchange for the breached currency. Should the lower band be breached, the solution would entail the breacher buying their own currency for the breached currency using their foreign currency reserves.

The emergence of increasingly free market governments in the United Kingdom and the United States, and the disintegration of the state run command economy in the former Soviet Union, signalled a new era of changed economic priorities in the 1980's. With such changes in the regulatory role of government and a refined perception of free trade and low inflation in some countries but not others, the deregulation of global financial markets appeared to cement the likelihood of a clash of aspirations and intentions across the ERM members. The Europe area anticipated freedom from exchange rate uncertainties and hoped to obtain increasingly competitive benefits of mutual collaboration, but did not put adequate structures in place to deal with the exchange rate uncertainties flowing from international trade and failed to appreciate the real difficulties in setting initial parity levels.

While most European governments were therefore focused on economic stimulation and unemployment levels, the German economy had been forced to address the financing of reunification. By 1992 this had resulted in a large budget deficit, forcing them to concentrate on inflationary controls and a tight monetary policy. The resulting increase in German interest rates led to inward capital flows from other European countries, as investors looked to take advantage of relatively high interest rates. This disparity had the potential to upset the sensitive exchange rate equilibrium among the members, and indeed it went on to set community instability in motion. Investors demonstrated little initial apprehension over exchange rate risk as European currencies were linked. However, the countries subjected to capital outflows now had reduced funds, which in turn increased their interest rates just as policy makers were trying to stimulate their economies through lower rates. The net effect was a spending reduction in those countries with higher rates.

The ERM currencies appreciated against the US dollar, highlighting the inadequacies of the exchange rate parities. This was exacerbated by a recessionary environment across some European states in the early 1990's. Following their agreed mandate, the European central banks directly intervened in the foreign exchange markets, trying to maintain exchange rates, but the monetary policies dictated by the ERM arrangements now came back to haunt them. Theory implied that increasing interest rates across the board would discourage this investment in the German mark, but the overly interventionist action was held to conflict with the goals of economic stimulation and was therefore not fully sanctioned. The British pound sterling was particularly vulnerable due to the pressures that low inflation and slow growth were placing on demands for lower interest rates.

Relating the IS-LM Model5) to the ERM crisis:


Apprehensions over the Danish referendum rejection of the Maastricht Treaty6) in May 1992 and the outcome of the French referendum in September 1992 added to the climate of uncertainty following these conflicting appraisals of rate regimes. The excessive influence of German interest rates undermined the rates of those ERM participants trying to strengthen their domestic economy. Thus in late 1992 what started as a test of the German Deutschmark/Pound Sterling (DM/GBP) boundary level began to snowball following the actions of currency speculators. By borrowing sterling in order to sell the currency at a high, and buying German marks, one noted speculator George Soros had placed a one way bet that he could now not lose. Sterling dropped in value by half a mark, from 2.77 to 2.20 DM/GBP and he was assured of his plan to buy low. With Germany’s increasing worries over inflation limiting their ability to help the United Kingdom7), the ties between the Central Banks proved largely useless in solving a problem that may have been lessened by more 'elastic' bands in the first place. The crisis highlighted that currency weakness is generally a symptom of an economy's problems rather than the cause. Cutting direct ties with the mechanism signalled an unwillingness to support the exchange rate at the cost of high domestic rates, and by definition cut the link with the mark and the other currencies. Referring back to the parity conditions; capital flows out of the ex-members and into the German economy would now be discouraged by the due to exchange rate risk, leaving United Kingdom and Italian rates increasingly dependent on local conditions.

Historically, policy makers preferred the construction of fixed exchange rate regimes on the premise that the burgeoning global economy does not need more economic variables to deal with. International trade, price discipline and increased competition through clear expectations and transparency have driven an emphasis on fixed systems. With the growth of more open trade and markets, particularly across the western liberal democracies but increasingly across the international trade spectrum, financial markets have attained a level of previously unprecedented power.

From the viewpoint of those charged with setting such policies, the choices are always difficult and often conflicting. Decisions will impact on the domestic economy; will now affect the position of that economy within a trading block(s), and increasingly affect the international economy as a whole. The ability to simply cut one variable is often too great a temptation to ignore. Despite the shaky history of fixed exchange rate regimes, the benefit of hindsight and the potential to reduce this uncertainty tend to push the executive powers towards the choice of fixed exchange rate systems.

The Bretton Woods regime demonstrates where exogenous factors determined how domestic economic policy was determined. Despite the disadvantages this may bring, the claim is that at its heart is a system with the potential to provide exchange rate stability. This kind of system it is argued, will further promote trade across national borders, offer a clearer expectation platform for decision making by all economic participants, impose more discipline on their own policies and lower the risk of currency speculation.

With established lower bounds across participating exchange rates, theory suggests the supply and demand curves would become perfectly elastic at the upper bounds. This would be achieved via the central banks supplying the domestic currency and in turn expanding their foreign currency reserves. Thus exchange rates are used as a fundamental instrument of policy, as part of an overall economic objective. With an acknowledged relationship between inflation and exchange rates, a fixed rate regime appears to provide reassurance that at least one important factor is under control within a larger context; beyond the manipulation of any one party.

However, there is no accepted or common wisdom on the usefulness of any exchange rate system, or on the economic fundamentals that actually influence exchange rates. A fixed exchange rate system offers advantages, as outlined previously, but this is never without a cost. What really determines the usefulness of any exchange rate regime is largely a question of the system for any one country or region. Mundell (1961) discusses the concept of optimum currency areas and relates the notion to a broad view of circumstances. A decision to accept the benefits of fixed exchange rate systems rests on an informed appreciation of economic integration despite the inevitable costs to the area that will accompany it. This has been defined simply as cost - benefit analyses and succinctly outline the rationale that should accompany any major policy decisions of this nature.

Therefore it is by definition a balancing act, subject to cross border trade and potential barriers, the mobility of the labour force, whether all economic structures are too divergent or consistent with providing an element of federal synergy (for example, the distribution of labour and capital), extent of fiscal federalism and non tariff barriers. A floating exchange rate system may enable quicker or automatic eradication of any imbalances, and at least in theory there should be no need for reserves. Despite past mistakes and naïve decision making, today’s trading realities do not leave global economic policy in a position to simply discard the benefits of stronger exchange rate movement forecasting that may come with a fixed regime. Considering the deregulation and growing power of the global capital markets, the increased trading uncertainties and potential to increase co-ordination presented by a floating regime must be debated very carefully.

However, the need for large reserves and the loss of some self-determination of internal economic and monetary policy will always provide contrasting conclusions on the best form of exchange rate control. Decisions of this nature are likely to be inexorably linked to an asymmetry of the reserve centre and a further federal tie-in with employment and trade policy. This is not necessarily a bad thing.


Mundell, R. A. (1961) A Theory of Optimum Currency Areas American Economic Review 51 (4) 657-665
Söderlind, P. (2000) Market Expectations in the UK Before and after the ERM Crisis Economica 67, 1-18


16 September 1992, when the British Pound Sterling was withdrawn from the ERM
The expansion of trade in goods and services between countries
Agreement on monetary and exchange rate management developed in Bretton Woods, New Hampshire, July 1944
European Currency Unit (a unit of account)
A Short run spending model by Hicks (1937), where money demand, tax, Investment, consumption and net export/import relationships hold
Pivotal criteria on monetary, fiscal and exchange rate convergence, and therefore the future of a monetary union
Many argue that they were more unwilling than unable to help, as the French Franc (FFR) did receive support from the German central bank (Bundesbank)

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