A stitch in time saves twenty-seven

The emergence of fiscal problems within the Eurozone raises key questions for European leaders. They need to strike a balance between the need to safeguard a central pillar of the European economic constitution and the need to guarantee financial stability in the European market. Each country participating in the euro is responsible for the viability of its fiscal policy and cannot be bailed out. But equally a crisis in any country can produce dangerous contagion and adverse systemic effects.

Member governments undertaking difficult retrenchment programmes require to be shielded against painful speculative attacks not necessarily motivated by fundamentals, even though the fundamentals may be weak.

In addition, such action occurs in a global economic and monetary context. At present the problems of the euro coincide with increased tension in the US-China relationship, and with increasingly radical rhetoric about the possibility of China dumping its dollar holdings.

A successful European response will require not only the identification of effective solutions on technical grounds. It will also require political agreement, unity, and coordinated actions.

There are striking historical examples of successful coordinated initiative with a strong political backing – the most striking of which is the euro itself. Unfortunately, we also repeatedly have had striking historical examples of the damage which may stem from the inability of European leaders to agree on a solution to an emerging problem, and Europe has repeatedly been close to collapse.

The most recent example is currency crisis that shook the European Monetary System in 1992-93 and almost tore Europe apart. Back then, there were three fundamental problems.

• First, the exchange rates within Europe were misaligned.

Many countries had kept their exchange rate fixed against the Deutsche Mark while allowing their inflation rate to exceed that in the core of Europe. This created a cumulative imbalance which needed to be corrected via real depreciation, via either a long process of disinflation or nominal devaluation, that is, a realignment.

• Secondly, on top of what was going on in the ‘periphery’ of the system, the re-unification of Germany coincided with a sustained fiscal expansion which fed internal demand and motivated an interest rate hike by the Bundesbank in order to maintain price stability.

The macro development in the “centre of the system” was therefore also putting pressure for a revaluation of the Deutsche mark.

• Third, the weakness of the dollar, that in August 1992 was portrayed as a “dollar crisis” on the cover of The Economist, also weighed on the exchange rate. Dollar weakness had traditionally been associated with tensions in the European system.

With the benefit of the hindsight, it is clear that a realignment of the European currencies could not be postponed any longer. But realignment need not necessarily have constituted a crisis.

In the history of exchange-rate agreements in Europe there had been several examples of more-or-less coordinated adjustment. Even if the removal of capital controls arguably made adjustment more difficult in 1992, a coordinated action of all central banks in Europe, jointly announcing and standing behind a moderate revaluation of the Deutsche Mark coupled by some devaluation of the weak currencies (notably, the lira, the pound, and the peseta) could have arguably prevented the system from entering a long crisis. The need for a revaluation of the Deutsche Mark was indeed repeatedly voiced by the Bundesbank. Unfortunately, the European leaders could never reach an agreement.

We will never know for sure whether a coordinated adjustment would have worked. But we understand that, under the circumstances, two different scenarios could have been envisaged. They are spelled out in Buiter et al. (1998). One involved a sizeable effective (multilateral) revaluation of the Deutsche Mark against all currencies, matched by a cut in German interest rates. The other also had a revaluation of the Deutsche Mark, but on a smaller scale, as the outcome of large devaluations (indeed crises) of only a few European currencies. The German interest rate would also fall in this equilibrium, but by less than in the first scenario. A smaller fall in the German interest rate, in turn, would increase the pressure on weak currencies, for a larger devaluation.

We did not experience the first scenario. We did experience something close to the second scenario, with a protracted period of continuous speculative waves against this or that currency. The only strong tie that appeared to emerge at the time was between Germany and France, with the former country intervening repeatedly in support of the French franc. The exchange rate system was no longer viable, and was effectively abandoned in the summer of 1993, with the exchange rates allowed to fluctuate up to 15% around parities. But this un-orthodox solution bought time for governments to implement the necessary reforms, and for the markets to settle on what they would see as sustainable exchange rates within Europe. Most important, it facilitated a renewed political commitment to European monetary unification, setting the process in motion again after a couple of years.

What are the lessons to be applied to the current European financial problems? The recipe for tackling them successfully is simple. A solution requires a credible demonstration of political will. Deferring a crisis in the end leads to greater costs and more extensive damage. At the moment, such a demonstration that there is a real meaning to the concept of Europe would involve the acceptance that in some closely defined circumstances, some greater degree of fiscal and financial centralisation is required.

The basis for such action was already clearly specified in the 1957 Treaty of Rome, where Article 108 provides for mutual economic assistance of member states.
The current crisis can and should be handled through the channels that are immediately available, i.e., the IMF. But as in September 1992 it is likely to lead to more crises unless it is accompanied by a clear and binding act of political solidarity.

The solution on the table for Greece and other countries facing the possibility of a fiscal crisis takes the form of a voluntary commitment to support a government in its efforts to consolidate its public finances with financial means provided at a penalty rate and against a clearly defined retrenchment programme. A solution that links fiscal support with a firm reform commitment is no bailout, but a reasonable way to rule out destabilising market excesses.
Such a solution requires, however, the backing of all European governments for a new, small, but essential piece of the European puzzle to finally fall into its proper place.

Buiter, Willem H, Giancarlo Corsetti, Paolo A. Pesenti (1998), Financial markets and European monetary cooperation : the lessons of the 1992-93 exchange rate mechanism crisis, Cambridge, UK ; New York : Cambridge University Press.