Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Was the ERM Crisis Inevitable?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Was the ERM Crisis Inevitable?

Article excerpt

European currency markets have been subject to recurring periods of turmoil since the summer of 1992. In the first wave of turmoil in September of 1992, the United Kingdom and Italy withdrew their currencies from the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). In the second wave of turmoil in August of 1993, the ERM temporarily suspended the narrow bands within which exchange rates of remaining ERM currencies were allowed to fluctuate. Understanding the reasons for the ERM crisis is essential for predicting the future course of European economic, financial, and political developments-all of which could affect the U.S. economy into the 21st century.

According to one interpretation, the ERM crisis was caused by a combination of bad luck and bad policy decisions. This interpretation was offered by monetary officials in Europe in their analysis of the reasons for ERM turmoil in 1992 (European Community, Monetary Committee). The bad luck was the timing of the large external shock to European economies resulting from German unification and monetary union in 1990. This shock imposed severe strains on European economies and thus on the ERM because it led to a divergence between the policy priorities in Germany and those in other EMS countries. These strains were exacerbated by inappropriate macroeconomic policy decisions that contributed to high inflation and budget deficits in some EMS countries--especially the United Kingdom and Italy. This interpretation of the ERM crisis leads to a relatively sanguine view that only minor modifications to the ERM system will allow a return to exchange rate stability as a step toward full monetary union in the European Community (EC) by the end of this decade, as envisioned in the Maastricht Treaty.

More skeptical analysts offer a much less sanguine interpretation of the crisis. They view the ERM as fundamentally flawed. Although not denying that German unification and unsound macroeconomic policies contributed to strains within the ERM, these analysts stress that the design of the system made it particularly vulnerable to such disruptive factors. Fundamental systemic changes would thus be required to achieve either exchange rate stability as a precursor to monetary union within the EMS.

The purpose of this article is to evaluate the reasons for the ERM crisis and the changes necessary to prevent a recurrence. The first section describes why Europeans want exchange rate stability and how they tried to achieve that goal before the new ERM evolved in the late 1980s. The second section analyzes the reasons the new ERM was vulnerable and how that vulnerability, while not making the crisis inevitable, nonetheless made the system susceptible to crisis. The final section evaluates prospective changes that might be necessary to reduce the vulnerability of the ERM.


The ERM crisis has led some to question whether exchange rate stability leading ultimately to monetary union is a feasible goal. Yet most European political leaders continue to express their determination to achieve that goal as soon as possible. This determination grows out of a long standing desire in Western Europe for greater economic, monetary, and political integration. The specific contribution of the ERM was intended to be greater stability of exchange rates among the currencies of EC countries.

Why Europeans want stable exchange rates

Europeans have a long history of trying to stabilize the exchange rates between their national currencies. Exchange rate stability is considered critical by member states of the EC for two reasons: 1) a history of exchange rate instability has led to economic hardship and social disruption, and 2) trade is important for economic performance.

The history of exchange rate instability in 1920s and 1930s has had an enduring effect on Europeans' perspective. Whereas exchange rates had been stable and European economies had prospered under the international gold standard in the third of a century leading up to World War I, exchange rate instability in the interwar period was accompanied by recurring financial crises and extreme economic hardship in Europe and elsewhere. …

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