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Opt out or integrate – Europe’s wounds and scars and the prospects of monetary union


Almost 40 years after the “snake in the tunnel” – a system of narrow fluctuation limits within the wider exchange-rate bands of the Bretton Woods system -, roughly 20 years after the removal of capital controls as first step towards a common currency in Europe, and 18 years after the dramatic rescue action of the European Monetary System (EMS) on its way to EMU, de facto not much has changed: 

As if there had never been a monetary union, expectations about currency movements in Europe dominate decisions in world financial markets as fluctuations in the European exchange rate easily eat up returns.

As if EMU were already in disarray, new entrance candidates are warned to be shunned by international investors because of the approaching membership.

Financial markets are testing one member country of the eurozone after another.  In contrast to the early 1990s, it is not exchange rate bands and currency devaluations they target but sovereign ratings resulting in downgrades and defaults. Just as interest rate differentials exploded in the currency crises of the EMS, these days, credit spreads are widening unbounded promising extraordinary profits to some, and intolerable burdens to others, if the bets are won.

Did the common currency experiment fail?

EMS legacy

During the first years of its existence EMU appeared as a shining success. When in January 1999 the euro replaced 12 national currencies integration of European financial markets advanced rapidly, in particular at the short end, and the Maastricht criteria promised further overall economic convergence. With each new member accession the miracle repeated and became more accepted. Markets adapted to the changing circumstances: While, for example, four years before the introduction of the common currency spreads for Italy, Spain and Portugal were about 500 basis points above the German bund, and Greece was not even able to issue domestic bonds of 10-year maturity until 1997, bond spreads for later joining Eastern European countries narrowed drastically as soon as they only started negotiating for EU entry.

However, recent developments unearthed long buried conceptual inconsistencies and fundamental weaknesses of the underlying approach raising doubts about the system’s sustainability. Striking parallels emerged between the current crisis in the eurozone and the events shaking – and eventually de facto destroying – the European Exchange Rate Mechanism in 1992/93. The timeline at the end of this blog allows to see the similarities between the two events. Not intended to be exhaustive, in sketching the main developments in 1992/93 with reference to newspaper headlines it wants to give an impression of the unfolding of the EMS crisis allowing to compare it with the current crisis and draw some important conclusions.

Without tracing the process in detail, several key characteristics catch the eye. As in the current situation, in 1992/93 the crisis unfolded slowly. Although it was one of the core currencies, the French franc, which since the start of the EMS had struggled heavily and had been forced to massively devalue against the D-mark several times (or the D-mark to revalue against the franc depending on the side you listened to), speculators first targeted other currencies. The reason became apparent when in September 1992 the French franc came under pressure and was most energetically defended in united interventions by both the Banque de France and the Bundesbank. However, this did not save the system. When after several rounds of speculative attacks the French foreign reserves were exhausted, and the franc was eventually defeated, the ERM de facto broke down.

Like these days, attacks came in waves. Usually, markets test one member country after the other. If not successful they pause or shift their focus searching for profit opportunities elsewhere before coming back for another round. However, as soon as a bet is won they turn to the next victim. In November 1992, speculators’ attention shifted to the Irish punt and the Danish krone immediately after the devaluation of the Spanish peseta and the Portuguese escudo. In 2011, market interest shifted immediately to Spain and Italy after the rescue package for Greece was decided.

One lesson to be learned from this process is that securing the system requires to start defending it in earnest against each and every attack at the first signs no matter where it materializes. A system is more than its parts and needs to be defended as such. Discriminating between less important periphery members and a more important core may prove a fatal mistake.

Another lesson is that if possible, pauses should be used to get the fundamentals right. As the experience with the French franc demonstrates even massive joint central bank interventions can win only temporary time to respire. The capacity of markets to enforce what they feel is “right” is without limits. This held for foreign exchange speculation in the 1990s and, as I will explain in a moment, currently holds again under the common currency. If, on the other hand, circumstances defy the necessary adjustments, pauses should be used to prepare for an orderly retreat in order to minimize economic frictions – which, in my feeling, is the most sensible advice that can be given to the eurozone members in the current situation.

NB: By fundamentals I do not mean government debt, budget deficits, current account imbalances or other macroeconomic variables found to be “out of equilibrium”. In my view, these rather serve as ex post explanations for market turmoil. In all financial crises past and present bewildered observers asked why perfectly healthy looking countries were drawn into the maelstrom of events before, after some searching, these or other macroeconomic crisis “causes” were named.

In both European financial crises markets were and are betting against an ill-devised monetary system. In 1992/93 they doubted policy commitment to the plans to create a common currency in Europe rightly regarding speculation at the ERM bands as a sure one-way bet. These days, again, markets doubt policy commitment to the common currency and this time official bailouts aimed at avoiding country default make their actions an almost sure one-way bet. The longer the process and the more indebted countries targeted, the higher the probability that official ammunition – which this time is not foreign exchange reserves but available bailout funds – comes to an end.

In this situation, getting the fundamentals right would mean restore the financial system and eliminate the fractions and inconsistencies resulting from policy interference. In order to find out how this could be done we have to ask why the current crisis, this bet against monetary union, happened so late, almost fourteen years after rates of member currencies were permanently fixed against the euro, and nine years after the new currency became legal tender.

Why now?

In retrospect, considering the beginnings from what must be seen as an almost perfect free float at one moment to a fully fledged monetary union at the next, EMU performance long appeared as a big victory over the skeptics – who might eventually enjoy a late and bitter triumph now.

The weaknesses of the system had become apparent long ago – even long before the introduction of the common currency as the EMS debacle indicated. But, the transition to the wide band of + 15% reintroduced an element of flexibility and vagueness which allowed policy to continue with its ambitious plans. Then the establishment of the euro suddenly deprived markets of one important means to test member countries one after the other: When in 2002 the euro replaced the French franc, German mark, Italian lira, Dutch guilder, Spanish peseta, Irish punt, Portuguese escudo, Finnish markka, Austrian shilling, Greek drachma and Belgian/Luxembourg franc a large number of Europe’s foreign exchange markets merged into a whole.  Instead of targeting individual countries speculators were only left with the possibility to test this whole: A huge market whose rules just had been rewritten in a highly committed and determined policy environment. There was no more possibility to discriminate between countries and target them individually. Less integrated financial markets such as those for bonds and stocks were no substitute. They are much smaller and, above all, lack one instrument which allows foreign exchange speculation to unfold such a force: a deep and highly liquid derivative segment.

In order to clarify this point I would like to come back to some basic technicalities: The peculiarities of the foreign exchange markets allow to bet against a country with a minimum of capital. As a rule, currencies are bought spot with delivery within two working days or forward for longer maturities. Open positions established in one of these markets are prolonged by means of swaps. As I wrote elsewhere a foreign exchange swap is an exchange of two currencies for a specific period with a reversal of that exchange at the end of the period. For example, in a euro/dollar swap a trader may buy the euro for delivery in two days at an agreed spot rate, simultaneously selling it back (buying the dollar back) for delivery in three months. Due to market practices, in this case, only the difference between spot and forward is paid.

The foreign exchange swap per se is by definition without risk: It contains both a long and short position of equal amount in the same currency and of the same maturity. However, combined with an outright (spot or forward) position swaps enable market actors to take risks with a high degree of flexibility at low cost: In currency markets swaps are frequently used to prolong an open position to exploit expected price movements. A trader with an open minus position in euro may buy the currency spot, thereby closing the initial position at maturity and at the same time sell the euros again against dollars for a future date. This new open currency position may serve to hedge an existing exposure or to speculate in order to benefit from an expected rise in the exchange rate. Keeping maturities short – the bulk of foreign exchange swaps is for seven days or less – and renewing swaps continuously, traders gain high flexibility to react to market events.

Therefore, what speculators required to test individual countries within the new European Monetary Union were swap markets in individual currencies. What they had was a swap market in euros which allowed no discrimination among eurozone members.

The situation changed with the emergence of Credit Default Swaps (CDSs), newly devised financial products which offered protection against credit default. Initially developed by JP Morgan in 1997, CDSs became notorious for their role in the US subprime crisis, and it was only much later that European markets discovered the opportunities they offered.

A CDS is a contract which allows a company or a bank to shed the risk related to a financial asset such as a loan or bond by buying protection paying the seller of the contract a fee or premium. In return, the seller agrees to compensate the buyer for losses occurring from default, credit rating downgrade or another negative credit event. A CDS contract is no insurance: It is not actually tied to the financial asset, but instead references it. Like a foreign exchange swap, it is a derivative, an off-balance sheet instrument whose value is derived from the credit risk of the underlying asset. Since both foreign exchange swaps and CDSs are traded over the counter (OTC), transparency is low in both cases. The following table lists their main characteristics.

Like a foreign exchange swap, a CDS can be used for hedging or speculative purposes. A holder of a bond may buy protection against default. The seller may want to take this risk and earn the premium. As Satyajit Das put it: “The CDS allows you to short credit easily, which allows you to profit from the decline in the fortunes of a company [or, in the eurozone case, the fortunes of a country]. Before the CDS this was hard. As the CDS is a derivative contract, it is also off-balance sheet. It can be leveraged, infinitely.” (And he added: “It is the killer derivative.” See Das 2010: p. 273)

As in foreign exchange markets trading is highly concentrated. Major CDS dealers are important counterparties to one another. According to the BIS those include Bank of America-Merrill Lynch, Barclays Capital, BNP Paribas, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan Chase, Morgan Stanley, Royal Bank of Scotland, Société Générale, UBS and Wells Fargo Bank. Market participants often hold with the same counterparty contracts with positive market value and contracts with negative market value.

Markets are highly volatile and speculative and there is continuous buying and selling. Contract values fluctuate with rumours and news of changing prospects of credit events. Investors need not own the financial asset in order to buy protection. Actually, outstanding notional of CDS contracts may exceed outstanding notional value of debt obligations or underlyings by several times which, for instance, is one reason why debating about the size of the EFSF to rescue EMU is futile. For the size of the CDS market, reducing a country’s debt does not matter. Its growth is detached from the underlying, solely expectation-driven and in contrast to public bailout funds without limits. Other currently tried measures appear likewise unpromising in this light. Focusing on austerity measures is of no avail because markets are less impressed by “good news” than by apparent or actual weakenesses that justify further “protection”. Banning short-selling of bank shares signals shere helplessness to stem the tide and risks provoking renewed speculative attacks.

Opt out or integrate, but DO it!

CDSs brought back to the markets an instrument which allows to discriminate between countries and in good old fashion target one after the other drawing from a bottomless pool of liquidity that no policy intervention can exhaust. Will the euro survive under these circumstances? The EMS experience indicates that the prospects are bleak. They are even worse than in 1992/93 since the policy option to go on calling the system a system and at the same time retreat to greater institutional flexibility has no parallel in the current situation.

Currently, the only alternatives left are either to let individual countries opt out temporarily in order to take pressure off them or, as mentioned above, to use the intervals between successive rounds of speculation to get the fundamentals right depriving the business of “default protection” of its basis. The only way to do this is to create a truly integrated system of financial markets in the eurozone, starting with bond markets.

The choice is between Scylla and Charibdys. The first option may provide temporary relief but also risks to slowly drive the system to extinction. The second may find no political consensus. So far, eurozone survival was more or less supported by the US debt crisis which in this bipolar world exchange rate system hindered a clear orientation of markets. However with “credit protection cost” on the rise everywhere in Europe a policy decision is needed and is needed soon. If markets are done with Spain, Italy, France and even Germany before a solution is presented the opportunity to establish a solid financial foundation for the European internal market will be lost for years.

Further reading

For a basic read on the integration of European financial markets I would like to refer to my book on European Financial Systems in the Global Economy (which comes with a great Companion Website with additional materials and a Lecturers Support Site containing an Instructor’s Manual).

A historical documentation of EMU is found here, and a brief overview is here.

Timeline EMS Crisis*

March 13 1979 Start of EMS with two fluctuations bands of + 2.25% (Belgium, Denmark, France, Germany, Ireland, Luxembourg, the Netherlands)  and + 6% (Italy)
October 4 1981 French franc devalued 8.5% against D-mark
June 14 1982 French franc devalued 10% against D-mark
March 21 1983 French franc devalued 8% against D-mark
April 7 1986 French franc devalued 6% against D-mark
June 19 1989 Spanish peseta joins ERM (wide band + 6%)
January 8 1990 Italian lira moves to narrow band
October 8 1990 Sterling joins ERM
December 20 1991 “German interest rate raised”, “Marching to the German drum”
April 5 1992 Portuguese escudo joins ERM (wide band + 6%)
July 17 1992 “Germany lifts discount rate”, “Europeans impeded by policies ‘made in Frankfurt’”
July 18/19 1992 “World financial markets tumble”
July 21 1992 “Huge operation to save dollar”, Lira falls to record low against D-Mark”
July 22 1992 “Italian lira: the sick currency of Europe – If Rome opts for devaluation others may follow and the EMS could fall apart”
August 12 1992 “Central banks step in to prop up dollar”
September 14 1992 Lira devalued 7%
September 16 1992 Lira and Sterling leave ERM, peseta devalued 5%
September 18 1992 “Speculators find new ERM targets after lira and peseta”
September 29 1992 United interventions of the Bundesbank and the Bank of France to stop franc devaluation, “Pound  hits new low against D-Mark as franc rallies”,  “French franc pays price for partnership with D-Mark”
October 2 1992 “Bank of France spent FFr80bn supporting franc through crisis”
October 16 1992 “Danes seek opt-outs from Maastricht”
November 3 1992 “French weaponry secured win in battle for franc”
November 20 1992 “Speculators force Sweden to drop link with ERM”
November 23 1992 Spanish peseta and Portuguese escudo devalued 6%, “Irish punt, Danish krone seen as targets for selling”, “Bundesbank under new rates pressure”
November 24 1992 “EC governments raise interest rates in effort to protect ERM”
December 2 1992 “Schlesinger calls ERM an incentive to speculators – Bank of France forced to intervene to support franc in tense trading”
December 3 1992 “French franc struggles in spite of intervention”
January 5 1993 “French franc under pressure”
January 6 1993 “Germany joins France to support embattled franc”
January 9/10 1993 “Costly siege of the franc fort – The defense of the French currency is putting a severe strain on the economy”
January 21 1993 “Counting the cost of weathering ERM storm – Battle for punt leaves long list of casualties – ‘Franc fort’ squeezes jobs, growth and prices”
February 1 1993 Irish punt devalued 10%, “Dealers warn of new ERM pressures”
February 4 1993 “Speculators push Danish krone to floor in ERM – European crisis deepens as currencies weaken and slow growth threatens EMU”, “Pound hits record low in heavy trading”
February 12 1993 Hard-core currencies under pressure in the markets, “Dealers scare the D-Mark’s Belgium shadow”, “France urges faster move towards EMU”
February 25 1993 “Spain warns of tax on currency speculators”
May 14 1993 Peseta devalued 8%, escudo devalued 6.5%
May 27 1993 “Peseta in sharp fall against D-Mark”
July 10/11 1993 “Franc falls closer to ERM floor”, “Intervention fails the franc”
July 14 1993 “Franc’s ERM parity defended”
July 15 1993 “Franc Spends Bastille Day Under Siege” (International Herald Tribune)
July 24/25 1993 “Lines of defence keep falling”, “French lift rates to defend franc”, “Commission confident ERM will hold”
July 29 1993 “Bundesbank cut raises ERM hopes”
July 30 1993 “Bundesbank ½ point rate cut fails to bolster ERM”
August 2 1993 Widening of ERM bands to + 15% (exception: D-mark/Dutch guilder which retained + 2.25%)
August 7 1993 “Paris sind keine Devisenreserven geblieben” (Frankfurter Allgemeine Zeitung)
April 2/3 1994 From the FT LEX COLUMN: “There is a refreshing candour about Deutsche Bank’s admission that it does not expect much by way of earnings increase this year. Last year’s 23 per cent jump in group net profit owed much to special factors that will not easily be repeated.”
* If not noted otherwise citations refer to Financial Times headlines.
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