From: ecpzp@csv.warwick.ac.uk (Mr V A Noronha)
Newsgroups: sci.econ
Subject: Re: how does European Exchange Rate Mechanism work (UK vs. Germany)?
Date: 11 Nov 1992 20:46:16 -0000
Organization: Computing Services, University of Warwick, UK
NNTP-Posting-Host: clover.csv.warwick.ac.uk

In article <1992Nov11.153842.11930@vision.ummed.edu> lml@vision.ummed.edu (Lawrence Mark Lifshitz) writes:>
>Question: why did the UK have to take the onus for the
>problem and not Germany?  I don't mean from an economic
>stance, eg, the UK mismanaged their economy so the exchange
>rate couldn't be maintained.  I mean how do the powers
>that be (whoever they are) decide that the UK is the one
>which is in violation of the ERM rules?  After all, it
>takes two to define an exchange rate.  Why wasn't Germany
>worried about violating the ERM rules?


Well, actually, the German central bank, the Bundesbank, did intervene to support the pound by buying
pounds and selling DM.  However, under ERM rules, this has to repaid to the Bundesbank by the British government.
The alternative action was for relative interest rates to fall in Germany.  This happened when the UK raised its interest
rates firstly to 12% and then to 15% on the same day, but as the markets were convinced that sterling was about
 to be devalued, no-one was prepared to buy sterling at its original rate.  Had the Germans lowered their
interest rates, this would have had a more convincing and widespread effect on the markets, relieving pressure on 
several ERM currencies, including the pound, peseta, lira and punt.  This did not happen, even
though ERM rules require it.  This is why the UK government was so upset with the Germans.

In defense of the Germans, it was their belief that the pound was overvalued at its parity of DM2.95 and
that devaluation was inevitable.  Also the ERM is somewhat perverse in that its credibility relies on no
devaluation (or realignments) as an anchor against inflation, and indeed this was the UK case for joining.
Then to argue that the Germans should have accommodated a devaluation of sterling was misleading, as this would 
have undermined the anti-inflationary stance of the ERM.  Also German internal monetary conditions, which are by
law the primary concern of the Bundesbank, did not warrant a drop in German interest rates, so Germany had to 
choose between the ERM's survival and domestic inflation.

It is worth noting that those economies which are most closely tied to the German (IE Netherlands, Belgium, Luxemburg
and to a lesser extent France and Denmark) successfully weathered the storm, some even experiencing an
appreciation of their currencies.


AS for violation of the rules, it was the UK government that decided to leave the ERM after it realized that
defending sterling at DM2.95 midpoint was impossible.  Overnight sterling had dropped well below its ERM floor
of DM2.77 and it was virtually impossible for the bank of england to restore it to its ERM band the following
morning, as would have been required under ERM rules.

AS for who defined the exchange rate, it is the market that does so, not government.  However, the decision for the
UK to join at a central rate of DM2.95 was taken by all the EMS members.

Technically, the pound was in breach of its ERM commitments several weeks previously, as it had fallen well outside its 6
percent band against the Spanish peseta, but it was only the Deutsche Mark band that was considered important by the 
UK government and the markets.

Vernon Noronha
Newsgroups: sci.econ