Econ 355: European Exchange Rate Mechanism (erm) The European exchange rate mechanism

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shadowing the Deutsche Mark. As the exchange rate was largely kept in place by the use of interest rates, they were set without the domestic economy in mind. This led to a couple of years of lower interest rates than would have otherwise been in place, and hence rising inflation.

The pressure came to a head in a clash between Margaret Thatcher's economic advisor, Alan Walters, and Lawson, when Walters claimed that the Exchange Rate Mechanism was "half baked". This led to Lawson resigning as chancellor to be replaced by his old protégé John Major.

John Major and Douglas Hurd, the then Foreign Secretary, pressured Margaret Thatcher to sign Britain up to the ERM in October 1990, effectively guaranteeing that the British Government would follow an economic and monetary policy that would prevent the exchange rate between the pound and other member currenices from fluctuating by more than 6%. The pound entered the mechanism at 2.95 Deutschmarks to the pound. Hence, if the exchange rate ever neared the bottom of its permitted range, 2.778 marks, the government would be obliged to intervene.

From the beginning of the 1990s, high German interest rates, set by the Bundesbank to avoid inflationary effects related to German re-unification, caused significant stress across the whole of the ERM. Issues of national prestige and the commitment to a doctrine that the fixing of exchange rates within the ERM was a pathway to a single European currency inhibited the adjustment of exchange rates. In the wake of the rejection of the Maastricht Treaty by the Danish electorate in a referendum in the spring of 1992, those ERM currencies that were trading close to the bottom of their ERM bands came under speculative attack in the foreign exchange markets by currency speculators.

When the French referendum on the Maastricht Treaty yielded a yes vote, the attack, which had gathered force over the first fortnight of September, concentrated on the Italian lira and the pound. On September 16 the British government announced a rise in the base interest rate from 10% to 12% in order to tempt speculators to buy pounds. Despite this and a promise later the same day to raise rates again to 15%, dealers kept selling pounds. Major currency traders like Goldman Sachs knew what the British Government was trying to do and knew that they would eventually prevail against the efforts to prop up the pound. This amounted to a major transfer of wealth from the government to the speculators, both individuals and investment banks. By 7pm that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would revert to 10%. Other ERM countries such as Italy, whose currencies had breached their bands during the day, remained in the system with broadened bands or with adjusted central parities. Even in this relaxed form, the ERM proved vulnerable, and ten months later the rules were relaxed further to the point of imposing very little constraint on the domestic monetary policies of member states.

The effect of the high German interest rates, and so the high British interest rates, had been arguably to put Britain into recession as large numbers of businesses failed and the housing market crashed.

In the months and years following Black Wednesday, the pound traded substantially below its ERM lower band. It dipped below 2.20 Deutschmarks in spring 1995. From this point onwards however, it began a sustained recovery and, at one point, touched the value of 3.20 DM. Some commentators believe that 'Black' Wednesday has proved to be good for the British economy in the long-term, as interest rates were allowed to find their natural level. However, the reputation of the Conservatives for competent handling of the economy was shattered.

1 However, at the outset, the United Kingdom, under pressure form Trade Unions and the Labor Party, opted out of the ERM for fear that it could not devalue the pound in order to maintain competitiveness and employment.

2 The European Monetary Cooperation Fund (EMCF) received monetary reserves in the form of gold and dollars from the Member States and issues ECUs to the monetary authorities of the Member States which they used as a means of settlement.

3 Unlike the ECU, the euro is a real currency, although not all member states participate (for details on Euro membership see Eurozone).

4 Denmark negotiated special "opt-outs" of the Maastricht Treaty that allowed the country to preserve the krone while the rest of the European Union adopted a common currency known as the Euro in 1999. A referendum held in 2000 reconfirmed the population's attachment to the krone. As of early 2004, the Liberal government of Anders Fogh Rasmussen was planning on holding another referendum on the adoption of the euro in the near future.

The krone is closely pegged to the euro via the ERM II, the European Union's exchange rate mechanism. Before the advent of the euro, the krone was linked to the Deutsche Mark, thus keeping the krone stable at all times.

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