European currenty crisis

European Currency Crisis
Emphasis on Sweden

Agenda • European context • Swedish case
– Background – The crisis (events of1991-1993) – The recovery

• Implications

European Monetary System overview
European Monetary System (EMS) • Joint system for coordination of monetary and exchange rate policies, consisted of two major components • An artificial unit of account named the EuropeanCurrency Unit (ECU) • A fixed exchange rate system known as the Exchange Rate Mechanism (ERM)

European Currency Unit (ECU) • A unit of account and not a medium of exchange (i.e. no ECU notes or coins issued and used to conduct transactions)
Source: Weerapana, Akila. “The ERM Crisis of 1992”. Wellesley College.

Exchange rate mechanism (ERM) • Managed float exchange rate system wherecountries’ currencies were allowed to fluctuate within prespecified bands.

European Monetary System implications
• Central exchange rates for each currency against the ECU were established • Member countries had to intervene so that their currencies stayed within the band • Since the ECU is fictitious, the bands were actually maintained against the most stable currency of the group, the German Mark(DM), therefore, the ERM is in fact a system where the exchange rates of all countries were allowed to fluctuate in a band around the DM • Sweden stayed outside the EMS but fixed its exchange rate to the German Mark perhaps in search of anti-inflation credibility from the Bundesbank

Member countries, and Sweden, lose autonomy to set monetary policy to Germany
Source: Weerapana, Akila. “The ERMCrisis of 1992”. Wellesley College.

The collapse of the ERM
1
Germany reunification (1990): amalgamation of a large, rich economy with a smaller one with a much lower standard of living Bundesbank started contractionary monetary policy given high inflation prospects by raising interest rates by ~3% in 1991-92

2

The West German government spent an enormous sum of money (the governmentbudget deficit rose from 5% to 13.2%). Combination of expansionary fiscal and contractionary monetary policy caused German interest rates to rise dramatically

3

Growth of German Mark increased in 1990 as the central bank issued DM in exchange for East German Marks.

4

Most East Germany demand for goods fell on West Germany made goods; inflationary pressures started to build

5

6

7Money flow into Germany as their interest rates are higher than in the rest of the world which causes the DM to appreciate

8

Interest rates rise both in Germany and in the Rest of the World, including Sweden that had fixed its exchange rate to the DM

9

Temptation to leave the ERM mounts for many struggling European economies in order to break off their fixed exchange rate system.10

Speculators figured that many European nations would be forced to leave the ERM and devalue their currencies, and attacked the Finnish Markka, the Swedish Krona, the British pound and the Italian lira by borrowing large sums of these currencies and selling them for German Marks

Source: Weerapana, Akila. “The ERM Crisis of 1992”. Wellesley College.

Agenda • European context • Swedishcase
– Background – The crisis (events of1991-1993) – The recovery

• Implications

Background
Financial control
• After World War, Sweden introduces capital account controls, complemented by instruments that allowed Riksbank to set interest rates • Sweden remains isolated financially from the world • Nominal interest rates kept low and tax system allowed large deductions for cost ofborrowing - (borrowing highly attractive) • Private sector in a permanent state of liquidity rationing (restricted) • Companies and households had been restricted but, financial deregulation gave strong incentives for them to expand their borrowing at prevailing interest rates (low)

Deregulation
• Financial regulations were softened in the 70’s and 80’s • 1985 – Riksbank abolished controls on...