The trauma of the European currency crises in the 1990s and the consequences until today

Thirty years ago, in September 1992, the European monetary system (the Exchange Rate Mechanism, or ERM, as it was then called) suffered a major cardiac arrest and almost died. Under the incessant attack of short sellers like Georg Soros, the UK Treasury folded and let the pound go. Other central banks had already found themselves in a similar position. Even the ‘main axis’ between the German Deutsche mark and the French franc came under pressure – but withstood. 

This trauma turned out to be a key moment in the evolution of the European monetary system. It highlighted the dangers of intermediate exchange rate regimes – a whole new generation of currency crisis theories stressed the disruptive effects of self-fulfilling expectations of devaluation when policy commitments are subject to ‘escape clauses’ (the possibility of devaluation). Theory matched the events to reinforce the view that exchange rate regimes are only stable at the corners, i.e. either free floating or irrevocably fixed rates. And a free float among a large collection of relatively small, very open and highly integrated economies – the case of European countries – was not considered seriously as an option. In this sense, the crisis still serves as a historical counterfactual for any notions of euro dissolution. In sum, the ERM crisis arguably produced the intellectual and political impulse needed to reinforce the ultimate adoption of a single, common currency in the form of the euro.

However, the crisis changed the way Europe moved towards currency unification, technically and politically, with long-lasting effects on its developments in the following decades. The excellent essays in a new CEPR eBook explains how this was possible (Corsetti et al. 2023). The book collects essays by economists who were there and directly involved with the crisis as well as scholars who have shaped the debates on European monetary unification ever since.

Ultimately, the euro was a brave experiment on a grand scale. At its birth, many economists on both sides of the Atlantic (but mostly on the west side) were deeply sceptical and predicted its quick failure. Yet, on its 10th birthday, the euro appeared robust and successful. It had been a good decade.

This cannot be said of the euro’s second decade, in which a sovereign risk crisis spread across the area producing economic and political fragmentation, and leaders were seen climbing summit after summit just to deliver the minimum necessary reforms and funding to prevent the union from falling apart. Against many odds, they succeeded – doubtless with the help of Draghi’s famous “whatever it takes” speech – in spoiling the many bets on the euro’s demise.

The Covid-19 pandemic provided another large-scale test of the system, and the Russian war of aggression in Ukraine is the latest in a series of negative economic shocks, this time also contributing to high inflation. The ECB had to quickly navigate away from the risks of stagflation while at the same time avoiding the substantial fiscal implications of rising interest rates. Today, however, the response to inflation by the ECB internalises the euro-wide effects of its policy decisions. Its determination to avoid inefficient divergence in the transmission mechanism – motivating the Transmission Protection Instrument (TPI) – reflects the much higher level of cross-border cooperation that a common currency requires.

This should not be taken for granted. Conflict and controversies over joint policy measures are still divisive. But as recent history shows, there is hope that crises will once again be resolved in the future.

Editors’ note: The contributions in Corsetti et al. (2023) came out of a webinar organised by CEPR, in collaboration with the Pierre Werner Chair at the EUI, to reflect on the potential lessons from the crisis. A recording of the webinar is available here.

References

Corsetti, G, G Hale and B Weder di Mauro (2023), The Making of the European Monetary Union: 30 years since the ERM crisis, CEPR Press.