PRINCETON STUDIES IN INTERNATIONAL FINANCE No. 84, March 1998 INTERPRETING THE ERM CRISIS: COUNTRY-SPECIFIC AND SYSTEMIC ISSUES WILLEM H. BUITER GIANCARLO M. CORSETTI AND PAOLO A. PESENTI INTERNATIONAL FINANCE SECTION DEPARTMENT OF ECONOMICS PRINCETON UNIVERSITY PRINCETON, NEW JERSEY PRINCETON STUDIES IN INTERNATIONAL FINANCE PRINCETON STUDIES IN INTERNATIONAL FINANCE are published by the International Finance Section of the Department of Economics of Princeton University. Al- though the Section sponsors the Studies, the authors are free to develop their topics as they wish. The Section welcomes the submission of manuscripts for publication in this and its other series. Please see the Notice to Contributors at the back of this Study. The authors of this Study are Willem H. Buiter, Giancarlo M. Corsetti, and Paolo A. Pesenti. Willem Buiter is Profes- sor of International Macroeconomics at the University of Cambridge and a member of the Monetary Policy Com- mittee of the Bank of England. He has previously served at Princeton and Bristol Universities, at the London School of Economics, and at Yale University, where he was Juan T. Trippe Professor of International Economics. Giancarlo Corsetti is Assistant Professor of Economics at the University of Rome III and has also taught at Yale and Columbia Universities. Paolo Pesenti is Assistant Professor of Economics and International Affairs at the Woodrow Wilson School at Princeton University. He is a research fellow of the National Bureau of Economic Research and has served as a consultant to the World Bank. The authors’ book Financial Markets and European Monetary Coop- eration: The Lessons of the 1992–93 Exchange Rate Mech- anism Crisis will be released this year by Cambridge University Press. PETER B. KENEN, Director International Finance Section PRINCETON STUDIES IN INTERNATIONAL FINANCE No. 84, March 1998 INTERPRETING THE ERM CRISIS: COUNTRY-SPECIFIC AND SYSTEMIC ISSUES WILLEM H. BUITER GIANCARLO M. CORSETTI AND PAOLO A. PESENTI INTERNATIONAL FINANCE SECTION DEPARTMENT OF ECONOMICS PRINCETON UNIVERSITY PRINCETON, NEW JERSEY INTERNATIONAL FINANCE SECTION EDITORIAL STAFF Peter B. Kenen, Director Margaret B. Riccardi, Editor Lillian Spais, Editorial Aide Lalitha H. Chandra, Subscriptions and Orders Library of Congress Cataloging-in-Publication Data Buiter, Willem H., 1949–. Interpreting the ERM crisis : country-specific and systemic issues / Willem H. Buiter, Giancarlo M. Corsetti, and Paolo A. Pesenti. p. cm. — (Princeton studies in international finance, ISSN 0081-8070 ; no. 84 Includes bibliographical references. ISBN 0-88165-256-3 (pbk.) 1. Foreign exchange rates—Government policy—European Union countries—Mathe- matical models. 2. European Union countries—Economic conditions—Mathematical models I. Corsetti, Giancarlo M. II. Pesenti, Paolo A. III. Title. IV. Series. HG3942.B853 1998 332.4′566′094—dc21 98-11535 CIP Copyright © 1998 by International Finance Section, Department of Economics, Princeton University. All rights reserved. Except for brief quotations embodied in critical articles and reviews, no part of this publication may be reproduced in any form or by any means, including photocopy, without written permission from the publisher. Printed in the United States of America by Princeton University Printing Services at Princeton, New Jersey International Standard Serial Number: 0081-8070 International Standard Book Number: 0-88165-256-3 Library of Congress Catalog Card Number: 98-11535 CONTENTS 1 INTRODUCTION 1 2 THE ERM CRISIS: A RECONSTRUCTION 6 Country-Specific and System-Wide Tensions in Europe 6 The Speculative Attacks of September 1992 13 Toward the Revamping of the ERM 25 3 BUILDING BLOCKS OF A SYSTEMIC MODEL OF CURRENCY CRISES 28 A Disinflation Game in a Center-Periphery Economy 28 The Theory of Currency Collapses—in a Nutshell 30 Market Expectations and Self-Fulfilling Prophecies 33 European Macroeconomic Spillovers: Theory and Empirical Evidence 35 Currency Crises in a Multicountry Framework 38 4 THE 1992–93 EVENTS AS A COORDINATION FAILURE 41 Expectations Shifts in Europe During September 1992 42 Systemic Effects in the ERM Crisis 46 Cooperation at a Dead Lock? 49 5 CONCLUSIONS 52 APPENDIX 54 The Center Country 54 The Periphery Countries 55 Shocks to Fundamentals, Monetary Innovations, and the Real Exchange Rate 56 Policy Preferences in the Periphery 59 Characterizing the Optimal Monetary Policy: The Shadow Devaluation Rate 60 Endogenous Wages 62 Multicountry Nash Equilibrium 62 Cooperative Equilibrium 65 REFERENCES 66 FIGURES 1 Key Interest Rates in Germany, 1987–1995 8 2 Time Series of Macroeconomic Variables in Europe, 1987–1995 10 3 Three-Month Interest Differentials against Germany, 1990–1993 22 4 The Shadow Devaluation Rate 33 TABLE 1 Deficit and Debt Ratios in the European Union 9 BOX 1 Parameter Definitions 58 1 INTRODUCTION The crisis of the European exchange-rate mechanism (ERM) in 1992–93 was a critical event in the post-Bretton Woods history of the international monetary system. The disruptive effects of speculative flows exposed the fragility of the European Monetary System (EMS) following the removal of exchange controls, shaking the entire process toward monetary union. Both inside and outside Europe, the events of 1992–93 represented a turning point for intellectual opinion—and policy priorities—regarding use of the exchange rate as an effective nominal anchor in the design of disinflation policies for integrated capital markets. A full understanding of the causes, origins, and implications of the ERM breakdown can provide policy lessons that are particularly relevant, although by no means confined, to the current debate on the monetary future of Europe. By shedding light on the dynamics of “systemic” crises, the lessons of 1992–93 can help to refine our interpretation of the other two large-scale episodes of international monetary instability occurring in the years after the European crash: the speculative attacks and financial crises following the collapse of the Mexican peso at the end of 1994 and the currency crises in East Asia during the second half of 1997. Against obvious differences in their dynamics and underlying causes, the currency crises of the 1990s are alike in sharing a rapid and “contagious” propagation of speculative waves from the original country or group of countries under attack to an entire region having (perceived) comparable macroeconomic features. For this reason, an analysis of the For their helpful comments and suggestions, we thank Michael Bordo, Barry Eichen- green, Jeffrey Frankel, Jeffry Frieden, Peter Garber, Koichi Hamada, Maurice Obstfeld, David Pearce, Guido Rey, Kenneth Rogoff, Chris Sims, Niels Thygesen, and an anony- mous referee. We also thank seminar participants at Harvard, Rutgers, Yale, Cambridge, and Koç Universities, the University of California, Berkeley, the University of Rome III, the London School of Economics, the Tinbergen Institute, the Banca d’Italia, the Danmarks Nationalbank, and the European Monetary Institute, and conference partici- pants at the Centre for Economic Policy Research conference on “Speculative Attacks on Foreign Exchange Reserves,” held in Sesimbra, Portugal, in April 1997. Giancarlo Corsetti gratefully acknowledges financial support from the Ministero dell’Università e della Ricerca Scientifica e Tecnologica. We thank Mukul Kumar for excellent research assistance. A previous version of this study has circulated as CEPR Discussion Paper No. 1466. 1 ERM crisis can enhance our tools for policy evaluation in an interde- pendent global economy.1 Most contributions to the recent literature have linked the ERM crisis to the international policy conflict generated by the policy mix adopted by Germany during its process of reunification in the early 1990s. Explanations have also stressed the persistent asymmetric performances of national price or unit-cost levels (reflecting divergent national monetary and fiscal policies), the destabilizing effects of deregulating international financial capital movements under the Single European Act, and the perceived change in the commitment of national policy- makers to fixed exchange rates after the results of the first Danish referendum in June 1992. Other contributions have emphasized the possible role of self-fulfilling speculative attacks triggered by sudden, essentially arbitrary, expectations shifts in the financial markets. Virtually all the interpretive schemes proposed by the literature have focused on the adjustment problems faced by individual European countries and have analyzed the country-specific sources of exchange- rate tension that eventually undermined the ability of individual coun- tries to maintain a stable parity against the deutsche mark after Sep- tember 1992. In other words, most contributions have represented the ERM as the sum of independent unilateral pegs against the currency of the “center” country, autonomously pursued by a number of “periph- ery” countries. The problem with such an approach is that it downplays or ignores altogether the presence of structural policy spillovers in Europe, an omission of no little consequence. Interpretations based on a country- by-country analysis cannot, by their very structure, adequately explain the ERM events as the crisis of an exchange-rate system. They are therefore unable to address the issue of contagious speculative attacks or to analyze the effects of coordination (or lack thereof) of monetary and exchange-rate policies. Theories based on country-specific imbal-