In Discussion Paper No. 1508, Hans-Werner Sinn ascribes the 1992-3 crisis in, and the eventual break-up of, the ERM to German unification. The very high demand for capital to finance unification boosted domestic interest rates relative to the rest of the world, leading in turn to overvaluation of the currency. Sinn argues that, prior to the crisis, the Deutschmark was almost exactly equal to its Purchasing Power Parity value; the subsequent overvaluation, therefore, was not the result of a stability premium on account of a low German inflation rate. The 1992-3 crises were caused by changes in economic fundamentals as resource demand expanded, and not by policy errors of the Bundesbank, which stuck to its objective of preserving price stability by following a restrictive monetary policy.

The shock that caused the overvaluation of the currency and the increase in German interest rates was temporary, but its consequences will be enduring. When EMU is formed at new parities, exchange rates will not be able to return to their previous values. To avoid a repetition of the ERM crisis, Sinn recommends a revaluation of some European currencies before they enter the ERM. Judged by the PPP criterion, these include Ireland, Spain, Italy, Austria, Portugal and the United Kingdom. The rest will not face great problems if they join at current rates.

International Implications of German Unification
Hans-Werner Sinn