The September 1992 crisis on Europe's currency markets called the future of the Maastricht Treaty into question. In Discussion Paper No. 817, Research Fellows Barry Eichengreen and Charles Wyplosz review four interpretations. First, misguided beliefs that the `new EMS' could maintain the existing parities may have delayed an overdue realignment, but this accounts fully only for the collapse of the lira. Second, while German unification may have forced a DM appreciation on reluctant governments, this cannot account for its timing. Third, if worsening economic conditions fuelled opposition to Maastricht and reduced incentives to meet its terms, markets anticipated devaluations and the crisis only hastened an inevitable relaxation of monetary policy. Finally, investors could rationally anticipate that a speculative attack would relax monetary policy; since devaluation bars a country from entering monetary union and thereby weakens its incentive to maintain a tight policy, such an attack could be self-fulfilling.

Eichengreen and Wyplosz then consider various means of completing the transition. The least likely is to proceed as before, since ample scope remains for repeated, self-fulfilling speculative attacks. Marginally more likely is a shot-gun wedding of France and Germany to form a stable core which other north European currencies could join, but this implausibly requires Germany to allow Bundesbank representation to officials of the Banque de France. There could still be a rapid move to EMU within the Maastricht framework if a majority of member countries satisfy the convergence criteria in January 1994, but Germany would probably veto any union turning on participation by Ireland, Portugal or Spain. Wider bands in the transition would reduce opportunities for speculative profits but also undermine the credibility of the ultimate commitment to EMU.

Eichengreen and Wyplosz argue that the only remaining alternative is to slow down currency markets by introducing prudential regulation like that on other financial markets. Requiring all open foreign exchange positions to be matched, in full or in part, by non-interest-bearing deposits with the central bank would amount to a `Tobin tax' on transactions, which would rise with the interest rate and in particular during currency crises. This could not permanently support weak currencies, but it would allow sufficient time to organize orderly realignments.

The Unstable EMS
Barry Eichengreen and Charles Wyplosz

Discussion Paper No. 817, May 1993 (IM)