David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 29 Exchange rate regimes
the end of the Lawson boom. Unfortunately, this coincided with German reunification. Big subsidies to
East Germany caused German overheating. When Chancellor Kohl refused to raise taxes, the Bundesbank
raised interest rates to cool down the German economy. Interest rates high enough to do this job were far
too high for Germany's partners in the ERM. This provoked the crisis of 1992-93. The UK and Italy left the
ERM, slashed interest rates and depreciated their currencies. Other countries struggled on inside the ERM,
though many had devaluations (see Chapter 28).
German reunification was the biggest country-specific economic shock in post-war Europe. It was not a
good guide to how EMU would subsequently fare. Indeed, the mandate of the European Central Bank to
take an EU-wide view prevents it reacting in such extreme fashion to the needs of one country. But UK
voters remember the UK flirtation with a single European interest rate as an unhappy experience.
During 1996-98 EU countries scrambled frantically to get their budget deficits below the 3 per cent
Maastricht limit to be eligible for EMU. There was fiscal tightening in continental Europe. Since the UK
was enjoying the effects of looser policy after 1992 - the whole point of leaving the ERM had been to
reduce interest rates and stimulate the economy - the UK business cycle got out of phase with the rest of
Europe. This had little to do with any structural difference. It simply reflected the fact that, while the UK
had its foot on the accelerator, its EU partners still had the brakes on tight.
Membership of a common currency is easier the more the different members want to do the same thing.
The financial crash of 2007-09 placed huge strains upon the eurozone. Different countries wished for
differing degrees of fiscal expansion to offset the crash, and were left with different sizes of debt problem
as a result.
Germany, always the most prudent as well as most powerful member, resisted pressure to depreciate the
euro to stimulate aggregate demand, fearing this would also lead to inflation. Countries such as Ireland,
Greece and Portugal became trapped in a position involving an uncompetitive exchange rate, a substantial
fiscal debt, and no possibility of either creating money or depreciating the exchange rate to help resolve the
problem.
Whatever its previous view, the UK enjoyed more flexibility. Although more exposed to the banking
crisis than other European countries, the UK also possessed the ability to allow sterling to depreciate,
making exports more competitive, and/or to allow domestic inflation that would erode the real value
of government debt denominated in nominal terms. As of 2010, sterling had been allowed to depreciate
a bit, but inflation had yet to materialize. Although Lord Mandelson took the opportunity to restate
the eventual benefits of UK membership of the eurozone, most policitians, and most voters, reinforced
their view that the crisis had increased the likelihood of the UK remaining outside the eurozone for
some time to come.
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An optimal currency area
is a group of countries better
off with a common currency
than keeping separate national
currencies.
In 1999 Professor Robert Mundell won the Nobel Prize for Economics, in part for
his pioneering work on optimal currency areas.
Mundell, and the economists who came after him, identified three attributes that
might make countries suitable for a currency area. First, countries that trade a lot
with each other may have little ability to affect their equilibrium real exchange rate
against their partners in the long run, but they may face temptations to devalue to gain a temporary
advantage. A fixed exchange rate rules out such behaviour and allows gains from trade to be enjoyed.
Second, the more similar the economic and industrial structure of potential partners, the more likely it is
that they face common shocks, which can be dealt with by a common monetary policy. It is countryspecific
shocks that pose difficulties for a single monetary policy.
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