The Exchange Rate Mechanism (ERM)

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The Exchange Rate Mechanism (ERM)

The ERM was a fixed, but adjustable, exchange rate system for the countries of the European Union (EU) that started in 1979. Although there were the standard economic reasons for the new system (stability, discipline, etc.), it was also a precursor to European Monetary Union (EMU), the final stage of which was the creation of the euro, the single currency for the EU. It was felt that the single market of the EU would not be complete without a single currency as well. The single market came into force on the 1st January 1993, with the single currency starting exactly six years later.

The ERM was similar to the Bretton Woods system, except that it was not based on any currency or gold. The currencies were pegged to a central unit known as the ECU that was based on a weighted average of the participating countries in 1979. As with the Bretton Woods' system, where all currencies were measured against the dollar, even though gold was the actual basis of the system, the German mark soon became the currency against which other currencies were quoted (although the mark was not the basis of the system).

Like the Bretton Woods system, currencies were allowed to make small adjustments around their entry rate (±2¼%) and realignments were allowed if the entry rate was obviously not right. This happened quite often to start with, but after the first few years the currencies had found their correct levels and realignments were more rare.

The pound joined in October 1990. There was a lot of political pressure to join, with the completion of the single market over the horizon. In hindsight it was the wrong time (as the UK entered a recession) and at the wrong rate (£1 = 2.95DM was too high). The pound was allowed larger band's (±6%), but by the summer of 1992 the pound was already hovering around the bottom band (£1 = 2.78DM).

The rules of the ERM stated that all members had to help struggling currencies stay within the permitted bands. This meant buying pounds or (in the case of non-UK countries) cutting interest rates to make the pound more attractive to investors and speculators. In practice, help was minimal. There was no point buying pounds when the effect would be small compared with the might of global money flows. Also, Germany was in the process of reunification, and the resulting increase in the money supply needed higher interest rates. In fact, it was because Germany's interest rates were relatively high over the period 1990-92 that the UK had to keep their interest rate higher than they would have liked given that the UK was in the depths of a recession.

The pressure was too much. Speculators continually sold the pound in September and the only buyer was the UK government! On the 16th September 1992, the government lost £7 billion buying pounds. They even raised interest rates by 5% in one day (from 10% to 15%). This was taken as a sign of desperation and the speculators kept selling pounds. They knew the pound was only going one way. The Chancellor announced the UK's suspension of their membership of the ERM that evening. The pound fell by 15% instantly and has been floating ever since.

Other countries suffered as well. The bands were widened to ±15%. These bands were so wide that the ERM was barely an exchange rate system any more. The experience of the ERM was similar in some respects to that of the Bretton Woods system. Whilst frequent realignments would disrupt the stability on which the system was based, too little realignment puts pressure on countries not to realign however bad the problems are. There were no realignments between 1987 and 1992. The pound should probably have been realigned earlier in 1992, but membership of the ERM was the foundation stone around which the rest of government macroeconomic policy was built. Realignment was seen as failure just as rising inflation would be today.

John Major

As John Major found out when he lost the 1997 General Election, even though devaluation out of the ERM helped the economy recover, his reputation for economic management was in tatters. Many voters in opinion polls cited the ERM fiasco as the reason for voting the government out. What made it worse was the fact that the recovery of the economy after the pound fell out of the ERM suggested that government policy of being in the ERM was simply wrong.

As you have seen, each system has its good and bad points. We shall summarise them below, starting with fixed exchange rate systems.

The advantages of a fixed exchange rate system

Stability

Some economists would argue that this is the most significant advantage. If exchange rates are stable over a given period of time, exporting firms will be able to plan ahead without worrying about huge swings in the value of the pound eliminating their profit margin. This will encourage more investment and trade between countries, both of which are important if economies are to grow in the long term.

Discipline

If a country is part of an exchange rate system, they cannot devalue their currency at the first sign of trouble (i.e. a large current account deficit). They have to try and cure the fundamental problem by, for example, improving the competitiveness of their exporters through increased productivity and improved quality.

One can also argue that fixed exchange rate systems discipline countries into keeping inflation down. Again, there is no option to devalue if increasing inflation leads to reduced competitiveness. This was the case with the UK in the ERM. Their actions were effectively dictated by the actions of the strongest member of the system, Germany. They were notoriously strict on inflation, perhaps keeping interest rates higher than they needed to be. The UK was forced to follow suit and keep interest rates relatively high to keep the pound within the ERM. The system almost forced the UK to keep inflation down. Others would argue that the ERM simply forced the UK to stay in a recession. Anyone can keep inflation low by having a recession!

Avoid speculation?

Theoretically, fixed exchange rates should eliminate speculation because there is no point buying and selling currencies that will not change in value. In the real world, this is not always the case. The story of the pound falling out of the ERM is a classic example where this theory went a bit wrong!

Having said that, in the run up to the introduction of the euro (a totally fixed exchange rate system!) the rates were fixed six months before the start date of the 1st January 1999 and lots of speculation against these rates was predicted. In this case, it simply did not happen. Speculators believed the politicians when they said that these rates were forever, and so did not see the point in buying or selling the currencies involved. Of course, the euro was sold after its introduction, but that is a different story (see the next Learn-It).

The lesson, therefore, is that systems that are credible will experience less speculation. Systems, or members within systems, that do not inspire confidence may well have to put up with lots of speculative buying and selling.

The disadvantages of a fixed exchange rate system

The loss of monetary policy

As the UK government found when they were part of the ERM, a commitment to a fixed exchange rate means that you lose control over all other instruments of monetary policy. Although the government pretended that UK interest rate decisions we still their own (and technically they were) any movement of the German interest rate was usually quickly followed by a similar change in the UK. Today the Monetary Policy Committee (MPC) can set interest rates at whatever level they want, but they cannot control the value of the pound at the same time. Controlling one of these two instruments means a loss of control of the other.

The need for a large pool of reserves

To maintain the pound's value within the ERM, the government had to have a large pool of foreign reserves with which to buy the pound when it fell to the floor of the bottom band. Apart from being expensive in itself, some countries may find it hard to get their hands on sufficient stocks of reserves to support their currency. One of the main jobs of the IMF in the Bretton Woods system was to help poor countries in times of trouble and lend them reserves when they were short.

Problems of uncompetitiveness

With a freely floating currency, a deteriorating trade situation should automatically cause the pound to fall (speculators permitting!), which, in turn, would improve the competitiveness of British exporters and improve the trade balance.

Economies stuck in a fixed exchange rate system with a deteriorating trade balance may feel that they joined the system at too high an exchange rate. Although they may be allowed to devalue eventually, the exchange rate may be at the wrong rate for significant periods of time. This can cause permanent job losses and recession. Some economists feel that the recession of 1990-92 in the UK was prolonged due to membership of the ERM.

Advantages of a floating exchange rate system

Theoretical elimination of trade imbalances

As we have stated before, floating exchange rates should adjust automatically to trade imbalances, which, in turn, will eliminate the trade imbalance. Of course, it has also been noted that this does not always work in the real world because so few currency transactions that take place are for trade.

No need for reserves?

On the whole, foreign reserves are used to help maintain a currency's position within a fixed exchange rate. If a currency is freely floating, then there is no need to use reserves to affect its value. In the real world, governments will always have some reserves, in case of a crisis in the balance of payments, or if they feel that their currency is getting a bit too high or too low.

More freedom over domestic policy

As was stated above, if the government is not controlling their exchange rate, then they can control their rate of interest. The evidence of the past five years suggests that, although exporters suffer with a strong pound, the economy as a whole is best served when the authorities can control domestic monetary policy.

The disadvantages of a floating exchange rate system

Speculation

Again, there are two ways of looking at this. You could argue that with floating exchange rates, speculation is less likely because an exchange rate can move freely up or down, so it is more likely to be at its true level. But the very fact that it does move up and down easily means it can move a long way if speculators think that it is at the wrong level. The quick rise in the value of the pound in the second half of 1996 showed that big swings in currencies do not just happen when speculators force them out of fixed exchange rate systems.

Uncertainty

The biggest advantage of fixed exchange rate systems was their stability and certainty. This tended to increase investment and trade, both good things. The biggest disadvantage of floating exchange rate systems is their uncertainty, reducing the rate at which investment and trade increase. Firms often use the currency markets to hedge against large fluctuations in the exchange rate, which helps to a certain extent, but there is still felt to be too much uncertainty.

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