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September 24, 1992
"Europe Likely to Patch Up Fiscal System"
San Jose Mercury News

By Timothy Taylor
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PROBLEMS WITH exchange rates occur because they serve at least three economic purposes: as an instrument to assist trade; a reflection of other economic variables; and a policy tool for managing the economy. When these purposes conflict, as they did in the European currency markets last week, the result can be chaos.

Stable exchange rates help to grease the wheels of international trade, because businesses are far more willing to make long-term plans for investing and selling in a variety of countries if they know that exchange rates will be fairly stable. Under Europe's Exchange Rate Mechanism, countries undertake to keep their currencies at a target value relative to each other, plus or minus a couple of percent.

But exchange rates also indicate how an economy is doing. If one country has consistently lower interest rates, higher inflation or lower productivity than another, its currency will gradually become worth less, and tend to depreciate in value. For example, the United Kingdom had higher inflation and lower productivity than most of its competitors through the mid-1970s and early 1980s, and while a British pound would have cost $2.50 back in 1973, it would have cost only $1.30 by 1985.

Policy Tool
Finally, the exchange rate can be a policy tool to stimulate production. As a nation's currency becomes cheaper, its exports become less expensive on world markets, and it can sell more. But this tool is double-edged; the cheaper currency also means that imports cost more, which raises inflation and reduces the ability of consumers and businesses to buy imported products and supplies. Notice that exchange rates cannot serve all three purposes at once. A nation with stable exchange rates cannot also depreciate its currency. Moreover, to keep exchange rates stable, a nation must have roughly the same inflation, productivity, and interest rates as its neighbors, or the relative value of currencies will begin to shift.

The currency crisis of last week started as an attempt to preserve stable exchange rates across Europe, but seems to be evolving into an attempt to stimulate the European economy. Although Europe's fixed exchange rates had held pretty well for the last few years, needing only minor adjustments, they were under extraordinary pressure from events in the United States, Germany, Denmark and France.

In the United States, the Federal Reserve has been cutting interest rates for a few years, in an attempt to stimulate the household and business borrowing that could lead to economic recovery. Meanwhile, the costs of unifying Germany were pumping buying power into the German economy, and the German equivalent of the Federal Reserve, the Bundesbank, was worried about rising inflation. So it has been keeping German interest rates high, in an attempt to strangle inflation.

For international investors, the choice was obvious. Get out of dollar-denominated investments, with their low interest rates, and move toward the German mark.

But as the mark appreciated in value and the dollar depreciated, the other nations of Europe faced a tough choice. To keep their exchange rate aligned with Germany, and gain the benefits of stable exchange rates, they needed to keep their own interest rates high. However, to spur their own economies, they wanted to cut interest rates, even if it meant depreciating their currency.

Moreover, Denmark had already voted against the Maastricht treaty on European economic and political unity. If the French had voted it down Sunday -- instead of narrowly affirming it -- then the entire commitment to keep a system of fixed exchange rates across Europe would have been called into question.

To investors in international currency markets, this situation is like smelling blood. If a country appears unwilling to pay the price of higher interest rates to keep its exchange rate in place, or unable to do so because of underlying inflation or low productivity, then they begin to speculate that that nation's currency will fall. And by bidding down the exchange rate of the currency, they can turn their prediction of depreciation into a self-fulfilling prophecy.

Currency Chaos
Thus, by the end of last week, the British pound and Italian lira were officially out of the exchange rate system, the Spanish peseta was devalued by 5 percent. The system was in chaos, with no easy fix in sight.

Some suggest the solution is for Germany to worry less about inflation, and cut its interest rates instead. But while this step might have kept European exchange rates together a bit longer, it would have attached all of Europe's currencies to an inflating German dollar, rather than a stable one, which is hardly an ideal solution.

But if the mechanism for adjusting exchange rates were quick and easy, then exchange rates would tend to move frequently, which is to say they wouldn't really be fixed at all.

Therefore, in a backward sort of way, the fact that it took a currency crisis, newspaper headlines and embarrassment of public officials before the exchange rate mechanism broke down last week is an indirect sign of how much the nations of Europe value their Exchange Rate Mechanism, and thus why some new system of fixed rates is likely to be patched back together in the near future.

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