Exchange Rate Rules and Economic Policy Choices: Lessons from the Spanish and Italian Experiences of the ERM

Abstract

Turbulence in international financial markets has led to renewed calls for fixed exchange rate arrangements in several parts of the world. Proponents of such arrangements often cite the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS), which from 1979 until 1993 tightly pegged the currencies of member states, as a model, arguing that it produced convergence toward sound economic policies while attributing its collapse in 1992-93 to exogenous factors (the rise in interest rates caused by German unification and some perverse incentives for currency investors entailed in the 1991 Maastricht Treaty). Taking issue with this view, this article argues that the ERM's crisis was at least partly attributable to the system's own rules of adjustment. The basis for this argument lies in an analysis of the policy strategies pursued by governments in two of the ERM's higher-inflation members (Italy and Spain) in the four-year period prior to the crisis. With the lifting of capital controls, ERM rules actually bolstered the ability of these two governments to sustain an unbalanced macroeconomic policy-mix (that is, a restrictive monetary stance without commensurate fiscal restriction) for an extended period of time, while at the same time they limited the room for expansion for governments that were committed to a more balanced policy course. The result was an acute dissociation of exchange rates from the ‘fundamentals’ of member economies that increased speculative pressures, eroded the system's credibility, and set the basis for the crisis. The experience of Spain and Italy in the ERM suggests that, in the absence of capital controls, fixed exchange rate systems that are premised too heavily on the pursuit of monetary orthodoxy in an anchor currency country, are likely to fail.