Realigning Interests: Crisis and Credibility in European Monetary Integration (Europe in Transition: The NYU European Studies Series)

Realigning Interests

EUROPE IN TRANSITION: THE NYU EUROPEAN STUDIES SERIES

The Marshall Plan: Fifty Years After Edited by Martin Schain Europe at the Polls: The European Elections of 1999 Edited by Pascal Perrineau, Gérard Grunberg, and Colette Ysmal Unions, Immigration, and Internationalization: New Challenges and Changing Coalitions in the United States and France By Leah Haus Shadows Over Europe: The Development and Impact of the Extreme Right in Western Europe Edited by Martin Schain, Aristide Zolberg, and Patrick Hossay Defending Europe: The EU, NATO and the Quest for European Autonomy Edited by Joylon Howorth and John T.S. Keeler The Lega Nord and Contemporary Politics in Italy By Thomas W. Gold Germans or Foreigners? Attitudes Toward Ethnic Minorities in Post-Reunification Germany Edited by Richard Alba and Peter Schmidt Germany on the Road to Normalcy? Politics and Policies of the First Red-Green Federal Government Edited by Werner Reutter The Politics of Language: Essays on Languages, State and Society Edited by Tony Judt and Denis Lacorne Realigning Interests: Crisis and Credibility in European Monetary Integration By Michele Chang

Realigning Interests Crisis and Credibility in European Monetary Integration Michele Chang

REALIGNING INTERESTS

© Michele Chang, 2004 All rights reserved. No part of this book may be used or reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles or reviews. First published 2004 by PALGRAVE MACMILLANTM 175 Fifth Avenue, New York, N.Y. 10010 and Houndmills, Basingstoke, Hampshire, England RG21 6XS Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1–4039–6438–6 hardback Library of Congress Cataloging-in-Publication Data Chang, Michele. Realigning interests : crisis and credibility in European monetary integration / by Michele Chang. p. cm.—(Europe in transition) Includes bibliographical references and index. ISBN 1–4039–6438–6 1. Currency crises—European Union countries. 2. Monetary policy— European Union countries. 3. European Union countries—Economic integration. I. Title. II. Europe in transition (New York, N.Y.) HG3942.C47 2004 332.4⬘94⬘09048—dc22

2003064011

A catalogue record for this book is available from the British Library. Design by Newgen Imaging Systems (P) Ltd., Chennai, India. First edition: June, 2004 10 9 8 7 6 5 4 3 2 1 Printed in the United States of America.

To my family: Wayne, Adoracion, William, and Robert

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Contents

List of Tables

ix

List of Figures

xi

Abbreviations

xiii

Acknowledgments Chapter 1

Introduction

xv 1

Chapter 2 Rules and Norms of European Monetary Cooperation

17

Chapter 3 Political Economy of Currency Crises and Devaluation

41

Chapter 4

France, 1981–1986

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Chapter 5

France, 1988–1995

89

Chapter 6 Italy: Domestic versus International Origins of Currency Crises

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Chapter 7

Ireland

141

Chapter 8

Conclusion

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Notes

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Sources

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Index

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List of Tables

1.1 1.2 2.1 3.1 3.2 3.3 4.1 4.2 4.3 5.1 5.2 5.3 5.4 5.5

5.6 5.7 5.8 5.9

Summary of arguments to be tested: theories of currency crises Summary of arguments to be tested: theories of devaluation EMS realignments against central rates 1979–1993 Expectation of exchange rate realignment, 1979–1993 Expectation of devaluation by country, 1979–1993 Devaluation 1979–1993 Ifop-RTL-Le Point poll on intentions to vote for the PS Summary table of arguments on emergence of currency crises and devaluation, 1981–1986 Summary table of arguments on devaluation in France, 1981–1986 Sofres poll on voters’ expectations of France’s seven-year outlook Intention to vote in the 1988 legislative elections (%) Poll: “If the franc had been devalued against the mark, do you think this would contribute to the . . .” Predicted future distribution of seats in new national assembly Poll: “Do you hope that in the next legislative elections voters will manifest their support for Mitterrand and the current government or that the voters will use this occasion to manifest their discontent?” Summary table of French economic indicators, 1991–1994 Progress toward fulfilling Maastricht criteria: deficits and debt as percentage of GDP Poll: Do you think the following personalities would make a good president of the Republic? Intentions to vote in second round: Le Nouvel Observateur polls

14 14 36 47 48 55 85 88 88 94 96 107 107

107 111 112 114 116

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5.10 5.11 5.12 5.13 5.14 8.1 8.2 8.3

List of Tables

Intentions to vote in the second round: IFOPL’Express polls First-round results of the presidential election Second-round results of the presidential election Summary table of arguments on the emergence of currency crises in France, 1988–1995 Summary table of arguments on devaluation in France, 1988–1995 Accession countries’ EMU convergence, 2002 Economic indicators and the Maastricht Treaty convergence criteria Population, GDP, and growth rates of EU versus accession countries

116 118 118 123 123 167 168 171

List of Figures

4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12

Monthly inflation, 1981 electoral period Quarterly current account balance, 1981 electoral period Monthly reserves, 1981 electoral period One-month Eurofranc interest rates, 1981 electoral period Monthly inflation, 1983 electoral period Quarterly current account balance, 1983 electoral period Monthly reserves, 1983 electoral period One-month Eurofranc interest rates, 1983 electoral period Monthly inflation, 1986 electoral period Quarterly current account balance, 1986 electoral period Monthly reserves, 1986 electoral period One-month Eurofranc interest rates, 1986 electoral period Ifop-RTL-Le Point poll: Do you have a good opinion or bad opinion of Mitterrand as president? Poll: Do you have a good opinion or bad opinion of Fabius as prime minister? Monthly inflation, 1988 electoral period Quarterly current account balance, 1988 electoral period Monthly reserves, 1988 electoral period One-month Eurofranc interest rates, 1988 electoral period Le Nouvel Observateur polls: intentions to vote in the first round, January–April 1988 Intention to vote in the second round, Mitterrand versus Barre Intention to vote in the second round, Mitterand versus Chirac Poll: Which of the following would make a good president of the republic in the next seven years? Monthly inflation rates, 1993 electoral period Quarterly current account balance, 1993 electoral period Monthly reserves during 1993 electoral period Eurofranc interest rates, 1993 electoral period

63 64 65 66 72 73 73 74 81 82 83 84 85 85 92 92 92 93 95 95 96 96 104 105 105 105

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5.13 5.14 5.15 5.16 5.17 5.18 5.19 5.20 6.1 6.2 6.3 6.4 6.5 6.6 7.1 7.2 7.3 7.4 7.5

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List of Figures

Summary of polls on intentions to vote (%) in 1993 election Gallup-L’Express poll on approval of the prime minister First-round intentions to vote First-round intentions to vote Monthly inflation, 1995 electoral period Quarterly current account balance, 1995 electoral period France monthly reserves, 1995 electoral period One-month Eurofranc interest rates, 1995 electoral period Italian elections and devaluations, 1979–1995 French elections and devaluations, 1979–1995 Current account balance and elections, 1979–1995 Inflation rate and elections, 1979–1995 Interest rates and elections, 1979–1995 Real exchange rates and elections, 1979–1995 Irish elections and devaluations, 1979–1996 Annual current account balance as percentage of GDP, 1979–1983 Exchange rates and elections in Ireland, 1979–1983 Quarterly current account balance, 1987 electoral period Quarterly current account balance, 1989 electoral period

108 113 115 115 119 119 120 120 126 126 129 130 131 132 141 147 148 152 152

Abbreviations

AN CERES DC DM EC EMS EMU ERM EU GDP MSI OECD PCI PD PDS PRI PPI PS PSI PSDI RPR STF TD UDF

National Alliance (Italy) Centre d’études de recherches et d’éducation socialistes (France) Christian Democratic Party (Italy) Deutsche mark European Community European Monetary System European Monetary Union Exchange Rate Mechanism European Union Gross Domestic Product Italian Social Movement Organization of Economic Cooperation and Development Italian Communist Party Progressive Democrat (Ireland) Democratic Party of the Left (Italy) Italian Republican Party Italian People’s Party Socialist Party (France) Italian Socialist Party Italian Social Democratic Party Rassemblement pour la Republique (France) Short-Term Facility Member of Parliament (Ireland) Union pour la Démocratie Française (France)

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Acknowledgments

M

y greatest debt is to my adviser, Stephan Haggard. His guidance, criticism, and encouragement made possible both my dissertation and the successful completion of this book. I also offer my thanks and gratitude to the other members of my dissertation committee: Neal Beck, Graham Elliott, Miles Kahler, Ross Starr, and Kaare Strom. Others who have assisted me in various ways by reading drafts, helping me in the research process, or talking through some of the ideas with me include: David Andrews, Bill Bernhard, the Bundesbank Press Office, Benjamin Cohen, Harold Colson, Russell Dalton, Paul DeGrauwe, Jeff Frieden, John Freeman, Peter Gourevitch, Daniel Gros, Peter Hall, Mark Harmon, Erik Jones, Peter Katzenstein, Peter Kenen, David Lake, David Leblang, Arendt Lijphart, Ivo Maes, Mat McCubbins, Kate McNamara, Jacques Mélitz, Michael Moran, Andrew Moravscik, Thomas Oatley, Paul Papayoanou, Dennis Quinn, Kevin Rask, Larry Ryan, Jerry Sheridan, Pierre Siklos, Chris Way, and participants of the 1995 Harvard Graduate Student Workshop, the 1995 APSA meeting, the 1996 Conference of Europeanists, and the 1996 Institute on Western Europe Graduate Student Conference. I also thank all those who graciously allowed themselves to be interviewed for this book. I would like to thank the following organizations for providing me with funding: the Ford Foundation, the Institute on Global Conflict and Cooperation, the Deutscher Akademischer Austausch Dienst, and Colgate University’s Faculty Development Council. The University of California, San Diego and Colgate University provided the institutional support necessary to complete this book. I also thank my editors at Palgrave, Anthony Wahl and Heather Van Dusen, for their role in bringing this book to completion. Venn Saltirov and Maura McClelland provided excellent research assistance. The following individuals offered much needed and much appreciated support during the writing of this book: Stephen Applebaum, Alex Bergmann, Bob Bowman, Marci Bowman, Maureen Feeley, Bill

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Griswold, Kathleen Hancock, Lisa Hilbink, Jamie Gerber, Chris Harrison, Carolyn Hsu, Karen Leahy, Jennifer Smith, Cami Townsend, and Ali Yegulalp. I would also like to thank the friends I made in Europe, especially the Rothenburg Posse and my Dresden buddies, for renewing my interest in Europe and giving me reasons to keep going back. Finally, I dedicate this book to my family: Wayne and Adoracion Chang, my parents, and my brothers William and Robert. Through the years, your belief in the importance of my education and your unwavering support allowed me to pursue my interests, and I thank you for all that you have done.

CHAPTER 1

Introduction

W

hy do crises occur within fixed exchange rate systems? How do governments react to currency pressure? With major currency crises affecting both developed and developing countries in the 1990s, identifying the variables that lead to currency crises has become a major concern of both economists and political scientists. While economic fundamentals play a large role in these matters, an accepted model of currency crises has not yet been developed because such conditions do not necessarily predict the timing, size, or duration of currency crises. The onset of currency crises preoccupies analysts, but the resolution of these crises also illustrates important political and economic dynamics. Currency crises are not synonymous with devaluation; either can occur in the absence of the other. What determines when and if a government will devalue? Elections and political instability can provide at least a partial answer to both of these questions. First, we need to understand what factors contribute to market valuations and make a currency vulnerable. Second, we must determine how and why a government responds to market attacks through either the defense of the currency, its devaluation, or both. Currency crises expose critical political interests and have both international and national repercussions. Thus it should not be surprising that many currency crises and devaluations occur during electoral periods, as government changes have serious consequences for the country’s policy direction and therefore future economic conditions. Monetary policy and other economic policies have the possibility of changing in ways that would alter future economic conditions and therefore the sustainability of the exchange rate. Factions within political parties jockey for dominance while competing parties and coalitions

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do the same thing. Differences between the relevant political actors are emphasized in order to distinguish policy objectives and to make a case for why one party/faction should be the preferred choice of voters. This endemic conflict in the political system during an election makes the currency vulnerable to market speculation due to the uncertainty it engenders about future policies and economic conditions. Of course, neither currency crises nor devaluations occur in an international political vacuum. Maintaining a fixed exchange rate within a regime such as the European Monetary System (EMS) (now European Monetary Union (EMU)) involves sharing credibility and resources. Participating countries draw on the resources and reputations of other members in order to buttress their own currencies. Moreover, member states decide on exchange rate realignments collectively. Therefore, the shared nature of crisis management and resolution make an understanding of the dynamics between the countries as important as those occurring within the state that precipitated the crisis. Monetary cooperation has always been connected with European cooperation in general, and thus has important repercussions for foreign policy. This book argues that electoral instability generates market speculation regarding the intentions of the future government. A close election (or the lack of a dominant preference for a party/coalition) destabilizes market expectations and provokes currency speculation. Despite such market pressures, the incumbent government strives for continuity and defends the currency until the election passes. Devaluation becomes more feasible politically after an election has passed, and the government is more likely to favor devaluation at this time, if at all. Moreover, the government may be able to enlist the assistance of its allies in holding off a currency crisis and in externalizing the adjustment costs. This has important implications for theories of the international political economy as well as international cooperation in general.

The Economics and Politics of Exchange Rates Explaining Currency Crises The central premise of this book is that explanations of exchange rate instability must incorporate political analyses that can explain the timing and severity of an exchange rate crisis. Economists have conducted the bulk of the work on exchange rate crises, and the same economic factors do not necessarily play the same role in each crisis. Current theories also lack a sense of when a currency crosses a critical threshold that

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determines that economic conditions no longer support a given exchange rate. The first-generation work has focused on economic fundamentals as the main cause of currency instability. As the government’s policies become inconsistent with the maintenance of a given exchange rate level, the defense of the currency depletes reserves until devaluation becomes necessary (Krugman 1979). Though some argue that economic fundamentals continue to drive exchange rate crises (Bordo and Schwartz 1996; Goldstein et al. 2000), others counter that a single exchange rate equilibrium does not exist. Therefore, economic fundamentals can support a range of different exchange rate values, provided that markets expect the government to support those rates; governments still retain considerable autonomy when making policy, despite rising capital mobility (Lukauskas and Minushkin 2000; Mosley 2000). But if the exchange rate is attacked, it may not be sustainable, even in the absence of appreciable differences in economic fundamentals (Obstfeld 1986, 1996). This idea of a self-fulfilling speculative attack implies that market expectations may be at least as important in explaining currency crises as economic fundamentals. Government credibility becomes critical, and this necessarily hinges on politics. Market expectations of policy change can have a similar effect to an actual policy change as markets attempt to ascertain future economic conditions based on these expectations. If the market expects inflation to continue in a high-inflation environment, these expectations lead to the selling of and depreciation of the currency, which in turn exacerbate inflation. If markets believe a government will act a certain way in the future, investors will try to act first so as not to be caught by surprise. Can governments control or at least influence these expectations? Economists and political scientists have constructed a myriad of explanations regarding what makes an exchange rate credible. One of the primary theories is that institutions, specifically and independent central bank, contribute to government credibility by removing incentives to generate surprise inflation or to manipulate the economy for political motivations. By removing monetary policymaking from the hands of politicians, governments delegate authority to a body with preferences geared toward price stability rather than short-term political gains (Cukierman 1992). Though institutional attributes like central bank independence may affect the general trajectory of the exchange rate (with higher degrees of central bank independence associated with lower inflation and a stronger currency), such structural characteristics explain neither the onset of a currency crisis nor its resolution. For example, countries like

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France and Britain had politically weak central banks during the 1980s; they also were prone to a greater number of currency crises and had weaker currencies than countries with stronger central banks such as Germany. France and Britain were not, however, in a perpetual state of crisis. Though economic fundamentals may have been weak (high inflation posed a particularly vexing problem), pressure to devalue generally came suddenly, as demonstrated by rapid flight of capital in the wake of Socialist François Mitterrand’s 1981 electoral victory. The institution (a weak central bank) remained constant, but the currency and threat of crisis did not: what happened? An alternative explanation of currency credibility rests on partisan interpretations of policy formation (Leblang and Bernhard 2000). Empirical analysis shows that macroeconomic outcomes have classrelated distributional effects in Britain, which have consequences for the support of political parties (Hibbs 1982). Left governments prefer higher growth while conservative governments favor price stability; left governments may therefore be prone to implementing policies that would reduce price stability. In the aforementioned example, the transition in France from a conservative president to a Socialist president occurred concurrently with exchange rate pressure. Another societal explanation emphasizes sectoral interests that may defy traditional partisan interpretations of policy, as exchange rate levels and volatility have differential effects on various economic sectors (Frieden 1991). Actors extensively involved in international trade, for example, would prefer exchange rate stability despite the loss of monetary sovereignty. Domestically oriented sectors, on the other hand, would rather the government not fix the exchange rate and thus retain the ability to form an independent monetary policy. Moreover, additional conflict may arise due to divergent interests on the level of exchange rates. Partisanship and explanations based on the preferences of various economic sectors, however, also fail to explain the timing of currency crises. Like institutional measures of government credibility, societal accounts of exchange rate determination do not consider the rapidity with which markets overturn previously accepted exchange rates. Why did the Mitterrand election provoke capital flight in advance of the formation of any policies or abrupt changes in economic conditions? Understanding exchange rates requires an explanation not only of longrun determinants of currency valuation but how and why markets associate political change with economic change.

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Elections and changes in government can cause markets to shift expectations regarding future policy. Elections also affect exchange rates because they alter the current government’s willingness and ability to maintain the exchange rate (Bernhard and Leblang 1999, 2002; Leblang and Bernhard 2000). In Latin America, for example, the probability of a large depreciation during normal times is only 3.84 percent. This figure falls almost 40 percent immediately prior to elections to 2.66 percent, indicating that incumbent governments prefer not to devalue before an election, but the probability then jumps to almost 10 percent following the inauguration of a new government, which may have different priorities and constituents (Frieden and Stein 2001: 15–16). Such behavior can also be seen in European countries for similar reasons. When a change in government is at hand, market expectations of the incoming government’s preferences regarding the exchange rate can be divided into three probabilities: (1) government preferences will be unchanged, (2) government preferences will change, or (3) government preferences are unknown. In the first case, there is no reason to expect a correlation between currency crises and political instability caused by the election or change in government; any crises that occur in this instance would be attributed to other factors. The second and third instances, however, present markets with a challenge as to how to protect investments and circumvent any losses that could be generated by potential policy changes. If markets expect the new government to have different preferences than the most recent government, this provides forward-looking markets with the incentive to act on this information in advance of the actual change in government. The incoming government may represent a different constituency than its predecessor, which could alter the level of the exchange rate or even lead to the abandonment of a fixed exchange rate system altogether, depending on how the existing system affects the interests of the politically favored sectors. The aforementioned Frieden argument considers the different effects that fixed versus flexible exchange rates have on various economic sectors in detail (Frieden 1991, 1994). The effect of these expectations can be either positive or negative in terms of the strength of the exchange rate. The expectation of a government committed to price stability and a strong currency, for example, could bolster the exchange rate as easily as the opposite expectations could lead to capital flight. Thus the direction of the exchange rate can vary depending on the interests of the future government.

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As noted earlier, this process need not be limited to elections but may also apply to changes in government (Bernhard and Leblang 2002; Leblang and Bernhard 2000). A factional change in either the ruling coalition or ruling party could result in exchange rate instability. Within a coalition government, the parties in the coalition could change or the relative strength of the parties could shift in a way that favors different economic policies. Even within a government composed of similar parties in terms of left–right differences, substantial conflict can emerge over policy as elections and government changes can consolidate power in favor of one faction or another. The government’s strength and coherence indicate its ability not only to cope with a crisis swiftly and resolutely, but also its capacity to initiate policy adjustment. If the crisis erupts after a period of deteriorating economic fundamentals, the government may be reluctant to stabilize the economy because of the distributional consequences (Alesina and Drazen 1991). Also, this may make it difficult for a party to claim credit for formulating popular economic policies and implement tough choices prior to an election (Frieden 1997). Thus stabilization would be delayed until one side emerges as politically dominant and therefore may impose the costs on the other side. In addition to these problems, markets must also contend with the possibility of not knowing the incoming government’s preferences. This might stem from uncertainty regarding the outcome of the election and/or the composition of a coalition government. This political instability creates a bias in forward exchange rates that indicates the shift in market expectations as market actors try to make adjustments in anticipation of government changes (Bernhard and Leblang 2002). Thus expectations of changing government preferences or uncertainty surrounding government preferences could cause changes with regard to exchange rates that are less related to economic conditions than early economic analyses have indicated. Even with the absence of changing economic conditions or official policy changes, forward-looking markets can drive currency fluctuations during politically uncertain times. Variables relating to electoral instability reduce the government’s credibility and influence market expectations. A country undergoing an election with either an uncertain outcome or an outcome expected to change the direction of monetary and economic policy will be vulnerable to currency speculation. The aforementioned arguments assume that markets look forward as they act on their expectations of future economic conditions. Presumably voters and other relevant actors could also see through any

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attempts at preelectoral manipulation of the economy and negate its effects. This contrasts with the pre-rational expectations revolution theorists (Nordhaus 1975) who argued for myopic voters who regarded the government’s past record (rather than expectations of future deeds) as the basis for evaluation. The possibility of contrariety between past performance and future expectations presents an interesting conundrum for analysts: if an economy weakens relatively gradually and a currency crisis occurs during a period of government transition, to what extent can the crisis be attributed to economic fundamentals as opposed to the changing political conditions? For those who advocate an explanation based on economic fundamentals, the question becomes one of timing. Did the conditions reach that unknown threshold that made a currency unsupportable at its current rate, or did a crisis occur in reaction to political instability? Did political factors act as catalysts that precipitated an economic crisis? Or alternatively, can political factors calm potentially volatile market forces? The “correct” policy and institutional mix could prevent elections from triggering market jitters. Domestic as well as international political factors can affect market speculation both positively and negatively. The prospect of international cooperation in managing exchange rate levels can impact the onset and duration of a crisis. Participation in an international regime like the EMS can stave off speculative attacks by boosting the credibility of the currency peg. First, joining a multilateral organization sends markets a signal of what type the government is. Governments publicly proclaim their commitment to exchange rate stability (and whatever other goals are involved in membership), and the public nature of joining an exchange rate regime enhances the credibility of the pronouncement by raising the cost of defection. Membership removes the ambiguity surrounding government goals and provides governments with a clear blueprint for action. International obligations constrain national policymakers’ ability to implement partisan policies that could result in an electoral cycle (Lohmann 1993). Second, exchange rate fluctuations are extremely easy to monitor and deviations are very easy to spot. Deviation in the case of an exchange rate commitment is particularly costly because devaluation decisions are made jointly. The government and central bank have partially delegated their authority to the international institution, making markets more likely to believe in the government’s policy. Realignment negotiations can become heated and it is within a government’s rights to request another government to make costly concessions in exchange for realignment. A government may agree to cut public spending, for example, in

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order to secure a realignment agreement from its partners. Cheating is difficult when one is dealing with the exchange rate, and retribution is possible for other countries if a partner slacks with regard to its commitment. The government can lose influence within the international organization and possibly risk exclusion. It can also lose any side-payments that the government enjoyed while being a member of the system. Third, audience costs raise the stakes for governments considering breaking an international obligation (Fearon 1994; Martin 1993) are higher. The international audience is larger and failure is highly visible. Exchange rate fluctuations demand attention in a way that they did not when the rates were floating. Frequent realignments signal the weakness of a government and its inability to maintain its commitment. Although realignments are technically permitted, if it happens too frequently it goes against the spirit and purpose of the agreement, which is to create a zone of monetary stability and to encourage the convergence of monetary policy. A fixed exchange rate system would become worthless if currencies were realigned too readily because it would neither strengthen a government’s credibility with markets, nor would it promote economic coordination among participants. Furthermore, membership in a regime can also benefit a country suffering from a currency crisis. If a country has access to additional funds via international arrangements, which countries participating in the EMS did, this augments their power and increases the ability to defend against speculative attacks by increasing available reserves. Explaining Devaluation While market expectations (based either on current conditions or expectations of future ones) affect the timing of currency crises, do they also drive devaluation? According to rational expectations theory, markets should be able to anticipate any opportunistic behavior on the part of governments and to neutralize their effect. For example, in the political business cycle literature, rational expectations prevent governments from successfully generating economic cycles to create a preelection boom because markets and the public would be able to anticipate opportunistic behavior given past behavior (Cukierman and Meltzer 1986). If this were the case, one should not expect governments to engage in opportunistic behavior regarding the timing of the devaluation either. If markets and the public could predict that a government would devalue after an election, the government would not be able to fool them otherwise. Henceforth, the government would not have the discretion to push the devaluation to a more politically palatable time period.

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However, the electoral process adds a considerable amount of noise to the development of rational expectations when the preferences of the incoming government are uncertain due to a close election or uncertainty about the composition of the constituents. A government may therefore have some leeway with regard to the timing of the devaluation; after all, an election may cause devaluation to be more likely, but it does not make it a certainty. Governments may also be able to engage in some opportunism when it comes to devaluation. They can retain an information advantage that allows them to engage in cyclical behavior based on elections (Rogoff 1990; Rogoff and Sibert 1988a,b) or partisanship (Alesina and Roubini 1990; Alesina et al. 1997). Whether or not a government will do this depends on the audience that a government targets. On the one hand, defending the exchange rate could involve rising interest rates and slower economic growth, neither of which would be popular before an election. On the other hand, changing a major policy like the exchange rate parity shortly before an election could send negative signals regarding the government’s competence in managing the economy. After all, why would a currency be under attack if the government were able to make the economic fundamentals support the exchange rate? This indicates that there are three possible audiences for government actions during periods of election and government change: markets, primary constituents, and voters. Whichever audience the government decides to target could yield different policy outcomes at different times. The question becomes: Why does a government devalue or not devalue, and under what circumstances? In the first instance, the government could respond to exchange rate pressure as a challenge to currency markets. By defending the exchange rate vigorously, the government could try to signal that market estimations regarding either the government’s unwillingness or its inability to defend the exchange rate were mistaken, and that the government is indeed committed to seeing the continuation of current exchange rate policy. Much has been made of the power of global capital to influence policy and to create incentives for governments to implement similar policies so as to attract or at least not drive off international capital (Goodman and Pauly 1993). If the government does not manipulate policy for electoral advantage, there should be no reason why devaluation should occur at election time more than at any other time. Next, there is the issue of coalition costs. Exporters, particularly large businesses, have traditionally supported governments of the right while the more domestically oriented groups such as labor generally vote for the left. Business interests prefer low inflation, and exchange rate pegs

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are one way of achieving this. Thus, if the primary constituents were the main targets of government response, one would expect governments of the right to be less likely to devalue because this would disrupt exchange rate stability and alienate one of its core constituencies. On the other hand, left-wing parties may be more amenable to breaking an exchange rate peg because it does not benefit from fixed exchange rates and in fact labor suffers from the economic adjustment needed to maintain it (Leblang and Bernhard 2000; Simmons 1994). Partisan effects can be muted, however, by institutional mechanisms such as an independent central bank or exchange rate commitments (Clark et al. 1998). Finally, governments could target voters when responding to exchange rate crises. Devaluation so soon before an election could indicate to the electorate that the exchange rate policy was a mistake, or that the government was incapable of carrying it through. A government would be particularly vulnerable to such charges if the economy really was in a weak state and/or the reelection of the incumbent government was in jeopardy, for devaluation would confirm economic mismanagement. Market intervention can have a paradoxical effect an electorate’s perceptions of government competence. For example, intervention may remind voters of negative economic conditions (Alt 1988: 243): in order to intervene in the economy so that it will be better later, the government must first call attention to the fact that there is a problem. The very act of intervention indicates that something is wrong with the economy. When a government makes a bid for reelection, it is apt to engage in credit-claiming and position-taking to enhance its prospect (Mayhew 1974). In credit-claiming, a government tries to assert its responsibility for causing a desired outcome—such as economic growth—in order to boost support for its reelection bid. When a government engages in position-taking, it asserts its stance on politically relevant issues, like an announcement that it will defend the exchange rate or pursue price stability. Both credit-claiming and position-taking become nearly impossible during market speculation. The unstable markets send a signal that there is a problem with the economy, justified or not. The government wants to celebrate its track record and its accomplishments before an election, not begin new policies that will confuse voters and markets. Governments use exchange rate pegs because they are more transparent than other mechanisms like central bank independence (Broz and Frieden 2001: 13; Broz 2002); as a result, “politically, the word ‘devaluation still carries a notion of defeat’ ” (Ungerer 1997: 175), making “devaluations cost votes” (Mélitz 1988: 58). Moreover, the

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government would likely not benefit from any positive effects of devaluation until after the election. The fall in exports and outputs due to the stronger currency (also known as the J-curve effect) would not happen for months. Governments therefore have stronger incentives to postpone devaluation until after election (Frieden 2001; Klein and Marion 1997; van der Ploeg 1989). This allows governments to defer difficult questions of adjustment (Alesina and Drazen 1991) and to defend its economic record and the exchange rate. After the election has passed, however, the incoming government could try to shift blame for the devaluation on the previous administration. The Outline of the Book Chapter 2 summarizes the operations and the development of the EMS, and it places monetary cooperation in the context of European integration. The European playing field is not level, and some economies are more vulnerable than others due to different economic and political strengths. Economic power obviously confers advantages on a country; greater resources make the currency less susceptible to an attack in the first place and improve its chances of surviving the crisis. Political power refers to the influence a country has in the EMS and its ability to externalize the costs of adjustment. The bilateral parity grid of the EMS indicates that a currency crisis affects both a strong currency (such as Germany’s DM) and a weak currency, driving their currencies in opposite directions. The onus of adjustment falls more on the country with the weaker currency because it depletes its reserves that would be needed to prop up the currency. Once the crisis reaches a point where devaluation is preferable to defense, then all of the EMS countries negotiate the terms. During this process, currencies not involved in the original crisis can become part of a collective adjustment. A country with a weaker currency like France can externalize some of the costs of the devaluation, not just onto Germany but onto other countries as well. Its ability to do so is a function of its power and influence within the EMS and the European Community (EC). Chapter 3 is a quantitative study of currency crises and devaluation. An economic model developed to explain currency instability in exchange rate “target zones” like the EMS discerns the relative importance of economic and political variables in the onset and resolution of currency crises. First, a pooled time-series analysis of currency crises from 1979 to 1993 (the period known as the ERM I) establishes that

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currency crises coincide with electoral periods. Time series regressions for each country supplement this section, allowing one not only to draw inferences from a large number of cases but also to situate each country and currency crisis within a specific political environment. After exploring the economic and political causes of currency crises, another regression uses the same variables to determine the sources of exchange rate devaluation. This target zone model adds political variables to test how political variables like electoral cycles and government coherence affect the timing of devaluations. Chapters 4 and 5 consider the electoral impact of the French government, not only on the franc but also on the other EMS currencies. The fluctuations of the franc–DM exchange rate drive the EMS because French participation distinguishes it from being a strictly mark zone (as the snake eventually became) and makes the EMS a possible platform for further cooperation and integration. Without France the Germans would not have proceeded with monetary integration and would have been less willing to adjust its own policies to suit the needs of the EMS. French power and influence in the EC also manifested itself in France’s unique ability to externalize its exchange rate adjustment. French currency crises not only correlate with French elections but also with the general realignments of the EMS. These general realignments were enacted to placate France and to ease the stigma associated with devaluation by making it a European problem rather than a strictly French problem. Chapter 6 considers the politics of another major player in the European Union (EU)—Italy—in determining the timing of a currency crisis. The connection between political instability and currency instability will be examined and contrasted with the French experience. Though the Italian economy is not substantially smaller than the French economy, the Italians have wielded considerably less influence in European integration (and monetary cooperation). Italy, therefore, has found itself more often on the receiving end of currency contagion and requests for devaluation. Currency crises based on changing domestic political expectations were unlikely because the same parties dominated Italian politics for most of the postwar period. The changing nature of the party system in the mid-1990s and the effort to make the first round of monetary union made politics a relevant factor by 1994. Thus the Italian system began to exhibit similar political imperatives to the French system with regard to competition for policy credibility and perceived economic competence. Chapter 7 evaluates the experience of a smaller country, Ireland. Like Italy, its party system did not have the clearly defined partisan

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competition found in France for the last two decades. Currency crises based on changing political expectations were also be muted by the size of the Irish economy and its vulnerability to outside shocks. Despite these constraints, the Irish government not only found itself on the receiving end of devaluation requests from other Member States, but in 1992 it also found itself in the position of fending off a speculative attack on its currency shortly before an election. Political developments— both external and internal—had the power to drive currency market decisions and government responses in states of varying size, power, and openness. Chapter 7 considers the implications of these currency crises for Europe under monetary union as well as for non-European states. The expansion of Europe and eventually EMU eastward makes such crises a continued issue of concern, as they will be vulnerable to similar market pressures prior to EMU membership.

Summary of Findings This study traces the evolution of the EMS and how domestic and international political concerns increasingly dominated the occurrence and resolution of currency crises. Countries facing uncertain electoral results or elections that could change the course of policy will find their currencies vulnerable to speculation, whereas countries with predictable outcomes or outcomes that would not change major policies will not be subject to such currency instability. The timing of devaluation coincides with the consolidation of political power after an election because elections frequently incur other policies of adjustment (see table 1.1 and 1.2). Why should the origins of European exchange rate crises concern us in the wake of Economic and Monetary Union? The eastward expansion of the EU and the choice of several governments not to participate in monetary union make the question of currency crises of current relevance. Understanding the domestic and European origins of currency crises will provide analysts with a guide to what the new EU members may encounter as they struggle to bring their economies up to par prior to EMU membership. Currency crises are not unique to Europe, and despite substantial differences in financial infrastructure and economic development, many currency crises may also be explained by government instability. The inability to predict the onset, length, and severity of crises on economic

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Table 1.1

Realigning Interests Summary of arguments to be tested: theories of currency crises

Theories of currency crises

Independent variables

Implications for the exchange rate

Economic conditions (backward-looking)

Indeterminate combination of economic variables

Weaker economic conditions lead to a weaker currency

Partisanship (backward-looking)

Left governments likely to prefer policies with inflationary consequences

Current right government has a stronger exchange rate than a left government

Expectation of policy change (forward-looking)

Expected new government, new party/partisanship Changing coalition

Expected right government leads to a stronger currency

Policy uncertainty (forward-looking)

Uncertain polling results Coalition governments

Currency volatility; tendency to err on selling currency rather than holding

Table 1.2 Summary of arguments to be tested: theories of devaluation Reasons for devaluation

Indicators

Timing of devaluation (if any)

Economic conditions Governments target markets

Indeterminate Defense of currency by incumbents and new governments

Indeterminate None

Governments target primary constituents

Partisanship

Governments target voters

Defense by all incumbents

Defense of currency by right government, incumbent or new; devaluation by left, incumbent or new After election; when no election looms

Systemic pressure

General or shared realignments

According to the realignment needs of the strong states in the EMS

fundamentals alone indicate the government’s willingness and ability to handle a crisis could be a determining factor explaining such crises. Finally, this question of currency instability involves a larger issue of monetary cooperation and cooperation in general. When a government

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devalues its currency in the context of an international arrangement like the EMS, this decision affects other members and must be resolved jointly. The factors that alter a country’s ability to uphold one policy (like a fixed exchange rate) may similarly affect its ability to maintain other international commitments. Moreover, the joint nature of credibility and the ability of countries to externalize adjustment costs across an international organization like the EU can be applied to a variety of regimes. As we shall see, power, issue-linkage, ideas, and the institutionalization of interests all play a role in European monetary cooperation.

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CHAPTER 2

Rules and Norms of European Monetary Cooperation

Explaining European Monetary Cooperation

W

hat drives monetary integration? Countries can participate in a variety of systems, ranging from general statements of support for economic cooperation and policy coordination, to the extreme case of monetary union. A fixed-but-adjustable exchange rate peg like the EMS fell in between these two poles by offering participants some flexibility. In the EMS, countries were able to periodically realign the exchange rate to adapt to changes in the monetary environment. Under the best of circumstances, this would mean that participants would enjoy the benefits of exchange rate stability such as enhanced trade and investment flows due to the removal of exchange rate uncertainty, without entirely sacrificing the exchange rate as an adjustment tool. The delegation of monetary policy to a more credible institution than a national finance ministry or a national central bank (such as the central bank of another country within the exchange rate agreement) also could make monetary policy announcements more credible, thus allowing lower interest-rate premiums and making it easier to achieve price stability. Monetary union both offers more rewards and poses more risks for countries. On the one hand, monetary union eliminates the risk of exchange rate pegs becoming less credible against one another and generating speculative attacks against their respective currencies (as they share a single currency). When an arrangement demands financial support from participating governments (as the EMS did), market speculation can be quite costly for both the country with the weak

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currency and the country with the strong currency. A single currency also offers the region greater autonomy in the international monetary realm and makes it less prone to fluctuations from other currencies. This promotes trade within the region, further strengthening the ties between the countries and potentially leading to the synchronization of participating economies and their business cycles (Frankel and Rose 1998). These positive effects of monetary integration contribute to further regional cooperation and lead to even more intra-regional trade and investment. On the other hand, monetary union removes the exchange rate as a tool of adjustment because it demands a single monetary policy. If the composite regions are not sufficiently integrated, economic shocks that affect the region asymmetrically cannot be offset with exchange rate changes. Economic theory therefore points to the importance of states that share a currency to form an optimum currency area (Mundell 1961). If a region forms such an area, this indicates that a single monetary policy could be used in the adjustment process for an economic shock that affects the region similarly; or, in the case of an asymmetric shock, that adjustment could be facilitated via labor mobility or with the use of fiscal transfers. High labor mobility and the ability to make fiscal transfers are thus two potential indicators of an optimum currency area, along with the trade patterns of the constituent components of the area and the level of synchronization of business cycles. Though economists have argued that the existing members of EMU did not form such an optimum currency area (Eichengreen 1992a), the intensified trade patterns and expected higher correlation of business cycles in a postEMU environment could rectify this situation in the future (Frankel and Rose 1998). However, though monetary integration can offer these benefits that ultimately lead to greater trade and investment and therefore better long-term growth prospects, in the short to medium term there will be actors whose interests may be harmed by such exchange rate commitments and will try to impede its progression. At the international level, some states will benefit more than others because they will pay fewer costs while enjoying the benefits. Fixed exchange rate systems have leaders (also known as the anchor) and followers. The anchor currency can make monetary policy without regard to the monetary policy of the followers (known as the “n minus one problem” in the economics literature). Costs to the anchor currency vary according to the type of commitment it has made to other countries in the exchange rate agreement. In the case where a country unilaterally pegs its currency to

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another (which some countries in Latin America have done to the U.S. dollar), the anchor currency pays no costs. But if the government of the anchor currency agrees to support other currencies and adjust its policies for the sake of an exchange rate agreement, this can entail substantial costs. The country could suffer from a loss of currency reserves used to buy and sell currencies in order to keep them within the exchange rate agreement. It may also suffer from the implementation of an inappropriate monetary policy (normally in the form of interest rate changes) for that country’s particular economic circumstances. The follower countries must adjust their monetary policy in order to support the exchange rate, a situation referred to as the “unholy trinity” in which countries may choose only two out of the following three: monetary sovereignty, capital mobility, or fixed exchange rates (Cohen 1993, 1996). The extent to which a follower country will be willing to do so depends in part on the degree of openness of the economy, with more open economies suffering more from exchange rate turbulence and enjoying little monetary independence anyway. While these structural factors indicate when monetary cooperation will become more or less likely, political factors often determine the timing and the terms of the cooperative arrangement. Changing external circumstances can affect domestic calculations and make monetary cooperation more desirable. Alternatively, changing internal circumstances also can drive countries toward more cooperation as changing government coalitions pursue different policies than their predecessors. Likewise, changing internal events can tip the balance of power toward political actors that favor a fixed exchange rate and its benefits (such as trade effects and price stability) over monetary autonomy. The incorporation of monetary integration within the framework of European integration provided additional incentives that favored participation, and these incentives increased over time with rising capital mobility and the dynamics of the creation of the internal market, as well as the political exigencies caused by the end of the Cold War. In the case of European monetary integration, we see changing external circumstances, namely the instability of the U.S. dollar in the 1960s, driving the participants of the EC into monetary cooperation in an arrangement known as the Snake. This fixed exchange rate system envisioned the economies coming together in a monetary union by 1980, although this did not come to pass. Countries dropped in and out of the exchange rate arrangement when the adjustment burden became costly, thus opting for monetary sovereignty over the fixed exchange rate. The exceptions were the German mark and a small group of countries that

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depended on the German economy for much of their trade, a group that basically turned the Snake into a mark zone in which participants followed the movements of the DM (Gros and Thygesen 1998: 16–19; Tsoukalis 1977: 181). Generally speaking, however, the pegs were therefore not credible and did not serve as a basis for trade and investment, or for further European cooperation. By the early 1970s the EC fell into a state known as “Eurosclerosis” during which cooperation stagnated. External events continued to drive monetary integration later that decade, as the dollar’s continued volatility and the desire to jump start European cooperation led to the creation of the EMS in March 1979. This came about through the work of German Chancellor Helmut Schmidt, French President Valéry Giscard d’Estaing, and European Commission President Roy Jenkins. Jenkins proposed the idea of renewing monetary cooperation in the hopes of reawakening European integration (Giscard d’Estaing 1988; Jenkins 1989; Ludlow 1982; Schmidt 1990). The purpose of the EMS was to create a “zone of monetary stability” in the wake of the large exchange rate fluctuations that followed the end of the Bretton Woods regime and the first oil crisis. These fluctuations exposed Germany to currency instability and the prospect of imported inflation. This instability also wreaked havoc with the Common Agricultural Policy, a treasured benefit of EC membership for the French (Giavazzi and Giovanninni 1989: 11–19). The EMS offered France and Germany political and economic opportunities that they could not achieve on their own. Monetary cooperation offered France the chance to offset what it viewed as an irresponsible American monetary policy. An exchange rate arrangement embedded within European integration also provided the Conservative government, led by Prime Minister Raymond Barre, with a scapegoat for its austerity policies. Monetary cooperation gave Germany the chance to stabilize its exchange rate with some of its major trading partners and to promote its interest in European cooperation. But relevant actors within Germany gave a mixed reaction to the prospect of European monetary cooperation. Schmidt argued that the EMS could prevent the excessive depreciation of the French franc and the Italian lira (De Cecco 1989: 89), which would hurt the competitiveness of German firms. The chemical and steel industries, for example, had been losing market shares to competitors because of the strong mark; these industries reacted positively to the prospect of exchange rate stabilization (De Cecco 1989: 89). The banking community, however, expressed divided opinions on the subject, and, “although privately hostile, in public, the Bundesbank did not reject the system outright” (Henning 1994: 187).

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Schmidt reportedly threatened to revoke the Bundesbank’s independence if it did not agree, claiming that the EMS was a matter of high politics. The EMS and monetary integration were essential aspects of foreign policy, and Schmidt made its political significance clear from the beginning. He even attended a meeting of the Bundesbank Central Council in Frankfurt to plead his case, an unprecedented act that indicated that the political stakes were very high (Henning 1994: 188). The Bundesbank and the government formed a truce in the informal agreement known as the “Emminger Letter”: in exchange for not interfering with the establishment of the EMS, the Bundesbank retained the right to discontinue intervention if it threatened the German money supply (Heisenberg 1998: 63–5; Henning 1994: 188–9). Chancellor Schmidt essentially agreed not to compromise the Bundesbank’s independence for the sake of European integration. This act set the tone for the rest of development of the EMS, as independence from political interference in the setting of monetary policy was seen as the key to credibility. If monetary policy could credibly be de-coupled from political considerations, such as with the delegation of policy to an independent central bank, governments would supposedly enjoy greater price stability and exchange rate stability without painful costs like high interest rates. Decision-making would be delegated to the German Bundesbank, and later plans would be made for a European-wide version of the Bundesbank. The development of this norm will be discussed in greater detail later in this chapter. However, these norms did not evolve until several years after the inception of the EMS. The EMS was clearly a political project, initiated by politicians at the highest levels in a setting that deliberately excluded central bankers until relatively late in the process. The political nature of the EMS and its relationship to the EC was exemplified by its membership: all members of the EC were automatically official members of the EMS and participated in the European Currency Unit (ECU), a basket of currencies. Members were not obliged to participate in the fixed exchange rate commitment of the EMS, known as the Exchange Rate Mechanism (ERM). Thus Britain had been an official member of the EMS since it began in 1979, but it became a member of the ERM in 1990 when it committed the pound to a fixed exchange rate.1 The early period of the EMS was marked by frequent realignments, and for the most part they involved just Germany and one other country. European governments did not make a concerted effort to coordinate policy, and there was no overt linkage between EMS membership

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and other aspects of EC membership. Domestic issues still dictated government decisions; Belgium, Denmark, and France all devalued within months of their respective legislative elections. The underlying cause was the eroding competitiveness of their economies, but the immediate cause could be linked to their changing political landscapes. While the Belgians dealt with rising government subsidies, the Danish and French governments had to contend with the influence of unions over the government and Socialist parties that advocated monetary and fiscal laxity. The EMS was originally designed to make the burden of adjustment more equitable between the weak currency country and the strong currency country, but these institutional innovations fell into disuse, and by 1983 Germany had assumed a de facto leadership position in the EMS. The 1981 and 1982 devaluations of the French franc began as bilateral negotiations between the French and German delegations, with France turning to Germany for devaluation before asking the Monetary Committee. Chancellor Schmidt agreed to revalue the mark in exchange for some promises of policy change by the French government, which began the U-turn of the French Socialist government’s l’autre politique. This policy program had attempted to buck the European and American trend of monetarism in favor of Keynesian policies. Internal factors (primarily the weakening of the Communist Party in the French government) strengthened the faction in the French government that supported exchange rate stability within Europe and allowed monetary cooperation to intensify. By 1983 the Socialist U-turn was complete, and the French government had done a 180-degree turn away from its original 1981 policy objectives. German emulation was seen as the key to stability and prosperity (McNamara 1998, 1999). The DM’s fluctuations had normally been relatively small, and the Bundesbank guarded against the erosion of its competitiveness. The size of the German economy also made it a natural reference point for other currencies, and its strength served as proof that German economic policy was superior. After the 1983 realignment, the EMS went into a new phase of development that was characterized by fewer realignments and greater consultation between governments on realignment decisions. January 1987 marked the last EMS realignment for over five years, not including the devaluation of the Italian lira in January 1990, which was done in conjunction with the currency’s move into the narrow bands. During this period the bands “hardened”; no realignments occurred, and the currencies began being treated as if the exchange rate pegs were

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permanent (Frankel and Phillips 1992). A growing sense of “Europhoria” was heightened by the burgeoning plans for the single market. By the late 1980s, enthusiasm for a truly free trade union had spread to create renewed interest in monetary union. In 1989 the Delors Report was published, outlining a plan for economic union. Though this report was not the first such plan drafted by the EC, the events of 1989 gave the plan a sense of urgency lacking from previous initiatives. The prospect of German unification and the end of the Cold War made it necessary to reexamine the direction and pace of European integration to ensure that the EC survived these tumultuous events (Sandholtz 1993). At the end of 1991 the heads of state and government of EC members met in Maastricht, and the result of their dialogue was the Treaty on European Union (also known as the Maastricht Treaty). The centerpiece of this treaty was the plan for monetary union. The political roots of the Maastricht Treaty rested in Germany’s desire for unification, France’s desire to harness Germany’s power, and the desire of all EU nations to finally enjoy monetary credibility, lower interest rates, and greater stability (Dyson and Featherstone 1999). While countries participating in the EMS enjoyed more exchange rate stability and took advantage of rising trade opportunities with one another, monetary union offered additional advantages. Transaction costs would be even lower under a single currency than under a fixed exchange rate system that still required hedging. With the Single Market due for completion in 1992, a single currency seemed to be a natural step in consolidating its benefits (Emerson et al. 1992). The interest rates and inflation rates of EMS countries also had converged substantially, indicating a possible endogeneity of the creation of an optimum currency area: greater trade and monetary cooperation made the economies more similar to one another, thus reducing the costs of giving up national currencies. There also would be greater transparency in prices, which would make firms more competitive both with one another and outside the region. Politically, monetary union provided a potent symbol of European cooperation and unity in the aftermath of the end of the Cold War and gave the EC direction during a politically charged time (Baun 1995–1996, 1996). In addition, rising capital mobility during the 1980s had further eroded governments’ ability to pursue independent monetary policy and made currencies more vulnerable to speculation, as the EU discovered in 1992. Monetary union would thus alleviate such concerns. For the follower countries, under EMU monetary policy would allow all participating countries the opportunity to formulate policy for

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the region. While the countries had unofficially abdicated monetary leadership to Germany, neither the German government nor the Bundesbank accepted responsibility for crafting a European-wide monetary policy, and the Bundesbank continued to direct policy toward German developments. In addition, a single European currency could eventually rival the U.S. dollar, which retained its status as the international anchor currency even after the end of Bretton Woods (Henning and Padoan 2000). For the EC’s anchor currency, further monetary integration offered few economic benefits (Mélitz 1994: 62; Moravcsik 1998: 391) but would potentially reap great political rewards. At a time when the commitment of a reunified Germany to European cooperation was being questioned, sacrificing the DM would prove how much the German state had changed since the 1940s and that it would not allow unification and the fall of the Iron Curtain to interfere in its desire for European cooperation and further integration. European integration provided Germany with the means to successfully consolidate democratic ideals while further uniting its country to Europe and promoting greater European cooperation (Baun 1995–1996, 1996; Dyson and Featherstone 1999; Garrett 1993). In addition, the strength of financial interests within Germany made further monetary integration politically feasible since they would be able to take advantage of the consolidation of the European financial markets (Frieden 1998). The German Bundesbank did not want to risk a monetary union that would ruin German price stability, and the other states did not want to give up the credibility and economic benefits that they had earned under the EMS. Monetary integration along the lines of Maastricht therefore would combine the anti-inflationary bias of German emulation with a regime that gave all participants a voice in the decision-making. The convergence criteria of the Maastricht Treaty demanded an inflation rate within 1.5 percent of the three best performing EC economies, budget deficits of less than 3 percent of GDP, government debt below 60 percent of GDP, satisfactory performance within the ERM over two years; and interest rates no more than 2 percent above the EC average. In addition, countries had to grant national central banks independence and remove capital controls. The EC Council would decide in December 1996 if the majority of EC countries had met the convergence criterion. If so, it would set a starting date for Stage Three; if not, Stage Three would automatically start on January 1, 1999 (the latter of which occurred). The years following German unification tested Europe’s resolve for monetary integration despite the economic convergence that had been

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achieved under the EMS. At first, the promise of enhanced credibility under monetary union seemed to confer genuine credibility onto the EMS countries. Markets treated the currencies as if they were already fixed, ignoring signs of the weakening economies of Britain and Italy until the political events in spring 1992, which triggered a wave of speculative attacks that would last over a year (Buiter et al. 1998a,b; Cobham 1994; Connolly 1995; Eichengreen and Wyplosz 1993; Harmon and Heisenberg 1993; Johnson and Collignan 1994). When the political credibility of several major EU countries toward fulfilling the plans for monetary union became questionable, markets took a closer look at the economic feasibility of fulfilling the Maastricht criteria. Either weak economic fundamentals or a perceived weakness of political resolve (to follow through on the Maastricht Treaty criteria) could provoke a market attack. Electoral cycles that were once based on different domestic objectives became replaced by cycles predicated on European resolve. Rapid German unification had produced an unexpected shock to European integration (Loedel 1999; Owen 1991; Smyser 1993). Increased demand and rising imports replaced export-led growth. As early as 1989 Bundesbank officials and policymakers called for a revaluation of the mark to accommodate the changing economic environment. Germany’s European partners, in particular France, refused these requests on the grounds that devaluation would destroy the credibility gains acquired since 1987 and could damage prospects for monetary union. Trouble began brewing for the EMS in June 1992 with the failure of the Danish referendum on the Maastricht Treaty. To many, this was the first sign that EMU was not a done deal. If monetary union were derailed, then governments would not have an incentive to carry out the inflation-squeezing policies that were planned in order to qualify for EMU later on. If they did not carry out these policies, the real exchange rate would fall and, without the promise of monetary union in the future, the currencies of many of the EU countries would eventually be devalued. With the liberalization of capital markets in the early 1990s, markets were in a better position than ever to overwhelm governments and force devaluation given the removal of constraints on the movement of funds across borders as well as the technological innovations that made it easier to move greater amounts of money (Goodman and Pauly 1993). In addition, the need to raise interest rates to defend the currency placed governments in a politically difficult position given the poor economic conditions of the early 1990s (Gros 1992).

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The relaxation of U.S. monetary policy during summer 1992 exacerbated Europe’s currency woes. As the dollar sank, the mark grew stronger and its EMS partners weaker. The Italian lira in particular was under constant attack during the summer until it finally withdrew in September 1992. The British pound fell victim to massive speculation and withdrew from the ERM that month. The currency pressure spread to other currencies including the French and Belgian francs, the Irish punt, the Iberian, and even the Nordic currencies, the latter of which were not even participating officially in the EMS. More currencies devalued in 1993 as speculators continued the onslaught against the European currencies. Many expected the Bundesbank to provide some relief by lowering interest rates in July. When rates were lower than expected, the pressure grew. The Monetary Committee met on the weekend of July 31–August 1. The German delegation suggested a widening of the fluctuation bands to 6 percent. France rejected this idea and proposed that the ERM be anchorless, an idea that was rejected by Holland and Belgium. Spain advocated eliminating the ERM altogether. Finally the French suggested a 15 percent margin. Once its ERM partners agreed, the period now referred to as ERM I ended. Despite the 1992–1993 crises, monetary integration continued in the ERM II under the wider fluctuation bands. In 1998 the nations adopted the Stability and Growth Pact (SGP) to ensure that fiscal laxity would not jeopardize monetary union once countries passed the Maastricht Treaty’s convergence criteria. In 1999 monetary union began in earnest as Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain became the original EMU members, with Greece joining the group in 2000. As of this writing, Britain, Denmark, and Sweden have not joined EMU. In January 2002 the euro replaced national currencies. Despite the weakness of the euro in the first years of its operation, overall it enjoyed a successful launch free of major difficulties and has enjoyed widespread acceptance. Some of the countries in Central and Eastern Europe even expressed an interest in adopting the euro prior to EU membership, though the EU did not support this idea. The Functioning of the EMS The initial concern of the EMS was to correct what were seen as the mistakes of the Bretton Woods system and the Snake. Not wishing either to be captive to a hegemon as they were during the Bretton Woods system, or to have the burden of adjustment rest squarely on

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weaker currencies as it did during the Snake, EMS architects designed the divergence indicator and the ECU. Both these mechanisms were created to make the EMS a symmetrical system in which pressure would be exerted on both deficit and surplus countries to adjust their respective currencies (Ludlow 1982). The divergence indicator would show the movement of the exchange rate of each currency against the (weighted) average movement of the other participating currencies. The criterion used was the divergence of the actual daily rate of the currency, expressed in ECUs, from its ECU central rate. Adjustments were made for those currencies contained in the ECU but not participating in the ERM and the wider margins observed by certain currencies.2 When the currency crossed 75 percent of its fluctuation margin, it has crossed the divergence indicator, signaling the need for intervention. At least two currencies are always identified in this, the strong currency and the weak currency, and it was expected that the strong currency would purchase foreign currencies while the weak would sell. Thus, both the strong and the weak currencies would adjust. In practice, this provision played only a limited role. The EMS developed into an asymmetric system in which the German mark acted as the role of the anchor currency (Cohn 1988; Giavazzi and Giovanninni 1989; Herz and Roger 1992). The divergence indicator fell into disuse, as countries were unwilling to allow their currencies to substantially deviate from the central rate. Instead, countries chose to intervene intra-marginally and prevented the currency from ever reaching the divergence indicator (Gros and Thygesen 1998: 66). They suspected that allowing the currency to reach the divergence indicator sent a signal to markets that the government only weakly supported the parity. This prevented the strong currency from having to intervene in the foreign exchange market to prop up the weak currency in many instances, and the burden of adjustment largely remained with the weak currency country. Because of this preference for intra-marginal intervention, the EMS intervention system of very short-term financing in unlimited amounts also played a smaller role than expected. The central banks of the strong currencies were obligated to extend financing in unlimited amounts to defend bilateral margins when they crossed the divergence indicator. Settlements were to be made within 45 days after the end of the month of the intervention, though extensions could be granted. Intra-marginal intervention by weaker currency countries precluded the need to resort to these loans and thus the need for stronger currency adjustment.

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The other major innovation of the EMS was the ECU, a weighted basket of currencies participating in the EMS. A country could participate in the basket without committing to fixing the exchange rate. Each country deposited 20 percent of its gold and dollar reserves into a common fund. Designed to serve as the numéraire of the system, it would have diluted the influence of the stronger currencies and allowed policies to be tailored to something closer to an average exchange rate rather than the needs of the strongest currency. However, “as a unit of account, the ECU was never widely used in the private sector” (Gros and Thygesen 1998: 247). Thus the EMS I was a system of fixed but flexible exchange rates. Each currency had a bilateral exchange rate with the other participating currencies, and under the EMS II they are fixed against the euro. When the EMS was originally designed, the currencies were not permitted to fluctuate more than 2.25 percent above or below its central currency rate, thus moving within a fluctuation band. Some currencies such as the Italian lira and the Spanish peseta were permitted wider fluctuation bands of ⫾6 percent. In August 1993, the fluctuation bands for all of the participating currencies were widened to ⫾15 percent. For the Central and Eastern European countries hoping to accede to monetary union later in the decade, the definition of exchange rate stability under the Maastricht Treaty’s convergence criteria reverts to ⫾2.25. Realignments of the EMS took place within the Monetary Committee, composed of central bankers and finance ministers from the participating EU Member States, along with two observers from the European Commission. While the early realignments of the EMS occurred outside of this framework, the Monetary Committee became an essential part of the management of the EMS over time. Though the EMS deviated substantially from some of its original objectives, it largely fulfilled its primary goal of creating a zone of monetary stability in Europe. As the quest for symmetric adjustment eluded Europe in the EMS, other norms arose to regularize expectations and create more predictable patterns of behavior in monetary cooperation. The origins and effects of these norms are discussed later. Norms of the EMS Germany is the Unofficial Leader The German mark was the anchor currency of the EMS, thus permitting Germany to operate with more independence than the other countries. As mentioned earlier, the “n minus one problem” means that in a fixed

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exchange rate regime only one currency enjoys an independent monetary policy; the other currencies must adjust to it. Although Germany did not take an active leadership role in the EMS in the same way as the United States did during the Bretton Woods era, Germany alone set its own interest rates (which in turn became the floor for other interest rates sets in Europe). This was problematic because the mark often found itself subject to different exchange rate pressures than the other European currencies. When the dollar weakened, for example, investors flocked to the mark and drove up its value against the dollar and the weaker European currencies. This wreaked havoc on European monetary stability, and gave rise to the various attempts at European monetary cooperation (Giavazzi and Giovanninni 1989; Henning 1998). Though the mark served as the anchor currency of the system, this does not mean that Germany served as the system’s hegemon. Economists have found evidence of asymmetry using various economic measures (Kutan 1990; Wyplosz 1989), with Germany at times also being affected by other members’ currency movements despite the general asymmetry (Fratianni and von Hagen 1990; Hafer and Kutan 1994; Weber 1991). However, Germany’s reluctance to assume this role makes the term “hegemon” difficult. Political scientists have referred to Germany’s “leadership” (McNamara 1998, 1999) and “standard-setting” (Kaelberer 2001), with other countries emulating the German model. This emulation resulted from Germany’s relative economic success during the postwar period. Germany enjoyed strong growth, a healthy balance of payments, and low levels of inflation. Many attribute this success to the Bundesbank’s independence. The literature on central bank independence argues that an actor who is not politically accountable (like an independent central bank) could make a more credible monetary policy than politicians subject to electoral cycles and interested in pleasing important political constituents. Central bank independence can therefore lead to a reduction in the inflation bias, a reduction in the variability of monetary policy according to government partisanship, and a decrease of preelectoral manipulation of monetary policy (Alesina 1988). The logic of such reasoning hinges on the assumption that a political reward exists for lax monetary policy (at least in the short run), and that parties are differentiated by the degree to which they are inclined to exploit this. If this is the case, the independent central bank can serve as a guardian of monetary stability to the untrustworthy politicians who would sacrifice long-term stability for short-term political profit.

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The Bundesbank has often been given credit for the country’s price stability. As one of the most independent central banks in the world, it is free from political pressure (to inflate the economy in order to promote growth) originating from both the government and pressure groups. If the case of a high fiscal deficit, the central bank can raise interest rates in order to counteract its inflationary effects, possibly negating the results of the fiscal expansion. The central bank, not concerned with upcoming elections and the purchasing power of any particular group, can afford to make tough decisions that would be good for the economy in the long run, although political suicide in the short run. While governments tend to be more concerned about unemployment, independent central banks have a higher preference for price stability. An independent central bank provides the economy with a stabilizing force; the bank’s independence shields interest rate decisions from political interference and smoothes out market expectations of changing policies due to different political configurations. But even the mighty Bundesbank is not as independent as it may first appear. First, although the Bundesbank was in charge of interest rate policy3 and the government of exchange rate policy, the Bundesbank was obligated to support the government’s overall monetary policy.4 And while the Bundesbank was not obligated to form interest rate policy in order to support the government’s fixed exchange rate, the decision to devalue the exchange rate belonged to the government alone. Former Bundesbank President Schlesinger stresses “the Bundesbank . . . is not a state within a state,”5 underlying the fact that the Bundesbank works in conjunction with other institutions for the good of the German economy. Finally, as will be emphasized later, the EMS operated under German leadership, not hegemony. Thus even Germany made compromises and sacrifices for the good of the EMS. Credibility is Conferrable In lieu of national central bank independence (and more recently, supplementing it) the EMS participants chose to abdicate monetary policymaking decisions to the Bundesbank. The reasoning is similar to that of granting independence to the central bank: by “tying your hands” to noninflationary targets set by the Bundesbank via international commitments, the promise not to inflate becomes more credible (Giavazzi and Pagano 1988). The international agreement with its accompanying entanglements and reputation concerns form a bond that the governments offer markets: If the government reneges and foregoes

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the bond, presumably it will lose its accumulated credibility, and its international ties and commitments will fall into disarray. With EMU, the EMS countries were “buying” Germany’s credibility by handing over monetary policymaking authority to central authority that has been explicitly modeled after the German Bundesbank. The advantage of this over continuing to delegate authority to the actual Bundesbank was that the governments had been forced to respond to Germany’s shocks, rather than domestic shocks or even European shocks. The cost of responding to an asymmetric shock that hits the anchor currency became clear in the years after German unification. Blindly following German policy was difficult when that entailed raising interest rates during the middle of a deep recession. While the other countries could attempt to mimic German policies, this did not mean that the markets conferred the same sort of credibility to simple policy statements. Germany had well-developed and well-established institutions in place, along with a proven track record for resisting short-term growth that could be inflationary. Furthermore, the rest of Europe lacked the political consensus on the importance of price stability that had given the Bundesbank much of its power. The independence of the Bundesbank could technically be revoked through a legislative act, but its widespread support makes this highly unlikely, and the system of coordinated wage bargaining reinforces the effects of its independence (Hall 1994; Hall and Franzese 1998; Iversen 1998; McNamara and Jones 1996). Thus, Germany’s European partners were forced to set their interest rates higher than Germany’s lest investors flee toward the safer and more stable German investments. The transference of credibility was imperfect, as seen by the interest rate differentials across countries that existed until shortly before monetary union commenced in January 1999. Though monetary cooperation had some role in stabilizing expectations, credibility still needed to be earned. The Franco-German Axis Runs the System Given Germany’s past aggression in Europe, German foreign policy has not been as active as one would expect from such a large and powerful state. This pattern of reluctance pertained to European integration as well: Germany did not seek leadership of European monetary cooperation but found itself at its center by virtue of the strength of its economy and the influence of ideas on central bank independence. Monetary integration required a country to act as a leader and to push cooperation

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forward, something Germany could not be relied upon to do. The German foreign policy establishment viewed monetary cooperation favorably as a way to promote further integration, but Germany would serve as no more than a passive leader given the trepidation of its partners to more overt signs of German leadership and power. Furthermore, as noted earlier, important actors like the Bundesbank eyed monetary cooperation warily because it could compromise German goals. Thus a monetary system revolving solely around German leadership would resemble the mark zone of the Snake—composed of Germany and smaller countries willing to follow its lead. Without France, the EMS would not have encouraged a Europe-wide membership, it would not have been linked to other issue areas, and it would not have served as an impetus for further integration. Since the European Coal and Steel Community was founded in the 1950s, European integration has rested on the Franco-German axis. Although the French franc was a weaker currency during most of the 1980s, the French government never let it be forgotten that France traditionally served as one of the motors of European integration, and that it is the Franco-German axis around which the EC revolves. Thus the French government could exert a moral authority during negotiations that only it and Germany possessed, since they held the power to make cooperation move forward (Chang 2002). If France dropped out of the EMS it would be no better than the Snake and ultimately would fail in its objectives of stabilizing exchange rates and promoting European integration. After the 1992–1993 crisis, French involvement kept the system from collapsing and allowed exchange rate stability to return and monetary integration to move forward (Abdelal 1998). Cooperation and Consensus Rule, but Adjustment Begins at Home Participating in an international arrangement like the EMS could strengthen the government’s commitment not to inflate because it combines elements of rules and discretion (Kahler 1989). These rules were relatively informal and reflected the developments that took place in the EMS rather than a fixed set of rules designed at the outset of the system. The early years of the EMS were very informal and involved little coordination or adjustment between members. As the system progressed and some of the aforementioned norms took shape, so did the presumption that the EMS would entail cooperation and adjustment, both at the international and domestic levels.

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In the early years of the EMS, realignment decisions were arranged bilaterally and involved only the countries devaluing or revaluing their currencies. For example, Belgian and German representatives handled the early Belgian realignment by telephone. As noted previously, the French delegation approached the Germans in advance of a Monetary Committee meeting to discuss the terms of the devaluation. With the 1983 realignment, however, the rules and norms of the EMS began to solidify and began to exhibit recognizable patterns. The 1983 realignment not only marks the end of the French Socialists’ experiment but also the first time a general realignment took place. The decision to have the Italian lira and the Irish punt devalue (along with the French franc) demonstrates the newly developing ethos within the EMS. This was a joint project rather than the unilateral pegs that characterized the operation of its predecessor, the Snake. Realignment decisions became collective proceedings, and the Member States turned to consensus building to create a monetary regime that would serve as a launching pad for further cooperation later in the decade. This meant that the Europeans were embarking on a truly cooperative monetary involving mutual adjustment. Countries would take a hit for one another in order to preserve the system; currencies would devalue even if they had not been the targets of a market attack. This spirit of cooperation, however, did not extend to all countries. Only France could convince other governments to devalue their currency alongside the French franc, making French devaluation decisions pivotal. This stems largely from the need for French participation in order to make monetary cooperation meaningful and a springboard for further integration. Without France, monetary cooperation would not move forward; the threat of French exit (actively wielded during the 1983 realignment) provided France with a critical bargaining chip during realignment negotiations. The desire to keep the French on board and sustain the momentum of monetary cooperation convinced other states to accept the short-term cost of devaluation for the greater good of the system. Although devaluation costs could be externalized (at least by the French), ultimately monetary stability rested with a government’s ability to bolster its international commitment through domestic policy. The regime provided governments with rules and goals, but governments implemented policies to support these objectives and retained a considerable amount of discretion regarding the timing and extent of adjustment. In that sense, participation in an international agreement like the EMS was symptomatic rather than a causal force. If a government

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would not adjust domestic policy to suit the demands of the regime, it would quickly lose credibility and become meaningless. International cooperation must be part of a coherent domestic policy and economic program. As former German Bundesbank President Karl Otto Pöhl writes, Necessary disciplines must be acceptable to all partners, they must all see advantages for themselves in abiding by them, and they must be willing to do so even though at times this may appear unpalatable. The necessary disciplines cannot be imposed upon countries from outside.6

Devaluation is a Sign of Weakness Though the EMS countries negotiated realignments according to a consensus model, states came to the bargaining table with clearly conflicting preferences. In the EMS, as it was with the Snake, the burden of adjustment fell on the weaker currency countries. Governments viewed devaluation as an admission of failure (Mélitz 1988), a public indication of the government’s inability to provide an economy that could sustain the exchange rate level. This explains why France periodically devalued alongside other countries in order to avoid being the sole “problem country”; a general realignment (one involving all the EMS countries) allowed the rationalization of a system-wide problem. This also made politically significant the issue of the amount the strong currency country revalues its currency versus how much the weak currency country devalues. In economic terms this seems to be primarily cosmetic; whether Germany revalues 5 percent and France devalues 10 percent (or the reverse) the end result is a devaluation of 15 percent for the franc vis-à-vis the mark. Politically, however, this issue involved blame-shifting for the cause of the imbalance (such as blaming overly tight German monetary policy instead of lax French policy) and avoiding the appearance of incompetence or irresponsible behavior (Andrews 1993). One Monetary Committee member highlighted the politicized nature of devaluations by contrasting normal meetings concerning day-to-day operations of the EMS versus realignment meetings. The subject of domestic politics and upcoming elections may be raised during the regular meetings, and participants acknowledge and try to accommodate domestic constraints that other Member States face, such as elections. But once the realignment process begins, the members become government representatives and they try to secure the best deal possible for their

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government. 7 As another former Monetary Committee member remarked, “We aren’t sitting around that table talking about neofunctionalism, we’re talking about politics and elections!”8 The importance of giving the appearance that a country’s national currency was not the problem could be seen in the politics of realigning currency. France, for example, had been successful in persuading Germany to revalue its ECU central rate whenever the French franc required adjustment. In terms of bilateral franc/mark exchange rates, however, the end result was still a devaluation of the franc. According to Gros and Thygesen (1998: 69), the cumulative effect of the realignments against the DM from 1979 to 1990 range from a deprecation of 63.5 percent for the Italian lira to just 4.0 in the case of the Dutch guilder. Despite the realignments that occurred in which the DM revalued upward, the outcome was devaluation for weaker currency countries. The burden of adjustment ultimately fell on the shoulders of the government of the devaluing country, which was forced to alter its policies in order to make the postdevaluation parity credible. Politically speaking, however, the realignment decisions appeared more equitable and were therefore easier to justify to the electorate. France had also been able to prevent unilateral realignments in which it was the only country to adjust its currency. This demonstrates the ability of the French government to use its status within the EC to advance its interest in not devaluing alone and thereby sharing the blame for the realignment with other European states (see table 2.1). These two norms of consensus building and devaluation-as-failure competed against one another during realignment negotiations. Governments looked out for their own best interests domestically and internationally while convincing each other of the validity of their preferences for the group as a whole. Persuasion and compromise emerged as essential elements to a successful realignment negotiation. Strong Currencies are More Stable and Provide a Source of Power and Influence The natural corollary to the norm that devaluation means failure is that strong currencies connote strength. Though an argument can be made that devaluation would make the economy stronger by promoting exports, such gains pale in comparison to the prestige and political influence granted to stronger currencies. This status stems in part from the aforementioned success and acceptance of the German model as the one to copy. German policy advocated a strong currency and price stability to

Table 2.1

EMS realignments against central rates 1979–1993

Date

24 31 2 5 22 14 21 21 7 4 12 8 13 17 22 10 13

Belgian franc September November March October February June March July April August January January September September November January May

Source: Eurostat.

1979 1979 1981 1981 1982 1982 1983 1985 1986 1986 1987 1990 1992 1992 1992 1993 1993

4.8

Danish krone 2.9 4.8

8.5

3.0

1.5 2.0 1.0

2.5 2.0 1.0

2.0

French franc

German mark

Dutch guilder

Irish punt

Italian lira

Portuguese escudo

Spanish peseta

2.0 3.0

5.5

5.5

5.75 2.5 2.0 3.0

4.25 5.5 2.0 3.0

4.25 3.5 2.0 3.0

3.0

3.0

6.0 3.0 3.5 2.0

2.75 2.5 6.0

8.0 3.7 7.0 10.0

6.0

5.0 6.0

6.5

8.0

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sustain its international competitiveness and thus its economic strength. A strong currency dampens inflationary pressures, and investors have greater confidence in the currency’s future value. This creates a virtuous circle of growth and stability. “Competitive disinflation,” credited to Treasury Director Jean Claude Trichet (Masson 1997: 441) and Finance Cabinet Minister Jean-Baptiste de Foucault,9 became the economic rationale for basing monetary policy around a strong and stable currency. This contrasted with the inflation-crisis-devaluation scenario faced by weaker currency countries during the early part of the EMS (Dyson and Featherstone 1999: 81–3). The economic woes faced by the weaker currency countries during the early 1980s diverged sharply from the stronger currency countries like Germany. This evidence of successful policy provided Germany with even greater influence that rested not only on its economic and political muscle, but also on the wide acceptance of German economic ideas (McNamara 1998, 1999). The power of these ideas was evident during the Maastricht Treaty negotiations. Germany and the Netherlands, the biggest advocates of a strong currency and price stability, fought to make price stability the overriding function of the European Central Bank. They later sought to incorporate various safeguards to ensure that inflation did not creep in through the back door after monetary union. Although differences of opinion still existed regarding the optimal level of price stability and the trade-offs involved (otherwise the issue would not have been so contentious), a strong currency had become equated with power, and European countries could not ignore the standard that the Germans had already set in the EMS. The extent to which a strong currency confers political power, however, remains in doubt. During the early 1990s the French had succeeded in their goal of creating a franc fort, but they did not dislodge the mark from its role as anchor currency. Despite the fact that the French economy was at least as strong if not stronger than Germany’s economy in 1992, the franc still fell victim to speculation. When France attempted to lower its interest rates in 1993 (below the floor set by Germany) and to assume the role of the new anchor in light of Germany’s unification-related economic difficulties, markets quickly demonstrated the futility of these actions and forced the government to raise rates again. Despite its best efforts to strengthen its currency and its economy, France was not able to dislodge Germany as the standard to which others were compared. Its best chance at wresting more power

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comes as a participant of monetary union, rather than as a player in a game seemingly played according to German rules. Conclusion This chapter provides an introduction to the history and operation— formal and informal—of the EMS. Originally a political project designed by the leaders of the EC’s principal countries, the EMS developed into a system that ostensibly prized the removal of politics from monetary policymaking but exhibited political priorities at critical junctures. On the one hand, despite the best efforts of Schmidt and Giscard to make the EMS a symmetrical system, within the first few years of its operation it became a DM system. The importance of Germany and the DM in this system resulted from its economic power, which later translated into political power. The use of the DM in international transactions and the less restrictive regulation of its use made it a natural anchor currency. The success of the German economy made it an ideal type to be emulated so that other countries could enjoy greater credibility and eventually prosperity. This gave German policy and preferences considerable authority. The German institutional structure of an independent monetary policymaking body exemplified the benefits of separating politics from policymaking. On the other hand, one could not escape the political implications of these policies, making their separation illusory. Though Germany possessed a certain moral authority that granted it even greater influence than it would have had on the basis of its economic strength, monetary cooperation could not be separated from European cooperation. Countries did not slavishly follow German policies, but rather were willing to adjust, even when it went against their short-term interest of not devaluing. Moreover, the second most powerful country in the system, France, could expect to adjust less than its weaker currency comrades, and could even persuade the other states to share in the devaluation burden. This indicates the existence of a hierarchical system that follows political principles and exigencies at least as much as one dedicated to pursuing price stability. Therefore the operation of the EMS demonstrated distinctive political elements in the handling of its currency crises and realignments. The next few chapters will examine not only the international roots of the onset and resolution of these crises but also their domestic origins. While factors such as the aforementioned norms and relative power factor into realignment decisions, the occurrence of these crises can be

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traced to domestic policies and sources of instability. This also indicates the significance of domestic politics in determining when and how these exchange rate tensions are dealt with. The intersection of international norms and demands with domestic political pressures form the crux of any explanation of a currency crisis.

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CHAPTER 3

Political Economy of Currency Crises and Devaluation

T

he effect of political transitions on market expectations of a currency’s value offers analysts a clear example of how domestic politics can impact international relations. Changes in government can lead to currency volatility that can spread to other countries not involved in the original crisis. This could necessitate exchange rate intervention and possibly a currency realignment, which would be negotiated among the finance ministers of the various Member States while currency market transactions in their respective countries are suspended. While currency crises may be domestic in origin, they can have ramifications for international politics as well. Such volatility can emerge because markets are aware that the prospect of a change in government alters the government’s willingness and ability to maintain an exchange rate commitment. The government’s willingness can be compromised by its desire to lower interest rates, engage in inflationary spending and project a sense of economic growth and prosperity before an election. Economic fundamentals may thus deteriorate prior to an election as the government attempts to engineer preelectoral booms. These may or may not be interpreted as political manipulation, as governments may be expressing the preferences of its primary constituents. However, even in the absence of policy changes market pressure can arise due to uncertainty surrounding the government’s policy preferences. Elections and government change would not be problematic if the outcome were easily predicted. When markets expect the incoming government’s exchange rate preferences to differ from its predecessor’s, markets will try to anticipate the change before the fact and move the

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currency in that direction. If markets cannot discern the incoming government’s preferences, either because of a close election or uncertainty surrounding the composition of a coalition government, general instability may ensue as markets try to hedge their bets. If either of these two scenarios occurs, the exchange rate instability generated by markets will force governments to either defend the exchange rate or to devalue. Such crises are likely to end in devaluation when a new government takes office and can blame its predecessor for poor economic policies. Currency Crises and Devaluations in the EMS The EMS began in March 1979 as a fixed-but-adjustable exchange rate system in which the participating currencies were pegged to one another in bilateral exchange rates that could fluctuate within a narrow band. The original members of the ERM of the EMS were Belgium, Denmark, France, Germany, Ireland, Italy, and the Netherlands. In 1989 Spain joined the ERM, followed by Britain in 1990, and Portugal in 1992. In September 1992 both Britain and Italy left the ERM; Italy rejoined several years later, but Britain has yet to commit the pound. In 1995 Finland, Austria, and Sweden joined the EU and became participants of the ERM. All the aforementioned countries except Britain, Sweden, and Denmark have become members of EMU, the final stage of which began in 1999. Greece joined EMU in June 2000. In joining the EMS, these countries made a commitment to defend the value of their exchange rate pegs; any changes in the official exchange rate values were to be made within the multilateral framework of the Monetary Committee.1 This makes exchange rate instability and devaluation easier to identify than in floating exchange rate systems as the government explicitly assumes responsibility for an announced exchange rate. Any deviation from the announced exchange rate value (and fluctuation band) clearly reflects a departure from this policy and can readily be observed by market participants as well as voters. This heightens the expectations placed on participating governments to adhere to policies that would support this exchange rate in both the long run as well as in the short run. When governments will not or cannot follow such policies, exchange rate instability ensues. Are currency crises determined by a government’s unwillingness to maintain the parity? If this were the case, one would expect economic fundamentals to be decisive in determining the onset of currency crises. On the other hand, perhaps the government’s ability to maintain the exchange rate comes into jeopardy given a precarious political situation,

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such as those found in elections and changes in government. In order to determine this I construct a political economy model of currency crises based on the drift adjust method of target zones. Previous political economy analyses of currency crises have largely focused on exchange rate fluctuations in a range of regimes from fixed to floating (Bachman 1992; Eichengreen et al. 1994; Leblang and Bernhard 2000). This study looks only at the fixed currencies in the EMS because exchange rate volatility demands a coherent government response in such systems, much more so than under floating systems. When a currency is in a floating rate system, the government has the option of allowing the volatility to continue without a short-term policy response. Currencies in fixed rate systems demand either a response or a repudiation of the currency peg shortly after speculation occurs, lest the currency fall from its peg. This increases the stakes among those countries that have committed to the EMS in order to enhance their credibility with markets, lower their disinflation costs, and ultimately lower interest rates and enjoy higher economic growth. Devaluation could undermine a government’s quest for greater credibility by demonstrating to markets that its commitment to defending the exchange rate and buttressing it through domestic economic policies is weak. Focusing on fixed exchange rates sharpens our awareness of the incentives of both governments and markets to diverge from the status quo through currency realignment. Examining countries in fixed exchange rate systems also tests the extent to which political considerations can be removed from the equation. Work on central bank independence and exchange rate regimes indicate that such constraints allow governments to form more credible monetary policies because monetary policy will no longer be dictated by politically motivated actors. Clark et al. (1998), for example, found that a high degree of central bank independence and an exchange rate commitment decreased the likelihood of opportunistic political business cycles. The countries under study are long-term members of the EMS. Are they vulnerable to market speculation despite their increased credibility? And are their currencies prone to politically motivated speculation despite their external exchange rate commitment? Empirical testing indicates an affirmative response to both questions. The primary economic model for explaining currency devaluation for exchange rates that fluctuate within a band is the target-zone model (Krugman 1991). The “drift adjust” model (Svensson 1993) is a type of target-zone model that has been used to measure the expectation of exchange rate realignment and thus serves as our proxy for market instability. This is done by subtracting the deviation of the currency’s spot rate

44

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from its central rate (its bilateral fixed exchange rate with the DM) at time t and time t ⫺1, taking the difference of this result, and subtracting it from the home country’s interest rate differential with Germany, the anchor of the system. This number measures market expectations of realignment for currencies in a target zone by accounting for exchange rate pressure within the constraints of a fixed rate system. Thus: expected rate of realignment ⫽ (domestic interest rate ⫺ German interest rate) ⫺ [(spot rate ⫺ central ratet ⫹ 1) ⫺ (spot rate ⫺ central ratet)]. A high value of the left-hand variable indicates poor credibility; a low or negative value demonstrates high credibility and the expectation that the government will not realign its currency. The economic data are taken from the IMF’s International Financial Statistics. The exchange rates are the period average ECU rates. The monthly data covers the ERM I period of March 1979–August 1993, before the target-zone bands were widened from 2.25 percent up and down to 15 percent in August 1993. The following OLS estimation serves as the basis for subsequent analysis: (domestic interest rate ⫺ German interest rate) ⫺ [(spot rate ⫺ central rate t ⫹ 1 ) ⫺ (spot rate ⫺ central rate t )] ⫽ constant ⫹ inflation ⫹ real exchange rates ⫹ reserves ⫹ output ⫹ trade balance ⫹ partisanship ⫹ elections ⫹ type of government ⫹ capital controls ⫹ central bank independence ⫹ previous exchange rate realignment. The economic variables included in this study are the same as those used in the target-zone model developed by (Rose and Svensson 1994): ●

●

●

Inflation: percent change in consumer price levels. As inflation differentials with Germany increase, so should the expectation of realignment as higher inflation increases the cost of imports, affecting the country’s balance of payments position and weakening the value of the currency. Higher inflation can also lead to an outflow of capital, which would also weaken the currency. Real exchange rates: ratio of domestic price indices between two countries. An increase in the real exchange rate implies a worsening of competitiveness for a country and therefore increases the likelihood of realignment. Reserves: total reserves minus gold; as the reserves decrease the government loses a major resource in combating speculation, thus increasing the probability of realignment.

Currency Crises and Devaluation ●

●

●

45

Output: index of industrial production; a decrease of this variable indicates a weaker economy and therefore a weakening of a currency and higher probability of realignment. Trade balance: exports over imports; a strong trade balance is generally associated with a stronger currency, and a weakening trade balance could indicate the need for a realignment.

With the exception of the inflation rate, these variables have been transformed by taking deviations of natural logarithms of domestic values from German values, following Rose and Svensson (1994). In addition to the aforementioned economic variables, the following political variables were also considered: ●

●

Partisanship: Left governments represent different constituencies than right governments, and they purportedly have different policy preferences. Left governments are more likely to suffer currency crises because they are both more likely to favor loose monetary and fiscal policy, and because they would be less willing to increase interest rates to defend the currency. This variable provides a more nuanced approach to evaluating the effect of partisan differences than traditional left–right distinctions. Taken from the European Journal for Political Research, dummy variables that distinguish between governments that are right-wing, right–center, balanced, left–center, and left-wing were created. A right-wing government is defined as holding over 66 percent of the seats in government and parliament. A right–center government means that the right holds between 33.3 and 66.6 percent. The numbers for the left are the same. If a left-wing government were in power, the expectation of realignment would be higher as it would allow the government to follow a more lax fiscal and monetary policy that benefits its primary constituents. If a right-wing government were in power, however, the expectation of realignment would decrease because of the inflationary effects that are associated with devaluation. The closer either of these polar spectrums converges toward the middle, the less likely this variable will influence outcomes. Elections: The prospect of a new government coming to power could lead to a currency weakening if the incoming government were expected to either devalue the currency or pursue policies that would not support the existing exchange rate. Alternatively, the currency could strengthen if the incoming government were expected to implement policies that would strengthen the exchange

46

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●

●

●

●

Realigning Interests

rate. A dummy variable was constructed in which the value is 1 if an election occurs in that month, 0 if otherwise. Type of government: The type of government has previously been found to be significant in the reduction of interest rate differentials and nominal exchange rate stability (Oatley 1997). It stands to reason that a government’s type may also affect market confidence regarding its ability to defend an exchange rate. Government type is operationalized as follows: 1 ⫽ single party majority, 2 ⫽ minimum winning coalition, 3 ⫽ surplus coalition, 4 ⫽ single party minority, 5 ⫽ multiparty minority, 6 ⫽ caretaker. There should be a negative correlation between government type and the expectation of exchange rate devaluation. The greater the number of parties involved, the more interests and constituencies the government need to satisfy, making it difficult to rapidly respond to changing circumstances. Similarly, a government lacking a majority would also find it difficult to craft a coherent response to rapid changes in economic policy given its need to maintain the support of parliament. Data were taken from the European Journal of Political Research, various issues. Capital controls: The use of capital controls makes it easier for a government to deal with capital flight, at least in the short run. Hence Dennis Quinn’s index of openness was used, and a higher degree of financial openness should be associated with a lower expectation of devaluation. Central bank independence: An independent central bank removes the possibility that monetary policy will be pursued for short-term political objectives prior to an election, boosting a government’s credibility to maintain an exchange rate. Hence central bank independence is associated with a reduced expectation of currency crises. An index constructed by Grilli et al. (1991) was used, which measures the legal independence of central banks. Devaluation: Currency realignments were also included in order to control for their effect on exchange rate expectations. Realignments were marked as dummy variables: 1 when a devaluation of the currency’s central rate occurs, 0 if otherwise.

Data from the following countries were studied: Belgium, Denmark, France, Ireland, Italy, and the Netherlands. Country dummy and year dummies were added in order to control for any fixed effects. Lags of the dependent variables were also added in order to correct for autocorrelation problems, and the lack of autocorrelation was verified through Durbin’s m test (see tables 3.1–3.2).

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47

Table 3.1 Expectation of exchange rate realignment, 1979–1993 Coefficient (t-statistic) Constant Lag real exchange rate Lag inflation Lag output Lag trade Lag reserves Devaluation Capital controls Central bank independence Partisanship Type Elections R N

3.156 (2.178)* ⫺3.005 (⫺1.322) ⫺.238 (⫺4.675)** ⫺3.370 (⫺3.061)** .271 (.318) 2.248 (5.153)** 2.947 (4.879)** 4.986E⫺02 (.455) ⫺.773 (⫺5.916)** 6.553E⫺02 (.903) ⫺.148 (⫺1.610) 1.690 (3.584)** .728 997

Notes: Not shown: lags of dependent variable, country dummies, year dummies. * Significant at .05 level; ** Significant at .01 level.

Consistent with economic studies of economic variables and exchange rate determination, a political economy explanation best captures the dynamics of market expectations of realignment. Economic variables like inflation, output, and reserves were found significant. Taming inflation became one of the major economic goals of many countries both in and out of Europe during this time period; as mentioned in chapter 2, membership in the ERM provided an additional means toward that end. A rising inflation differential with the anchor country, Germany, would thus affect interest rate differentials and expectations of the currency’s future value. The government’s ability to defend an exchange rate in case of attack will depend, in part, on its

Table 3.2

Expectation of devaluation by country, 1979–1993

Constant Lag real exchange rate Lag inflation

Lag output

Lag trade

Belgium

Denmark

France

Ireland

Italy

7.678 (2.043)* 8.580 (1.337)

3.356 (1.109) 10.638 (1.489)

3.079 (.495) 3.456 (.474)

21.663 (4.040)** 13.831 (2.614)**

4.512 (.456) 20.908 (2.072)*

6.428 (2.436)* 13.155 (3.404)**

.530 (2.799)**

.398 (3.404)**

.332 (2.717)**

.161 (1.487)

.164 (2.093)*

6.400 (.659)

9.169 (2.568)*

2.292E 02 (.136) 12.807 (1.814)

1.210 (.600)

.455 (.217)

1.176 (.181)

.114 (.039)*

2.612 (1.227)

.560 (.466)

1.649 (.673)

Netherlands

4.281E 02 (.030) 1.255 (2.203)

Lag reserves Type

Partisanship Capital controls Election Government change Devaluation R square N

2.728 (2.411)* 8.117E 02 (.368) .636 (2.356)* 4.785E02 (.293) 1.124 (1.859) — .781 (.347) .642 169

Notes: Not shown: lags of dependent variable. * Significant at .05 level; ** Significant at .01 level.

1.654 (2.565)* .470 (2.386)* .653 (3.687)** .288 (1.478)

.737 (2.417)* 1.589 (1.768) .719 171

3.722 (3.000)** .505 (2.544)* .449 (3.457)** 7.963E02 (.161) 5.737 (4.707)** — 9.355 (7.514)** .771 170

5.753 (3.788)** .411 (1.891) .690 (1.113) .753 (2.138)* 3.895 (3.235)** — 3.763 (2.468)* .618 170

3.123 (2.250)* 1.843 (1.740) .712 (.298) 8.152E02 (.199) .921 (1.178) — .769 (.582) .656 160

1.763 (4.292)** 3.998E02 (.475) .170 (1.788) .322 (1.924) .738 (2.463)* — Not applicable .655 171

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reserves, and declining resources would make the currency ever more vulnerable. The reasoning of this becomes circular once the initial attack occurs: once confidence in the currency wanes, the government must spend its reserves to prop it up, and the more of its reserves that are spent, the less able it will be to defend against ongoing attacks. The pooling of resources in the form of both the strong and weak currency governments intervening assisted in this endeavor, but most of the market’s attention focused on the weak currency and the future prospects of that economy. Declining reserves are not only symptomatic of a weak currency, but a weak currency also often leads to falling reserve levels. The model also yielded the presence of elections as a significant variable. The prospect of changing government preferences and policies positively correlates with market expectations of devaluation, and therefore currency crises. Surprisingly, capital controls did not have a significant effect on the expectation of exchange rate devaluation, though the sign was correct. Central bank independence, however, did significantly reduce realignment expectations, reinforcing the significance of politics and institutions in influencing market expectations. Neither government type nor partisanship, however, was significant. While such pooled time-series analyses provide a useful first-cut for understanding currency crises, the EU comprises a variety of countries that differ from one another to the extent that their aggregation could lead to a significant loss of information. For instance, elections may not have the same impact on a country with frequent turnover of its government (such as Italy, e.g.) versus countries whose elections precipitate the transfer of power. Political factors like elections, partisanship, and government type may not have the same effect in different countries, even in an area as integrated as Western Europe. However, running the same variables as individual time-series allows one to parse out how countries may respond differently to the aforementioned variables. The above regressions reveal that the economic and political variables differ in significance for the various European countries, differences that are lost in aggregation. Though the type of government was not significant for the group as a whole, it was significant for Denmark and France. In the case of France, for example, some of the problems the Socialist government had in maintaining the exchange rate concerned the demands of their Communist coalition partners. The policy preferences of the faction within the Socialist party that allied with the Communists contributed to the already high inflation, capital flight, and lack of confidence in the currency that caused it to be the object of several major

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attacks. Once the role of the Communists in the government was reduced in 1983, the government was able to enact stabilization policies that reduced inflation and improved the strength and stability of the currency. Similarly, some of the problems the Conservative government had in the early 1990s concerned the conflicting preferences over the desirability of monetary union between the RPR and UDF parties. This helped precipitate the currency crisis in spring 1993. Disagreements within government are more likely to occur with additional partners, since this reduces the government’s ability to make policy decisions due to concern over their conflicting effect on partners’ interests. In the Danish case, it is not surprising that government type made a difference in market expectations given the relatively recent development of its multiple party system. Prior to 1973, four parties—the Social Democrats, the Radical Liberals, the Conservatives, and the Liberals—dominated Danish politics. The 1973 elections stand as a watershed in Danish politics for its introduction of five new parties to the Folketing, along with the losses sustained for the major parties. The proliferation of new parties made it difficult for any single party to muster a majority, making minority governments common in Denmark and potentially contributing to uncertainty surrounding government intentions. In Denmark from 1945 to 1987, the average duration of government for a minimum winning coalition was almost twice that of a minority government (Laver and Schofield 1991: 152). This indicates that minority governments tended to be less stable and in a weaker position to pursue policies that could stabilize the exchange rate, hence the negative correlation between government type and devaluation expectations. Danish inflation also tended to run higher than the inflation rates of other European countries, which would contribute to its higher interest rate differential with Germany and weaken the currency. The partisanship variable was not significant for the EMS countries as a group, but it was for Belgium, Denmark, and France. Once again drawing on the French example, in the early 1980s the government attempted its Socialist experiment that included policies such as industry nationalizations, a reduced workweek, and various public works programs, which led to a massive flight of capital and several devaluations of the currency. Though the Socialists improved their macroeconomic performance and credibility after the policy U-turn in 1983, the left continued to pursue some distinctive policies, such as the introduction of the 35-hour workweek in the late 1990s. Moreover, its relatively frequent devaluations earlier in the period may have also damaged the reputation of the party with markets.

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The Belgian case also indicates a positive relationship between governments of the left and the expectation of devaluation. Union participation in economic decision-making during this period remained high, which was strongly associated with the participation of the left in government (Compston 1994). High levels of government debt also continually plagued Belgium. Like France, this is the classic relationship hypothesized between left governments and currency instability: the participation of left governments (and in particular unions) in the formation of policy leads to capital flight since they favor stronger growth over price stability. The Danish case is interesting because the sign of the partisanship variable is negative. This is contrary to the positive association between left governments and currency instability in the aforementioned countries. Partisan politics experienced a shift in Denmark during the 1980s, as the importance of unions declined and the system shifted from a centralized bargaining regime to one more decentralized, flexible, and reliant on market forces (Iversen 1996). This suggests that the link between parties and unions has changed and can no longer account for economic conditions. Partisanship may need to be combined or replaced by another variable measuring union density and/or labor involvement in government policymaking in order to explain how markets consider partisanship from case to case. Partisanship may thus serve as an imperfect proxy for something else, hence the unexpected relationship between partisanship and currency crises. In cases where the hypothesized relationship between unions/labor and left governments does not hold, the partisan label no longer possesses the same meaning. One can also question the meaning of partisanship in countries where this did not register as a significant variable. Unlike in countries such as France and Germany, where the lines between left and right have traditionally been clearly drawn by parties, the major cleavage in Ireland has not been socioeconomic but rather nationalist. The two largest parties, the Fianna Fail and Fine Gael, are both considered right-ofcenter. Their primary difference has been the degree to which they support Irish autonomy (with the Fianna Fail being the more militant party and the Fine Gael more accommodating toward Britain). In the late 1980s the Progressive Democrats, a breakaway faction of the Fianna Fail, joined these parties of the right. It is therefore not surprising that partisanship was not significant in determining market expectations of devaluation in this case. When elections were not found significant in Belgium, Denmark, and Italy, an alternative variable of government change was used, with the information coming from the European Journal of Political Research.

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Only in Denmark was this alternative measure of political change found significant. Interestingly, though elections were found significant in France, Ireland, and Denmark, the signs of the variables were different. In Ireland and France they are positive, indicating the expectation that markets anticipate the incoming government to either devalue the currency and/or the incoming government to pursue policies inconsistent with maintaining the current exchange rate. In France, the national elections frequently served as a referendum on the state of the economy. The incumbent government consistently denied problems with the long-term maintenance of the exchange rate, while challengers would question the competence of the government’s economic policy, arguing that devaluation was needed in order to correct the damage done to economic competitiveness under the current administration. Elections and the accompanying changes in administration hence heralded an upcoming devaluation. Ireland’s statistical relationship between devaluation expectations and elections, however, may be a red herring. The early 1980s were a tumultuous time both politically and economically for Ireland. The country experienced three elections within a year and a half, and one of the primary issues concerned proposed austerity measures. The credibility of the government to carry out such measures given the general political instability at the time (exacerbated by issues concerning Northern Ireland) was not very strong. Coupled with the nonmembership in the ERM of Ireland’s primary trading partner, Britain, the punt suffered as the government was unable to credibly commit to stabilization policies. However, the competing political parties did not diverge significantly in how to handle the economic crisis, and as we shall see in chapter 7 on Ireland, many of its devaluations were conducted as part of joint realignments that coincided with elections. In contrast with the other cases under examination, elections in the Netherlands lowered the expectation of realignment. This indicates that markets had more confidence in the willingness and ability of the expected incoming government to maintain the exchange rate. As previously noted, elections can have either a strengthening or a weakening effect on the exchange rate, but pooled time-series analysis may drown this out. These results are broadly consistent with others who have found that either elections (Bachman 1992; Blomberg and Hess 1997; Siklos and Tarajos 1996) or cabinet instability (Leblang and Bernhard 2000; Simmons 1994) have affected devaluation expectations. If markets react to political developments in addition to economic fundamentals,

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periods of government instability pose an added source of insecurity for governments in the form of currency speculation. Thus the government’s ability to maintain exchange rate commitments can become weaker as a result of market expectations as well as of economic conditions. How governments react to such threats is the subject of the next section. Do these governments devalue their currency in the face of market speculation? Or do the same forces that incited market speculation also alter government incentives to devalue? The timing of devaluation exhibits political influences, as governments prefer to defer devaluation until after an election has passed. Explaining Exchange Rate Realignments A target-zone model developed by Edin and Vredin (1993) uses both lagged interest rates and economic fundamentals to explain currency devaluations. They argue “a devaluation, which involves a change from one target zone to another, is related to ‘fundamentals’ (other than interest rate differentials), just like the change in the exchange rate within a target zone is determined by such ‘fundamentals’ ” (Edin and Vredin 1993: 161). Specifically, there exists a “shadow rate” (determined by a set of economic indicators), which, if it diverges too far from the central parity, will lead to a change in the central parity itself. Devaluation occurs if: shadow rate(t ⫹ 1) ⫹ error(t ⫹ 1) ⬎ central parity(t) ⫹ constant. In other words, currency devaluations are driven by economic fundamentals. Unlike earlier versions of the target-zone model, Edin and Vredin do not limit these fundamentals to studies of the money supply and interest rates, but they also include other economic indicators. Siklos and Tarajos (1996) extended this model to include political variables as well. The probit analysis below (see table 3.3) uses these same economic and political variables; the control variables discussed in the previous models of currency crises; and interest rate differentials with Germany. None of the economic variables found to be significant in the exchange rate crises models registered as significant in the devaluation model; interest rate differentials and real exchange rates were the only ones found to be significant. A weakening exchange rate fuels continued currency speculation; governments defend a currency by raising interest rates and spending foreign exchange reserves, so a large interest rate differential makes it more costly to defend the exchange rate. These

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Table 3.3 Devaluation 1979–1993 Coefficient (t-statistic) Capital controls Central bank independence Preelection period Postelection period Type Partisanship Lag inflation Lag output Lag real exchange rate Lag reserves Lag trade Interest rate differential

⫺1.55154 (⫺2.38140)** 4.73072 (2.42393)* ⫺.39831 (⫺.63134) 1.27197 (2.92977)** ⫺.91149 (⫺2.38709)* ⫺.26052 ⫺1.17105) ⫺.04846 (⫺.39893) ⫺5.44125 (⫺1.56788) ⫺12.08416 (⫺2.39191)* ⫺.23035 (⫺.22129) ⫺.30741 (⫺.19894) .11915 (3.67369)**

Notes: Not shown: country dummies, year dummies. * Significant at .05 level; ** Significant at .01 level.

economic indicators are also among the most publicly scrutinized, which can help explain their power in predicting devaluation. In addition, interest rates and exchange rate provide useful composite indicators of general economic conditions because they are influenced by economic fundamentals like the inflation rate and expected growth. While economic conditions are a motivating force in the onset of currency crises, the decision to devalue also reflects political motivations. Despite the rational expectations model’s assumption that markets should be able to predict such decisions ex ante, it appears that elections provide sufficient noise and inject uncertainty in the process of trying to predict government interests and hence government policies. Capital controls did enable governments to manipulate the timing of devaluation; greater financial openness made devaluation a more likely

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possibility. Consistent with analyses that attribute the relaxation of capital controls with greater exchange rate instability, the results shown here confirm that capital controls were an important tool in managing exchange rates in the 1980s and early 1990s. Central bank independence also registered as a positive and significant influence on devaluation decisions. While capital controls enabled countries to skirt devaluation and market forces, the presence of independent central banks signaled less politically motivated, growthoriented manipulation of monetary policy. Countries with higher levels of capital controls (like France and Italy) also tended to have politically dependent central banks, reinforcing the notion that governments try to assert greater control over monetary policy for political gain. Government type has a significant negative effect on the decision to devalue. This corresponds to the previous analysis of the role of government type in determining the onset of currency crises. The fewer interests that a government needs to accommodate, the easier it is for the government to act decisively, particularly when pursuing a policy that diverges from the status quo. Minimum winning coalitions and singlemember governments are more likely to devalue a currency than surplus coalitions or minority governments. The latter group of governments needs to be concerned with pleasing the various members of the coalition and/or the supporting elements in the legislature that allow it to govern. Thus a clear policy break like an exchange rate devaluation may be difficult to make when a myriad of conflicting interests needs to be satisfied. So which audience does a government target when devaluing? The positive and significant coefficient of the postelectoral variable points to the general electorate, at least during electoral periods. If the government targets markets, there should be no significant correlation between the political variables and devaluation—the emphasis would be on economic fundamentals. The lack of significance of the partisan variables suggests that partisanship also does not come into play strongly during devaluation decisions. This makes sense intuitively, as the government already should be able to count on the support of its primary constituents. One can assume that the government has already enacted numerous policies to satisfy this constituency, and the exchange rate level and stability should already be satisfactory. Last-minute adjustments to policy could actually alienate these constituents and call into question the government’s preferences in relation to their own. Thus the status quo should be the optimal policy for a government when it faces exchange rate

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pressure, and there should be no correlation between elections and devaluation. The significance of the postelection variable points to the electorate as the target audience. During an election time the government will try to appeal to as broad a range of voters as possible in order to secure reelection. Those voters who are not firm supporters of the government already are more likely to be swayed by last-minute policies that could negatively influence their perception of government competence and reliability. Therefore, the government does not devalue before an election. The average voter would not perceive the government favorably after devaluation, and the government may also lack the needed support within the legislature to make such decisions so close to the time of an election. The government can also manipulate its participation in the EMS as a political symbol that reinforces its effort to sway votes based on its credibility. A government can use its EMS obligations to participate in two activities that Mayhew (1974) argues politicians engage in to enhance their prospects for reelection: credit-claiming and positiontaking. The government can take credit for saving the currency from the evil speculators and preventing a humiliating devaluation. Credit can also be accrued from improving or at least not damaging the country’s influence in the EU. In addition, by not devaluing before an election, governments take a strong stance on their preferences for exchange rate and price stability. By demonstrating its willingness to spend foreign reserves and raise interest rates to defend the currency, the government signals to the market its commitment to a strong currency and lower inflation. The public also perceives this commitment, and this enhances perceptions of government competence. Eichenberg and Dalton (1993: 521–3) found a correlation between rising inflation and declining public support for European integration. This indicates that the public is aware of and is concerned with inflation. If it can affect their support of the EC, it could also affect their support of the government responsible for the economy. The fact that the defense of the currency takes place within the context of the government’s obligation to uphold the EMS also provides the government with a scapegoat for the unpopular consequences that the defense of an exchange rate may require. This enables the government to implement policies that might otherwise be deemed too constrictive (Andrews 1993). The period immediately after an election, however, is the best time to introduce new policies like a lower exchange rate or even switches in

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exchange rate regimes. The new government has likely consolidated its hold on power during the election and has a greater mandate to make policy changes. This is particularly true when, as mentioned previously, the new government is one that is strong and internally coherent—thus able to break with the previous exchange rate level. Conclusion This chapter illustrates the link between politics and economics when it comes to currency crises and devaluation. Economic fundamentals are important: inflation, output, and reserve levels determine a currency’s strength and the government’s propensity to devalue. However, economic fundamentals have been poor predictors of currency crises because clear thresholds do not exist for determining when weak economic fundamentals mean that an exchange rate is unsustainable. Thus political variables can be of great value when trying to understand the timing of realignment expectations since they can tip the balance of expectations toward devaluation when economic fundamentals indicate that a given exchange rate would be unsustainable in the long term. Both currency crises and devaluation tend to cluster around periods of political instability—specifically elections. Understanding this phenomenon requires not only looking at market motivations for speculative attack but also government responses to them. While elections may cause markets to question a government’s commitment to a fixed exchange rate, the timing of such attacks also influences how a government reacts. Despite the possibility of lowering interest rates via devaluation, governments prefer not to devalue so as to appeal to the maximum range of voters prior to an election. After their power has been consolidated, however, the new government may decide to devalue in the months following an election. These findings not only illuminate both government and market preferences during currency crises, they also point to the political nature of credibility. Governments still possess some discretion in determining the timing of devaluation, despite the power of markets in an age of high capital mobility. First, credibility is not easily quantifiable, it rests largely on perceptions and expectations of what governments are likely to do in the future. Governments can attempt institutional fixes like granting the central bank greater independence in order to signal its intentions, but it is unclear how and why this signal has differed on the international stage as opposed to nationally. Why was the independent Bundesbank associated with a strong currency and low inflation but the

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even more independent European Central Bank with a weak currency during its first few years of operation? Why is central bank independence not associated with the same type of economic phenomena in developing economies as they are in developed economies? Influencing market expectations via enhanced credibility is a complex task that requires taking stock of changing political circumstances in addition to structural factors like institutions. Governments still play an important role in global finance; they supply the environment of political and economic stability that is necessary for investments to prosper (Rodrik 1997). They also retain some decision-making authority in determining the value of the currency and the type of exchange rate regime in which it chooses to participate. The relationship between governments and markets may have been altered by capital liberalization, but governments still play a vital role. And as long as governments matter, so will issues like credibility, authority, and accountability. Politics not only complements economic explanations of exchange rate determination, they interact with one another to form the ideas and expectations generated by the market.

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CHAPTER 4

France, 1981–1986

T

he elections studied in this chapter took place during the early years of the EMS, when its norms and purpose were still developing. Over time countries adjusted their domestic economic policies in order to conform to the demands of EMS participation, but during the first few years of operation most countries prioritized domestic concerns, and realignments were more common. When monetary union becomes a serious prospect for Europe in the second half of the decade, countries expressed an even greater willingness to adjust for the good of the system, though domestic political interests are clearly discernible. Nevertheless, one can still observe the role power plays in monetary politics by looking at how the French successfully avoided the embarrassment of devaluing alone and convinced other Member States to join them in realignments. By 1983 they negotiated the first general realignment of the EMS that involved all the participating countries. During both the early period of the EMS and the post-1987 Europhoria phase, France remained the only country that could persuade other countries to participate in joint devaluations. Given the link between French political consolidation and the timing of its currency crises, the French government was led to seek general realignments involving other currencies in order to externalize the costs to the government’s reputation.

1981 Presidential and Legislative Elections The 1981 presidential election was scheduled for May 10. Incumbent President Valéry Giscard d’Estaing faced rival François Mitterrand in the second round.1 President Giscard defended the franc against relatively

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mild attacks prior to the election, but most analysts predicted a continuation of the Giscard-Barre team that had been leading France down the path of austerity. Mitterrand’s victory took observers by surprise, and a crisis emerged immediately after the election as markets predicted a radical shift in policy under the new Socialist president. While economic fundamentals had been eroding steadily, the election provoked massive capital flight. While the conservative Giscard remained in power, currency pressure remained manageable. When markets expected the continuation of Prime Minister Barre’s austerity policy, devaluation pressure was weak. Mitterrand, however, defied expectations that the Socialist president would devalue the currency. Therefore, partisan theory correctly predicts exchange rate instability preceding the presidential election, but not Mitterrand’s decision to defend the currency. Economic Policy and International Conditions: Austerity Under the Right President Giscard had the misfortune of governing during difficult economic times. The combination of the oil crisis and global recession left few countries unscathed. Germany’s terms of trade suffered and its current account went into deficit, weakening the DM. The disciplining effects of the EMS had not yet begun, and even the Bundesbank had accepted the need for the DM to depreciate in order to preserve competitiveness in the face of a growing current account deficit. The DM’s slide continued until August 1981, with the Bundesbank intervening in the foreign exchange markets with higher interest rates and capital controls (Henning 1994). The DM’s weakness allowed participants like France and Italy to put off painful reforms during economically difficult times (Heisenberg 1998: 80), at least for a little while. The election results, however, and the transfer of power from the conservative coalition to the Socialists in France would soon shatter this uneasy equilibrium. Prime Minister Barre tried to lift France out of its economic woes through austerity: the government enacted price freezes, introduced wage and salary restraint, reduced money supply growth, and raised taxes (OECD 1980). The higher interest rates needed to attract capital in the face of deficits and inflation further reduced growth and employment (IMF 1982). France’s trade balance went into substantial deficit given its dependence on foreign energy. Eichengreen et al. (1995) have noted patterns for countries about to devalue. First, there is a weakening of the reserves for several quarters

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15 14.5 14 13.5 13 12.5 12 11.5 11 10.5 10 Nov-80 Figure 4.1

Feb-81

May-81

Aug-81

Nov-81

Monthly inflation, 1981 electoral period

due to the weakness of the external account. Second, inflation runs higher and faster. Third, there tends to be an increase in imports and current account deficits. Fourth, interest rates rise as the devaluation approaches, but do not decline significantly afterward—perhaps in the expectation of more attacks. Figures 4.1–4.4 show the patterns of these variables before and after the 1981 French elections, with the midpoint of each chart being the election month/quarter. The scholarly literature on this subject consistently states that the franc was overvalued by this time. Its negative trade balance, high inflation, and poor expectations for economic growth and output seemed to make it a natural candidate for devaluation. Despite these weak economic conditions, however, the franc retained its value; reserve levels had actually been gradually increasing for months before the election and

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1,000

500

Millions of US$

0

–500

–1,000

–1,500

–2,000

–2,500

Figure 4.2

-1 82

-4 81

-3 81

-2 81

-1 81

-4 80

80

-3

–3,000

Quarterly current account balance, 1981 electoral period

interest rates held steadily (albeit at a high level) until the election. Therefore, while economic fundamentals had steadily deteriorated, devaluation pressure (which would be indicated by the defense of the franc through foreign exchange and interest rate intervention) was absent due to the expectation that Prime Minister Barre would not devalue (Fonteneau and Muet 1985: 163). The economic fundamentals support the need for devaluation, but the sudden nature of the crisis suggests political developments altered market expectations of future policy. Policy Promises: Continuity on the Right, Growth on the Left The campaign officially started on April 13, but it unofficially began to get underway as politicians announced their candidacy in January and February. Giscard and Barre kept economic policy on track during this time, offering continuity in policy and expectations. In January 1981,

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30,650 29,650 28,650

Millions of US$

27,650 26,650 25,650 24,650 23,650 22,650 21,650

Figure 4.3

N

ov -

81

1 -8 Au g

81 M

ay -

1 -8 Fe b

N

ov -

80

20,650

Monthly reserves, 1981 electoral period

the prime minister told a colloquium on the television station TF1 that the government would not give up its constrictive policies. He warned: 1981 will be a difficult year. The crisis is neither French nor European, it is worldwide. This is not a superficial or short crisis . . . all of our partners have chosen to fight inflation and progressively redress their external accounts. All refuse to engage in dangerous stimulation policies, of which the consequences would be . . . catastrophic.2

This news from the incumbent reassured markets as the election approached. If reelected, the government would continue on its current economic path, and there would be no surprises. Mitterrand’s cure for the French recession included the selective stimulation of the economy, a reduction in the working week, public and private investment programs, the creation of 150,000 new jobs in the public sector,3 and a 30 percent rise in minimum wages, all of which

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35

30

25

20

15

10

5 Nov-80 Figure 4.4

Feb-81

May-81

Aug-81

Nov-81

One-month Eurofranc interest rates, 1981 electoral period

would send the already high inflation rate soaring.4 Moreover, a Mitterrand victory implied the distinct possibility of Communist participation in the government, which would send markets into a tailspin. While the Socialists remained coy about the inclusion of the Communists in government, Giscard tried to play on the fears of a Socialist government. In an interview with Figaro Magazine, he declared that the choice was between “moi ou désordre.”5 He predicted that the left would jeopardize the franc, free enterprise, nuclear independence, and France’s role in the world: “adieu la solidité du franc!”6 The Polls: Ambiguous Outcome Polls taken during the electoral period indicated the gradual decline of Giscard’s popularity. Beginning in January, dissatisfaction with Giscard began to erode his approval ratings according to several sources. 7 Giscard’s lead continued to slip in February, with Le Figaro predicting a Mitterrand victory in the second round (52 percent versus 48 for Giscard), and Paris-Match predicting a tie. By April the election looked far from certain. Despite the radically different economic programs the candidates espoused and the lack of a clear winner in the published polls, there was

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seemingly little reaction from the market before the election. There was a widespread expectation that Giscard would emerge victorious and economic activity would continue as usual. In January, L’Express proclaimed, “Giscard appears invulnerable . . . nothing, not the economic difficulties . . . not the attacks against his person . . . appear to be able to stop his easy reelection.”8 Le Nouvel Observateur also expressed interest in the curious lack of DM activity so close before the election,9 while Le Monde attributed the market calm to expectations of Giscard’s reelection. In May, the pressure on the franc increased as the dollar rose and the election drew near. Interest rate hikes in the United States accelerated the dollar’s rise and put more pressure on the franc. Giscard defended the currency and proclaimed, “The franc remains one of the most stable currencies in the world.”10 Giscard’s defense of the franc can be understood on the grounds that his primary constituents preferred price stability (devaluation would contribute to inflation), and voters would perceive devaluation as a signal of government incompetence. The currency is a symbol of the French economy, monetary stability, and the success of monetary policy (Fonteneau and Muet 1985: 149). As French economist Jacques Mélitz has observed, “Devaluations cost votes” (Mélitz 1988: 58), and empirical analysis of the 1981 French elections confirms that exchange rate movements significantly impacted the president’s popularity (Lafay 1985). The Election: Mitterrand Wins, the Crisis Begins, No Devaluation The first round of the election was held on April 26, 1981; Giscard did not win the required 30 percent to stave off a second round.11 On May 10 Mitterrand won the second round with 51.82 percent of the vote, versus 48.17 percent for Giscard. The next day, the franc hit the floor of the EMS band.12 The Banque de France authorized more than $3 billion in interventions and raised interest rates from 16 percent to 18 percent on May 14.13 While interest rates had been creeping upward since mid-1980, this represented a sharp rise. The financial world appeared stunned by the victory. Business Week reported that “billions of dollars worth of business decisions were stopped in their tracks,” and that on May 11, only 12 of the 200 major stocks on the Paris Bourse could be quoted, due to impending nationalizations.14 As Mitterrand’s inauguration approached, interest rates set record highs as capital fled the country in droves. The base des banques

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rose from 14.75 percent to 15.75 percent on May 20, setting a new record. This was the second rise in eight days, having risen to 14.75 percent from 12.75 percent on May 13. Intervention rates rose from 16 to 17.5 percent on May 19, another record. The Banque de France lost approximately $400–600 million daily.15 Between the election and the inauguration, the Banque de France had lost a third of its total reserves. Newly appointed Prime Minister Pierre Mauroy recalled driving with President Mitterrand down the Champs-Elysée toward the Tomb of the Unknown Soldier on May 21 (Mitterrand’s inauguration day), advising the president to take action on the currency that evening. Earlier that morning Mauroy had received a note from the Banque de France regarding the massive capital flight that was expected to worsen. Mitterrand replied: “One does not salute the victory of the left with a devaluation” (Mauroy 1982: 19). Mitterrand was determined not to allow devaluation and its negative connotations to taint that moment. The new government repeated its resolve that evening during a meeting with Banque de France Governor Renaud de la Genière. When counseled to devalue the franc, the governor was met with the response “One does not devalue the currency of a country that has just placed its confidence in you” (Bauchard 1986: 19). Even outgoing President Giscard acknowledged the impossibility of Mitterrand devaluation. When Barre noted the need for a quick devaluation, Giscard knowingly replied, “They wouldn’t dare” (Denis 1983: 13). Mitterrand knew that the upcoming legislative elections made devaluation unthinkable for fear that it would “break the electoral dynamic” (Denis 1983: 15). Later that evening, the Mauroy team16 raised interest rates to 22 percent, implemented capital controls, and employed a policy on the repatriation of exports, which was employed to stem the capital flight. Jacques Delors explained, The franc will remain in the EMS and will be strongly defended . . . The franc is in effect the object of three different attacks: the pressure of international interest rates and the rise of the dollar; the result of the election of François Mitterrand, which is now being absorbed; and finally, the persistent rumors that the franc must be devalued against the DM . . . The defense of the franc is a priority of the new government.17

On May 22 President Mitterrand dissolved the parliament. The Banque de France once again raised short-term interest rates to 22 percent.18 Mauroy’s cabinet continually raised the prospect of devaluation, though not in the immediate future. The government prioritized

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the fulfillment of their campaign promises (which included the defense of the franc) in order to win the legislative elections. Jacques Delors stressed the need to establish a credible government and to finally fulfill the hopes and aspirations of the Socialist Party: “The sin of treason is more fatal than that of error” (Alexandre and Delors 1985: 73). Despite market pressure and the high cost of the franc’s defense, the new Socialist government refused to devalue prior to the National Assembly elections. Contrary to partisan predictions of a greater tolerance for the inflationary tendencies of devaluation, the Mitterrand government sought to establish a reputation for credibility and competence with the French electorate. The Legislative Elections: More of the Same, No Devaluation The legislative elections were scheduled for June 14 and 21. Mitterrand and Mauroy agreed upon the need for an electoral majority in order to carry out the Socialist program.19 On June 3 Mitterrand announced a set of policies designed to appeal to the electorate, such as raising the minimum wage and creating over 50,000 new jobs in the public sector (Northcutt 1992: 88). On June 21, Mitterrand himself announced the results of the Socialists’ massive victory. Markets did not react immediately, as this win had been expected.20 The announcement of the inclusion of Communists in the cabinet, however, broke the market calm. Capital flight weakened the franc beginning on June 23, and the Banque de France once again intervened to prevent the franc from passing its ceiling against the DM. Many anticipated devaluation,21 with an official at a nationalized French bank noting, “ . . . Between 80 percent to 90 percent of the people in the foreign exchange market believe the franc will still be depreciated after the parliamentary elections.” 22 Mitterrand later acknowledged that it was a mistake not to have devalued immediately afterward (Bauchard 1986: 34). Instead of devaluing immediately, the government tried to prove that it could succeed where the right had failed. The IMF recommended the following policy measures to combat the recession: not to bring down unemployment through expansionary fiscal or monetary policies; not to resort to protectionism; and not to implement compulsory work-sharing measures such as a reduction of the workweek (IMF 1982). The government had gone against all these proposals. They expected the recession to end in the OECD countries by the end of the year, and studies done by the IMF and the EC corroborated this prediction. The economic

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recovery failed to materialize, however, and on October 5, the French government devalued the franc. Summary of the 1981 Elections The presidential and legislative elections support a political explanation of the timing of the currency crisis and devaluation. Though the poor state of the French economy indicates the importance of economic fundamentals, speculation did not occur until after the Mitterrand victory. Giscard’s expected victory had allayed market speculation. There was no perception of policy uncertainty, and the logic of the partisan theory seemingly prevailed: the left and the right offered different policy programs, and while the right was in power (and expected to remain in power), the currency remained stable despite poor economic conditions. The crisis began only after the left came to power. Yet the legislative elections did not support the partisan theory, which would have predicted devaluation before the legislative elections. The decision to devalue was up to Mitterrand, and he chose not to devalue despite the massive pressure on the currency after the presidential elections. Instead, the timing of the devaluation indicated the political significance of the upcoming legislative elections. 1983 Municipal Elections: The U-Turn and Beginning of European Monetary Policy Delegation This interim election supports theories that credit partisanship with the emergence of a currency crisis, as well as the expectation of policy change due to a change in government. The timing of the devaluation, on the other hand, does not play to partisan logic but rather to electoral exigencies. The Socialist government’s policies led to the further weakening of the economy and the currency. The outcome of the election was uncertain, but there was the expectation of either a conservative victory or a small left victory that would lead to the erosion of the Communist Party’s power in the cabinet, thus signaling a policy change. The Socialist policy U-turn had already begun, and the election was expected to consolidate this trend. Despite pressure from speculation on cabinet changes and the concurrent German legislative elections, the government resisted devaluation until after the municipal elections were completed. This was followed by the solidification of power of the franc fort faction of the Socialist government.

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Economic Policy, International Conditions, and the Beginning of Austerity Under the Left The Socialist government’s predictions of a worldwide economic recovery at the end of 1981 failed to materialize, and the economy continued to decline. The government embarked on a policy of austerity, known as riguer, and reducing inflation overtook improving unemployment as the government’s primary goal. The government disagreed on how to deal with the malaise. The Communists still wanted France to spend its way out of the recession, so they repeatedly called for reflation and rising wages, leading to open disagreement within the government. The Socialist Party was torn, with some advocating further riguer and others siding with the Communists. Jacques Delors and Pierre Mauroy pushed for an austerity plan; l’autre politique had failed to improve economic conditions in France, and the franc devalued a second time in June 1982. Pierre Bérégovoy and Minister of Industry Jean-Pierre Chevènement, however, wanted to return to l’autre politique. They supported French withdrawal from the EMS so that interest rates could be lowered without concern for franc–DM exchange rate fluctuations. The issue was not definitively decided until after the municipal elections of 1983 and the subsequent realignment (Bell and Criddle 1988; Cameron 1996; Gourevitch 1986; Hall 1986). Complicating matters for the French government was the growing interest of Germany in French monetary affairs. In October 1982, Helmut Kohl’s conservative coalition of the Christian Democrats and Free Democrats replaced social–liberal coalition led by Helmut Schmidt. This reversed the expansionary policies within Germany as the new government focused on tax cuts, fiscal consolidation, the reduction of the welfare state, and a reduced role for government (Goodman 1992; Henning 1994). The German government increasingly pressured the French government to bring its policies more into line with the conservative and economically stringent German policies. The political shift in Germany also had implications for European cooperation more generally, as German Foreign Minister Hans Dietrich Genscher viewed the Franco-German partnership as the key to further European integration (Henning 1994). The 1982 realignment had signaled the rising interdependence of monetary policy decisions within the EMS. Germany negotiated changes in French economic policy (including a salary freeze) in return for the DM’s revaluation (Heisenberg 1998: 83). The devaluation

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provoked the first of several rounds of austerity measures to improve the deteriorating competitiveness of the French economy. The government limited the public sector deficit to 3 percent of GDP, cut public spending by 20 billion francs, froze prices and wages until the end of October, froze social security contribution levels for one year, and reduced company taxes by 10 percent (Hall 1985, 1986). Figures 4.5–4.8 indicate a still-weak economy suffering from high inflation and a current account deficit. The increase in reserve levels belies the tenuous position of the franc, as the government borrowed 28 billion francs (US$4 billion) from American, Arab, and Japanese banks in November 1982 (in anticipation of future intervention) (Bauchard 1986: 123; Favier and Martin-Roland 1990: 406–7). The sharp interest rate hikes in the run-up to the election also imply that politics played a role in influencing the timing of the crisis. The municipals were scheduled for March 6. They were the first national elections since the Socialists took power two years ago, and they were widely viewed as a referendum on the Mitterrand government. Although the municipal elections would not affect the composition of either the cabinet or the National Assembly, most French citizens believed a Socialist defeat could send a message and force the government

10.5

10

9.5

9

8.5

Figure 4.5

Monthly inflation, 1983 electoral period

3

83 Se p-

-8 Ju l

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3 M

-8 ar M

82

83 Ja n-

ov N

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8

France, 1981–1986 1,000 0

Millions of US$

–1,000 –2,000 –3,000 –4,000 –5,000

Figure 4.6

-4 83

-3

-2

83

-1

83

-4

83

-3

82

82

82

-2

–6,000

Quarterly current account balance, 1983 electoral period 22,000

20,000

Millions of US$

18,000

16,000

14,000

12,000

Figure 4.7

Monthly reserves, 1983 electoral period

3 p8 Se

3 Ju n8

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82 ec D

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10,000

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74

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Realigning Interests 28 26 24 22 20 18 16 14 12

Figure 4.8

83 p-

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3

3 M

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-8 Ja n

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10

One-month Eurofranc interest rates, 1983 electoral period

to reevaluate its economic policies. According to one French public relations executive “if you lose in the municipals, you declare that it will have no affect whatsoever on your political program and then you change it.”23

Policy Promises: Continuity and No Devaluation The opposition portrayed the municipal elections as a national referendum on the Mitterrand presidency and the left’s first two years in power. The government, however, downplayed any national significance and concentrated on local issues. Though Mitterrand insisted that he would not change any of the government’s long-term goals after the election, he remained vague about whether or not Mauroy would remain prime minister, fueling speculation.24 The Socialists decided that a devaluation before the municipal elections would be “suicide,”25 despite the need to sharply raise interest rates in the franc’s defense. Politically, the government could not afford a third devaluation, which would make it appear incompetent and further divide the ruling coalition; Chevènement’s CERES faction and the Communists refused to consider implementing more austerity policies, so major policy decisions were put on hold. But as the election approached, the discord became more publicized.26 The government tried to dispel expectations of devaluation and promised

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policy continuity. Lionel Jospin said, “there is not one policy for before the municipals and one for after . . . the rumors . . . are inaccurate.”27 Mauroy declared, “there is not a hidden plan”28 and “there is no [new] austerity plan.”29 In his memoirs, he recalled the words of General de Gaulle: “To take the franc is to weaken France,” opining that the “currency should not be used as an electoral stake” (Mauroy 1982: 29). But the possibility of a currency crisis was strong, and in the two months preceding the election, French institutions borrowed almost $3 billion to defend the franc during the election period.30 A week before the election, Mauroy finally acknowledged that there could be a policy shift after the elections in order to reduce the trade deficit and inflation rate, though he still denied the possibility of devaluation.31

The Polls: Dissatisfaction with the Government Polls revealed that the government could face problems in the election due to the electorate’s judgment of the government’s handling of the franc and the subsequent effect on government popularity. A Sofres poll taken in August 1982 asked for the sources of the previous two devaluations, and a large majority blamed either the Mitterrand government’s policies or the international economy.32 Perhaps more damaging was another Sofres poll taken February 1983 that indicated blame was being shifted away from international conditions and toward the government; when asked if the franc’s value (compared with other currencies) had improved or deteriorated, over half of those polled replied “deteriorated.”33 The same poll suggested the French regarded the defense of the franc as a government priority in the coming months, putting additional pressure on an already beleaguered government.34 Polls on government popularity delivered equally discouraging news for the government. Polls indicated that a majority of the French (46 percent against 36 percent) negatively judged the president’s record since the election,35 and 49 percent of those polled hoped to demonstrate their discontent during the elections, with only 31 percent wishing to express support (Le Figaro, February 15, 1983).

The Election: Speculation and Rumors of Devaluation The Conservatives swept the first round of the municipal elections, which were interpreted as dissatisfaction with the Mitterrand government. Prominent Socialists like Mauroy, Delors, and Chevènement were

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forced into a second round, prompting a resignation promise by Mauroy in the event of a definitive defeat (Pfister 1985: 238). Communist and Socialist leaders acknowledged that their poor electoral showing indicated voters’ dissatisfaction with the economy.36 Devaluation rumors continued, which the government repeatedly denied. 37 French bankers, however, concurred that the only thing holding back the government from its third devaluation was the next round of elections.38 After the first round, Mitterrand had privately decided to withdraw from the EMS and to seek a policy of growth that would be unencumbered by the necessity to keep high interest rates, such as the government was obliged to do in the EMS in order to defend the currency. He was convinced, “by staying in the system, we are condemned to the policy of a dead dog drifting in the water. For the sole profit of Germany” (July 1986: 96). The German parliamentary elections were also held on March 6, the timing of which weakened the franc. The German government had been reluctant to grant France too high of a revaluation of the DM in the 1982 realignment so as not to penalize German industry during its own power transition (Bauchard 1986: 90). In addition, the Bundesbank had originally intended to cut interest rates in January 1983, but then held off for fear of appearing politically biased when the government announced the elections in March (Goodman 1992: 97–8). Speculators predicted a revaluation of the DM once Chancellor Kohl emerged victorious. A victory of the conservative Christian Democrats would mean a strict budget that would be favorable to investment and would buoy Germany’s economy, fueling speculation for realignment. The Bundesbank intervened heavily in the foreign exchange markets to prop up the Belgian franc, Danish krone, and French franc, all of which threatened to reach their floor during this period. The Banque de France spent considerable sums of money to prevent the franc from falling below its floor. During the week of February 24, for example, the bank spent approximately 6 billion francs ($700 million dollars).39 From January through March, French officials discussed the need for the DM to revalue, negotiating with their German partners and threatening the exit of the franc from the EMS. The Banque de France continued to engage in massive intervention in the foreign exchange markets after the first round of the French municipal elections. The Banque de France allowed the franc to sharply drop early in the trading day vis-à-vis the DM in order to qualify for short-term support (45-day loans) from the other central banks. The bank spent at least $200 million dollars on March 7 to keep

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the currency at its existing level.40 The government also raised the daily lending rate of Eurofrancs to 250 percent to discourage the speculation.41 By March 11 the Banque de France had driven up short-term French Eurofranc deposit interest rates to 1,000 percent to stall the inevitable realignment. Delors repeatedly argued that the DM’s rise caused pressure not only on the French franc but the Belgian franc, Danish krone, and Italian lira. A German Economics Ministry official reiterated the German position on the need for France to get its own economic house in order. Talks of a cabinet reshuffle in Paris continued. The Socialists rebounded during the second round on March 13, causing analysts and politicians to describe the election as a warning to the government.42 The Communist Party, however, fared the worst during the second round, losing 16 of the 73 major towns they had controlled since 1977. Communist influence over government policy would weaken due to this serious blow to the party’s financial base, which was tied to their control of important municipalities. The First General Realignment As French Socialists struggled to retain political control, German Conservatives cemented their hold on power. The Christian Democrat–Free Democratic coalition won the March 6 election, and pressure intensified on the weaker currencies as the DM strengthened from the Kohl victory. Though the EMS was still in its early years, complete with symmetric rules and obligations for intervention, the asymmetric bias was already apparent. The following is an excerpt from a German newspaper: Like Bretton Woods before it, the EMS suffers from faulty construction: when inflationary developments in one country are passed to another, it is not only the country with the weaker currency that is obliged to adjust . . . no member with a stronger currency should be changed for political reasons when another currency is weak. Germany cannot allow interest rates to be reduced.43 [emphasis added]

The German government initially opposed revaluation of the DM. Despite French demands for them to behave “like good Europeans” and “take significant measures” to save the EMS, German representatives contended that they had fulfilled all of its monetary obligations.44 Agreement between the French and Germans preceded the agreement made within the Monetary Committee, making the realignment

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essentially occur in two stages (Tsoukalis 1989: 64). The 1983 realignment negotiations produced the biggest crisis of the four-year-old EMS, and the Monetary Committee could not reach an agreement over the weekend, forcing foreign exchange markets to remain closed on Monday. France pushed for a massive DM revaluation, maintaining that the problem for the past two weeks rested with the DM and not with the franc. Despite German intervention, France had also paid a high price: the Frankfurter Allgemeine reported that the Banque de France lost 23 billion francs during the week of March 10, “all to postpone the devaluation of the franc for a couple of days.”45 French Finance Minister Jacques Delors threatened to exit the EMS. Although such statements may have been posturing on the part of the French, it marked the first threat of its kind and thus opened the possibility for the EMS to fall the way of the Snake. The negotiations resulted in a revaluation of the DM along with Belgium, Denmark, and the Netherlands while the franc, Italian lira, and Irish punt devalued against it, marking the first general realignment of the EMS. However, German Finance Minister Gerhard Stoltenberg emphasized that EMS countries could not be complacent with the realignment and ought to implement domestic policies that supported the new exchange rates and promote sound economic fundamentals. Initially, France publicly resisted the pressure. Bertrand Delanoe, speaker for the Socialist Party, argued, “[The] European will . . . [would not change France’s] adaptation to politics of a different sort . . . [there exist] difference[s] in politics between the Members of the EC . . . the German government practices austerity and monetarism, while France, for its part, leads the fight against the crisis.”46 Days after the realignment, however, Mitterrand announced another round of austerity measures, including the pursuit of lower inflation, lower budget deficits, and the elimination of the trade deficit. The 1983 realignment marked a new era for the EMS as French monetary policy became dedicated to upholding the franc–DM exchange rate and taming inflation. The French were perceived as the winners of the 1983 realignment, having achieved a large DM revaluation, yet Germany undoubtedly won the war. German dominance solidified during this period, and other countries emulated the low-inflation/strong currency model that was the hallmark of the Kohl years. Germany’s credibility became the foundation for the operation of the EMS, and the franc fort policy became a staple of French monetary policy over the subsequent years. In addition to confirming the budding norm of German leadership in European monetary policy, the 1983 realignment also demonstrated

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the other part of the EMS hierarchy—that of France’s special place in the EC. The French delegation not only convinced Germany to revalue the DM and thus assume public responsibility for some of the exchange rate tensions, but it also orchestrated the first general realignment. The French government argued that international developments, rather than French imperfections, generated the crisis, thus shifting more blame for the crisis (and thus the political costs of devaluation) onto its European partners. Though some may dismiss such distinctions as cosmetic, this indicates an additional hierarchical element of monetary cooperation that continued to rear its head as European cooperation progressed. Summary of the 1983 Municipal Election The 1983 municipal elections confirmed the partisan hypothesis and the expectation of policy change. The left presided over an economy that was spiraling out of control because of l’autre politique, and the currency instability under the left government confirmed partisan theory expectations of the left government’s preference for policies oriented toward growth rather than stability. Polls indicated trouble for the left and therefore policy discontinuity. A cabinet shuffle was imminent whether the right won the election outright or merely made some inroads. Therefore, elements of partisanship and the expectation of policy change contributed to the franc’s troubles. In addition to the partisan element, the upcoming election highlighted differences within the government and made it difficult to predict future policy and therefore future economic conditions. The left claimed that there was no austerity plan or devaluation in the works, but conflict between factions within the Socialist Party belied such definitive statements. France’s economic and exchange rate policies would not be decided until after the municipal elections and the weakening of the Communist Party. After the election results came in, Mitterrand threw his support behind the faction led by Jacques Delors. The political consolidation of this wing of the Socialists was now complete, and the government could embark on its stabilization program that included devaluation without fear of electoral reprisal. Furthermore, the government could do so in coordination with its European partners, thus saving some political face. 1986 Legislative Elections The 1986 elections and the currency crisis that accompanied it conform to several theoretical predictions. Economic conditions indicated

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that eroding French trade competitiveness would soon necessitate realignment. A currency crisis preceded the election, and according to partisan theories the left would consider devaluation politically advantageous if it allowed interest rate reductions and higher growth. However, the Socialists’ U-turn in 1983 had made their economic policies nearly identical to the ones being advocated by the right. Partisan politics was becoming less relevant starting with this election, though the left was still paying for the aftermath of l’autre politique in terms of an accumulated decline in French competitiveness and the loss of face with its core constituency. The expectation of a change in government can also account for the crisis, as polls indicated a victory for the conservative coalition, which had already promised a devaluation to combat the economic ills brought on by the incumbent government. The certainty of devaluation (given polling data that consistently showed the opposition in the lead) meant that markets would prepare for this outcome by selling the currency. Finally, the timing of the devaluation indicates the targeting of the electorate rather than the primary constituencies of the respective parties or market opinion. The Socialists defended the currency prior to the election, contrary to assumptions about the preferences of the left for growth over price stability. The conservative government devalued the franc after the election, in contrast to expectations that conservative governments would prefer a stronger exchange rate. The incumbent government wanted to avoid the appearance of weakness and incompetence that would accompany devaluation, and the incoming government blamed the need for devaluation on its predecessor. The elections for the new legislature were scheduled for March 1986, and a huge victory for the opposition had been expected ever since the municipals in 1983. The European elections of 1984 and the cantonal elections of 1985, for example, demonstrated the RPR–UDF coalition’s growing popularity. Many voters had lost faith in the Socialists after the U-turn, despite improving economic conditions. Economic Policy and International Conditions: Improving, but Generally Declining in Competitiveness After two years of rigueur, economic conditions had improved considerably. Inflation had decreased as a result of wage and salary moderation, and lower hydrocarbon import prices, dropping below 6 percent for the first time in 13 years (Economic Intelligence Unit 1985). The current account balance had also improved, but unemployment was still a major

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6

5

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Figure 4.9

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Monthly inflation, 1986 electoral period

problem and was once again a critical issue for the election (see figures 4.9–4.12). The money supply rose in the months preceding the 1983 election and the devaluation, possibly indicating that the government was stockpiling reserves in anticipation of currency instability. The interest rates corroborate this story, as they progressively rose in anticipation of a conservative victory and the promised devaluation. This expectation of devaluation caused the rising interest rates rather than uncertainty over future policy. Meanwhile, the conservative coalition in Germany continued its economic policy based on a restrictive money supply and the reduction of government expenditures. The government became increasingly concerned with fighting inflation via austerity policies and deregulation. The fall in oil prices at the end of 1985 and the beginning of 1986 assisted in the reduction of German price levels to zero (Johnson 1998: 107). Moreover, the Bundesbank’s policy of sterilizing the German money market when it intervened in the foreign exchange market generated falling inflation rates in Germany that enhanced its trade position. Despite the realignments, the DM was perpetually undervalued (Huffschmid 1998: 91–2). This put additional competitive pressures on its trade partners.

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1,500

Millions of US$

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Figure 4.10

-4 86

-3 86

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-4 85

-3 85

85

-2

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Quarterly current account balance, 1986 electoral period

The relative success of the German economy and the growing consensus on the efficacy of promoting competitiveness via price stability meant that the DM increasingly became the reference point for other countries. The EMS members stabilized their exchange rates against the DM via intra-marginal intervention, hoping to import some of the credibility of the German economy. As the focus of the EMS continued to center around Germany, countries also began using the DM for foreign exchange interventions rather than the dollar (Ungerer 1997: 177). Policy Promises: No Devaluation, Further Austerity Experts indicated the need for devaluation in light of the weakening competitiveness of French industry (International Monetary Fund 1986) and continued inflation differentials between France and Germany (Economic Intelligence Unit 1986). German Finance Minister Gerhard Stoltenberg concurred when he said, “a readjustment of the parities of the EMS will be necessary.”47 Short-term interest rates rose sharply in expectation of a postelection devaluation. Despite these indicators, the Socialist government again rejected the need for devaluation before the election. Mitterrand pointed to

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36,000 34,000

Millions of US$

32,000 30,000 28,000 26,000 24,000 22,000

Figure 4.11

pSe

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Monthly reserves, 1986 electoral period

improvements in French inflation and current account balance, arguing that devaluation was “not envisioned because it would not be useful.”48 Edith Cresson, Minister of Foreign Trade, reasoned, “devaluations do not automatically solve competitiveness problems” and pointed to the long-term decline of French industry, an explanation corroborated by an OECD study published in December 1985 indicating that French industrial production in 1985 was inferior to that of 1980. The Socialist platform noticeably lacked a grand societal project as in 1981. Instead, it was pragmatic—striving not to contradict policies followed since 1983. Their slogan was “le vote utile à gauche, c’est le vote socialiste.” The 1985 budget tried to woo business support through corporate tax cuts and the elimination of subsidies to nationalized industries, while retaining the support of this base. The combination of the government’s betrayal of its 1981 platform and insistence on pushing through policies that hurt its core constituency made this an impossible task. The auto and shipbuilding industries in Lorraine, the Nord, Auvergne, and the upper Loire—traditional bastions of the left—saw unemployment rise precipitously (Friend 1989: 106).

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16

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Figure 4.12

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One-month Eurofranc interest rates, 1986 electoral period

The conservatives promised to denationalize industry, liberalize prices, and devalue the franc in a program they called “the Renewal,” which was very much in line with the Fabius government’s plan. Though there would be policy continuity in most areas, the promise of devaluation in the event of a victory by the right fueled speculation.

The Polls: Victory for the Right The polls consistently showed a victory for the right, though as the electoral period continued, the margin grew smaller. Satisfaction with Mitterrand slowly rose after a poor autumn, and Fabius’s popularity started to pick up again a month before the election (see figures 4.13 and 4.14). A Sofres-Le Figaro poll in February gave 41 percent of the intended vote to the left (an increase of 3 percent since December) and 57 percent to the right (down one point since December). A BVA-Paris Match poll had 55 percent of the vote going to the right and 42.5 percent to the left.49 The results of a Gallup poll published in February also showed that there was only a four-point difference between the left and the

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60 40 20 0

Aug-85

Oct-85

Nov-85 Good

Jan-86

Feb-86

Mar-86

Bad

Figure 4.13 Ifop-RTL-Le Point poll: Do you have a good opinion or bad opinion of Mitterrand as president?

60 40 20 0

Aug-85

Oct-85

Nov-85 Good

Figure 4.14

Jan-86

Feb-86

Mar-86

Bad

Poll: Do you have a good opinion or bad opinion of Fabius as prime minister?

Table 4.1 Ifop-RTL-Le Point poll on intentions to vote for the PS

November 1985 January 1986 February 1986

Right %

Left %

55 55.5 55

41 41.5 42

Source: Le Point, March 10, 1986.

right; the left received 47.5 percent of the expected vote compared to the right’s 51.5 percent. The narrowing was attributed to the rising credibility of the Socialists with those who normally voted for the right50 (see table 4.1). The Election: Victory for the Right The right predictably won the election, though by a smaller margin than the polls had indicated. The new majority, the RPR–UDF coalition, won 277 seats out of a possible 577—48.0 percent. They needed to

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appoint 14 “divers droite” politicians in order to form a new majority. Jacques Chirac was named the new prime minister; and Barre gave assurances that he would do nothing to disrupt the new government, despite his trepidation (Colombani and Lhomeau 1986). Another Realignment In March, the Bundesbank had reduced the discount rate, allowing the French government to follow up with its own rate cut. The day after the elections, the franc momentarily rose and the DM weakened in Paris, causing markets to push back the date of the next realignment. This respite did not last long. Over the next weekend, the “weekend syndrome” appeared, causing the Banque de France to spend approximately 2 billion francs to support the franc’s level against the DM. The French governments suspended official currency quotations on Friday, April 4, and the other central banks of the Community also suspended their quotations and did not intervene—a move that was unprecedented in Community history.51 The 12 finance ministers met in Ootmarsum, Netherlands over the weekend. The weakness of the franc and the strength of the DM, thanks to a large German commercial surplus, caused the EMS tension.52 But since it is generally the weaker currency that suffers during speculative attacks, the onus was on France to take the initiative. The Germans refused to threaten the DM or price stability for the sake of propping up the franc. Chirac and Edouard Balladur requested an 8 percent devaluation, which was refused. France settled for an official 3 percent devaluation, though it actually came closer to 6 percent given the 3 percent revaluation of the DM. According to Stoltenberg, Germany’s actions indicated, “a major step in strengthening cooperation and coordination within the EMS” (Loedel 1999: 74). Summary of the 1986 Election The correspondence of a currency crisis with an election conforms to both partisan theory and the expectation of policy change on the part of foreign exchange markets. On the one hand, the left faced a still-weak economy and could have been expected to devalue and thus lower interest rates. On the other hand, one could interpret market instability as a reaction to the expected victory of the conservative coalition and the devaluation they had promised during their campaign. The pattern of devaluation, however, follows the expectation that governments appeal

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to voters by bolstering credibility before an election. The Socialists defended the currency, and afterward the new government devalued with no negative political effects. Conclusion The early years of the EMS brought about an abrupt policy shift in France that would have important repercussions for the French economy and its place in the world over the next two decades. These elections contained primarily domestic overtones, and exchange rate decisions were predicated on domestic imperatives more so than international ones. All three elections covered in this chapter generated some exchange rate instability for reasons that can be attributed to either partisanship or the expectation of policy changes. The 1981 election saw calm under the conservative government of Giscard before the presidential election and panic under Mitterrand prior to the legislative elections. The subsequent elections faced by the Socialists in 1983 and 1986 continued this pattern—suggesting partisan explanations. On the other hand, one could also attribute these crises to the expectation of changes in government. The calm before Mitterrand’s election could have indicated the expectation of a Giscard victory and therefore policy continuity. Similarly, the 1983 and 1986 elections also held the promise of policy changes. But neither weak economic fundamentals nor partisanship can explain the timing of these crises. The weakening of the economy had begun prior to the elections, and in 1986 a partisan analysis would predict a strengthening of the franc in anticipation of a conservative government. The coalition’s commitment to devalue belies this expectation. The timing of devaluation in all three cases, however, demonstrates considerable continuity; all devaluations occur after an election. Government commitment to the defense of the exchange rate prior to realignment (despite the costs) shows a concern for voter perceptions of government competence before an election. Even though Mitterrand could have devalued prior to the 1981 legislative election and blamed it on the policies of his predecessor (as the conservatives did in 1986), he chose to support the exchange rate—citing the importance of retaining voter confidence. The inclusion of the Communists in the government and dissent with the Socialists prior to the 1983 municipals supports the findings from chapter 3 on the importance of a cohesive government. This contributed to the weakening of the franc and the speculation against it.

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Table 4.2 Summary table of arguments on emergence of currency crises and devaluation, 1981–1986 Explanations for currency crisis

French 1981 elections

French 1983 elections

French 1986 elections

Economic fundamentals Partisanship Electoral instability Expectation of policy change

Yes

Yes

Yes

No No No

Yes No Yes

Yes No Yes

Table 4.3 Summary table of arguments on devaluation in France, 1981–1986 Explanations for devaluation

French 1981 elections

French 1983 elections

French 1986 elections

Economic fundamentals Government targets markets Government targets core constituents Government targets voters

Yes

Yes

Yes

Indeterminate

Indeterminate

Indeterminate

Yes

No

No

Yes

Yes

Yes

Though domestic considerations drove the timing of the crises and devaluation, the latter also indicated that political elements at the international level would prove decisive in later crises. In 1983 the French were able to offset the political costs of devaluation by embedding the franc’s devaluation within a larger general realignment. Though this was not the first time a French devaluation also precipitated devaluation by another currency (in 1982 Italy devalued alongside France), it was the first time that the EMS underwent a general devaluation. The importance of French politics and its effect on exchange rate developments in other countries reveals the relative power of France in Europe and how it is able to shape European monetary cooperation (see table 4.2 and table 4.3).

CHAPTER 5

France, 1988–1995

T

his chapter serves as a continuation of chapter 4 and covers the French elections that fell into the second half of the history of the EMS. The French story has been divided in half not only for issues of length but also because of the important changes that took place in French politics and European integration that altered the nature of monetary cooperation. During this time the exchange rate fluctuation bands “hardened” as there were no realignments for over six years. Europe enjoyed economic growth during much of this period, and European integration took on new life as plans for the Single Market were quickly followed by preparations for monetary union. In 1992 the Europhoria gave way to the biggest crisis in EMS history, and in 1993 the fluctuation bands were widened to 15 percent in order to stop the speculation against its currencies. The increasing importance of European integration during this period had strong repercussions with regard to devaluation. Not only did devaluation have negative connotations with regard to domestic economic policymaking, but it also had the potential to jeopardize a government’s standing within the European hierarchy and its participation in future EU projects. The costs of devaluation therefore increased as it could preclude a country from joining monetary union (one of the criterion was no realignment within two years). The stigma of incompetence that devaluation suggested grew as the stakes became larger. Domestic politics and elections also remained salient during this period. Markets looked for signs that a government would be unwilling or unable to meet the convergence criteria of the Maastricht Treaty and thus put monetary union (and monetary cooperation in general) in jeopardy. The question first arose in 1992 with the Danish referendum on the

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Maastricht Treaty. When the Danes returned a “no” vote, observers had to ask if monetary union would still occur. If the answer were negative, government incentives to endure painful economic policies in order to qualify for EMU would be substantially reduced. Loosening monetary and fiscal policy would likely result in inflation and a depreciating currency. As economic conditions in Europe deteriorated, markets tried to discern the commitment of each government to monetary union and the fulfillment of the convergence criteria, making elections and government changes important indicators of not only domestic economic policy but also European integration itself. Expectations of government and policy changes continued to interact with economic conditions to determine exchange rate stability or the lack thereof. 1988 Presidential Election The major candidates for the May 1988 presidential elections included Socialist President François Mitterrand, Prime Minister Jacques Chirac of the conservative RPR, and former prime minister, Raymond Barre, of the UDF,1 the same three men who dominated the 1986 legislative campaign.2 The improving economic conditions and split of the Conservative vote guaranteed Mitterrand an easy and widely anticipated victory. The campaign contained no currency crises, as an expectationsbased analysis would predict, and the lack of market unrest obviated the need for devaluation. Economic Conditions and International Circumstances: Cautious Optimism The Chirac government targeted economic stimulation as its primary goal and pursued it through privatization, the removal of price controls, and the easing of most exchange control restrictions (Economic Intelligence Unit 1987). While government policies became increasingly liberal, for the most part the new government continued the policy trajectory of its Socialist predecessor (McCarthy 1990). Moreover, by the end of the year plans for a Single Market in the EC dominated the policy agenda and underscored the economic shift in Europe (and elsewhere) toward market liberalization (Sandholtz and Zysman 1989; Moravscik 1991). Despite these measures, French competitiveness continued to wane. Energy and manufacturing prices sharply declined, worsening France’s economic trajectory (Blanchard and Muet 1993). The French trade deficit contributed to the weakness of the franc, necessitating higher

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interest rates that hindered growth. The dollar’s decline in the wake of the Plaza Accord led to an upward surge in the DM, reversing the favorable conditions of March 1983–July 1985 in which the strong dollar shielded the EMS currencies from speculation (Funabashi 1988: 124). In January 1987, the German government revalued the DM by 3 percent after “acrimonious talks.”3 French Finance Minister Edouard Balladur had refused to consider devaluation (Boche 1993), arguing that the crisis originated from the DM, not the franc (Funabashi 1988: 123). The French government had become increasingly insistent that the EMS countries share the burden of adjustment. Balladur later pressed for the Basle-Nyborg agreement of September 1987, which increased the availability of short-term financing and encouraged less reliance on intra-marginal intervention (Gros and Thygesen 1998: 396–7). This was the first solution to the problem of the EMS asymmetry that centered on the DM (McCarthy 1993c: 58–9). The negotiations predictably pitted the strong currency nations against the weaker currency nations, while the Bundesbank asserted the right to assess the monetary situation prior to committing funds (Kennedy 1991). Ultimately the Basle-Nyborg agreement did not have a significant impact on the asymmetry of the system, and the French government continued to seek out alternatives. Despite the pursuit of a more symmetrical monetary system, the French government continued to adjust domestic policies in order to reduce costs and prices, calling the policy one of “competitive disinflation” (Dyson and Featherstone 1999: 81–3; Masson 1997: 441). The French were emulating the successful policies of Germany and trying to create a virtuous circle of price stability and lower interest rates in order to encourage competitiveness and growth. The J-curve effects4 (Dornbusch and Krugman 1976; Sachs 1981) of the 1986 and 1987 realignments had already been played out by the time of the 1988 election, and there was no prospect of relief in the short term for the trade balance (Economic Intelligence Unit 1988). In addition, unemployment rates remained in the double digits and had worsened during cohabitation. Moreover, almost half of the unemployed in France were long-term unemployed, compared with a third of the unemployed in Germany, 10 percent in the United States, and 15 percent in Japan. Inflation had been tamed, however, and there was no expectation for significant change in the coming year (see figures 5.1 and 5.2). The Economic Intelligence Unit (1988: 26), for example, predicted that there would be no radical change in government policy after the election, regardless of the winner. Few anticipated devaluation, unlike in

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the previous elections. Reserve data indicated neither a substantial buildup nor weakening immediately before the election, when expectations of a Mitterrand victory had already been factored in; similarly, interest rate data showed only modest increases shortly before the election (see figures 5.3 and 5.4). 3.5

Percentage

3 2.5 2 1.5 1 0.5 88 ov -

88

N

p-

8

M

Se

Ju l-8

8 ar

ay -

-8

8

-1 89

-4 88

-3 88

-2 88

-1 88

-4 87

-3

0 –500 –1,000 –1,500 –2,000 –2,500 87

Figure 5.2

M

Ja n

-8

87 ov N

Monthly inflation, 1988 electoral period Millions of US$

Figure 5.1

88

0

Quarterly current account balance, 1988 electoral period

Millions of US$

37,000 35,000 33,000 31,000 29,000 27,000

Figure 5.3

Monthly reserves, 1988 electoral period

88 N ov -

88 Au g-

88 ay M

88 Fe b-

N ov -

87

25,000

Figure 5.4

●

93

10 8 N ov -8 8

p88 Se

-8 8 Ju l

M ay -8 8

-8 8 M ar

Ja n

-8 8

6

N ov -8 7

Percentage

France, 1988–1995

One-month Eurofranc interest rates, 1988 electoral period

The Campaign: Candidates Promise to Uphold the Status Quo Chirac announced his candidacy in January 1988. He tried to promote the government’s record on inflation and unemployment, arguing that while the latter remained unacceptable, the government was at least able to “stop the hemorrhage.”5 Although he led the majority coalition in the government, he could not credibly claim to be the leader of the majority or the right in general. Barre’s popularity and the growing appeal of the National Front’s Jean-Marie Le Pen prevented him from fully exploiting his role as a Conservative leader. Barre declared his candidacy in February. His team claimed that Chirac had been “compromised” by the cohabitation experience, and that he (Barre) therefore had greater “credibility.”6 Yet Barre’s voting record contrasted with these assertions, as he had consistently voted with the government during cohabitation. Chirac noted, “There exist between us nuances more than real differences.” 7 Mitterrand waited until late March to formally announce his bid for reelection. He presented himself as a candidate who could unify France, using his experience as cohabitation arbiter to his advantage (Cole 1989). He enjoyed the prestige of the office of the presidency without having to bear responsibility for government policies. Chirac tried to stir up dormant fears of another Socialist experiment. In a televized interview, Chirac warned that if Mitterrand were elected, France would once again become Socialist.8 On April 8, nine national and regional newspapers published Mitterrand’s response in the form of his “Letter to the French People.” This manifesto differed sharply from his campaign promises of 1981: he did not criticize the government’s actions,9 but rather promised to maintain the economic and social status quo. The ambivalent atmosphere pervading the French electorate could be best demonstrated by the results of the following Sofres poll in which a plurality of those polled indicated that they expected no changes in France’s economic outlook after the election (see table 5.1). The French

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Realigning Interests Table 5.1 Sofres poll on voters’ expectations of France’s seven-year outlook If we elect Barre Chirac Mitterrand

Better

No change

Worse

Don’t know

Difference (1–3)

25 22 28

38 39 43

29 30 21

8 9 8

⫺4 ⫺8 ⫹7

Source: L’Expansion, February 19–March 3, 1988.

electorate clearly understood that the large similarities in the candidates had narrowed their choices. Mitterrand strongly supported French participation and leadership in European affairs. He is widely quoted as having said, “France is our homeland, Europe is our future.” Ever since his decision to remain within the EMS in 1983, Mitterrand’s France had become an engine of European integration. Mitterrand increasingly became a critical player in European cooperation during the cohabitation period, fully capitalizing on his role as president of the republic in international affairs. Barre also enthusiastically supported the EMS, having served as prime minister when it began in 1979. He forcefully argued, “Can one want to make progress in Europe, realize the 1992 Common Market and simultaneously abandon the EMS? This would be incoherent . . . to make progress in the EMS, we have to believe in our ability to attain parity with the German economy in Europe.”10 Chirac favored some sort of EMS reform, but he made no moves to indicate he favored withdrawal. He and Balladur even began inquiries about a possible European central bank and currency.11 Whichever candidate won, there would be no major shift in economic or European policy. The Polls: Mitterrand the Certain Winner Polls after June 1987 (see figures 5.5–5.8) consistently predicted that Mitterrand would defeat either Barre or Chirac in 1988. 12 The Election: Mitterrand Victory Mitterrand won the election easily. The split on the right badly damaged its electoral fortunes; Chirac and Barre took votes away from each other rather than from Mitterrand (Platone 1994). The reelection caused scarcely a ripple in markets. Interest rates had remained stable throughout cohabitation, moving less than half of a percentage point during the election. On May 14, Mitterrand dissolved the National Assembly.

France, 1988–1995

●

95

45 40 35 30 25 20 15 10 5 –9 r8 Ap

Ap r1 –2

M

ar 15 –1 7 M ar 25 –2 6

ar 1– 3 M

16 –1 9 Fe b

Fe b

Ja n

1– 3

88

0

Mitterrand

Barre

Chirac

Figure 5.5 Le Nouvel Observateur Polls: intentions to vote in the first round, January–April 1988 60 55 50 45

Mitterrand Figure 5.6

M

r-8 8 Ap

ar

-8

8

88 Fe b-

8 -8 Ja n

D

ec

-8

7

40

Barre

Intention to vote in the second round, Mitterrand versus Barre

Source: L’Express, various issues.

The Legislative Elections: Another No-Surprise Victory for the Left Socialists ran on the theme “support the president,” but could not reach as many voters as they had in 1981. The right campaigned on more local issues. Polls showed another (albeit smaller) victory for the left (see table 5.2). The election produced a record number of abstentions. The Communists won 27 seats, but leader Georges Marchais immediately

96

Realigning Interests

●

60 55 50 45

8

-8

Ap

ar M

Mitterrand

Figure 5.7

r-8

8

8 -8 Fe b

D ec

Ja n

-8

-8

7

8

40

Chirac

Intention to vote in the second round, Mitterrand versus Chirac

Source: L’Express, various issues.

Mitterrand

Barre

-8 8 Fe b88 M ar -8 8

Ja n

7 -8

87

ec D

N

ov -

-8

O

ct

pSe

7

87

7 -8

Ju n

87

7

ay M

M

ar

-8

7 -8

Ja n

N

Se

p-

86 ov -8 6

70 65 60 55 50 45 40 35 30

Chirac

Figure 5.8 Poll: Which of the following would make a good president of the republic in the next seven years? Source: Le Nouvel Observateur, various issues.

Table 5.2 Intention to vote in the 1988 legislative elections (%) Communists Extreme Left Socialist Party Ecology Movement UDF RPR National Front

7 1 40 4 15.5 22 10.5

Source: Le Nouvel Observateur, May 20, 1988.

France, 1988–1995

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97

announced his refusal to join a Socialist government. The Socialists aligned with the left radicals to form their majority. Michel Rocard, Mitterrand’s main rival within the Socialist Party, was named prime minister. Summary of the 1988 Presidential Election Partisanship seems to make little difference. Given the fact that the Socialists’ economic policies had, overall, been quite conservative since 1983, the party label had lost much of its meaning for distinguishing between the left and the right. Economic expectations were downsized along with electoral promises, and no magic cure for unemployment existed. Economic fundamentals did not dictate a strong need to devalue: though the current account exhibited weakness, inflation remained steady and the outlook was good. The combination of a predictable election and a predictable (and stable) policy outlook made this period crisis-free. 1993 Legislative Elections In the late 1980s Europhoria dominated the continent as most of its nations enjoyed low inflation, steady growth, and low interest rates. Plans for the Single Market by the end of 1992 proceeded according to schedule, and monetary union came to the forefront of the policy debate in Europe. The French continued their efforts toward a more equitable system of monetary cooperation in Europe in the late 1980s. Both Conservative Finance Minister Edouard Balladur and his Socialist predecessor Jacques Delors had devised plans for monetary union. They found an ally in German Foreign Minister Hans Dietrich Genscher, who worked with Italy’s Emilio Colombo on proposals that would further integrate Europe, including plans for monetary union (Genscher 1995). German Chancellor Helmut Kohl also preferred monetary union; both he and Genscher believed that this could end the tensions that the EMS had caused in Germany’s relationship with France (Kennedy 1991). The Bundesbank remained skeptical, and Finance Minister Gerhard Stoltenberg expressed his willingness to consider such reforms in exchange for capital liberalization (Mazzucelli 1997: 41), but only after economic convergence (Dyson and Featherstone 1999: 333). For the weaker currency states, monetary integration offered them a seat at the bargaining table and the opportunity to set monetary policy with the European economy in mind instead of following the lead of the

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Bundesbank, which set interest rates according to German economic conditions. This seemed to be the most attractive option because it would allow them to retain the monetary credibility they had earned over the last few years under a stable EMS (with no realignments from 1987 to 1992, save for the Italian lira’s transition to the narrow exchange rate band in 1990) while being able to pursue policies more suited to their national economies. Monetary union should come sooner rather than later under this view; also known as the “monetarist view” (not to be confused with the monetarism associated with Milton Friedman), adherents believed monetary union would foster greater convergence as actors’ expectations and policies shifted in the wake of the institutional changes. In addition, monetary union would offer Europe the opportunity to speak with a single voice in monetary affairs and potentially challenge the dominance of the U.S. dollar. Harnessing Germany’s monetary power would allow the other countries to have a greater presence on both the European and the international stage (Chang 2002; Dyson and Featherstone 1999). The stronger currency countries like Germany represented the “economist view,” meaning they preferred that greater economic convergence occur before monetary union. Economically speaking, monetary union offered low-inflation countries, particularly Germany, small rewards. The EMS could be viewed as at least a good situation for Germany if not better since under this system Germany would not have to adjust its own monetary policy to adapt to wider European conditions, yet it still enjoyed exchange rate stability with its major trading partners and price stability (Moravcsik 1998: 391–6). In addition, it conferred trade advantages through the undervaluation of the DM (Mélitz 1988; Giavazzi and Pagano 1988). Economists agree that the EC countries did not form an optimum currency area in which asymmetric shocks could be dealt with via labor mobility or fiscal transfers (Eichengreen 1992a). Shocks affected the countries in Europe more idiosyncratically than in the United States, and Europe was slower to respond to them (Bayoumi and Eichengreen 1993; Dibooglu and Horvath 1997). Labor mobility between European countries remained low, and countries steadfastly refused measures geared toward fiscal harmonization (Eichengreen 1992b). Recent studies continue to emphasize optimum currency area theory to justify monetary union. Proponents argue that it is possible for the countries in EMU to become an optimum currency area in the future if business cycles become more similar as trade and financial integration between the countries increase (Frankel and Rose 1998). In addition,

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automatic fiscal stabilizers may be adequate in offsetting shocks (Verdun 1999). The lack of fulfillment of optimum currency area criteria need not jeopardize the eventual success of EMU. The second set of economic theories used to justify European monetary integration argues that the alleged benefits of central bank independence should be extended to Europe as a region through the creation of an independent European central bank. Conventional wisdom posits that a consensus has emerged in Europe (and elsewhere) concerning the benefits of central bank independence in bestowing greater credibility on governments with such institutions (Andrews and Willett 1997: 191). The success of Germany since 1945 in sustaining strong growth with low inflation, even when other countries were mired in recession, made the German model the one to emulate in the 1990s (McNamara 1998). While it has been demonstrated that countries with independent central banks tend to have lower inflation (Cukierman et al. 1994; Grilli et al. 1991), this relationship is not necessarily causal (Alesina 1988). In addition, the purported outcomes of central bank independence are not robust when different variables are used to measure and interpret central bank laws, even though the measures may be the same in principle (Eijffinger and Haan 1996). Eichengreen (1992b) cites a study by Collins and Giavazzi (1993) that demonstrates that monetary union is neither necessary nor sufficient for bolstering price stability Moreover, lower inflation is not promoted as an end in itself. Proponents of central bank independence claim that it would lead to a virtuous circle of low inflation, investment, and growth. But studies have demonstrated that central bank independence does not impact real economic performance (Alesina and Summers 1993). In addition, the benefits of central bank independence on an international scale are uncertain. As far as central bank independence functions in offering greater credibility (Sandholtz 1993) and allowing countries to reduce inflation with lower economic costs (Grilli et al. 1991; Mélitz 1988), the empirical evidence does not lend overwhelming support. Governments must still earn credibility over a period of time, there is no quick institutional fix (Burdekin et al. 1993; Posen 1993). Countries with independent central banks do not enjoy lower disinflation costs (Eijffinger and Haan 1996), and they may even aggravate short-term adjustment problems and increase the sacrifice ratio of unemployment increase for inflation reduction (Walsh 1995). Central bank independence also fails to improve government finances: there is no correlation between delegation

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to an independent central bank and countries with higher government debt, political instability, or employment-motivated inflationary bias (De Haan and Hag 1995). Thus economic explanations based on optimum currency area theory and central bank independence did not provide compelling reasons for monetary integration in the late 1980s and early 1990s. Though the EC countries could have formed an optimum currency area in the future, this presupposed a desire for further integration and policy convergence, and the reasons for this interest across both the strong currency and weak currency states requires further explanation. The benefits of central bank independence could arguably be achieved in other ways, also indicating the need for additional factors to be considered when trying to understand EMU. In short, political exigencies overtook economic logic, and monetary union became the cornerstone of European integration in the post–Cold War era. The end of the Cold War and German unification caused many to question the political and economic future of Europe. The prospect of a united Germany caused apprehension among its European partners for fear that it would follow a different path than Germany and disrupt the power balance in Europe (Baun 1996; Dyson and Featherstone 1999). Both Mitterrand and British Prime Minister Margaret Thatcher sought to delay unification despite Kohl’s insistence that a united Germany would exist within an integrated Europe and the Western alliance more generally (Gillessen 1998). By April 1990 both Kohl and Mitterrand swore, “German and European unity would be two sides of the same coin” (Teltschik 1991: 208) as German unification became embedded in the European integration process (Katzenstein 1997). In December 1991 the European Council negotiated the Maastricht Treaty, which set monetary union as a goal for 1997 at the earliest and 1999 at the latest. Participation in monetary union would be subject to countries achieving a set of convergence criteria to ensure that the economies were sufficiently similar and that the weaker economies would not bring down the stronger economies. Monetary union provoked criticism and concern, both in and out of Germany. For example, a week after the Maastricht summit, the Bundesbank hiked interest rates in a move that was interpreted by analysts as a signal that it would take its commitment to maintaining price stability even more seriously (Marsh 1992). Unification had stoked German inflation at a time of slowing growth and rising unemployment in Europe. The former German Democratic Republic had received massive transfers, leading to a large deficit and an increased demand in

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imports. Further aggravating the German economy were the generous conditions of German monetary union. While the Bundesbank had suggested an Ostmark to DM conversion rate of 2:1, the government chose 1 : 1 for the first 4,000 Ostmarks as well as for wages, salaries, and pensions (Henning 1993: 220–1). The average conversion was between 1.8 : 1 and 1.6 : 1 in order to gain an electoral advantage in the East later that year as well as to control migration to the West (Hefeker 1994: 6). Germany’s real economic troubles, however, stemmed from transfer payments, fiscal policy, wages, and the need to privatize and transform the East (Henning 1994: 223). In order to combat rising inflation, the Bundesbank ran a tight monetary policy and propped up interest rates. German officials tried to negotiate a realignment of the EMS to ease pressure, but its partners, particularly France, refused so as not to harm their accumulated credibility (Boche 1993). High interest rates thus aggravated the economic downturn in Europe and contributed to a recession. In the second half of 1992 an unprecedented wave of currency speculation jeopardized the European integration process. Recession in the United States caused American interest rates to fall, and the dollar reached historical lows vis-à-vis the mark. The mark strengthened as the Bundesbank implemented higher interest rates in order to combat postreunification inflation in Germany exacerbating tensions within the EMS. In addition, the decision to liberalize capital in preparation for monetary union gave speculators even more resources than during prior currency attacks. In spring 1992, the Danish referendum on the Maastricht Treaty resulted in a surprising “no” vote that potentially jeopardized the entire project of monetary union. Once monetary union no longer seemed assured, markets questioned the willingness of countries to fulfill the Maastricht Treaty’s convergence criteria, which included no realignments for two years prior to monetary union, as well as reforms that would bring down government deficits and public debt (Eichengreen and Wyplosz 1993). The currencies of the most vulnerable countries, Britain and Italy, faced market speculation during the summer of 1992. On July 16 the Central Bank Council of the Bundesbank raised interest rates, sending its EMS partners a strong signal that it would continue to fight German inflation despite the tension it caused in the exchange rate mechanism (Heisenberg 1998: 131–2). The Bundesbank had repeatedly attempted to orchestrate a general realignment in the EMS after unification, but to no avail. The other currencies did not wish to risk their accumulated exchange rate credibility by devaluing (Loedel

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1999: 160–1; Mélitz 1994: 63). The Bundesbank’s official role as guardian of price stability in Germany clashed with its unofficial role as central bank for Europe, as German and European monetary interests sharply diverged. Currencies that were not participating in the ERM but shadowing it, such as Finland and Sweden, faced massive speculation in early September. Despite an adjustment of the lira’s exchange rate over the weekend of September 12–13, markets continued to speculate against the lira as well as the pound. On September 16, also known as “Black Wednesday,” both currencies exited the ERM. Markets quickly turned their attention to other currencies, including the French franc, Spanish peseta, Portuguese escudo, and Irish punt (Cobham 1994, 1996; Connolly 1995; de Boissieu 1994; Eichengreen and Wyplosz 1993; Harmon and Heisenberg 1993; Johnson and Colignon 1994). While other countries ratifying the Maastricht Treaty held referenda for constitutional reasons, the French referendum was called for electoral reasons; the government wanted to expose the conflict within the right on the subject of European integration. While it succeeded in this goal, it also divided the left, resulting in “as many divisions within parties as between them” (Guyomarch 1993: 620). The referendum ultimately split the Socialists, with Jean Pierre Chevènement leading the anti-Maastricht campaign, and further alienated of the Communist Party (Guyomarch 1995: 103). As anticipated by the government, the Maastricht Treaty referendum exposed disagreements within the RPR and the RPR–UDF coalition. Party unity had been declining in the RPR for several years. In 1990, Jacques Chirac and Alain Juppé had drafted a party manifesto that accepted France’s loss of sovereignty to the EU but sought to protect France’s right to invoke its national interest in the tradition of de Gaulle. However, they indicated that monetary union would be acceptable given the proper economic conditions. Charles Pasqua and Philippe Séguin, on the other hand, argued that the traditional Gaullist vision of France and Europe ought to be reconsidered given the end of the Cold War, and they objected to monetary union on political grounds (Risse 1998). Moreover, Lyon Mayor Michel Noir made an unsuccessful but damaging bid for party leadership, and the rift between the party leadership and its rank and file became increasingly exposed (Guyomarch 1993: 113). Given the inroads made by the National Front, the RPR leadership could ill afford to ignore the more conservative, nationalist wing of the party, which increasingly brought them into conflict with their ally, the UDF. In January 1992 Chirac warned that Europe must not divide the right (Appleton 1996: 304).

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On May 5, 1992 the RPR group in the National Assembly split on a procedural motion that sought to throw out the Maastricht Treaty, with half of the party voting in favor and half the party abstaining. To complicate matters further, the UDF voted almost unanimously against the motion, indicating splits both within the party (RPR) and the coalition (RPR–UDF) on the Europe issue. The RPR’s secretary general, Alain Juppé remarked, “Mr. Mitterrand set a trap for us, and we fell right into it. If we go on like this, we shall continue to lose three or four points in the polls every week.”13 When the National Assembly voted on the Maastricht Treaty, the bill passed 398 votes to 77. The UDF voted once again in favor of the bill while both the RPR leadership and the majority of its deputies abstained. Chirac tried to minimize public attention on the party’s split by demanding that its members not participate in the pro-Maastricht movement alongside the Socialists, but this demand was unheeded. The UDF demanded a clarification of the position of Chirac and the RPR on the referendum. In response, Chirac claimed that he would vote in favor “without enthusiasm but without any complexes” (Appleton 1996: 307). There would be no official party line, and members would be able to vote according to their own preferences. The division within the party precluded the party leadership from directing the party on how to vote (Ross 2000: 93). Chirac’s strategy allowed him to avoid exacerbating tensions with the UDF, which had already announced that it would only support a presidential candidate that favored European integration. This tactic also saved him from having to punish Séguin and Pasqua, who had already embarked on the “no” campaign (Appleton 1996: 307). While Séguin did not support the Maastricht Treaty and its threat to French sovereignty, he did envision France’s continued participation in the EU and fulfillment of its obligations from the Treaty of Rome and the Single European Act (Criddle 1993: 232). He drew attention to the weakness of the social and industrial chapters of the Maastricht Treaty and warned of weaker economic growth when the Bundesbank achieved official control of European monetary policy through EMU (McCarthy 1993c: 68). During the French referendum on the Maastricht Treaty, one side argued that European integration would restrain a united Germany while the other side claimed that it would bring Europe under German domination (Gillessen 1998). The French narrowly avoided a “no” vote by half a percentage point. Despite considerable speculation, the franc escaped devaluation, thanks in part to the extraordinary support received from the German government and the Bundesbank. Monetary union could not proceed without France and Germany, and the “petite oui ” was enough to keep the momentum going. The British government

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complained bitterly about this preferential treatment toward the franc (versus the pound) during the crisis (Connolly 1995). Other currencies like the Spanish peseta, the Portuguese escudo, and the Irish punt devalued over the next few months, and the French franc continued to experience periodic bouts of speculation. The Danish “no” vote had unleashed a floodgate of speculation against most of the European currencies, and the future of monetary union looked uncertain. As the legislative elections approached, the expectation of a conservative victory in the face of a recession and their internal division on monetary union contributed to the unstable climate and led to further speculation against the franc prior to the election. But contrary to partisan theory predictions, the incumbent Socialist government did not devalue. The newly elected conservative government also maintained the value of the franc immediately after assuming office for the sake of the monetary union project, but within months the speculation became overwhelming, and the franc was effectively devalued by the widening of the fluctuation bands. Economic Conditions: The Beginning of a Recession The economic outlook for 1993 was less than rosy, and many thought the franc was approaching its breaking point with the mark (see figures 5.9–5.12). Over three million French citizens were unemployed, and business and banking sectors predicted that the government would soon cast off its shackles and release the franc from its peg. Since the fourth

2.5

Percentage

2 1.5 1 0.5

Figure 5.9

Monthly inflation rates, 1993 electoral period

Se p

-9

3

3 -9 Ju l

ay M

-9 ar M

93

3

3 -9 Ja n

92 ov N

Se p

-9

2

0

France, 1988–1995

●

6,000 5,000 Millions of US$

4,000 3,000 2,000 1,000 0

Figure 5.10

-4 93

-3 93

-2 93

-1

92

93

-4

-3 92

92

-2

–1,000

Quarterly current account balance, 1993 electoral period

Millions of US$

40,000 30,000 20,000 10,000

Figure 5.11

93

3

Se

Ju n

p-

-9

3 -9 ar M

D

Se

ec

p-

-9

92

2

0

Monthly reserves during 1993 electoral period

Percentage

14 12 10 8

Figure 5.12

Eurofranc interest rates, 1993 electoral period

p93 Se

3 -9 Ju l

ay -9 3 M

-9 3 ar M

-9 3 Ja n

ov -9 2 N

Se

p92

6

105

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quarter of 1992, France experienced a negative growth rate as the economy slid toward recession. Interest rate differentials with Germany grew in anticipation of the election; L’Expansion expressed the view of many when it wrote, “Can the franc hold on? Yes . . . until the elections.”14 The devaluations that many of France’s major trade partners undertook in fall 1992 and winter 1993 meant that French exports would suffer considerably. Business leaders expressed more pessimism than they had been in over a decade, according to a series of polls by L’Expansion-Enterprises. Even the 1983– 1984 riguer period had not provoked such pessimism. The Campaign: The Left Explores New Alternatives, the Right Dissents on the Subject of the Franc Fort The campaign exposed discord within both the left and right with regard to economic policy as well as monetary union, contributing to the air of instability surrounding the successive speculative attacks against most currencies of the ERM and even those outside of it. Prominent members of the left such as Michel Rocard and Pierre Bérérgovoy, for example, indicated the need for big policy changes to cope with the economic slowdown. Jean-Pierre Chevènement advised rethinking the logic of the EMS, questioning the wisdom of subsuming domestic monetary policy objectives in order to maintain the exchangerate parity.15 He did not, however, support devaluation or floating the franc, which would lead to higher interest rates in the long term.16 The RPR–UDF coalition’s most prominent members also offered differing opinions on how to stave off a recession. Philippe Séguin (RPR) and Alain Madelin (UDF) favored easing the constraints on the franc in order to reduce interest rates and revive the economy. The majority sided with Giscard and Balladur, however, supporting a continuation of the franc fort policy. In addition, the conservative coalition issued a manifesto announcing its intention to make the Banque de France independent. Unemployment once again dominated the campaign. The RPR–UDF coalition advocated the privatization of some companies, reducing taxes, and slowing down immigration (Ysmal 1993). In addition, contributions normally paid by employers would be transferred to the state in order to reduce unemployment. They also planned to give generous exemptions to employers that created new jobs. 17 The Socialists suggested reducing the workweek, as it had in 1981. The election promised substantial policy changes and possibly only tepid support for monetary union and the austerity policies that it would necessitate.

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The Polls: Victory for the Right Polls showed that voters generally favored the government’s franc fort policy, despite its high costs. An opinion poll taken by Sofres-Ministère des Finances indicated that 60 percent of the French favored the EMS and thought France should continue its participation thereof, since this brought benefits such as a solid currency and low inflation. Only 24 percent thought that the EMS was not good for the economy. Seventy-two percent of those questioned were against a devaluation of the franc. Thirty-three percent thought inflation was still too high, while only 16 percent thought inflation ought to be higher. 18 Another poll done by IPSOS-L’Expansion also showed public support for the strong franc (see tables 5.3–5.5 and figure 5.13). Table 5.3 Poll: “If the franc had been devalued against the mark, do you think this would contribute to the . . .”

Revival of the French economy Fight against unemployment

Yes

No

No opinion

20 16

52 61

28 23

Source: L’Expansion, March 18, 1993.

Table 5.4 Predicted future distribution of seats in new national assembly Party

Number of seats (555 total)

Communists Socialists Ecologists UDF RPR National Front

24 82 3 218 224 1

Source: Le Nouvel Observateur, February 4, 1993.

Table 5.5 Poll: “Do you hope that in the next legislative elections voters will manifest their support for Mitterrand and the current government or that the voters will use this occasion to manifest their discontent?”

Show support Show discontent No opinion

23–25 Feb

23–27 Jan

18 64 18

6 68 16

Source: Le Nouvel Observateur, March 4, 1993.

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25 20 15 10 5

Fr o

nt

ite

al

D ro N at

io n

s

R PR

D ive r

U D F

m Fr e en Le c Pr h ft og Al re lia ss nc -S e oc for ia lis ts Ec ol og is ts

tre Ex

C om

m un

is t

s

0

Le Nouvel Obs.-Sofres 23–25 Feb 1993 Figaro-Sofres, 6-10 Feb 1993 Le Nouvel Obs.-Sofres 23–27 Jan 1993 Le Nouvel Obs.-Sofres Nov 1992 Le Nouvel Obs.-Sofres Feb 1992

Figure 5.13

Summary of polls on intentions to vote (%) in 1993 election

Source: Le Nouvel Observateur, March 4, 1993.

Pundits referred to 1993s expectation of another cohabitation as “the ‘surprise free’ scenario for 1993” (Economic Intelligence Unit 1993: 36). The Election: Massive Victory for the Conservative Coalition The Socialists lost the election, ushering in another cohabitation. The Ecologists failed to make as strong a showing as expected, which damaged the Socialists (Machin 1993). Unlike the previous cohabitation in which the right had only a slim majority, the right’s victory was massive. The Socialists had suffered their worst defeat in 25 years. The new government selected Edouard Balladur of the RPR for prime minister.19 The Balladur government expressed its commitment to the franc fort and to the ERM, continuing the Socialists’ policies. The banks’ prime

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lending rates, applying to 90 percent of consumer borrowing, had been kept artificially low at 10 percent to reduce the suffering. Only 30 percent of the debt was long-term, mainly affecting small businesses, which depended on banks for funds. The artificially low levels of base rates helped, but a large numbers of firms were forced into bankruptcy. By remaining committed to the ERM, the Banque de France had to keep short rates above long rates, which would eventually destroy the solvency of the banking system, destroy the public finances, and lead to a credit crunch. The government in effect was counting on monetary union and/or a reduction in German interest rates to help reduce the risk premium in French interest rates.20 However, neither happened soon enough, and in August 1993 the franc participated in what was then considered to be a de facto devaluation by widening its fluctuation bands so that the currencies could fluctuate by a total of 30 percent. Summary of 1993 Legislative Election The 1993 legislative elections demonstrated the complicated nature of exchange rate values and economic fundamentals at the beginning of the decade. On the one hand, France had one of the strongest economies in Europe in 1992, boasting low inflation and strong export growth. However, interest rates remained high in order to prevent capital from fleeing to Germany’s higher post-unification interest rates. French monetary policy was dictated by German exigencies and concern for European integration more so than ever before. Despite the certainty of the incoming government, however, the franc still suffered from speculation. The division within the RPR–UDF coalition may have encouraged the instability despite denials from all sides that the new government planned to devalue. The narrow “yes” vote of the Maastricht Treaty referendum also hung over the elections and added to increasing doubts about monetary union becoming a reality. Speculation continued throughout the fall and winter, and interest rates roses accordingly as the election approached. Partisan theories may have predicted a crisis due to the fact that the left was in power at the time, and that left governments are more prone to inflationary economies that cause currency problems later. However, such theories would predict the 1993 crisis correctly, but for the wrong reasons: inflation was not the issue, as French economic fundamentals surpassed those of most of its neighbors. The Socialists had not been pursuing policies that were significantly different from the right for a decade, so partisan differences did not cause the crisis. Uncertainty

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surrounding the willingness and ability of France to continue to follow German policy en route to monetary union generated the speculation. Yet government reaction to the speculation went in accordance with theories emphasizing governments targeting voters. The Socialists did not devalue before the election, despite the need to hike up interest rates during a period of high unemployment and to ease the strain on exporters suffering from the prior devaluations of its major trading partners. What makes this election different from previous ones is that the RPR–UDF did not try to use currency speculation to its political advantage. The right also favored monetary union and maintaining France’s commitment to the EMS—despite the demonstration of fractious elements during the referendum campaign. The 1995 Presidential Elections The currency turmoil of 1992–1993 subsided after August 1993, at least for France. The fluctuation bands of the EMS had been widened to 15 percent in either direction, and an export-led recovery began to take place. In January 1994 the Banque de France gained independence, and the Maastricht criteria for monetary union continued to have a large impact on economic policy. On the French political scene, the presidential race heated up as early as 1993.21 Jacques Chirac, leader of the RPR, did not want to be compromised by cohabitation and thus jeopardize his chances for the presidency again. He therefore supported Edouard Balladur for the position of prime minister. Ironically, Balladur benefited tremendously from this role, gaining both popular support and support from the UDF. His popularity soared, and as early as December 1993, UDF politicians such as Defense Minister François Léotard and Social Affairs Minister Simone Veil publicly offered their support for the prime minister’s unannounced presidential bid.22 On the left, former First Secretary of the Socialist Party Lionel Jospin ran for the office after European Union Commission President (and former French finance minister) Jacques Delors announced that he would not run, despite his overwhelming popularity.23 While the three men once again offered similar conservative economic policies, key differences remained. For example, Jospin advocated a moderate policy shift leftward in the form of a reduced workweek. All three candidates expressed support for monetary union, but Chirac was openly skeptical about EMU, Maastricht-style. These differences were enough to cause an expectations-based crisis.

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Economic Conditions and International Circumstances: Recovery and Crisis The French economy recovered during 1994 (strongly driven by rising exports), and the OECD predicted a favorable outlook for demand in 1995 (see table 5.6). Unemployment remained high, however, and future prospects seemed grim. Strikes swept through the country in March, and the candidates correspondingly espoused lenient views about wage restraint. Nevertheless, forecasters did not expect any radical measures from any of the candidates, as all supported France’s commitment to the Maastricht Treaty. Low inflation, controlled government spending, and the defense of the franc comprised the main objectives of the candidates, despite Chirac’s wavering on participation in monetary union. The healthy current account surplus attested to the competitiveness of French products despite the appreciation of the franc; wage restraint was the key. An OECD report (1994–1995: 15) on France noted that the economy remained “buoyant” at the beginning of 1995 and the trade surplus continued to grow during the first quarter. The financial community regarded Balladur’s policy proposals favorably because his election would signal policy continuity.24 As domestic pressures increased, Germany’s insistence that monetary union would progress only if price stability could be assured hardened. The budgetary requirements of the Maastricht Treaty proved vexing for many countries, and both banking and industrial organizations as well as public opinion polls in Germany showed rising concern over the impact of monetary union on stability. In November 1995, German Finance Minister Theo Waigel promoted the creation of a stability pact to extend the budget deficit limits to the operations of monetary union itself (Kaltenthaler 2002: 86). Within such an environment, the

Table 5.6 Summary table of French economic indicators, 1991–1994 Economic indicators GDP Growth % Inflation % Current Account $bn Reserves excl gold $bn Unemployment %

1991

1992

1993

1994

0.6 3.2 ⫺7.0 31.28 9.4

1.2 2.4 3.7 27.03 10.4

⫺1.0 2.1 10.2 22.65 11.7

2.5 1.7 9.8 26.3 12.3

Sources: EIU Country 1995: 3; OECD 1994–1995.

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government’s commitment to monetary union and achieving the convergence criteria was closely scrutinized. The Maastricht Treaty stipulated that the countries achieve convergence in inflation rates and interest rates, exchange rate stability. They were also expected to get public deficits and debt under control, which proved to be the most difficult; even when monetary union commenced in 1999, not all participants had strictly fulfilled these criteria. Table 5.7 shows where the original EMU members were in fulfilling these two criteria in 1995. The difficulties many countries experienced in trying to lower their debt and deficit levels continued to place a question mark over whether or not monetary union would actually occur— further focusing market attention not only on data that affected exchange rates, but also on the fulfillment of the convergence criteria. At the start of 1995, France met the debt criterion, but not the deficit criterion. The Campaign: Dissent Over Monetary Union Balladur had long seemed most likely to succeed Mitterrand as president of the French Republic, creating a rift within the government and the RPR over the expected challenge to Chirac. Balladur’s polls continued to rise through the beginning of 1995, due to his successful handling of an Air France hijacking.25 In February, inquiries into his financial affairs combined with a local government scandal (and other assorted minor debacles) resulted in a popularity decline (see figure 5.14). Table 5.7 Progress toward fulfilling Maastricht criteria: deficits and debt as percentage of GDP Country

1992 deficit

1993 deficit

1994 deficit

1992 debt

1993 debt

1994 debt

Austria Belgium Finland France Germany Ireland Italy Netherlands Portugal Spain

⫺4.2 ⫺7.1 ⫺8 ⫺5.8 ⫺3.2 ⫺2.4 ⫺9.5 ⫺3.2 ⫺6.1 ⫺7

⫺5 ⫺4.9 ⫺6.4 ⫺5.8 ⫺2.4 ⫺1.7 ⫺9.2 ⫺3.8 ⫺6 ⫺6.3

⫺5.1 ⫺4 ⫺4.6 ⫺4.9 ⫺3.3 ⫺2.1 ⫺7.7 ⫺4 ⫺5.7 ⫺7.1

62.7 135.2 58 45.3 48 96.3 119.1 81.1 63.1 60

65.4 133.2 59.6 48.5 50.2 88.2 124.9 77.9 63.8 62.6

69.4 132.2 58.1 52.8 58.3 78.9 125.3 79 65.9 64.2

Source: International Financial Statistics.

France, 1988–1995 53 51 49 47 45 43 41 39 37 35 Oct-94 Figure 5.14

Nov-94

Dec-94

Jan-95

●

113

Feb-95

Gallup-L’Express poll on approval of the prime minister

Source: L’Express, various issues.

Chirac had launched his campaign in early November 1994. He concentrated his efforts at the local level, trying to assert that alternative economic policies were possible despite the Maastricht Treaty’s economic convergence criteria. Balladur’s economic plan closely resembled Chirac’s in that both promoted lower income taxes, but both candidates also lacked a coherent program to deal with the unemployment problem in France. For example, Balladur’s goal was to reduce the number of unemployed by one million by the year 2000. Experts were skeptical of this plan and its numbers, noting that in order to reduce unemployment by that much, France’s GDP would have to grow at least 4–4.5 percent per year for five years. Yet just 3.5 percent growth was expected for 1995, and a French economic research institute predicted that unemployment would be lowered by just 40,000. Chirac, on the other hand, offered a plan with no numbers—his suggestions including subsidizing businesses that created jobs and hired workers who had been unemployed for long periods of time.26 Perhaps the most striking difference between the two men was their European credentials. Balladur was known as a stalwart supporter of monetary union and the Maastricht Treaty (even pushing for monetary union by 1997), while Chirac was noticeably less enthusiastic. While Balladur reaffirmed his commitment to meeting the conditions of the Maastricht Treaty by reducing the budget deficit, Chirac hedged on this issue, saying that the government had “a tendency to exaggerate our own constraints.”27 In an effort to stoke concern over Chirac’s lack of enthusiasm for EMU, an adviser of Balladur warned, “Chirac is a dangerous man. If he were elected president of the Republic, European construction would be endangered.”28 The Balladur team also accused Chirac of putting the

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franc’s stability in jeopardy with his penchant for announcing programs and make promises without giving numbers or ideas as to how to pay for them.29 In addition, one of Chirac’s principal allies was Philippe Séguin, a staunch opponent of the Maastricht Treaty. Chirac himself, however, said that he was “personally committed to full realization” of the Maastricht Treaty’s plans for economic and monetary union, though he did not commit himself to a date for its implementation.30 Like his opponents on the right, Socialist candidate Lionel Jospin made unemployment the cornerstone of his campaign and publicly supported monetary union. He advocated employment-creating policies similar to the ones proposed by his conservative rivals in an effort to meet the convergence criteria, but he also favored reducing the workweek from 39 hours to 37 hours, with no reduction in pay. His opponents criticized this plan, recalling Mitterrand and the 1981 experiment that reduced the workweek from 40 to 39 hours. The Polls: Uncertain Winner Jospin faced an uphill battle from the beginning. In January (after Jacques Delors declared that he would not be a candidate and before the Socialists had decided upon a new one), a poll was taken in which voters were asked who would be the best candidate to represent the Socialists (see table 5.8). Jospin came in fifth.31 But as the campaign progressed, Jospin’s popularity rose while Balladur’s declined, as can be seen in the following series of opinion polls (see figures 5.15 and 5.16; see tables 5.9 and 5.10). By April, Chirac had become the front-runner, but a large number of voters had indicated that their positions were “soft,” and that they were still basically undecided. According to an IFOP-L’Express survey, as many as 36 percent of the voters remained undecided before the election. The race was still wide open. Table 5.8 Poll: Do you think the following personalities would make a good president of the Republic? Jan

Balladur Chirac Jospin

Feb

Mar

Yes

No

Yes

No

Yes

No

66 44 21

29 51 71

62 49 32

33 46 61

58 48 49

36 46 41

Source: Le Nouvel Observateur, various issues.

France, 1988–1995 30

Percentage

25 20 15

r Ap

III M

ar

II M

Balladur

Figure 5.15

ar

ar M 1-

Fe b

Ja n

10

Chirac

Jospin

First-round intentions to vote

Note: When the January poll was taken, the vote was for “the Socialist candidate.” Source: Le Nouvel Observateur, various issues.

30 28 26 Percentage

24 22 20 18 16 14 12

Balladur

Figure 5.16

First-round intentions to vote

Source: IFOP-L’Express polls, various issues.

Chirac

r Ap

III M

ar

II ar M

ar 1M

Fe b

Ja n

10

Jospin

●

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Realigning Interests Table 5.9 Intentions to vote in second round: Le Nouvel Observateur polls Jan

Feb

March

March II

April

Balladur vs. 58 Jospin 42

55 45

55 45

51.5 48.5

55 45

Jospin vs. Chirac

49 51

47 53

40 60

43 57

42 58

Chirac vs. Balladur

36 64

47 53

60 40

61 39

58 42

Source: Le Nouvel Observateur, various issues.

Table 5.10 Intentions to vote in the second round: IFOPL’Express polls Jan

Feb 3

Feb 23

Mar

April

April 8

Balladur vs. Jospin

64 36

64 36

55 45

53 47

51 49

54 46

Jospin vs. Chirac

44 56

42 58

47 53

43 57

42 58

42 58

Chirac vs. Balladur

36 64

36 64

46 54

56 44

62 35

62 38

Source: L’Express, various issues.

The Crisis As Balladur’s political troubles intensified, so did pressure on the franc. In late February the franc hit a 16-month low against the mark. Esther Baroudy, senior economist at the Crédit Lyonnais in Paris, credited the drop to “political factors and polls.”32 Most investors perceived Balladur as the candidate most committed to the franc fort and to fiscal discipline, while Chirac seemed less concerned about the budget deficit and maintaining a tight monetary policy. Though the market’s favored candidate, Balladur, argued for the virtues of the government’s strict monetary policy and the necessity of keeping France’s commitments to Europe, Chirac reasoned that such constraints hurt employment because of the need to keep interest rates high. Even Lionel Jospin spoke more favorably of the merits of the franc fort policy and the Maastricht Treaty when he said a “single currency will be . . . a source of stability.”33 The franc faced continued instability; in March, the dollar’s fall led to a rise in the mark, which in turn weakened the franc. This exacerbated

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the effects of the electoral uncertainty, though analysts predicted that the franc would stabilize after the elections (Economic Intelligence Unit 1995a). The Banque de France suspended its 5–10 day “repurchase” lending rate of 6.4 percent, replacing it with a 24-hour lending rate of 8 percent. This was the same technique that was used to defend the franc during the 1992–1993 crises: the Banque de France raised the cost of borrowing while shortening the lending period in order to discourage speculation. However, the bank’s base rate was left at 5 percent, conveying to the markets and the public that the problems were seen as shortterm fluctuations due to the dollar’s weakness and the elections in France. The measures worked, and the franc rallied with the help of the Germans: at its low point, the franc was 3.58 against the mark when the Bundesbank cut the German interest rates. This allowed the Banque de France to lower the repo rate to 7.75 percent by early April. Banque de France Governor Jean-Claude Trichet was matter-of-fact about the bank’s handling of the crisis; he said that the Maastricht Treaty was “a democratically ratified treaty, that we obviously have to apply. The European central banks are there to assure its [the EMS] solidity.”34 Economics Minister Edmond Alphandéry had no formal role in the matter, but he publicly approved of the decision and emphasized the government’s “unshakable determination” to defend the franc. The Chirac team then tried to jump on the bandwagon and began to stress the importance of fiscal discipline and currency stability, asserting that Chirac wished to reduce the budget deficit further.35 Chirac also clarified his position on monetary union, favoring its implementation. This seemed to assuage market tension as Election Day drew near. Yet as the elections approached in late April and early May, tension resurfaced. As expected, the franc recovered afterward and the repo rate was cut twice. The Election As table 5.11 indicates, what had been nearly unthinkable in January had happened: Balladur did not even make it into the second round. An even bigger shock was that Jospin received more votes than either of the two “front-runners.” A federal secretary of the RPR hypothesized, “certain cadres . . . have played with fire: they have voted for Jospin so that Balladur (would not be) in the second round.”36 Despite the strong campaign waged by Jospin, Chirac won the second round of the elections, having benefited from votes that had gone to Balladur in the previous round (see table 5.12). His new

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Realigning Interests Table 5.11 First-round results of the presidential election

Lionel Jospin (PS) Jacques Chirac (RPR) Edouard Balladur (RPR) Jean Marie Le Pen (FN)

Votes cast

% of vote

7,097,786 6,348,375 5,658,796 4,570,838

23.30 20.84 18.58 15.00

Source: Economic Intelligence Unit 1995b.

Table 5.12 Second-round results of the presidential election

Jacques Chirac (RPR) Lionel Jospin (PS) Abstentions

Votes cast

% of Vote

15,763,027 14,180,644 8,131,125

52.64 47.36 20.33

Source: EIU Country Report, France, 3rd quarter 1995.

government was largely pro-European, and he named EMU supporter Alain Juppée as his prime minister. Bonds, futures contracts, and the franc all rose after the second round. The sustainability of the franc fort policy had been in doubt during the campaign, but the Chirac victory seemed to reassure markets, according to Paul Hammet, a French economist at Paribas Capital Markets.37 Chirac’s commitment to the Maastricht Treaty’s need for monetary and fiscal discipline finally seemed to be credible. The 1995 election was an excellent example of an expectations-based currency crisis. The economic fundamentals of the country were strong with low inflation and a trade surplus. The interest rate pattern was exactly that which would be predicted by the model on devaluation— rising sharply and then falling sharply (see figures 5.17–5.20). However, no devaluation occurred, indicating that the expectation of devaluation had been strengthened due to instability surrounding the presidential election. Summary of 1995 Elections The 1995 presidential election demonstrates the impact that opinion polls and electoral expectations can have on markets. As the most proMaastricht candidate began to decline in popularity, the currency took a similar dive. In March the electoral tensions were aggravated by the fall

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2.5

Percentage

2 1.5 1 0.5

Figure 5.17

95

95

5

p-

N ov -

M

Se

ay -

ar M

Ju l-9

95

5 -9

-9 Ja n

N ov -

94

5

0

Monthly inflation, 1995 electoral period

Millions of US$

8,000 6,000 4,000 2,000

Figure 5.18

-1 96

-4 95

-3 95

-2 95

-1 95

-4 94

94

-3

0

Quarterly current account balance, 1995 electoral period

of the dollar and the rise of the mark, but France’s economic fundamentals were still strong: growth was expected for the upcoming year, inflation was low, and there was a widening trade surplus. The partisan theory was again found wanting. A simple left–right distinction could no longer predict market reactions. When the franc suffered from speculation in February and March, it was because Chirac had begun to overtake Balladur. Both men were from the same political party and had been political allies for many years. However, Chirac’s commitment to monetary union was questionable, so his credibility suffered. Markets were unsure as to whether he would continue the franc fort policy or lower interest rates after assuming office.

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●

28,000

Millions of US$

27,000

26,000

25,000

24,000

Figure 5.19

95

5 Au g

N ov -

-9

95 ay M

Fe b

N ov -

-9

5

94

23,000

France monthly reserves, 1995 electoral period 9

Percentage

8 7

6

Figure 5.20

N

ov -

95

95 pSe

-9 5 Ju l

95 M

ay -

5 M

ar

-9

95 Ja n-

N

ov -

94

5

One-month Eurofranc interest rates, 1995 electoral period

Finally, government reaction to market speculation during this time was consistent with previous elections. Balladur’s government publicly supported the Banque de France’s measures to defend the franc, even though the government no longer had a formal role in the matter (central bank independence had been granted in 1994). The government could have criticized the measures and interest rate hikes as being too severe so close to an election, but it did not. The franc would not

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devalue before the election, and this remained the government’s primary wish for monetary policy during this time. The 1988–1995 Period in Perspective The elections presented in this chapter demonstrated that political business cycles were still a relevant force in French politics, but they had taken on a different character. In 1981, the prospect of a left government sent the markets into a tailspin with the anticipation of profligate spending and lax policy. However, after the 1983 U-turn, the partisan variable ceased to have the same sort of meaning that it had in the earlier period. The left and the right were offering similar policies in terms of monetary and fiscal austerity, and the old partisan labels did not matter anymore. Instead, the defining characteristic that determined how the markets responded to the news of a leader in the polls was the party/candidate’s commitment to monetary integration. No longer was the left–right distinction the primary determinant of market movements. A left candidate who staunchly supported monetary integration was less likely to experience exchange rate instability than a right candidate who did not. Even within parties, distinctions were made between the candidates and factions that favored monetary union. When an anti-monetary union faction was perceived as gaining power, this would lead to market speculation. What made a government’s policy credible had changed. As Europe moved closer and closer to monetary union, markets were carefully assessing the commitment of each individual government and the likelihood that it would defend the exchange rate against speculation. Prior to 1992, it was almost taken for granted that every government possessed the political will to defend its exchange rate and ensure its participation in monetary union. But the Danish “no” vote and the precarious outcome of the French referendum on the Maastricht Treaty showed the fragility of the process. It was clear that there was a chance monetary union might not come to pass, at least not for every government in the union, and that profits could be made if they could determine which currencies were the most vulnerable. Even France, a country with strong economic fundamentals, experienced substantial exchange rate pressure. While France had succeeded in lowering its interest rates, inflation rate, and exchange rate fluctuations, it was still not given equal status with Germany. France did not find the level of credibility it sought through German emulation, even when its central bank was granted

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independence. It attempted to achieve this level of credibility through monetary union and the formal delegation of its policymaking authority to a European central bank modeled after Germany. The combined muscle of the European economies would grant this economically interdependent region greater credibility and stability than they could achieve on their own as well as take into account national interests rather than purely German ones. But once again, elections were sources of uncertainty. The possibility of a change in government and the consolidation of political power by a faction that was less supportive of the EMU process meant that monetary union could be derailed. If this were the case, governments would no longer have an incentive to follow tight monetary and fiscal policies, and the currency would depreciate rapidly once these constraints were loosened. Markets reevaluated which governments were most likely to defend the exchange rate and continue to pursue the Maastricht Treaty convergence criteria, judging not only a country’s economic fundamentals but also its political will, something that had become more difficult to predict based on partisanship alone. In summary, expectations about future policy were originally linked to party labels, but over time they were no longer derived from a left–right continuum because commitment to the EMS and currency stability had transcended party politics in the mid-1980s. One had to look beyond parties and to individual candidates to determine varying degrees of commitment to this stability. All parties professed some level of commitment to the EMS, so judgments about a government’s future monetary rigor had to become more nuanced. But the political business cycles were still based on expectations of policy change, not along socioeconomic party labels. Political business cycles and international cooperation became inexorably linked in a way that was hard to envision back in 1981 when these cycles were based on domestic calculation and traditional left–right labels. By the early 1990s, political business cycles and currency speculation occurred largely as the result of differing stances on the feasibility and desirability of international cooperation, specifically monetary union. Finally, government responses to market speculation before an election was consistent in both periods: the government always defended the currency. This strongly supports the thesis on government credibility and the importance of maintaining a reputation for competent policymaking before an election. Governments do not devalue the currency before an election, even in the face of currency speculation. Devaluation had negative connotations of failure and irresponsible policymaking,

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and by the early 1990s devaluation could jeopardize a country’s participation in monetary union and therefore the European hierarchy (see tables 5.13 and 5.14.) The desire to win the election and maximize the number of votes made devaluation prior to an election political suicide. Table 5.13 Summary table of arguments on the emergence of currency crises in France, 1988–1995 Explanations for currency crisis

French 1988 elections

French 1993 elections

French 1995 elections

Economic fundamentals weak Partisanship Expectation of policy change Electoral uncertainty

NAa

No

No

NA NA

Yes Yes

Yes Yes

NA

No

Yes

a

Not applicable because no crisis occurred.

Table 5.14 Summary table of arguments on devaluation in France, 1988–1995 Explanations for devaluation

French 1988 elections

French 1993 elections

French 1995 elections

Government targets markets Government targets primary constituents Government targets voters Systemic pressure

NA

No

NA

NA

No

NA

NA

Yes

NA

NA

Yes

NA

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CHAPTER 6

Italy: Domestic versus International Origins of Currency Crises

I

taly, unlike France, was never able to pass off the cost of devaluation to other countries. Though the size of the Italian economy was roughly in the same league as that of the French, Italy never assumed a similar leadership position within the EC. On the contrary, Italy was typically on the receiving end of devaluation request, though this has not been problematic. Participation in monetary integration was uncontroversial, and the Italian government had been willing and able to devalue its currency upon request without fear that rival parties would exploit it to make the government appear incompetent. Both the domestic and international dimensions of Italian exchange rate policy changed dramatically by the early 1990s. Its party system underwent a fundamental transformation that made government change a factor in exchange rate speculation for the first time because it finally signaled possible shifts in government policy. At the same time, devaluation became a more difficult option for the Italian government as it threatened to jeopardize Italy’s participation in monetary union. However, the Italian government was still unable to transfer the cost of devaluation onto its EMS partners or to obtain the kind of support accorded the French by the German government. This indicates the enduring impact of power relations on exchange rate politics in the EU. The Italian Party System and the European Consensus Figure 6.1 is a useful starting point for analyzing the existence of political business cycles in Italy. The longer lines note the election date, and the shorter lines represent devaluation dates.

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Figure 6.1

Figure 6.2

French elections and devaluations, 1979–1995

There were only two devaluations that occurred in close proximity to elections, in 1983 and 1992. Currency realignments were correlated more with elections in France (see figure 6.2) than in Italy. Two of the French devaluations occurred within months of legislative elections and, as noted in chapter 5, other elections were marked by currency instability that did not end in devaluation. How can one account for these differences? France and Italy were similar in many ways. The size of their respective economies were comparable, they both had a history of high inflation and a weak currency, they were both founding members of the EC and the EMS, and they were both founding members of monetary union. Yet elections affected the currency stability of only one of these countries. The reason for this lies in both the nature of the Italian party system, which had determined the extent to which elections have been useful indicators of policy change, and the lack of controversy that EMU participation aroused in Italy. The party system in Italy for much of the postwar period precluded the possibility of currency crises coinciding with electoral cycles because of the continuity in government. The existence of governments that were largely composed of the same parties, all

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of which supported European monetary integration, made elections irrelevant for exchange rate policy until the early 1990s, when the party system changed. Italy did not qualify as a predominant-party system (Sartori 1976: 195, 197), despite the undisputed dominance of the Christian Democrats in politics. Sartori has instead classified the Italian party system as one of “polarized pluralism,” which was characterized by the existence of anti-system parties, bilateral opposition, a center party, polarization, centripetal competition, ideological patterning, and irresponsible opposition. Polarized pluralism led to a political system that was both unstable (Italy had more governments rise and fall than any other country in the EU since 1945) and yet marked by continuity. The political scene can be summarized as the pervasive rule of the Christian Democratic Party (DC) over all aspects of Italian political and social life (Donovan 1989; Furlong 1994; Hine 1993)—a rule that was in part marked by its attempts to rein-in the power of the second most powerful party, the Communists. The Communist Party (PCI and later PDS) was Italy’s anti-system party and was for many years not considered a potential party of government because of its ties to the Soviet Union and a general suspicion over the party’s commitment to Italy as a democratic republic. Although the Christian Democrats did not merit “predominant party” status, the fact that the DC’s largest competitor was not a potential party of government gave added significance to the DCs hold on power. As Daalder writes, the “combination of centre-based politics and irresponsible opposition1 . . . affects the mechanics of governmental turnover. There is no alternative government or coalition, as the center will govern as long as the system survives” (Daalder 1983: 220, emphasis added). In Sartorian terms, Italian governments had “peripheral turnover”(Sartori 1976: 139): only parties located near the center party were able to govern with the center party. Therefore government change was marginal. For the center party in polarized pluralist systems, “its destiny (was) to govern indefinitely . . . the DC owe(d) its power and its permanence in office precisely to the presence of the anti-system parties” (Sartori 1976: 143). Calise and Mannheimer have demonstrated empirically the continuity of the Italian cabinet in general, despite the short duration of the government. From cabinet to cabinet, they found that there was a “persistence ratio” (the number of ministers remaining from the previous one) of 57.7 percent (Marinotti 1986: 255). In addition, the partisan dimension of the electoral cycle is inconsequential for as long as government composition remains fixed, for party

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labels are not associated with meaningful policy changes. The primary difference between parties was the extent to which a party was prosystem versus anti-system (Daalder 1983). This is not to say, however, that the left–right cleavage was not a salient one in Italy. On the contrary, it was the most important one during the postwar period. The primacy of this cleavage, and the virulent reaction of many voters against the Communist Party (despite the existence of legions of supporters), drove many into the arms of the Christian Democrats and its partners. For those not interested in “wasting” their vote for a nongovernmental party, few alternatives existed other than the ruling DC coalition. The lack of government alternation made the left–right distinction irrelevant for parties that participated in government. The replacement of partisan labels for support of European monetary integration that occurred in France in the 1980s also had different repercussions for Italy. Despite France’s role as a leader of monetary integration over the years, this role had often been a source of contention between parties and even within parties. The level of monetary integration that France would support was not always clear due to the possibility that a party or a faction that favored less monetary integration would seize power. In Italy, however, all parties of government had supported European integration from the beginning. Monetary integration was not a source of controversy, thus eliminating partisan labels and varying levels of monetary support as predictors of policy. When the Italian party system changed and the continuity of government and policy were no longer assured, Italy’s participation in monetary integration came into doubt as markets questioned whether Italy could achieve the Maastricht convergence criteria in the midst of its political upheaval. Economic versus Political Conditions for Crisis and Devaluation There were 16 governments in Italy between 1979 and 1993. As previously mentioned, Italian governments had the shortest average life span in Europe. Yet until 1993, the major parties in government remained constant: the DC was in all 16 governments, the PSDI in 15, the PSI in 14, and the PRI in 10. This continuity in government parties presents a challenge to theories of electoral cycles and monetary instability. Did the stability in government composition translate into a muting of electoral cycles? Was there any pattern to when devaluations occurred?

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Did the elections lead to changes in monetary policy, or at the very least the expectation of monetary policy change? An analysis of Italian exchange rate politics indicates that economic conditions did not make the currency particularly vulnerable during electoral periods, nor did electoral cycles correlate with devaluation decisions. The Italian economy was not one of the healthiest in Europe during the 1980s. It persistently suffered from a current account deficit in 9 of the 15 governments during this period, Italy had a current account deficit at the time of government change. Out of 60 quarters, the current account was in deficit for 41. Inflation averaged over 6 percent until 1985, with the discount rate in the double-digits until 1993. Such conditions presented many possibilities for devaluation, and the lira was devalued seven times, more than any other currency in the EMS. However, in general the state of the economy did not worsen during electoral periods and make devaluation necessary to improve trade figures. In 1979, the current account balance was rising and had been in surplus for the last three quarters, implying that devaluation was not necessary based on trade figures (see figures 6.3 and 6.4). The 1983 election showed a rising current account balance; it had been in deficit in previous quarters, but the effects of the 1982 realignment were beginning to manifest themselves and improve the trade balance. The 1987 election also saw the current account balance in an upturn, coming out of a deficit the previous quarter. In 1992, however, the severe and 15,000

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ongoing current account deficit demonstrated a clear need for devaluation, and most analysts during the 1992 crisis had argued that the lira was overdue for devaluation. The link between inflation (and therefore a weakening exchange rate) and electoral cycles also fails to manifest itself in Italy. The value of the exchange rate did not weaken during electoral periods due to worsening price stability. During most of the elections, inflation was falling (rather than rising) before the election. Only in 1979 and 1987 was the inflation rate climbing during the electoral period, implying that on the basis of price stability, electoral periods were not always the most appropriate times for devaluation based on inflation data. As far as interest rates were concerned, they were generally rising before the elections, in accordance with what would be expected from arguments linking elections with exchange rate instability: political instability caused by elections can cause interest rates to rise as governments try to stem capital flight. However, the overall magnitude of these interest rate changes was very small (less than 1 percent), unlike the rate hikes seen in France during similar periods. Therefore it is difficult to attribute much significance to this pattern. The interest rate changes in 1994 did rise prior to the election, but by this time Italy no longer was committed to a currency band; as we shall see, the value of the lira was allowed to fall to historic lows. Finally, the exchange rate of the lira followed a general pattern where the exchange rate peaked the month of the election and then declined. This conforms to expectations that political instability causes a weakening

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of the exchange rate before and during an election, and that once the uncertainty has subsided, the exchange rate will once again strengthen. The connection between elections and devaluation, however, was extremely tenuous in the Italian case. Devaluation occurred within a three-month period of an election (in 1983), but closer examination of this crisis reveals that the devaluation was not instigated by Italy but was part of general realignment involving all of the European currencies (see figures 6.5 and 6.6). In summary, the majority of the elections did not coincide with periods of economic crisis that indicated a need for devaluation. Italy’s devaluations tended to occur as part of general realignments with other countries. Though interest rate and exchange rate movements roughly corresponded to the behavior described in previous chapters, these were relatively minor fluctuations and did not indicate a crisis. Italian devaluations instead coincided with French political instability rather than Italian instability. The desire of the French government not to have the franc singled out and devalued alone led to the negotiation of joint realignments. These realignments at first involved just Italy and Germany, but the rest of the EMS participants later took part in general realignments at the request of the French government. This pattern began in October 1981 when the lira took part in a realignment instigated by the French government shortly after the Socialists took power.

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The Italians were reluctant to devalue, having devalued the previous March. The Germans and the European Commission were able to persuade the Italian delegation to consent to the devaluation as a “favor to the regime.”2 This was the first instance of contagion in the EMS, and it was connected to the French electoral cycle. The French government had recently undergone a major political shift after the Socialists and Communists were swept into power in spring 1981, and was dealing with massive capital flight in the aftermath of the election. In June 1982, the lira participated again in a joint devaluation with the French franc. French Finance Minister Jacques Delors insisted that the franc not be the only currency to devalue, and Italy went along with the request since the government did not want to jeopardize its alliance with France on Common Agricultural Policy and budget issues (Connolly 1995: 26). Given Italy’s continued external imbalance, the devaluation was not viewed as abnormal, and there was no protest. In fact, the French devaluation could be seen as an opportunity for Italy to initiate stern economic measures and blame the EMS and the need for European solidarity. On June 23, the government announced new budget austerity measures in connection with the devaluation. In late March 1983, Italy participated in a general realignment of the EMS, which took place by request of the French government. Once again the Italians protested their involvement, having devalued less than a year prior to this. In addition, the government’s fight against inflation

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was bearing fruit: inflation fell from 19 percent in 1981 to 16.5 percent in 1983. Ultimately, the Italians acquiesced and devalued the lira alongside the French franc and the Irish punt in order to preserve European unity. By January 1986 trouble was again brewing for the lira and the Belgian franc in the run-up to the French legislative elections in March, after which a general realignment was expected. Italian authorities reinstated some capital controls to defend the lira during this speculative period. Surprisingly, during the realignment negotiations Italy requested that it retain its parity, having devalued less than one year prior and not wanting to aggravate its inflation difficulties. The EMS partners agreed. In summary, there has been no connection between domestic elections and the devaluations that transpired in Italy. On the contrary, pressure from other EMS countries explains the timing of three of the Italian devaluations during this period. The Italian economy was weak, and the devaluations were not out of line with the state of its economic fundamentals. However, political logic in the form of France’s desire not to be singled out during devaluations dictated when these devaluations occurred. Currency instability may have been exacerbated by the political instability within Italy prior to the realignment, but it was not the deciding factor; French electoral cycles determined the timing of most Italian devaluations. Despite the lack of political business cycles in Italy, the spread of the French business cycle to other countries renders the topic an important one for understanding European monetary cooperation in general. 1987–1992: Historical Changes Brewing The 1987 Italian election was historic for two reasons. First, it was the first election in which the Lombard League (which eventually became part of the Northern League) participated. The parties in the League were associated with reform and discontent with the traditional Italian political system, favoring regional solutions to centrist ones. Second, the 1987 elections also marked the beginning of the end of the Communist Party as its share of the vote fell drastically. Its support had been eroding since 1976 due to its increasingly moderate policy proposals that alienated traditional, militant supporters (Weinberg 1995). These events sparked the eventual reorganization of the Italian political system and therefore its exchange rate politics. By introducing greater competition, economic policies and exchange rate policies could now be affected by government changes to a degree previously unknown in Italy. Though

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the commitment to monetary integration did not waiver, the ability of competing parties to implement the economic policies that would ensure Italy’s participation varied, making the exchange rate subject to speculation. History and Italian politics began a new course during the Andreotti administration. In November 1989, the Berlin Wall fell, and with it fell all of the postwar conceptions of the efficacy of politics as usual. The DC would lose its raison d’être once its major nemesis no longer threatened Italian political life. In the end, the old guard of the DC–PCI would be unable to fulfill the desire for change within the Italian electorate, despite their attempts at reinvention. As the old Italian political system began to crumble, European monetary integration charged full speed ahead, and the Italians were determined to keep pace with these changes and to participate in monetary union. The period of the hard EMS began in 1987, with no devaluation save for the lira’s in conjunction with its entry into the ERM’s narrow band in 1990. The lira’s strength and Italy’s high interest rates led to a large influx of foreign capital, and the government was intervening to control upward pressure on the lira until September. Short-term interest rate differentials with Germany were gradually declining as the currency strengthened (OECD 1990/1991). From mid-1991 until October, short-term interest rates remained steady. Moody’s downgraded Italy’s ranking in July, leading to a weaker lira. From November 1992 to May 1992, short-term interest rates rose as Italian fiscal policy was increasingly scrutinized in light of the Maastricht Treaty’s entry conditions (OECD 1992). The questionable ability of Italy to satisfy the criteria of the Maastricht Treaty would wreak havoc on the lira, and currency instability would soon be exacerbated by the precarious domestic political situation. 1992–1994: The End of Politics as Usual The campaign for the new election began in January 1992 when the government voted to end the legislature early. The parliament was officially dissolved on February 2. The new PDS (formerly Communist Party) and the Soviet links of its predecessor dominated the 1992 election campaign as the DC sought to associate its traditional archrival with the failure attached to the collapse of communism. DC Secretary Forlani chose the theme “Without us, chaos” (Wertman 1993: 18). Amid the corruption scandals that were rocking the party system, the strategies of the major parties failed to garner support, and the popularity

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of the traditional government parties plummeted. The April 5 elections were the beginning of the end of postwar Italian politics. The Northern Leagues and their federalist ideology rode the crest of the antigovernment wave and made significant gains, becoming the fourth largest party in Italy. The League’s success had been widely predicted by preelection polls and the returns from the 1990 regional elections. The polls, taken by various public opinion institutes, showed that Italian voters were both undecided about which party to vote for, yet still inclined to depart from the traditional choices of the DC, PSI, PSDI, and PRI. Forecasting was complicated, however, by Italians’ reluctance to divulge their voting preferences prior to elections (Sani 1993: 117). The old four-party coalition preserved its majority by the slimmest of margins. The DC remained the largest party in Italy, though it was just a shadow of its former self. Assembling the government was not easy, and Italy was without a government until July. However, the cabinet looked essentially the same when all the negotiations were completed. In May, EC Ministers met in Brussels. Italy’s partners issued a “stern warning” to Italy at this time to get its fiscal house in order if it wanted to qualify for monetary union under the Maastricht criteria.3 Soon afterward, a series of exchange rate crises led to the withdrawal of the lira from the ERM in September 1992. The crisis began in June 1992 when the Danish referendum on the Maastricht Treaty failed to pass, putting into doubt the future of monetary union. This resulted in speculation against most of the European currencies (including France; see chapter 5), the devaluation of the escudo, peseta, and punt within the EMS, and the withdrawal of Italy and Britain from the EMS altogether. In addition to systemic uncertainty about the ability of monetary union to come to fruition, concern remained over the ability of individual countries to participate given the stringent requirements. The new Italian government had announced a package of large budget cuts and the formal abolition of wage indexation in order to qualify eventually for EMU. Unfortunately, this did not curtail the speculation against the currency. Official reserves decreased by 7.8 trillion lira in June, when in the preceding months the average was 1.3 trillion. Net outflows of capital also increased, from 6.5 trillion lire in June to 12.2 trillion in July. By August, things had improved due to the summer holiday and the effect of the agreement to stem labor costs, but in September the speculation started anew, prompting the devaluation of the lira and then its exit from the ERM. The bulk of Italy’s government debt was short-term; if the new interest rate–level continued, the cost of servicing the debt would have wiped out

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any budgetary gains in the Amato plan. This was before accounting for the depressing effect that higher interest rates would have on the economy and tax revenue (Banca d’Italia 1992). Markets deduced that high public debt would make Italy unable to sustain high interest rates to defend the currency, and Italy’s perceived inability to qualify for monetary union contributed to the fall of the lira (Dehay and Michelena 1994). The government had tried to initiate policies that would assuage market fears, but it was too little, too late. In early July, the government had announced spending reductions and supported the end of wage indexation, which was backed by employers and unions. The government took further steps to fulfill the Maastricht criteria in August, when it initiated policies to reduce the public spending deficit by 1.5 percent of GDP (McCarthy 1993a). Nevertheless, in September the lira left the EMS. Writing in 1994, Amato admitted that the EU heads of government were simply unaware of the magnitude of speculation in financial markets. The governments hoped to maintain the existing exchange rate policies until the French referendum in late September, since the French were worried that any policy change would be perceived as a sign of weakness and would be detrimental to the “yes” vote. He recalled a secret meeting with French Prime Minister Pierre Bérégovoy, during which Amato warned that Italy would most likely be unable to hold on until the September 20 French referendum date: The role [national pride] played during the currency crisis was due to a very specific set of circumstances: a long period of currency stability had led government to identify their national pride . . . with a certain parity. (Amato 1994)

After a tumultuous summer of defending the lira against market attacks at the cost of approximately $6 billion per day, this hubris was no longer sustainable. Between the start of June and September 11, the lira fell by 1.6 percent against the mark, having reached the lower limit of its fluctuation band in August. On September 4, the discount rate was raised to 15 percent, and the three-month interbank rate rose by 7.7 percent, exceeding 20 percent by September 11 (Banca d’Italia). Finally, on September 13 the lira devalued alone; the other EMS currencies (most notably Britain) refused to participate in a general realignment. The Bundesbank made minor interest rate cuts in exchange, but this was not enough. Days later, the lira and the British pound withdrew from the ERM. Exporters were relieved, but the rest of the nation viewed this as a symbol of the country’s weakness. This time officials could not hide

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behind claims of devaluation for the sake of European solidarity; devaluation and exit from the EMS now potentially jeopardized Italy’s bid for membership in monetary union. To add to the political quagmire, on September 30 the entire regional government was arrested in Abruzzo for fraud regarding the EU’s regional aid fund. The September 17 issue of L’Expresso asked “Can the men who destroyed the lira ever resuscitate Italy?” Municipal elections took place in December, and the traditional parties felt the wrath of voters as the League pocketed almost 40 percent of the votes in the north (Gilbert 1995: 133). After Amato’s resignation in 1993, the thought of a premiere that was in any way tainted by scandal was unthinkable. Hence, Banca d’Italia Governor Carlo Ciampi was the first non-parliamentarian to be appointed prime minister in Italy’s history. He was allowed to assemble his cabinet without the usual deal-cutting with the other parties, and he formed a cabinet of technocrats and experts (though the new administration was still based on the same four parties). He also included members of the PDS, all university professors, symbolizing the nonfactional character of his government. After the murder of Gianfranco Falcone, a leading figure in the fight against government corruption and Mafia infiltration of the government, magistrates and Banca d’Italia economists enjoyed newfound status as the proponents of change: the first group fought the Mafia, the second group those who would speculate against the lira (McCarthy 1993a). Italian President Scalfaro dissolved parliament in January, with elections slated for March 27. DC party leader Martinazzoli announced that the DC would run under the name of Partito Popolare Italiano (PPI): the old DC was dead. The Communists were dead. It was a new political era. In summary, the events that led to the 1992 devaluation and the collapse of the Italian party system were partially related to elections. Irresponsible fiscal spending and the questionable ability to meet the Maastricht Treaty’s entry requirements were the primary factors behind the crisis. The timing of the crisis can be attributed to a combination of factors, including uncertain election results, the Danish referendum, and the inability to form a government for several months. A Europeaninduced currency crisis had taken shape in Italy. 1994: The First Post-DC Era Election Media mogul Silvio Berlusconi began his own party during this period, the Forza Italia. A longtime friend of former Socialist Prime Minister Bettino Craxi, Berlusconi saw that the existing political order, which had benefited his conglomerate, was in danger. He sought to protect his

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interests from the encroaching power of the PDS, and therefore he crafted an alliance with several other parties, including the League and the former MSI’s new party, Alleanza Nazionale (AN). The left found itself in the strange position of defenders of the status quo as Berlusconi used his media savvy to launch a seductive campaign, complete with sound bites and full media coverage. The electorate viewed the left as opposing change and the right as the reformers (Gilbert 1995). Political instability exacerbated the weak lira both before and after the elections (Scobie et al. 1996). Though early polls predicted a left victory, during the last two weeks of the campaign the right made important inroads and managed a stunning upset victory. Polo della liberta (Liberty Pole, Berlusconi’s set of alliances) won a large majority, and Forza Italia became the largest party in Italy. However, the Berlusconi alliance was short-lived; questionable democratic credentials and a weak alliance led to political infighting that resulted in the eventual appointment of yet another “expert” government. The coalition had been together for only a few months when the League first began to threaten mutiny over pension reforms, and the lira plummeted. The League had tabled a no-confidence vote in December as more questions arose about Berlusconi’s media holdings and possible conflicts of interest in his new political career. Forza Italia representatives requested that the party be allowed to govern as a minority until elections could be held. Its opponents (The League, PPI, and PDS) requested that President Scalfaro appoint a technocratic government that would enact laws to restore market confidence in the Italian economy and push through reforms on electoral laws and antitrust laws concerning the media (the latter aimed at diminishing Berlusconi’s inordinate power). During this time the lira weakened as a result of the political uncertainty surrounding the collapse of the Berlusconi government. Scalfaro appointed Treasury Minister Lamberto Dini as head of the new government in January 1995. He was a senior official at the Banca d’Italia before becoming involved with Forza Italia and subsequently becoming a member of government. Dini appointed a new government composed entirely of non-parliamentarians. The precarious situation of the government did not sit well with markets, and by February the lira fell to historic lows against all major currencies except the dollar and sterling. The Banca d’Italia was forced to raise the discount rate by 0.75 percent to support the currency. The government’s budget had yet to be announced, and newly released reports on rising inflation along with the weak political support for the technocratic government contributed to the lira’s plight. The devaluation

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of the Mexican peso4 added to the currency instability that reverberated throughout Europe in anticipation of the upcoming French presidential elections. Monetary politics in Italy now resembled French monetary politics in that its currency had become vulnerable to domestic political developments as well as event in the international economy. Conclusion Econometric tests indicate that the Italian lira was not credible when it was devalued in 1992. What is surprising is that such tests reveal that markets had viewed the Italian bands with skepticism since 1990, the year that the lira entered the small fluctuation band (Belessakos and Papioannou 1996). Why was the lira able to survive two years before it was forced to devalue (and then abandon the exchange rate peg altogether)? The answer once again points to the nexus between political and exchange rate instability and how political developments can undermine market credibility. The lira and other overvalued currencies were able to survive for this long without realignment because the government’s commitment to the exchange rate was credible. Once markets no longer believed in the viability of the Maastricht Treaty, speculation became rampant. This, not partisanship, was the primary determinant of market credibility in the early 1990s. The economic shocks that led to this crisis in confidence—German unification in particular—occurred over two years prior to the crisis, leading to incompatible fiscal and monetary policies within the EU. What precipitated the crisis was a referendum on the Maastricht Treaty in Denmark. This election cast doubt on popular support for monetary union and the policies needed to achieve it. Generally, as the electorate registers its favor or disfavor with the current government and its economic policies, future economic policy is uncertain. This can lead to political business cycles and currency speculation, as happened to France during 1992–1993 due to its Maastricht Treaty referendum and legislative elections. The fallout of the referenda held in Denmark and France incited currency instability in other EMS countries, including Italy. Yet speculation due to political instability did not happen in Italy until 1994. The reason for the delay lies in the lack of effective competition in the Italian party system, which made elections irrelevant when it came to predicting policy. The same parties governed Italy from 1945 until 1994, with the DC as the centerpiece of each ruling coalition. Changes in policy were not based on elections or partisanship. The party

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of the prime minister, which changed for the first time in the postwar era in the 1980s (first with a Republican prime minister and later a Socialist), did not noticeably affect when moves toward austerity took place, or when the government reverted to inflationary policies. Elections did not provoke market speculation because they indicated neither party change (the same parties always governed) nor policy change (since the exchange rate was not a point of contention between potential government). Devaluations were neither electorally motivated nor instigated by markets as a result of policy uncertainty; on the contrary, they were often undertaken as part of a general realignment at the request of the other EMS members. When the lira devalued, it was generally done in relation to the French political business cycle and without controversy. For Italy, the partisan element never played an important role in determining exchange rate expectations because continuity had marked Italian politics. However, European monetary integration gradually became a factor in the credibility of the government to uphold the value of the lira. While Italy’s commitment to European integration was not in question, its ability to reach the goals set out by the Maastricht Treaty was. This was a major source of its instability following the tenuous results of the 1992 elections. Although the old coalition had won, it was by a very slim margin, making its ability to institute the tough policies required by the Maastricht Treaty uncertain. It was not until 1994, with the destruction of the old guard, that the exchange rate instability and elections became connected. The lira fluctuated due to market speculation5 during this politically uncertain period. It was the first election of the new era, complete with new parties and the possibility of new policies. With the prospect of government change and accompanying policy change, Italy had become vulnerable to politically induced currency crises.

CHAPTER 7

Ireland

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he Irish case presents many of the same challenges to electoralbased theories of currency crises as Italy. In both countries, government coalitions typically defy partisan labels, making partisan theories of currency crises irrelevant. In addition, both countries often find themselves at the receiving end of devaluation requests from larger countries like France. Moreover, Ireland’s small size makes its economy even more vulnerable to external constraints and the fluctuation of larger currencies than the Italian or French currencies. However, elections and changes in government still provide some insight into the timing of currency crises and devaluation despite these mitigating factors. Figure 7.1 shows that Irish devaluations cluster around election dates, separated by only a few months, and two-thirds of the devaluations occur after an election. Does this mean that currency crises followed similar economic and political patterns in Ireland as they did in France? Or in Italy? In some cases they do, though significant differences exist.

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This chapter examines the salient differences between Ireland and its larger counterparts, Italy and France, in terms of party systems, left–right cleavages, economic size and openness, and, finally, the political economy of currency crises and realignments. Although open economies are more vulnerable to external shocks that can impact the exchange rate, political calculations still enter into devaluation decisions; when devaluation can be politically contentious, even small countries can delay currency realignment. The Irish Party System Irish elections were competitive in the sense that there was the possibility for alternation in government with each election (Mair 1987). No party was so dominant that it monopolized government in the way that the Christian Democrats consistently dominated politics in Italy. Though the Fianna Fail Party enjoyed a period of dominant status in the years prior to 1977, this changed in 1993 when (for the first time) it was forced to form a coalition government. Therefore the Irish system can be characterized as a two-and-a-half party system (Lijphart 1984) or one of moderate pluralism (Sartori 1976). Since government change is possible, so is a currency crisis based on electoral cycles. The key issue then becomes the extent to which the elections mattered for the conduct of monetary and exchange rate policy. The traditional divisions within the Irish political system complicated this issue. In Ireland, the major cleavage was not socioeconomic but rather nationalist. The two largest parties, the Fianna Fail and the Fine Gael, were both right-of-center. Their primary difference had been the degree to which they support Irish autonomy from Britain, with the Fianna Fail being the more militant party and the Fine Gael more accommodating. The two major parties had been described as “nonprogrammatic [as the party system] lack(s) . . . a substantial left-right cleavage” (Sinnot 1987: 61–2). They are both essentially catchall parties. In the late 1980s, the Progressive Democrats (a breakaway faction of Fianna Fail) joined these parties of the right. There are several parties of the left, but they have only recently made significant electoral strides. The Labour Party had often been a coalition partner in government with the Fine Gael, but economic policy always bore the Fine Gael stamp. The Workers’ Party (formerly Sinn Fein Workers’ Party) also represented workers’ interests, but their share of seats in the Dail was too small to affect policy. In summary, while the potential for currency crises based on changing or uncertain political expectations existed, the threat was minimal given

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the dominance of center–right parties in the Irish political systems. Currency crises were more likely to be driven either by economic fundamentals from other currencies such as the French franc or British pound. This did not, however, remove politics from the equation, for the 1993 devaluation indicated political calculations when the government delayed devaluation until after a new government had formed following the November 1992 election. The Irish Economy and the EMS Ireland is one of the smallest countries in the EU, and it has historically been highly dependent on trade with Britain, which remained its largest single trading partner throughout the EMS period (although Irish trade with EU countries has risen considerably since 1979). The decision for Ireland to join the EMS was not without controversy, since the Irish punt had traded at 1 : 1 parity with the British pound since 1928, and ERM membership meant severing this link and making the D-mark its new anchor. However, membership provided the punt with greater exchange rate stability as well as the opportunity to reduce Irish inflation through its peg to the German mark. As a small, open economy, Ireland would have a strong interest in exchange rate stability so as to protect wages and prices from excessive currency-related fluctuations. Open economies like Ireland favor fixed exchange rates because of the greater susceptibility of domestic wages and prices to nominal exchange rate variations (McKinnon 1996). The case for fixed exchange rates is even more compelling if the economy is also small (Mundell 1961); shocks quickly affect the domestic economy, so limiting exchange rate fluctuations helps to insulate the economy from volatility. Experts at Central Bank of Ireland were early proponents of Germany’s competitive disinflation strategy, believing that by pegging the punt to a low-inflation currency such as the D-mark, Ireland would import monetary discipline, leading to lower inflation rates and lower interest rates (Dornbusch 1988; Weber 1992). While a period of adjustment was expected, it was predicted to be short-lived. Britain had suffered from substantially higher inflation rates than other countries in the EC in the 1970s, transmitting price instability to Ireland. When Ireland’s Central Bank Governor was asked how much Irish monetary policy would really change as a result of the ERM, he responded “not very much” (O’Donnell 1991: 78), because Ireland would still peg its exchange rate. Under the new system, however, the currency would be

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tied to a low-inflation currency, which would eventually improve the credibility of Irish monetary policy. A credible monetary policy would allow Irish interest rates to fall, a considerable benefit when considering Ireland’s significant debt burden. Ireland’s dependence on imports also made exchange rate stability of paramount importance (McAleese and Hayes 1995). Finally, the EMS was one of the most significant EC initiatives that had been launched in years, and Ireland wanted to be a part of it, in keeping with its longstanding desire for closer cooperation with countries on the continent. Ireland received side payments in exchange for its participation in order to alleviate the adjustment costs. Furthermore, both Ireland and Italy were given interest subsidies that amounted to tens of millions of ECUs a year, helping assuage fears of EMS skeptics (Ludlow 1982). As European integration progressed, the Irish government never wavered in its commitment to the process, despite the reluctance of the British government. Ireland enjoyed lower inflation and greater currency stability as a result of EMS membership. When plans for the Maastricht Treaty were unveiled, the Irish government passed a national referendum on the issue on its first attempt, unlike the controversy that surrounded Denmark and France.1 The following sections illustrate the commitment of Ireland to the EMS over the years, as successive governments never faltered in their support for the EMS and the integration process. Irish elections did not instigate currency crises borne out of political uncertainty; instead, devaluations arose from adverse economic conditions and pressure from other EMS currencies. However, in 1992 Ireland did suffer from an externally induced crisis that occurred during an electoral cycle. As we had seen in the cases of France and Italy, Ireland’s government held off devaluation until after the election had passed and a new government had formed. Irish Elections and Devaluations, 1979–1983 Three elections occurred over this short period, as Irish parties struggled to attain an electoral mandate to impose their policies on a nation with a faltering economy. The campaigns focused on the need to impose austerity on the economy and on the Northern Ireland question. These elections did not produce currency instability, and it was only in March 1983 that the government devalued the currency, and this was due to the general realignment that took place at the request of the French. Fianna Fail leader Charles Haughey initially promoted austerity policies when he took over the party in 1979. He never implemented

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these ideas, however, and a year later he advocated greater expansion as the inflation rate, unemployment, and public sector borrowing requirement rose (O’Malley 1987: 32–4). This backpedaling by the government hurt its credibility during the June 1981 elections—it switched from promoting austerity in 1979 to expansion in 1980 and then austerity in 1981. The parties focused on the economy and Northern Ireland, and the two major parties, the Fianna Fail and the Fine Gael, presented voters with varying measures of austerity. The Fianna Fail sharply criticized Fine Gael’s economic program for being too austere, but in fact it was remarkably similar to the program that the Fianna Fail had supported in early 1981. Polls indicated that the outcome would be very difficult to predict (Farrell 1987: 14; O’Malley 1987: 32–4). In the end, a Fine Gael–Labour coalition prevailed with a knife-edge majority. Fine Gael had a very good showing, while the election was a disaster for both the Labour Party and the Fianna Fail. The coalition took charge of an ailing economy with high interest rates (a discount rate of over 16 percent), double-digit inflation, low growth (half of 1 percent in 1980), a worsening current account deficit, and an unemployment rate of 13 percent. Yet the exchange rate showed no sign of instability and remained steady throughout the electoral period, despite the economic turmoil. Finance Minister John Bruton presented an emergency budget package on July 21, which included increased charges on services (such as postal, electricity, phone), and an increase in excise taxes. Rumors persisted that the Dail would be dissolved early so that the coalition could seek a clear mandate for its austerity package. On January 27, 1982 Bruton introduced his budget package for the upcoming year, which included measures that would increase taxes and cut expenditures. The budget was defeated 82 to 81, the Dail was dissolved, and a new election date for February 18, 1982 was set. Taoiseach Garrett FitzGerald (the prime minister) defended the budget as it was. Though Haughey criticized the coalition’s economic strategy, the alternative budget that he constructed committed the government to similar borrowing and budget deficit targets as the ruling coalition. Nevertheless, the FitzGerald government had proposed one of the harshest budgets in Ireland’s history, and it was the kind of tough medicine that the economy needed. Ireland suffered from a budget deficit that was 17 percent of GDP, the highest in the EC. Foreign debt remained at high levels, and inflation continued unabated at 23 percent. The Irish pound, which was at parity with the British pound prior to its entry into the EMS, was now valued at only 81 pence. This worsened

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the inflation figures, especially given the large number of British imports that come into Ireland. According to the polls, once again the race would be very close (Farrell 1987: 8). The Fine Gael–Labour coalition and the Fianna Fail ran neck to neck, but FitzGerald’s popularity was estimated as 10–20 points higher than Haughey’s, having risen since the previous summer (O’Malley 1987: 43). An Irish Times poll on February 16 showed a surge in the Fianna Fail’s popularity after it released its new budget proposal, which was a softer version than the one being offered previously. Moreover, cracks were showing in the governing coalition as Labour registered deep misgivings on the severity of the budget proposals, indicating that it may not enter government with the Fine Gael again. Although the Fine Gael’s share of the vote rose by 8 percent, the party lost seats. The Fianna Fail won an additional three seats in the Dail, and although it did not achieve a majority, the tacit support of the Sinn Fein Workers’ Party allowed it to form a government three weeks after the election. Once again, despite the continuing economic crisis and the weakening punt–sterling rate, no mention was made of devaluation by any of the parties, and no currency crisis emerged. The competing parties, both right-of-center, offered similar cures for the nation’s economic woes. The November election was precipitated by a leadership crisis within the Fianna Fail as Charles Haughey narrowly escaped a no-confidence vote within his own party.2 The Fine Gael took advantage of Haughey’s weakness and put down a no-confidence motion in the Dail, following the rejection of his proposals for cuts in health services by the left-wing Workers’ Party that had been supporting his minority government. This necessitated another election, the third in two years. This election was a virtual replay of the previous two elections in which government finances were the key issue. The Fianna Fail actually trailed Fine Gael in the early opinion polls, despite the scant difference in their proposed economic policies. In any case, polls showed that, by this time, Irish voters had accepted the necessity of austerity. The campaign was fought at the local level rather than the national level as the TDs (Members of Parliament) concentrated on winning over the electorate one constituency at a time (O’Malley 1987: 46). As the campaign progressed, the only certainty was that none of the parties would be able to achieve a majority (Beamish 1983: 274). In a poll from October 22 (just prior to the dissolution of the Dail), the Fine Gael scored an all-time high approval rating of 41 percent, while the Fianna Fail polled its lowest since 1979 with 43 percent. Opinion polls taken later during the campaign showed no significant departure from

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this early trend, with Fianna Fail trailing the Fine Gael–Labour coalition by 6–8 points (O’Malley 1987: 45). The final election resulted in a Fine Gael–Labour coalition. Shortly after the elections were concluded, the punt came under pressure, not because of the Irish elections but as a result of the instability surrounding the outcome of elections in France and Germany in March 1983. When the French requested the first general realignment of the system (in which the central rates of all the currencies were altered), Ireland readily acquiesced. Economic Conditions and the Timing of Devaluation Ireland suffered from poor economic fundamentals during the entire period studied thus far. Since the inception of the EMS in 1979, the inflation rate had been in the double-digits, ranging from 12 percent to slightly over 20, eroding the punt’s competitiveness. The current account was consistently in deficit. Figure 7.2 shows that the current account was in its worst condition in 1981, yet the government did not devalue until 1983. After 1981 the current account gradually improved until it finally reached an annual surplus in 1988. Because of the vulnerability of the Irish economy to currency fluctuations, devaluations were not an option for restoring competitiveness to the economy since the devaluation’s effects would be transmitted to wages and prices relatively quickly. Figure 7.3 shows the exchange rate movements of the Irish punt from 1979 (the inception of the EMS) until the 1983 realignment, using

0 1

2

3

4

5

–0.02

–0.04

–0.06 –0.08

–0.1 1 = 1979, 2 = 1980, etc. Figure 7.2

Annual current account balance as percentage of GDP, 1979–1983

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0.694

0.689

0.684

0.679

0.674

0.669

Figure 7.3

3 -8

2

2

-8

ar M

Au g

1

-8 Ja n

-8

80 ov -

Ju n

0 N

79

r-8 Ap

pSe

D

at

e

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Exchange rates and elections in Ireland, 1979–1983

data taken at the end of each month. This figure indicates that Ireland’s exchange rate woes actually began in October 1980. The weakening of the punt coincided with the strengthening of the British pound, a petrocurrency that benefited from oil from the North Sea, while the rest of Europe suffered from high import prices. Ireland’s dependence on British markets exacerbated its problems by making British imports more expensive and by aggravating its already high inflation rate. There was no significant rise in instability during electoral periods, though Ireland found itself in a steady state of economic crisis. Despite uncertainty surrounding the elections, the competing parties offered similar policy programs, which could account for the lack of exchange rate speculation. The devaluation overlapped with a weakening of the British pound against the mark, making Irish exports less competitive. This, combined with the French desire for a general realignment, made this time period particularly opportune. The 1987 Election In June 1986, defections from both parties forced the Fine Gael–Labour coalition into minority government status. Internal fighting between the

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parties weakened the coalition further as the battle over the 1987 budget ran along party lines. By January 20, 1987, Labour withdrew from the government in protest of proposed expenditure cuts in the new budget, and the Fine Gael had to dissolve the Dail. Part of the government’s problems rested with a recession that continued to pound the Irish economy. The current account was constantly in deficit, the national debt comprised 150 percent of GNP, and unemployment stood at 20 percent. Unfortunately, the major parties offered no new solutions to Ireland’s problems. The Fianna Fail merely argued that Ireland needed a strong, unified party to govern, while the Fine Gael stood by the budget it had proposed in January and asked for a mandate to implement it. Meanwhile, the Labour Party and the Workers’ Party both argued for greater state intervention in the economy. These parties also advocated increased state employment and a wider tax base (Farrell and Farrell 1987). Initial polls showed that the Fine Gael enjoyed only weak support, and that the Fianna Fail would win a comfortable majority (Farrell and Farrell 1987: 237). Shortly before the election, polls showed a satisfaction rate of 43 percent with Fianna Fail’s Charles Haughey and only 36 percent for Fine Gael’s Garret FitzGerald. Even worse news for the Fine Gael was that support for its leader exceeded support for the party, which had only 24 percent of the intended vote. Likewise, Irish Times/Market Research Bureau of Ireland (MRBI) polls indicated that although the Progressive Democrats’ Desmond O’Malley had 53 percent of the public support, the Progressive Democrats had only 14 percent of the intended vote. Twenty percent of the electorate was still undecided. The indecision was understandable in light of the lack of policy alternatives being offered by the competing parties. The Fine Gael’s manifesto promoted reduced public spending and borrowing, privatization, and tax reform. Likewise, the Fianna Fail produced a manifesto that also contained public expenditure cuts and tax reform, but also made vague references to the need to “go for the growth” without specifying what this meant or how this growth would be financed. Similarly, the Progressive Democrats, formed in 1985 by disgruntled members of the Fianna Fail, promoted unabashedly conservative priorities, advocating fiscal austerity, reduced taxes, privatization, and reduced public spending. Although an offshoot of the Fianna Fail, they were an even bigger threat to Fine Gael; studies showed that most of the Progressive Democrats’ support came from former Fine Gael voters (Mair 1987: 240). Despite leader Desmond O’Malley’s claim that there was “no great divide between the right and left”3 in Ireland, the Fianna Fail seemed

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to take a middle-ground position as the Fine Gael and Progressive Democrats leaned more to the right (O’Leary 1987). None of the major parties could declare victory in the election; the Fianna Fail won a plurality but not a majority, its worst result since 1961. The Fine Gael’s vote dropped to record lows, as did the Labour Party’s. The Progressive Democrats, however, won an impressive 11.9 percent in its first electoral outing. A Fine Gael–Labour coalition would have been 20 seats shy of a majority, so the Fianna Fail took power. On March 10, Charles Haughey once again became Taoiseach. Later that month he presented a budget that was even more austere than his predecessors’. There was popular support for such action now, as the public sought to remedy the long-running recession by whatever means necessary. The 1987 Elections and the Exchange Rate By the time the February elections took place, the punt had been devalued twice more. In April 1986, the EMS underwent another general realignment at the request of the French, following the French legislative elections in March. The Irish delegation had requested a small devaluation of the punt at this time4 due to sterling’s instability. However, rather than accede to the request, the partners decided to leave the punt’s central rate unchanged for the time being. In August 1986, the Irish punt surprised markets when it devalued alone, with the fall of sterling precipitating the devaluation. By this time the punt had lost 40 percent of its competitiveness against the EMS currencies since 1986, and the realignments that had occurred did not fully account for price and wage differentials between the countries. Monetary policy was geared more toward the interests of the major countries such as Germany than toward the smaller countries like Ireland (McAleese and Hayes 1995). Ireland and its small-country counterparts (Belgium and Denmark) all joined the Netherlands in the “mark zone” during this time period of 1985–1986 in which their respective governments formed monetary policy in order to reduce inflation differentials with West Germany (Riché and Wyplosz 1993). This commitment to reducing inflation via an external currency anchor (the D-mark) served as an important precursor to plans for Economic and Monetary Union (EMU), which would require further commitments to externally designated monetary and fiscal targets. Despite the August 1986 devaluation, the Irish economy had not improved substantially in time for the election. The country remained deeply in debt, unemployment stood at 19 percent, and real interest

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rates were at 10 percent. In addition, the punt was still overvalued against its main trading partners (Britain and the United States), exacerbating the decline in exports. The fall of the dollar made Irish products less competitive in America, and the D-mark’s subsequent rise5 dragged the EMS currencies (like the punt) upward as well, causing the punt to revalue almost 20 percent against Britain. Still, no moves were made toward yet another formal devaluation so soon after the last one, though another general realignment occurred. The revaluation of other currencies averted the need for Ireland to devalue its own central rate, amounting to a de facto Irish devaluation. Once again, the exchange rate instability did not result from uncertainty surrounding Irish elections. The 1989 Election Since the 1987 elections, Haughey had injected a startling amount of economic austerity into the government, and the opposition (Fine Gael) supported him on every major piece of economic legislation. These policies soon produced results as the deficit fell along with inflation, allowing interest rates to drop below Britain’s. Haughey called a snap election for June 1989 in order to give the Fianna Fail a majority. However, he miscalculated the strength of the popularity of the Fianna Fail against the electorate’s annoyance at being called to the polls again; the Fianna Fail lost four seats in the Dail and had to enter a coalition with the Progressive Democrats. 1987 and 1989 Elections: The Economic Conditions Economic conditions in Ireland during the 1987 and 1989 elections did not indicate the need to devalue for the sake of the domestic economy. Though the Irish current account was in deficit in 1987 and 1989, the situation was improving, and inflation remained low. Currency pressure and devaluation decisions resulted from developments in the ERM countries and in Britain, not from changes in economic or political conditions in Ireland. Ireland’s nonparticipation in the general realignment in April 1986 was more the decision of the other EMS countries than of the Irish government. The punt had been under pressure due to the weakening of the pound, but the Irish government’s request for devaluation went unheeded. It was not until January 1987 that the punt received a de facto devaluation through the revaluation of the D-mark. But neither

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-3 87

-2 87

-1 87

86

86

Figure 7.4

-4

400 300 200 100 0 –100 –200 –300 –400 –500 -3

Millions of US$

152

Quarterly current account balance, 1987 electoral period

Millions of US$

400 200 0 –200 –400

Figure 7.5

-4 89

-3 89

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-1 89

88

-4

–600

Quarterly current account balance, 1989 electoral period

the failure to devalue the punt in 1986 nor its effective devaluation of 1987 played a role in the 1987 elections (see figures 7.4 and 7.5). By 1989 the punt’s fluctuations had evened out substantially as its economic fundamentals (and, some would argue, the credibility of the EMS) improved. Sterling was comparatively volatile, but nothing on the order of magnitude as in 1986. Improved economic conditions combined with the lackluster campaign and the lack of alternative policies that would affect the exchange rate offered no impetus for currency crises based on electoral cycles. Furthermore, the prospects for British participation in the EMS were mounting, which was good news for the punt. Irish elections continued to play a negligible role in exchange rate politics, though this situation changed in 1992. The 1992 Currency Crisis: Externally Induced Crisis, Politically Timed Devaluation The story of the 1992 currency crisis is familiar to many, at least as far as the major players (Germany, Britain, France, and Italy) are

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concerned. The story of Ireland has not been studied in as much depth, but it reveals some important insights in the making of Irish monetary policy and the behavior of small countries versus large countries during currency crises. In mid-1992, Ireland’s economic fundamentals were improving, which was reflected in its low interest rate differential with Germany. In the first half of 1992, Irish interest rates were moving downward and its external reserves were growing. Inflation had lowered, the fiscal deficit had improved, the debt/GNP ratio was healthier, and its current account was in surplus. However, unemployment remained high at 18 percent (OECD 1993). Pressure on the punt coincided with pressure on the pound during summer and fall 2002. The government hiked the Short-Term Facility (STF) rate (the interest rate at which the central bank supplies liquidity to the banking system) a quarter of a percentage point on August 21. Less than a month later, the British pound withdrew from the ERM, intensifying pressure on the punt as speculators continued their onslaught against the remaining ERM currencies. On September 24, the Irish central bank imposed currency controls,6 and on September 28 it raised the STF another 3 points to 13.75 (OECD 1993). The Fianna Fail government called for a general election, scheduled for November 25, in order to gain a clear majority and to govern alone. As the election approached, the punt weakened due to the instability of sterling. Although external indicators show that the attack on the Irish economy should have been avoidable (Giovannini 1993), the uncertain future of monetary union made currencies both in and out of the ERM vulnerable to speculation. But the Irish government fought off attacks on the punt, and its ERM partners supported this decision. When the Spanish peseta and the Portuguese escudo were devalued on November 23, German Secretary of State Kohler did not ask for a devaluation of the punt in order to spare the Irish government from political embarrassment so soon before the general elections being held on November 25. The announcement that the punt would not devalue alongside the peseta and escudo led to further exchange market pressure. In order to defend the rate, the central bank both raised its overnight advance-lending rate to 30 percent in its defense7 and suspended liquidity under the STF (OECD 1993). The significance of Ireland’s defense of the punt should not be neglected in the mayhem surrounding these crises. Ireland had the opportunity to participate in a broader realignment but did not accept it. When presented with a similar opportunity in 1983 the government

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readily seized it, but this realignment occurred after the general elections were out of the way. Moreover, the German government reportedly did not pressure the Irish because of the political sensitivity of devaluations so soon before elections. This indicates the importance of electoral cycles and devaluation for countries of any size. Despite the constraints put on Ireland’s monetary policy due to its small size, limited resources, and trade openness, it did not fully abdicate responsibility for its monetary policy. The unacceptability of devaluation before an election, not only to the Irish government but also to its EMS partners, reveals the political significance of devaluation. Though the crisis owed more to developments in Europe than within Ireland, the Irish government still resisted devaluation. It was not surprising that the punt suffered as a result of instability generated by larger countries (Britain and German). What was surprising was Ireland’s ability to respond to this instability in a similar fashion to its larger counterparts. Just as France undertook measures in 1981, 1983, 1986, and 1993 to sustain the exchange rate before elections, Ireland defended the punt until a new government could take office. This indicates that devaluation decisions and electoral calculations affect both large and small economies. The logic is not identical, and the constraints faced by the latter are real, but smaller economies like Ireland still face similar incentives not to devalue before an election, and larger countries respect the constraints posed by elections. As an editorial in the Irish Times argued, “It was the duty of a sovereign government to defend its currency as it would its national territory.”8 The Irish central bank made a similar analysis in its review of the exchange rate crisis, noting that political factors played an important role in the development of events (Central Bank of Ireland 1993). When the currency crisis began in September, the government was steadfast in its determination not to devalue. In January, exchange rate pressure renewed as the French franc, Danish krone, and Irish punt all came under attack. The relevant factors included the change of government in Denmark, the upcoming legislative elections in France, and the reduction of British minimum lending rates. To ease pressure on ailing businesses, the recently formed Irish government (a Fianna Fail–Labour coalition) enacted a special fund, allowing companies to receive loans at precrisis interest rates.9 Despite substantial intervention from the Irish central bank in the punt’s defense (Leddin and O’Leary 1995), on January 30 the government succumbed to market pressure and devalued. Foreign Minister Dick Spring bitterly accused the other member states of failing to cooperate more during the crisis, and Finance

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Minister Bertie Ahern complained, After months of hard struggling, calls to the EC and reluctance to devalue, the government has been compelled to observe that the community in spirit has been replaced by bilateral agreements between Germany and France, which have been advantageous to Paris but detrimental to the Irish Punt.10

Ahern repeated the British government’s accusation that the EMS needed to be reformed because it favored the Franco-German alliance.11 In this view, the Germans gave the French special consideration during the speculative attacks of 1992 that allowed the French not to devalue, whereas other currencies were left to fend for themselves and suffer devaluations that could jeopardize their participation in monetary union. Despite the recriminations against France and Germany, Ireland was able to sustain its exchange rate parity prior to its election. Had the Germans insisted on devaluation when the Iberian currencies were being devalued, Ireland would have probably been unable to put up much of a fight. Although the partners did not help each other equally, Germany did live up to its obligation to defend the weaker currencies at the margins, and the punt was permitted to retain its parity until after the election had safely passed. Conclusion Given Ireland’s small size and the openness of its economy, it is difficult to make a strong case for the existence of currency crises based on domestic political instability. Though several of its devaluations took place in close proximity to election dates, these devaluations were more the result of pressure from its trade partners and contagion effects from concurrent elections elsewhere in Europe than from partisan differences or uncertainty regarding domestic policies. Nevertheless, the Irish case still demonstrates the significance of theories of currency crises and devaluation based on politics, even for small open economies. Exchange rate instability can spread from country to country, and Ireland periodically suffered from the effects of electoral cycles in other countries (like France) and experienced exchange rate instability as a result. In 1983 and 1986, the timing of Irish devaluations was motivated by the needs and wishes of its European partners. In 1983, Ireland participated in the first EMS general realignment at the request of France and Germany

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following elections in both countries. In 1986, Ireland was forced to hold off devaluation during the general realignment that took place in April after a French election, despite requests for a small devaluation by the Irish delegation. Ireland’s 1993 devaluation could easily have been the 1992 devaluation were it not for the November elections in Ireland. The devaluation resulted from the 1992 crisis that was precipitated by the Danish referendum on the Maastricht Treaty. The negative result of this referendum called into question the future of monetary union and therefore the viability of the monetary and fiscal policies being pursued in Europe at this time. The punt came under pressure following the withdrawal of the pound from the EMS, and it could have devalued along with the Iberian currencies in November 1992, shortly before the Irish Dail elections. Instead, Ireland (with the tacit approval of Germany) chose to continue to battle speculators. For the first time, the exchange rate had the potential to be an electorally contentious issue; if the punt were devalued, the government would be vulnerable to accusations that it had jeopardized the nation’s future in Europe. The strong desire of the Irish to participate in EMU made devaluing so soon before the election unthinkable, even for a small economy that was usually forced to devalue by other countries. Though theories of electoral cycles and the timing of devaluation apply to Ireland, partisan theories do not. The differences in policy between left and right governments that characterized the French economy during the early period of the EMS never existed in Ireland. The size and openness of the economy, combined with a party system that provided little choice in terms of the left–right spectrum, meant that external (and in particular the European) economic and political developments often were more important to Ireland than domestic political developments, at least when it came to exchange rate decisions. The convergence in French economic policy among the major political parties during the mid-1980s brought France to a point similar to where Ireland had been all along: major parties’ economic credibility became predicated on their willingness and ability to fulfill their European commitments. Italy and Ireland in Comparative Perspective Italy and Ireland differ in many respects, such as in their respective size, political stature within the EU, and party systems. Despite these differences, they share a similar history in the EMS that has been characterized by most of their exchange rate devaluations being instigated by

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other countries, and their credibility being based on the political and economic strength of their European commitments. Italy and Ireland had sought greater credibility from the EMS. They were both strong supporters of the EMS since it began in 1979, and they readily acquiesced when their EMS partners requested that they devalue along with other currencies. This dedication to the EMS meant that the exchange rate per se was not relevant during elections. All the parties involved supported exchange rate stability and monetary integration. In Italy, uncertainty over the future of the Italian political system following the demise of the old parties led to currency instability, despite Italy’s commitment to monetary union. In both Italy and Ireland, instability from other countries spread to their respective economies. When this occurred during Ireland’s electoral cycle, however, the Irish government fought against the speculation until after the election was safely out of the way. Theories of political business cycles were of limited use in explaining the emergence of many crises in Italy and Ireland, but such theories offer insight into how governments respond to these crises. Opportunistic devaluation before elections was a nonissue in both these cases. Moreover, the significance of partisan labels is questionable in the highly integrated European economy where economic policy was often dictated by external events as much as (and sometimes more than) internal needs. Yet even in post-Maastricht Europe, a political theory of devaluation could predict government behavior. The emergence of currency crises and how governments deal with them still conform to a political logic in which markets exacerbate political instability with currency speculation, and governments try to reinstate stability, at least until the election.

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CHAPTER 8

Conclusion

The Argument

E

uropean monetary integration has been a search for market credibility through various means: first, through international cooperation in the shape of the pooling of resources in the EMS; second, through the emulation of the successful German model; and finally, through economic and monetary union. By analyzing the history of European monetary integration, we can better understand why states commit to international agreements, why they choose some mechanisms over others, and the circumstances under which these commitments are threatened. These domestic and international means of improving credibility tried to regularize market expectations of government actions. Governments generally lack credibility because they can renege on international agreements with few repercussions. International institutions are seen as a possible solution to the commitment problem, and as international institutions proliferate and become more powerful, they will wield greater influence and provide additional incentives for cooperation as well as the means to punish transgressors (Keohane 1984, 1989). The Maastricht Treaty compelled participants of monetary union to reduce inflation and budgetary deficits for the sake of membership and offered clear incentives and rewards for fulfilling its convergence criteria. EMU combined the idea of mutual adjustment with the emphasis on price stability to bind together both stronger and weaker currency states under the same system. The quest for credibility via international and domestic institutions has regularly been threatened, however, by elections and political

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business cycles, which can jeopardize international cooperation because of the risk they present to a government’s incentives to abide by old agreements. They pose regular threats to international cooperation and credibility by creating the potential for a new government with different policy priorities to take power. The possibility of involuntary defection (Putnam 1988) by governments can manifest at any time, not just when an agreement is being negotiated. It therefore stands to reason that involuntary defection is most likely to happen during electoral periods, when governments change and different factions consolidate political power. When the interests of the new government differ from those of its predecessor, currency speculation may occur, causing the government to respond with interest rate changes, exchange market intervention, and perhaps coordinated actions with other governments and central banks. Political business cycle theories provide us with explanations for why currency crises arise when they do, and how governments respond to market speculation. Theoretically, political business cycle theories might predict exchange rate instability for reasons of political opportunism or partisanship. Opportunistic political business cycle theories posit that governments try to engineer an economic boom before the election by using economic tools at their disposal that can threaten price stability (Nordhaus 1975). Partisan political business cycle theories, on the other hand, would explain the instability based on differences between policy preferences of left versus right governments: a government of the left that is in power is considered weaker against speculation than a government of the right because it would be reluctant to raise interest rates and choke off growth (Hibbs 1977). A forward-looking (rational expectations) explanation would argue that speculation occurs when markets anticipate that a government of the left will win an election and implement inflationary policies once it assumes power (Alesina et al. 1997). In addition to opportunism and partisanship, instability can be related to differences in government positions on European integration. I have argued for an expectations-based theory of currency crises, which combines the differences that were once associated with partisanship with market perceptions of a government’s willingness and ability to abide by its EU commitments. The key issue in both cases is the expectation of policy change. In the past, left governments were expected to enact inflationary policies that helped its core constituents and gradually weakened the currency. Right governments were expected to guard against price instability even at the cost of high unemployment and growth because of the interests of their core constituency.

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But in smaller countries like Ireland, the policy space between left and right governments was minor, and the demands of a small open economy dictated greater cohesion in determining monetary and exchange rate policy. In larger economies like France, the policy space diminished over time as the left decided in favor of fixed exchange rates and capital mobility as opposed to monetary independence. This entailed following Germany’s low-inflation model. Expectations based on partisanship have all but disappeared. What took the place of left–right distinctions in predicting politically motivated European currency crises was the government’s perceived commitment to the monetary integration process. Following Germany’s example was not always easy, given that the countries of Europe did not form an optimum currency area (Eichengreen 1992a). Emulating German policy became particularly trying when an asymmetric shock occurred, and Europe had to respond to such shocks as Germany did, even if it had a different effect on the national economy. In order to maintain credibility, markets had to believe that the government would abide by its international commitments and impose policies that could have been inappropriate for the national economy. If a government’s political will to implement the necessary policies as dictated by the Maastricht Treaty appeared to be shaky, the currency weakened. When the promise of monetary union and greater credibility became tenuous, the government’s incentives to inflict economic austerity diminished. Markets realized this and pressured governments to devalue once any sign of weakness was exhibited. Signs of weakness came in different forms. For France, it was the narrow outcome of the French referendum on the Maastricht Treaty. For Italy, it was the uncertain future of the Italian political system that made the Maastricht criteria seem almost unreachable given the sorry state of the Italian economy and the need to reorganize the Italian political system. For Ireland, it was the withdrawal of Britain from the ERM and the pound’s instability that threatened the Irish punt, due to the heavy trade flow between the two countries. Therefore, in addition to illustrating the meaning of monetary credibility, the history of political business cycles in Europe is also the story of the changing nature of domestic and international politics. The old labels of “left” and “right” are not as informative as they once were. Following the French U-turn of 1983, this distinction all but collapsed, with only occasional flare-ups during election time to remind voters that such partisan differences ever existed. Since the 1980s, Socialist governments have been producing policies comparable to those of Christian

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Democrats. Partisan differences have diminished due to economic integration and the globalization of the international economy, which have reduced the policy options of governments and encouraged the coordination of economic policy (Andrews 1994; Andrews and Willett 1997; Goodman and Pauly 1993). The sources of currency instability and a government’s response to such instability have both domestic and international political origins, and EU developments and domestic developments increasingly intertwine and become less distinguishable from one another. In any case, the incumbent government generally resists devaluation until after the election (Frieden and Stein 2001; Leblang 2002). Postponing devaluation allows the government to protect its reputation from accusations of incompetence and to avoid jeopardizing the country’s relationship with its EU partners in the run-up to an election. This has remained constant through the period of European integration, indicating the continued importance of domestic politics in determining international outcomes. The Evidence Econometric tests indicated the importance of economic fundamentals such as inflation rates and output levels in determining market expectations of exchange rate realignments. In addition to economic fundamentals, political factors like elections and changes in government also significantly impacted market beliefs. However, neither opportunistic nor partisan business cycles seemed to account for this: governments in Europe did not appear to be manipulating economic policy instruments for electoral advantage. The endogeneity of the timing of elections in Europe made this less likely than in systems with fixed electoral terms like the United States. The lag between when these policies were formed, when they were implemented, and how they had fit in the electoral schedule was less precise. Incumbent governments in Europe enjoyed the advantage of setting the dates for elections, which allowed them to choose a time when the economic and political climates were relatively favorable. Partisanship did not account for differences in market expectations in aggregate studies of the EMS, though time-series analysis for Denmark and France did show partisanship as a significant variable. With regard to the timing of devaluation, the modified target-zone model revealed that devaluations were more likely to occur after elections had passed, and qualitative analysis showed that elections mattered when they were likely to produce a policy change. The election was

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deemed likely to lead to policy change if the competing parties offered different policy programs than that of the incumbent, if the expected winner offered a policy that would change the exchange rate, or if there was EU-induced instability. The French case exhibited the clearest examples of the partisan cycle and the reverse political business cycle. The early years of the EMS indicated some evidence of a rational partisan cycle; the conservative incumbent government did not devalue before the 1981 presidential election, and there was considerable currency instability as markets anticipated a legislative win for the left after Mitterrand’s surprise victory. But Mitterrand did not devalue the currency before the legislative elections, nor did the left devalue the currency before the 1983 or 1986 elections. In both instances, contrary to partisan theories, the government waited until after the election had passed. In 1986, the last formal devaluation for the French franc occurred, but it experienced electorally induced instability in later years as well as speculation based on uncertainty surrounding its participation in EMU. However, no devaluations were made before the election. In Italy, the story of the political business cycle differed greatly from France, despite their similar economic profiles. The party system of polarized pluralism meant that the Christian Democrats and their partners had a lock on government for most of the postwar period. The left–right distinction was not significant because the left (i.e. the Communist Party) was permanently kept out of power. In addition to the removal of partisanship as an indicator of exchange rate volatility, Italy also lacked anti-monetary union parties and politicians that would incite currency instability. Italian devaluations were correlated more with French political business cycles than with Italian political developments, with the lira participating in most of the realignments instigated by the French. In 1992 the lira experienced some exchange rate instability after the elections that were related to the government’s perceived inability to balance the budget and qualify for monetary union, but it was not until 1994 that Italy showed the first signs of susceptibility to domestic political business cycles. The fall of the government and the installation of a technocratic government led to a record low for the lira. The lira was not participating in a fixed exchange rate regime at this time, so the government was not obligated to intervene. Nevertheless, the political crisis combined with the dramatic drop in the lira’s value, suggests that uncertain political expectations contributed to the currency instability. Political uncertainty not only meant that Italy’s economic future was uncertain, but that its future within the EU was uncertain as well. Italy

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needed to institute a myriad of economic reforms in order to bring the economy to a level acceptable to its European partners. A weak government could have meant that these policies would not be implemented, and that Italy would therefore have been ineligible to participate in the first round of monetary union. Although the competing parties expressed an interest in monetary union and integration, the unstable political environment meant that they might not be able to carry out the difficult policy measures that were required. Credibility was defined as a government being both willing and able to fulfill its commitment. In the French case, the government possessed the latter, but not always the former. In the Italian case, however, the government was willing to implement economic reforms, but may not have had the political backing that was necessary. Much like Italy, Ireland has a history of being a “good European” country that consistently supported exchange rate stability and European integration. Integration was not a point of contention among Irish parties, just as it was uncontroversial in Italy. The left–right dimension was also less significant in Ireland than in France, though it was stronger than it had been in Italy. What did this mean for the political business cycle in Ireland? In the early period, when left–right distinctions were more likely to matter, there were still not many differences between the parties in terms of the economic policies that they offered. Even before France taught the rest of Europe that going against the grain was futile, Irish parties had abandoned the economy as an issue on which to make their mark by distinguishing their policy platform from other parties. Even before this occurred, domestically induced political business cycles did not happen in Ireland, perhaps because its small size meant that it was destined to take its exchange rate cues from its larger partners by participating in general realignments. However, in 1992 Ireland experienced a political business cycle that originated from Britain’s exchange rate crisis in September. Ireland was scheduled to hold an election in November, and the exchange rate pressure on the punt was massive. Other countries like Spain and Portugal had already devalued, and the weakening British pound was wreaking havoc on the punt. Despite the pressure and speculation against the punt, the government’s commitment to the punt was firm. The punt was not devalued until after the election had passed and a new government had formed. Although the government could have used European currency instability as a scapegoat for its policy, there was still the possibility that the

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government would be viewed as incompetent and jeopardizing Ireland’s place in Europe. To be a full participant in the European integration process, participation in monetary union was imperative. Devaluing the currency could be seen as a sign of a lack of resolve to implement the policies needed to pass the Maastricht Treaty’s criteria. In the end, Ireland did devalue, but it did not devalue before the election. It even had the tacit help of the German government in this decision. Although the crisis had originated from abroad, the Irish government responded much like the French government had responded to exchange rate instability generated by electoral uncertainty. The government defended the rate until the election had passed, and then devalued. Looking Ahead: The Future of Future EMU EMU should theoretically provide countries with greater monetary credibility along with a larger voice in how monetary affairs are run, goals that European governments have proclaimed to be highly desirable and worthwhile. Should this reward at the end of the road disappear, there would be less of an incentive for governments to implement policies that could be to the detriment of their national economies. The promise of monetary union could disappear for various reasons. First, the consensus among participating countries could evaporate in the midst of weakening economies and domestic political pressure to shift government priorities toward growth and away from stringent price stability. Though this would no longer affect the exchange rates between EMU countries, it could damage the strength and credibility of the euro. Current EMU members could circumvent or even ignore the rigors of the Stability and Growth Pact (SGP), which was designed to ensure that countries remained true to the original idea of monetary integration based on tight monetary and fiscal policy. Such developments could threaten price stability within the Eurozone and encourage speculation against the euro. Disagreement over policy among Eurozone members also could prevent the EU from assuming a leadership role in international monetary affairs (McNamara and Meunier 2002). The French government’s repeated suggestions of the need for a political counterweight to the European Central Bank and a loosening or reinterpretation of the SGP further obfuscate the source of authority in European monetary policy, making international leadership difficult. In addition, it has been argued that having a European monetary policy run by technocrats does not pose a problem for the EU’s “democratic

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deficit” problem, because the public does not take an interest in the formation of monetary policy but rather cares only about its results (Moravcsik 2002). If monetary union delivers satisfactory results in the form of price stability, improved competitiveness, and ultimately economic growth, then the means through which these benefits are brought about are irrelevant. Accountability thus comes in the form of economic outcomes. This implies that the lack of coherence of monetary policy could contribute to popular dissatisfaction with EMU if it does not deliver the expected economic results. Reduced public support could further damage the ability of governments to implement politically difficult economic policies in the context of its EMU obligations and stall any moves toward further integration. Furthermore, the addition of the countries from Central and Eastern Europe could also alter the existing norms and agreement between the EMU countries and change the respective alliances. The most important agreement in EMU is the prioritization of price stability; Germany successfully secured agreement within the EU for an independent central bank with a mandate of the pursuit of price stability, and the German government also negotiated the SGP to ensure continued vigilance against inflation. During the first years of operation, however, the SGP proved to be a contentious issue among the Member States, as countries expressed different preferences for the level of price stability because it interfered with the pursuit of policies that would allow stronger economic growth. Enlargement will increase the diversity of an already heterogeneous group, and a shift in the needs of a greater proportion of the Eurozone population could precipitate some changes in economic priorities (Chang 2004). Before such shifts can take place, however, the enlargement countries must first become members of monetary union. The EU has determined an “equal treatment” policy toward the accession countries in regard to EMU. Neither exceptions from the convergence criteria nor shortcuts to monetary union will be permitted: all states will be required to complete two years of membership in the ERM II without realignments prior to membership. Enlargement countries also will not be granted an opt-out from EMU, such as that obtained by Britain and Denmark. This last point may be moot, as all of the enlargement countries have expressed enthusiasm at the prospect of joining EMU, with some even suggesting the possibility of early membership or a unilateral adoption of the euro (prior to the development of the “equal treatment” policy). Their eagerness for EMU membership is understandable, as membership will present the accession countries with substantial opportunities

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by making them less vulnerable to currency instability and thus more attractive for investment. Shortly after the plans for EU accession were set for 2004, Moody’s increased the foreign currency ratings of the accession countries on the basis of the inevitability of EU expansion and their participation in monetary union, which arguably reduced foreign exchange risk and the prospect of currency speculation.1 A myriad of reasons exist, however, for delayed entry to monetary union. The criterion on exchange rate stability within the ERM means at least a two-year lag between memberships in the EU vs. EMU. European Enlargement Commissioner Günter Verheugen noted that one “can expect that the new member states want to join the euro area as soon as they are ready . . . this date (2006) may very well be the actual target date for several of the new member states,” as most accession countries are close to reaching the Maastricht criteria. However, even though these countries may be closer to fulfilling the convergence criteria than some current members were just two years prior to their entry into EMU (see tables 8.1 and 8.2), Verheugen cautioned against rapid membership. The official explanation was, of course, based on economic rationale, since much of the monetary integration process has selfconsciously taken on a technocratic air that attempts to make the process seem impartial and de-politicized. Verheugen, for example, warned, “the future member states are well advised to take the time necessary and not rush the process . . . joining prematurely risks being negative both for the new member states and for monetary union.”2

Table 8.1 Accession countries’ EMU convergence, 2002

Reference value Czech Republic Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia

Inflation %

Interest rates 10-year

Fiscal deficit as % of GDP

Public debt as % of GDP

3.0

5.8

⫺3.0

60.0

1.8 3.6 5.3 1.8 0.3 1.9 3.3 7.5

4.0 3.6 6.3 7.8 6.4 5.4 7.4 8.1

⫺3.8 ⫺0.4 ⫺8.9 ⫺2.5 ⫺2.8 ⫺5.4 ⫺1.9 ⫺1.1

21.6 5.1 50.4 13.9 25.0 48.0 34.4 31.0

Source: Deutsche Bank, EU Monitor, April 2003: 26.

Table 8.2 Economic indicators and the Maastricht Treaty convergence criteria (excluding the exchange rate criterion) HICP inflationa

Belgium

1996 1997d 1998e Denmark f 1996 1997d 1998e Germany 1996 1997d 1998e Greece 1996 1997d 1998e Spain 1996 1997d 1998e France 1996 1997d 1998e Ireland 1996 1997d 1998e Italy 1996 1997d 1998e Luxembourg 1996 1997d 1998e Netherlands 1996 1997d 1998e Austria 1996 1997d 1998e Portugal 1996 1997d 1998e Finland 1996 1997d 1998e Sweden 1996 1997d 1998e United Kingdom 1996 1997d 1998e

1.8 1.4 — 2.1 1.9 — 1.2 1.4 — 7.9 5.2 — 3.6 1.8 — 2.1 ** 1.2 — 2.2 *** 1.2 — 4.0 1.8 — *** 1.2 1.4 — 1.4 1.8 — 1.8 * 1.1 — 2.9 1.8 — ** 1.1 1.3 — * 0.8 1.9 — 2.5 1.8 —

Long-term interest rate b

General government surplus (⫹) or deficit (⫺)c

General government gross debt c

6.5 5.7 — 7.2 6.2 — 6.2 5.6 — 14.4 9.8 — 8.7 6.3 — 6.3 ** 5.5 — 7.3 *** 6.2 — 9.4 6.7 — *** 6.3 5.6 — 6.2 5.5 — 6.3 * 5.6 — 8.6 6.2 — ** 7.1 5.9 — * 8.0 6.5 — 7.9 7.0 —

⫺3.2 # ⫺2.1 # ⫺1.7 # ⫺0.7 # 0.7 # 1.1 ⫺3.4 # ⫺2.7 # ⫺2.5 ⫺7.5 ⫺4.0 # ⫺2.2 ⫺4.6 # ⫺2.6 # ⫺2.2 ⫺4.1 # ⫺2.9 # ⫺0.4 # ⫺0.4 # 0.9 # 1.1 ⫺6.7 # ⫺2.7 # ⫺2.5 # 2.5 # 1.7 # 1.0 # ⫺2.3 # ⫺1.4 # ⫺1.6 ⫺4.0 # ⫺2.5 # ⫺2.3 ⫺3.2 # ⫺2.5 # ⫺2.2 ⫺3.3 # ⫺0.9 # 0.9 ⫺3.5 # ⫺0.8 # 0.5 ⫺4.8 # ⫺1.9 # ⫺0.6

126.9 122.2 118.1 70.6 65.1 # 59.5 60.4 61.3 61.2 111.6 108.7 107.7 70.1 68.8 67.4 # 55.7 # 58.0 # 58.1 72.7 66.3 59.5 124.0 121.6 118.1 # 6.6 # 6.7 # 7.1 77.2 72.1 70.0 69.5 66.1 64.7 65.0 62.0 # 60.0 # 60.0 # 55.8 # 53.6 76.7 76.6 74.1 # 54.7 # 53.4 # 52.3

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Table 8.2 Continued *, **, *** ⫽ first, second and third best performer in terms of price stability. #, general government deficit not exceeding 3% of GDP; general government gross debt not exceeding 60% of GDP. Notes a Annual percentage changes. b In percentages. The harmonized series for Greece starts in mid-1997. Before this, data were based on available best proxies; for the period from March to June 1997, yield data for long-term bonds with shorter maturities than the harmonized series were used; before that period, yields at issue for long-term bonds with shorter maturities than the harmonized series were used c As a percentage of GDP. d Data for HICP inflation and long-term interest rate refer to the 12-month period ending January 1998; European Commission (spring 1998 forecasts) for general government surplus or deficit and general government gross debt. e European Commission projections (spring 1998 forecasts) for general government surplus or deficit and general government gross debt. f General government gross debt figures are not adjusted for the assets held by the Danish Social Pension Fund against sectors outside general government, nor for government deposits at the central bank for the management of foreign exchange reserves. According to statements 5 and 6 relating to Council Regulation (EC) No. 3605/93 of 22 November 1993, the Council and the Commission agree that, for Denmark, these items shall be specified in the presentation of general government gross debt. They totaled 9.6% of GDP in 1996 and 8.0% of GDP in 1997. In addition, the data are not adjusted for the amounts outstanding in the government debt from the financing of public undertakings, which, according to statement 3 relating to the aforementioned Regulation, will be subject to a separate presentation for the Member States. In Denmark this item amounted to 5.2% of GDP in 1996 and 4.9% in 1997. Source: European Monetary Institute, 1997 Annual Report (EMI: Frankfurt am Main, 1998: 27).

The European Banking Federation echoed this concern over a too-rapid integration of the acce ssion countries into monetary union, pointing to the still-divergent business cycles in the accession countries versus the Eurozone along with the transitional nature of their economies. These factors would make the removal of the exchange rate as an adjustment tool costly and force countries to endure a “more painful and longer adjustment process . . . nominal convergence ‘a la Maastricht’ may not be the best way to achieve real growth and real convergence.”3 Bundesbank council member Franz-Christoph Zeitler took this argument even further in July 2000 when he argued that the accession countries should be subject to additional criteria before admission to EMU. In order to achieve his suggestion of increasing the per capita income to 70 percent of the EU average, economists estimated that it would take more countries at least ten-years, and that poorer countries such as Poland would require 20 or 30 years.4 Such warnings run counter to the preferences expressed by representatives of some of the accession countries that a rapid transition would be more desirable. For example, Zsigmond Jarai of the National Bank of Hungary argued, “it is in the interest of Hungary to minimize the time spent in ERM 2.”5 Similarly, Slovenia’s prime minister had announced his hope that Slovenia would become a member of EMU as soon as possible, even before accession to the EU itself (Backé 1999).

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But the experience of the EMS I members suggest that accession countries should take every means necessary to strengthen their credibility and convince markets of their willingness and ability to fulfill the Mastricht Treaty’s convergence criteria in order to protect their respective currencies from market speculation. There are good reasons to believe that the accession countries will lack the ability to do this in the near future, due to differences in the nature of developing economies versus those of the Eurozone. Despite the ability of these countries to meet the EU accession requirements for having a competitive market economy, the accession economies and their regulatory infrastructure are still in transition. Pursuit of the convergence criteria could actually damage their respective economies and be politically difficult. The accession countries not only need to deal with structural problems in social security, health care and education, they also need to invest in infrastructure and the environment. Such restructuring could lead to social unrest and decrease public support for European integration (Backé 1999), elements that produced substantial speculation in more developed economies like that of France on the road to monetary union. The financial sectors of the accession countries’ economies are also relatively underdeveloped and fragile, especially in light of the large capital inflows that are expected after accession. Pursuing monetary union too soon could lead to more harm than good for the accession countries. The Maastricht Treaty’s convergence criteria were designed with the advanced industrial economies in mind, not for emerging economies. Much has been made of the economic differences between the economies of the accession countries and the current members, especially with regard to their respective levels of industrialization and employment. The accession countries are well positioned for meeting the Maastricht Treaty’s convergence criteria, and some have even argued that these countries satisfy the criteria for an optimum currency area at least as well as the current participants of EMU (Eichengreen and Ghironi 2003). But despite their rapid progress in fulfilling the criteria, many argue that these countries will not be ready in the near future for the rigors of monetary union and the demands of a single monetary policy. A debate has formed over the degree to which the accession countries have achieved “nominal” versus “real” convergence. Nominal convergence refers to achieving the convergence criteria. Real convergence, on the other hand, refers to the institutional and legal restructuring of the economy in order to make it market-oriented and competitive. It has been argued that real convergence is necessary in order for the accession countries to become viable EMU members,

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Table 8.3 Population, GDP, and growth rates of EU versus accession countries Country

Bulgaria Cyprus Czech Republic Estonia Hungary Latvia Lithuania Malta Poland Romania Slovak Republic Slovenia EU-15

Population in GDP in millions billions of euro 7.9 0.762 10.2 1.4 10.2 2.4 3.5 0.394 38.6 22.4 5.4 2.0 375

15.2 10.2 63.3 6.2 58.0 8.5 13.4 4.0 196.7 44.4 22.8 20.9 8828.9

Growth rate in % GPD per capita in over previous PPS as a percentage year 2001 of EU average 4.0 4.0 3.3 5.0 3.8 7.7 4.9 ⫺0.8 1.1 5.3 3.3 3.0 1.5

28 80 57 42 51 33 38 na 40 25 48 69 100

Source: Eurostat.

because they need to catch up with the more developed economies of the EU with regard to productivity and per capita levels (Eden et al. 1999). The accession countries tend to possess less capital than the current EMU countries, have less productive economies, and have a higher share of their workforce engaged in agricultural production, making these countries more vulnerable to economic shocks (Bolle and Jacobsen 2001). These differences could have negative consequences for EMU, because although their economies will comprise a small part of the EU’s GDP, their relative population means that a large number of citizens could be forced to live under inappropriate monetary conditions, thus threatening public support for EMU (Maier and Hendrikx 2002) (see table 8.3). The expected growth of the accession economies could also result in inflationary pressure that could jeopardize both the fulfillment of the convergence criteria and threaten compliance with the SGP in the future. The Balassa-Samuelson effect posits that countries that are poor but growing rapidly will experience higher structural inflation. Some have noted that a trade-off may exist for the accession countries between meeting the Maastricht Treaty’s criterion on inflation versus the criterion on exchange rate stability (Natalucci and Ravenna 2002). Economists have placed the inflation differential between current EMU members and the accession countries to be 2–3 percent per annum (Halpern and Wyplosz 2001).

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Higher inflation rates could result in overvaluation and currency instability, which would endanger the fulfillment of the Maastricht Treaty’s criterion of two years of exchange rate stability prior to entry into monetary union (De Grauwe and Lavrac 1999a,b). Such differences between the accession countries versus the original EMU members make the principle of “equal treatment” problematic, especially when one considers that the ERM II does not provide for support against currency speculation (Wyplosz 2002). The accession countries therefore face even greater challenges than their predecessors en route to monetary union, for they not only need to achieve the same convergence criteria, but they must do so in an environment of substantially less support for and momentum toward further integration. As discussed in previous chapters, monetary union took place in the context of the end of the Cold War. The geopolitical demands of the day, combined with the potential economic rewards of monetary union, made it possible for a critical mass of countries not only to agree to the project and timetable of monetary union, but also to interpret the rules laid out by the Maastricht Treaty rather liberally (so as to ensure greater participation in EMU). The Maastricht Treaty allows countries entry into EMU so long as the Council agrees that the government is making adequate progress toward achieving the criteria and moving toward its fulfillment. This loose reading of the convergence criteria permitted several countries to become charter members of EMU despite not having fulfilled the criteria. The accession countries will not enjoy such leniency, and keeping them out of EMU for a long period of time could lead to the creation of a two-tiered Europe. Times have changed since the Europhoria surrounding the Single European Act and Maastricht Treaty negotiations, and it is unlikely that the enlargement countries will receive special consideration. They lack fortuitous circumstances that would promote rapid integration, and the Central and Eastern European countries also lack the political and economic weight that might make the EU more amenable to making exceptions to the Maastricht Treaty’s rules. Furthermore, no new major policy initiatives have emerged to further integrate and deepen ties between the member states, which makes it even less likely that the Eurozone will rush toward early membership for the enlargement countries. Therefore, the primary lesson that enlargement countries can take away from the EMS I experience is the importance of establishing market credibility. If the nature of their still-developing economies means that the enlargement countries could not or should not conform

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to the standards set in the Maastricht Treaty and the SGP, then this could damage not only the credibility of EMU but also the long-term stability of their national economies. The second lesson of the ERM I experience is that market sentiment can shift suddenly and lead to a sudden outflow of capital, and that this is more likely to occur when a government pursues policies inconsistent with maintaining the exchange rate. The current EMU countries discovered this in 1992–1993: in the wake of the liberalization of capital controls, the currencies became more vulnerable to speculation. Credibility based on the strength of the country’s commitment to monetary union suddenly evaporated for many countries, and most of the ERM’s members found themselves under attack. In addition, the crises that hit many of the emerging markets (like Mexico in 1994–1995 and the Asian financial crisis of 1997–1998) demonstrated how even the definition of sound economic policy has become a moving target. Prior to these crises, most analysts were concerned with macroeconomic indicators like inflation. Afterward, the stability of the banking and financial system, as well as a host of microeconomic factors such as government–business relations, became important indicators of vulnerability to currency instability. The accession countries have much to learn from the experiences of both the ERM I countries as well as other emerging market economies. The greater economic and political vulnerability of their economies makes a delayed entry into EMU advisable. They need to strengthen and promote real convergence before giving up the exchange rate as a tool of adjustment. In 1992–1993 even some of the most advanced economies of the world came under speculative attack and were unsuccessful at staving off devaluation; the accession countries would no doubt fare worse under a similar scenario. Increased economic and financial integration have made domestic economic and political considerations even more important because such developments have consequences far beyond national borders.

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Notes

Chapter 2 Rules and Norms of European Monetary Cooperation 1. As the ERM is the substantive part of the EMS, this book, like most American works, will use the two interchangeably. 2. From March 1979 to July 1993 most of the members of the ERM observed a fluctuation range of plus or minus 2.25% from the currency’s central rate. For a time Italy enjoyed a 6% fluctuation band, as did Spain. 3. The European Central Bank now sets interest rates for countries participating in EMU. 4. The clearest example of this was the handling of German Monetary Union in 1990. The Bundesbank expressed its desire for a less favorable exchange rate between the Ostmark and the DM, but its pleas fell on deaf ears. In the end, that situation demanded a political solution, and the Bundesbank was forced to acquiesce to the government’s wishes. 5. Interview, Frankfurt, October 1997. 6. Karl Otto Pöhl, 1987, “The European Monetary System—a Model for a More Stable International Monetary Order?” in Deutsche Bundesbank, Auszüge aus Presseartikeln 33 (May 1987). 7. Interview, Brussels, February 1995. 8. Interview, Brussels, December 1995. 9. Le Monde, April 8, 1986.

Chapter 3 Political Economy of Currency Crises and Devaluation 1. The only country to substantially deviate from this arrangement was Britain, which declared the value of the pound without consultation with its European partners when joining the ERM in 1990. In 1992 Britain again made the unilateral decision to withdraw from the ERM.

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Chapter 4

France, 1981–1986

1. The other presidential candidates were Huguette Bouchardeau, Jacques Chirac, Michel Crepeau, Michel Debré, Marie-France Garaud, Brice Lalonde, and Georges Marchais. 2. Le Monde, January 9, 1981. 3. L’Express, April 11, 1981. 4. Business Week, May 25, 1981. 5. Le Monde, March 3, 1981. 6. Le Monde, March 4, 1981. 7. Le Monde, January 11, 1981; Le Monde, January 17, 1981; Le Point, January 12, 1981; Le Quotidien de Paris, January 23, 1981. 8. L’Express, January 10, 1981, 22. 9. Le Nouvel Observateur, March 30, 1981. 10. Le Monde, May 7, 1981. 11. The results were as follows: 28.3% for Giscard, 25.8% for Mitterrand, 17.9% for Chirac, and 15.3% for Marchais. 12. Le Monde, May 13, 1981. 13. Le Monde, May 15, 1981. 14. Business Week, May 25, 1981. 15. Le Monde, May 21, 1981. 16. Pierre Bérégovoy, Jacques Delors, and Jean Yves-Haberer, Treasury Director. 17. Le Nouvel Observateur, May 25, 1981. 18. Le Monde, May 23, 1981. 19. Le Nouvel Observateur, June 1, 1981. 20. Le Monde, June 23, 1981. 21. Le Monde, June 25, 1981. 22. Business Week, June 8, 1981, 99. 23. Wall Street Journal, March 1, 1983, 1. 24. Le Point, January 10, 1983. 25. Financial Times, January 11, 1983. 26. Le Monde, February 2, 1983; Le Point, February 7, 1983. 27. Le Monde, February 5, 1983. 28. Le Monde, February 8, 1983. 29. Le Monde, February 18, 1983. 30. Financial Times, March 3, 1983. 31. Financial Times, March 1, 1983. 32. Voters were given the choices of the Mitterrand government’s policies, the international economy, the previous Giscard/Barre government, and undecided Socialists and Communists were much more likely to blame the international economy and the Giscard/Barre government, the UDF and RPR blamed the Mitterrand government’s policies. 33. The wording of the question was “Since Mr. Mitterrand came to power, do you think that the situation of franc has improved or deteriorated as far as these issues are concerned?” “Value of the franc compared to other currencies.”

Notes

34.

35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52.

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7% replied improved, 61% replied deteriorated, 19% no change, and 13% no opinion. The question read, “Among the following issues, which two or three must the government deal with as high priority in the coming months?” “Defense of the franc compared with other currencies” received more responses than any other category, irrespective of party preference. Other top categories included “sales of French products abroad,” “defense of human rights in the world,” “defense of French interests in the world,” and “interdependence of France vis-à-vis the superpowers.” Le Parisien Libéré, January 5, 1983. Wall Street Journal, March 8, 1983, 38. Le Monde, March 4, 1983; Wall Street Journal, March 7, 1983. Wall Street Journal, March 8, 1983, 38. Le Monde, March 3, 1983, 35. Wall Street Journal, March 8, 1983, 38. Le Monde, March 9, 1983, 1. Wall Street Journal, March 8, 1983, 38. Frankfurter Allgemeine, March 15, 1983. Frankfurter Allgemeine, March 15, 1983. Frankfurter Allgemeine, March 21, 1983. Frankfurter Allgemeine, March 23, 1983. L’Expansion, March 20, 1986. Le Monde, March 27, 1986. Le Point, February 10, 1986. L’Express, February 7, 1986. Le Monde, April 4, 1986. Le Monde, March 23, 1986.

Chapter 5

France, 1988–1995

1. The RPR and the UDF were part of a conservative electoral coalition at this time. 2. The other candidates were Jean-Marie Le Pen, André Lajoinie, Pierre Juquin, Arlette Laguiller, and Antoine Waechter. 3. Financial Times, January 13, 1987. 4. The J-curve phenomenon is a short-run decline in net exports that follows exchange rate depreciation. It is then followed by an improvement in net exports. The current account deteriorates sharply after currency depreciation because the majority of foreign trade orders, both imports and exports, are placed several months in advance. For several months after the depreciation, export and import volumes will reflect decisions based on the previous exchange rate, so the depreciation would raise the value of the precontracted level of imports in terms of domestic products. However, exports measured in domestic output do not change, so there is an initial

178

5. 6. 7. 8. 9.

10. 11. 12. 13. 14. 15. 16. 17. 18. 19.

20. 21.

22. 23.

24. 25. 26. 27. 28. 29. 30.

●

Notes

fall in the current account. Even after the remaining trade contracts have been fulfilled, it can still take time for new orders to fully adjust to the relative price changes, hence the existence of a time lag for a real currency depreciation to improve the current account balance. L’Express, March 4, 1988. Le Point, February 15, 1988. L’Express, March 4, 1988. Le Point, March 14, 1988. It was generally believed that Barre would be a more formidable opponent than Chirac on the second ballot, so Mitterrand took care not to criticize the government so as not to give Barre an added advantage. Le Point, February 1, 1988. L’Expansion, February 5, 1988. For a critique of polls and their accuracy, see Le Nouvel Observateur, April 22, 1988. The Economist, May 16, 1992. L’Expansion, January 7, 1993. Le Monde, March 3, 1993. Le Monde, March 2, 1993. L’Expansion, January 21, 1993. Le Figaro, January 20, 1993. Chirac decided beforehand that he did not wish to repeat the 1986–1988 cohabitation experience. He supported Balladur under the belief that he would not run for the presidency in 1995. Financial Times, March 26, 1993. The first round would take place on Sunday, April 23 and the second on Sunday, May 7. The winning candidate would assume presidency on May 20. In the event that Balladur or Chirac were to win the presidency, most assumed that the National Assembly would not be dissolved given the large parliamentary majority enjoyed by the RPR–UDF coalition, which still had another three years to run before an election must be called. Financial Times, December 21, 1993. The other candidates were Jean Marie Le Pen (National Front), Robert Hue (Communists), Arlette Laguiller (Workers’ Struggle), Philippe de Villiers (Movement for France), Dominique Voynet (Greens), and Jacques Cheminade (Independent). Financial Times, February 23, 1995. Financial Times, December 28, 1994. Le Nouvel Observateur, April 20, 1995. Financial Times, February 18, 1995. Le Nouvel Observateur, March 9, 1995. Le Nouvel Observateur, March 9, 1995. Financial Times, March 17, 1995.

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179

31. Martine Aubry came in first, followed by Jack Lang, Bernard Kouchner, Michel Rocard, and finally Lionel Jospin. Le Nouvel Observateur, January 11, 1995. 32. L’Express, March 16, 1995. 33. L’Express, April 6, 1995. 34. L’Express, March 23, 1995. 35. Financial Times, March 9, 1995. 36. Le Nouvel Observateur, April 27, 1995. 37. Financial Times, May 8, 1995.

Chapter 6

Italy: Domestic versus International Origins of Currency Crises

1. Irresponsible opposition refers to an opposition that knows that it will not have to live up to its promises because it is in permanent opposition. Extremist and anti-system parties would be more prone to being irresponsible because the likelihood of achieving power and being held accountable for its promises is much lower. Sartori 138–9. 2. Le Monde, October 6, 1981. 3. European Report, May 23, 1992. 4. Financial Times, February 22, 1995. 5. By this time the lira had been withdrawn from the EMS and was floating, making devaluation a moot point.

Chapter 7

Ireland

1. In 2001, however, Irish voters rejected the Treaty of Nice, necessitating a second referendum that did pass. 2. This was due to a political miscalculation on his part. Haughey had offered a prestigious post in the European Commission to a Fine Gael TD (member of parliament), in the mistaken belief that the Fianna Fail would win the subsequent by-election for his seat and thus strengthen its majority. Haughey’s prediction proved inaccurate, and the result was no increased majority, and a Fine Gael TD now had a prestigious post in the EC. 3. Irish Times, January 17, 1986. 4. European Report, April 8, 1986. 5. The fall of the dollar usually led to a strengthening of the D-mark and vice versa, as market actors sought better returns on their investments. 6. European Report, September 26, 1992. 7. European Report, November 25, 1992. 8. Irish Times, January 9, 1993. 9. European Report, January 27, 1993.

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10. European Report, February 3, 1993. 11. European Report, February 3, 1993.

Chapter 8 1. 2. 3. 4. 5.

Conclusion

Prague Business Journal, November 18, 2002. Enlargement Weekly, March 11, 2003. European Report, February 6, 2002. Wall Street Journal, July 31, 2000. AFX European Focus, December 9, 2002.

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Index

Ahern, Bertie 155 Alphandéry, Edmond 117 Amato, Giuliano 136–7 anchor currency 18–19 DM as 24, 26, 27, 28, 29, 31, 37, 38, 44, 47, 82, 91, 143, 151 audience 56–7 audience costs 8, 9–10 Austria 26, 42, 112, 168 Balassa-Samuelson effect 171 Balladur, Edouard 86, 91, 93, 94, 97, 106, 108–9, 110, 111, 112, 113, 114–18, 119, 120, 178 Banca d’Italia 137, 138 Banque de France 67, 68, 69, 76, 77, 78, 86, 106, 109, 110, 117, 120 Barre, Raymond 20, 62, 64–5, 68, 86, 90, 93–6, 176, 178 Basle-Nyborg 91 Belgium 22, 26, 42, 46, 48, 51, 52, 78, 112, 150, 167 Bérégovoy, Pierre 71, 106, 136 Berlusconi, Silvio 137, 138 Bretton Woods 20, 24, 26, 29, 77 Britain 4 and 1992 crisis 25, 42, 101, 135, 136, 152–3, 154, 161, 164 and EMU 27, 166 and ERM membership 21, 42, 175 and Ireland 52, 53, 142, 143, 151, 154, 161, 164 Bruton, John 145

Bundesbank 20–6, 29–31, 32, 34, 58–9, 62, 76, 81, 86, 91, 97, 98, 100, 101–2, 103, 117, 136, 169, 175 business groups 83, 104, 106, 109, 113, 154, 173 capital controls 46, 47, 48, 50, 55–6, 62, 68, 133, 173 capital flight 4, 5, 9, 44, 50, 51, 52, 62, 67–8, 69, 109, 130, 135, 173 capital mobility 3, 19, 23, 24, 25, 44, 58, 59, 97, 101, 161 central bank independence 3–4, 10, 17, 21, 29–30, 31, 43, 44, 46–7, 50, 55, 56, 58–9, 99–100, 120, 121–2, 166 Chèvènement, Jean-Pierre 71, 74, 75–6, 102, 106 Chirac, Jacques 86, 90, 93, 94, 95, 96, 102, 103, 110, 111, 112, 113–19, 178 Ciampi, Carlo 137 coalitions 1–2, 6, 9, 14, 19, 42, 46, 50, 51, 56, 62 France 62, 74, 80, 85, 86, 87, 93, 102, 103, 106, 108, 109 Germany 71, 77, 81 Ireland 141, 142, 145, 146, 147, 148–9, 151, 154 Italy 127, 128, 135, 138, 139, 140 Cold War 19, 23, 100, 102, 172 Colombo, Emilio 97 competitive disinflation 37, 91, 143 Craxi, Bettino 137

196

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Index

credibility 2–4, 6, 8, 44, 46, 139, 159–61 and central bank independence 99 and EMS 7, 12, 15, 21, 30–1, 34, 43, 57, 58–9, 101, 140, 170, 172–3 and EMU 23, 25, 152, 156, 157, 161, 165 and France 51, 69, 85, 87, 98, 101, 119–22, 164 and Germany 24, 38, 78, 82 and Ireland 53, 144 credit-claiming 10–11, 57 Cresson, Edith 83 currency crisis 1–8, 11, 13–15, 41 and contagion 12, 144, 148, 152–4, 155 and economic fundamentals 3, 6, 42, 53–4 and elections 86, 142 and EMS 11, 37, 75–9 and France 62, 64, 65, 67–70, 72, 75, 79–80, 86, 88, 97, 116–18, 123 and Ireland 144, 152–5, 165 and Italy 128–33, 135–7 European-induced 25, 89, 137 expectations-based 3, 5, 6, 7, 8, 12, 13, 30, 41–2, 44–7, 50, 52, 53–4, 58–9, 64, 74, 90, 110, 118, 122–3, 131, 142–3, 160–1, 163 government reaction to 9–10, 13–4, 53 self-fulfilling 3, 43, 58 timing 4, 12, 43 currency crisis 1992–3 ERM 32, 51, 89, 102, 103–4, 109–10, 135–7, 139, 152–6, 164, 173 de Foucault, Jean-Baptiste 37 Delanoe, Bertrand 78 Delors Report 23 Delors, Jacques 68, 69, 71, 75–6, 77, 78, 97, 110, 114, 132, 176

democratic deficit 165–6 Denmark 22, 26, 42, 46, 48, 50, 51, 52, 53, 78, 139, 144, 150, 154, 162, 166, 168 devaluation 1–2, 8–15, 25, 33, 34–7, 38, 42–3, 46, 50, 53, 55–6, 58, 67, 87, 101, 122, 162–3 and capital controls 46, 50, 55, and central bank independence 46, 56 and elections 9–11, 53, 57, 58, 70, 80, 87, 88, 122–3, 133, 162 and government type 46, 51 and partisanship 45, 51–2, 56–7, 70, 80, 88, 123 economic fundamentals 3, 54–5, 118, 123 expectations of 6, 53–4, 87–8, 91–2, 120–3, 160 France 22, 25, 33, 53, 61–4, 67, 68–70, 71–2, 74–9, 81–4, 86, 87–8, 91–2, 103–4, 106, 107, 109, 110, 118, 123, 132, 133, 163 Ireland 53, 141–2, 143, 144, 146–8, 150–7 Italy 22, 125–6, 128–33, 134, 135, 136–7, 140, 163, 179 Mexican peso 138–9 target zone model 54 timing of 9–10, 54, 58, 70, 80, 87, 88 Dini, Lamberto 138 divergence indicator 27 DM and French franc 12, 35, 62, 67, 68, 69, 71, 76, 77, 78, 86, 104, 107, 116, 117, 119 and Irish punt 143, 148, 150, 151 and Italian lira 136 deutsche mark and D-mark 179 deutsche mark and mark 11, 22, 24, 26, 32, 62, 67, 68, 81–2, 91, 98, 101

Index DM revaluation 22, 25, 34–5, 36, 71, 76, 77–8, 79, 86, 91, 151 DM zone 12, 19–20, 32, 150 DM-Ostmark conversion 101, 175 dollar 19, 20, 24, 26, 28, 29, 67, 68, 82, 91, 98, 101, 116, 117, 119, 138, 151, 179 elections 1–2, 45–6, 48, 50, 53, 55, 57, 122 and currency crises 2, 14, 41–2 and devaluation 2, 5–6, 8–11, 13, 14, 54, 57–8, 162–3 and economic policy 41, 46, 162–3 euro 26, 28, 165, 166, 167 European Banking Federation 169 European Central Bank 37, 59, 94, 99, 122, 165, 175 European Currency Unit 21, 27, 28, 35 European Monetary System and France 12, 20, 31–2, 61, 67, 68, 71–2, 76, 78–9, 82, 91, 94, 101–2, 106, 107, 110, 117, 122–3, 163 and Germany 12, 20–1, 24–5, 26, 27, 28–32, 37, 77, 78–9, 97, 101–2 and Italy 33, 125–6, 129, 131–3, 134, 135–7, 140, 156–7, 179 functioning 26–8, 82 history 20–6, 87 Ireland 33, 143–4, 150–7 norms 21, 28–38 European Monetary Union 2, 18, 23–4, 25–6, 31, 42, 90, 98–100, 102, 110, 112–14, 122, 126, 135, 150, 156, 159, 163 and enlargement 13, 166–7 future of 165–73 Exchange Rate Mechanism I (also European Monetary System I) 21, 26, 28, 170, 172–3 Exchange Rate Mechanism II (also European Monetary System II) 26, 28, 166, 172

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197

Finland 26, 42, 102, 112, 168 FitzGerald, Garrett 145, 146, 149 France 1981 currency crisis 67–70 austerity 20, 62, 71–2, 74, 75, 78, 79, 81, 82, 106, 121 Communist party 22, 50–1, 66, 69, 70–1, 74, 76, 77, 79, 87, 95–6, 102, 107, 108, 176, 178 devaluation 22, 80, 87, 122–3, 163 economy 62–4, 71–4, 80–2, 104–6, 111–12, 118–20 elections 12, 161–2 elections 1981 5, 61–70, 87, 123, 132, 163 elections 1983 70–7, 79, 87, 123, 163 elections 1986 79–87, 123, 163 elections 1988 90–7, 123 elections 1993 97–110, 123 elections 1995 110–21, 123 elections Maastricht referendum 102–4, 109, 121–2, 139 franc fort 37, 70, 78, 106–8, 116, 118–19 party system 161 political business cycle 140, 163 Socialist party 4, 22, 50–1, 62, 66, 69, 70–4, 76, 78, 79, 82–3, 87, 90, 96–7, 104, 106, 108, 110, 114, 161–2 Socialist U-turn 22, 51, 70, 80, 90, 121, 161–2 Franco-German axis 31–2, 71, 155 Genscher, Hans Dietrich 71, 97 German leadership 22, 24, 28–32, 35–8, 78–9, 161 German unification 23–5, 31, 37, 100–1, 109, 139 Germany 1983 Elections 76–7 austerity 78 Giscard d’Estaing, Valery 20, 38, 61–2, 64, 66–7, 68, 70, 87, 106, 176

198

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Index

government type 46, 50, 56 Denmark 51 Haughey, Charles 144–6, 149, 150, 151, 179 hegemony 26, 29–30 ideas 15, 31–2, 37, 59 inflation 3–4, 9–10, 14, 20, 23, 24, 25, 29, 30, 31, 37, 41, 43, 44, 45, 47–8, 50, 51, 55, 57, 58 International Monetary Fund 69 Ireland and Germany 143, 151, 153–4, 155–6 Ireland and Britain 143, 146, 148, 151, 153, 155, 164 and France 147, 155–6 and Italy compared 156–7 austerity 53, 144, 145, 146, 149, 151, 161 Central Bank of 143, 153, 154 devaluation 144–8, 155 devaluation 1983 147–8 devaluation 1986 150 devaluation 1993 153–5, 157, 164–5 economy 143, 145–6, 147–8, 150–2, 153 election 1981 145 election 1987 148–51 election 1989 151–2 election February 1982 145–6 election November 1982 146–7 election November 1992 143, 144, 153–4, 156, 164 elections 12–13, 141, 142 Fianna Fail 52, 142, 144–5, 146–7, 149–50, 151, 153, 179 Fianna Fail-Labour coalition 154 Fine Gael 52, 142, 145, 146, 149, 150, 179 Fine Gael-Labour coalition 146, 147, 148–50 Labour Party 142, 149

partisanship 141, 164 party system 142–3 political business cycle 164 polls 146–7, 149 Progressive Democrats 149–50 Workers’ Party 142, 146, 149 Italy Alleanza Nazionale 138 austerity 132, 140 Christian Democratic Party 127–8, 163 Communist party 127, 128, 132, 133, 134, 135, 137, 139, 163 devaluation 131, 163 economy 129–31, 135–6, 163–4 elections 12, 125–8, 131, 163 elections 1979 130 elections 1983 129 elections 1987 129, 130, 133–4 elections 1992 129–30, 134–5, 137, 140 elections 1994 130, 137–9, 140 Forza Italia 137–8 Maastricht Treaty 135, 139–40 Partito Popolare Italiano 137, 138 PDS See Italy, Communist Party political business cycle 163 J-curve effect 11, 91 Jenkins, Roy 20 Jospin, Lionel 75, 110, 114–18, 179 Juppé, Alain 102, 103, 118 Kohl, Helmut 71, 76, 77, 78, 97, 100, 153 labor mobility 18, 98, labor unions 9–10, 22, 52 l’autre politique 22, 71, 79, 80 Lombard League see Northern League Maastricht Treaty 23, 24, 25, 103, 112, 139, 157, 159, 161, 165, 172 accession countries 28, 167–73

Index and France (for referendum on 110, 111–14, 116–18 and Ireland 144, 156, 165 and Italy 128, 134, 135–7, 139, 140 convergence criteria 101, 167, 169, 170–2 Danish referendum 25, 89–90, 101–2, 104, 121, 135, 139, 156 negotiations 37, 100 Madelin, Alain 106 Mauroy, Pierre 68–9, 71, 74, 75–6 Mitterrand Francois 1981 election 4, 61–2, 65–70, 87, 163, 176 Francois 1986 elections 84–5 Francois 1988 election 90, 92, 93–7, 178 Francois and 1993 elections 103, 107 Francois and 1995 elections 112 Francois and devaluation 68, 69, 78, 82–3, 163 Francois and European integration 94, 100 Francois and German unification 100 Francois and the 1983 municipal elections 72–4, 75–7, 79 monetarism 22, 78, 98 Monetary Committee 22, 26, 28, 33–5, 42, 77–8 Netherlands 26, 37, 42, 46, 47, 53, 78, 86, 112, 150, 168 Noir, Michel 102 Northern Ireland 53, 144, 145 Northern League 133, 135 oil shocks 20, 62 O’Malley, Desmond 149 optimum currency area 18, 23, 98–9, 100, 161, 170 output 11, 45, 47–8, 50, 55, 58, 63, 162, 177–8

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199

partisanship 4, 9, 14, 29, 45, 47, 50, 51, 55, 56, 160, 161, 162 Belgium 52 Denmark 52 France 51, 70, 79, 87, 88, 97, 119, 122, 123, 161 Ireland 141 Italy 127–8, 140, 163 party system Ireland 52, 142–3, 161 Italy 125–8, 134, 139–40 Pasqua, Charles 102, 103 political and government change 1, 4, 6, 9, 41, 52–3, 90, 125, 127, 129, 133, 140, 142 political business cycles 6–7, 8–9, 14, 18, 157, 159–60, 162, 163 political business cycles, opportunistic 160, 162 political business cycles, partisan 4, 10, 45, 50, 56–7, 109, 121, 160, 161–2 political business cycles, rational expectations 8–9 polls France 66–7, 75, 79, 80, 84–5, 93–5, 106–8, 112–16, 117, 121, 178 Germany 111 Ireland 145, 146, 149, 151 Italy 135, 138 Portugal 42, 112, 165, 168 position-taking 10–11, 57 Progressive Democrats 52, 142, 149–50, 151 rational expectations 7–9, 55, 160 real exchange rate 25, 44, 47, 54, 55, 132, realignment 2, 7–8, 22, 28, 33, 34–7, 40, 43–7, 50, 53, 54, 58, 61, 89, 98, 101, 136, 139, 140, 142, 153–4, 162, 163, 164, 166 1981 131–2 1987 91, 133, 151–2

200

●

Index

realignment 1982 71–2, 76–9, 129, 132–3, 147 realignment 1983 33, 75–80, 131, 132–3, 144, 147–8, 153–4, 155–6 realignment 1986 86–8, 133, 150–1, 156 reserves 3, 8, 11, 19, 24, 44–5, 47–50, 54–5, 57, 62–3 France 65, 68, 73, 81, 83, 92, 105, 111, 120 Ireland 153 Italy 135 Rocard, Michel 97, 106, 179 RPR 51, 80, 85, 90, 96, 102–3, 106, 107, 108, 109, 110, 112, 115, 117–18, 176, 177, 178 Sartori, Giovanni 127, 179 Scalfaro, Liuigi 137, 138 Schmidt, Helmut 20–2, 38, 71 sectors 4, 5, 9–10, 104, 170 Séguin, Philippe 102, 103, 106, 114 Single Market 23, 89, 90, 97 snake 12, 19–20, 26–7, 32, 33, 34, 78 Spain 26, 42, 112, 164, 168, 175 Spring, Dick 154

Stability and Growth Pact 26, 165, 166, 171, 173 Stoltenberg, Gerhard 78, 82, 86, 97 Sweden 26, 42, 102, 168 target zone 11–12, 43–4, 54, 162–3 drift adjust 43–4 Thatcher, Margaret 100 trade 4, 17, 18, 19–20, 23, 37, 45, 47, 48, 55, 98 France 62, 63, 75, 78, 80, 83, 90–1, 106, 111, 118, 119 Germany 62, 81 Ireland 143, 154, 155, 161 Italy 129 Treaty on European Union see Maastricht Treaty Trichet, Jean Claude 37, 117 UDF 51, 80, 85, 90, 96, 102–3, 106, 107–10, 176, 177, 178 unholy trinity 19 Verheugen, Gunter

167

Zeitler, Franz-Christoph

169