Financial Markets and European Monetary Cooperation: The Lessons of the 1992-93 Exchange Rate Mechanism Crisis.

• Author: Wadhawan, Anup
• Position: Review

By Willem H. Buiter, Giancarlo Corsetti, and Paolo A. Pesenti. Cambridge, MA: MIT Press, 1998. Pp. xii, 223. $49.95.

This book is aimed at extending the theoretical framework to better explain the 1992-1993 crisis in the European Exchange Rate Mechanism (ERM). At the outset, the authors trace the history of the "quest"(1) for exchange rate stability in Europe. The Snake, which had its roots in the breakdown of the Bretton Woods system, was the first significant step in this direction. The Snake spelled out narrower bands than those implied by Bretton Woods. Exchange rate fluctuations between member states were to be confined within these bands. The Snake had distinct shortcomings in the form of limited financing arrangements and an asymmetry in the crisis management responsibility. This asymmetry confined the stabilizing role mainly to the central banks of the state with the currency under devaluation pressure. The Snake was propped up by widespread capital controls. Encouraged by the convergence in European inflation rates in the preceding years, the (new) European Monetary System (EMS) was launched in 1987 with augmented financing arrangements and greater symmetry in the support role to be played by member central banks. The degree of realignment flexibility in the target bands was reduced. Capital controls were largely done away with. The remarkable stability of the system in its initial years encouraged acceptance of the Delors report in 1989 and the signing of the Maastricht treaty in 1991. These steps were aimed at a phased movement toward complete monetary unification. These plans came under threat with the 1992-1993 crisis in the ERM, which is the subject of this book.

The authors briefly recount the economic and politico-economic arguments that have led to this long "quest" for exchange rate stability in Europe. The authors discuss the well-known explanations of this "quest" in terms of preserving economic integration, inducing macro policy coordination in the face of spillovers, reducing uncertainty, preventing misalignment in international relative prices (supposedly caused by unregulated financial markets), and needing to ensure the viability of the Common Agricultural Policy. The politico-economic reason, rather than efficiency justification, for eventual monetary union is apparent.

The factors that led to the 1992-1993 ERM crisis are classified into two categories. The first category includes macroeconomic and political...