Guest contribution: Currency independence

Guest contribution: Currency independence

A guest contribution by Prof. Dr. Dr. h.c. Starbatty

Never again entrust the fate of monetary policy to a foreign power!

An economy has three action parameters to secure or restore its international competitiveness:

Wages, interest rates, exchange rates

The economically appropriate measure is devaluation; it takes place from one minute to the next and directly compensates for cost disadvantages.

Cutting consumption and investment by means of higher interest rates in order to free up economic capacities for exports is a protracted, procyclical and highly uncertain method — not recommended.

Restoring international competitiveness through wage cuts is probably the most painful form of adjustment, as it is usually accompanied by recession and higher unemployment.

In a monetary union, an economy can no longer use exchange rates and interest rates to secure its international competitiveness. It loses its economic sovereignty.

The British had imposed an "Opt-out clause" in the Maastricht Treaty: They could decide whether they wanted to apply the articles applicable to the creation of the European Monetary Union to themselves. From the outset they had not decided whether to make use of the "Opt-out clause". They took part in the pre-stage of European Monetary Union, the European Monetary System (EMS).

In the EMS, the exchange rates of the Member States were to be kept within a margin of 2.25%. The central banks of the Member States had to intervene in the foreign exchange markets when their national currencies approached the lower or upper exchange rate margin. This was also to be the case for the Deutsche Bundesbank. However, before the establishment of the EMS, its policy was regarded as stability-driven and predictable. The Member States assumed that it would also pursue this policy in the EMS. Therefore, the other Member States intervened on their own initiative in D-Mark, when it was weak, in the expectation that a stock of Deutsche Mark would be helpful if their own currency had to be supported. They would then be able to draw on their D-Mark holdings to stabilise the national currency exchange rate. In this respect, the Bundesbank (German Federal Bank) was able to dispense with the need to maintain the Deutsche Mark. The other Member States did this for it.

Thus the D-Mark grew into the role of an anchor currency and the Bundesbank was the guardian of this anchor currency. In this role, the Deutsche Bundesbank also set the monetary policy course. If it raised the refinancing rate, the Member States had to follow suit in order not to come under pressure to devalue. If it lowered it, the member states central banks also followed suit. The originally symmetrical design of the EMS thus turned into an asymmetric decision-making process: The Bundesbank sets the course and the others follow.

It was precisely this dependence that led to United Kingdom's withdrawal from the EMS. German reunification — starting on 11 November 1989 — triggered a reunification boom because the strong pent-up demand for private consumption and investment drove prices up. The Bundesbank raised interest rates in order to control the economy. But that proved harmful for the British economy, which was just going through a recession. Instead, it would have needed a sharp cut in interest rates. The British pound came under pressure. It was faced with the decision either to pursue this procyclical policy or to withdraw the pound from the EMS. It was determined to do it the hard way.

In this situation, the President of the Deutsche Bundesbank, Helmut Schlesinger, announced that this policy could not be sustained. When a private person says this, it is an opinion; when the President of the Bundesbank says this, it is an official statement. Speculative attacks against the British pound started immediately. The British government was forced to remove its currency from the EMS. In the ensuing House of Commons debate, Helmut Schlesinger was sharply attacked. And the British did not hold back. Schlesinger was attacked because, firstly, as President of the Bundesbank, he oriented policy towards national interests and, in doing so, forced the Member States to follow a disastrous policy, and secondly, because his verbal intervention forced the pound from the EMS. The spokesman in the House of Commons was the conservative Chancellor of the Exchequer, Norman Lamont. In a later interview, he was asked how, with hindsight, he assessed this event. His answer consisted of two parts:

It was only right that the Bundesbank should have considered itself bound to German interests. This was the legal mandate given to it; it would also have been fatal in the long run if the anchor currency had no longer had a firm hold.

For Great Britain, the withdrawal had been advantageous because it was now possible to fight the recession with monetary policy. And they were successful.

This episode from the autumn of 1992 marked the British with an indelible experience: Never again to entrust its monetary fate to a foreign power or institution.


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