Europe's Currency Crisis

September 18, 1992

Europe's rolling currency crisis should serve as a reminder that all governments ultimately are prisoners of economic fundamentals, market forces and nationalist impulses. Eurocrats plotting political and financial union by the end of the century may get away with ignoring that reality, but elected politicians do so at their peril.

Consider the plight of British Prime Minister John Major, who vowed never, never to devalue the pound sterling against the mighty German deutsche mark -- and suffered the humiliation this week of having to do so. With some success he had convinced his compatriots that their future did, indeed, lie inside of Europe, not outside. But to prepare for a common market at the end of this year and political and economic union at the end of the century, he had to join the 12-national European Monetary System (EMS) with its Exchange Rate Mechanism (ERM) as a necessary step toward a common currency under the umbrella of the European Community (EC).

Under this system, European currencies are supposed to fluctuate in value with one another only within set limits. This is a fixed-rate exchange system, a sort of regional version of the worldwide Bretton Woods system that collapsed in 1971 as President Nixon floated a drooping dollar when it got out of whack with the mark. For the moment, Mr. Major has floated the pound, and his counterparts in Italy, Spain and Portugal, weak economies all, may have to do the same. History repeats.

Where did Mr. Major go wrong? Well, the natural British instinct is to blame the Germans -- a supposition not without some merit. But even if the Germans had not gone on a wild borrowing binge to finance their reunification, even if the haughty Bundesbank had not resisted worldwide pressure to lower its interest rate lest inflation get out of hand, even if its chairman had not mischievously hinted that pound devaluation was needed, economic fundamentals and market forces would have caught up with Mr. Major.

First, the fundamentals: A currency is basically no stronger than its economy. While the exchange rates set in 1987 might have accurately reflected the relative situations in Germany and Britain at that time, in the years since the Germans have achieved much stronger growth, a better trade balance and a larger store of reserves. Output of goods and services in recession-plagued Britain last year dropped 2.6 percent. As long as Mr. Major was willing to ignore Margaret Thatcher's warning ++ that "fixed rates don't stay fixed," the pound and the mark were bound to get as out of sync, just as the dollar and the mark did 20 years ago.

Second, market forces: As represented in world currency exchanges, they generate trading that totals $650 billion a day -- a sum double the notorious U.S. annual deficit. When they smell blood, these markets can overwhelm national governments operating individually or collectively. Those supposedly naughty Germans bought $16 billion of Italian lira in a vain attempt to prop up that overvalued currency. But neither their central bank nor any others could save the pound once it became obvious its value was dropping through the floor set in the Exchange Rate Mechanism.

So we had a humdinger of a currency crisis this week, one that many did not anticipate, if at all, until after the French vote Sunday on whether they really want full European union and its consequent loss of sovereignty. The whole concept of European unity is up for grabs, not least because the end of the Cold War has enflamed separatism from the Atlantic to the Urals.

Even if Britain decides to re-enter the ERM with sterling devalued, it might not be able to resist another wave of speculation. Like some other European governments, it is caught in limbo between going-it-alone floating without fixed rates and an eventual common currency. Makeshift interim arrangements are decidedly unsatisfactory.

Americans can observe from afar, waiting for the dust to settle, knowing that the protectionist impulses so evident in EC policies are a heavy price to pay for the supposed political stability of European union. But at least the lesson should be learned that if the United States continues to ignore economic fundamentals by running up unsustainable public and private debt, world market forces will catch up with us one day. The result could be a catastrophic currency crisis all our own.

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