Getting to Yes (Again) with Germany

GENEVA – Europe’s slow-motion sovereign-debt crisis may appear unique, but it is not. Just a few decades ago, Europe had the Exchange Rate Mechanism, which collapsed during a crisis very much akin to the one afflicting Europe today. Will the outcome this time be different?

The ERM was an arrangement that pegged most European currencies’ exchange-rate movements within limited bands. But ERM members’ monetary policies remained home-grown, which, no surprise, occasionally led to fiscal imbalances. When capital markets smelled a problem among ERM members, they invariably shorted the most vulnerable currency and pushed that country’s authorities to devalue. Authorities resisted, blamed speculators, and then, usually over a frantic few days, gave in.

Markets also tested the resolve of policymakers in otherwise sound ERM countries, particularly when there were big strikes or important elections. In those cases, even a government with the proper economic fundamentals and its financial house in order could still run into trouble. European Central Bank President Jean-Claude Trichet is well aware of this: in the early 1990’s, he confronted such a crisis as Governor of the Bank of France.

Some contemporary observers of the ERM thought that there was an easy fix for these troubles. If the central bank of the country that printed its “strong currency” (Germany) had been willing to provide unlimited support to a “weak currency,” things would have been sorted out. Germany’s Bundesbank, it was suggested, would stand ready to buy “unlimited quantities” of lire or francs, so no one would dare to short either currency.