In today’s New York Times, business columnist Floyd Norris proposes a new eurozone0 conspiracy hypothesis: suppose the ongoing eurozone crisis was actually planned all along by Germany.
Better sit down because this is a good one. According to Mr. Norris’s model, the story begins in 1992. Having been frustrated twice in the 20th century in their attempts to take over Europe by military force, the government decided to use economics instead. His reading of the history of the euro as a German conspiracy is entertaining and insightful. Unfortunately, he is limited to the space allocated by his Times editors. Here on GonzoEcon we are our own editors and can consume as much space as we want. Let’s look back at the real beginning, 33 years ago.
Ancient History: The ERM
In March, 1979, France and Germany formed the Exchange Rate Mechanism (ERM). The ERM was designed to “stabilize exchange rates, reduce inflation, and prepare for monetary integration.” Other countries joined the ERM, including Italy, the Netherlands, Belgium, Denmark, Ireland, and Luxembourg. Participating countries were required to keep their exchange rates within a 2.25% band around each bilateral exchange rate. However, the peg was, to some extent, a crawling peg. There were nine realignments between 1979 and 1985.
Naturally, other countries joined the ERM. The United Kingdom signed up in 1990 at an exchange rate of 2.95 deutschemarks per pound and a band of 6%. Everything was fine until the West German government made a critical policy error involving German reunification.
More Recent History: German Reunification
Once upon a time there were two countries named Germany. West Germany was a modern democracy, while East Germany was part of the Soviet Union (USSR). In 1987 former U.S. president Ronald Reagan gave his famous “tear down this wall” speech, calling on Soviet leader Gorbachev to remove the concrete wall separating East and West Germany. Two years later, the wall came down, the Soviet Union dissolved, and the two Germanies became one in 1990.
The problem was the exchange rate conversion. West Germany used the deutschemark, while East Germany used the ostmark. The ostmark was a nontraded currency, but the black market rate was around 8 ostmarks per deutschemark. However, to integrate peacefully, the West German government agreed to convert ostmarks to deutschemarks at a 1:1 ratio. Effectively, there was a huge transfer of purchasing power from West Germany to East Germany. In response, the Bundesbank began printing deutschemarks. Inflation surged and the Bundesbank reversed course, causing interest rates to rise. As predicted by Irving Fisher and Robert Mundell (among many others), German interest rates were high relative to other countries in the ERM. There was a financial flow into Germany, increasing the demand for deutschemarks and causing the DM to appreciate. To maintain the peg, other ERM members were forced to raise their interest rates. However, those countries were not facing an inflation problem. Many experienced recessions.
The United Kingdom and George Soros
The United Kingdom was in an especially difficult situation because their economy was already in a recession. Raising interest rates would make the recession worse. The choice was stark: make the recession worse or get rid of the peg. The lowest-cost alternative was to drop out of the ERM. Incidentally, George Soros placed huge bets on the pound depreciating, effectively selling the currency short and putting pressure on the Bank of England. The Bank bought £15 billion. Not enough. On September 16, 1992 (“Black Wednesday”) the Bank raised interest rates from 10 to 12%. Still not enough. The Bank announced its intention of raising interest rates to 15%. Finally, at 7 pm, Chancellor Norman Lamont announced that Britain would leave the ERM and interest rates would be reduced to their initial 10% level. Italy also dropped out of the ERM. In testimony before the House Banking Committee, C. Fred Bergsten, the director of what later became the Peterson Institute for International Economics said, “Successfully defending a fixed rate can also be quite costly. Mr. Bachus [Rep. Spencer Bachus, R-Alabama] asked, ”Are there alternatives?” Well, you can defend a fixed rate if you are willing to push interest rates to 20 percent, 50 percent, 100 percent or if you are willing to push the economy into a recession, but those are huge, costly steps. Countries usually aren’t willing to do it; and, as a result, they may get the worst of all worlds — huge costs in trying to defend the fixed rate and then it is still knocked off by speculation, and all sorts of crises result.”
Mr. Soros made a huge pile of money on the deal. But it’s pretty clear that the fundamentals were on his side. The ERM was simply untenable without macroeconomic coordination among the member countries. The fundamental condition proposed by Dr. Mundell’s theory of optimum currency areas is a high degree of economic integration among members of the currency union. Germany was experiencing inflation while the U.K. was in a recession. There is hardly any better indicator of a lack of integration.
A Conspiracy in Three Steps
Which brings us back to Mr. Norris. Remember him? The guy with the conspiracy theory? Contrary to Dr. Bergsten’s earlier statement, Europeans learned a different lesson from the collapse of the ERM. “… common currencies had to be rigid, so there was no possibility of an attack on a weak currency by speculators.” And, of course, a single currency is the ultimate defense against speculation.
Speaking of speculation, here’s what Mr. Norris has to say (hypothetically, of course). Germany learned three lessons.
- Their export-oriented industries would be subjected to periodic devaluations from other European countries. These ongoing devaluations would reduce German exports and have a deflationary impact on the economy.
- A currency union would, on the other hand, be helpful to Germany. The exchange rate of the common currency — let’s call it the euro — would be below the deutschemark exchange rate because the euro’s exchange rate would be kept low by less competitive economies. After all, the euro’s exchange rate is nothing more than the weighted average of hypothetical individual country currencies.
- After the currency union, Germany could adopt a low interest rate policy. This would create low interest rates for other Eurozone members, banks would “open the credit spigot and create a debt-financed boom in much of Europe.” The result: massive imbalances, deeply indebted countries (Greece, Italy, …) and a crisis that could only be solved by acquiescing to German policies. The debtor countries would be forced to give up a large part of their national sovereignty.
There is much more in Mr. Norris’s column. I urge everyone to read it. Are Germany’s politicians and economists really that smart? I don’t know, but some people apparently believe it.
 Notably, in order to join the ERM, Ireland had to give up pegging the Irish pound to the British pound.
 For those keeping score at home, eight countries mean 28 bilateral exchange rates for each country to track. The formula is n(n-1)/2.
 The actual ratio included two steps. Ostmark balances above 4,000 were converted at a 2:1 ratio. Wikipedia has a good page explaining all this in detail.
 Those who see an analogy with Greece, Spain, et. al. today are not alone.
 Again, this sounds eerily familiar.
Better sit down because this is a good one. According to Mr. Norris’s model, the story begins in 1992. Having been frustrated twice in the 20th century in their attempts to take over Europe by military force, the government decided to use economics instead. However, history shows the actual beginning was in March, 1979, when a number of European countries