Behind the European Currency Crisis

...Germany had increased the interest rate to discourage demand within Germany, by making it more costly for individuals and business firms to borrow money...

...This was during the Vietnam War, when the costs of the war kept spiraling...

...By forcing the other countries in "the snake" to raise their interest rates too, it was forcing Great Britain and other countries in Europe to adopt a deflationary policy at exactly the wrong time for them...

...But today, although the United States still talks of "free trade," its policies move strongly along the path of "managed trade," as we see in the quotas for automobiles, textiles, steel, and the like, as well as export subsidies for farmers...

...The field of battle becomes economics...

...The European currencies were managed through the Exchange Rate Mechanism (ERM), called colloquially "the snake...

...It remains paramount as a military force...

...Against the pressure of markets, nations have four options: to increase their interest rates in tandem with the paramount power, but also to accept, in this instance, the deflationary consequences...

...When England joined the ERM in 1990, it did so at a high rate of the pound to the mark, which indicated that the pound was highly overvalued...

...Already the large Dow Chemical company has taken the step of denominating its sales outside the United States in German marks...

...Twenty years ago, 31 percent of its trade was with European Community nations...

...President Bush proposed to dampen exchange fluctuations by linking national currenWINTER • 1993 • 53 cies to a basket of commodity prices, including gold, and making this basket an "independent reference point...

...To all this there is a great historical irony...

...The paradox is that on January 1, 1993, all restrictions on the movement of capital within the European community were supposed to be lifted...

...The increase in the government's budget deficit was so great that 20 percent of the budget simply went for interest payment, had reduced the savings and investment rate by half...

...in short, when political differences became irreconcilable, wars break out between countries...

...The huge amount of marks now available for the goods-starved East German population created a huge increase in demand, so much so that the money growth in Germany began running at about 9 percent a year, as against the target of 5 percent...

...But Britain felt that it wanted a Copyright © 1993 by Daniel Bell...

...In effect, it was paying for the war by cheapening the value of the dollar through inflation...

...Now all that is gone...

...The currency debacle that destroyed European monetary unity arose for the simple reason that when the "moment of truth" arose Germany put its own national interest above all others...

...In economic strength there are three major economic powers—Germany, the United States, and Japan...

...England, struggling to maintain parity with the mark, raised its base lending rate to 12 percent and then to 15 percent, creating huge pressures on real-estate mortgages and borrowing costs for business, actions that economically and politically created so great a set of shocks that England finally withdrew from the ERM and let the value of the pound fall...

...No nation would willingly accept the consequences of such freedom, the way the United States, developing as it did unchecked and on a continent-wide basis, was able to do in the first two hundred years of its existence...

...Much of the turbulence in the world currency markets has been blamed on "speculators" and securities firms and trust funds...

...The United States is no longer the single hegemonic power in the world in the three dimensions of military, political, and economic strength...

...But today, war between the advanced industrial societies, in the sense of military weapons, has little purpose, for there is little to gain in respect to security or resources from such attempted conquests...

...The first steps were supposed to be a move toward a common currency by the end of the decade...

...These have been the immediate events and effects...

...With Britain in a deep recession, the last thing that its political leaders wanted to do was to discourage domestic spending by raising interest rates...

...We are left then with the messy situations of nations seeking to adopt policies favorable to their own national interests and protecting themselves against the buffeting of the tidal waves of capital and goods and labor as propelled by the riptides of markets...

...But Lyndon Johnson, and Richard Nixon who followed him, did not wish to pay for those costs by increasing taxes, because they feared a popular reaction from a hesitant people who had begun to question the war...

...Yet what the events of September showed was that contrary economic pressures had forced each nation to defend itself and to adopt divergent economic policies...

...In a minor sense, speculation is a "hedge" against a future change in the values of assets or the future prices of commodities that one may need to buy, or the value of currencies sold but for which payment has not been received...

...exporters, for the while, a price advantage...

...We see it as a tool to keep money sound and the rate of inflation low...

...But as all world commodity prices were—and still are— denominated in dollars, it was also exporting its inflation to the rest of the world...

...Yet to blame Germany alone is to miss the larger context of responsibility, which is the world recession itself...

...But devaluation is a competitive weapon...

...In 1970, France demanded that the United States redeem the dollars held abroad in gold, which was written into the Bretton Woods agreement, where the United States had pledged to convert dollars into gold for foreign central banks at $35 an ounce...

...This was supposed to maintain a fixed relation of each currency to one another in order to provide stable expectations for exchange rates for those buying and selling goods and services within Europe...

...For almost any other country in Europe, 3.5 percent would be quite low...

...And this the German Bundesbank was forced to do when the German Chancellor, Helmut Kohl, put his own party's interest above all others...

...The decisive question is the nature of power in the different spheres of dominance...

...Equally, the cost of reunification in subsidies and welfare payments is estimated at about $130 billion a year...

...The deflationary pressures initiated by Germany may not have as sharp an effect on other countries, since Britain and the others took quick defensive action by devaluation...

...Because of the move by Finland, the Swedish krona fell, and the Swedes initiated a series of sharp increases in the interest rate to dampen fluctuations and build a wall around its currency...

...Maastricht was the treaty that was supposed to create a political framework for a united Europe...

...But given "the snake," Germany was, actually, "exporting" its deflation to the rest of Europe...

...If Germany increases its interest rates, money is going to flow to where it gets the highest returns...

...The more direct step that unhinged the European system was taken by Italy, which devalued the lira by 7 percent...

...To some extent they are, but this is to misread the inevitable role of markets...

...to introduce capital and currency controls, as did Spain, Portugal, and Ireland, but this is, with modern communications systems, inherently porous and can only be temporary...

...It took more than ten years and an interest rate of almost 20 percent to break the recurrent inflationary expectations that had fed on the distrust of government, and to wring doubledigit inflation out of the system...

...The inflation initiated by the United States at that time almost wrecked the world economy...

...The immediate "trigger" for the collapse was that the German Bundesbank set its interest rate at 91/2 percent, almost three times higher than one could get, for example, in the United States...

...50 • DISSENT Currency devaluations are crucial for European currencies (as against the United States, for example), for these countries, like Japan, depend heavily on imports...

...The misfortune of the German actions, seeking to protect their country from the rising domestic unrest, was that the deflation they were initiating to stop their own inflationary rise came at a time when the other European economies, which had already gone through a deflationary cycle, in some instances had begun to need a fiscal stimulus to begin recovery...

...The famous German geopolitical theorist Karl von Clausewitz said that war is the continuation of politics by other means...

...Although the greatest attention during September focused on Great Britain, the first steps in the "domino" process were taken, actually, by Finland, which, at the beginning of September, announced that it would let the markka, its currency, fluctuate against others, effectively devaluating it...

...What happened and what does this mean for the future of Europe...

...In consequence, there was a huge increase in borrowing and a massive rise in deficit spending, so that inflation rose to 3.5 percent a year...

...Sterling, for example, went to $2 for the pound...

...What the Germans wanted to do was to "deflate" their economy...

...By the end of the decade there was even supposed to be a single unified currency for all of Europe, replacing the different national currencies...

...Thus, if the mark is strong relative to the dollar, and the German currency is rising faster than the basket of commodities, it would be a signal that the Germans would need to lower the value of the mark, presumably by cutting the interest rate...

...A commodity standard, however, is increasingly unstable as technological substitutions limit the use of natural resource commodities — raw-material commodities have been in a slump for more than ten years—and it is doubtful whether commodity prices would be a useful indicator of real economic trends...

...In the United States, the debt-fueled boom of the Reagan years resulted in such heavy borrowing that at one point last year the amount of debt in the country reached 130 percent of the Gross Domestic Product...

...It has already begun to oppose American policy vis-à-vis Russia on the foreign-debt issue...

...The basic fact is that in the 1980s almost every advanced economy was living beyond its means by perilously inflating its assets or by going heavily into debt and borrowing from the future...

...But this was predicated on the proposition that each country would align its economic policy toward each other in a move toward convergence and a common European interest...

...to almost shut down their economy to deter speculation, as did Sweden in raising its interest rates to an unheard-of 500 percent...

...In both instances, that of the United States in the 1970s and Germany in the 1990s, the national interest, and within that, the domestic political interests, came first...

...and that was right...

...or to devalue, as did Italy and Great Britain...

...England, though it has decamped from the Exchange Rate Mechanism, is still, and increasingly, oriented toward Europe...

...In the nineteenth-century view of the liberal utopia, markets alone would rule, and prices and capital movements and labor mobility would adjust freely to the varying demands in the capital and product and labor markets...

...The situation became so perilous (especially as many banks would be unable to meet the new international capital requirements set by the Bank for International Settlements) that the Ministry of Finance stepped in to prick the balloon of the "bubble economy," though it miscalculated its ability to control the steep decline in the stock market and the assets of the banks, thus plunging many into deeper trouble than it had expected...

...That movement was also supposed to flow along the smooth track of a managed system that would provide stability through the fixed parities of each currency—the mark, the pound, the franc, the lira, and so on—to each other...

...What, then, of the future...

...In the larger sense, given the logic of the market, such "speculation" is simply the rational behavior of money managers dealing with risks and the protection of their assets...

...Logically, if there were to be a world monetary reorganization, the denominator, or world standard, would be a basket of dollars, marks, and yen...

...This has been called "casino capitalism," as if all currency markets are a gambling casino...

...Thus, the United States began borrowing heavily and printing money...

...For Germany, given its traumatic memories of past inflations, this was high...

...WINTER • 1993 • 51 Kohl decided, for political reasons, not to raise taxes...

...As a German bank official stated: "We don't see interest rates as do many people in the United States or in Britain, as a way of influencing unemployment or stimulating business activity...

...between the mark and the Spanish peseta by 6 percent...

...Not surprisingly, either, the price of the German mark rose quickly as traders had difficulty buying German currency...

...OCTOBER 1992 "strong" pound...

...England may have been obliged to increase its interest rates, as it did 52 • DISSENT for a short while, but it is only prudent for money managers to be skeptical and change the asset allocations in their portfolios to reduce the proportion of sterling-based investments...

...In one chaotic month of September 1992, it all broke up...

...Not surprisingly, investors around the world sought to buy German marks and deposit these, for the higher interest, in German banks...

...Harmonization and convergence of policies are nice words but have little meaning when countries are in contradictory situations to one another, especially when all are in a worldwide recession...

...In Europe, the German mark has emerged as the single strong currency, and there is talk of a "two-track" system wherein a core group of currencies—of Germany, France, and the Benelux nations (Belgium, the Netherlands, and Luxembourg)—will remain as a "managed" group in relation to the mark...

...Let me put forth two theorems that may provide the foundation for such a framework: 1. Economics today is the continuation of war between countries by other means...

...In Europe, Germany has begun to take the political lead, as instanced in its role in recognizing Croatia, against American wishes, and thus precipitating the breakup of Yugoslavia...

...So it was perfectly logical for the Bundesbank to raise the interest rate to 91/2 percent as a way of dampening demand or, in effect, to be deflationary...

...today it is about 54 percent...

...Yet if some of the economic effects have been mitigated, there is still the political "fallout" in the breakup of European political unity and the postponement, if not the demise, of a single European currency...

...Europe no longer wants the presence of the United States, now that the Soviet threat has receded...

...But it is already questionable whether it is paramount as a political force...

...In world markets, the dollar has cheapened, giving U.S...

...But when the United States reneged on the pledge and President Nixon closed the gold window, the Bretton Woods system of pegged exchange rates collapsed...

...The "bets" made were that devaluation was the logical choice...

...54 • DISSENT...

...The Bush proposal, however, was an effort to find a supposedly neutral reference point to determine whether a currency is undervalued or overvalued...

...But when the German actions would have forced deflationary policies on Great Britain, Italy, and other European countries, they defected and the ERM system collapsed...

...This is the world where economics is the continuation of war by other means, and where each nation is caught in the turbulence of the contradictory currents of economics and politics...

...But these ratios were already six years old, and most analysts felt they were inappropriate...

...At one point, Sweden increased its base lending rate to 500 percent, almost shutting down its economy...

...Japan and the United States are two major instances in point...

...Because of "the snake," the price of other European currencies, in relation to the dollar (since all commodity prices are denominated in dollars), also rose...

...The variations between the "strong" currencies, such as the German mark and the English pound, were supposed to vary by only 2 percent...

...2. In the global economy, where the technologies of communication make it possible for capital to flow around the world in "real time," once a pivotal economic decision has been made by a paramount power, the logic of the market will override the efforts of any subsidiary countries to counter such decision by their own powers or controls and force these countries to yield to the power of the markets...

...In Europe today, as the events of Black September have demonstrated, Germany is the paramount power...

...Currencies were allowed to float freely...

...But that also would imply a harmonization of policies regarding trade, purchasing-power parities, and fiscal policies...

...In Europe, the European Economic Community remains, and by 1993 there will be a common market of almost 360 million persons, as the tariff and other barriers between the nations fall...

...All through this time, the German Bundesbank stood like a rock, lowering its interest rates only once (by a quarter of a point) to help the French government, which was facing a referendum on Maastricht...

...The European Exchange Rate Mechanism came into effect to provide a new stability by the managed parities of the European countries within a narrow range...

...As the "domino effect" continued, Spain and Portugal took the more direct steps of establishing overt currency and capital controls to set up protective walls and choke off the flight of capital for individuals seeking to unload those currencies...

...For in the early 1970s, by the system of managed currencies at that time—the Bretton Woods agreement—the United States exported its inflation to the rest of the world...

...But the larger question is the ability of the dollar to remain as the single denominated currency for world commodity prices...

...In Japan, the banks were using the inflated rise in real estate prices to count as assets to inflate their own portfolios in order to increase loan money at home (often for further rises in real-estate prices) or to use as capital for purchases abroad...

...Devaluation raises the price of foreign goods, bringing higher living costs and inflation...

...The "special relationship" with the United States was a consequence of World War II and the cold war, but that political relationship is now changing as the United States no longer feels a responsibility for Europe, and the American troops there are being withdrawn...

...But other countries, such as Great Britain, would have to raise their interest rates to halt the outflow of the pound and keep their currency attractive to investors...

...But is there some broader conceptual framework for understanding what happened, one that can help us understand and interpret the larger movements within the emerging global economy that will be in place by the end of the century...

...The picture was equally true of Sweden...

...But what nation, to the extent it can, would readily accept the decision of markets— especially of migrant and labor markets...

...The idea of a commodity basket was discussed by Keynes more than fifty years ago, and the International Monetary Fund (IMF) bases its special drawing rights for third-world countries on the commodities these countries deposit in the fund as collateral, so to speak, for the monies they draw from the IMF...

...The problem began with the German unification, when Kohl made the mistake of placing too high a value on the East German mark in buying out that currency...

...That was, in retrospect, a fatal mistake...