Currency Collapse in Europe Patterns Past
THE foreign-exchange crisis in Europe reminds Rudiger Dornbusch of the fall of the United States dollar in 1971.
"It is exactly like the end of Bretton Woods," says the Massachusetts Institute of Technology economist, referring to the international monetary system set up after World War II that collapsed under President Nixon. "We are seeing that policies to stop inflation by using hard exchange rates have their own rendezvous with overvaluation and collapse."
As he predicted earlier this week, the pound and lira withdrew from the European Exchange Rate Mechanism yesterday, and underwent a temporary devaluation. And the Spanish peseta was also devalued 5 percent.
This currency realignment won't be catastrophic economically. "There is no permanent damage," Dr. Dornbusch says.
Indeed, the adjustment should permit interest rates in Europe to be lowered and boost the Continent's slow-growing economies. But it will have a political impact. Already there are some in Britain calling for the resignation of Prime Minister John Major. Dornbusch thinks it likely the chancellor of the exchequer, Norman Lamont, will have to go.
"Every second British chancellor of the exchequer has said `never, never' and had to do it," says Dornbusch, exaggerating on the number of devaluations of the pound.
In 1971, the German Bundesbank decided it would no longer support the dollar on the foreign-exchange markets. So a revaluation of the mark combined with a devaluation of the dollar was negotiated. That didn't last long. The dollar was soon "floating" against other major currencies, with buying and selling on the foreign-exchange markets largely determining the price of the dollar in terms of other currencies.
Again, the Bundesbank has decided it didn't want to or couldn't afford to support weak currencies - this time in Europe. If the Bundesbank buys a weak currency - say the lira or the pound - in huge quantities and that currency is subsequently devalued, literally billions of dollars can be lost. The Bundesbank told the Italians it would no longer maintain the value of the lira. Immediately the Italians, having perhaps put up about $25 billion to support the lira, agreed to a devaluation of 3.5 percent com bined with a revaluation of 3.5 percent by the German mark and the other currencies belonging to the European Monetary System. The revaluation was probably something of a political face-saver for the Italian government - just as the revaluation of the German mark was a face-saver for Nixon in 1971.
The Bundesbank probably told Britain it would no longer support the pound. But the German interest-rate cut of one-quarter percentage point Monday is seen as merely symbolic. It didn't stop speculation against the pound.
Already, according to reports from Britain, dealers on the foreign-exchange market have made 600 million British pounds in commissions alone. That's more than $1 billion at Wednesday's price for the pound. With the pound down about 5 percent against the mark, speculators can expect to make a handsome gain in a short period of time. The loser will be primarily the government, i.e., the British taxpayer.
"There isn't enough money in the world to defend the pound," Dornbusch says. In a realignment of the European currencies, the French franc, Belgium franc, and the Dutch guilder would join the German mark in a revaluation, he says. The French have already brought down their inflation rate dramatically. In fact, French inflation is currently running below that of Germany.
The British hoped to use the same trick - using a fixed exchange rate with the German mark as a political excuse for the tough economic policies needed to reduce inflation. Dornbusch says it didn't work - that the British will have to try again with a devalued pound. Like some other economists, he says Britain fixed the pound at too high a rate when it joined the European Monetary System. He says it will be possible in the years before 1998, when Europe is supposed to have a single currency for the Briti sh to move more smoothly to a lower rate of inflation.
Speaking of the Bundesbank, he comments, "Think of her as Mother Reality." As for the state of European unity after this fuss, "it needs a fresh coat of paint."