Birth of Euro due to German Unification

Ø Scenario in Germany

a. 1991 – German Unification

b. Newly formed Germany went into major FISCAL EXPANSION (increased Government spending) after unification to revamp infrastructure of East Germany

c. East German Marc became relevant and East German went to West for purchase of Goods, which increased the demand of goods in Germany.

d. Hence, overall demand in Germany was boosted (From Points 2 & 3) which resulted in inflation to rise.

e. Germans are obsessed with price stability. Hence, German central bank sucked out liquidity from the economy (MONETORY POLICY CONTRACTION) to lower the inflation and hence, increased interest rate

f. Europe was bound together by ERM (Exchange Rate Mechanism), where West German Deutsche Mark was fluctuating vis-à-vis other hard currency of the world. Rest EU currencies were pegged to Deutsche Marc (Range of +-2.25)

g. Because of High Interest rate in Germany, Deutsche Mark was in demand and everyone was dumping the other currency

Ø Scenario in UK

a. To maintain the peg, UK started buying their own currency from their domestic market to increase its demand, in exchange of Deutsche Mark from their reserves (to avoid further weakening of UK pound)

b. The above resulted in sucking of liquidity (pound) from UK market, thereby increasing the interest rate (MONETORY POLICY CONTRACTION)

c. SEPTEMBER 16, 1992 – Speculator George Soros knew that this process can’t continue & hence, he started buying Deutsche Mark ($10 billion) by selling British pound (Government was buying pound at a relatively high price).

d. But at a certain point, Bank of England didn’t had enough Mark to sell to Soros. Finally, they announced that they can’t maintain the peg because

i. They were out of reserve of Deutsche Mark

ii. UK needed low interest rate, but pegging meant high interest rate

e. Result – $ 1 billion USD in profit for George Soros, UK came out of ERM

Ø How to avoid such speculation in future

a. Have flexible exchange rate – But EU wanted to have fixed / pegged currency in order to promote peace through economic stability, cooperation and inter-dependence (to avoid one more WW II)

b. Have single currency – EURO was born a little early

Ø EURO was born - Hence, it represents early birth of EURO, united monetory policy, but no unified fiscal policy