Building blocks of a systemic theory

By focusing the analysis on the role of international spillovers and policy games, Chapter 8 has concluded our journey through the conceptual and analytical dimensions of the literature on currency crises. The goal of Chapter 9 is to assess the ERM crisis from the perspective of our Center–Periphery model. We start in this section by reviewing our analysis of the role of policy coordination in a currency crisis. In Section 9.2, we provide a detailed reinterpretation of the 1992–1993 events in the light of our results. While the formal analysis in Chapters 6 through 8 will instruct our reading of the crisis, in what follows we will widen the scope of the discussion beyond the strict boundaries of our model and consider additional elements that, for the sake of analytical tractability, were not incorporated into our formal analysis.

It may be helpful to restate the main features of our theoretical framework. Our construction conforms to the traditional view of the ERM as a way of borrowing or importing anti-inflationary credibility from Germany (the consensus view at the time of the crisis). Since individual Periphery countries are affected by an inflationary bias, they agree on the desirability of limiting exchange rate flexibility. The international exchange rate agreement provides the commitment technology that policy makers cannot find at home, although such a commitment is known to be less than perfect and market participants perceive the abandonment of the peg as a possible policy option in the presence of domestic or external shocks.