The Credibility of the United Kingdom's Commitment to the ERM: Intentions versus Actions

WP/94/147-EA
The Credibility of the United Kingdom's Commitment
to the ERM: Intentions Version Actions by Paul Masson

Credibility is defined in the paper as the likelihood that policy
commitments will be carried out, as viewed by private agents. This concept
of credibility is viewed as having two components: the private sector's
assessment of the government's type--with respect to its commitment to
fighting inflation--and, given the type of government, an assessment of the
probability that an optimizing government will actually decide to carry out
its announced policies in the face of adverse shocks. A formal model
assessing the type of government and the policy choice that it will make is
developed, which is then applied to the credibility of the U.K. commitment
to its deutsche mark parity during the October 1990-September 1992 period of
exchange rate mechanism (ERM) membership. It is assumed that private agents
perceive that there are two types of government, which differ by the
importance attached to fighting inflation, but that they do not know which
one applies. A crucial assumption is made that even a government that is
fully committed to fighting inflation also attaches some cost to
unemployment.

The violence and suddenness of the September 1992 crisis have naturally
raised the issue of self-fulfilling speculation. Was the ERM crisis due to
a speculative attack that took on a life of its own, rather than to
fundamentals? The model allows for the possibility of multiple equilibria
and, hence, of self-fulfilling attacks. In particular, unemployment is
assumed to depend on exchange rate surprises: an unexpected devaluation
will tend to stimulate employment. Conversely, if private agents expect a
devaluation, but the authorities do not change the parity, there are
employment losses. Therefore, a credibility crisis, in which, for
instance, investors doubt that the government is committed to a particular
parity or gives as much weight to inflation as it says that it does, may
make the costs of maintaining the parity very high, if the government also
cares about unemployment, as is assumed. This circumstance may then trigger
a devaluation.

The model is tested by using Kalman filter estimation to account for
the variation of credibility over time. The estimates suggest that at least
in the case of the United Kingdom, lack of credibility in the summer of 1992
was due not to doubts about the type of government, that is, its commitment
to the ERM, but rather to concerns about the unemployment costs of
maintaining the parity. Consequently, even a government committed to the
ERM might not want to continue to bear those costs. In fact, continuing
downward pressure on sterling and upward pressure on interest rates made the
costs too high to bear, and the pound sterling was floated on
September 16, 1992. Although speculation made the defense of the pound
sterling more difficult, the model estimates suggest that speculation was
linked to fundamentals and, hence, was not purely self-fulfilling.