The first reaction of some has been to pull up the drawbridge to shut out the speculators. Ireland yesterday followed Spain in tightening exchange controls. The Irish central bank intervened for the fourth time in a week to support the currency, as it hit the floor of its permitted range in the EMS. Short-term interest rates hit 18 per cent yesterday. Some analysts said Ireland's reserves may have been cut by a third.
The Bank of Portugal, also under attack as investors target the escudo, announced measures to limit the amount of cash that local banks can move abroad to lend in offshore markets. This also had the effect of raising short-term interest rates.
The problem with pulling up the drawbridge to speculators is that it also scares off investors. Indeed, in modern integrated financial markets, the distinction is virtually impossible to make. Lewis Preston, the World Bank president, warned yesterday that currency controls were not the answer. 'I certainly hope the response will not be controls,' he said in Washington, 'because, as usual, that would be treating the symptom and not the disease.'
Spain was already counting the cost of its decision to reintroduce currency controls yesterday, as the stock market sank to its lowest level in more than six years. The Bank of Spain brought in emergency controls on Wednesday to defend the peseta, which had been devalued by 5 per cent last week but faced heavy selling. The currency strengthened yesterday, but investors' confidence weakened, raising local interest rates.
Part of the problem is that the credibility of the EMS has been dealt a crippling blow by the decision of Britain and Italy to pull out of the exchange rate mechanism (ERM). John Major said yesterday that Britain would only return to the ERM when it had been made 'to work for the benefit of all its members'. Giuliano Amato, the Italian Prime Minister, reiterated on Wednesday that he intended to return the lira to the ERM soon, but gave no indication of the timing.
Leaving the ERM is virtually unthinkable for the smaller countries. The link with Europe has been the passport to prosperity and modernity; life outside would be even bleaker than it is inside. It is political credibility as much as financial virtue that is at stake.
All of the peripheral economies had been struggling to come up to the levels of the richer countries of western Europe. The Maastricht treaty on European union included a stick and a carrot to help them achieve this.
It contains targets that they must stick to for budget deficits and inflation. But it also contained funds to help them upgrade their economies - so-called cohesion funds, aimed at Spain, Portugal, Ireland and Greece.
Now that the treaty is tottering on the brink of extinction, both the sticks and the carrots look illusory. Investors simply do not believe that governments under pressure will make the necessary adjustments. In several countries, there are protests and strikes aimed specifically against plans to cut budget deficits.
In Italy, Carlo Azeglio Ciampi, the governor of the Bank of Italy, warned that it was essential to proceed with the tough 1993 budget and the recent package of austerity measures designed to cut back the disastrous state deficit. 'Credibility is fundamental for the re-entry of the lira and I hope the Italian parliament will speed up its examination of the budget and try to pass it as soon as possible so as to have these elements of clarity and credibility which would allow us to establish at what rate to re-enter,' he said.
Although Mr Amato has said he will call a vote of confidence if necessary in order to get his economic plans through parliament - a move that is likely to ensure they are passed - the bills are highly controversial and it is not certain how long the process will take. The country already faces a 'hot autumn' of violent protests against the government's austerity measures.
Greece has already hit trouble in its attempts to rein in inflation, currently around 15 per cent, and bring government debt down from 100 per cent of annual economic output. Thousands of state employees staged a 24-hour strike yesterday protesting against government cuts, the latest in a month of disturbances. Hundreds of thousands of workers have attacked the austerity measures imposed by the Prime Minister, Constantine Mitsotakis.
The sad irony of the currency collapse is that some of the peripheral economies have made big sacrifices to get into shape. Ireland, for instance, has brought inflation down to under 3 per cent though unemployment is soaring.
Yet the decisions by Britain and Italy to let their currencies float also undermines the competitiveness of the smaller European economies. If competitive devaluations are followed by measures to limit the openness of capital markets, some economists fear that the result may be a 1930s-type spiral into chaos. Some of the peripheral economies are relatively young democracies, and political stability could go out of the window with economic prosperity.Reuse content