European Monetary System

European Monetary System (EMS) was an arrangement established in 1979 under the Jenkins European Commission where most nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations relative to one another.

After the demise of the Bretton Woods system in 1971, most of the EEC countries agreed in 1972 to maintain stable exchange rates by preventing exchange rate fluctuations of more than 2.25% (the European "currency snake"). In March 1979, this system was replaced by the European Monetary System, and the European Currency Unit (ECU) was defined.

The basic elements of the arrangement were:

1. The ECU: With this arrangement, member currencies agreed to keep their foreign exchange rates within agreed bands with a narrow band of +/- 2.25% and a wide band of +/- 6%.
2. An Exchange Rate Mechanism (ERM)
3. An extension of European credit facilities.
4. The European Monetary Cooperation Fund: created in October 1972 and allocates ECUs to members' central banks in exchange for gold and US dollar deposits.

Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank soon emerged as the centre of the EMS. Because of its relative strength, and the low-inflation policies of the bank, all other currencies were forced to follow its lead if they wanted to stay inside the system. Eventually, this situation led to dissatisfaction in most countries, and was one of the primary forces behind the drive to a monetary union (ultimately the euro).

Periodic adjustments raised the values of strong currencies and lowered those of weaker ones, but after 1986 changes in national interest rates were used to keep the currencies within a narrow range. In the early 1990s the European Monetary System was strained by the differing economic policies and conditions of its members, especially the newly reunified Germany, and Britain (which had initially declined to join and only did so in 1990) permanently withdrew from the system in September 1992. Speculative attacks on the French Franc during the following year led to the so-called Brussels Compromise in August 1993 which established a new fluctuation band of +15%.

1992 crisis

• On 13 September 1992 Italy decided to devalue Italian Lira by 7% (other currencies revalue of 3.5%: Lira devalues 3.5%)
• On 16 September 1992 UK withdrew from ERM.
• On 17 September 1992 Italy withdrew from ERM.

Background

European currency exchange rate stability has been one of the most important objectives of European policy makers at least since the Second World War.

Two primary factors account for this:

• The history of exchange rate instability leading to social and economic instability, for example during the hyper inflation after the First World War in Germany or the competitive devaluations of the 1930s.

• The inter-dependence and "openness" of European economies.^[1]

Stage II

The European Monetary System was no longer a functional arrangement in May 1998 as the member countries fixed their mutual exchange rates when participating in the euro. Its successor however, the ERM-II, was launched on 1 January 1999. In ERM-II the ECU basket was discarded and the new single currency euro has become an anchor for the other currencies participating in the ERM-II. Participation in the ERM-II is voluntary and the fluctuation bands remain the same as in the original ERM, i.e. +15 percent, once again with the possibility of individually setting a narrower band with respect to the euro. Denmark and Greece became new members.

Stage III

The ERM-II is sometimes described as "waiting room" for joining the Economic and Monetary Union of the European Union. In the EMU (stage III) the actual currencies in the participating member states are replaced by euro banknotes and coins; thus, entering the Euro Zone.

References

• Ludlow, Peter. The making of the European monetary system. A case study of the politics of the European community. London: Butterworth, 1982