European Monetary System

The European Monetary System (EMS) was a multilateral adjustable exchange rate agreement in which most of the nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations in relative value. It was initiated in 1979 under then President of the European Commission Roy Jenkins as an agreement among the Member States of the EEC to foster monetary policy co-operation among their central banks for the purpose of managing inter-community exchange rates and financing exchange market interventions.

The EMS functioned by adjusting nominal and real exchange rates, thus establishing closer monetary cooperation and creating a zone of monetary stability. As part of the EMS, the EEC established the first European Exchange Rate Mechanism (ERM) which calculated exchange rates for each currency The ERM let exchange rates to fluctuate within fixed margins, allowing for some variation while limiting economic risks and maintaining liquidity.

The European Monetary System lasted from 1979 to 1999, when it was succeeded by the Economic and Monetary Union (EMU) and exchange rates for Eurozone countries were fixed against the new currency the Euro. The ERM was replaced at the same time with the current Exchange Rate Mechanism (ERM II).

History

Background, 1960 to 1971

The origins of the EMS can be traced back to the end of 1960 when the Heads of the member states of the EEC, known as the European Council today, met in The Hague and agreed to begin moving toward the goal of a single European economy. In 1969, the European Council decided to create an economic and monetary union to be implemented by 1980. The currency snake established a single currency fluctuation band of +/-2.25%, however Italy left the snake already in 1973.

The EMS is created

At a meeting of the EEC in Brussels on 5 December 1978, French President Valéry Giscard d'Estaing and German Chancellor Helmut Schmidt successfully championed the EMS, which was implemented via resolution at the meeting.

Creation of the European Currency Unit

European currency exchange rate stability has been one of the most important objectives of European policymakers since the Second World War. Between 1982 and 1987, European currencies displayed a range of stable and unstable behavior. For example, the Dutch guilder remained quite stable with respect to the Mark, the Italian lira exhibited a sharp downward trend throughout the life of the EMS, and the French franc, the Belgian franc, the Danish krone and the Irish pound all escaped trends of successive devaluations to emerge more stable.

German monetary policy dominates

The EMS was similar to the Bretton Woods system, in that it pegged member currencies within a fluctuation band. Furthermore, the EMS came to be 'de facto' centered on the Deutschmark similarly to how the Bretton Woods system had been based on the US Dollar. The influence of the US dollar also entailed strong disturbances within the EMS. Eventually, this situation led to dissatisfaction in most countries and was one of the primary forces behind the drive to a monetary union.

Changing operating principles and preparing for the Euro

The EMS went through two distinct phases. During the first period, from 1979 to 1986, the EMS allowed member countries a certain degree of autonomy in monetary policy by restricting the movement of capital. The second period, from 1987 to 1992, the EMS was more rigid. In 1988, a committee was set up under EEC President Jacques Delors to begin changing the EMS to provide favorable starting conditions for the transition to Economic and Monetary Union (EMU). The Delors plan was a three-stage process that lead to a single European currency under the control of a European Central Bank.

1992 crisis

The year 1990 saw a crisis in the EMS. The European single market had been created in 1986 with the main goal of removing control on capital movements. Periodic adjustments raised the value of strong currencies and lowered those of weaker ones, and national interest rates were changed to keep the currencies within a narrow range. In early 1990, 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, subsequently joining in 1990. The opt-out of Denmark from the EMU in 1992 and exchange rate adjustments of the currencies from weaker countries by the EMS also contributed to the crisis.

Criticism

Michael J Artis (1987) assessed the credibility of the EMS, stating that the EMS had low credibility during the first eight years of its history. Artis also states that the system demonstrated its resilience despite working relatively non-smoothly. He also remarked that EMS was supposed to have improved the stability of the intra-EMS bilateral exchange rates but that the improvement was less marked for effective rates when compared to nominal rates and stability weakened with the passage of time.

Additionally, Axel A. Weber (1991) claims that the EMS was a de facto Deutsche Mark zone. Moreover, it was often called "tying one's hands" because the policy adopted a fixed exchange rate which had short-run effects. The German central bank independently chose its monetary policy whilst all remaining EMS member countries' hands were tied on monetary policy and they were simply forced to target their exchange rates to the German mark.