European Monetary System (EMS)

Created in 1979 with the intention of enhancing monetary policy cooperation between countries that were members of the European Community.

The European Monetary System (EMS) was created in 1979 with the intention of enhancing monetary policy cooperation between countries that were members of the European Community (EC).

European Monetary System

As part of this effort, the European Economic Community (EEC) instituted the European Monetary System, abbreviated as EMS, in 1979.

The nine members of the European Community adopted the system in 1979 to promote stability by minimizing exchange rate fluctuations.

The European Monetary Cooperation Fund was in charge of the issuance of the euro and the supervision of exchange rates. 

Its three key elements were:

  1. European Currency Unit (ECU

  2. The monetary unit used in EC transactions

  3. The Exchange Rate Mechanism (ERM). 

Member states of the European Monetary Cooperation Fund agreed to limit currency fluctuations within certain limits. 

Following the 1992 Maastricht Treaty, the Economic and Monetary Union (EMU) was established along with its European Monetary Institute, European Central Bank (ECB), and single European currency.

The EMS members were not harmonizing their policies sufficiently to reduce their inflation rates to those of the rest of the EMS members. Inequalities in the competitive environment resulted from this.

In its place was a new system called the European Economic and Monetary Union (EMU), which introduced a new currency, the euro, to the market.

Creation of the European Monetary System 

The European Monetary System (EMS) emerged after the breakdown of the Bretton Woods Agreement. It was established at the end of World War II (WWII) to stabilize economies and consolidate the financial power of Western Allied governments.

Finance

Following the abandonment of the practice in the early 1970s, currencies flopped, causing their values to fluctuate. As a result, the EEC countries sought a new means of stabilizing exchange rates to complement their customs union

A primary objective of the European Monetary System (EMS) was to stabilize inflation and alleviate large exchange rate fluctuations between European countries. 

Developing the common currency was part of a broader, overall objective of fostering economic, political, and social unity in Europe, which ultimately led to the establishment of the common currency, the euro.

Euros

Pegging the euro currency unit (ECU) to each member country's national exchange rate was one of the most crucial functions of euro monetary policy. A weighted average of 12 currencies of EU member countries served as the basis for the calculation.

The International Monetary Fund used sanctioned accounting methods to determine exchange rates between currencies of countries that actively participated in the ECU and helped formulate exchange rate policy.

Exchange rate mechanisms (ERM) were designed and implemented in order to control currency fluctuations. 

History

During the initial years of the EMS, currency values were uneven, and adjustments were made that increased the value of stronger currencies and lowered the value of weaker currencies. 

All euro-backed countries began to change interest rates in 1986 in order to keep their currency values stable at a level that could satisfy the population's needs.

Pie Chart

At the beginning of the 1990s, the EMS experienced a new crisis. It was in 1992 that Britain permanently withdrew from the EMU due to the different economic and political conditions of its member countries, notably the German Reunification.

This withdrawal by Britain paved the way for its later demand for independence from continental Europe; Britain, along with Sweden and Denmark, refused to join the eurozone.

During this time, increased efforts took place to forge a common currency and to pour more resources into economic ties between nations. The European Union was created by signing the Maastricht Treaty on 28 November 1993. 

A year later, in 1993, the European Union created the European Monetary Institute, which became the European Central Bank (ECB) in 1998. Eurozone monetary policy and interest rates were the primary responsibilities of the European Central Bank.

Several countries in the EU simultaneously lowered interest rates to promote growth and prepare for the euro's introduction by the end of 1998. A new unified currency, the euro, was introduced in January 1999. Most EU countries now use the euro. 

A second economic and monetary union, called the European Monetary Union (EMU), was established in March 2004 to replace the European Monetary System (EMS) as the European Union's central monetary and economic policy organization.

Goals of the European Monetary System

Cash

As part of the European Monetary System, the following macroeconomic objectives were pursued:

  • The promotion of trade within the European Union and other parts of the world

  • The stability of exchange rates among trading members

  • Relatively stable inflation rates within Europe

Implementation

In the early years of the EMU, the ECU and the existing exchange rate mechanism mainly sustained the union. 

In order for exchange rates to diverge from a fixed central point, the deviation had to be within certain limits.

Currency

As part of the European Monetary System, the exchange rate fluctuations between currencies of EM members were limited to 2.25 percent from the central point determined by the EEC.

Benefits of the EMS

The benefits are as follows:

  • Stabilization of the currency - During times of volatility in the international market, the EMS maintained currency stability in Europe.

  • Singular market creation - In the eyes of many, the founding of the EMS was a significant step toward building the European Union and the single market.

  • Unity in Europe - A pivotal period in the history of Europe saw the EMS promote political and economic unity across the continent.

Criticism of EMS

The EMS only permitted exchange rate changes if the member countries and the European Commission agreed. Such a move was unprecedented and triggered a tremendous amount of criticism.

Following the global economic crisis of 2008 and 2009, it was evident that there was a definite tension between the principles of the EMS and the policies of national governments.

In certain nations, the government adhered to the policies, resulting in high national deficits. These nations included Greece, Spain, Portugal, and Cyprus. 

Balance

Over time, the phenomenon became known as the European sovereign debt crisis. It was not possible for these countries to devalue their currencies, so they could not spend to offset unemployment.

Since its inception, the European Monetary System (EMS) was intended to prevent the need for bailouts to economically struggling eurozone countries. 

Although some members of the EU with stronger economies were vocal about their opposition to bailout measures, the EMU finally developed bailout measures to help struggling members.

The 1992 Crisis

The EMS introduced fixed exchange rates and a unified monetary policy. Germany increased interest rates to combat inflation in 1992, resulting in an economic crisis due to member countries' need for lower interest rates and increased exports, which put pressure on exchange rates.

Germany

Due to the different economic characteristics of each country, the increase in interest rates impacted each economy differently - some were export-oriented, and some were driven by cheap labor.

As a result of fixed exchange rates, many countries experienced turmoil and eventually decided to give up their ECU pegging system, which allowed exchange rates to float. 

Over time, the EMS has expanded the bandwidth for exchange rate volatility from 2.25% to 15%.

Drawbacks of the EMS

1. Fixed exchange rates

Fixed exchange rates impacted different members of the EMU in different ways, which did not benefit all the member nations equally. The 1992 crisis is a clear example of this.

2. Common monetary policy

By promoting uniform monetary policy, the EMS affected all economies differently, just as its exchange rate system affected all economies differently.

The End of the European Monetary System

After 1988, the Euro monetary system (EMS) would undergo a three-stage reform that eased the transition to a common monetary union for Europe. 

The first stage, introduced during the 1992 crisis, was to introduce free capital movements throughout Europe. Under the terms of the 1992 Maastricht Treaty, this institution continued to function as part of the European Union.

Map

The second and third stages of the scheme were introduced in 1998 and 1999, respectively, after the introduction of the Euro. 

A new exchange rate system based on the Euro replaced the EMS and its exchange rate system. Now the European Central Bank controls the euro's monetary policy.

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EMS Framework

EMS was composed of three interrelated elements, each based on existing Community structures. These included:

(1) A mechanism to link exchange rates

(2) A proposed European Monetary Fund

(3) A credit facility to support mutual payments

This exchange rate arrangement relied on the old "snake" scheme. It intended to reduce the fluctuation margins between member currencies that had first been implemented seven years earlier, in April 1972.

The snake scheme had hoped to encompass all nine currencies of the Community. 

However, two years after the Community was formed, five of its members, Britain, Denmark, France, Ireland, and Italy, withdrew because of various issues. After Denmark re-joined, France also tried re-joining but failed. 

In 1976, the joint float consisted of just five Community members (the Benelux countries, Denmark, and Germany) plus two outsiders (Norway and Sweden) and two informal "associates" (Austria and Switzerland).

Europe

At the start of the EMS negotiations in 1978, one of the outsiders (Sweden) had left, and Norway filed its withdrawal in December 1978.

At the Brussels summit, a French delegation vowed to rejoin the snake. Irish and Italian governments moved in the same direction after some hesitation, although Italy's decision to leave was initiated by a narrower range of 6 percent either way. 

British officials refused to commit, arguing that their financial situation was still unstable. The pound sterling continues to float independently, as it has since 1972. 

In developing this new, innovative "super snake," the biggest problem was determining how monetary policy should operate to maintain joint floats.

Among the mechanisms considered were:

  1. A parity grid solution, under which each currency links to the others through bilateral cross-rates.

  2. The "basket" solution where currencies are assigned an ECU, renamed the European Currency Unit (ECU), whose value would equal a weighted average of all the currency values. 

The choice between the two mechanisms generated controversy because they implied completely different obligations under varying circumstances.

The basket solution would only have required one country's central bank to intervene if the currency began moving sharply out of line. It differs from the parity-grid solution, which requires all national banks to intervene.

Basket

It is not surprising that countries like Italy and Britain argued for the basket approach, given the anticipated strength of the Deutsche mark. However, German opposition ultimately led to the parity grid becoming the primary guide for intervention. 

Nonetheless, concessions were made to the weaker countries, but the ECU remained. These included:

  1. Exchange arrangements based on the central rate of the parity grid.

  2. Divergence measures (which indicate when a country's currency deviates too far from its weighted average) were put in place.

As a result of a divergence signal, a "presumption" would arise that the country must act, either through changes to exchange rates or monetary and fiscal policies.

Euro

The European Monetary Cooperation Fund (EMF) aims to be a private European central bank in charge of all community loans related to exchange rates and fair balance-of-payments financing. However, it has only existed in name, having neither a headquarters nor a staff.

EMF's central bank governors' proxy committee always handles debt settlement between the snake's central banks through the Bank for International Settlements in Basel.

EMS breathed new life into the EMF by combining a portion of gold and dollar reserves with community members, in exchange for receiving deposits in the EMF, denominated in ECU, to settle intra-community debts. 

As in the past, credit continues to be provided by loans from one member country to another. Examples include:

(1) Short-term loans must be repaid within 45 days and are only available to snake participants. Very short-term loans are available in unlimited amounts.

(2) Medium-term loans have a nine-month repayment period 

(3) Long-term loans do not need to be paid back for up to five years. 

In the EMS agreement, the "effectively available credit" was raised from 5.5 billion to 14 billion ECUs (approximately 18 billion USD) under the short-term facility, and from 4.5 billion to 11 billion under the medium-term facility.

Cash

In effect, Germany, potentially the largest creditor in the Community, increased payments to weaker members such as Britain, Ireland, and Italy. 

In addition to supplementary EIB subsidized loans, Germany backed additional financial concessions to weaker members. Such "resource transfers" were vital for vulnerable countries if they were to cope with the potential harshness of a joint float. 

Ireland and Italy had been adamant that increased transfers were a precondition for their agreement to re-enter the snake, but were not convinced until they received additional financial concessions. 

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Researched and authored by Saif Ali | LinkedIn 

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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