The European Monetary SystemEuropean Economic IssuesReading: Sloman Chapter 25Baldwin & Wyplosz 2003 Ch 10 & 12Swann Chapter 7

A Brief Monetary History of Europe Pre 17th C.Money originally based on metalsCostly and dangerous to engage in long distant trade.Problems with quantity and divisibility Even then no guarantee that value is trueEmergence of bills of exchange Essentially guaranteeing that goods to the value of x could be purchased in A

17th & 18th Century Amsterdam set up Public bank to weigh coins and therefore warranty deposits Which could be transferred between merchantsAND which could be lent onwards1694 Bank of England establishedto facilitate the King - with the right to issue promissory notes to others on the Kings behalf. Complemented by private banks (former goldsmiths) issuing notesParis - Banque Royal and the Mississippi Company

A Brief Monetary History of Europe 19th C.Bills of exchange still backed by (some?) metalUncertainty as to true valueTrade between cities as difficult as between nationsSorted in UK by 1844 designation that notes of the Official Bank Bank of England - were legal tender and guaranteedBut internationally problem remained

A Brief Monetary History of EuropeCurrencies issued by governments of different perceived stabilityNo agreement on how currency should be backed gold or silver often both circulating simultaneously and fluctuating in relative value Trade involved frequent movements of commodity gold or silver

A Brief Monetary History of EuropeGolden age of Gold Standard UK: 1821-1914Paris Conference 1867Latin European Monetary Union-1865-1926, F,B,I, Switz, & 1867 Gr & Bul.Scandinavian monetary union 1873-1924 Dn, Sw & NorEssentially a quasi-monetary union or set of unionswww.euromove.org.uk/publications/europeanhistories/chron2

A Brief Monetary History of EuropeNot so Golden Really Frequent revaluations, devaluations and currency crisesNeed strict monetary discipline, particularly on growth of monetary supply for this to work. Did not exist.1914 UK came off the Gold Standard at outbreak of war.

A Brief Monetary History of EuropeAfter WWI attempt to return to Gold StandardBut huge interwar debts had devalued currenciesBut UK returned to Gold at Pre-war rateFrench expected Germans to pay Frances war debtsGermans could not raise enough taxes, printed money at home, causing hyper-inflation Result was interwar chaos

A Brief Monetary History of EuropeAfter WWII international attempt to restore monetary order Breton Woods systemA Gold Standard based on the dollar. Worked well for a time. Currencies allowed to fluctuate by 1% around paritySome devaluations and revaluations but reasonably well behaved until Vietnam War.US paid for deficits by printing more dollarsEventually foreign governments lost faith and system started to collapse.

A Brief Monetary History of EuropeAgreed to widen the band vis-a- vis the dollar from 1% to 2.25.But if DM 2.25 above & FF 2.25 below then 4.5% differenceAnd if FF 2.25 above & DMF 2.25 below then total fluctuations of DM/FF is 2 x 4.5% = 9% difference.Response: Werner Report in 1970 forerunner of EMSThe (original) six Member States set up a snake in the tunnel mechanism to narrow the fluctuation margins between the Community currencies (the snake) in relation to fluctuations against the US dollar (the tunnel).

Snake in the tunnel: Commitment to keeping European rates within narrower band compared with Breton Woods SystemOExchange rateNointerventionCentral bankbuys domesticcurrencyNointerventionCentral banksells domesticcurrencyNointerventionTime+4.50%-4.50%+2.25%- 2.25%

A Brief Monetary History of Europe1973 First Oil CrisisSnake outside the tunnel link with dollar brokenGovernments responded by trying to reflate economies spending and issuing (forging) money expansionary fiscal and monetary policyDifferences across countries meant exchange rates unsustainableCollapsed, and then revived in 1979

The EMS-1: Key FeaturesA parity grid:bilateral central paritiesassociated margins of fluctuations. Mutual unlimited support:exchange market interventionsshort-term loans.Realignments:tolerated, if not encouragedrequire unanimity agreement.The E.C.U.:not a currency, just a unit of accounttook some life on private markets.

The ECUA basket of all EU currencies.

Source: Baldwin & Wyplosz 2003

The EMS: Interpretation and AssessmentImproving on the Snake to stabilise intra-European exchange rates:mutual supportrealignment unanimity rule.Respecting the EU equalitarian approach:no centre currencybilateral interventions by strong and weak currency central banks.No role for the US dollar: Europe on its own.

The EMS: Past and PresentThe EMS was originally conceived as the solution to the end of the Bretton Woods System.Over the years, its nature changed and it became a kind of DM area, with the Bundesbank very much in command.This, and the speculative crisis of 1993, made the monetary union option attractive.Now the EMS is mostly the entry point for future monetary union members.

Four Incarnations of the EMS1979-82: EMS-1 with narrow bands of fluctuation (2.25%) and symmetric.1982-93: EMS-1 centered on the DM, shunning realignments.1993-99: EMS-1 with wide bands (15%).1999- : EMS-2, assymmetric, on the way to euro area.

History of the ERMSource: Sloman (2006)

Mar

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Belgian franc

En21/4%

8.5

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Danish krone

En21/4%

2.9

4.8

3.0

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German mark

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+2.0

+5.5

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French franc

En21/4%

3.0

5.75

2.5

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Irish punt

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3.5

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8.0

Italian lira

En6%

6.0

3.0

2.75

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6.0

B21/4%

Dutch guilder

En21/4%

+5.5

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En6%

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French franc

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10.0

B15%

+3.0

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Ex

En15%

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Dutch guilder

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En6%

Ex

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5.0

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Portuguese escudo

En6%

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6.5

B15%

3.5

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En15%

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En15%

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Greek drachma

En15%

S

=% devaluation; + =% revaluation. B% = new band; En% = entry band; Ex = exit; S = join single currency

=% devaluation; + =% revaluation. B% = new band; En% = entry band; Ex = exit; S = join single currency

Evolution: From Symmetry to DM ZoneFirst a flexible arrangement:different inflation rates: long run monetary policy independencefrequent realignments.

Evolution: From Symmetry to DM ZoneInflationSource: Baldwin & Wyplosz 2003

The EMS: Interpretation and AssessmentCan EMS have monetary policy independence ?The Impossible trinity:widespread capital controls to preserve at least the ability to have different inflation rates.But Single Market Act ruled outFixedExchangeRateMonetary union Free floatEMSFull Capital MobilityMonetary IndependenceSource: Baldwin & Wyplosz 2003

Evolution: From Symmetry to DM ZoneBut: realignments:barely compensated accumulated inflation differenceswere easy to guess by marketsput weak currency/high inflation countries on the spot:Continuing current account deficitsSpeculative attacks.The symmetry was broken de facto.The Bundesbank became the example to follow.

The DM ZoneWhat shadowing the Bundesbank required:giving up much what was left of monetary policy indepedenceaiming at a low German-style inflation rateavoiding realignments to gain credibility.

History of the ERMSource: Sloman (2006)

Mar

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2.9

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3.0

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En21/4%

+2.0

+5.5

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En21/4%

3.0

5.75

2.5

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En21/4%

3.5

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8.0

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En6%

6.0

3.0

2.75

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6.0

B21/4%

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En21/4%

+5.5

+4.25

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En6%

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B15%

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B15%

B21/4%

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B15%

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French franc

B15%

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Irish punt

10.0

B15%

+3.0

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7.0

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En15%

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B15%

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En6%

Ex

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5.0

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En6%

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En15%

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En15%

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En15%

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=% devaluation; + =% revaluation. B% = new band; En% = entry band; Ex = exit; S = join single currency

Mar

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En21/4%

2.9

4.8

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En21/4%

+2.0

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En21/4%

3.0

5.75

2.5

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En21/4%

3.5

+2.0

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En6%

6.0

3.0

2.75

2.5

6.0

B21/4%

Dutch guilder

En21/4%

+5.5

+4.25

+3.5

+2.0

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Spanish peseta

En6%

Oct

Apr

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'90

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Belgian franc

B15%

S

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B15%

B21/4%

German mark

B15%

S

French franc

B15%

S

Irish punt

10.0

B15%

+3.0

S

Italian lira

7.0

Ex

En15%

S

Dutch guilder

B15%

S

UK pound

En6%

Ex

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5.0

6.0

8.0

B15%

7.0

S

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En6%

6.0

6.5

B15%

3.5

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Austrian schilling

En15%

S

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En15%

S

Greek drachma

En15%

S

=% devaluation; + =% revaluation. B% = new band; En% = entry band; Ex = exit; S = join single currency

=% devaluation; + =% revaluation. B% = new band;

En% = entry band; Ex = exit; S = join single currency

Breakdown of the DM zoneBad design:full capital mobility established in 1990 as part of the Single Act: EMS in contradiction with impossible trinity unless all monetary indepdence relinquished.Bad luck:German unification: a big shock that called for very tight monetary policythe Danish referendum on the Maastricht Treaty.A wave of speculative attacks in 1992-3:the Bundesbank sets limits to unlimited support.

History of the ERMSource: Sloman (2006)

Mar

Sept

Nov

Mar

Oct

Feb

June

Mar

July

Apr

Aug

Jan

Jun

Jan

'79

'79

'79

'81

'81

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'90

Belgian franc

En21/4%

8.5

+1.5

+2.0

+1.0

+2.0

Danish krone

En21/4%

2.9

4.8

3.0

+2.5

+2.0

+1.0

German mark

En21/4%

+2.0

+5.5

+4.25

+5.5

+2.0

+3.0

+3.0

French franc

En21/4%

3.0

5.75

2.5

+2.0

3.0

Irish punt

En21/4%

3.5

+2.0

8.0

Italian lira

En6%

6.0

3.0

2.75

2.5

6.0

B21/4%

Dutch guilder

En21/4%

+5.5

+4.25

+3.5

+2.0

+3.0

+3.0

UK pound

Spanish peseta

En6%

Oct

Apr

Sept

Sept

Nov

Jan

May

Aug

Jan

Mar

Oct

Nov

Mar

Jan

Jan

'90

'92

'92

'92

'92

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'95

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'01

Belgian franc

B15%

S

Danish krone

B15%

B21/4%

German mark

B15%

S

French franc

B15%

S

Irish punt

10.0

B15%

+3.0

S

Italian lira

7.0

Ex

En15%

S

Dutch guilder

B15%

S

UK pound

En6%

Ex

Spanish peseta

5.0

6.0

8.0

B15%

7.0

S

Portuguese escudo

En6%

6.0

6.5

B15%

3.5

S

Austrian schilling

En15%

S

Finnish markka

En15%

S

Greek drachma

En15%

S

=% devaluation; + =% revaluation. B% = new band; En% = entry band; Ex = exit; S = join single currency

Contradictory Lessons From 1993 (1)The two-corner view:even the cohesive EMS did not survivego to one of the two corners (pick one!).The EMS should be made even more cohesive:the monetary union is the way to go.The EMS was a bad idea:float is the future.Unlimited interventions cannot be unlimited:need more discipline and less support.

Contradictory Lessons From 1993 (2)The Bundesbanks selection of countries to be supported:left scars (e.g. Britain)raises question on who decides what.Speculative attacks can hit even robust systems and properly valued currencies (suggesting self-fulfilling crises).Both facts strengthen the two-corner view, providing arguments for each corner.

The Wide-Band EMSWay out of crisis:wide band of fluctuation (15%)a soft EMS on the way to monetary union.

Four Incarnations of the EMSSource: Baldwin & Wyplosz 2003

EMS-2EMS-1 ceased to exist on 1 January 1999 with the launch of the Euro.EMS-2 was created to:host currencies of existing EU members who cannot/dont want to join euro area:Denmark and the UK have a derogation, but Denmark has adopted the new ERMSweden has no derogation but has declined to adopt the new ERMhost currencies of new EU members before they are admitted into euro area:potentially ten new members.

How Does EMS-2 Differ From EMS-1?

A Revival of The EMS?In principle, ERM membership is compulsory for the all new members.They must stay at least two years in the ERM before joining the euro area.They must also eliminate all capital controls.The impossible trinity says that they will have to fully give up monetary policy.The risk of self-fulfilling crises says that may not be enough to avoid trouble.

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