EMS Notes

The EMS: Past and Present

• The EMS (European Monetary System) was initially conceived as a response to the end of the Bretton Woods System.
• Over time, it evolved into a DM (Deutsche Mark) area effectively controlled by the Bundesbank (German central bank).
• The influence of the Bundesbank and the speculative attack of 1993 made the monetary union option more appealing.
• Currently, the EMS serves primarily as a pathway for countries seeking to join the monetary union.

Four Incarnations of the EMS

• 1979-82: EMS-1
  • Characterized by narrow bands of fluctuation (±2.25%).
  • Symmetric arrangement.
• 1982-93: EMS-1
  • Centered on the DM.
  • Avoided realignments.
• 1993-99: EMS-1
  • Featured wide bands (±15%).
• 1999- : EMS-2
  • Asymmetric.
  • Serves as a transition to the Euro area.

EMS-1: Key Features

• Parity Grid:
  • Bilateral central parities.
  • Associated margins of fluctuations.
• Mutual Unlimited Support:
  • Exchange market interventions.
  • Short-term loans.
• Realignments:
  • Tolerated, if not encouraged.
  • Required unanimous agreement.
• The E.C.U. (European Currency Unit):
  • Not a currency but a unit of account.
  • Gained some traction in private markets.

ECU Composition

• The ECU was a basket of EU currencies, each with a specific amount and weight:
  • Belgian franc: 3.43100 (8.71%)
  • Danish krone: 0.19760 (2.71%)
  • Deutschemark: 0.62420 (32.68%)
  • Dutch guilder: 0.21980 (10.21%)
  • French franc: 1.33200 (20.79%)
  • Greek drachma: 1.44000 (0.49%)
  • Italian lira: 151.80000 (7.21%)
  • Irish punt: 0.00855 (1.08%)
  • Portuguese escudo: 1.39300 (0.71%)
  • Spanish peseta: 6.88500 (4.24%)
  • UK pound sterling: 0.08784 (11.17%)

EMS: Interpretation and Assessment

• Improved upon the "Snake" arrangement to stabilize intra-European exchange rates through:
  • Mutual support mechanisms.
  • The unanimity rule for realignments.
• Reflected the EU's egalitarian approach by:
  • Avoiding a central currency.
  • Implementing bilateral interventions by both strong and weak currency central banks.
• Excluded the US dollar, emphasizing Europe's independence.
• Raises the question of whether monetary policy independence is lost.
• Highlights the Impossible trinity:
  • Widespread capital controls were used to maintain the ability to have different inflation rates.

Evolution: From Symmetry to DM Zone

• Initially, a flexible arrangement:
  • Allowed for different inflation rates, providing long-run monetary policy independence.
  • Employed frequent realignments.
• However, realignments:
  • Barely compensated for accumulated inflation differences.
  • Were easily anticipated by markets.
  • Put weak currency/high inflation countries in a difficult position due to:
    • Continuing current account deficits.
    • Speculative attacks.
• The symmetry was broken in practice.
• The Bundesbank became the de facto model to follow.

The DM Zone

• Shadowing the Bundesbank required:
  • Giving up much of the remaining monetary policy independence.
  • Aiming for a low, German-style inflation rate.
  • Avoiding realignments to build credibility.

Breakdown of the DM Zone

• Bad Design:
  • Full capital mobility established in 1990 as part of the Single Act created a contradiction with the impossible trinity unless all monetary independence was relinquished.
• Bad Luck:
  • German unification was a major shock that necessitated a very tight monetary policy.
  • The Danish referendum on the Maastricht Treaty added to the instability.
• A wave of speculative attacks in 1992-3 occurred because:
  • The Bundesbank set limits to unlimited support.

Contradictory Lessons From 1993

• The two-corner view:
  • Argues that since even the cohesive EMS did not survive, countries should choose one of the two extreme corners.
• The EMS should be made even more cohesive:
  • Suggests that monetary union is the necessary path forward.
• The EMS was a bad idea:
  • Argues that floating exchange rates are the future.
• Unlimited interventions cannot be unlimited:
  • Emphasizes the need for more discipline and less support.

Contradictory Lessons From 1993 Part 2

• The Bundesbank’s selection of countries to be supported:
  • Left scars (e.g. Britain).
  • Raised questions about decision-making criteria.
• Speculative attacks can impact 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 EMS

• Emerged as a way out of the crisis:
  • Featured wide bands of fluctuation (±15%).
  • Represented a soft EMS on the path to monetary union.

EMS-2

• EMS-1 ceased to exist on January 1, 1999, with the launch of the Euro.
• EMS-2 was created to:
  • Host currencies of existing EU members who cannot or do not want to join the Euro area:
    • Denmark and the UK have a derogation, but Denmark has adopted the new ERM.
    • Sweden has no derogation but has declined to adopt the new ERM.
  • Host currencies of new EU members before they are admitted into the Euro area:
    • Potentially ten new members.

A Revival of The EMS?

• In principle, ERM (Exchange Rate Mechanism) membership is compulsory for all new EU members.
• They must remain in the ERM for at least two years before joining the Euro area.
• They must also eliminate all capital controls.
• The impossible trinity implies that they will have to fully give up monetary policy.
• The risk of self-fulfilling crises suggests that this may not be sufficient to avoid trouble.