The European Monetary System

1
European Economic Issues
The European Monetary System
Reading Sloman Chapter 25 Baldwin Wyplosz
2003 Ch 10 12 Swann Chapter 7
2
A Brief Monetary History of Europe Pre 17th C.

• Money originally based on metals
• Costly and dangerous to engage in long distant
  trade.
• Problems with quantity and divisibility
• Even then no guarantee that value is true
• Emergence of bills of exchange
• Essentially guaranteeing that goods to the value
  of x could be purchased in A

3
17th 18th Century

• Amsterdam set up Public bank to weigh coins and
  therefore warranty deposits
• Which could be transferred between merchants
• AND which could be lent onwards
• 1694 Bank of England established
• to facilitate the King - with the right to issue
  promissory notes to others on the Kings behalf.
• Complemented by private banks (former goldsmiths)
  issuing notes
• Paris - Banque Royal and the Mississippi Company

4
A Brief Monetary History of Europe 19th C.

• Bills of exchange still backed by (some?) metal
• Uncertainty as to true value
• Trade between cities as difficult as between
  nations
• Sorted in UK by 1844 designation that notes of
  the Official Bank Bank of England - were
  legal tender and guaranteed
• But internationally problem remained

5
A Brief Monetary History of Europe

• Currencies issued by governments of different
  perceived stability
• No 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

6
A Brief Monetary History of Europe

• Golden age of Gold Standard
• UK 1821-1914
• Paris Conference 1867
• Latin European Monetary Union-1865-1926, F,B,I,
  Switz, 1867 Gr Bul.
• Scandinavian monetary union 1873-1924 Dn, Sw
  Nor
• Essentially a quasi-monetary union or set of
  unions
• www.euromove.org.uk/publications/europeanhistories
  /chron2

7
A Brief Monetary History of Europe

• Not so Golden Really
• Frequent revaluations, devaluations and currency
  crises
• Need 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.

8
A Brief Monetary History of Europe

• After WWI attempt to return to Gold Standard
• But huge interwar debts had devalued currencies
• But UK returned to Gold at Pre-war rate
• French expected Germans to pay Frances war debts
• Germans could not raise enough taxes, printed
  money at home, causing hyper-inflation
• Result was interwar chaos

9
A Brief Monetary History of Europe

• After WWII international attempt to restore
  monetary order Breton Woods system
• A Gold Standard based on the dollar. Worked well
  for a time.
• Currencies allowed to fluctuate by 1 around
  parity
• Some devaluations and revaluations but reasonably
  well behaved until Vietnam War.
• US paid for deficits by printing more dollars
• Eventually foreign governments lost faith and
  system started to collapse.

10
A Brief Monetary History of Europe

• Agreed 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
  difference
• And 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 EMS
• The (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).

11
Snake in the tunnel Commitment to keeping
European rates within narrower band compared with
Breton Woods System
4.50
2.25
- 2.25
Exchange rate
-4.50
O
Time
Central bank sells domestic currency
No intervention
No intervention
Central bank buys domestic currency
No intervention
12
A Brief Monetary History of Europe

• 1973 First Oil Crisis
• Snake outside the tunnel link with dollar
  broken
• Governments responded by trying to reflate
  economies spending and issuing (forging) money
• expansionary fiscal and monetary policy
• Differences across countries meant exchange rates
  unsustainable
• Collapsed, and then revived in 1979

13
The EMS-1 Key Features

• A parity grid
• bilateral central parities
• associated margins of fluctuations.
• Mutual unlimited support
• exchange market interventions
• short-term loans.
• Realignments
• tolerated, if not encouraged
• require unanimity agreement.
• The E.C.U.
• not a currency, just a unit of account
• took some life on private markets.

14
The ECU

• A basket of all EU currencies.

Source Baldwin Wyplosz 2003
15
The EMS Interpretation and Assessment

• Improving on the Snake to stabilise
  intra-European exchange rates
• mutual support
• realignment unanimity rule.
• Respecting the EU equalitarian approach
• no centre currency
• bilateral interventions by strong and weak
  currency central banks.
• No role for the US dollar Europe on its own.

16
The EMS Past and Present

• The 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.

17
Four Incarnations of the EMS

• 1979-82 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.

18
History of the ERM
Source Sloman (2006)
19
Evolution From Symmetry to DM Zone

• First a flexible arrangement
• different inflation rates long run monetary
  policy independence
• frequent realignments.

20
Evolution From Symmetry to DM Zone
Inflation
Source Baldwin Wyplosz 2003
21
The EMS Interpretation and Assessment

• Can 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 out

Fixed Exchange Rate
Monetary union
EMS
Full Capital Mobility
Monetary Independence
Free float
Source Baldwin Wyplosz 2003
22
Evolution From Symmetry to DM Zone

• But realignments
• barely compensated accumulated inflation
  differences
• were easy to guess by markets
• put weak currency/high inflation countries on the
  spot
• Continuing current account deficits
• Speculative attacks.
• The symmetry was broken de facto.
• The Bundesbank became the example to follow.

23
The DM Zone

• What shadowing the Bundesbank required
• giving up much what was left of monetary policy
  indepedence
• aiming at a low German-style inflation rate
• avoiding realignments to gain credibility.

24
History of the ERM
Source Sloman (2006)
25
Breakdown of the DM zone

• Bad 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 policy
• the Danish referendum on the Maastricht Treaty.
• A wave of speculative attacks in 1992-3
• the Bundesbank sets limits to unlimited support.

26
History of the ERM
Source Sloman (2006)
27
Contradictory Lessons From 1993 (1)

• The two-corner view
• even the cohesive EMS did not survive
• go 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.

28
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.

29
The Wide-Band EMS

• Way out of crisis
• wide band of fluctuation (?15)
• a soft EMS on the way to monetary union.

30
Four Incarnations of the EMS
Source Baldwin Wyplosz 2003
31
EMS-2

• EMS-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 ERM
• Sweden has no derogation but has declined to
  adopt the new ERM
• host currencies of new EU members before they are
  admitted into euro area
• potentially ten new members.

32
How Does EMS-2 Differ From EMS-1?
33
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.