L7 the european monetary system

The European Monetary System

European Economic Issues

Reading: Abdul Rishad

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

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 King’s behalf.

– Complemented by private banks (former goldsmiths) issuing ‘notes’

• Paris - Banque Royal and the Mississippi Company

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

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


• ‘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


• ‘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.


• 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 France’s war

debts• Germans could not raise enough taxes, printed

money at home, causing hyper-inflation • Result was interwar chaos


• 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.


• 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).

Snake in the tunnel: Commitment to keeping European rates within narrower band compared with Breton Woods System

O

Exc

hang

e ra

te

Nointervention

Central bankbuys domestic

currency

Nointervention

Central banksells domestic

currency

Nointervention

Time

+4.50%

-4.50%

+2.25%

- 2.25%


• 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

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.

The ECU

A basket of all EU currencies.

Source: Baldwin & Wyplosz 2003

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.

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.

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.

History of the ERMMar Sept Nov Mar Oct Feb June Mar July Apr Aug Jan Jun Jan'79 '79 '79 '81 '81 '82 '82 '83 '85 '86 '86 '87 '89 '90

Belgian franc En21/4% –8.5 +1.5 +2.0 +1.0 +2.0Danish krone En21/4% –2.9 –4.8 –3.0 +2.5 +2.0 +1.0German mark En21/4% +2.0 +5.5 +4.25 +5.5 +2.0 +3.0 +3.0French franc En21/4% –3.0 –5.75 –2.5 +2.0 –3.0Irish punt En21/4% –3.5 +2.0 –8.0Italian 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 +3.0UK pound – – – – – – – – – – – – – –Spanish peseta – – – – – – – – – – – – –En6%

Oct Apr Sept Sept Nov Jan May Aug Jan Mar Oct Nov Mar Jan Jan'90 '92 '92 '92 '92 '93 '93 '93 '95 '95 '96 '96 '98 '99 '01

Belgian franc B15% SDanish krone B15% B21/4%German mark B15% SFrench franc B15% SIrish punt –10.0 B15% +3.0 SItalian lira –7.0 Ex – – – – – – – En15% SDutch guilder B15% SUK pound –En6% Ex – – – – – – – – – – –Spanish peseta –5.0 –6.0 –8.0 B15% –7.0 SPortuguese escudo – En6% –6.0 –6.5 B15% –3.5 SAustrian schilling – – – – – – – – En15% SFinnish markka – – – – – – – – – – En15% SGreek 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

Source: Sloman (2006)

Evolution: From Symmetry to DM Zone

• First a flexible arrangement:– different inflation rates: long run monetary

policy independence– frequent realignments.

Evolution: From Symmetry to DM ZoneIn

flatio

n


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

FixedExchange

Rate

Monetary union

Free float

EMS

Full Capital Mobility

Monetary Independence


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 deficitsSpeculative attacks.

• The symmetry was broken de facto.• The Bundesbank became the example to follow.

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.





Mar Sept Nov Mar Oct Feb June Mar July Apr Aug Jan Jun Jan'79 '79 '79 '81 '81 '82 '82 '83 '85 '86 '86 '87 '89 '90




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


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.






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.

Contradictory Lessons From 1993 (2)

• The Bundesbank’s 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 EMS

• Way out of crisis:–wide band of fluctuation (15%)–a soft EMS on the way to monetary

union.

Four Incarnations of the EMS


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/don’t 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 ERM– host currencies of new EU members

before they are admitted into euro area:potentially ten new members.

How Does EMS-2 Differ From EMS-1?

ECB explicitly allowed to suspend intervention

Automatic unlimited interventions

‘Normal’ (±2.25%) and ‘standard’ (±15%) bands

Margin explicitly set

Asymmetric, all parities defined vis a vis euro

Symmetric, no anchor currency

EMS-2EMS-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.

Economy & Finance

L7 the european monetary system