the european monetary system european economic issues reading: sloman chapter 25 baldwin &...

The European Monetary System

European Economic Issues

Reading: Sloman Chapter 25

Baldwin & Wyplosz 2003 Ch 10 & 12

Swann Chapter 7

A Brief Monetary History of Europe Pre 17A Brief Monetary History of Europe Pre 17thth C. C.

• Money –originally based on metalsMoney –originally based on metals

• Costly and dangerous to engage in long Costly and dangerous to engage in long distant trade.distant trade.

• Problems with quantity and divisibility Problems with quantity and divisibility

• Even then no guarantee that value is ‘true’Even then no guarantee that value is ‘true’

• Emergence of bills of exchange Emergence of bills of exchange

• Essentially guaranteeing that goods to the Essentially guaranteeing that goods to the value of x could be purchased in Avalue of x could be purchased in A

1717thth & 18 & 18thth Century Century

• Amsterdam set up Public bank to weigh Amsterdam set up Public bank to weigh coins and therefore warranty deposits coins and therefore warranty deposits – Which could be transferred between merchantsWhich could be transferred between merchants– AND which could be lent onwardsAND which could be lent onwards

• 1694 Bank of England established1694 Bank of England established– to facilitate the King - with the right to issue to facilitate the King - with the right to issue

promissory notes to others on the King’s promissory notes to others on the King’s behalf. behalf.

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

• Paris - Banque Royal and the Mississippi Paris - Banque Royal and the Mississippi CompanyCompany

A Brief Monetary History of Europe 19A Brief Monetary History of Europe 19thth C. C.

• Bills of exchange still backed by (some?) Bills of exchange still backed by (some?) metalmetal

• Uncertainty as to true valueUncertainty as to true value

• Trade between cities as difficult as between Trade between cities as difficult as between nationsnations

• Sorted in UK by 1844 designation that Sorted in UK by 1844 designation that notes of the ‘Official Bank’ – Bank of notes of the ‘Official Bank’ – Bank of England - were legal tender and guaranteedEngland - were legal tender and guaranteed

• But internationally problem remainedBut internationally problem remained

A Brief Monetary History of EuropeA Brief Monetary History of Europe

• Currencies issued by governments of Currencies issued by governments of different ‘perceived’ stabilitydifferent ‘perceived’ stability

• No agreement on how currency should be No agreement on how currency should be backed – gold or silver –often both backed – gold or silver –often both circulating simultaneously and fluctuating circulating simultaneously and fluctuating in relative value in relative value

• Trade involved frequent movements of Trade involved frequent movements of commodity gold or silvercommodity gold or silver


• ‘‘Golden age’ of Gold Standard Golden age’ of Gold Standard • UK: 1821-1914UK: 1821-1914• Paris Conference 1867Paris Conference 1867• Latin European Monetary Union-1865-1926, Latin European Monetary Union-1865-1926,

F,B,I, Switz, & 1867 Gr & Bul.F,B,I, Switz, & 1867 Gr & Bul.• Scandinavian monetary union 1873-1924 Scandinavian monetary union 1873-1924

Dn, Sw & NorDn, Sw & Nor• Essentially a quasi-monetary union or set Essentially a quasi-monetary union or set

of unionsof unions• www.euromove.org.uk/publications/www.euromove.org.uk/publications/

europeanhistories/chron2 europeanhistories/chron2


• ‘‘Not so ‘Golden’ Really Not so ‘Golden’ Really

• Frequent revaluations, devaluations and Frequent revaluations, devaluations and currency crisescurrency crises

• Need strict monetary discipline, particularly Need strict monetary discipline, particularly on growth of monetary supply for this to on growth of monetary supply for this to work. Did not exist.work. Did not exist.

• 1914 UK came off the Gold Standard at 1914 UK came off the Gold Standard at outbreak of war.outbreak of war.


• After WWI attempt to return to Gold StandardAfter WWI attempt to return to Gold Standard• But huge interwar debts had devalued currenciesBut huge interwar debts had devalued currencies• But UK returned to Gold at Pre-war rateBut UK returned to Gold at Pre-war rate• French expected Germans to pay France’s war French expected Germans to pay France’s war

debtsdebts• Germans could not raise enough taxes, printed Germans could not raise enough taxes, printed

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


• After WWII international attempt to restore After WWII international attempt to restore monetary order – Breton Woods systemmonetary order – Breton Woods system

• A Gold Standard based on the dollar. Worked well A Gold Standard based on the dollar. Worked well for a time. for a time.

• Currencies allowed to fluctuate by 1% around Currencies allowed to fluctuate by 1% around parityparity

• Some devaluations and revaluations but Some devaluations and revaluations but reasonably well behaved until Vietnam War.reasonably well behaved until Vietnam War.

• US paid for deficits by printing more dollarsUS paid for deficits by printing more dollars• Eventually foreign governments lost faith and Eventually foreign governments lost faith and

system started to collapse.system started to collapse.


• Agreed to widen the band vis-a- vis the dollar Agreed to widen the band vis-a- vis the dollar from 1% to 2.25.from 1% to 2.25.

• But if DM 2.25 above & FF 2.25 below then 4.5% But if DM 2.25 above & FF 2.25 below then 4.5% differencedifference

• And if FF 2.25 above & DMF 2.25 below then total And if FF 2.25 above & DMF 2.25 below then total fluctuations of DM/FF is 2 x 4.5% = 9% difference.fluctuations of DM/FF is 2 x 4.5% = 9% difference.

• Response: Werner Report in 1970 forerunner of Response: Werner Report in 1970 forerunner of EMSEMS

• The (original) six Member States set up a ‘snake The (original) six Member States set up a ‘snake in the tunnel’ mechanism to narrow the in the tunnel’ mechanism to narrow the fluctuation margins between the Community fluctuation margins between the Community currencies (the snake) in relation to fluctuations currencies (the snake) in relation to fluctuations against the US dollar (the tunnel).against the US dollar (the tunnel).

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

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

O

Exc

ha

nge

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 Crisis1973 – First Oil Crisis

• Snake outside the ‘tunnel’ link with dollar Snake outside the ‘tunnel’ link with dollar brokenbroken

• Governments responded by trying to Governments responded by trying to reflate economies spending and issuing reflate economies spending and issuing (‘forging’) money (‘forging’) money

• ––expansionary fiscal and monetary policyexpansionary fiscal and monetary policy

• Differences across countries meant Differences across countries meant exchange rates unsustainableexchange rates unsustainable

• Collapsed, and then revived in 1979Collapsed, and then revived in 1979

The EMS-1: Key FeaturesThe EMS-1: Key Features

• A parity grid:A parity grid:– bilateral central paritiesbilateral central parities– associated margins of fluctuations. associated margins of fluctuations.

• Mutual unlimited support:Mutual unlimited support:– exchange market interventionsexchange market interventions– short-term loans.short-term loans.

• Realignments:Realignments:– tolerated, if not encouragedtolerated, if not encouraged– require unanimity agreement.require unanimity agreement.

• The E.C.U.:The E.C.U.:– not a currency, just a unit of accountnot a currency, just a unit of account– took some life on private markets.took some life on private markets.

The ECUThe ECU

A basket of all EU currencies.A basket of all EU currencies.

Source: Baldwin & Wyplosz 2003

The EMS: Interpretation and AssessmentThe EMS: Interpretation and Assessment

• Improving on the Snake to stabilise intra-Improving on the Snake to stabilise intra-European exchange rates:European exchange rates:– mutual supportmutual support– realignment unanimity rule.realignment unanimity rule.

• Respecting the EU equalitarian approach:Respecting the EU equalitarian approach:– no centre currencyno centre currency– bilateral interventions by strong and weak bilateral interventions by strong and weak

currency central banks.currency central banks.• No role for the US dollar: Europe on its own. No role for the US dollar: Europe on its own.

The EMS: Past and PresentThe EMS: Past and Present

• The EMS was originally conceived as the The EMS was originally conceived as the solution to the end of the Bretton Woods solution to the end of the Bretton Woods System.System.

• Over the years, its nature changed and it Over the years, its nature changed and it became a kind of DM area, with the became a kind of DM area, with the Bundesbank very much in command.Bundesbank very much in command.

• This, and the speculative crisis of 1993, made This, and the speculative crisis of 1993, made the monetary union option attractive.the monetary union option attractive.

• Now the EMS is mostly the entry point for Now the EMS is mostly the entry point for future monetary union members.future monetary union members.

Four Incarnations of the EMSFour Incarnations of the EMS

• 1979-82: EMS-1 with narrow bands of 1979-82: EMS-1 with narrow bands of fluctuation (fluctuation (2.25%) and symmetric.2.25%) and symmetric.

• 1982-93: EMS-1 centered on the DM, 1982-93: EMS-1 centered on the DM, shunning realignments.shunning realignments.

• 1993-99: EMS-1 with wide bands (1993-99: EMS-1 with wide bands (15%).15%).• 1999- : EMS-2, assymmetric, on the way to 1999- : EMS-2, assymmetric, on the way to

euro area.euro area.

History of the ERMHistory of the ERM

Source: Sloman (2006)

Evolution: From Symmetry to DM ZoneEvolution: From Symmetry to DM Zone

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

policy independencepolicy independence– frequent realignments.frequent realignments.

Evolution: From Symmetry to DM ZoneEvolution: From Symmetry to DM ZoneIn

flatio

n


The EMS: Interpretation and AssessmentThe 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

• 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 ZoneEvolution: From Symmetry to DM Zone

• But: realignments:But: realignments:– barely compensated accumulated inflation barely compensated accumulated inflation

differencesdifferences– were easy to guess by marketswere easy to guess by markets– put weak currency/high inflation countries on put weak currency/high inflation countries on

the spot:the spot:Continuing current account deficitsContinuing current account deficitsSpeculative attacks.Speculative attacks.

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

The DM ZoneThe DM Zone

• What shadowing the Bundesbank required:What shadowing the Bundesbank required:– giving up much what was left of monetary giving up much what was left of monetary

policy indepedencepolicy indepedence– aiming at a low German-style inflation rateaiming at a low German-style inflation rate– avoiding realignments to gain credibility.avoiding realignments to gain credibility.

History of the ERMHistory of the ERM


Breakdown of the DM zoneBreakdown of the DM zone

• Bad design:Bad design:– full capital mobility established in 1990 as part full capital mobility established in 1990 as part

of the Single Act: EMS in contradiction with of the Single Act: EMS in contradiction with impossible trinity unless all monetary impossible trinity unless all monetary indepdence relinquished.indepdence relinquished.

• Bad luck:Bad luck:– German unification: a big shock that called for German unification: a big shock that called for

very tight monetary policyvery tight monetary policy– the Danish referendum on the Maastricht the Danish referendum on the Maastricht

Treaty.Treaty.• A wave of speculative attacks in 1992-3:A wave of speculative attacks in 1992-3:

– the Bundesbank sets limits to unlimited the Bundesbank sets limits to unlimited support.support.

History of the ERMHistory 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


Contradictory Lessons From 1993 (1)Contradictory Lessons From 1993 (1)

• The two-corner view:The two-corner view:– even the cohesive EMS did not surviveeven the cohesive EMS did not survive– go to one of the two corners (pick one!).go to one of the two corners (pick one!).

• The EMS should be made even more cohesive:The EMS should be made even more cohesive:– the monetary union is the way to go.the monetary union is the way to go.

• The EMS was a bad idea:The EMS was a bad idea:– float is the future.float is the future.

• Unlimited interventions cannot be unlimited:Unlimited interventions cannot be unlimited:– need more discipline and less support.need more discipline and less support.

Contradictory Lessons From 1993 (2)Contradictory Lessons From 1993 (2)

• The Bundesbank’s selection of countries to be The Bundesbank’s selection of countries to be supported:supported:– left scars (e.g. Britain)left scars (e.g. Britain)– raises question on who decides what.raises question on who decides what.

• Speculative attacks can hit even robust systems Speculative attacks can hit even robust systems and properly valued currencies (suggesting self-and properly valued currencies (suggesting self-fulfilling crises).fulfilling crises).

• Both facts strengthen the two-corner view, Both facts strengthen the two-corner view, providing arguments for each corner.providing arguments for each corner.

The Wide-Band EMSThe Wide-Band EMS

• Way out of crisis:Way out of crisis:

– wide band of fluctuation (wide band of fluctuation (15%)15%)

– a soft EMS on the way to monetary a soft EMS on the way to monetary union.union.

Four Incarnations of the EMSFour Incarnations of the EMS


EMS-2EMS-2

• EMS-1 ceased to exist on 1 January 1999 with the EMS-1 ceased to exist on 1 January 1999 with the launch of the Euro.launch of the Euro.

• EMS-2 was created to:EMS-2 was created to:– host currencies of existing EU members who host currencies of existing EU members who

cannot/don’t want to join euro area:cannot/don’t want to join euro area:Denmark and the UK have a derogation, but Denmark and the UK have a derogation, but

Denmark has adopted the new ERMDenmark has adopted the new ERMSweden has no derogation but has declined Sweden has no derogation but has declined

to adopt the new ERMto adopt the new ERM– host currencies of new EU members before they host currencies of new EU members before they

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

How Does EMS-2 Differ From EMS-1?How Does EMS-2 Differ From EMS-1?

ECB explicitly allowed ECB explicitly allowed to suspend interventionto suspend intervention

Automatic unlimited Automatic unlimited interventionsinterventions

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

Margin explicitly setMargin explicitly set

Asymmetric, all parities Asymmetric, all parities defined vis a vis eurodefined vis a vis euro

Symmetric, no anchor Symmetric, no anchor currencycurrency

EMS-2EMS-2EMS-1EMS-1

A Revival of The EMS?A Revival of The EMS?

• In principle, ERM membership is compulsory In principle, ERM membership is compulsory for the all new members.for the all new members.

• They must stay at least two years in the ERM They must stay at least two years in the ERM before joining the euro area.before joining the euro area.

• They must also eliminate all capital controls.They must also eliminate all capital controls.

• The impossible trinity says that they will have The impossible trinity says that they will have to fully give up monetary policy.to fully give up monetary policy.

• The risk of self-fulfilling crises says that may The risk of self-fulfilling crises says that may not be enough to avoid trouble.not be enough to avoid trouble.

the european monetary system european economic issues reading: sloman chapter 25 baldwin &...

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