European Monetary System (EMS) and the European Monetary Union (EMU) - dummies

European Monetary System (EMS) and the European Monetary Union (EMU)

By Ayse Evrensel

In the case of euro, the European Monetary System (EMS) and the Economic and Monetary Union (EMU) reflect preparation periods during which countries in the common currency area are ready to use the common currency.

The EMS (1979–1998) originally included eight members: Belgium, Denmark, France, Germany, Ireland, Italy, Luxembourg, and the Netherlands. Among other things, the EMS introduced the European Exchange Rate Mechanism I (ERM I) to reduce exchange rate variability among the EMS countries, which was a step toward the introduction of the common currency.

While the EMS countries’ currencies were floating against other currencies, the ERM I introduced a pegged exchange rate system for the EMS countries’ currencies. The changes in EMS currencies were forced to be within an interval of +/– 2.25 percent, in other words, with a maximum increase of 2.25 percent and a maximum decline of 2.25 percent.

As with any other pegged exchange rate regime, the EMS had problems. When the previously mentioned interval was reached in an exchange rate between two EMS countries, both countries’ central banks had to intervene so that the exchange rate remained in the interval. The central bank intervention can also be unilateral to defend its currency.

When defense wasn’t possible, countries such as France and Italy introduced capital controls to limit the possibility of speculative attack and the outflow of funds. Additionally, central banks of stronger currencies provided credit to countries with weaker currencies, to prevent the EMS from disintegrating.

Toward the early 1990s, some currencies were finding it increasingly difficult to remain within the EMS interval, even with interventions in the foreign exchange markets. In these cases, some countries in the EMS realigned their exchange rates by revaluing and devaluing their currencies.

Additionally, the German unification in 1990 put pressure on the EMS. The unification of East and West Germany required an expansionary fiscal policy that resulted in higher inflation in Germany. The Bundesbank had no choice but to follow a contractionary monetary policy and raise its key interest rates.

For EMS pegs to remain within the band, other countries in the system should have followed similar monetary policies. However, countries such as France, Italy, and the U.K. weren’t willing to adhere to the EMS rules at the expense of a recession in their countries.

Despite the many pressures on the EMS, the system helped inflation rates converge among the member countries. Although most EMS countries started out with higher inflation rates (in some cases, double-digit, inflation rates) in the late 1970s (except for Germany), by the mid-1990s, inflation rates in the EMS countries converged with rates in Germany.

As the EMS was making progress in aligning the exchange rates of the participating countries, a big push for a single currency came from the Maastricht Treaty of 1992. This treaty introduced the Economic and Monetary Union (EMU) part of EU law that a single currency will be established by 1999, and countries in the EU are expected to eventually join the common currency area.

Following the introduction of the euro as an accounting unit in 1999, the Exchange Rate Mechanism II (ERM II) was introduced. The reason for the ERM II was that the original eight members of the ERM I closely worked together up to the introduction of the euro. But as of 1999, there were other EU countries such as Estonia, Lithuania, and Cyprus, which were not in the ERM I and therefore not in the euro-zone.

The objective of the ERM II was to acclimatize the more recent member countries of the EU toward becoming members of the Euro-zone. The ERM II provided non-euro countries with a larger leeway of 15 percent to have their currency fluctuate above or below the determined exchange rate.

Entry into ERM II required agreement among the ministers and central bank governors of the candidate country, the Euro-zone countries, and the European Central Bank (ECB). The conditions of ERM II reflect how the Euro-zone works, to ensure a smooth transition of the countries from ERM II into the Euro-zone. Countries must successfully participate in ERM II for at least two years before becoming a member of the Euro-zone.

To maintain price stability in the then-planned Euro-zone, the Maastricht Treaty of 1992 introduced convergence criteria related to controlling inflation, public deficit, and public debt, as well as to exchange rate stability and the convergence of interest rates. These conditions imply the benchmarks for joining the EMU as well the Euro-zone:

  • The inflation rate must be no more than 1.5 percentage points higher than the average of the three lowest-inflation member states of the EU.

  • The ratio of the budget deficit to the GDP (gross domestic product) must not exceed 3 percent at the end of the preceding fiscal year.

  • The ratio of gross government debt to GDP ratio must not exceed 60 percent at the end of the preceding fiscal year.

  • Applicant countries must join ERM II under the EMS for two consecutive years and must not devalue their currency during the period.

  • The nominal long-term interest rate must not be more than 2 percentage points higher than those in the three lowest-inflation member states.

Additionally, in 1997, based on Germany’s initiative, the Stability and Growth Pact (SGP) was introduced. This pact aimed to avoid large budget deficits among the EMS countries and suggested a budget close to balance or in surplus. Germany’s concern was that fiscal imbalances such as large budget deficits in some countries may pressure monetary policy to be expansionary.