European Monetary System's Strengths and Weaknesses

Drawing lessons from history, determine the European Monetary System’s strengths and weaknesses.

The European Monetary System was a reaction to the large exchange rate variability of Community currencies during the 1970s, at the beginning this system was neglect of experience and full of scepticism but in the time of its life showed an ability to survive and its resilience.

The EMS was instituted in 1979 and its heart was the ERM (Exchange Rate Mechanism), an adjustable peg system, which was seen as a big impact for the integration process in Europe. The countries who participated in the ERM determined an official rate for all the currencies, and a band around these central rates within which the exchange rates could fluctuate freely (cf. De Grauwe, 2005, p. 120).

During the life time of the EMS, the world economy has passed through a period of exceptional instability, with large swings in the main currencies’ exchange rates and rapid disinflation, together with the build-up of unprecedented imbalances in the leading countries’ external payments (cf. Giavazzi, Micossi, Miller, 1989, p. 52).

Strengths

• While several strains have occasionally arisen, the EMS has on the whole been remarkably prospering in resisting exchange-rate variations when these were not warranted by fundamentals, managing central-rate realignments (relatively) smoothly, and foresting the convergence of inflation performances.

• In the case of the EMS experience, most observers tend to conclude that the exchange-rate regime helped the high-inflation economies. They have described the EMS as an arrangement for France and Italy to purchase a commitment to low inflation by accepting German monetary policy in 1987. Even in countries considering EMS membership the main advantages of membership are associated with Germany’s reputation.

• The ERM represent for the members the independence of the dollar because the system was entirely European, it was no more connection or reference to the dollar or to gold. Also, this was a great step to show that Europe can built a exchange rate system standing on its own and the feature of this symmetric system means that no currency had an special role (cf. Baldwin, Wyplosz, 2004, p. 314).

• The EMS was considered as a flexible yet cohesive arrangement and it was so flexible that some countries unhappy with fixed exchange rate regimes not to join the ERM. The band of fluctuation was set at 2,25% and – 2,25% around the central rate for most member countries (Belgium, Denmark, France, Germany, Ireland, an the Netherlands). Italy was allowed to use a larger band of fluctuation (6% and -6%). The three new members: Spain, the UK and Portugal used the band of fluctuation. In 1993, the band was raised to 15% and -15%.

Weaknesses

• When the limits of the band were reached, the central banks of the currencies involved were committed to intervene so as to maintain the exchange rate within the band but this commitment was no absolute and the countries could decide to change the parity rates of their currency, which was called realignment. These realignments were very frequent and more than ten, took place in the 1980s (De Grauwe, 2005, p. 120). The problem was that the date of the realignment would be easily to anticipate, many observers identified many of them by looking at the date of elections or another political action, so it was almost obvious to guess the date of realignment and at this point were also easy for the speculators to play against the currencies of high-inflation countries and collect the currencies of low-inflation countries and of course the result was that the realignment happened in the middle