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

17 th & 18 th Century Amsterdam set up Public bank to weigh coins and therefore warranty depositsAmsterdam 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 established1694 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 CompanyParis - Banque Royal and the Mississippi Company

A Brief Monetary History of Europe 19 th C. Bills of exchange still backed by (some?) metalBills of exchange still backed by (some?) metal Uncertainty as to true valueUncertainty as to true value Trade between cities as difficult as between nationsTrade 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 guaranteedSorted in UK by 1844 designation that notes of the Official Bank – Bank of England - were legal tender and guaranteed But internationally problem remainedBut internationally problem remained

A Brief Monetary History of Europe Currencies issued by governments of different perceived stabilityCurrencies 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 valueNo 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 silverTrade involved frequent movements of commodity gold or silver

A Brief Monetary History of Europe Golden age of Gold StandardGolden age of Gold Standard UK: UK: Paris Conference 1867Paris Conference 1867 Latin European Monetary Union , F,B,I, Switz, & 1867 Gr & Bul.Latin European Monetary Union , F,B,I, Switz, & 1867 Gr & Bul. Scandinavian monetary union Dn, Sw & NorScandinavian monetary union Dn, Sw & Nor Essentially a quasi-monetary union or set of unionsEssentially a quasi-monetary union or set of unions anhistories/chron2www.euromove.org.uk/publications/europe anhistories/chron2

A Brief Monetary History of Europe Not so Golden ReallyNot so Golden Really Frequent revaluations, devaluations and currency crisesFrequent revaluations, devaluations and currency crises Need strict monetary discipline, particularly on growth of monetary supply for this to work. Did not exist.Need strict monetary discipline, particularly on growth of monetary supply for this to work. Did not exist UK came off the Gold Standard at outbreak of war.1914 UK came off the Gold Standard at outbreak of war.

A Brief Monetary History of Europe 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 Frances war debtsFrench expected Germans to pay Frances war debts Germans could not raise enough taxes, printed money at home, causing hyper-inflationGermans could not raise enough taxes, printed money at home, causing hyper-inflation Result was interwar chaosResult was interwar chaos

A Brief Monetary History of Europe After WWII international attempt to restore monetary order – Breton Woods systemAfter WWII international attempt to restore monetary order – Breton Woods system A Gold Standard based on the dollar. Worked well for a time.A Gold Standard based on the dollar. Worked well for a time. Currencies allowed to fluctuate by 1% around parityCurrencies allowed to fluctuate by 1% around parity Some devaluations and revaluations but reasonably well behaved until Vietnam War.Some devaluations and revaluations but 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 system started to collapse.Eventually foreign governments lost faith and system started to collapse.

A Brief Monetary History of Europe Agreed to widen the band vis-a- vis the dollar from 1% to 2.25.Agreed to widen the band vis-a- vis the dollar from 1% to But if DM 2.25 above & FF 2.25 below then 4.5% differenceBut 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.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 EMSResponse: 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).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 Exchange rate No intervention Central bank buys domestic currency No intervention Central bank sells domestic currency No intervention Time +4.50% -4.50% +2.25% %

A Brief Monetary History of Europe 1973 – First Oil Crisis1973 – First Oil Crisis Snake outside the tunnel link with dollar brokenSnake outside the tunnel link with dollar broken Governments responded by trying to reflate economies spending and issuing (forging) moneyGovernments responded by trying to reflate economies spending and issuing (forging) money –expansionary fiscal and monetary policy–expansionary fiscal and monetary policy Differences across countries meant exchange rates unsustainableDifferences across countries meant exchange rates unsustainable Collapsed, and then revived in 1979Collapsed, and then revived in 1979

The EMS-1: Key Features The EMS-1: Key Features A parity grid:A parity grid: –bilateral central parities –associated margins of fluctuations. Mutual unlimited support:Mutual unlimited support: –exchange market interventions –short-term loans. Realignments:Realignments: –tolerated, if not encouraged –require unanimity agreement. The E.C.U.: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:Improving on the Snake to stabilise intra- European exchange rates: –mutual support –realignment unanimity rule. Respecting the EU equalitarian approach: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.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.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.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.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.Now the EMS is mostly the entry point for future monetary union members.

Four Incarnations of the EMS : EMS-1 with narrow bands of fluctuation ( 2.25%) and symmetric : EMS-1 with narrow bands of fluctuation ( 2.25%) and symmetric : EMS-1 centered on the DM, shunning realignments : EMS-1 centered on the DM, shunning realignments : EMS-1 with wide bands ( 15%) : EMS-1 with wide bands ( 15%) : EMS-2, assymmetric, on the way to euro area : EMS-2, assymmetric, on the way to euro area.

History of the ERM Source: Sloman (2006)

Evolution: From Symmetry to DM Zone First a flexible arrangement:First a flexible arrangement: –different inflation rates: long run monetary policy independence –frequent realignments.

Evolution: From Symmetry to DM Zone Inflation Source: Baldwin & Wyplosz 2003

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 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 Free float EMS Full Capital Mobility Monetary Independence Source: Baldwin & Wyplosz 2003

Evolution: From Symmetry to DM Zone But: realignments: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 Continuing current account deficits Speculative attacks. Speculative attacks. The symmetry was broken de facto.The symmetry was broken de facto. The Bundesbank became the example to follow.The Bundesbank became the example to follow.

The DM Zone What shadowing the Bundesbank required: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.

History of the ERM Source: Sloman (2006)

Breakdown of the DM zone Bad design: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: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 :A wave of speculative attacks in : –the Bundesbank sets limits to unlimited support.

History of the ERM Source: Sloman (2006)

Contradictory Lessons From 1993 (1) The two-corner view: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 EMS should be made even more cohesive: –the monetary union is the way to go. The EMS was a bad idea:The EMS was a bad idea: –float is the future. Unlimited interventions cannot be unlimited:Unlimited interventions cannot be unlimited: –need more discipline and less support.

Contradictory Lessons From 1993 (2) The Bundesbanks selection of countries to be supported: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).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.Both facts strengthen the two-corner view, providing arguments for each corner.

The Wide-Band EMS Way out of crisis:Way out of crisis: –wide band of fluctuation ( 15%) –a soft EMS on the way to monetary union.

Four Incarnations of the EMS Source: Baldwin & Wyplosz 2003

EMS-2 EMS-1 ceased to exist on 1 January 1999 with the launch of the Euro.EMS-1 ceased to exist on 1 January 1999 with the launch of the Euro. EMS-2 was created to: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 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 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. 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.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 stay at least two years in the ERM 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 to fully give up monetary policy.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.The risk of self-fulfilling crises says that may not be enough to avoid trouble.