European Financial System

The early years of the European Monetary System (EMS) were marked by uneven currency values and adjustments that raised the value of stronger currencies and lowered those of weaker ones. After 1986, changes in national interest rates were specifically used to keep all the currencies stable.

The early 90s saw a new crisis for the European Monetary System (EMS). Differing economic and political conditions of member countries, notably the reunification of Germany, led to Britain permanently withdrawing from the European Monetary System (EMS) in 1992. Britain’s withdrawal reflected and foreshadowed its insistence on independence from continental Europe, later refusing to join the eurozone along with Sweden and Denmark.

Meanwhile, efforts to form a common currency and cement greater economic alliances were ramped up. In 1993, most EC members signed the Maastricht Treaty, establishing the European Union (EU). One year later, the EU created the European Monetary Institute, which later became the European Central Bank (ECB).

At the end of 1998, most EU nations unanimously cut their interest rates to promote economic growth and prepare for the implementation of the euro. In January 1999, a unified currency, the euro, was born and came to be used by most EU member countries. The European Economic and Monetary Union (EMU) was established, succeeding the European Monetary System (EMS) as the new name for the common monetary and economic policy of the EU.

The European Monetary System (EMS) was a multilateral adjustable exchange rate agreement in which most of the nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations in relative value. It was initiated in 1979 under then President of the European Commission Roy Jenkins as an agreement among the Member States of the EEC to foster monetary policy co-operation among their Central Banks for the purpose of managing inter-community exchange rates and financing exchange market interventions.

The EMS functioned by adjusting nominal and real exchange rates, thus establishing closer monetary cooperation and creating a zone of monetary stability. As part of the EMS, the ECC established the first European Exchange Rate Mechanism (ERM) which calculated exchange rates for each currency and a European Currency Unit (ECU): an accounting currency unit that was a weighted average of the currencies of the 12 participating states. The ERM let exchange rates to fluctuate within fixed margins, allowing for some variation while limiting economic risks and maintaining liquidity.

The European Monetary System lasted from 1979 to 1999, when it was succeeded by the Economic and Monetary Union (EMU) and exchange rates for Eurozone countries were fixed against the new currency the Euro. The ERM was replaced at the same time with the current Exchange Rate Mechanism (ERM II).

The European Monetary System (EMS) was created in response to the collapse of the Bretton Woods Agreement. Formed in the aftermath of World War II (WWII), the Bretton Woods Agreement established an adjustable fixed foreign exchange rate to stabilize economies. When it was abandoned in the early 1970s, currencies began to float, prompting members of the EC to seek out a new exchange rate agreement to complement their customs union.

The European Monetary System’s (EMS) primary objective was to stabilize inflation and stop large exchange rate fluctuations between European countries. This formed part of a wider goal to foster economic and political unity in Europe and pave the way for a future common currency, the euro.

Currency fluctuations were controlled through an exchange rate mechanism (ERM). The ERM was responsible for pegging national exchange rates, allowing only slight deviations from the European currency unit (ECU) a composite artificial currency based on a basket of 12 EU member currencies, weighted according to each country’s share of EU output. The ECU served as a reference currency for exchange rate policy and determined exchange rates among the participating countries’ currencies via officially sanctioned accounting methods.