European Monetary System

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 European Monetary System (EMS) was an adjustable exchange rate arrangement set up in 1979 to foster closer monetary policy cooperation between members of the European Community (EC). The European Monetary System (EMS) was later succeeded by the European Economic and Monetary Union (EMU), which established a common currency, the euro.

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).

History of the European Monetary System (EMS)

The early years of the 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.

A new crisis for the EMS emerged in the early 1990s. Differing economic and political conditions of member countries, notably the reunification of Germany, led to Britain permanently withdrawing from the EMS in 1992. Britain’s withdrawal foreshadowed its later insistence on independence from continental Europe; Britain refused to join the eurozone, along with Sweden and Denmark.

During this time, 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 became the European Central Bank (ECB) in 1998. The primary responsibility of the ECB was to institute a single monetary policy and interest rate.

At the end of 1998, the majority of EU nations simultaneouslyy 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 created; the euro is used by most EU member countries. The European Economic and Monetary Union (EMU) was also established, succeeding the EMS as the new name for the common monetary and economic policy organization of the EU.

Criticism of the European Monetary System (EMS)

Under the EMS, exchange rates could only be changed if both member countries and the European Commission were in agreement. This was an unprecedented move that attracted a lot of criticism.

In the aftermath of the global economic crisis of 2008-2009, significant tension between the principles of the EMS and the policies of national governments became evident.

Certain member states Greece, in particular, but also Ireland, Spain, Portugal, and Cyprus pursued policies that created high national deficits. This phenomenon was later referred to as the European sovereign debt crisis. These countries could not resort to the devaluation of their currencies and were not allowed to spend to offset unemployment rates.

From the beginning, the European Monetary System (EMS) policy intentionally prohibited bailouts to ailing economies in the eurozone. Despite vocal resistance from EU members with stronger economies, the EMU finally established bailout measures to provide relief to struggling members.

Benefits of the European Monetary System

Working towards a single market

The EMS was considered an important step towards the establishment of the EU and the single market in Europe.

Ensuring currency stability

The EMS ensured currency stability in Europe during times of international market volatility.

Unity in Europe

The EMS promoted political and economic unity across Europe at a pivotal time in European history.

Drawbacks of the European Monetary System

Common monetary policy

The EMS promoted a common monetary policy; therefore, raising or decreasing interest rates affected all economies differently just like the exchange rate system.

Fixed exchange rates

Fixed exchange rates affected different members of the EMS in different ways, which were not beneficial to all economies. It became evident in the 1992 crisis.