EUROPEAN MONETARY SYSTEM

The European Monetary System (EMS) is an organization established in 1979 for the purpose of stabilizing the exchange rates of those European Community (now European Union) members who wished to participate in it. "Exchange rate" refers to the value of a country's currency in relation to the currency of another country. The EMS came about because of the high global inflation and economic stagnation that characterized much of the 1970s. Contributing greatly to these problems was the sorry financial predicament of the United States during this decade. The dollar, which served as a peg for European currencies, was plagued by a ballooning American deficit, the oil crisis, a rapid rise in the demand for gold in world commodity markets, and unemployment and "stagflation" at home. The currency exchange rates of European Community (EC) members fluctuated wildly against the dollar which the Nixon administration, because of domestic demands, refused to devalue. As a result the central banks of most western European countries, in an effort to stabilize their own currencies, were unable to continue buying these inflationary dollars. This led to increased speculation against the dollar, driving its value down even further. EC members were increasingly uneasy about this financial morass and gave birth to the EMS out of fear that these monetary problems would derail plans for European economic integration.

In 1978 the European Council, which then was the principal policy making organ of the EC, agreed to establish the EMS. Its purpose was twofold: stabilize the currency exchange rates of participating countries and protect each member's currency from the fluctuating dollar and other perceived weaknesses in American fiscal policy. Participating initially were Belgium, Denmark, France, Ireland, Italy, Luxembourg, the Netherlands, and West Germany. Spain became a full participating member in 1989 as did the United Kingdom in 1990. Portugal and Greece are members but do not participate fully. The EMS had its antecedent in the Werner Report of 1970 and the so-called "snake system" initiated in 1972. The Werner Report proposed a gradual ten-year move towards an economic union focusing on a single unit of currency and a single monetary policy. The European currency "snake" was an agreement whereby participating EC members agreed to manage their respective currency exchange rates so that they fluctuated with each other within a narrow prescribed band or "snake" of plus or minus 2.5 percent.

The most important feature of the EMS is the exchange rate mechanism (ERM) which, like the "snake," keeps each member's respective currency within a prescribed range of fluctuation. The hoped-for range was plus or minus 2.25 percent. Those currencies that were floated were allowed to fluctuate as much as plus or minus 6 percent but only on a temporary basis. In 1993, however, the band of fluctuation was temporarily increased to plus or minus 15 percent as a response to currency speculation pressure. In order to stabilize these exchange rates there is an obligatory intervention procedure. Central banks of countries having stronger currencies are obliged to "intervene" or buy weaker currencies whose value has fallen below the prescribed range or band. Likewise, the central banks of countries having the weaker currencies are obliged to sell their currencies to the central banks of financially stronger countries.

A central feature of the EMS is a common unit of currency. Created in 1974 it was initially called the European unit of account but soon became known as the European currency unit (ECU). The unit was backed by pooling specified amounts of member nations' currency. The amount of currency deposited by each member country was related to the economic strength of that country. In 1990 30 percent of the ECU pool or basket was in deutsche marks, 19 percent in French francs, 12 percent in pound sterling, and 10 percent in Italian lira. The balance of the basket came from the remaining EMS participants. The ECU represented a stable unit of exchange and could be used in commercial transactions.

In 1995 the European Council, which consists of the heads of state of the EC's 12 members, renamed the ECU the "euro." Although the acronym "ECU" made sense as an English term, it had no basis of meaning in any other European language. Germany proposed the term" euro" be combined with the name of each national currency as a suffix. In this case the new unit of exchange could be known as the "euromark," "euro-franc," "euro-lira," etc., but ultimately, the simpler "euro" was selected.

One question the EMS and the Maastricht Treaty did not address, at least not explicitly, was the problem of exchange-rate relationships between respective EMS members and non-EMS members, or the "ins and outs." Subsequent debate on this issue began in the mid-1990s and fell under the term "European Monetary System II." The primary focus of EMS II, like its predecessor, is the avoidance of fluctuations in currency exchange rates between EMS participants (the "ins"), nonmembers (the "outs"), and new members (the "pre-ins").

Although monetary integration was not an original goal of the European Economic Community, the concept seemed to gain support with each European economic crisis. The EMS is credited with helping to avert economic crises by stabilizing exchange rates, reducing inflation, and coordinating the monetary policy of members' central banks. The EMS is thus a major step towards European monetary integration.