The European Monetary System (EMS)

1. The European Monetary System (EMS) Pegged exchange system (1979-1993) Paul De Grauwe The Economics of Monetary Integration, Third Edition, Oxford: 1997. Chapter 5.

2. Problems of Fixed Exchange Rate Systems • The credibility problem of governments that decide what the exchange rate will be • Devaluation may be the least-cost solution • Differences in the reputation of governments • The liquidity problem • Follow the leader solution • Cooperative solution

3. Adjustment Problems Lower the Credibility of a Fixed Exchange Rate A supply shock takes place (oil price increase, economy-wise wage increase). Inflation and unemployment rise, exports fall, imports rise. If $wage and price flexibility, real wages will P P AS2 P AS1 AD2 AD AD2 Y Y Y fall, AS will shift back and equilibrium regained. If $ labor mobility, emigration will take place, unemployment will disappear. Otherwise, trying to solve unemployment problem by expansionary policies will exacerbate inflation and current account deficit. Trying to solve current account deficit by contractionary policies will deepen the recession. Devaluation could solve the current account deficit easily. Speculators know this too and run away from this country’s currency destabilizing the situation further. The credibility problem can be solved only if speculators are convinced that the government’s sole objective is fixed FX.

4. Differences in Reputation Lead to Low Credibility of a Fixed Exchange Rate • High inflation country A pegs its FX to low inflation country B. • A has an incentive to follow inflationary policies so that it can benefit from low unemployment caused by expansionary policies. • Since its FX will be overvalued and chronic current account deficit is experienced, devaluation becomes inevitable. • Speculators expect this and attack the currency.

5. Liquidity Problem • When two countries fix their exchange rates they will have to maintain the same real interest rate, the same inflation, and hence the same nominal interest rate. • Same real interest rate eliminates one way flow of capital. • Same inflation eliminates pressure to devalue the high inflation currency. • But nominal interest rates can be set at any level. • Asymmetric solution • Symmetric solution r1 r2 MD MD M1 M1 M2 M2

6. Asymmetric (Follow-the-Leader) Solution • Country A determines its own money supply. Given the money demand in A, its interest rate is fixed. • Country B has no choice but to match the interest rate in A. Given B’s money demand, the authorities have no choice but to pick one unique money supply. • Country A is the anchor country with independent monetary policy. • Country B has no freedom to choose its monetary policy.

7. Symmetric (Cooperative) Solution • The EMS used ECU as the anchor to which exchange rates would be fixed. If a currency deviated from the central rate, monetary authorities would respond. • If currency got stronger, expand money supply. • If currency got weaker, contract money supply. • Coordinated interventions in the foreign exchange market. • If future devaluation of B’s currency is expected, to keep the capital from fleeing B, interest rates in B should rise relative to A. • Speculators sell B currency to acquire A currency. B Central Bank buys its own currency and provides A currency to the market. Money supply in B drops. • According to EMS agreement, A Central Bank loans A currency to B Central Bank. Money supply in A increases.

8. Under EMS, Symmetric Solution Did Not Work Well • The strong currency country (Germany) did not allow its money supply to expand by resorting to sterilization. • Weak currency country (Italy) floods the market with DM as it buys IL. • Bundesbank engages in open-market-operations of selling government securities and mopping up the DM. • The weak currency is forced to do all the adjustment, deepening the contraction. • This is similar to US role under Bretton Woods.

9. Advantage of Asymmetric System • It imposes discipline on the peripheral country. • Suppose, Italy decided to increase its money supply. • Italian interest rates fall. • Speculators leave IL, forcing Italian Central Bank to provide them with DM. • Italian money supply contracts, interest rates rise. • Nothing happens in Germany because it sterilizes.

10. Disadvantages of Asymmetric System • Business cycles in the periphery are made more intense. • Recession in the periphery. • Income falls => Money demand falls => interest rates fall. Capital outflow: peripheral currency is exchanged for center currency by the periphery CB. Periphery money supply is reduced, deepening the recession. • Center CB sells government securities to keep its money supply and interest rates constant. • Boom in the periphery. • Income rises => Money demand rises => interest rates rise => capital inflow => foreign currency exchanged for periphery currency => Periphery CB accumulates foreign reserves and provides more periphery currency to the market => money supply is increased => boom is accentuated. • Center CB practices sterilization.

11. The Political Fallout From Unsynchronized Business Cycles • If the center country practices sterilization, the periphery has to bear the societal costs. • Periphery will put pressure on the center to not sterilize and adjust symmetrically. • If peripheral countries are similar in size to the center country, e.g. EMS, they will not be willing to subordinate national interest to the survival of the system. More cooperative system emerges. • If center refuses, periphery may abandon fixed exchange rate regime.

12. Why Low-Inflation Country Becomes The Anchor • Both countries are in long-run equilibrium. • If they decide on the high inflation country interest rate, misery index for low inflation country increases; no change in high inflation country misery index. • If they decide on the low inflation country interest rate, misery index for high inflation country drops; no change for low inflation country. • When US stopped being the low-inflation country in the Bretton Woods system, others dropped out.

13. How Come EMS Withstood The Credibility and Liquidity Problems • Bands of fluctuation were wider than Bretton Woods • Bretton Woods: 1+1%; EMS: 2.25+2.25% (Italy until July 1990, Portugal, Spain, UK: 6+6%). • High-inflation countries could devalue the currency by up to 12% annually without speculative attacks because the market rate would be commensurate with the official rate. • Under Bretton Woods, even after the officially allowed 2% devaluation, the market expectations would not be fulfilled and speculation would continue. • After 1987 the flexibility of EMS was abandoned in favor of a rigid fixed exchange rate system. • Capital controls reduced the funds available for speculative attacks • At the end of 1980s capital controls were eliminated.

14. Disintegration of EMS • In the 1990s, EMS became a fixed exchange rate system with perfect capital mobility. • The lira and peseta crises - credibility problem • The sterling and French franc crises - liquidity problem