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From the European Monetary System to the European Exchange Rate Mechanism. A brief history

From the European Monetary System to the European Exchange Rate Mechanism.  A brief history

A brief history of what we presently call the Eurozone and what led to it

In a previous article, we mentioned EMS and ERM. Now, we've decided to dedicate an article to those terms specifically to understand them better. After reading this, and finding words that you don't know, look at our Financial Dictionary. The article is divided into two parts, each corresponding to one of the terms. This being said, let's dive in:

1. The European Monetary System

The beginnings

The European Monetary System (EMS) was launched in 1979, and it was an arrangement meant to adjust the exchange rate between the Euro and other European currencies. The purpose was to ensure close momentary policy cooperation amongst the European Community (later known as the European Union).

The EMS came into focus after the collapse of the World War II Bretton Woods Agreement. The Agreement's purpose was to establish a fixed foreign exchange rate to stabilize the war-battered economies. By the Agreement, the USD was pinned to the Gold, while the other currencies were pegged to the USD's value. Moreover, it promoted international economic growth, and it prevented the competitive devaluation of currencies. However, it was short-lived, coming to an end in the early 1970s after the US President Richard Nixon stated that the country would stop exchanging Gold for USD.

The goal

EMS’s main goal was to balance inflation and prevent large exchange rate fluctuations between European countries. Its final goal was to create economic and political unity in Europe and set the stage for a common currency – the Euro. To do so, the Exchange Rate Mechanism (ERM) was formed and implemented later in 1999.

Member states had to take some measures to comply with the EMS, and in 1986, the national interest rates got modified to keep the currencies stable.

Though the intentions were good, the outcome didn't live up to the expectations. The early 90s brought tension and an overall crisis over the System. Due to the economic and political differences that came with Germany's unification, the depreciation of the USD, and the maneuver pulled by George Soros, Great Britain had to withdraw from the EMS in 1992. The UK’s exit just paved the way for other countries to not accept the EUR as currency such as Sweden and Denmark.

However, in 1993 countries signed the Maastricht Treaty and formed the European Union, which one year later launched the European Monetary Institute, commonly known now as the European Central Bank (ECB).

By the beginning of 1999, the EUR came to be used by most of the European Union member countries.

The criticism

One requirement of the System was highly criticized, and it concerned the exchange rates. The rates would be changed only if member countries and the European Commission were both in Agreement.

Also, since day one, the EMS policy forbade bailouts to in-need economies that were in the Eurozone. Moreover, the 2008-2009 financial crisis brought into attention the omissions of the EMS policy. Countries like Portugal, Spain, Ireland, Cyprus, and the hardest-hit Greece faced significant national deficits that transformed into the European sovereign debt crisis. These countries weren't allowed to spend to offset unemployment and could not apply devaluation.

Now that we understand what happened roughly three decades ago, let's see what the European Exchange Rate Mechanism (ERM) is.

2. The European Exchange Rate Mechanism

The beginnings

The Mechanism implemented on January 1st, 1999 is now commonly known as ERM II, which is the second iteration of the European Currency Unit - ECU – a basket of currencies used before the EUR adoption - when the use of a single currency was introduced to obtain monetary stability in Europe.

The ERM II works based on fixed currency exchange rate margins, but at the same time, the exchange rates are variable within the specified margins. This is the so-called semi-pegged System. According to the Mechanism, the margin within which the currency fluctuations had to be contained was 2.25%. At that time, the Spanish Peseta, the Portuguese Escudo, the GBP, and the Italian Lire could fluctuate by ±6%.

If the necessary margin for currency fluctuations was 2.25% and ±6% in the beginning, now the majority of countries keep it at ±15% against the central rate.

The goals

The ERM II goal is to ensure that the exchange rate fluctuations between the Eurozone and other European Union member states do not impact the overall market economic stability. Also, it prepares the non-euro countries to enter the Eurozone.

1999 – present

In January 1999, 11 member states established the Eurozone. Within just a couple of years, the first enlargement of the Eurozone came. The new member was Greece, which joined on 1 January 2001 – one year before the EUR entered circulation.

Every one or two years, other European countries joined the Eurozone: Slovenia – 2007, Cyprus – 2008, Malta – 2009, Estonia – 2011, Latvia – 2014, Lithuania – 2015.

In 2020, three new currencies will be part of the ERM: the Bulgarian Leva, the Danish Krone, and the Croatian Kuna.

It doesn’t matter if countries want to be part of the ERM or not, under the Maastricht convergence criteria, European Union members must join the Mechanism.

The criticism

According to economist James Tobin, the whole movement set in motion by this Mechanism, and the Eurozone formation, could not have been possible without changes from the European institutions. As far as the European Central Bank is concerned, it prioritizes price stability instead of economic growth and reducing unemployment. That's why the unemployment rate of the bloc is higher than the US's one since 1982.

Moreover, under the Treaty of Maastricht, each member of the Eurozone must run its budget deficit lower by 3% compared to the country's GDP.

A study from the Centre for European Policy conducted in 2019, showed that the Eurozone had both positive and negative impacts on member countries. While some countries gained and developed after adopting the EUR, others were poorer than they would have been if they wouldn't have chosen the EUR, Italy, and France especially. However, according to the study's authors, it's all because of competition.

If you've read this far, you have a clear picture of how the Eurozone emerged, and which were the steps taken to that point. Now, as stated before, it wasn't all fun and games for some countries; see the case of the UK and its Black Wednesday.

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