European Monetary System - Term Paper Example

Introduction European Monetary System (EMS) started as an arrangement in 1979 between different European countries to peg their currencies to preventfluctuations in foreign exchange rates. After the collapse of Bretton Woods agreement in 1971, most of European countries agreed to keep their currencies at stable level in order to prevent any sharp variability and help currencies to float in a particular band (Bean, 1992). This arrangement took place in different stages and gradually evolved however, it collapsed during 1992 when Italy and England failed to keep their currencies at the level above the required minimum threshold level of the band. (Aykens, 2002) The ERM was developed as a managed float exchange rate system in which currencies of member countries were only to fluctuate within a particular band. Only those members were considered as the permanent members of ERM who committed themselves to keep their currencies within that particular band and made policy initiatives to keep them within that range. This system gradually evolved in such a manner that most of the currencies were linked with stronger currency of the region. Ultimately all the currencies were pegged or linked with the German Mark because Germany was the largest economy in Europe. (Baldwin & Wyplosz 2006) One of the key events which created the crisis was the unification of Germany in which a larger economy has to merge with a smaller economy. As a result of this reunification, West Germany has to spend on fiscal expansion which further widened its fiscal deficit to as much as 13 % of GDP. (Heitger & Waverman, 1993). Consumers in Eastern Germany spent the voluntary government transfers received from West Germany in rather quicker manner. At the time of reunification, East Germany’s currency was pegged at a ratio of 1.8:1 however, such disparity discouraged firms to sell their inventory at loss. Higher demand from consumers versus low level of supply therefore resulted into inflationary pressures on the economy. (Mulhearn & Vane, 2008) At the time of ratification of Maastricht Treaty in 1993, differing opinions started to emerge against EMS as referendums in Denmark and France gave a hint about small minority which was against the treaty itself. This was mainly due to higher German interest rates and impact of same on foreign exchange rates of other countries. In September 1992, Italy decided to devalue Lira by 7% followed by UK’s withdrawal from the ERM. As a prelude to this, currency speculators were able to precisely forecast that European economies may exit ERM and started to speculate against the British Pound on the basis that the GB pound will lose its value. Massive short selling took place for British Pound putting further pressure on British Sterling in global markets. To what extent the crisis impeded the realization of European Union Basle-Nyborg agreements paved the way for further liberalization as they allowed for interamarginal intervention by the States. Further, Delors Report, published in April 1989, outlined the steps required for complete liberalization of capital flow across whole EU region. Despite such efforts, failure of ERM actually delayed the materialization of complete capital liberalization and establishment of EMU. It is generally believed that through Basle-Nyborg agreements, France actually attempted to punish Western Germany by forcing it to take care of the problems of countries with weaker currencies. (Frankel, 1996)  Though the failure of ERM may be considered as a phenomenon which resulted due to some historical facts i.e. the reunification of the Germany however, the differences within the political and economic policies of the countries may also be considered as one of the reasons for its failure. Germany was going through a period which forced it to raise interest rates in order to curb its fiscal deficit. However, for Italy and UK, it was a necessity to keep their interest rates at relatively lower level. The 1992 crisis also raised serious questions over the fiscal stability of countries and overall focus shifted from managing monetary policy to managing fiscal policy also. This was mainly due to prevalence of higher interest rates in Germany causing inflation as well as an increase in the fiscal deficit. This event also forced countries like France to shun the community objectives and look for safeguarding its national interests first. Such change corroborated by hegemonic position of Germany therefore resulted into further delay for establishment of EMU. It is also critical to understand that the growth in Europe is still largely driven by Germany where other countries follow Germany. During 1992 crisis, most countries actually tried to peg their currencies with German Mark by taking austerity measures. However, these measures failed and currencies devalued over the period of time leaving other economies ill prepared for any further move towards economic convergence. ERM was launched in order to control the ability of the member countries to actually keep their exchange rates within a constrained limit. However; it failed to cast any doubts over the ability of the countries to manage their exchange rates on their own. The establishment of EMU was considered as a logical step towards the achievement of this objective. The development of EMU can also be considered as a step forward towards completely restricting the members to not to pursue the independent monetary policy and indirectly the fiscal policy also. The crisis during 1992 relatively impeded the dream of establishing EMU because some of the flaws of the EMS were mostly due to EMU. EMS visualized a system which was based upon the autonomy and independence along with the control over the running of the economic affairs of the country. However, it could not happen as the crisis critically impeded the ability of the European countries to move towards stage 3 where the European Monetary Union was to be established and Euro was to become a single currency across whole Europe. (Howarth & Loedel, 2003)  One of the immediate impacts of the crisis was the polarization of the exchange rate mechanism within and outside EU. Due to failure of the ERM, many countries within EU adhered to the broad-band ERM approach which was more akin to a dirty float mechanism rather than following a fixed exchange rate regime in which currencies were pegged with a single currency. As a result of the crisis, an intense political and economic debate rose within UK regarding the role of Germany and adaptation of single currency. The tension between Germany and UK therefore largely remained non-reconciled for most part of the 1990s which further delayed the introduction of EMU on a wider level. Due to massive reduction in value of British pound and the economic recession, British government faced strong political pressure on the domestic level. In order to cope with that situation, there emerged a blame-game between Britain as well as the Germany thus further delaying the transition towards EMU. (Cini,2007) In the aftermath of the shocks received by the Italy and UK during the crisis, other countries also became relatively more cautious in their approach. Speculation on the Franc as well as on Portuguese currency further delayed the dreams of European members to move towards EMU. The failure of ERM, also gave rise to a debate on two-speed monetary union during 1989. This was typically against what has been envisaged in Maastricht Treaty for establishing single currency. The multi-speed currency union therefore required for the establishment of a small core group of countries which will implement the single currency and other countries will follow their success. (De Grauwe, P. et al. 1994). British government focused on this approach and did not subscribe to Euro in order to gain time to properly assess the success and failure of Euro. This proposal failed to raise any further interests but resulted into further delay for the establishment of EMU. (Gros & Thygesen, 1999) Unification of Germany also increased the overall fiscal expenditure for Germany too despite the fact that they were already running in fiscal deficit. Due to unification, the overall fiscal expenditure further increased to cover for the expenditure in the Eastern Part of the country. Higher fiscal expenditure therefore raised the inflation rates by more than 4% during this period forcing Germany to take measures which were against the interests of other member countries in the block. Increase in interest rates by other countries also helped Germany but caused recession in countries like UK, France and Portugal. (Molle,1997)  Germany unification can also be considered as one of the reasons for the creation of Euro because unification actually forced many countries to participate in Euro. The unification has actually increased the overall size of the economy of Germany and made the labor force more mobile. (Heitger & Waverman, 1993)  Other countries viewed this as an economic opportunity to gain access to such a large market and were willing to join Euro to take advantage of the same. Some argue that the very unification of Germany was conditional to European Integration and German’s concessions to the monetary union of the Europe. This highlights that the Germany’s unification may have paved the way for stronger European Integration as well as the introduction of Euro as a single currency. Lessons to be learned for the current EMU Debt Crisis The current debt crisis in EU and the crisis of 1992 suggest a room for policy initiatives to be taken at EU wide level in more aggressive manner. There is a growing concern within Germany especially to develop a mechanism which can oversee the problem being solved slowly and on permanent basis. This view requires taking a long term approach to solve the problem through the creation of fiscal union and by involving other organs of EU to ensure that member countries oblige on their commitments to manage their debts within prescribed levels. Integrated economies run the risk of being affected by the Contagion effect where economy of one country can be critically affected by the failing economy of another country. Integrated economies therefore rely on each other a lot and the crisis in one country can lead to a crisis in another country. As such it is important that besides integration, there may be a mechanism which can allow such economies to develop their own internal mechanism through which they can deal with problems such as debt crisis. Minimization of the external shocks should be one of the top priorities of the countries in EU region. What is different this time that the ERM crisis was the indigenous crisis of Europe, the current debt crisis may be considered as a result of wider global level crisis. What is critical is the understanding that integration of economies can seriously lead to economic hardships. Probably, most important implication of the current and previous crisis is the lack of focus of major or core countries. It happened both of the times that the core members of the EU discriminated against the periphery members. This approach led to a point where the debt crisis in smaller economies like Greece and Ireland created strong exogenous shocks for the whole EU region. It is therefore critically important that the minor members should also be properly monitored in order to prevent the impact of their failure on other member states. Another important point to be learned is the correction of the fundamentals right because of the policy interventions. It has been observed that despite the integration some inconsistencies and frictions remained within the system which could not allow the system to properly integrate at the larger level. Like previous attempts, this time policy members are taking one way bets focused just on avoiding the defaults by any particular country rather than making an effort to correct the fundamentals. This approach therefore can lead the EU as a whole to fall into a trap where policy frictions and inconsistencies can actually result into its demise. The reunification of Germany created opportunity for Euro to be introduced at EU wide level and forced other countries to join it. The current debt crisis may also force countries to look for a fiscal union and better centralized management of their fiscal policy also. References 1. Aykens, P. (2002) Conflicting Authorities: States, Currency Markets and the ERM Crisis of 1992-93,Review of International Studies, 28(2), p.359-380 2. Baldwin, R. and Wyplosz, C. (2006) The Economics of European Integration, 2nd ed. New York: McGraw-Hill Higher Education. 3. Brandner, P. and Grech, H. (2005) Why Did Central Banks Intervene in ERM I? The Post-1993 Experience, IMF Staff Papers, 52(1), p.120-147. 4. Cini, M. (2007) European Union politics, Oxford: Oxford University Press. 5. De Grauwe, P. et al. (1994) Towards European Monetary Union without the EMS, Economic Policy, 9(18), p.149-185. 6. Frankel, B. (1996) Realism: restatements and renewal, London: Routledge. 7. Gros, D. and Thygesen, N. (1999) European Monetary Integration, 2nd ed. London: Longman Group. 8. Heitger, B. and Waverman, L. (1993) German unification and the international economy, London: Routledge. 9. Howarth, D . and. Loedel, P. (2003) The European Central Bank: the new European leviathan, New York: Palgrave Macmillan,. 10. Molle, W. (1997) The economics of European integration: theory, practice, policy, 3rd ed. London: Ashgate. 11. Mulhearn, C. and R. Vane, H. (2008) The euro: its origins, development and prospects, London: Edward Elgar Publishing. 12. R. Bean, C. (1992) Economic and Monetary Union in Europe, The Journal of Economic Perspectives, 6(4), p.31-52. 13. R. Masson, P. (1995) Gaining and Losing Erm Credibility: The Case of the United Kingdom, The Economic Journal, 105(430), p.571-582. Read More