European Payment Union (1950-1958)

1. History of the European Monetary Integration European Payment Union (1950-1958) • Facilitated multilateral clearing of payment imbalances. The Bank of International Settlements acted as a clearing house. European Monetary Agreement (1958-1972) • Many European currencies became convertible. The Agreements facilitated central banks in making settlements in gold and dollars.

2. Bretton Woods System (De facto, 1946-1958, De Jure 1958-1971) • Currencies were allowed to fluctuate by±1% margin of fluctuations with respect to dollar. • European currencies could fluctuate as much as 4% with each other since  1% against the $ meant 2% against each ± 2% margin of fluctuations for EC currencies (against each other). other. • European Monetary Agreement (1958-1971) implied narrower margins: ±0.75% margin of fluctuations with respect to dollar and ± 1.5% with respect to each other EC currency. • December 1971-Smithsonian agreement=> a 7.9% devaluation of the dollar against gold setting 1ounce of fine gold=$38. Also, DM was revalued by 4.6%, Dutch Guilder by 2.8 % and 7.7 % for yen against gold. (All references to the gold content of a currency was formally abolished by IMF in 1978). • With the Smithsonian Agreement on December 1971, the band was enlarged to 2.25%

3. Why fixed rates? • General dislike of EC countries for floating exchange rate regimes because of • a) its negative impact on trade and investment flows due to exchange rate volatility, • b) experience in 1919-1926, • c) difficulties to administer the CAP under the flexible exchange rate regime when the fluctuations in exchange rates make it possible to revise price supports to farmers, • d) inherent instability of the flexible exchange rates due to speculation.

4. Basle Agreement (Snake in the Tunnel ) (1972) • EC currencies jointly moving within a dollar tunnel. • Bilateral exchange rates with respect the dollar 2.25%. • Bilateral exchange rates among European currencies 1%. (2.25% band) (Narrower Band for European currencies) • Intervention mechanism and monetary support for member countries.

5. Snake in the Tunnel Bilateral band among European currencies 1% Fluctuation band against the dollar 2.25%

8. European Monetary System (1979)and The Exchange Rate Mechanism:ERM(1979-1998) • Shepherded by Schmidt and D’Estaing: A zone of “monetary stability” and a “nursery” for European Monetary Union (EMU). ERM was the institutional mechanism for stability between EC currencies while floating them against all others, including the dollar. • Creation of a “cocktail” currency, a numéraire : ECU (European Currency Unit) consisted of weighted values of EC currencies based on their GDP and trade. Just as the dollar was at the center of the BW system and was its de facto numéraire and reserve asset (the dollar was “as good as gold”), the ECU was the reserve asset of the EMS (used for settlement of accounts between Central Banks) and its unit of account.

12. European Monetary System (1979)and The Exchange Rate Mechanism:ERM(1979-1998) (Continued) • The ERM created a set of central rates of exchange between participating currencies expressed in terms of ECU. • Each currency was to maintain exchange rates vis-à-vis each other within ± 2.25%of the central rate, subject to the possibility of a formal realignment. (For Italy and Ireland, later for UK (1990), and Spain (1989), this was ± 6%. Italy moved to ± 2.25%in 1990 but left it again after the EMS collapsed in 1992). • Financing facilities and short-term credits were provided to member Central Banks. • Possibility of realignments allowed within the EMS. • The Central bank of the weak (strong) currency had a legal obligation to defend these margins by buying its weak currency (selling its strong currency).

13. The Exchange Rate Mechanism:ERM (1979-1998)-Continued • Frequent realignments at first, less frequent later, no realignment after 1987 (the hard EMS): Compare 27 currency realignments in 1979-1983 (Soft EMS) with only 12 parity changes in 1983-1989 (Hard EMS) • DM as the nominal anchor currency due to her low inflation. Other currencies targeted a constant exchange rate against DM and were able to ‘import’ Germany’s low inflation success and the credibility of the Bundesbank. • The EMS: A mechanism to embark anti-inflationary policies through relatively fixed exchange rates with respect to DM (the low inflation currency). • The period was a stepping stone to full Monetary Union. With its narrow bands, infrequent realignments and its orientation on DM, participation in the hard EMS implied that the resort to independent monetary policy would be undertaken only under exceptional conditions.

14. The Exchange Rate Mechanism:ERM (1979-1998)-Continued • The Disintegration of the EMS during the 1992 and 1993 Exchange Rate Crises: Under Conditions of almost fixed exchange rates (after 1987) and capital mobility. • 1992 Lira and Peseta Crisis Divergent inflation rates from German levels (30% higher in Italy compared to Germany), loss in competitiveness and balance of payments problems which proved unsustainable. Expectations of devaluation breed speculation (sell Lira and buy DM! Once the devaluation occurs, buy back Lira and gain a windfall profits.)

15. The Exchange Rate Mechanism:ERM (1979-1998)-Continued • 1993 Pound and French Franc Crisis No evidence of divergent inflation patterns and competitiveness of France or UK relative to Germany. • An irrational speculative attack on these currencies driven by an “Anglo-Saxon plot” against the monetary unification?? Not really! The policy conflicts between Germany on the one hand, and Britain and France on the other about the appropriate monetary policy to deal with the1992 recession which hit these economies. Complications of the German unification in 1990=> Large increase in German government spending created inflationary pressures. But Bundesbank was determined to fight inflation through restrictive monetary policy (high interest rates!). Britain and France, by contrast, opted for an expansionary policy with low interest rates. • Speculators noticed that UK and France were about to cut their links with the Mark, and attacked the pound and the franc (sold pound (franc), bought DM) leading to a sharp depreciation of both of these currencies against the mark. • Two currencies-Italian Lira and UK’s pound- were driven out of the system. • The resolution of the second crisis was to widen the bands of fluctuation to ± 15%-not too different from a free float, quasi-floating exchange rate regime.

16. The Exchange Rate Mechanism:ERM (1979-1998)-Continued • The role of speculation and impossibility of realigning currencies in a speculation-proof manner. Dispelled the illusion that Germany would feel bound to support the system against speculative attack by unlimited intervention in the forex markets. During these crises, Germany supplied DM to the Central Banks of the weak currencies so as to support their fight against the speculative attack (buying their weak currency by selling DM while maintaining the fixed exchange rate with DM). But after a while, large increases in DM money supply led Bundesbank to stop supplying DM as it was getting too difficult to sterilize the DM expansion. Large increase in DM supply meant Bundesbank would relax its restrictive stance on monetary policy but it was unwilling to do so with inflation as its top priority. Unconditional defense of the weak FF and pound would mean changing their policy stance.

17. The Exchange Rate Mechanism:ERM (1979-1998)-Continued • After 1987, the EMS became almost a fixed exchange rate regime and quite rigid with infrequent realignments of the exchange rates. Quasi-fixed exchange rate regimes like EMS are prone to speculative attacks unless the countries coordinate economic policies well. Speculation inevitably proves self-fulfilling and some call for capital controls to reduce the amount of funds that can be mobilized by speculators to protect such regimes. True, capital mobility affected the timing and the dynamics of the disintegration of the EMS, but it was not responsible for its inherent instability under conditions of divergent economic conditions and policy preferences. • The crises did not, however, spell the end of aspirations for a monetary union. Just the opposite: Full monetary union was the only viable fixed-rate solution, this was well understood.

18. The EMS from 1993 to 1998 • Enlargement of the band of fluctuation to 30% (± 15%) reduced the scope of speculative attacks after 1993. • The start of European Monetary Union (EMU) was scheduled for 1 January 1999. • Maastricht Treaty (1991): One condition for entry into the EMU was that the candidate countries would maintain the exchange rates within the band from January 1, 1997. This raised the cost of devaluation for the applicant countries.