European Monetary System - EMS

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DEFINITION of 'European Monetary System - EMS'

The European Monetary System (EMS) is a 1979 arrangement between several European countries which links their currencies in an attempt to stabilize the exchange rate. This system was succeeded by the European Economic and Monetary Union (EMU), an institution of the European Union (EU), which established a common currency called the euro.

INVESTOPEDIA EXPLAINS 'European Monetary System - EMS'

The European Monetary System originated in an attempt to stabilize inflation and stop large exchange rate fluctuations between European countries. Then, in June 1998, the European Central Bank was established and, in January 1999, a unified currency, the euro, was born and came to be used by most EU member countries.

History of the European Monetary System

The European Monetary System (EMS) was founded in 1979 after the collapse of the Bretton Woods Agreement in 1972, to help foster economic and political unity in the European Union (EU) and pave the way for a future common currency, the euro. The Bretton Woods Agreement, formed in the wake of World War Two’s aftermath, established among other European unity advances an adjustable fixed foreign exchange rate in order to stabilize economies within Europe. Due to various economic and political pressures this agreement was abandoned in 1972.

The EMS established a new policy of linked currencies between most countries in the EU in order to stabilize foreign exchange and prevent large fluctuations in inflation among members. Another important tenet of the EMS was the formation of the European Currency Unit (ECU), a prelude to the euro. The ECU determined exchange rates among the participating countries’ currencies via officially sanctioned accounting methods. The early years of the EMS were marked by uneven currency values, with adjustments that raised the values of stronger currencies and lowered those of weaker ones. However, after 1986 changes in national interest rates were specifically used to keep all currencies more stable.

The early 90s saw a new crisis for the EMS. Differing economic and political conditions of member countries, particularly the reunification of Germany, led to Britain permanently withdrawing from the EMS in 1992. This reflected and foreshadowed Britain’s insistence on independence from continental Europe, later refusing to join the eurozone along with Sweden and Denmark.

Efforts to push on to a common currency and greater economic alliance continued. In 1994 the EU created the European Monetary Institute in order to transition to the European Central Bank (ECB), which was formed in 1998. The primary responsibility of the ECB was to institute a single monetary policy and interest rate – working with national central banks – including the euro common currency. Like a typical central bank, the ECB is responsible for controlling inflation; however, unlike most central banks it was not charged with boosting employment rates or functioning as a lender to governments during financial difficulty. At the end of 1998, most EU nations unanimously cut their interest rates in order to promote economic growth and prepare for the implementation of the euro.

The European Economic and Monetary Union (EMU) was then established, succeeding the EMS as the new name for the common monetary and economic policy of the EU. The euro was fully adopted and brought into circulation by EU member states, with Greece joining last, by 2002. This was considered a major step towards European political unity, and together participating nations acted to reduce debt, curb excessive public spending and attempt to tame inflation. As more countries subsequently joined the EU, many have adopted the euro.

The EMS/EMU and the European Sovereign Debt Crisis

With the global economic crisis of 2008-2009 and the ensuing economic aftermath, major problems in the foundational European Monetary System policy became evident. Certain member states; Greece in particular but also Ireland, Spain, Portugal and Cyprus, experienced high national deficits that went on to become the European sovereign debt crisis. Without national currencies these countries could not resort to devaluation, and were not allowed to spend in order to offset unemployment rates. From the beginning EMS policy intentionally prohibited bailouts to ailing economies in the eurozone. With vocal reluctance from EU members with stronger economies, the EMU finally established bailout measures to provide relief to struggling peripheral members.

In 2012 the European Stability Mechanism, a permanent fund to aid the struggling economies of EU member nations, was implemented across the EU. With new bailout measures and mandated austerity measures in the afflicted countries, several economies such as Ireland, Portugal and Spain have managed a tentative recovery. However Greece’s continuing economic recession, political strife and rampant unemployment rate continued in 2015. By June 2015 Greece defaulted on an International Monetary Fund loan and on July 5, 2015 the Greek people voted against further austerity measures imposed by the EU. The future of Greece’s participation in the eurozone remains uncertain, revealing the weaknesses of the original European Monetary System policy in terms of true European fiscal and political unity.

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