What Is the European Monetary System (EMS)?

The European Monetary System (EMS) was an adjustable exchange rate arrangement set up in 1979 to foster closer monetary policy co-operation between members of the European Community (EC). The European Monetary System (EMS) was later succeeded by the European Economic and Monetary Union (EMU), which established a common currency called the euro.

Key Takeaways

  • The European Monetary System (EMS) was an arrangement between European countries to link their currencies.
  • The goal was to stabilize inflation and stop large exchange rate fluctuations between these neighboring nations, making it easy for them to trade goods with each other.
  • The European Monetary System (EMS) was succeeded by the European Economic and Monetary Union (EMU), which established a common currency called the euro.

Understanding the European Monetary System (EMS)

The European Monetary System (EMS) was created in response to the collapse of the Bretton Woods Agreement. Formed in the aftermath of World War II (WWII), the Bretton Woods Agreement established an adjustable fixed foreign exchange rate to stabilize economies. When it was abandoned in the early 1970s, currencies began to float, prompting members of the EC to seek out a new exchange rate agreement to complement their customs union

The European Monetary System’s (EMS) primary objective was to stabilize inflation and stop large exchange rate fluctuations between European countries. This formed part of a wider goal to foster economic and political unity in Europe and pave the way for a future common currency, the euro.

Currency fluctuations were controlled through an exchange rate mechanism (ERM). The ERM was responsible for pegging national exchange rates, allowing only slight deviations from the European currency unit (ECU)—a composite artificial currency based on a basket of 12 EU member currencies, weighted according to each country’s share of EU output. The ECU served as a reference currency for exchange rate policy and determined exchange rates among the participating countries’ currencies via officially sanctioned accounting methods.

History of the European Monetary System (EMS)

The early years of the European Monetary System (EMS) were marked by uneven currency values and adjustments that raised the value of stronger currencies and lowered those of weaker ones. After 1986, changes in national interest rates were specifically used to keep all the currencies stable.

The early 90s saw a new crisis for the European Monetary System (EMS). Differing economic and political conditions of member countries, notably the reunification of Germany, led to Britain permanently withdrawing from the European Monetary System (EMS) in 1992. Britain's withdrawal reflected and foreshadowed its insistence on independence from continental Europe, later refusing to join the eurozone along with Sweden and Denmark.

Meanwhile, efforts to form a common currency and cement greater economic alliances were ramped up. In 1993, most EC members signed the Maastricht Treaty, establishing the European Union (EU). One year later, the EU created the European Monetary Institute, which later became the European Central Bank (ECB).

Important

The primary responsibility of the ECB, which came into being in 1998, was to institute a single monetary policy and interest rate.

At the end of 1998, most EU nations unanimously cut their interest rates to promote economic growth and prepare for the implementation of the euro. In January 1999, a unified currency, the euro, was born and came to be used by most EU member countries. The European Economic and Monetary Union (EMU) was established, succeeding the European Monetary System (EMS) as the new name for the common monetary and economic policy of the EU.

Criticism of the European Monetary System (EMS)

Under the European Monetary System (EMS), exchange rates could only be changed if both member countries and the European Commission were in agreement. This was an unprecedented move that attracted a lot of criticism.

With the global economic crisis of 2008-2009 and the ensuing economic aftermath, significant problems in the foundational European Monetary System (EMS) 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. These countries could not resort to devaluation and were not allowed to spend to offset unemployment rates.

From the beginning, the European Monetary System (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.