The European Monetary System (EMS) was created by France and Germany in 1979 to resolve these deficiencies. Participating currencies were still held within their bilateral margins of +/- 2.25% but were now accompanied by capital controls to allow a degree of monetary policy autonomy. More importantly, a new entity - the European Monetary Fund - was established to provide credits known as ecus to members experiencing balance of payment problems. In practice, the EMS was a Deutschmark-centred system with German monetary policy serving as the nominal anchor – other countries reduced their inflation towards Germany’s which was the lowest in Europe. This time none of participants had to withdraw and a far greater degree of exchange rate stability was achieved, particularly after 1985.
In 1991, the EMS members were full of optimism. The EMS had proven resilient to the collapse of the USSR and German reunification. In this spirit, they set out their commitment to monetary union under the Maastricht Treaty, agreeing that by 1999 they would:
- hold their currency within the EMS band for at least two years
- run an inflation rate over the preceding year that did not exceed that of the three lowest inflation member states by more than 1.5%
- reduce their public debt as a percentage of GDP and GDP growth to 60% and 3%, respectively
- maintain a nominal long-term interest rate in the preceding year that did not exceed 2% of the three most price-stable members
Yet the following year, the EMS faced its severest test. In mid-September, Britain crashed through its EMS limit and ignominiously withdrew from the system, less than two years after joining. Italy likewise fell through its band and was forced to float but somehow remained part of the system. Most other EMS currencies came under speculative pressure and were forced to realign. Essentially the crisis stemmed from the inability of European governments to raise interest rates in the face of grinding recession but speculative attacks such as that of George Soros’s on the pound also played a role, creating self-fulfilling crises in otherwise solvent national economies.
Following the early 1990s crisis, the situation improved – with expansion in Europe, austerity became easier to implement and the absence of laggards such as Britain removed a drag. EMS members locked in their exchange rates in 1999 and the euro was introduced in 2002. The euro brought numerous benefits such as fewer disruptions to intra-European trade, improved price transparency, and a reduced cost of capital for European firms. Yet there were several structural weaknesses with which we are now well acquainted. Adapting to a single monetary policy wasn’t easy. Slow-growing economies such as Italy preferred looser European Central Bank (ECB) policy and a weaker euro whilst fast growing economies such as Ireland preferred tighter policy to cool down their overheated economies. Moreover, the interest rates of “convergence economies” – EU slang for poor, peripheral economies such as Greece and Portugal - suddenly fell to German levels. Consumption and investment surged, and wages were pushed up dramatically. After their booms, convergence economies were saddled with excessive wages, lagging competitiveness and increasing unemployment, necessitating painful austerity measures.