European Monetary System (EMS)

European Monetary System (EMS), system designed to increase financial cooperation and monetary stability within the European Union (EU). The EMS was created in 1979 in response to the fluctuation of European exchange rates that occurred in the wake of dramatic increases in oil prices in 1974. The primary purposes of the EMS were to stabilize exchange rates in the EU and to aid the long-term process of European monetary integration.
The central component of the EMS was the Exchange Rate Mechanism (ERM), a voluntary system of fixed exchange rates. This system was based on the European Currency Unit (ECU, which became the euro in 1999), the unit of account of that the EU adopted at the creation of the EMS. Under the ERM, the currencies of participating countries were allowed to fluctuate in relation to one another and to the ECU, but only by small amounts. This amount was set at 2.25 percent for all countries except Italy, Spain, and the United Kingdom, which had 6 percent margins of fluctuation.
The ERM was an important part of the plan to achieve Economic and Monetary Union (EMU). Under EMU, the economies of the EU states would be united and the EU would have a single currency administered by an EU central bank. EMU was the ultimate aim of the EMS and was a central part of the 1992 Maastricht Treaty that founded the EU.
The ERM was not without problems. First of all, not all EU members belonged to the ERM, and this limited its effectiveness. Greece never joined, and the United Kingdom did not join until 1990. In addition, by the early 1990s the system had become too rigid, and currencies were unable to fluctuate in relation to each other even in times of crisis. This came to a head in 1992 when currency traders began to have doubts about the value of some EU members’ currencies, leading to speculative attacks. The large-scale buying and selling of these currencies weakened the ERM severely, and the difficulty in maintaining the fixed exchange rates led the United Kingdom and Italy to withdraw from the ERM.
To prevent more countries from being forced out, in 1993 the ERM margin of fluctuation was widened for all currencies except the Dutch guilder and the German currency, the deutsche mark. This action left only The Netherlands and Germany within the 2.25 percent band. Since being within this band was one of the original conditions for participation in economic and monetary union and for adopting the single currency, many EU states were concerned that widening the fluctuation margins would seriously jeopardize the EMU. By April 1994 Belgium, Denmark, France, Ireland, and Luxembourg were back within the 2.25 percent band, but Spain and Portugal remained under pressure; in March 1995 they were forced to depreciate their currencies against the ECU. At the same time, the United Kingdom and Denmark, concerned about the potential problems of EMU, negotiated the right to opt out of monetary union.
On January 1, 1999, EMU went into effect. The euro replaced the ECU as a common currency on a one-to-one basis, but for only 11 states: Greece had failed to qualify, while the United Kingdom, Denmark, and Sweden declined to join. (Greece later met the economic criteria and adopted the euro on January 1, 2001.) The EMS was effectively transformed into economic and monetary union, with a single currency controlled by a European central bank. However, the ERM was revised as a mechanism for regulating relations between the euro and the currencies of those EU countries not participating in EMU.
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