The European Monetary System and the Crea;on of the Euro. Prof. George Alogoskoufis Fletcher School, TuAs University

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1 The European Monetary System and the Crea;on of the Euro Prof. George Alogoskoufis Fletcher School, TuAs University

2 The Crea;on of the European Monetary System (EMS) The European Monetary System (EMS) was created in 1978 in order to ensure rela;vely stable exchange rates in the European Community (EEC now EU). This stability was a prerequisite for the effec;ve func;oning of the Communi;es other mechanisms, such as the free intra- Community trade, the Common Agricultural Policy (CAP), regional and structural policy and, more recently, the Single Market Programme. The ini;a;ve belonged to the French-German axis and arrangements were agreed in two European Councils in Bremen in July 1978 and in Brussels in December of the same year. 2

3 The Structure of the European Monetary System European Currency Unit (ECU) Exchange Rate Mechanism (ERM) Financing Facili;es Exchange Rate Realignments 3

4 The ECU and Bilateral Exchange Rates The first element of the EMS was the European Currency Unit, the ECU, defined as a weighted average of the Communi;es s na;onal currencies. For each na;onal currency a central rate was set against the ECU. For any two currencies, the ra;o of their central rates against the ECU provided their central bilateral exchange rate, and total of bilateral central rates defined the parity grid of the system. 4

5 The Exchange Rate Mechanism The second element of the system was the Exchange Rate Mechanism (ERM). For currencies par;cipa;ng in the ERM, na;onal central banks undertook to maintain market rates against any other currency in the system within predetermined limits rela;ve to the bilateral central rates. These limits, un;l 1993, were ± 2.25%. For some currencies, wider limits were allowed, i.e a range of ± 6%. 5

6 Exchange Market Interven;ons Exchange market interven;ons had to take place when a bilateral rate reached the band limit, and involved both of the central banks concerned. These were called marginal interven;ons. With regard to marginal interven;ons, the central bank of the strongest currency undertook to provide the central bank of the weaker currency with unlimited credit, aaer the la`er had used all of its foreign exchange reserves in that currency. Intra-marginal interven;ons also took place, by the central bank of the weaker currency. These were not compulsory, and required the approval of the central bank whose currency was used in the interven;ons. The was also a divergence indicator, which did not play an essen;al role. 6

7 Financing Facili;es The third element of the EMS were the financing facili;es, which were divided into three types: 1. The Very Short Term Financing Facility, 2. The Short Term Monetary Support and 3. The Medium Term Financial Assistance. The management of the first two belonged to the jurisdic;on of Central Banks, while the third was under the jurisdic;on of the Council of Ministers. The Short Term Monetary Support provided short-term credits for financing deficits in the balance of payments, while the Very Short Term Financing Facility was aimed at financing interven;ons within the Exchange Rate Mechanism. 7

8 Exchange Rate Realignments The fourth and final element of the EMS were the periodic realignments of bilateral central pari;es. Ini;ally the decision to reading the central pari;es was unilateral, but later, aaer 1981, collec;ve decisions were required within the Community s Monetary Commi`ee and the ECOFIN Council. AAer 1981, realignments did not cover the full infla;on differen;al between the currency being devalued and the other currencies. 8

9 How the EMS Worked? The EMS reduced fluctua;ons in nominal and real exchange rates in Europe, thus contribu;ng to exchange rate stability. However, despite its symmetrical design, the EMS operated asymmetrically. Asymmetries came from the fact that German monetary policy was systema;cally more restric;ve than in other economies par;cipa;ng in the system, and by the fact that the DM was an interna;onal currency to a much greater extent than the other currencies of the European Union. 9

10 A Broad DM Zone The more restric;ve monetary policy of the German Bundesbank led to the need for intramarginal interven;ons by other central banks. Thus, monetary policy became more restric;ve in all the countries that par;cipated in the system. Otherwise, the pressure on weaker currencies was strong and resulted in the need for realignment (devalua;on) of their exchange rates. Because of collec;ve decisions for realignments, devalua;ons in countries with loose monetary policy and high infla;on, was never equal to the cumula;ve infla;on differen;al between the economy with the weak currency and Germany. Thus, Germany was becoming more and more compe;;ve. Between 1986 and 1992, realignments virtually ceased. The EMS became in a broad DM zone, where monetary policy was determined essen;ally by the policy of Bundesbank. The rest of the system "borrowed" the an;-infla;onary reputa;on of the Bundesbank, and thus the rest of the countries ended up with low infla;on. At the same ;me, Germany was gaining in compe;;veness, as it had lower infla;on than the rest and any realignments did not fully cover this infla;on differen;al. Consequently, all came with something out of the system, with Germany probably with more as it was gaining in compe;;veness and was the focus of the system. 10

11 The Path Towards the Euro The ini;a;ve for the crea;on of the single currency belonged to France, which early in 1988, with a memorandum of the Minister of Finance to his EEC colleagues proposed the march towards the single currency. Italy agreed immediately and Germany had no op;on but to agree as well. The European Council in Hanover in June 1988 set up an eight-member commi`ee, chaired by Jacques Delors, then President of the European Commission, which would study the ma`er. The Commi`ee, in April 1989, submi`ed a report to the Council of Finance Ministers (ECOFIN) proposing a three stage process for crea;ng a single currency. 11

12 The Three Stages Towards Monetary Union The first stage envisaged capital account liberaliza;on for the countries par;cipa;ng in the EMS, un;l July No country would be allowed to maintain capital controls. The second stage, which began on January 1, 1994, aimed at the greatest possible convergence of fiscal and monetary policies of EU member states, as envisaged in the Maastricht Treaty of 1992, in order to achieve fiscal convergence and price stability, which were deemed necessary and sufficient condi;ons for monetary integra;on. The third stage was the monetary union itself, which would transfer all monetary policy decisions to an independent European Central Bank. 12

13 The Maastricht Treaty and the Euro In late 1991, aaer an intergovernmental conference (IGC), all EEC member states signed in Maastricht in Holland the Treaty on European Union. Under this treaty, the EEC was renamed European Union, and in addi;on to the Single Market program, EEC members agreed on a detailed ;metable and condi;ons for adop;ng the single currency. The deadlines for the introduc;on of the new currency were adopted by the Madrid European Council in December This Council also decided that the "euro" would be the name for the single currency. 13

14 The Timetable for the Adop;on of the Euro The ;metable s;pulated that un;l January 1, 1994 the EU would complete the single market and all na;onal parliaments will have ra;fied the Maastricht Treaty. It also provided for the prohibi;on of monetary financing of budget deficits, the liaing of all restric;ons on the movement of capital and prepara;on for par;cipa;on in the Exchange Rate Mechanism of the European Monetary System for the countries that were not part of it, as well as the poli;cal independence of central banks. When these condi;ons were sa;sfied, the second stage of Economic and Monetary Union (EMU) would begin. 14

15 The Convergence Criteria The Maastricht Treaty on the European Union also provided for the adop;on of targets for 1. reducing budget deficits below 3% of GDP, 2. reducing public debt below 60% of GDP and 3. reducing infla;on and nominal interest rates close to the average of the three countries with the lowest infla;on rates. Achieving these objec;ves was considered as a prerequisite for a country to par;cipate in the third stage of EMU. The European Commission and the European Central Bank would judge, in so called Convergence Reports, whether a country did or did not sa;sfy these criteria. 15

16 Pressures on the Exchange Rate Mechanism The second asymmetry of the system resulted from the interna;onal posi;on of the German mark, which was an interna;onal reserve currency, unlike other currencies in the EMS. This meant that there were pressures in the ERM, when there were disturbances in interna;onal financial markets affec;ng the exchange rate of the dollar or the yen. These disturbances caused greater changes in demand and supply for DMs in rela;on to other European currencies, resul;ng in significant pressure on the bilateral exchange rates of european currencies against the DM. The ERM faced considerable pressures in such periods, such as , or in These pressures lead to realignments of central pari;es. 16

17 The Crisis The complete aboli;on of capital controls since the early 1990s made the ERM extremely vulnerable, as demonstrated by the specula;ve a`acks of September 1992 and August A series of adverse shocks broke down the defense mechanisms of the system,such as the mechanism for coordina;ng macroeconomic policies and the realignment of exchange rates. In September 1992, the credibility of the ERM was tested, and the system could not stand the pressures. Both the Italian lira and the Bri;sh pound ceased to par;cipate in the ERM. AAer a year of realignments and periodic crises un;l late July 1993, and following further pressure on the exchange rates of weaker currencies, the ECOFIN decided to extend the fluctua;on margins to ± 15%, in order to defuse pressures. 17

18 Factors that Contributed to the Crisis Firstly, German unifica'on, which transformed Germany from a net creditor to net borrower in the global economy. Second, US monetary policy. In 1992, due to the elec;ons and the recession in the US, monetary policy was more relaxed, and the dollar entered into a deprecia;on path against the DM, that increased pressures on the ERM. Thirdly, the poli'cal crisis in Italy. This took place at a ;me when there was a large increase in the fiscal deficit and public debt, which caused a crisis of confidence and specula;ve pressures on the Italian lira. Fourth, the nega've result of the referendum in Denmark on the ra;fica;on of the Maastricht Treaty, the prospect of the French referendum and the ambiguous adtude of poli'cians in Great Britain, caused general crisis of confidence in the system and in the process of Economic and Monetary Union. 18

19 FF/DM Exchange Rate FF DM Exchange Rate 19

20 ITL/DM Exchange Rate ITL DM Exchange Rate 20

21 /DM Exchange Rate DM Exchange Rate 21

22 $/DM Exchange Rate $ DM Exchange Rate 22

23 Infla;on in France and Germany 20.00% 15.00% 10.00% 5.00% 0.00% % France Germany 23

24 Infla;on in Italy and Germany 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% Italy Germany 24

25 Infla;on in the UK and Germany 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% UK Germany 25

26 Infla;on in the USA and Germany 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% % USA Germany 26

27 The Final Stage of EMU The third stage began on January 1, 1999 by irrevocably fixing the bilateral exchange rates of the currencies of the par;cipa;ng countries and the single currency., the Euro. In May 1998 it was decided which countries will par;cipate in the third stage of EMU. The selec;on of the 11 countries was based on the five fiscal and monetary convergence criteria of the Maastricht Treaty. The third phase was completed on January 1, 2001 with the introduc;on of the euro in accoun;ng form. From January 1, 2002 the euro became legal tender, with the introduc;on of cash in everyday transac;ons. On this day, the circula;on of banknotes and coins and the gradual (within two months) withdrawal of na;onal currencies began throughout the Euro Area. 27

28 The European Central Bank and the Stability and Growth Pact From January 1, 2001 in the Euro Area economy there is a single monetary policy for all countries, decided upon and implemented by the European Central Bank, which aims to ensure price stability. A central pillar of macroeconomic policy coordina;on is the Stability and Growth Pact (SGP). The pact requires all economies in the Eurozone and the EU to maintain fiscal deficits below 3% of GDP, pursuing budgetary balance over the medium term and to ensure that public debt does not exceed 60% of GDP, or that it tends towards this objec;ve. 28

29 The Implementa;on of the Stability and Growth Pact The Stability and Growth Pact (SGP) provides for remedial ac;on for those economies that do not meet their fiscal targets. The Pact was revised in 2005, aaer several economies, including Germany and France, failed to correct their excessive deficits. The revised Pact was more flexible regarding the ;me available for the correc;on of excessive deficits, but at the same ;me more demanding in terms of achieving fiscal balance. Countries were required to tend towards fiscal balance (zero budget deficits) during so called "good ;mes, by reducing their deficits by at least 0.5% of GDP annually. AAer the crisis of 2008, the European Commission proposed and the ECOFIN Council decided to apply the pact in a more flexible way. 29

30 Government Deficits in the Euro Area 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Deficit of General Government (% of GDP) 30

31 Government Debt in the Euro Area 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Debt of General Government (% of GDP) 31

International Environment Economics for Business (IEEB)

International Environment Economics for Business (IEEB) Sergio Vergalli sergio.vergalli@unibs.it Vergalli - Lezione 1 The European Currency Crisis (1992-1993) Presented By: Garvey Ngo Nancy Ramirez Background