Performance of the System

Underlying the ERM were all the standard beliefs about the virtues of fixed rate regimes that we have discussed. EU members believed the system imposed monetary discipline, removed uncertainty, limited speculation, and promoted trade and investment within the EU. For most of the EMS's existence, it achieved these objectives. When the ERM was established, wide variations in national interest rates and inflation rates made its prospects seem shaky. For example, in early 1979, inflation was running at 2.7 percent in Germany and 12.1 percent in Italy. By 1992, however, both inflation rates and interest rates had converged somewhat. As this occurred, the need for intervention and realignments declined, and the system appeared to become more stable.

However, there had long been concern within the EU about the vulnerability of a fixed system to speculative pressures. Many of these concerns were realized dramatically in September 1992, when two of the major EMS currencies--the British pound and the Italian lira--were hit by waves of speculative pressure. Dealers in the foreign exchange market, believing a realignment of the pound and the lira within the ERM was imminent, started to sell pounds and lira and to purchase German deutsche marks. This led to a fall in the value of the pound and the lira against the mark on the foreign exchange markets. Although the central banks of Great Britain and Italy tried to defend their currencies by raising interest rates and buying back pounds and lira, they were unable to keep the values of their currencies within their respective ERM bands. As a consequence, first Great Britain and then Italy pulled out of the ERM, leaving the EMS on the brink of collapse.

The speculative pressures and subsequent withdrawal of Britain and Italy from the ERM led the EU countries to make two major changes to the EMS in August 1993. First, the 2.25 percent fluctuation bands were widened to 15 percent. The idea was to loosen the rigidities in the system and hence reduce the scope for speculation. Second, the EMS no longer obligated the central banks of countries with strong currencies to intervene in the foreign exchange market to purchase weaker currencies. This change essentially recognized what had already occurred. In the crisis of September 1992, for example, the German central bank did not intervene aggressively to help keep the value of the British pound within the prescribed fluctuation bands.¹²

After 1993 this modified system again performed fairly well. The biggest strain occurred in March 1995 when speculative pressures again forced devalutations of two EMS currencies, this time the Spanish peseta and Portuguese escudo. This was a relatively minor crisis compared with that of September 1992.¹³ By mid-1998, the system appeared to have delivered what it was designed to do--low and convergent inflation rates among the EU's member states. In 1998, the average annual rate fell to 1.6 percent (1993 = 4 percent), with the differential between the lowest and the highest rates at 1.7 percent (1993 = 5 percent). On January 1, 1999, the exchange rates of 11 EU states were fixed against national currencies and the euro became a full-fledged currency for commercial purposes, replacing the ecu basket of currencies. Until 2002, the euro will be used in financial markets only. On January 1, 2002, the single currency will become part of daily life, as euro notes and coins finally come into circulation.