EMS Setting-up and Institutional Architecture

The idea of a monetary integration is already present in the Treaty of Rome of 1957 where, in art� 108, the policy of exchange rates is defined as a “matter of common concern”� In the late 1960s and early 1970s the Barre Plan and the subsequent Werner Report put forward the proposal to form a European monetary union�

This proposal was not implemented because, after the oil crisis, European countries faced this shock adopting very different economic policies� Because of these differences, the so-called currency snake, which included limits on exchange rate fluctuations, failed�

The first impetus to the establishment of the EMS came from Roy Jenkins, President of the European Commission from 1977 to 1981� In a Jean Monnet lecture delivered in October 1977, he asked for a new Community initiative in the monetary sphere�²

Such a solicitation was endorsed by French President Giscard d’Esteing and German Chancellor Helmut Schmidt who started contacts and negotiations in order to initiate this project�³ The EMS became operational on March 13, 1979� The countries that at the beginning gave their adhesion to this exchange rate agreement were eight (France, Denmark, Belgium, Luxembourg, Ireland, Netherland, Germany and Italy)�

The EMS have been given different interpretations� A first interpretation leads back the monetary agreement to the desire of European countries to anchor their currencies to the Deutschmark and import the German anti-inflation credibility�⁴

The hypothesis just mentioned does not explain the wide support given by Germany, in particular by Chancellor Schmidt, to the establishment of the EMS� Why this country, with high anti-inflation credibility, should have had an interest in promoting an exchange rate agreement in order to reduce domestic inflation? Similar considerations can be done for the other founding countries who enjoyed a low inflation rate�

A second interpretation of the EMS leads back its creation to interest groups’ pressures� According to Frieden (2002) cross-border investors, financial actors and export-competing producers of specialized manufactured goods are in favor of fixed exchange rates� These interest

2 See Jenkins (1977)�

3 See Ludlow (1982)�

4 On this aspect see Giavazzi and Pagano (1988), Weber (1991), Broz (2002) and Fratianni and Von Hagen (1992)�

groups exerted pressure in European countries for the establishment of a fixed exchange rate system that in some way, at least in a limited area, subrogate the Bretton Woods system ended in 1971�

This interpretation, however, does not explain why the pressures of the interest group just mentioned were higher than those of producers of standardized import-competing and export goods� Moreover, it does not take into account politicians and governments� The latter, of course, being interested in elections, care about the consequences of a particular exchange rate regime on output growht and on the distribution of income�

They, however, besides to be subject to pressures, generally are political entepreneurs: they have ideals and projects to pursue and realize� In a few words, their choices do not reflect in any way the preferences of interest groups�

A third interpretation of the EMS gives a primary role to political factors, in primis to international relations� In a phase of substantial retreat of USA compared to the growing influence of the USRR in different theaters of the world, it was felt by the major European powers the need to make progress towards a political union of Europe�

This behaviour would have allowed to deal with four main problems:⁵ i� counter the military threat of the Soviet Union at a time of relative

weakening of the United States;

ii� consolidate the European economy, and thus its political and military force, by encouraging intra-European trade with the adoption of a fixed exchange rate system;

iii� finde a solution to the German question, anchoring the renewed economic strenght of Germany to western Europe, in a context of friendly relations with France, its traditional enemy� This process would be facilitated by a fixed exchange rate system, which would have protected Germany from policies of beggar-thy-neighbour from the other European partners;

iv� favoring a higher political stability in countries such as France and Italy, marked by a pronounced distributive conflict and high inflation�

The political hypothesis just illustrated seems the most convincing explanation, even though on the founding countries’ adhesion decision also other factors, such as those evoked in the other interpretations, may have played a role�

5 See De Vries (1980)�

It should, finally, be remarked how in the political hypothesis, the exchange rate agreement was promoted by Germany and France not so much with the intention of encouraging the emergence of a third Power, an alternative to the United States and Soviet Union, but rather to strenghten the Atlantic Alliance’s role in Europe at a time of weakening US�

The validity of the political hypothesis is confirmed when one considers the way in which Italy decided to join the EMS� The debate in our country was very eager�⁶ A large part of the political parties, trade unions, entrepreneurs and economists⁷ believed that Italy had no convenience to join the EMS� This opinion was shared by the government led by Giulio Andreotti�

Also the governor of the Bank of Italy, Paolo Baffi, believed that Italy, given the high growth in labor costs and the heavy imbalances in the public finances, was not able to maintain a fixed exchange rate with countries, such as Germany, marked by a low rate of inflation�⁸

In early November 1978, however, Chancellor Schmidt met the Italian Prime Minister in Siena� The terms of that meeting are still unknown� The fact is that after this meeting Andreotti changed his mind, and in this way also changed the government line�⁹ The result was a upheaval in the Italian political equilibrium, and a change of the majority political coalition�¹⁰

The above arguments lead us to conclude that the underlying political reasons for the construction of the EMS were dominant over economic ones�

The decision to set up the EMS, taken at a European Council meeting in Brussels in December 1978, foresaw a system of fixed, but adjustable, exchange rates (Exchange rate mechanism, ERM)�

The main components of ERM were four pillars:¹¹ a� parity grid;

b� mutual support;

6 A survey of the debate among economists can be found in Masini (2004)� Some important contributions were by Andreatta (1978), Modigliani (1978), Ossola (1978) and Masera (1980)�

7 See, for example, Monti (1978) and Padoan and Rodano (1978)� Spaventa (1978) in an important parliamentary speech gave expression to the point of view of the political opposition, arguing that EMS would have determined in Italy a slow-down of GDP growth and an increase in the unemployment rate�

8 See Baffi (1978a; 1978b)�

9 See Ludlow (1982) and Varsori (2004)�

10 See Gualtieri (2004: 189)�

11 A description of the way the EMS worked can be found in Gros and Thygesen (1992)�

c� joint management of exchange rate realignments;

d� the European currency unit�

The parity grid was a matrix-like table collecting all pairwise central parities and their associated margins�

All currencies were fixed to each other, with a band of fluctuation of

±2�25 around the central parity (ECU)�

The responsability of maintaining the bilateral parity was equally divided between the two countries concerned� With the mutual support, it was expected that when the bilateral parity of a currency is threatened the central banks of both countries would undertake unlimited interventions to defend the fixed parity�

In order to avoid “beggar-thy-neighbour” behaviours, EMS member countries committed to a joint management of exchange rate realignments.

In this way it was categorically excluded the possibility of unilateral realignments�

The last pillar was represented by the creation of a unit of account, the ECU� The latter was a basket of the currencies of all countries participating in the EMS� Each currency was weighted with the GDP and the share of trade of the country�