and the Setting up of the Snake
3. Was the EMS a Success or a Failure?
Behind the establishment of the EMS there was the intent to strenghten Europe’s political unity, by stabilizing the exchange rates of the European countries�
In fact, as shown by several scholars,17 the variability of exchange rates among EMS countries plummeted� By contrast, non-EMS exchange rate variability increased significantly after the establishment of the EMS�
The reduction in the exchange rate volatility within EMS countries was mainly due to the reduction of inflation differentials (Table 1)�
Table 1 – Consumer price inflation
1978 1983 1987 1992
Germany 2�7 3�3 0�2 4�0
France 9�1 9�6 3�3 2�4
Italy 12�1 14�7 4�7 5�3
UK 8�2 4�6 4�1 3�7
Source: Banca d’Italia (1988; 1993)�
The decrease in the inflation rate between 1978 and 1987 was particularly high for countries that, at the time of their adhesion to the EMS, were suffering from high inflation rates�
In these countries the rate of inflation decreased a lot between 1983 and 1987, i�e� when the effects of the second oil shock were finished�
In this span of time, for example, the inflation rate was reduced by 10 percentage points in Italy and 6�2 percentage points in France�
There is a debate, not yet conclusive, on the question whether the EMS has been a determining factor in encouraging the reduction of inflation for those member countries characterized by high inflation�
Some empirical studies confirm this hypothesis,18 others reject it�19
17 See, among others, Ungerer et al� (1986) and Artis and Taylor (1989)�
18 See among others Giavazzi and Giovannini (1988), Gressani et al� (1991) and Bini Smaghi (1994)�
19 See Ungerer et al� (1986), De Grauwe (1990) and Eichengreen (2000)�
The fact remains that by joining the EMS countries marked by high inflation rates could adopt an exchange-rate based stabilization process�20 They could, therefore, benefit from the advantages that a disinflation process of this type involves, in particular, of the gradualism with which it acts on output�21
The relatively low costs in terms of output loss that accompany an exchange-rate based disinflation policy imply lower political costs than those involved by a money-based disinflation policy�
Countries characterized by a high social conflict and uncertain political majorities may find it difficult to undertake a money-based disinflation process, i�e� to take responsibility for decisions that involve a drastic reduction in output and rising unemployment�
As shown by the cases of France and Italy, at least in the short-term, the costs of disinflation in terms of decrease of real GDP22 were limited and, in any case, much lower than those suffered by the UK, which used a money-based disinflation process (Table 2)�
Table 2 – Output growth since the beginning of disinflation(1) In the following
three years
In the following four years
In the following eight years
Italy +1�1 +2�4 +11�8
France +2�8 +6�0 +13�0
UK -3�3 +1�3 +14�6
(1) Sum of outuput growth in the period after the peak of inflation of 1979�
Source: Banca d’Italia (1988)�
We have to wonder if the comparison between the costs of the two different disinflation processes considered, i�e� money-based and exchange-rate based, should only relate to the loss of output and not even to changes in the production structure they entail�
For example, it is likely that an exchange-rate disinflation process, when it determines a protracted appreciation of the real exchange rate, significantly penalizes the producers of import-competing and export goods� In the “flexible” phase of the EMS this distorting effect
20 Generally we distinguish between two different paths of disinflation: the money-based stabilization (MBS) and the exchange-rate-based stabilization (ERBS)� The difference between these mechanisms of stabilization lies in the selection of the nominal anchor to bring inflation down�
21 See among others Calvo and Vègh (1994)�
22 See Okun (1978)�
was avoided thank to frequent realignments of exchange rate parities
Despite these frequent realignments, between 1978 and 1986, and even more between 1978 and 1992, the structure of the productive apparatus of our country has changed profoundly�23 The share of services in GDP and even more the share of employed in this sector on total employment increased significantly (Table 4)�
Table 4 – Employment by sector in Italy (in percentage)
Self-employed Employees Total
Agricolture Industry Services and other activities
Total
1979 28�3 5�5 32�2 34�1 71�7 100
1987 29�4 3�8 26�7 40�0 70�6 100
1992 28�3 3�5 26�4 41�8 71�7 100
Source: Banca d’Italia (1988; 1993)�
The pronounced increase in the employment share of not-for-sale services suggests that the public sector has absorbed part of the employed expelled from the industrial sector� This suggest that part of the
23 See Pittaluga and Seghezza (2012: 128-129)�
disinflation costs have been absorbed in our country through an increase in current public spending�
The process of convergence of inflation rates within the EMS has been accompanied by a similar process in monetary growth (Table 5)�
Table 5 – Money growth (1)during the “flexible” EMS phase 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987
Germany 11�0 5�7 6�2 5�0 7�2 5�5 4�5 7�8 6�8 6�0
France 13�4 13�1 8�2 13�6 11�9 13�6 9�5 5�9 4�0 4�3
Italy 22�6 20�8 12�7 10�0 18�1 12�3 12�1 11�0 9�4 8�4
UK 15�5 12�5 18�3 25�6 8�9 11�1 10�0 13�2 20�4 22�8
(1) For France and Italy M2; for Germany and UK, M3�
Source: Banca d’Italia (1988)�
Because of the Fisher effect,24 the process of convergence of money market real interest rates was slower than that of the inflation rate�
In particular, in countries like France and Italy, characterized by high inflation rates upon entry into the EMS, these interest rates have become positive and growing since 1981 (Table 6)�
Table 6 – Money market real interest rates(1)
1978 1979 1980 1981 1982 1983 1984 1985 1986 1987
Germany 1�4 5�4 4�7 4�5 1�3 2�2 3�4 2�6 5�0 3�4
France -2�4 1�8 -1�9 1�9 0�9 2�6 3�3 3�2 5�4 5�5
Italy -0�3 0�9 -4�2 3�6 2�6 2�3 3�9 3�9 4�4 7�0
UK 4�2 3�4 -3�3 3�6 1�9 3�8 4�8 5�7 7�0 4�6
(1)Deflationated using the Consumer price index inflation�
Source: Banca d’Italia (1988)�
Based on the considerations and evidence discussed in this section we conclude that the EMS was an exchange rate arrangement which drew benefits to all participating countries� It created an area of stable exchange rates, prevented beggar-thy-neighbours policies, and, thus helped to consolidate the EU, while preserving the Common Agricultural Policy�
In addition, countries characterized by high inflation rates at the time of the establishment of the EMS, anchoring their exchange rate to the mark (i�e� the currency of a virtuous country under the inflation profile), could disinflationate their economies�
24 See Ungerer et al� (1986)�
The costs of disinflation were relatively low because it was an exchange-rate-based stabilization and because of the frequent realignments that occurred between 1979 and 1987�