The European Monetary System (EMS) that existed between 1979 and 1998 attracts increasing attention among those who oppose the European austerity regime. A discretionary exchange rate regime such as the EMS would better fit to Europe’s heterogeneous economic conditions than the Euro does, but it would surely not eliminate all transnational tensions within today’s Eurozone.

Strong real under- and overvaluations have cumulated among Eurozone members due to heterogeneous wage and price increases since the exchange rates were fixed in 1999. The strategy of so-called ‘internal devaluation’ (union busting, destruction of collective labor law and welfare state retrenchment until wages fall, in the hope that prices will fall subsequently) in Southern Europe proved to be a cynical experiment which must not be continued. In principle, Germany and other former Deutschmark bloc countries could free the European south from at least a part of the brutal disinflation pressure by inflating on their part. However, after eight years of Euro crisis, all hopes that this will happen have gone. If the current distortions of real exchange rates within the Euro zone persist, the Euro will be nothing else than a programme for accelerated de-industrialisation in Southern Europe.

This makes the move to a more flexible exchange rate regime an option which we should carefully consider. The move to full flexibility would by no means guarantee fair exchange rates, given the inherent instability of financial markets. But a politically managed regime that combines protection against erratic financial markets with adjustable exchange rates could be an attractive alternative to the Euro. The EMS of former times was such a system.

The old EMS in nutshell

The EMS was an exchange rate regime within the framework of the European Economic Community. It was introduced in 1979 as successor of the earlier European ‘currency snake’ and existed until the transition towards the Euro at the turn of the years 1998/99. Basically, the EMS was designed to prevent large exchange rate fluctuations of the currencies that joined this arrangement. The respective central banks were mutually obliged to intervene on the financial markets in order to stabilize their own and other currencies participating in the system if exchange rates exceeded fluctuation thresholds which had been mutually negotiated before. Thus for most of the participating countries fluctuations were allowed within a bandwidth of +/- 2.25 per cent of the respective reference quota. In some cases the bandwidth could be +/- 6 per cent, and after the EMS crisis of 1992/93 it was fixed at +/- 15 per cent for all. Realignments beyond the bandwidths were possible but had to be politically decided in the ECOFIN council.

During the time of its existence, 62 negotiated realignments occurred, distributed over 18 different points in time, as well as temporary accessions to and withdrawals from the EMS by some countries. The EMS was sophisticated, complex, ponderous, unpopular and putting much strain on policy makers to negotiate and find agreement. Admittedly, all this does not sound very attractive. With respect to its capacity to limit transnational economic imbalances, however, the EMS was far more successful than the Euro.

Four reasons why a new EMS should be considered

Given that the EMS was rather disliked as long as it existed, shouldn’t we remain silent about it? I don’t think so, for four reasons. Firstly, referring to the EMS signals that we do not have to start from zero when alternatives to the Euro are concerned, since the main feature of the EMS, the exchange rate mechanism, is still in place – though it only applies for the currency relations between the Eurozone and the Danish currency, the Krona. So, if the Krona fell out of the bandwidth of +/- 15%, the ECB would be obliged to defend its agreed reference quota. This mechanism could be revitalized, especially for countries that wish to leave the Eurozone.

Secondly, we have empirical evidence on the functioning of the regime. For example, some progressives deny that nominal devaluations can help countries to adjust. The experience of the EMS proves that devaluations do actually help. In the EMS period, devaluations were followed by a sequence of about two years with higher economic growth and relieved pressures on current account positions. Also, there was no considerable rise of inflation after devaluations, and there emerged no downward spiral of ‘competitive devaluation’. These things did not happen within the old EMS and it is far from clear why they should occur within a new and modified EMS.

Thirdly and fourthly, taking the experience of the EMS as a reference point helps to avoid two misunderstandings. Supporting an EMS-like regime as an alternative to the Euro has nothing in common with neo-liberal critiques. Neo-liberals dream of fully flexible, market-driven solutions, not of regimes in which politicians negotiate exchange rates. Supporting discretionary exchange rate regimes, in contrast, signals that we emphasize the primacy of politics over markets. Equally, a new EMS would clearly not imply a ‘return to the national corral’ but would offer an ambitious European solution to the Euro crisis.

A new EMS – and all problems solved?

Discretionary exchange rate regimes open up room for more country-specific solutions. But we must not confuse more room with endless space. Note that the aim of a new EMS, compared to fully flexible currencies, would still be to stabilize exchange rates. Now consider the classical Mundell trilemma (the ‘unholy trinity’): Under conditions of free movement of capital, stabilizing the exchange rate will always put constraints on monetary policy. It is, in other words, not possible to stabilize exchange rates and to steer domestic economic activity at the same time. As long as the economic conditions in Europe lack homogeneity (in other words, in all foreseeable future), there will remain a fundamental tension between two equally desirable policy aims. Progressive forces should warn against all kinds of ‘radical’ solutions, such as fully flexible and fully fixed exchange rates. Rather, it should be up to politics to decide discretionarily.

European policy makers have understood that we must not let markets determine exchange rates. But Europe is, at the same time, too political-economically diverse to permanently stabilize its currency relations. All European monetary regimes since the end of Bretton Woods were attempts to cope with this fundamental and ever-lasting tension. The tragedy is, however, that those who founded the Euro opted for the worst available option. It will be on our generation to correct their mistake.

Martin Höpner is head of the Research Group on “The Political Economy of European Integration” at the Max Planck Institute for the Study of Societies and Adjunct Professor (apl. Prof.) at the University of Cologne.

Further reading:

Martin Höpner, Mark Lutter (2014): One Currency and Many Modes of Wage Formation. Why the Eurozone Is Too Heterogeneous for the Euro. MPIfG Discussion Paper 14/14. Köln: Max-Planck-Institut für Gesellschaftsforschung. Download PDF

Martin Höpner, Alexander Spielau (2015): Diskretionäre Wechselkursregime. Erfahrungen aus dem Europäischen Währungssystem, 1979–1998. MPIfG Discussion Paper 15/11. Köln: Max-Planck-Institut für Gesellschaftsforschung. Download PDF