Exchange Rate Mechanism

Exchange Rate Mechanism (ERM), arrangement entered into in March 1979 whereby most members of the European Monetary System (EMS) that was established at the same time agreed to limit the fluctuations of their bilateral exchange rates. Members of the EMS also agreed to provide one another with credit facilities and to institute the European Currency Unit (ECU) as the formal unit of account for the European Union (EU). The exchange rates of the participating countries of the EMS were formally defined with reference to the ECU (though in practice the mark has been the fulcrum of the system).

The founder members of the EMS in 1979 were Belgium, Denmark, France, Germany, the Republic of Ireland, Italy, Luxembourg, the Netherlands, and the United Kingdom. Of these, all but the United Kingdom agreed to participate in the ERM, which was the centrepiece of the EMS. The United Kingdom joined the ERM in 1990. Spain and Portugal, which became members of the European Community (now EU) in 1986, joined the ERM in 1989 and 1992 respectively. Greece joined the ERM in 1998. The ERM faced a major crisis in September 1992 when Italy and the United Kingdom left it after pressure on their currencies in world markets (Italy rejoined in 1996). On January 1, 1995, Austria, Finland, and Sweden joined the EU as well as the EMS. Austria joined the ERM in 1995. Finland and Sweden, however, have signified their intention to float their currencies for the time being.

The central feature of the ERM was the commitment by each participating country to maintain and defend its bilateral exchange rates with every other participating country within a margin of fluctuation of 2.25 per cent with reference to the central rate. (As an exception, Italy was given a permissible margin of 6 per cent; so were Spain and the United Kingdom when they joined.) It is important to note that the ERM is not a fixed rate system. The central rates can be altered by negotiation between the participating governments. It is thus an “adjustable peg” system of exchange rates, akin to the system that was first organized in 1944 at the Bretton Woods Conference but which broke down in 1973.

Originally, the motive behind the ERM appears to have been to provide short-term exchange rate stability, which was seen as important in stimulating intra-EU trade and investment. The system survived because the exchange rate parities were not excessively rigid in practice. There were 11 realignments from 1979 to 1987, in every instance a devaluation of one or more currencies relative to the Deutschmark. Another factor that contributed to the survival of the system was the fact that France and Italy operated exchange controls on capital movements. Though these controls allowed some movement of funds, they reduced sudden and large flows of hot money.

Exchange rate realignments became less frequent after 1983, and from 1987 they ceased altogether (until the crisis of September 1992). During this period, the ERM acquired the more ambitious objective of serving as an anti-inflationary anchor to the system. The basic underlying idea was that a fixed exchange rate with Germany would have a favourable effect on inflationary expectations and therefore reduce wage demands. There is no doubt that inflation rates did fall sharply in the member countries of the ERM. The role of the ERM in producing this fall is, however, a matter of some controversy, as inflation also fell in other industrial countries such as the United States and the United Kingdom. Even so, bringing down inflation was an important motive in Britain’s decision to enter the ERM in 1990 and in Italy’s decision in the same year to narrow its intervention band from 6 per cent to 2.25 per cent.

In September 1992 there was a major speculative crisis. In retrospect, it appears that the effort to maintain fixed exchange rates was doomed to failure in the face of the severe pressures on the system. The main pressure came from German reunification. Fiscal deficits in Germany had increased, but monetary policy was tightened in order to keep inflation in check. As a result, German interest rates rose, putting upward pressure on interest rates in the rest of Europe. France and the United Kingdom, which were suffering from recession, were reluctant to raise interest rates; indeed their domestic requirement was for lower interest rates, which was of course incompatible with the existing exchange rate parities. Moreover, inflation in Italy, Spain, and the United Kingdom, though low by their respective historical standards, had been faster than in Germany for several years. As a result, the exchange parities had also become inappropriate from the viewpoint of competitiveness. The main political reason for the crisis, however, was that doubts arose about the commitment of countries to the formation of a monetary union. The speculative attack on currencies came soon after the Danish referendum on the Treaty of Maastricht, which returned a negative verdict, and shortly before the French referendum, whose outcome seemed distinctly uncertain (in the event, the French voted yes by a narrow margin).

In the wake of the speculative crisis, Italy and the United Kingdom floated their currencies and left the ERM (Italy rejoining the ERM in 1996). Other countries retained formal membership of the system, though some of them (Spain, Portugal, Republic of Ireland) devalued their currencies several times. France managed to hold firm but not for long. There was another speculative crisis in July 1993; in response, the intervention margins were widened to 15 per cent. In the event, the French franc, which was the object of attack, depreciated very little; but with such a wide intervention margin, the claim of the ERM to provide an anchor against inflation had clearly collapsed. The ERM is the most notable quasi-fixed exchange rate arrangement since the breakdown of the Bretton Woods system. Ironically, it suffered the same fate, illustrating the great difficulty of maintaining such a system in the face of inflation differentials between participating countries and shocks in the global economy.