European Monetary System Failure and the Rise of the Euro
European Monetary System Failure in 1992
In the 1970s, there was excessive exchange rate volatility due to the abandonment of the fixed exchange rate system based on the gold standard. In 1979, the European Economic Community created the “currency snake,” a system of fixed exchange rates in which currencies could only fluctuate within a band of 2.25%. The main goal was to bring financial and monetary stability, as well as reducing the risks associated with devaluations. These measures would promote trade and investment between EU members. This institution was transformed into the EMS, also known as the European Monetary System.
However, the system failed. Once the freedom of capital flows had been established, together with the instability derived from the economic policy applied in some countries, the central banks were unable to maintain the exchange rate within the set limits. This resulted in great financial turbulence rising from speculative flows of capital in the financial markets, which led to the exit of some currencies, such as the Swedish krona, and the devaluation of others, such as the peseta. All these problems made the project of a single currency gain popularity.
The European Economic and Monetary Union
To avoid excessive exchange rate volatility, in 1979, the European Economic Community created the “currency snake,” a system of fixed exchange rates in which currencies could only fluctuate within a band of 2.25%. The main objective was to bring monetary and financial stability and reduce the risk associated with devaluations; conditions that would promote trade and investment between members. This institution was transformed into the European Monetary System (EMS). This system failed once the freedom of capital flow had been established, together with the instability derived from the economic policy applied in some countries. The central banks were unable to maintain their exchange rates within the set limits.
The common currency was accessible for those countries which fulfilled certain requirements of macroeconomic stability or nominal convergence, which were established in December 1991 in the Maastricht Treaty. After various avatars, in January 1999, the monetary union was initiated. The euro has substantially improved the macroeconomic conditions in Europe, setting up an environment of macroeconomic stability. This stability has been reached because of the culture and behavior patterns acquired to comply with the nominal convergence criteria, necessary for access to the euro. Also, the Stability Pact obliges countries to limit their public deficit under the threat of severe penalties in the event of non-compliance.
It is important to note that problems of over-indebtedness of these countries were exacerbated as they did not have any possibility of monetizing the deficit to create money to pay their creditors. There are, however, disadvantages. The euro increases the risks arising from the loss of autonomy of the monetary and exchange rate policy. Countries cannot use devaluation as an instrument to recuperate external competitiveness and to promote exports when they suffer an asymmetric economic shock. If a country suffers a shock and the exchange rate cannot be used, a new external equilibrium can be achieved through three alternative or combined ways.
At the same time, the advantages of a monetary union increase with the degree of trade openness, as the savings in transaction costs are larger. In this way, we can graphically represent the cost and benefits of a monetary union according to the level of trade openness, as shown in the following chart. Trade openness level “A” represents the point from which the benefits outweigh the costs.