How can we evaluate a currency system

Better than Reputation: The European Monetary System, 1979–1998

Martin Höpner and Alexander Spielau

There is currently controversial discussion in politics, economics and social sciences as to whether the euro should be replaced by an adjustable exchange rate regime in view of the duration and severity of the euro crisis. With the establishment of the euro, the exchange rates between the participating currencies were irrevocably fixed, revaluations and devaluations are no longer possible. That decision would not be made again today. This is because the developments in price levels in the euro area were not uniform enough. If the currencies of the northern European countries could be revalued today and the currencies of the southern European participating countries devalued in return, a major step would be taken in overcoming the euro crisis.
The European Monetary System (EMS), which existed from 1979 to 1998, was one such flexible exchange rate regime. Could it serve as a blueprint for a future European monetary order? What experiences have participating countries had with the exchange rate adjustments? Would an adaptable exchange rate regime replace the currently lamented German dominance with equal cooperation between Europeans? In the new MPIfG Discussion Paper 15/11 we take these questions as the starting point for a review of the EWS.

«Could the former European monetary system serve as a blueprint for a future European monetary order? »

The European monetary system was based on mutual obligations of the central banks. You should intervene in the foreign exchange markets in favor of your own and other currencies if the rates threatened to leave predefined ranges. These ranges were usually +/- 2.25 percent deviation from the target exchange rate, but in some cases also +/- 6 percent and after the EMS crisis in 1992 and 1993 +/- 15 percent. This was intended to limit the fluctuations of currencies and thus limit the uncertainty of economic operators about future exchange rate developments. However, if there was agreement that the desired exchange rates no longer adequately reflected the economic realities, the finance ministers could renegotiate the exchange rates, i.e. make revaluations and devaluations.
If you review your experiences with the European Monetary System today, you can say that it was better than its reputation. But his balance sheet was mixed nonetheless. Stabilizing exchange rates was only possible in the short term. The option of adjusting the exchange rate often had to be used: In the EMS there were a total of sixty-two revaluations and devaluations at eighteen different points in time, as well as temporary entries and exits of the participating countries. These exchange rate adjustments helped countries cope with their economic problems. In the course of about two years after devaluation, economic growth improved and foreign trade eased. After that, new pressure to adapt usually built up.

“Exchange rate adjustments helped the countries cope with their economic problems. »

The revaluation countries coped well with the revaluations. At no corner of the so-called “magic square” of growth, employment, price level stability and foreign trade did they suffer a slump. It should be borne in mind here, however, that the appreciating countries around Germany always remained the more stable countries of the European monetary system and could therefore always quickly return to a real and effective undervaluation constellation. For these countries, too, every exchange rate adjustment was followed by the emergence of new adjustment pressure in the medium term. The situation in the EWS was never finally "tidied up"; adjustment after adjustment followed. But this constant adjustment cycle prevented real, effective undervaluations and overvaluations from accumulating over long periods of time. The participants in the European Monetary System were therefore spared imbalances in the current account as we know them today from the euro crisis.
However, this does not mean that the EMS participating countries were satisfied with their exchange rate regime. Because the most stable participant currency, the Deutsche Mark, acted as the de facto anchor of the EMS, the Deutsche Bundesbank had more freedom in structuring its interest rate policy than the central banks of its German neighbors. They therefore generally followed German monetary policy - which became a problem in particular when the Bundesbank stopped the German reunification boom in 1992 with record interest rates. The prospect of many European participating countries to swap the Bundesbank for a multilateral European Central Bank was one of the main impulses for the establishment of the euro. We also looked forward to the elimination of the need to repeatedly renegotiate exchange rates in grueling disputes.
The participants in the European Monetary System had good reasons when they decided to take the big step forward with the transition to the euro. And yet it will have to be said in retrospect that it was left too early. The fact that the possibility of revaluation and devaluation no longer exists has knocked an important instrument of macroeconomic adjustment out of the hands of European countries, which is urgently needed today. Today we know that the euro is not doing much to the inflation convergence of its participating countries. However, this convergence is a prerequisite for the advantages of a common currency to outweigh the disadvantages.

“The elimination of the possibility of appreciation and depreciation has knocked an important instrument of macroeconomic adjustment out of the hands of the European countries. »

The history of the European exchange rate regime can be imagined as a constant search in the same fundamental contradiction. The contradiction is that the economically closely interlinked countries of Europe, on the one hand, are striving to stabilize exchange rates for good reasons, but on the other hand they are too heterogeneous for this stabilization to succeed in the long term. There is no perfect solution to this contradiction - but the founders of the euro may have resorted to a particularly imperfect solution. The advantages and disadvantages of the currency systems conceivable for Europe should be discussed without taboos and with recourse to the available historical experience.

Martin Höpner is a research fellow at the MPIfG and has headed the research group "Political Economy of European Integration" since 2008. Since 2012 he has also been an adjunct professor at the University of Cologne. After studying and obtaining a doctorate in political science, he completed his habilitation in 2007 at the University of Cologne.
Research focus: Political economy, European integration, monetary union, industrial relations.

Alexander Spielau has been a PhD student at the International Max Planck Research School on the Social and Political Constitution of the Economy (IMPRS-SPCE) since 2012 and is a member of the research group "Political Economy of European Integration" at the MPIfG. He studied political science at the Free University of Berlin.
Research focus: Comparative political economy, monetary and fiscal policy, regional economic integration, financial market capitalism.

For further reading
  • Martin Höpner and Alexander Spielau: Discretionary Exchange Rate Regimes: Lessons from the European Monetary System, 1979–1998. MPIfG Discussion Paper 15/11. Cologne: Max Planck Institute for the Study of Societies, 2015.

Martin Höpner and Alexander Spielau: Better than its reputation The European Monetary System,
1979-1998. In: Society Research 2/2015. Cologne: Max Planck Institute for the Study of Societies, 2015, 2-3.