European Monetary System

European Monetary System (EMS) A system of exchange-rate stabilization involving the countries of the European Union, which began operations in 1979. There were two elements: the Exchange Rate Mechanism (ERM), under which participating countries committed themselves to maintaining the values of their currencies within agreed limits, and a balance of payments support mechanism, organized through the European Monetary Cooperation Fund. The ERM operated by giving each currency a value in ECUs and drawing up a parity grid giving exchange values in ECUs for each pair of currencies. If market rates differed from the agreed parity by more than a permitted percentage, the relevant governments had to take action to correct the disparity. In 1992 the UK pound and the Italian lira were forced out of the ERM and the Spanish peseta also fell below its floor value; some of the currencies remaining within the system were subsequently allowed wider (plus or minus 15%) fluctuations.

Although some saw the EMS as no more than a mechanism to facilitate monetary cooperation, the view that its ultimate goal should be European Monetary Union (EMU), with a single European currency and a European Central Bank, gained ground in the 1980s and 1990s. The decision to create a single currency was part of the Maastricht Treaty of 1991. In June 1998 11 EU countries – all the then member states except Denmark, Greece, Sweden, and the UK – committed themselves to monetary union. Their currencies were then locked together irrevocably and the European Central Bank was established to direct the single monetary policy essential for EMU. The euro was launched for all purposes except cash transactions in January 1999. Euro bank notes and coins came into circulation in January 2002 and the national currencies were withdrawn after a short transitional period. A new exchange-rate mechanism, known as ERM II, was established in January 1999 to link the currencies of other EU states to the euro (with fluctuation rates of plus or minus 15% as the basic rule). Its initial members were Denmark and Greece; the latter adopted the euro in 2001. In mid-2004 three of the new accession states – Estonia, Lithuania, and Slovenia – joined ERM II, with others announcing plans to follow suit in due course. Countries must participate in ERM II for a minimum of two years before adopting the euro.