UNIVERSITY OF SARAJEVO

SARAJEVO SCHOOL OF ECONOMICS AND BUSINESS

THE EUROPEAN MONETARY SYSTEM BEFORE AND

AFTER 1992

Sarajevo, 29.8.2016.
TABLE OF CONTENTY

1.

INTRODUCTION...............................................................................................................3

2.

MONETARY INTEGRATION............................................................................................4

3.

TWO MAJOR TYPES OF EXCHANGE-RATE UNION..................................................4

4.

EUROPEAN MONETARY INTEGRATION.....................................................................5

4.1.

FROM BRETTON WOODS TO THE WERNER REPORT.......................................6

4.2.

THE WERNER REPORT............................................................................................7

4.3.

THE 'SNAKE-IN-THE-TUNNEL' AND THE EUROPEAN MONETARY SYSTEM

8

4.4.

TOWARDS AN ECONOMIC AND MONETARY UNION.......................................9

5.

ADVANTAGES AND DISADVANTAGES OF MONETARY INTEGRATION.............11

6.

CONCLUSION.................................................................................................................13

7.

REFERENCES..................................................................................................................14

1. INTRODUCTION

A full-fledged monetary union replaces its members national currencies with a single
currency (the euro in the European case) and establishes a single central bank (such as the
ECB) to pursue a single monetary policy for the whole union. If its members economies
experience large idiosyncratic shocks, the unions monetary policy will not always be optimal
for each member. It follows that the benefits of monetary union are more likely to outweigh
the potential costs, the greater is the degree of real economic integration among its members.
Yet the adoption of a single currency is apt to foster further integration, including the
integration of the financial sector, as is now occurring in Europe.
The creation of a supranational central bank calls for political cooperation too. There must be
agreed arrangements for choosing the banks leadership and holding the bank accountable for
its monetary policy. There is also the need for constraints on the members fiscal policies,
even the harmonisation of those policies.
In this paper, The European Monetary System before and after 1992, I am going to define
and explain the term monetary integration.I will mention the comonents that comprise the
monetary integration and talk about the history of the monetary integration in Europe. Finally,

2. MONETARY INTEGRATION
When we talk about the Monetary integration, we need to introduce two essential
components.
The first component introduced is exchange-rate union, which is an area in which exchange
rates relationships with each other are permanently fixed, even though the rates of union
currencies may vary, relative to nonunion currencies.
Convertibility is the second component that we will introduce, and it is defined as the
permanent inexistance of all types of exchange controls within the area, both for current and
capital transactions.
The second type of convertibility, convertibility for capital transactions, which among other
things includes both interest and dividend payments, is the key element in capital-market
integration, which is defined as the creation of a unified capital market with no geographic
restrictions of any kind on capital movements within the area.
In conclusion we can say that the monetary integration has two major parts:
1. Exchange-rate union, combined with
2. Capital-market integration.
Even tough these two components are interrelated, for the purposes of analysis it is useful to
observe them seperately, due to the possibility that some groups of countries may maintain
fixed exchange rates, relative to each other over the longer periods of time and yet restrict the
complete freedom of capital movements among them.

3. TWO MAJOR TYPES OF EXCHANGE-RATE UNION

After determining that monetary integration is composed of two interrelated parts: exchangerate union and capital-market integration, we will go into more detail about the first of the two
concepts.
In the theory of international economics, two major types of exchange-rate union are
mentioned as the most widely used ones:
1. The pseudo exchange rate union
2. The complete exchange rate union
The pseudo-exchange-rate union is a type of exchange rate union in which member countries
agree to maintain fixed exchange-rate relationships within the union, however they do not

synchronize their economic policy, they have no common pool of foreign-exchange reserves
and no single central bank for the union.
On the other hand, countries within the complete exchange-rate union in addition to agreeing
to maintain a fixed exchange-rate relationships within the union, they usually have a
synchronized econmic policy, some form of common foreign-exchange reserves and a union
central bank. The central bank of this type of union would be in charge of running and
managing the common fund and would work on maintaining the exchange rate relationships
among various union country currencies.

4. EUROPEAN MONETARY INTEGRATION

After introducing the term of monetary integration and its two main components and defining
the two most commonly recognized types of exchange-rate union's (the first one being
characteristic for European Union, the other for United States of America), I will talk about
the long history of european monetary integration that has led to the creation of Eurozone.
The countries in Europe have a long history of trading among themselves, even before the
introduction of 19th century monetary standards like bimetallism, or the Gold Standard.
However, in combination with the industrial revolution, that has changed the world as we
know it, and a period of great technological innovation, the newely adopted standards had a
massive influence on a unprecedented increase in trade and other economic transaction
between european states in the 18th century.
The trend of greater economic cooperation and trade between european has been temporarily
halted by the First World War. The WW1 had a negative effect both on political and economic
environment on the European continent and during the interwar period an economic
stagnation and resources were chanelled to the preparation for another conflict.
These 'beggar-thy-neighbour' policies, that manifested themselves through currency
devaluation and protectionist measures, which eventually led to the end of the Gold Standard.
Consequently, the cooperation between countries has been damanged as well and the situation
remaind as such until the signature of the Bretton Woods Arrangement in 1944.

4.1.

FROM BRETTON WOODS TO THE WERNER REPORT

'The Breton Woods system was based on the idea that international economic transactions
should be promoted via free trade and fixed exchange rates.'1
In order to adopt fixed exchange rate, the european countries came up with the dollar
exchange standard: they fixed the gold to the price of US$35/ounce and the currencies of
other countries were fixed in to the US$.
Even though the agreement was signed in 1944, it was not put into use immediately due to the
fact that after World War II many currencies were not convertible and the trade between
countries was only conducted under non-transferable bilateral credit lines.
After the end of World War II, the United States of America came up with a plan to help the
economies of european countries to recover from the damage they took in the World War II:
The Marshall Plan. In order to make sure that the aid under the Marshall Plan is appropriately
distributed and used, the Organisation for European Economic Cooperation (OEEC) and the
Eruopean Payments Union were created in 1948 and 1950 respectively.
The next big step for the european monetary integration was the adoption of the Treaty of
Rome in 1957, however even before signing the treaty, the convertibility of currencies was
pretty much restored and the European Monetary Agreement was established.
In accordance with this agreement, a European Fund and a Multilateral System of Settlements
were created, both aiming to help members facing balance of payment problems and to
facilitate the settlement of transactions between them. The Treaty, however, did not provide
for the monetary organisation of the European Economic Community (EEC).
Instead, more importance was given to the establishment of a common market, a customs
union and common policies and only limited steps (like the Marjolin Memorandum in 1962,
which launched discussion on a common currency and prompted several measures in the field
of monetary cooperation1 ) were taken at European level.
The problems in the european economic community started appearing however. Tensions
were began built as the US experienced balance of payment problems, which led other

1 Michele Chang quote

countries to question the stability of the dollar in general, and consequently the stability of the
international monetary system as created in Bretton Woods.

4.2.

THE WERNER REPORT

The situation got even worse in 1968-69, when market turbulence forced a revaluation (rise in
value) of the German mark and devaluation of the French franc. This endangered the common
price system of the Common Agricultural Policy (CAP) and had a negative effect on the intraCommunity and international trade of Member States. As a result, the Heads of State or
Government requested the Council to draw up a plan for closer monetary integration.
The result was the Werner Report, published in 1970. It was a ambitious project that
envisioned a three-stage process striving to achieve economic and monetary union, within a
ten-year period.
The integration strategy outlined in the Werner Report was based on the assumption that
exchange rates to the US dollar would remain stable. However, in August 1971, the United
States of America made the decision to temporarily suspend the dollar's convertibility into
gold.
Even tough the Werner Report was never fully implemented, the principles suggested in it,
like staged introduction or transfer of decision-making powers on economic policy from
national to the community level, set the foundation for further advancements towards
monetary integration.
The weakened belief in the stability of the dollar caused the EEC member to decide to shift
their focus, which ment weakening their ties to the dollar and introducing community
currency fluctuation margins.

4.3.

THE

'SNAKE-IN-THE-TUNNEL'

MONETARY SYSTEM

AND

THE

EUROPEAN

On 24 April 1972, EEC central-bank governors concluded the 'Basel Agreement', creating a
mechanism called the Snake in the tunnel. Under this mechanism, Member States'
currencies could fluctuate (like a snake) within narrow limits against the dollar (the tunnel)
and central banks could buy and sell European currencies, provided that they remained within
the fluctuation margin of 2.25%.
The original participants in the mechanism were France, Germany, Italy, Luxembourg and the
Netherlands. Denmark, Norway and the United Kingdom joined shortly afterwards. However
this agreement fell apart as well, because of the first oil crisis in 1973 and the weak
compliance and frequent Member State departures from the scheme.
Nonetheless, the momentum built over the previous decade endured, and efforts to create an
area of currency stability continued. A new proposal for monetary union was put forward in
1977 by the then President of the European Commission, Roy Jenkins, but was met with
scepticism.
A more limited form was supported by the French President Valery Giscard d'Estaing and the
German Chancellor, Helmut Schmidt and was launched as the European Monetary System
(EMS) in March 1979 with the participation of eight Member States.
The basic elements of EMS were the definition of the European Currency Unit (ECU) as a
basket of national currencies and an Exchange Rate Mechanism (ERM), which set an
exchange rate towards the ECU for each participating currency. On the basis of those 'central'
rates, bilateral rates were then established among Member States. The system also included a
preventive tool to avoid breaking the set exchange rates.
In its early years, EMS produced modest results. According to experts, the turning point came
in 1983 when the 'French government decided to closely follow the moentary policy used by
the German government, while becoming increasingly market oriented.
By committing to EMS discipline, France and other inflation-prone countries achieved a
reduction in inflation and their interest rates converged to a lower level.

4.4.

TOWARDS AN ECONOMIC AND MONETARY UNION

During a period of intensifying efforts to create a single market (from the adoption of the
Single European Act (SEA) in 1986 to its completion in 1992, the costs created by the
existence of several currencies and unstable exchange rates became more evident. In this
context, France and Italy led initiatives for stronger European cooperation. This resulted in the
creation of a Committee for the Study of Economics and Monetary Union, chaired by
Commission President Jacques Delors.
The Committee's report, submitted in April 1989, defined the objectives of monetary union
and indicated that they could be achieved in three stages.The Madrid European Council of
June 1989 decided to proceed to the first stage of EMU in July 1990, and the 1989 Strasbourg
European Council in December called for an Intergovernmental Conference to determine the
Treaty revisions that would be needed to move to the second and third stages and implement
the Economic and Monetary Union. With the fall of the Berlin Wall just a month before, the
political climate in Europe was remarkably conducive to stronger integration.
Thus, in December 1991, the Heads of State or Government meeting in Maastricht approved
the Treaty on European Union, declaring that they were 'resolved to achieve the strengthening
and the convergence of their economies and to establish an economic and monetary union
including, in accordance with the provisions of this Treaty, a single and stable currency'.
The Treaty provided for the introduction of a monetary policy2, implemented by a single and
independent central bank3, with price stability as its primary objective. It provided legal
grounds for the establishment of a single currency.
Finally, the Treaty set convergence criteria, which each Member State had to meet in order to
participate in the third stage of Economic and Monetary Union (EMU). Despite these
stabilisation efforts, the destabilising effects of deregulating international financial capital
movements under the SEA, and the diverging national monetary and fiscal policies of EMS
members (e.g. the UK and reunified Germany) combined with uncertainties related to the
ratification of the Maastricht Treaty (following its rejection by referendum in Denmark and
difficulties in its ratification in France), led to increasing market speculation, culminating in a
currency crisis during 1992-93, forcing some Member States (the UK and Italy) to leave the
ERM and some others (Spain and Portugal) to devaluate their currency.
2 Article 3a TEU
3 Article 4a TEU

In an effort to restore stability and discourage speculation, Member States decided in August
1993, to temporarily widen the ERM margins to +/-15%.This move, as well as the positive
result of the second referendum in Denmark (after the Edinburgh Agreement and its opt-out
from the EMU) eased tensions and the project went forward with the creation of the European
Monetary Institute, charged with ensuring the coordination of Member States' monetary
policies and providing surveillance.
According to Michele Chang, by April 1994, 'none of the EU Member States had fulfilled the
convergence criteria' and 'all Member States, save for Ireland and Luxembourg, were found to
be in breach of the deficit targets'. Nevertheless, the Cannes European Council in June 1995
confirmed that the year 1999 would be the starting date for the Economic and Monetary
Union and European leaders at the Madrid European Council in December decided to name
the new European currency the 'euro'.
With the date for the launch of the EMU approaching, public scepticism towards monetary
integration grew, especially in Member States with strong currencies, like Germany, which
were concerned about maintaining price stability. At the same time, other countries such as
France and Spain were more concerned about growth than price stability. This led to the
organisation of a European leaders' meeting in Dublin in December 1996, with the propose of
proposing a Stability and Growth Pact, which was a compromise between a German proposal
for the creation of a Stability Pact which would maintain convergence obligations after
Member States joined the euro area and the French, Spanish and Italian concerns that
excessive focus on budgetary discipline would be at the expense of growth.
In June 1997, the European Council adopted a Resolution to set up an exchange rate
mechanism after the creation of the euro area in 1999. This mechanism, called 'ERM II'
because it essentially replaced the ERM mechanism of the EMS, fixed the exchange rate of
non-euro area Member States against the euro and allowed it to fluctuate only within set
limits, to ensure that exchange rate fluctuations between them would not impact on the
economic stability of the single market. Meanwhile, the Member States considerably
increased their efforts towards convergence: whereas in 1997 only Finland, Luxembourg and
Portugal had achieved all the convergence criteria, by May 1998, the Council decided that 11
Member States satisfied the necessary conditions.
Finally, in July 2000, the Council agreed that Greece also fulfilled the convergence criteria
although it needed to continue the intensive structural reforms undertaken and could

therefore adopt the single currency. On 1 January 2002 the euro became legal tender in the
participating countries and by the end of February 2002 national banknotes and coins ceased
to be legal tender. Since then, the euro area has undergone six rounds of enlargement
Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011, Latvia in
2014 and Lithuania in 2015 bringing the number of member countries to 19.
There are currently nine EU Member States whose currency is not the euro. Of those nine
Member States, Denmark and the United Kingdom have a special status (based on 'opt-out
clauses'), whereas the other seven are prospective candidates for adoption of the euro (i.e.
'Member States with a derogation') and have committed to joining the euro area as soon as
they fulfil the entry conditions.

5. ADVANTAGES

AND

DISADVANTAGES

OF

MONETARY

INTEGRATION

Now, after analyzing the concept of monetary integration and its elements, and talking about
the history of the monetary integration in Europe, I will ask the following question: Should a
nation be a part of the monetary integration?
Like everything else, monetary integration has its advantages and disadvantages. The most
commonly recognized advantages are the following:
1. Transaction cost reduction as a consequence of removal ofthe need for currency
exchange. According to Daniel Portone, 'by switching to the euro, members of the
EMU were expected to save as much as $30 billion a year.
2. Investment increase as a consequence of a lower transaction cost. The lower
transaction cost enable the large amount of cross border investment.
3. Exchange rate stability, that arises from usage of a common currency. A common
currency generates a platform that enables the revision of price relationships between
the countries. Along with the erasing the need for currency exchange, it helps the
countries to cope with the problem of volatility of exchange rates as well. When the
exchange rate fluctuates, it affects the profitability of the companies within the nations
as well and the increased risk causes the net investment into the country to decrease.
In order to avoid the risk and try to stabilise the situation, it is useful for a country to
enter in a currency union.

4. Free movement of workers which enables the countries facing high unemployment and
high inflation to ease each other's problems. The unemployed workers can find work
in other countries and the country emplying them faces a possibility of inflation
release. A win-win situation.
5. The prevention of competitive devaluations and speculation that arise due to the
competitiveness in todays' global market, as countries are trying to steal businesses
from each other in order to progress their economies further.
On the other hand, the some of the recognised disadvantages are:
Loss of sovereignty, which means that country adopting the common currency has to give up
the Monetary policies to the body which is controlling the union. The biggest misfortune that
the loss of sovereignty can ring is during the economic crisis, when the situation in one
country has a major impact on the situation in other countries.
Cost of adopting the new currency, which is a very huge cost to the economy.
New negative cross-border spillovers of fiscal policy a national fiscal expansion raises the
demand for savings, ceteris paribus pushing up the long-run interest rate and discouraging
investment. In an integrated capital market strengthened by monetary unification, this effect
will spread to other countries, imposing a negative externality. A monetary union may also
generate new negative spillovers. An increase in domestic government purchases, in affecting
the demand for domestic products, raises local inflation, thereby pushing up average euro-area
inflation and forcing the ECB to contract monetary policy for the entire area. Further, a
national fiscal expansion may cause an appreciation of the euro, thereby undermining the
external competitive position of all union members.4
Difference in languages which in turn can lead to the decrease in the mobilitz of labour.
However, this disadvantage is the one that is the easiest to overcome.

6. CONCLUSION

European monetary integration refers to a 30-year long process that began at the end of the
1960s as a form of monetary cooperation intended to reduce the excessive influence of the US
4 http://www.voxeu.org/index.php?q=node/4305

dollar on domestic exchange rates, and led, through various attempts, to the creation of a
Monetary Union and a common currency. This Union brings many benefits to Member States.
However, over the past decade, the build-up of macroeconomic imbalances, and the
imprudent fiscal policies of some Member States, resulted in the continuing double crisis
(banking and sovereign).
As a result of this crisis, many individual Member States face difficult re-adjustment
processes, and Member States collectively must reappraise the governance architecture of
Monetary Union and adopt new mechanisms to detect, prevent, and correct problematic
economic trends. Whatever one's opinion on the process and the outcome of European
monetary integration, it is still remarkable that so much progress has been achieved. It should
also be kept in mind that 1999 was not the end of the process of monetary integration, as the
adjustments during the first decade and during the financial and sovereign debt crises have
shown. It is rather a 'work in progress' and its ultimate success or failure will depend on many
factors: not only economic, but also political.

7. REFERENCES

1. https://www.europarl.europa.eu/RegData/etudes/BRIE/2015/551325/EPRS_BRI(2015
)551325_EN.pdf

2. https://www.princeton.edu/~ies/IES_Essays/E93.pdf
3. http://ec.europa.eu/economy_finance/publications/publication12081_en.pdf
4. http://www.bloomberg.com/bw/articles/2012-08-02/how-the-2004-olympics-triggered
greeces-decline
5. http://voxeu.org/article/regional-monetary-integration
6. https://www.ukessays.com/essays/economics/advantages-and-disadvantages-ofjoining-a-currency-union-economics-essay.php