The European Monetary System (EMS) was established in 1979 for a mixture of economic and political reasons. The central element in the system was the Exchange Rate Mechanism (ERM), a fixed exchange rate arrangement which sought to restrict the extent to which volatile exchange rates interfered with fair competition among EU producers. From an economic viewpoint, fixed exchange rates became essential once the International Monetary Fund's fixed exchange rate system had started to come under pressure in the late 1960s. Under the IMF system, the exchange rates of EU countries could vary against each other by a maximum of ± 2 per cent. However, in August 1969, the French franc was devalued by 11.11 per cent and later the Deutschemark was revalued by over 9 per cent. In December 1971, the band which each currency had to maintain against the dollar was increased to 2.25 per cent, widening the allowable variation in the value of one European currency against another to ± 4.5 per cent. The combination of the wide band and possible changes in the exchange rate parity was thought to interfere too much with the fairness of competition among producers in different EU states and to raise the possibility of countries acting to push down the relative values of their currencies in order to improve the competitiveness of their industries.

Volatile exchange rates also caused a specific problem for the Common Agricultural Policy (CAP) of the EU. The policy had been designed in the 1960s

on the assumption that the exchange rates among the EU currencies would remain unchanged. Prices in the CAP were fixed in terms of the EUA - the European Unit of Account, the forerunner of the ECU. A fall in the value of the franc, say, against the dollar and the EUA meant that farm prices in France would have risen in terms of French francs but remained the same elsewhere. This would have given French farmers an advantage over other farmers within the Union and would have encouraged them to increase production, adding to the already strong incentives for European farmers to over-produce. In 1971 a formal system of levies and subsidies (known as MCAs - Monetary Compensatory Amounts) was introduced. This established a dual system of exchange rates - the actual market rate and the Green rate of exchange which was used to convert farm prices set in EUAs into national currencies. Countries whose market exchange rates fell below their Green rates would pay MCAs, those whose market rates rose above their Green rates would receive MCAs. Although MCAs adjusted to some extent for the exchange rate changes in terms of fairness, these modifications to the CAP meant that there was no longer a system of common prices throughout the Union.

Although the Treaty of Rome had contained nothing about monetary integration, there had always been considerable support on political grounds for the idea that monetary integration should eventually occur. Proposals for steps to be taken towards a single currency and single monetary policy were made as early as 1961. Serious discussion of monetary integration began at The Hague summit in December 1969 and this was followed in 1971 by the Werner Committee report which recommended the achievement of European Monetary Union by 1980. Any possibility that this might happen was removed by the volatility of exchange rates following the complete breakdown of the Bretton Woods system in 1972.

This also destroyed any chance of success for the system of fixed exchange rates, known as the Snake in the Tunnel, which was established in Europe in April 1972 and struggled on until March 1979, when the EMS replaced it. The Snake attempted to limit the freedom of European currencies to move against each other to ±2.25 per cent around the established central rates - half the freedom which had been possible under the modified IMF arrangements. However, only Benelux, West Germany and Denmark remained members of the Snake for the seven years of its existence. At various times, France, the UK, Sweden, Norway and Italy all entered and left. The `fixed' parities were altered thirty-one times.

An attempt was made to allow for the problems of particular countries by requiring those which had not survived within the Snake only to maintain the value of their currency within a very wide band of ±6 per cent around the central rates which were established against the ECU. Despite this attempt at increased flexibility, the mechanism faced many early problems and seven adjustments were made to central rates in the first four years. After much talk in 1982 and early 1983 of French withdrawal and of the system's virtual collapse, things began to settle down and there were only three further realignments prior to the general realignment of January 1987. Towards the end of this period of relative exchange rate stability, talk began to be heard again about the possibility of a movement to monetary union.

The period up until September 1992 was one of capital liberalization and a determined attempt to achieve exchange rate stability as a step towards monetary union. The only change in central rates in over 5½ years was a small reduction in the central rate of the lira to allow it to move from the ±6 per cent band to the ±2.25 per cent band. There was growing evidence of inflation rates among members converging on the lower rate of inflation experienced by Germany. For several countries, this convergence of inflation rates was accompanied by large increases in unemployment but most governments seemed prepared to accept this as a necessary cost of lower inflation. In 1990, the EMS was generally held to have been a success because it had reduced the variability of members' bilateral exchange rates.

The second half of the 1980s also saw a renewed political push towards monetary integration. In 1985, when member countries adopted the Single European Act, they increased the need for the progressive development of EMU. In June 1988 the Council of Europe set up a committee under Jacques Delors, the President of the European Commission, to study and make proposals regarding the necessary stages for the achievement of EMU. The result, submitted in April 1989, was The Report of the Committee on Economic and Monetary Union, also known as the Delors Report. It set out the goal to be reached, the reasons for it and its possible implications, as well as specifying the desired stages leading up to EMU. The Delors Report was accepted as the basis for the debate at the European summit held in Madrid on the 26th June 1989. Its principal recommendations were then incorporated into the Treaty on European Union, agreed upon at Maastricht in December 1991.

The Treaty on European Union set out the nature, functions and constitution of the new central banking system which would manage the single currency, monetary policy and foreign exchange in EMU. It also explained how fiscal and budgetary policy would be managed and set out the stages through which EMU would be reached. The first stage was seen retrospectively as having commenced in July 1990 with the liberalization of capital flows and the integration of financial markets under the single market programme. During this first stage, all EU countries were to become full members of the ERM in the narrow band. There was to be an increase in the coordination of national monetary policies and the pooling of 10 per cent of national foreign exchange reserves to allow intervention in currency markets.

Stage 2 was to begin in January 1994 with the establishment of the European Monetary Institute (EMI) which would have the task of preparing the way for EMU. During Stage 2, responsibility for the execution of monetary, exchange rate and fiscal policy would still rest with the member states. However, the EMI would plan monetary policy, monitor the policies of member states, and advise member governments. Changes would only be allowed to central exchange rates in the ERM under exceptional circumstances.

The EMI would be replaced at the beginning of Stage 3 by the European Central Bank (ECB) which, together with the central banks of the member states, would form the European System of Central Banks (ESCB). In Stage 3 exchange rates would be irrevocably fixed and national currencies would eventually be replaced by a single EU currency. The ECB would take over from the EMI, and would assume responsibility for exchange rate and monetary policies. A decision was required before the end of December 1996 as to when Stage 3 would commence. If, however, no date had been set by the end of 1997, then the third stage would start on 1 January, 1999.

With regard to membership of EMU, the Treaty set out a number of convergence conditions, which EU member states would need to meet to be allowed to join. Membership would require:

1. demonstration that the country's inflation rate had converged on the lowest

rates of inflation within the union - to be judged specifically by whether the

average rate of inflation, observed over a period of one year before the

decision regarding membership was within 1.5 percentage points of the average

of the three lowest national rates;

2. evidence that the inflation convergence was durable - to be shown by a long

-term interest rate within 2 percentage points of the average of the long-term

interest rate of the three countries with lowest inflation;

3. a sustainable government financial position defined as (i) a general government

budget deficit no greater than 3 per cent of GDP at market prices and (ii) a

ratio of gross public debt to GDP at market prices no greater than 60 per cent

- unless this debt ratio is falling `at a satisfactory pace';

4. observance of the normal fluctuation margins provided for by the ERM of the

EMS for at least two years with no devaluations against any other member

currency.

In addition, the Commission and the EMI were required to take account of development of the ECU, the results of the integration of markets, the situation and development of the balances of payments on current account, and the development of unit labour costs and other price indices.

A majority of the member states were required to be economically fit for EMU if the currency union were to go ahead from December 1996 but no such `critical mass' was required for the union to be established on the 1st January 1999 (with membership being determined before 1st July 1998).

The specific numbers included in the convergence conditions had nothing in particular to recommend them. At the time of the signing of the Treaty on European Union, they looked to be achievable targets for many EU member states while appearing sufficiently tough to hope to persuade financial markets that the monetary policies pursued after 1999 would be strong, anti-inflationary policies.

At the beginning of 1992, everything seemed to be going well for the EMS and hopes were high of meeting the deadlines of the Treaty on European Union for the formation of EMU by 1997 or by 1999 at the latest. Yet by September of that same year, two major currencies (sterling and the lira) had been forced out of the ERM while three others (the peseta, the escudo and the punt) had devalued. Three more currencies (the French franc, the Danish krone and the Belgian franc) remained under severe pressure at various stages in the following months and in August 1993, the allowable band around central rates within which countries were required to keep their exchange rates was widened to ± 15 per cent in order to preserve the central rate of the French franc and to make life more difficult for speculators.

What had gone wrong? Almost inevitably, both economic and political factors contributed to the crisis. Part of the problem was that by 1992 exchange rates were well out of line following the prolonged period without adjustment of central rates. Although inflation rates had converged to a considerable extent, the differences which remained had meant that a number of countries had become seriously uncompetitive at the existing exchange rates. This seemed clear in the case of the UK because the current account of its balance of payments remained firmly in deficit despite the country being in a deep economic recession. The standard response of increasing interest rates to counter a deficit was, for political reasons, not available in the middle of a recession.

The economic problem of misaligned exchange rates was added to by popular concerns regarding the increased speed of integration of the EU. In Britain's case this was nothing new. The British government's doubts had been expressed at the Maastricht conference by its insistence that Britain be given the right to opt out of membership of EMU. In other member states, uncertainty about the future had clearly increased and this was shown by the narrowness with which the referendum held in France to approve the Treaty on European Union was passed and the loss of the first referendum held in Denmark on the same question. The increase in doubt about the future of the EU expressed itself in foreign exchange markets through a weakening of currencies already weakened by worries about competitiveness.

The final element was the increased freedom which speculators had to exploit the difficulties of weak currencies because of the capital liberalization which had occurred under the Single European Act. Speculators knew that if they sold weak currencies in large quantities for sufficient periods of time, currencies were very likely to be forced either to devalue or to leave the ERM. In the second case, once weak currencies floated outside the ERM they would be very likely to fall sharply. In either event, speculators would be able to buy the weak currencies back at much lower rates than they had sold them for, thus making very large per annum rates of profit. Because central banks could no longer impose capital controls and because the capital movements were so very large, central banks were in no position to resist the downward pressure on weak currencies. Where they tried and failed, as with the Bank of England, they experienced very large losses.

There were two apparent solutions. The first was that interest rates should be generally lowered across the EU to help countries in recession. This would have required the Bundesbank to lower its interest rate. This it was unwilling to do for two reasons - one local and one related to the aims of the EMS as a whole. The local, if very large, problem which Germany faced was the absorption by West Germany of the very weak East German economy following German unification in 1989. The German government had, for internal economic and political reasons, exchanged Deutschemark for the East German currency, the Ostmark, at equal value. This had increased the total German money supply much more than total German production had increased as a result of unification and raised fears of increasing inflation. These fears were augmented by the promise of the government not to increase taxation rates during the unification process. Public expenditure and budget deficits inevitably increased.

The Bundesbank's natural response was to raise interest rates, rather than to lower them as the UK wanted. This made sense in terms of the system as a whole, if one accepted (as many appeared to do) that a major advantage of the EMS was that it allowed inflation-prone countries to lower their rates of inflation by linking their currencies to that of low-inflation Germany. This possibility would have disappeared had inflation rates in Germany climbed very sharply.

The solution from the German perspective was then for the weak currency countries to accept a realignment within the EMS. The devaluation of those currencies would, however, have increased inflationary pressures and caused doubts to arise about their future determination to fight inflation. Thus the UK, in particular, was unwilling to countenance an organized, ordered devaluation. The increase in tensions between the Bundesbank and the British government caused further doubts in the foreign exchange market and led to more downward pressure being exerted on sterling. Italy was also thought to be uncompetitive at the existing central rates and speculators spread their attack to the lira. Spain and Portugal were able to contain the pressure to some extent both because they were still in the 6 per cent band of the EMS and because they were able to reintroduce controls over the flow of capital. Until the changes of August 1993, speculators were able to go on attacking weak currencies with very little risk of loss.

This period of exchange rate turmoil marked the beginning of a long period of doubt about both the prospects of EMU occurring in 1999 and the countries likely to qualify to join at its beginning. Doubts were intensified as it became clear that most EU members would have grave difficulty in meeting the convergence conditions laid down at Maastricht. Worse, it began to seem possible that Germany itself might not be able to do so. The principal difficulty related to the requirement of a sustainable government financial position. European economies experienced deep recessions in the early 1990s and this inevitably led to budget deficits in most countries well beyond the limit of 3 per cent of GDP. As we said above, there was no particular reason for choosing 3 per cent as the target in the first place but once the target had been set, it took on a life of its own. Any attempt to increase the figure to allow more countries to qualify for membership ran the risk of being interpreted as a weakening of anti-inflationary resolve. The fear then was that markets would assume that inflation rates would be higher after EMU, calling the value of the EMU single currency against the dollar and the yen into doubt. That would lead to a higher risk premium being built into interest rates on the single currency and into the long-term interest rates of all EU members during the run-up to EMU.

In addition to the problems over government finances, the exchange rate disturbances of 1992 and 1993 had made the achievement of the fourth convergence condition very difficult. To begin with, by March 1997, the UK had not rejoined the ERM and Greece and Sweden were still to become members. The narrow band had all but been destroyed and, with bands of ±15 per cent, the phrase `observance of the normal fluctuation margins provided for by the ERM' had very little meaning. The exchange rate changes had also interfered with the convergence of inflation rates.

By 1997 doubts about EMU had risen to the extent that postponement of the 1999 starting date seemed increasingly likely. Few countries seemed likely to meet all convergence criteria by July 1998.

Ten countries were meeting the inflation convergence target of 2.63 per cent or less. All of these plus the U.K. were meeting the long-term interest requirement of 8.7 per cent or less. However, only Denmark, Ireland, Luxembourg and the Netherlands were meeting the requirement that General Government Borrowing be no more than 3 per cent of GDP. Of these four, only Luxembourg and Denmark strictly qualified on the General Government Gross Debt criterion. Ireland, too, effectively was qualifying since it had been judged for three successive years to be moving sufficiently quickly towards the required 60 per cent. Optimistic forecasts suggested that one or two other countries might qualify by 1998. The big worries were France and Germany.

The governments of France and Germany remained strongly committed to EMU on political grounds but faced increasing doubts from their own populations. France had for some time been in favour of EMU as the only sure way of tying Germany firmly to the rest of Europe. Ever since the unification of Germany, the German chancellor, Kohl, had appeared to share the French fear that, in the event of a loosening of European ties, Germany could become more introspective and nationalist and more concerned with the position of German minorities in other European countries. EMU was thus as much a symbol of European integration as it was an economic arrangement.

France, however, had unemployment of over 12 per cent and had experienced both social and industrial unrest. There was a strong feeling that the high unemployment was at least partly the result of the Franc fort policy of maintaining the value of the franc in terms of the German mark in order to keep alive hopes of EMU. This had required constant downward pressure on government expenditure but yet more cuts in expenditure would be needed to push government borrowing below 3 per cent of GDP. The extreme right wing political party, the National Front, had gained considerable strength partly on immigration and racist issues but partly on the basis of its anti-EU rhetoric. Meanwhile, Germany had high unemployment also, although this could still be seen to a significant extent as one of the costs of unification. Of more concern to the German supporters of EMU were the widespread fears that the replacement of the Deutschemark by the Euro, the name accepted for the EMU single currency, would mean higher inflation.

In an attempt to counter these fears and, at the same time, to persuade the financial markets of the anti-inflation credibility of post-EMU monetary policy, the German government had, in December 1996, obtained acceptance of a stability pact which set out rules for government borrowing of EMU members after January 1999. These rules converted the 3 per cent of the Maastricht agreement into a ceiling which should only be breached under exceptional circumstances. `Exceptional circumstances' were defined to cover a natural disaster or a fall in GDP of at least 2 per cent over a year. Such a severe recession is not at all common, having occurred only 13 times in any of the 15 EU members in the past 30 years. In cases where GDP has fallen between 0.75 per cent and 2 per cent, EU finance ministers will have discretion on whether or not to impose penalties, taking into account factors such as the abruptness of the downturn. Members who broke the 3 per cent barrier in other circumstances would be required to make heavy non-interest bearing deposits with the European Central Bank. Continued failure to return below the 3 per cent limit would see these deposits converted into fines. From an economic point of view this made little sense since the fines would make it even more difficult for the governments in question to get their borrowing back down below 3 per cent of GDP. But this was beside the point. The stability pact was an attempt to enhance the anti-inflation credibility of post-EMU monetary policy in the eyes of the German population.

The doubt was whether Germany itself would be able to achieve the 3 per cent target by 1998. In March 1997, the German Finance Minister argued that the achievement of the convergence conditions was more important than the timing of convergence. This added to the feeling that Germany might be willing to accept a postponement of the 1999 commencing date for EMU. The German fear, as we have seen, was that any weakness on the entry criteria would be taken badly by both the markets and the German population. Further, in October 1993, the German constitutional court had attached conditions to Germany's ratification of the treaty on European Union which specified that Germany could not be committed to an `unclear, automatic and uncontrollable mechanism leading to currency union'. This meant that the court retained the power to prevent Germany's entry to EMU if the conditions for monetary union in the Maastricht Treaty were not adhered to. Although this seemed unlikely, the court ruling added to pressure on the German government to ensure that the full achievement of the Maastricht convergence conditions remained the test of entry to EMU. Stressing the inviolability of the convergence conditions was also a way of discouraging the increasing push of Spain, Italy and Portugal to be allowed to join from 1999. Their presence in the first wave of EMU membership would have greatly added to the feeling that the post-EMU single currency would be weak and the EMU inflation rate much higher than most Germans seemed prepared to accept.

Yet the risks associated with delaying the start of EMU seemed rather high, particularly for countries on the fringe of joining. Interest rates in countries such as Spain and Italy had fallen sharply in anticipation of EMU as the markets judged that all potential candidates for membership would be working hard to meet the entry conditions. Delay in the start would re-open the possibility that countries, particularly those with high unemployment, would come under increased domestic pressure to ease their economic policies, leading to higher inflation and a fall in the value of their currencies. In anticipation of this, the markets would demand higher risk premiums for holding their currencies and interest rates would rise. This would increase the cost of financing their existing government debts and would make it less likely that they would be able to meet the convergence conditions in the future.

In any case, there was no provision in the Treaty on European Union for delay. The 1st of January 1999 was the compulsory date for the start of EMU. To delay the start would require a formal renegotiation of the Treaty with all fifteen members agreeing on the change and with the change needing to be ratified by each member, either through national parliamentary approval or popular referendum. Another possibility would be for EMU to go ahead on time but with the European Council ruling that no countries had met the convergence criteria. EMU would be left as an `empty shell' waiting for later activation. But This would increase the risks associated with delay since it would leave the possible date for the later commencement of EMU completely uncertain. This would be much more difficult for countries to cope with than would the substitution of a stated new date for the existing one. Also, the `empty shell' option would require manipulation of the rules since, as we have seen, at least three countries - Luxembourg, Denmark and Ireland - seemed likely to qualify fully for membership. The only way to make these countries ineligible would be to suspend the ERM for a few hours so that no country could meet the requirement of two years of uninterrupted ERM membership.

Under these circumstances, it was best in March 1997 to treat Germany's not very veiled warnings of the possibility of delay as a continuation of its determination to stress the importance of the convergence criteria and to bet that EMU would indeed commence in some form or other on the 1st January 1999. But many problems other than the initial membership of the monetary union remained. These included the relationship which would be maintained between the currencies of EMU members and those of the EU countries outside of EMU as well as the likelihood of those countries excluded from EMU at the beginning later being able to meet the conditions of membership.

The principal danger for EMU members would come from the values of the currencies of non-members falling sharply following the beginning of EMU, damaging the competitiveness in trade of EMU members. The extent of this danger can be well-illustrated by the events following the departure of the lira and sterling from the ERM in September 1992. Both currencies, the lira in particular, depreciated sharply increasing the competitiveness of Italy and Britain and making life much more difficult for producers within the countries which remained within the ERM. The way in which it was hoped to avoid this problem after EMU was to require all EU members who are outside of EMU to join a new version of the EMS (EMS II) which would maintain fixed exchange rates among its members and with the single currency of the EMU. This would have an advantage also for aspiring EMU members since it would assist them in achieving the convergence necessary for later entry.

However, this scheme almost certainly underestimated the strength of the currency markets. It seemed very likely that the currencies of countries excluded from the first wave of EMU membership would come under very great selling pressure and that there would be, at the least, a once-and-for-all devaluation of several currencies. It was probably also the case that downwards pressure would remain on EMSII member countries after EMU especially if it appeared that their chances of becoming members of EMU were not strong.

We have already mentioned the principle problems for non-EMU members after EMU. Initial devaluations of their currencies might well be beneficial for trade and employment but would make future convergence on the lower inflation rate within EMU more difficult. The attempt thereafter to maintain a fixed exchange rate with the single currency would almost certainly require higher interest rates, reducing the chances of achieving the government finances conditions. Later entry would become yet more difficult if the EMU members succeeded in applying the rules of the stability pact for then the EMU members might wish to apply a tighter test for future membership than that specified in the Maastricht convergence conditions.