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European Monetary History: Euro is Born of Fixed Exchange Rate Failures

By Frances Coppola

The famous “trilemma” of classical economics says that it is not possible for a country to maintain both a pegged exchange rate and autonomous monetary policy without capital controls. But capital controls can limit trade and investment between neighboring countries. Many countries outside Europe have retained control of monetary policy in today’s world of free capital flows by floating their currency exchange rates. But the member states of the Eurozone have gone in the opposite direction. To achieve their goal of complete freedom of movement of goods, services and capital across borders, they have given up their national currencies – and with them, national control of monetary policy.

End of Bretton Woods Fixed Exchange Rate System Marked the Start of Europe’s Path to Monetary Union


The movement towards monetary union in Europe was born in the last days of the Bretton Woods fixed exchange rate system. After U.S. President Nixon suspended the dollar’s convertibility to gold in 1971, there was severe currency volatility and high inflation throughout the developed world, disrupting trade and causing fiscal crises in several countries.


The European Economic Community (EEC), as it was then known, tried to stabilize the exchange rates of its member states. In 1972, it created what was known as the “snake in the tunnel,” under which EEC member states' currencies could fluctuate within narrow limits against the U.S. dollar. Central banks could buy and sell European currencies as long as they remained within the fluctuation margin of 2.25 percent.1


The “snake” did not last long. In 1972-3, a severe oil price shock caused a sharp rise in inflation and disrupted currency markets. Several EEC member states were unable to keep their currencies within the fluctuation bands, so abandoned the “snake.”2


But the EEC remained committed to the idea of fixed exchange rates. In 1977, a proposal for monetary union was put forward by then-President of the European Commission, Roy Jenkins, but was rejected. With the support of France and Germany, a more limited version was launched as the European Monetary System (EMS) in March 1979.3


A Slow Crawl to Monetary Union


The basic elements of EMS were the European Currency Unit (ECU), defined as a basket of national currencies, and an Exchange Rate Mechanism (ERM), which set an exchange rate towards the ECU for each participating currency. Exchange rates could fluctuate within set limits, both against the ECU and against other participating currencies.


Over the ensuing decade, the EEC progressively relaxed trade barriers between member states, and dismantled capital controls. But as capital and trade barriers were gradually removed, EEC countries increasingly found that keeping their currencies within the ERM’s fluctuation bands meant aligning their economic policies with that the largest economy in the bloc, Germany.


In 1983, France adopted the “franc fort” policy, which effectively imported Germany’s anti-inflationary monetary stance, thereby ensuring that the franc’s exchange rate held within the ERM peg.4 The U.K. did not join the ERM until October 1990, but from 1985 to 1988 it operated an informal exchange rate peg to the deutschmark by allowing its own interest rate settings to track those of Germany.


But many believed that national currencies obstructed the operation of the single market by introducing exchange rate risk. In response to this, a committee headed by Jacques Delors, then President of the European Commission, produced a report recommending eventual creation of a single currency and outlining three stages by which it would be achieved.5


The first stage of monetary union commenced in July 1990. It removed the remaining barriers to the movement of capital, allowed free use of the ECU, encouraged cooperation between central banks and fostered greater economic convergence between states.6


How Exchange Rate Crisis Hastened Euro’s Creation


The fall of the Berlin Wall in 1989, followed by the reunification of Germany, put intolerable strain on the ERM. When the U.K. joined in October 1990, Germany’s monetary policy was dominated by the need to control inflation arising from the costs of reunification: but the U.K. was already entering recession due to a property market collapse.7 The pound was widely viewed as having entered the ERM at too high an exchange rate, but the U.K. Treasury chose to maintain very high interest rates to keep the pound within its ERM bands, rather than devaluing the pound so soon after entry to the ERM.


But market participants were determined to force the pound down. On Wednesday September 16, 1992, despite raising interest rates twice in one day, the U.K. Government was unable to protect the pound from heavy speculative selling. The U.K. left the ERM, never to return.


The U.K. was not the only country forced out of the ERM at that time. Italy was forced out too, but later re-joined as the remaining participants agreed to temporarily widen the exchange rate fluctuation bands.8


The ERM crisis strengthened the movement towards a single currency. Economists thought that if national currencies no longer existed, capital and trade movements could be liberalized without fear of currency crisis.9 The Maastricht Treaty, signed in 1992, had created the “European Union,” and committed all member states except the U.K. and Denmark to eventually adopting a single currency.10 Now, it was time to move ahead with the next stages of monetary union.


In 1994, the second stage commenced with the creation of the European Monetary Institute, which promoted further economic convergence between states and coordination of monetary policy. Central banks were separated from fiscal authorities and prohibited from creating money to support government spending.11 In 1998, the European Central Bank (ECB) was founded.


The final stage of monetary union came on January 1, 1999, when the new currency – the “euro” – came into being and 11 EU member states irrevocably locked their exchange rates to the euro. By 2002, all 11 states had abandoned their national currencies.12 Since then, eight more countries have joined the single currency.13



For the EU, resolving the “trilemma” meant eliminating national autonomy over monetary policy as far as possible. The ECB now controls monetary policy for the Eurozone member states; since the Eurozone crisis of 2012-13, the ECB has also had a say in national fiscal policies for some countries. The euro has become an important international currency, widely used for trade not only in the Eurozone but around the world.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.


1.“A history of European monetary integration,” European Parliament;
4.“Reshaping Economic and Monetary Union,” Shawn Donnelly;
5.Report on economic and monetary union in the European Community, European Union;
6.“Economic and Monetary Union (EMU),” European Central Bank;
7.“Long-term profile of GDP in the UK,” U.K. Office for National Statistics;
8.“A history of European monetary integration,” European Parliament;
9.“The Economics of Money, Banking and Finance: A European Text,” Howells & Bain;
10.Maastricht Treaty, European Union;
11.Economic and Monetary Union (EMU),” European Central Bank;
12.“Introducing the Euro,” OANDA Corporation;
13.“The euro,” European Union;

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