While the Member States were divided over some of the Werner Report’s main recommendations, in March 1971, they agreed in principle on a three-stage approach to European Monetary Union. The creation of the European Monetary System in 1979 laid the foundations for a new era of monetary co-operation.
The first stage, narrowing of exchange-rate fluctuations, was to be tried on an experimental basis without any commitment to the other stages. Unfortunately, the Werner strategy took for granted fixed exchange rates against the dollar. When the USA effectively floated the dollar from August 1971, the ensuing wave of market instability put upward pressure on the Deutschmark and squashed hopes of tying the Community's currencies more closely together.
To retrieve the situation, in March 1972, the Member States created the ‘snake in the tunnel’. This was a mechanism for managing fluctuations of their currencies (the snake) inside narrow limits against the dollar (the tunnel). Hit by oil crises, policy divergence and dollar weakness, within two years the snake had lost many of its component parts and was little more than a German-mark zone comprising Germany, Denmark and the Benelux countries.
The quick ‘death’ of the snake did not diminish interest in trying to create an area of currency stability. A new proposal for EMU was put forward in 1977 by the then president of the European Commission, Roy Jenkins. It was taken up in a more limited form and launched as the European Monetary System (EMS) in March 1979, with the participation of all Member States’ currencies except the British pound, which joined later in 1990 but only stayed for two years.
The European Monetary System was built on the concept of stable but adjustable exchange rates defined in relation to the newly created European Currency Unit (ECU) – a currency basket based on a weighted average of EMS currencies. Within the EMS, currency fluctuations were controlled through the Exchange Rate Mechanism (ERM) and kept within ±2.25% of the central rates, with the exception of the Italian lira, the Spanish peseta, the Portuguese escudo and the pound sterling, which were allowed to fluctuate by ±6%. In August 1993, these bands were widened to 15% in order to counter speculative pressures, but by 1996 all currencies had moved back to their original fluctuation margins.
The system included an intervention mechanism and a preventive tool – once the exchange rate of a currency reached 75% of the maximum fluctuation margin authorised, the currency was considered as 'divergent' and the country had to take remedial action through interest rates and fiscal policy adjustments. In the event of the maximum fluctuation margin being reached, central banks had to intervene by buying or selling the currency to avoid the margin being exceeded.
The EMS was a radical new departure because exchange rates could only be changed by mutual agreement between participating Member States and the Commission – an unprecedented pooling of monetary sovereignty.