The failure of the Exchange Rate Mechanism was a setback for UK’s ambitions to join the European Monetary Union and adopting the single currency. However the recent studies argue that there were many factors that lead to the currency crises of 1992-93, which resulted with the UK’ pound (and other currencies) leaving ERM. This essay attempts to critically analyze to what extent the failure of the ERM was decisive for the UK’s decision to stay out of EMU. It will begin with a brief overview of the history of the ERM, continuing with a critical elaboration of its functionality and the UK’s decision to join the ERM. It will then deepen in the analysis by discussing more intensely the causes of the ERM failure and the implications that UK faced in the system. The essay will give a glance of the optimal currency area and how it affected the UK’s opt out of EMU. Finally a conclusion will be offered.

Since World War II, attempts had been made to maintain currency stability amongst major currencies through a system of fixed exchange rate – the Bretton Woods System. Albeit the Bretton Woods System collapsed in the early 1970s, European leaders were keen to maintain the principle of stable exchange rates rather than moving to the policy of floating exchange rates, which was gaining popularity in the USA. In the 1972, the so-called currency snake, or joint float, of some EEC currencies came into existence. The snake suffered early defections by the United Kingdom and Italy, and France was an intermittent participant. However in the 1978 a fixed system “Exchange Rate Mechanism” that would supersede the snake was launched (Thygesen 2004). The launch of European Monetary System and its centrepiece, the exchange rate mechanism (ERM) was generated by the German chancellor, Helmut Schmidt, and the French president, Valery Giscard d’Estaing (Mulhearn and Vane 2008, pp.37). The EMS was established to pursue three main policy objectives: the creation of a ‘zone of monetary stability’ involving both low inflation and stable exchange rates; the provision of a framework for improved economic policy cooperation between member states; and the easing of world monetary instability through the adoption of common policies in relation to third countries (European Commission, 1989, p. 2, in Arestis et.al. 2001, pp.20). The new EMS plan was different from the previous attempts at a fixed exchange rate system in two major ways. First, it set its own central rates independent of the U.S. dollar. Second, the EMS was formed with economic and political objectives in mind. The EMS consisted of three elements–the Exchange Rate Mechanism (ERM), the European Currency Unit (ECU), and the European Monetary Fund (EMF). These three elements were designed to work together to achieve monetary integration among the EC member states.

The ERM became operational in March 1979. The central economic purpose of the ERM was to create a zone of monetary stability in Europe. This had two dimensions:

ERM members’ exchange rates would be stabilized against one another.

This would simultaneously necessitate the maintenance of low and stable inflation rates.

The Exchange Rate Mechanism (ERM) consisted of four components: European Currency Unit (ECU), the parity grid, the divergence indicator and credit financing.

The ERM and the ECU work in tandem to form the hybrid exchange system on which the EMS is based. This hybrid system forces the EC currencies to be pegged to each other, but allows them to float against the U.S. dollar. According to the EMS, central or “parity” rates are established for the various currencies in terms of ECUs. Once these central rates have been fixed, a table of cross rates is tabulated for all EC currencies. This arrangement is, in effect, a system of fixed exchange rates. The ECU is a weighted basket of all EC currencies. The weight of each currency is determined in proportion to the economic strength of each country. Since Germany is by far the strongest EC nation, the deutschemark holds the most weight in the ECU basket. Because of this strength, the deutschemark is often referred to as the anchor of the ECU. Initially, each EC currency was allowed to fluctuate within a margin of 2.25 percent around the central rate. A few exceptions to this general rule were Italy, the United Kingdom, and Spain, which were each allowed a larger margin of plus or minus 6 percent (Hamvi and Niroomand, 1995).