The asymmetry between the behaviour of the franc and the Deutschmark has often been considered as a distinctive characteristic of the EMS. The DM and the franc are not affected in the same way by fluctuations of other currencies: when the dollar depreciates, for example, the DM appreciates relative to the franc. In Discussion Paper No. 245, Research Fellows Daniel Cohen, Jacques Melitz and Gilles Oudiz consider several explanations of this asymmetry. One explanation focuses on an asymmetry in the reactions of French and German monetary authorities to fluctuations of the dollar. The policy of the Bank of France, they argue, is designed to attenuate the impact of dollar fluctuations, while that of the Bundesbank is to refrain from interfering with the market. The shocks which the dollar undergoes will therefore have a greater impact on its exchange rate with the DM than on that with the franc, particularly in the event of downward pressure.
This interpretation may give insight into the benefits to France of EMS membership, the authors argue. If the French authorities wanted to behave more like Germany then, outside the EMS, they could experience acute problems of policy credibility. Membership may give French fiscal and monetary policy greater credibility, since inside the System devaluations impose extra costs that would not otherwise exist. EMS parity realignments may, for example, reveal to voters more clearly the responsibility of their elected officials for depreciations of their currency. But if the EMS can promote monetary discipline in France, it can also make it easier for the country to endow itself with a conservative, independent central bank closely resembling the Bundesbank. This could eventually eliminate the rationale for EMS membership itself.
The authors also explore the relationship between the EMS and European policy coordination. The European economies, particularly France and Germany, display a high degree of interdependence. Uncoordinated macroeconomic policies can as a result lead to an equilibrium detrimental to both countries, largely through exchange rate movements. France and Germany therefore have an interest in maintaining a certain degree of policy coordination, but anything less than full coordination would mean that beggar-thy-neighbour policies, though driven out by one door, would re-enter by another and destroy all the potential advantages of limited cooperation. Yet the EMS is a framework for accords about exchange rates: it has nothing to do with fiscal policy coordination and shows no signs of evolving in this direction. Nonetheless, fiscal policies in Europe have been tempered by the EMS. The fear that such policies might disrupt the exchange rate accord has led EMS members to pursue conservative fiscal policies, counting on their neighbours to take any expansionary initiatives.
Can this deflationary bias be avoided in the future? Cohen, Melitz and Oudiz argue that close coordination of fiscal policies among EMS members is unlikely to occur. They argue that, in the absence of such agreements, the best way to avoid the bias towards restrictive fiscal policies in the EMS would be to move towards monetary integration. If the ECU were to become a common European currency, each government could pursue the fiscal policy it desired, in the manner of a US state or Swiss canton, constrained only by the requirement of solvency as judged by the national and international capital markets. Although this prospect is somewhat unrealistic, the authors conclude that monetary unification nonetheless seems to offer Europe the only way of avoiding the deflationary spiral to which competition between national economic policies seems to lead.

The European Monetary System and the Franc-Mark Asymmetry
Daniel Cohen, Jacques Melitz and Gilles Oudiz

Discussion Paper No. 245, June 1988 (IM)