Initially EMS parities were subject to relatively frequent realignments. Most explanations of the System's success in helping inflationary convergence have focused on the role of capital controls in sheltering weaker currencies. In advance of stage two of the Delors Report, however, capital markets are being liberalized and this shelter is now virtually removed, without bringing the destabilization of the EMS that many observers predicted. In Discussion Paper No. 369, Programme Director Francesco Giavazzi and Research Fellow Luigi Spaventa examine why financial liberalization seems to have strengthened, rather than weakened the EMS. They argue that this is because, with exchange controls gone, policy-makers realized that realignments became virtually impossible because the mere possibility of a realignment could stir up an unsustainable speculative attack. The commitment to fixed exchange rates then became the only alternative to abandoning the EMS and letting exchange rates float freely, and governments' commitment to stick to existing parities has become credible.
Other arguments, however, point to the increased vulnerability of the EMS after the abolition of exchange controls. These were discussed at a January lunchtime meeting by Francesco Giavazzi, which will be reported in Bulletin No. 37.

The `New' EMS Francesco Giavazzi and Luigi Spaventa

Discussion Paper No. 369, January 1990 (IM)