"Chaos in the Currency Markets" demonstrates the challenges and opportunities in pursuing a fixed exchange rate system. The currency crisis of September 1992 almost led to a collapse of the EMS, but the EU are forging ahead to create an Economic Monetary Union by 2002.

The European Monetary System (EMS), established in 1979, is a system of fixed exchange rate (similar to Bretton Woods System that collapsed in 1971) between the currencies of the member-countries of the European Union (EU). During the 1980s, the system was widely credited for closing the inflation rate differentials among member countries and was considered as a foundation to establishing a common currency for the EU. The EMS consists of two instruments:

ECU (European Currency Unit) – is a basket of currencies that serve as a unit of account for the EMS. The economic strength of the country determines the portion of the basket, and all exchanges go through the ECU.

ERM (Exchange Rate Mechanism) – each national currency in the EU is given a central rate via the ECU. These central rates provide the flow for a series of bilateral rates, which provides the operational basis for the ERM parity grid. Within this parity grid, a currency may not depart by more than 2.25 percent (6 percent for new members, such as Britain and Spain) bilateral intervention bandwidth. Intervention by the stronger economic country is required if the weaker currency hits the outer margin by buying a weaker currency (and vice versa). A second mechanism is the provision of short-term loans via credit lines from pools of ECU. The availability and the size of member quota are determined by the loan size.

However, the system was exposed to speculative pressures in 1992 that nearly shattered the validity of the fixed exchange rate system of the EMS. Speculators bet on the devaluation of the EU currencies against devaluation of EU against the Deutch Mark. Italy and Britain were forced to raise interest rates, which eventually forced them out of the EU and transition to a "managed float" system. The speculative pressures turned against France, which was forced to raise interest rates and exhaust their reserves. Both the central banks of France and Germany stepped in to defend the currency valuation, which provided a temporary relief in the speculative pressures.

Currency speculation has experienced "hyper-growth" in the 1990s. This growing number of transactions has increased the power of speculative pressures on the currency market. While speculative influence power is increasing the European Union’s economic strength has been weakened since the change of the United Kingdom and Sweden to a managed float system. This will only intensify over time as currency speculation and Eastern European country’s membership will grow and create new challenges for the EU. The EU must take action NOW or reach the same end as the Bretton Woods agreement.

In looking at the structure of the post-1992 European Union, some weaknesses are apparent.

Here, commitment to reserves is more important than the reserves themselves. As noted in 1992, England, Sweden, and Italy were unsuccessful in defending their currencies. However, when France and Germany announced their intention to defend attacks against the French Franc (FF), the speculation subsided. This shows the dependence of the EU for quick decisive action and intervention of its largest members.

The EU common currency is a weighted conglomeration of member currencies. Like Bretton Woods, the fixed rate system is only as strong as the common currency. Larger currencies such as Germany are still susceptible to speculation pressures. Interest rate differentials involving the DM and the Dollar sparked the fuel for the speculative bandwagon effect. Thus, larger economic EU members must carefully keep their inflationary rates, interest rates, and valuations under stable control to avoid a similar situation in 1992.

Currency speculators bet on the fact that EU members had to intervene when currencies fluctuated outside the 2.25% intervention band. Thus, the "bandwagon effect" by investors can push country currencies outside these bands. As a result in 1992, the "bandwagon effect" was so great that both Sweden and England were unable to defend against these pressures and were forced to let their currencies float freely.

Looking to the future, the European Union’s success is dependent on being able to defend against speculative pressures which now have the volume amounts ($32 trillion annually) which are larger than the entire EU’s reserves combined. They can attack this through EU member commitment to unity. Our recommendations are broken into two categories.