Introduction

The formal objective of the Exchange-Rate Mechanism (ERM) of the European Monetary System (EMS) is the stabilisation, within generally narrow pre-agreed bounds, of member countries' nominal exchange rates. Since the EMS is an exchange-rate mechanism of a customs union, however, it must be expected (if it is to survive in the long run) to ensure that member countries' competitiveness is protected; otherwise, the protection-reducing achievements of the customs union must be called into question as countries seek to restore their terms of trade. This is to suggest that, at the same time as the immediate and formal objective of the system is to stabilise nominal rates of exchange, its inner long-run rationale involves a requirement on real rates of exchange. This fundamental ambiguity accounts for what Goodhart (1986) has termed an ‘unholy alliance’ among those advocating British participation in the ERM – between those who seek to consolidate the counter-inflation gains of recent years and those who wish to protect the competitiveness of sterling from any repetition of the devastating overappreciation of the 1980–1 period. The two objectives are clearly not compatible without a convergence of inflation, at equilibrium levels of activity and external balance, between the member countries. In the period of the system's functioning so far, progress towards this objective has been provided in the historical context of the second OPEC oil shock, which induced among countries generally – and members of the EMS in particular – a strong desire to reduce inflation. Given Germany's low inflation rate and (recent) historical reputation for counter-inflationary policy, this has implied to a degree convergence on the German standard.