Introduction

This study looks at the question of whether, and under what circumstances, the European Monetary System (EMS) might be stable and sustainable without the support of capital controls. Most of the countries participating in it have maintained capital controls over the years since the start of the EMS (1979), and these controls are widely thought to have been essential to its successful operation, permitting intermittent and at least partly predictable discrete realignments to take place without large capital flows and large fluctuations in onshore interest rates in devaluing countries. Currently, exchange controls are being dismantled, and discussions are now under way to remove all remaining controls, following the meeting of European Commission finance ministers in Nyborg (Denmark) in September 1987. The question of how the EMS is expected to operate in the absence of controls is one which naturally arises.

A variety of views on the possibility of sustaining something like the EMS in its present form without capital controls have been expressed. Giavazzi and Pagano (1986), for example, have commented that the effects of greater capital mobility would be greater volatility of shortterm interest rates but that the costs would be relatively small, because direct costs are offset by the greater credibility of low inflation policies in countries such as Italy with relatively high inflation.