Take a British company which makes valves and exports them to Germany. It aims to sell the valve for pounds 10. This includes pounds 9 of cost plus pounds 1 of profit. If the exchange rate against the German mark meant that pounds 1 was worth DM3, then German customers would be charged DM30 for each valve. But what if the pound suddenly dropped in value so pounds 1 was equal to DM2? The valve would only cost DM20 and German customers would demand many more of them, probably more than the company was able to produce.
Conversely, if the pound rose to be worth DM4, the valves would have to be sold for DM40 to make pounds 10. The company would face a loss because sales would drop sharply at the higher price or - if the German price was kept constant - the company would receive only pounds 7.50 per valve, making a loss of pounds 1.50 on each one.
Fixing or limiting the variation between exchange rates is aimed at reducing these uncertainties. In the case of the EMS this was seen as particularly important because the European economies are small relative to the likes of America and Japan. Many European companies thus sell their goods elsewhere in the Continent.
Under EMS rules each currency can stray only 2.25 per cent either side of its target central rate against other member currencies. Until last week the pound, the escudo and the peseta were allowed to vary by 6 per cent because they were more volatile. But last Wednesday the British government gave up its attempt to keep the pound within its limits and pulled out of the system. The Italian lira, with 2.25 per cent bands, followed suit.
There are two main ways in which countries try to keep to their bands. The Bank of England was last week reported to have spent nearly half Britain's dollars 45bn ( pounds 25bn) stockpile of foreign currencies to buy more than pounds 10bn in sterling to prop its price up. It also raised interest rates twice in three hours - from 10 to 15 per cent - in an attempt to make holding pounds more attractive to overseas investors. Both moves failed because currency dealers feared correctly that the Government would give up the battle. When Norman Lamont, the Chancellor, announced he would no longer attempt to keep the pound in its band, the markets were free to sell sterling below its previous DM2.7780 floor level and it fell to around DM2.60.
Spain responded differently. It remains committed to keeping the peseta within a given band, but has moved the band downwards by 5 per cent. Italy moved the lira band down 7 per cent last Monday, but still failed to defend it. These 'realignments' were common in the early years of the system because European economies - and particularly their rates of inflation - differed widely. There were three in 1979, two each in 1981 and 1982, one each in 1983 and 1985.
To see why inflation undermines the credibility of bands, take another look at our valve maker. Say prices rise 10 per cent a year in Britain, but are stable in Germany. After a year the exporter will want pounds 11 per valve. If pounds 1 is worth DM3, the price in Germany will rise from DM30 to DM33, but valves made by German competitors will not change in price. Unless the pound weakens against the mark to keep the price of the British-made valve stable, the exporter's sales will fall.
Until last week there had been no realignments since Britain joined the ERM in October 1990, and only one in the previous three years. France, in particular, saw the ERM as a dry run for permanently fixed exchange rates and a single currency. But last week's chaos has changed all that.