The European Monetary Union (EMU) represents countries within the European Union that have agreed to have a common currency, the euro, and a common monetary policy. As of July 2008, 15 of the 27 countries that form the European Union were part of the EMU.
The EMU is the culmination of the process that began in 1971. Just before what was to be the advent of the floating exchange rate regime in 1973 after the collapse of the Smithsonian agreement of 1971, European Common Market (later to be known as European Union) countries had agreed to stabilize the values of their currencies against each other within a narrow band. A new set of parities had been agreed to in 1971, but the central banks were still responsible for maintaining the exchange rates of their currencies within bands of ± 2.25 percent agreed at the Smithsonian Institution.
In 1972 Common Market countries agreed to maintain parities of their currencies within a narrower band of ± 1.25 percent (called a snake) than the band within which the same currencies could float against the dollar (called a tunnel) set by the Smithsonian agreement. The system came to be known for a while as the “snake within the tunnel.” After the collapse of the Smithsonian agreement in 1973, it was agreed that the “snake” would be retained but the “tunnel” would be abandoned. Other industrialized countries had by that time adopted the fluctuating exchange rate system in which the markets determined the values of the currencies.
The turbulence that followed the advent of the floating rate regime proved incompatible with the goal of promoting intra-union trade and integration of the Common Market economies. To counter the effects of the volatility of exchange rates, a European Monetary System was established in March 1979. The centerpieces of this system were (1) the Exchange Rate Mechanism that limited the exchange rate movements between the currencies of the member countries to within ±2.25 percent (± 6 percent for Italian lira) of the established parity rates, and (2) a basket currency called European Currency Unit (ECU). The exchange rates were to be maintained within their defined bands through a European Monetary Cooperation Fund. One of the unique aspects of this Exchange Rate Mechanism was that when an exchange rate between two currencies moved close to one of the limits defined by the 2.25 percent bands, both the countries whose currencies constituted that exchange rate were required to intervene in the foreign exchange market. The usual practice in the international financial markets had been that the country whose currency depreciated with respect to others was required to intervene and protect the value of the currency.
The Cooperation Fund was also used to coordinate the monetary policies of member countries. The basket currency ECU was an artificial concept that consisted of fixed amounts of national currencies. There were nine national currencies in the basket in 1979 and 12 by 1989 (addition of more currencies was barred by the Maastricht Treaty). ECU was to be used only for settling accounts between countries and in financial markets. Actual notes and bills denominated in ECU were never issued, although individuals could open bank accounts denominated in ECUs. Over time, the currency became a popular unit for issuance of financial instruments such as bonds.
The foundations of the European Monetary Union were laid in December 1991 when the Maastricht Treaty was put forward for approval by member countries. In spite of the currency crisis of 1992–93, and initial rejections by voters in some countries, the treaty was adopted in November 1992.
The essence of the treaty was the formation of a monetary union and adoption of one currency. The common currency would be issued by the European Central Bank (ECB) and ECB would conduct the monetary policy for the countries using the common currency. These countries would give up their control over the monetary policy in their economy. Countries’ existing central banks would become instruments of ECB.
Following the recommendations of the original report, countries were allowed to join the monetary union if they met all four of the following convergence criteria—known as Maastricht criteria—established in 1998. Countries have the option of “opting out” of the union.
- Fiscal deficits: The government deficit must not exceed 3 percent of the country’s gross domestic product and the total government debt must not exceed 60 percent of the gross domestic product—declining debt level is, however, acceptable.
- Price stability: The inflation rate of the country over the previous year must not exceed by more than one and a half percentage points the average inflation rates of the three member states with the lowest inflation rates.
- Interest rates: The long-term nominal interest rate must not exceed by more than two percentage points the average of the long-term interest rates of the three member states with the lowest interest rates.
- Exchange rate: The exchange rate of the country must have remained within the fluctuation margins (± 15 percent since the 1992–93 exchange rate crises) provided for by the exchange-rate mechanism and must not have faced severe tensions for at least the last two years before entry.
In addition, it is required that there be legal compatibility for the central bank to join the monetary union in the form of freedom from political interference. The treaty also requires compatibility on factors like balance of payments, integration of markets, and unit labor cost without setting specific numerical goals. These criteria are not applied very rigidly—the final decision as to whether a country will be allowed to join or not is political.
The European Monetary Union was formally launched on January 1, 1999, with 11 countries (Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal, and Finland). Euro was the name chosen for the common currency and its value was fixed in terms of the national currencies. Greece joined two years later. Three other countries have since joined the EMU (Cyprus, Malta, and Slovenia). Other countries (Bulgaria, Czech Republic, Denmark, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, Slovakia, Sweden, and the United Kingdom) are members of the EU but do not use the euro as their currency. Of these, Denmark and the United Kingdom have decided to “opt out” from participation, while the remainder (many of the newest EU members plus Sweden) have yet to meet the “convergence criteria” for adopting the single currency.
For the first three years, the euro was used simultaneously with the national currencies for financial statements and public accounts. Bank notes and coins were introduced on January 1, 2002, and by July 1 of that year old national currencies were no longer legal tender in their countries.
The European Monetary Union has not been an unqualified success. It has improved economic efficiency because introduction of one currency has eliminated risks associated with exchange rate changes within the euro area as well as transaction costs associated with conversions of currencies. After an initial bout of inflation resulting from the tendency of retailers to take advantage of conversion of prices from national currencies into euro, prices in member countries have shown a tendency to convergence. Use of one currency has encouraged development of integrated financial markets. Early in 2008, the volume of bonds denominated in euros exceed that of dollar bonds for the first time ever. The share of euro in international reserves held by countries has increased over the past decade.
On the down side, countries are feeling the effects of loss of independence of monetary policy. When the euro rises in value against other currencies, as it has done since 2002, member countries feel the effects differently. Lacking ability to implement different monetary policies in the absence of full factor mobility may lead to loss of a country’s international competitiveness. This is indeed the case for Greece, Spain, Italy, and Portugal in 2008.
Introduction of a common currency in Europe has been one of the landmark events in European history. There is very strong will in large parts of Europe for this experiment to succeed. Chances are the euro will be around for a while.
- European Commission, EMU @ 10: Successes and Challenges after Ten Years of Economic and Monetary Union, European Economy, 2008, No. 2 (Office for Official Publications of the European Communities, 2008);
- European Commission, One Currency for One Europe: The Road to the Euro (Office for Official Publications of the European Communities, 2007);
- R. Lane, “The Real Effects of European Monetary Union,” Journal of Economic Perspectives (v.20/4, 2006);
- Anna Lipińska, “The Maastricht Convergence Criteria and Optimal Monetary Policy for the EMU Accession Countries,” Working Paper No. 896 (European Central Bank, 2008);
- P. Mongelli, “What Is European Economic and Monetary Union Telling Us About the Properties of Optimum Currency Areas?” Journal of Common Market Studies (v.43/3, 2005);
- Hanspeter Scheller, The European Central Bank—History, Role and Functions, 2nd ed. (European Central Bank, 2006);
- Emil Stavrev, “Growth and Inflation Dispersions in EMU: Reasons, the Role of Adjustment Channels, and Policy Implications,” IMF Working Paper, WP/07/167 (International Monetary Fund, 2007);
- Malcolm Townsend, The Euro and Economic and Monetary Union: An Historical, Institutional and Economic Description (John Harper, 2007);
- Wyplosz, “European Monetary Union: the Dark Sides of a Major Success,” Economic Policy (v.21/46, 2006).
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