Towards the European Monetary Union (EMU)

1. Towards the European Monetary Union (EMU) • Successes of the single market program, the EMS and the economic convergence created a favorable economic and political climate for the establishment of a full-fledged monetary union. • EMS was successful in insulating intra-European trade from turbulence in global currency markets and from the wild swings in the value of the dollar that marked the Reagan years. • As EMS evolved into a de facto fixed rate regime, the logical step became a move to full EMU. • Recognition that single market program was inconsistent with different currencies within the EC as currency fluctuations affected the prices of goods and services and constituted a barrier to trade (transaction costs). “One Market, One Money”

2. Delors Report (1989) and the Maastricht Treaty (1991) • Based on principles of gradualism and convergence. • Delors Report was approved in 1989 (Madrid European Council) • Defines three stages in the process towards monetary union. First Stage (from 1 July 1990 to 31 December 1993): The EMS countries abolished all remaining capital controls (Free movement of capital). The degree of monetary cooperation among the EMS central banks were strengthened. Realignments were possible. Member states undertake programs that make possible fixed exchange rates. Second Stage (from 1 January 1994 to 31 December 1998): A new institution, the European Monetary Institute (EMI) was created.

3. The Maastricht Treaty (1991) • The European Monetary Institute (EMI) was a precursor to the European Central Bank (ECB) and was created to • Coordinate monetary policies and ensure price stability. • Prepare the establishment of the European System of Central Banks (ESCB) overseen by the European Central Bank (ECB). • Prepare the introduction of a single currency in stage 3. • Examine the achievement of economic convergence among EU states as established by the Maastricht Treaty (1992).

4. The Maastricht Treaty (1991) • Third (Final) Stage (from 1 January 1999 to 31 June 2002): The exchange rates were irrevocably fixed. Establishment of the European Central Bank in charge of the European monetary policy.The ECB issued the euro. The transition to this final stage was made conditional on a “number of convergence criteria.” • Third Stage was divided into three sub-stages: • From 1 January 1999 until 31 December 2001, the national currencies continued to circulate alongside the euro, albeit at irrevocably fixed exchange rates. Commercial banks used the euro in interbank transactions. Individuals had the choice of opening euro accounts. Note that during this period the euro did not exist in the form of banknotes and coins. All transactions between the ECB and commercial banks were in euros. New issues of government bonds were also in euros.

5. The Maastricht Treaty (1991) • During the period 1 January to 1 July 2002, the euro would replace the national currencies which would lose their legal-tender status. • From 1 July 2002 on, a true monetary union would come to existence in which the euro would be the single currency managed by one central bank, ECB. • The Maastricht Treaty was finally ratified in the fall of 1993 and 12 countries (except UK, Sweden and Denmark) began to implement Stage 2 of EMU- the convergence phase in which states were required to cut their deficits and lower inflation to qualify for Stage 3.

6. What is Monetary Union? Weak version • Fixed bilateral exchange rates (rigidly or within a band) • Each member undertakes monetary policies to defend the rates Strong version • Individual currencies are replaced by a single currency • Individual monetary authorities are replaced by a single authority

7. Maastricht Treaty (1991): The Convergence Criteria for Membership in EMU • A country can join the union only if: • Price stability • For the preceding year the average inflation rate must not exceed that of the three best-performing states (with lowest inflation) by more than 1.5%. • Interest rate convergence • For the preceding year the average long-term interest rate must not exceed that of the best three states (with lowest inflation) by more than 2%. • Budget discipline • Government budget deficit must be less than 3% of GDP. • Government (Public) debt cannot exceed 60% of GDP.

8. Maastricht Treaty (1991): The Convergence Criteria for Membership in EMU • Exchange rate stability • During the two years preceding the entrance into the union, no exchange rate realignments. This means two years membership in the ERM without devaluation. • Independent CB with price stability as its primary objective. • Motivation for the Maastricht Criteria: • Impose fiscal prudence and prevent free riding (e.g. on low interest rates) • Eliminate threat of national governments seeking bail-outs from the ECB. • Increase stability of the EMU and the common currency. • Stability and Growth Pact (1996)

9. The European Monetary Union (2002) • In May 1998, 11 EU countries satisfied the convergence criteria with the exception of Greece. Denmark, Sweden and the UK decided to stay out of Euroland despite the fact that they satisfied the convergence criteria. Sweden deliberately failed to satisfy the requirement of ERM membership. Danish subjected its entry to a national referendum.

12. Implications of EMU • Economic Union • Customs Union: Free movement of goods and services, mutual recognition of norms and standards (i.e. no non-tariff barriers), common external tariff. • Free mobility of capital and labor • EU-wide competition policy • Coordination of macroeconomic policies • Economic and social cohesion (solidarity) and regional development.

13. Implications of EMU (II) • Monetary Union • Irrevocably fixed exchange rates • Replacement of national currencies by the euro. • Single monetary policy determined by an independent ECB • Restrictions on and coordination of national fiscal policies

14. Implications for Macroeconomic Policy • Single Interest Rate set by the ECB • Exchange rates can not be readjusted to correct for changes in “fundamentals” (e.g. inflation differential between two countries) • Single Monetary Policy ECB is nominally independent although representatives of national CBs sit on ECB council. • Monetary policy can not respond to country specific shocks. • Use of Fiscal Policy as an adjustment policy is limited by the Maastricht Criteria Prices may need to be more flexible (micro flexibility), labor mobility may need to bear a greater share of adjustment to shocks,  Increased need for “fiscal risk sharing”, case for fiscal federalism?

15. Costs and benefits of the Euro • Benefits: • Reduction in transaction costs. • Elimination of the exchange rate risk. • Greater competition leading to greater efficiency. • Greater integration among the European financial markets and greater investment efficiency. • Inflation discipline guaranteed by the independence of the European Central Bank. • Fiscal discipline as a requirement to enter and stay in the system. • Increase the urgency of structural reforms in Europe.

16. Costs: • The system of fixed exchange rates eliminate the possibility of using exchange rate adjustments as a policy tool in the presence of asymmetric shocks. • Individual countries cannot use monetary policy to face country-specific shocks. • Europe may not be an optimal currency area due to: • Likelihood of asymmetric or country-specific shocks. • Limited labor mobility. • Structural labor market rigidities. • Limited ability to use fiscal policy as a stabilization tool in absence of monetary independence. • Absence of a system of fiscal redistribution to insure against regional/national shocks.