European Monetary Union Prof' Dr' Jovan Pejkovski

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European Monetary UnionProf. Dr. Jovan Pejkovski
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• Since 1 January 2002, more than 300 million
  European citizens have been using the euro as a
  normal part of daily life.
• It took only 10 years to get from the Treaty of
  Maastricht (February 1992), enshrining the
  principle of a single European currency, to the
  point where euro notes and coins were circulating
  in 12 EU countries.

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• This is a remarkably short time to carry through
  an operation that is unique in world history.
• The euro has replaced currencies that were, for
  many of the countries concerned, centuries-old
  symbols and instruments of their national
  sovereignty.

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• In doing so, the new currency has moved Europe
  considerably closer to economic union. It has
  also given EU citizens a much clearer sense of
  sharing a common European identity.
• With euro cash in their pockets, people can
  travel and shop throughout most of the Union
  without having to change money.

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• How was the idea of a single European currency
  born?
• As long ago as 1970, the Werner Report, named
  after the then Prime Minister of Luxembourg,
  proposed a convergence between the economies and
  currencies of the six EEC countries.
• The first step in this direction was not taken
  until March 1979, when the European Monetary
  System (EMS) was set up.

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• The EMS was designed to reduce variations in the
  exchange rates between the currencies of the
  member states.
• It allowed them fluctuation margins of between
  2.25 and 6. But its mechanisms were weakened by
  a series of crises caused by the instability of
  the US dollar and the weakness of some currencies
  that became prey to speculators, especially at
  times of international tension.

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• The need for an area of monetary stability was
  felt increasingly as Europe made progress in
  completing the single market.
• The Single European Act, signed in February 1986,
  logically implied convergence between European
  economies and the need to limit fluctuations in
  the exchange rates between their currencies.

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• How could a single market, based on the free
  movement of people, goods and capital, be
  expected to work properly if the currencies
  involved could be devalued?
• Devaluing a currency would give it an unfair
  competitive advantage and lead to distortions in
  trade.

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• In June 1989, at the Madrid European Council,
  Commission President Jacques Delors put forward a
  plan and a timetable for bringing about economic
  and monetary union (EMU).
• This plan was later enshrined in the Treaty
  signed at Maastricht in February 1992.
• The Treaty laid down a set of criteria to be met
  by the member states if they were to qualify for
  EMU.

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• These criteria were all about economic and
  financial discipline
• --curbing inflation,
• --cutting interest rates,
• --reducing budget deficits to a maximum of 3 of
  GDP,
• --limiting public borrowing to a maximum of 60
  of GDP and
• --stabilising the currencys exchange rate.

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• In protocols annexed to the Treaty, Denmark and
  the United Kingdom reserved the right not to move
  to the third stage of EMU (i.e. adoption of the
  euro) even if they met the criteria.
• This was called opting out. Following a
  referendum, Denmark announced that it did not
  intend to adopt the euro. Sweden too expressed
  reservations.

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• There would have to be some way of ensuring the
  stability of the single currency, because
  inflation makes the economy less competitive,
  undermines peoples confidence and reduces their
  purchasing power.
• So an independent EuropeanCentral Bank (ECB) was
  set up, based in Frankfurt, and given the task of
  setting interest rates to maintain the value of
  the euro.

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• In Amsterdam, in June 1997, the European Council
  adopted two important resolutions.
• The first, known as the stability and growth
  pact, committed the countries concerned to
  maintain their budgetary discipline. They would
  all keep a watchful eye on one another and not
  allow any of them to run up excessive deficits.

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• The second resolution was about economic growth.
• It announced that the member states and the
  Commission were firmly committed to making sure
  employment remained at the top of the EUs agenda.

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• In Luxembourg, in December 1997, the European
  Council adopted a further resolution on
  coordinating economic policies.
• This included the important decision that
  "ministers of the States participating in the
  euro area may meet informally among themselves to
  discuss issues connected with their shared
  specific responsibilities for the single
  currency".

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• The EUs political leaders thus opened the way to
  even closer ties between countries that adopted
  the euro ties that went beyond monetary union
  to embrace financial, budgetary, social and
  fiscal policies.

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• Progress in achieving EMU has made it easier to
  open up and complete the single market.
• In spite of the turbulent world situation (with
  stock market crises, terrorist attacks and the
  war in Iraq), the euro area has enjoyed the kind
  of stability and predictability that investors
  and consumers need.

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• European citizens confidence in the euro was
  boosted by the successful and unexpectedly swift
  introduction of coins and banknotes during the
  first half of 2002.
• People appreciate being able to shop around more
  easily, now they can directly compare prices in
  different European countries.

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• The euro has become the worlds second most
  important currency.
• It is increasingly being used for international
  payments and as a reserve currency, alongside the
  US dollar.

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• Integration between financial markets in the euro
  area has speeded up, with mergers taking place
  not only between stockbroking firms but also
  between stock exchanges.
• An EU action plan for financial services is due
  to be implemented by 2006.

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STEP BY STEP TO THE EURO

• 7 February 1992 the Treaty of Maastricht is
  signed
• The Treaty on European Union and Economic and
  Monetary Union (EMU) is agreed in Maastricht in
  December 1991.
• It is signed in February 1992 and comes into
  force in November 1993.
• Under this treaty, the national currencies will
  be replaced by a single European currency
  provided the countries concerned meet a number of
  economic conditions.

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• The most important of the Maastricht criteria
  is that the countrys budget deficit cannot
  exceed 3 of its gross domestic product (GDP) for
  more than a short period. Public borrowing must
  not exceed 60 of GDP.
• Prices and interest rates must also remain stable
  over a long period, as must exchange rates
  between the currencies concerned.

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• January 1994 the European Monetary Institute is
  set up
• The European Monetary Institute (EMI) is set up
  and new procedures are introduced for monitoring
  EU countries economies and encouraging
  convergence between them.

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• June 1997 the Stability and Growth Pact
• The Amsterdam European Council agrees the
  stability and growth pact and the new exchange
  rate mechanism (a re-born EMS) designed to ensure
  stable exchange rates between the euro and the
  currencies of EU countries that remain outside
  the euro area.
• A design is also agreed for the European side
  of euro coins.

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• May 1998 eleven countries qualify for the euro
• Meeting in Brussels from 1 to 3 May 1998, the
  Unions political leaders decide that 11 EU
  countries meet the requirements for membership of
  the euro area.
• They announce the definitive exchange rates
  between the participating currencies.

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• 1 January 1999 birth of the euro
• On 1 January 1999, the 11 currencies of the
  participating countries disappear and are
  replaced by the euro, which thus becomes the
  shared currency of Austria, Belgium, Finland,
  France, Germany, Ireland, Italy, Luxembourg, the
  Netherlands Portugal and Spain. (Greece joins
  them on 1 January 2001).

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• From this point onwards, the European Central
  Bank takes over from the EMI and is responsible
  for monetary policy, which is defined and
  implemented in euro.
• Exchange operations in euro begin on 4 January
  1999, at a rate of about 1 to 1.18 US dollars.
• This is the start of the transitional period that
  will last until 31 December 2001.

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Irevocably fixed euro conversion rates

• 1 Euro

• 40.3399 Belgian francs
• 1.95583 Deutsche Mark
• 340.750 Greek drachmas
• 166.386 Spanish pesetas
• 6.55957 French francs
• 0.787564 Irish pounds
• 1,936.27 Italian lire
• 40.3399 Luxembourg francs
• 2.20371 Dutch guilders
• 13.7603 Austrian schillings
• 200.482 Portuguese escudos
• 5.94573 Finnish markkas

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• 1 January 2002 euro coins and notes are
  introduced
• On 1 January 2002, euro-denominated notes and
  coins are put into circulation. This is the start
  of the period during which national currency
  notes and coins are withdrawn from circulation.
  The period ends on 28 February 2002.
• Thereafter, only the euro is legal tender in the
  euro area countries.

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• Established by the EC Treaty, the ECB is embedded
  in the specific legal and institutional framework
  of the European Community.
• What distinguishes therefore the euro and the ECB
  from a national currency and a national central
  bank is their supranational status within a
  community of sovereign states.

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• Unlike comparable central banks, such as the US
  Federal Reserve System or the Bank of Japan,
  which are the monetary authorities of their
  respective national states, the ECB is a central
  authority that conducts monetary policy for an
  economic area consisting of 12 otherwise largely
  autonomous states.
• Another specific feature of EMU is the fact that
  the euro area does not encompass all EU Member
  States since the realisation of EMU follows an
  approach of differentiated integration.

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• QUESTIONS
• What is EMU?
• Gains and losses
• Rules of EMU
• Past The road to EMU
• Present The first five and half years 1999-2004
• Future Risk and reforms

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What is EMU?

• Common currency
• From 1 January 1999 irrevocably fixed exchange
  rates between 11, now 12, countries, The ins
• Common currency (notes and coins) and unit of
  account, the euro, from 2002
• Common monetary policy governed by European
  Central Bank in Frankfurt (ECB) from 1 Jan. 1999

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Three outs

• Exempted in Maastricht treaty
• Denmark, United Kingdom
• Not qualified
• Sweden (not in ERM) 56 No-vote in fall 2003

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Economic gain (long-run)

• Trade frictions Þ Trade Þ Increased
  specialization Þ higher productivity through
  comparative advantage and large scale production
  Þ GDP per capita Þ Welfare
• Large gain if
• Nation is trade dependent (small)
• EMU helps creating inner market

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Loss (short-run)

• No national monetary policy to counteract
  nation-specific (asymmetric) shock
• Small loss if
• 1) Small risk for asymmetric shock
• or 2) easy adjustment to asymmetric shock
• Flexible labor markets, or
• Large scope for international labor mobility, or
• Efficient fiscal policy

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Rules

• 1. Rules for ECB (Maastricht, 1991)
• 2. Stability and growth pact, SGP, 1997

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ECB goal

• Intermediate, legal goal Price stability,
  defined as
• Between 0 and 2 per cent inflation
• Wider goal of EMU increased welfare through 1)
  higher long-run growth (efficiency) and 2) more
  macroeconomic stability

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• Having adopted the euro as their single currency,
  the EU Member States that are part of the euro
  area have relinquished their monetary
  sovereignty.
• The ECB, as the core of the newly established
  central banking system called the European System
  of Central Banks (ESCB), has taken on
  responsibility for the monetary policy in the
  euro area.

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• Under the EC Treaty, the ESCB is entrusted with
  carrying out central banking functions for the
  euro.
• However, as the ESCB has no legal personality of
  its own, and because of differentiated levels of
  integration in EMU, the real actors are the ECB
  and the NCBs of the euro area countries.
• They exercise the core functions of the ESCB
  under the name Eurosystem.

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European System of Central Banks ESCB

• National central banks (NCB)
• European central bank (ECB)
• ESCB governed by
• The General Council of the ESCB
• The Governing Council of the ESCB
• The Executive Board of the ECB

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The General Council of the ESCB

• 25 national central bank governors in EU and
  chairman and vice chairman of ECB executive board
• Surveillance of the economy in non-EMU countries
• Prepares the introduction of the euro in the new
  countries

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The Governing Council of the ESCB

• National central bank governors in the 12 EMU
  countries and the members of the executive board.
• Council meets every other week to decide monetary
  policy
• Must work for price stability in the whole euro
  area average inflation weighted by country size

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Voting at ECB Council

• Board exclusive right to formulate propositions
  to vote on
• Board votes to stabilize EMU average.
• 63 wins EMU average outcome of voting
• (average wins over median vote)

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Independence of governing board

• Members
• Can not receive directives
• Directors have long (8 year) mandates
• Can not be reelected
• Motivation for independence
• Credibility of low inflation high since
  short-term motivation to increase inflation to
  achieve a) lower unemployment or b) reduce value
  of government debt is minimized
• ECB modeled after Bundesbank

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Control of ECB

• Reports to European Parliament
• Press conferences
• No minutes published

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• There are three main political and economic
  reasons why a system was established to carry out
  central bank functions for the euro, and not a
  single central bank
• 1. The establishment of a single central bank for
  the whole euro area (possibly concentrating
  central bank business in one single place) would
  not have been acceptable on political grounds.

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• 2. The Eurosystem approach builds on the
  experience of the NCBs, preserves their
  institutional set-up, infrastructure and
  perational capabilities and expertise
• moreover, NCBs continue to perform some
  non-Eurosystem-related tasks.

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• 3. Given the large geographic area of the euro
  area, it was deemed appropriate to give credit
  institutions an access point to central banking
  in each participating Member State.
• Given the large number of nations and cultures
  in the euro area, domestic institutions (rather
  than a supranational one) were considered best
  placed to serve as points of access to the
  Eurosystem.

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• 2.3.1 Basic tasks of the Eurosystem
• Article 105(2) of the EC Treaty and Article 3.1
  of the Statute of the ESCB confer upon the
  Eurosystem the sole competence for the following
  basic tasks
• to define and implement the monetary policy of
  the euro area
• to conduct foreign exchange operations
• to hold and manage the official foreign
  reserves of the euro area Member States
• to promote the smooth operation of payment
  systems.

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• Other related tasks include
• the issue of euro banknotes as the only such
  notes to have the status of legal tender in the
  euro area (Article 106(1) of the EC Treaty and
  Article 16 of the Statute)
• the collection of the statistical information
  necessary for the tasks of the Eurosystem
  (Article 5 of the Statute).

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Intra-Eurosystem legal acts

• There are three intra-Eurosystem legal acts,
  namely
• ECB guidelines
• ECB instructions
• internal decisions.
• ECB guidelines and ECB instructions are special
  types of legally binding and judicially
  enforceable instruments. They are enacted to
  ensure that decentralised operations are carried
  out consistently by the NCBs in line with the
  internal division of competences.

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• The monetary and economic aspects of EMU have
  been organised differently.
• Whereas monetary and exchange rate policies have
  been denationalised and centralised at the
  Community level, the responsibility for economic
  policy has remained with the Member States
  although national economic policies are to be
  conducted within a Community framework for
  cooperation in macroeconomic policies.

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• The Broad Economic Policy Guidelines (BEPGs) are
  the principal policy instrument for coordinating
  national economic policies.
• They contain orientations for the general conduct
  of economic policy and make specific
  recommendations to each Member State and the
  Community.

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• By outlining the necessary measures in different
  policy fields public finances, structural
  reforms, taxation, labour market regulation or
  training and education the BEPGs set the
  standard against which subsequent national and
  European policy decisions must be measured.

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The stability and growth pact

• Budget deficit lt 3 of GDP
• Government debt lt 60 of GDP
• Exceptions
• budget deficit gt 3 , if serious downturn (real
  GDP growth lt 0,75 )
• Government debt gt 60 , if debt is decreasing.

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Purpose of Stability and growth pact (SGP)

• Avoid spill-over effects
• Rising interest rates
• Risk of financial crisis
• Inflation through ECB buying government debt (
  printing press financing)
• The Bail-out problem The too large to fail
  syndrome

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Sanctions

• Interest-free deposit 0,2 of GDP 10 of the
  deficit that is over 3
• The deposit is transformed to a fine if the
  deficit still is above 3 after three years
• Commission issues recommendations and warnings
  acc. to Excessive Deficit Procedure (EDP)
• Council (ECOFIN) must decide on sanctions
• Commission has sued the Council at the European
  Court of Justice for breach of SGP, verdict June
  2004.

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Forces

• Interaction between political initiatives and
  legal procedure with binding agreements
• Focus on gains
• Focus on inner market
• EMU a political and economic project
• The German reunification 1989

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The first five and half years1999-2004

• Plus
• Stable euro
• Stable inflation
• Increased financial integration

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The first five years cont.

• Minus
• Relatively large spread of business cycle
  positions and inflation across members
• Debate over ECB goals, procedures and
  accountability
• Breach of SGP
• Low growth
• Too restrictive monetary policy?
• Big external shocks
• Euro not large reserve currency

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The futureMonetary policy risks and reforms

• 1. Enlargement average EMU inflation target
  threatened by many small countries
• reform new voting procedure to lessen influence
  of small countries
• 2. Central lender of last resort national bank
  supervision Þ increased risk for system-wide
  financial crisis
• reform European-level bank supervision
• 3. Degree of short-run stabilization
• reform increased accountability for ECB

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Fiscal policy risks and reforms

• Counteracting asymmetric shocks reforms
• EU fiscal policy transfers
• Labor market reforms
• Increased labor mobility
• Change SGP
• Scrap deficit rule, only debt rule
• redefine deficit as structural (cyclically
  adjusted) deficit to avoid pro-cyclical policy
• spending limits and other national institutional
  safeguards

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References

• Paul De Grauwe Economics of Monetary Union.
  Oxford University Press, 2003
• EMU after 5 years. 2004. European Commission,
  Directorate-General for Economic and Financial
  affairs
• http//europa.eu.int/comm/economy_finance/publicat
  ions/european_economy/eespecialreport0401_en.htm
• www.ecb.org