by Sara Eisen
The Past: Setting the Course2
The European Economic and Monetary Union (EMU) and the single European currency are of historical significance for the economic and political development of Europe. The countries participating in the EMU brought their traditional national currencies together at the beginning of 1999 to form a common currency—the euro. By giving up their independent monetary policies, these states permanently ceded their existing national sovereignty over important aspects of policy to the supranational authority of the newly formed European Central Bank (ECB). This decision to forgo national sovereignty in favor of sovereignty at the supranational level was unprecedented in monetary history.
Initially, the integration of European monetary policy proceeded very slowly. This was largely due to the existence of the Bretton Woods fixed-exchange-rate system, which applied until the early 1970s, and controls on international capital flows, which were still being enforced in Europe at that time. From 1950 onward, international payment transactions in Europe were initially settled under the Organisation for European Economic Co-operation (OEEC) through the multilateral payments system of the European Payments Union (EPU). Toward the end of the 1950s, however, the system waned as several European countries made their currencies freely convertible.
With a growing level of international capital movements and mounting financial market integration came rising tensions in the international monetary system. This had an impact on the European Economic Community (EEC), established in 1957 by the Treaty of Rome. In the mid-1960s, the EEC members—of which there were six at that time—focused primarily on enhancing the exchange of information between national monetary authorities and intensifying efforts at cooperation among national governments, essentially by forming committees without decision-making powers. By the end of the 1960s, however, the need for more extensive cooperation was becoming obvious. Following up on a memorandum from the European Commission in February 1969 (referred to as the Barre Plan), a working party led by the then prime minister of Luxembourg, Pierre Werner, developed a plan to create the EMU. On the basis of this Werner Plan, the European Council took a decision of principle in March 1971 that the EMU was to be achieved progressively by 1980.
However, the 1971 dollar crisis, when the dollar’s link to gold was severed amid concerns that the United States did not hold enough gold to redeem foreign-owned dollars, prevented the implementation of a formal resolution by the Council of Ministers of the European Communities (EC). Some countries, including the Federal Republic of Germany, temporarily abandoned the fixed link to the U.S. dollar and allowed their currencies to float freely. With the Washington monetary agreement of December 1971 (the Smithsonian Agreement), an attempt was made at an international level to restore stable exchange-rate parities. However, the disadvantage for the EC was that the general widening of the fluctuation margins against the U.S. dollar meant that exchange rates between EC currencies could fluctuate within an overall range of 9 percent. This widening of margins and its implications for the EC’s agricultural policy, for instance, gave fresh impetus to efforts to create a special arrangement with narrower margins within the EC.
On March 21, 1972, the EC Council of Ministers adopted a resolution that was given concrete form through the Basel Accord and put in force on April 24, 1972. Among other things, it established the European “currency snake” and the European Monetary Cooperation Fund (EMCF). In the snake, the EC member states were to undertake to allow their currencies to fluctuate against one another within a range of only ±62.25 percent. The linked European currencies were able to move freely against other currencies, especially the U.S. dollar, which was floated in 1973.
Initial experience with the stabilization of intracommunity exchange rates showed that in the long term, a system of fixed exchange rates could work only between countries with sufficiently similar approaches to economic policy and a corresponding degree of economic convergence. In an appraisal dated April 1973, the European Commission concluded that only some of the envisaged progress toward integration had been made. In particular, the commission considered it necessary to transfer real economic policy powers to community bodies. The member states found this unacceptable, and a negative decision was made regarding starting the second stage of the EMU in line with the Werner Plan. Ultimately, the EMU project of that time failed because of fundamental differences of opinion regarding the objectives being pursued through the EMU and, in particular, because of the EC countries’ unwillingness to subject themselves to a common stability objective. Consequently, their economic policy responses to the first oil crisis also diverged greatly.
The primary goal of the European Monetary System (EMS) was to strengthen monetary policy cooperation to create an area of monetary stability in Europe. The EMS helped to initiate far closer currency cooperation among member states, and in the 1980s, it also reinforced the growing willingness to see a closer convergence of economic and monetary policy among them. The EMS prompted most member states to gear their economic and monetary policies to developments in the most economically stable countries in the EC.
In June 1988, the European Council commissioned a working party to prepare for the EMU. The working party was chaired by Commission President Jacques Delors and included the EC central bank governors and three independent experts. It produced a report in April 1989 (referred to as the Delors Report) that proposed that the EMU be achieved in three stages. This project was approved by the European Council, which decided that the first stage of the EMU should begin on July 1, 1990, and that two intergovernmental conferences should be convened to prepare the amendments to the treaty, which were required in order to ensure that the further stages could be implemented. The outcome, after a year of discussion, was the Treaty on European Union, which was approved by the Heads of State and Government in Maastricht in December 1991. This Maastricht Treaty came into force on November 1, 1993, with the completion of national ratification procedures and formed the legal foundation for the further stages that were necessary to make the EMU a reality.
The First Stage
The first stage of the EMU was primarily concerned with gearing the national economic and monetary policies more closely to the requirements for monetary stability and budgetary discipline within the EC. This was to be achieved primarily by greater coordination of national economic and monetary policies.
The council decision on the attainment of progressive convergence in economic policies and performance during Stage 1 of the EMU introduced multilateral surveillance as a new coordination instrument for the community. This new innovative instrument covered all aspects of economic policy, both short and medium term, with particular emphasis on budgetary policy. In addition to the biannual surveillance procedures, the Council of Economic and Finance Ministers (Ecofin Council) was also able to make use of ad hoc consultations if economic developments within a member state or outside the community posed a risk to economic cohesion. The new coordination procedure was intended to initiate a learning process that would increasingly lead to compatible economic policies. The success of this process hinged crucially, however, on the willingness of the member states to comply. Apart from the freedom to publish its economic policy proposals and rulings, the council had no means of exerting pressure to make the member states subject their economic policy to the interests of Europe as a whole.
Another major innovation in the first stage of the EMU was the new approach to monetary policy cooperation. The tasks of the Committee of Governors established in 1964 were expanded by the Ecofin Council decision of March 12, 1990, on cooperation between the central banks of the member states of the EC. On the basis of a new mandate in which the objective of price stability was expressly given priority, the Committee of Governors was now able to express opinions to the national central banks on the orientation of monetary and exchange-rate policy, and also to express opinions to the Council of Ministers or individual governments. The Committee of Governors helped pave the way for the creation of the Europea
n Monetary Institute (EMI), established in the second stage of the EMU, which placed cooperation among the central banks on a new institutional footing.
The Second Stage
In keeping with the Maastricht Treaty, the second stage of the EMU began on January 1, 1994, and served to prepare for the transition to the final stage. This stage had two primary aims. The first was to create the legal, institutional, and organizational preconditions for the completion of the EMU in the third stage. The second was to intensify further the monitoring and coordination of economic policy so that a high degree of long-term convergence within the community could be achieved as a necessary prerequisite for entry into the final stage. Attention was focused on budgetary policy because the convergence criteria set out in the treaty could be met only if the member states followed a sound budgetary policy.
Pursuant to Article 121 of the EC Treaty, read in conjunction with the protocol on the convergence criteria referred to in Article 121 of the EC Treaty, a country’s eligibility for joining the EMU was to be assessed using the following four criteria: (1) the member state has to demonstrate sustainable price stability, (2) the government’s financial position, measured using the reference values set in the treaty, must be sustainable in the long term, (3) the member state must have participated in the exchange-rate mechanism of the EMS and have observed the normal margins without severe tensions and without devaluing for at least two years prior to the test, and (4) long-term interest rates may be no more than an average of two percentage points above the reference value of, at most, the three member states with the greatest price stability over a period of one year before the test.
The ban prohibiting central banks from lending to the public sector, which came into force at the start of the second stage, and governments’ renunciation of privileged access to financial services institutions were likewise aimed at strengthening budgetary discipline. These provisions, which continued to apply after the introduction of the euro, ultimately forced the public sector to raise funds on market terms in the credit and capital markets. This was intended to strengthen budget discipline and thus eliminate a potential source of inflation.
In the second stage of the EMU, the economic policy of most EU member states was completely focused on meeting the convergence criteria laid down in the Maastricht Treaty. The pressure exerted on those member states that wished to participate under these criteria as entry requirements for the third stage, combined with the decision to enter the third stage on January 1, 1999, led to a notable convergence of key economic data in most EU member states.
As a result of this development, and taking into account the EMI and European Commission convergence reports, the Ecofin Council determined on May 1, 1998, that, in its assessment, 11 member states (namely, Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain) met the preconditions for the introduction of the single currency. It recommended introducing the euro in these 11 countries on January 1, 1999. On the basis of this recommendation and of the European Parliament’s opinion on the matter, the European Heads of State and Government confirmed the next day that the countries named in the recommendation met the necessary criteria for introducing the euro.
The Third Stage
On January 1, 1999, the euro became the common currency in the euro area, comprising the 11 member states that had qualified by meeting the convergence criteria. The start of the third stage of the EMU saw those 11 states pass their monetary sovereignty to the EC. The responsibility for the single monetary policy in the euro area was transferred to the ECB Council. On January 1, 2002, after the preparations for the cash changeover were complete, the euro was introduced physically in the form of euro-denominated banknotes and euro- and cent-denominated coins.
The Present: Benefits and Reforms
A euro crisis?
Today, at least 10 years after euro notes and coins were first introduced in the euro countries, it is fair to say that the euro has lived up to its proponents’ expectations. Inflation is low, the currency is strong, and the euro’s role as one of the world’s most prominent reserve currencies is increasing.
Stable Inflation Rate at a Low Level
The euro has ensured internal price stability. De Grauwe (2008) argues that the “inflation record in the euro zone has been outstanding,” even during crisis years. Since the foundation of the EMU, the annual inflation rate within the euro zone has remained within the ECB’s target framework of 2 percent on average. The euro “has provided price stability to previously inflation-prone countries” (Pisani-Ferry and Sapir, 2009). Even in Germany, inflation rates have so far been lower than at the time of the deutsche mark. Since 1999, inflation in Germany (at 1.5 percent per annum) has, on average, been lower than it was during the last three decades of the deutsche mark era (when it stood at 3 percent per annum; see Figure 3-1). The euro also compares favorably against the U.S. dollar. While the eurozone inflation rate from 1999 to 2010 averaged 2 percent, inflation in the United States ran at 2.4 percent over the same period. In other words, over the course of just one decade, the U.S. dollar has lost about 20 percent of its purchasing power in comparison with the euro.
Figure 3-1 Price Development in Germany Before and After the Introduction of the Euro
Source: Federal Statistical Office of Germany
Stable Exchange Rate and Reserve Currency
Although the external value of a currency is not a value per se, it is important for psychological reasons. In scenarios in which a currency’s price is decreasing against the prices of other major currencies, analysts immediately fear capital flight and a loss of trust. The euro is also doing very well in this regard and has ensured external price stability. When it was introduced as an accounting currency, it was worth only US$1.18, and when euro notes and coins were physically introduced, its value even lay below parity with the U.S. dollar. Since then, the euro has traded at well above that rate (see Figure 3-2). The euro has also held up in comparison with the deutsche mark. The latter reached its all-time high against the U.S. dollar in May 1995 (when it was worth US$0.74, which was approximately the same as the exchange rate between the dollar and the euro in early 2012).
Figure 3-2 ECB Reference Exchange Rate, U.S. Dollar to Euro
Source: ECB
The euro has established itself as one of the world’s leading reserve currencies, surpassed only by the U.S. dollar (see Figure 3-3). While other internationally important currencies, such as the U.S. dollar and the yen, have seen their share of global currency reserves shrink, the percentage held in euros has continuously grown, from just under 18 percent in 1999 to around 26 percent in December 2010.3
Figure 3-3 Composition of Foreign Exchange Reserves (Average for 2001–2010)
Source: IMF COFER database
Benefits of the Euro
The countries of the euro zone benefit considerably from the fact that the “euro is as stable and credible as the best-performing currencies previously used in the euro area countries” (ECB, 2011). There is widespread agreement among experts that eurozone countries draw more benefits from the euro than they drew from strong and stable national currencies. These benefits go well beyond price and exchange-rate stability.
Studies on the EMU’s effect on trade yield different outcomes in terms of numbers; while using different methodologies, they still all suggest that the EMU has had a positive effect: “[T]he effect of EMU on bilateral trade between member countries ranges between 5 and 10 percent, when compared to trade between all other pairs of countries, and between 9 and 20 percent, when compared to trade among non-EMU countries” (Micco, Stein, and Ordoñez, 2003). One major reason for this is that considerable savings are realized every year by companies trading within the eurozone. The introduction of the euro eliminated foreign exchange transaction costs resulting from (1) buying and selling foreign currencies on the foreign exchange markets, (2) protecting oneself against adverse exchange-rate movements, (3) making cro
ss-border payments in foreign currencies, which entail high fees, and (4) keeping several currency accounts that make account management more difficult (ECB, 2011).
In the past, exchange-rate costs and risks hindered trade and competition across borders. The euro eliminated exchange-rate fluctuations and, therefore, foreign exchange risks within the euro zone, thus facilitating business planning and increasing cross-border investments. Experts estimate that the average positive effect of the euro on aggregate foreign direct investment (FDI) flows within the euro area is about 15 percent, while its impact on FDI flows from outside the euro area is about 7 percent (Mongelli and Wyplosz, 2009). Consumers naturally benefit from the euro as well because it facilitates price comparisons, thereby increasing competition and lowering prices. The single currency also gives tourism a significant boost because it makes traveling across European countries much easier.
Besides its economic benefits, the common currency is of inestimable political value. The euro is the most far-ranging result of and commitment to European integration—it is both a symbol of and a driving force behind that integration. According to research into public opinion, the euro is the most frequently mentioned EU symbol in the eurozone countries. When asked to say what the EU means to them personally, one out of two citizens in the euro area mentioned the euro, outranking “peace” and the “freedom to travel, study and work” (European Commission, 2010).
Sovereign Debt Crisis
The crisis, which began in 2010 in Greece, indicates that although the euro has been in good shape, the same cannot be said for all of the countries in the eurozone. Some of them have been severely affected by the sovereign debt crisis and face a high level of indebtedness—Greece has a debt-to-GDP ratio of 157.7 percent, Ireland 112 percent, and Portugal 101.7 percent (European Commission, 2011). The reasons are manifold. The sequence of serious crises has naturally placed a special burden on public budgets as a result of the emergency and economic stimulus packages that had to be introduced. However, the euro countries that are most indebted today are the ones that have too long pursued the wrong budgetary and fiscal policies while lacking competitiveness. A stunning market failure has made the situation still worse. Since the introduction of the euro, bond markets have not punished unsound fiscal and economic policies early enough. For a decade, the interest rates for euro countries were converging, although the countries’ national fiscal and economic policies diverged considerably (see Figure 3-4). The markets did not evaluate risks appropriately and exert discipline. They became increasingly risk-averse during the crisis, however, fueling it as a result.