The EMU and the ECB - How does the Eurosystem work

Contents

Introduction

1. Historical Background
1.1. The Road to the Euro (until 1999)
1.2. The Stability and Growth Pact (The Maastricht Criteria)
1.3. The Experiment Begins (1999-today)

2. Central Banking in Europe
2.1. The European Central Bank
2.2. The ECB’s Monetary Policy

3. Conclusion

Bibliography

Introduction

The creation of the European Monetary Union (EMU) and the introduction of the euro has been an experiment without comparable predecessor. The euro area combined has the second largest GDP in the world, only outperformed by the United States. Therefore, this historical event has been widely discussed, in different academic fields (economics, sociology, history, psychology and others), in different countries, and of course bars, newspapers and TV shows all around the world. As with probably every event of this impact, the opinions on whether the euro is a success or not are widely spread. This paper tries to give a brief overview on two major topics: the Stability and Growth Pact which sets the rules for the countries participating in EMU and the European Central Bank, the newly created institution which is set up to guard the price stability in the euro area and the confidence in the euro. The paper will first give an historical overview on the events that led to the creation of EMU, then, it introduces the Stability and Growth Pact (SGP) and the Maastricht Criteria. The field of economics is divided between supporters and opponents of the SGP therefore, their different points of view will be presented. Thereafter, the recent developments in the euro area will be discussed. The second part will present the ECB, the system it operates in and its functions. In order to include international financial theory, I briefly discuss the ECB’s monetary policy and its influence on inflation. Last but not least, a conclusion will present arguments for and against a successful euro, and also present my personal point of view.

1. Historical Background

1.1. The Road to the Euro

The euro today is the official currency of 12 of the EU Member States^[1] including all the countries that founded the predecessor of the European Union in 1957^[2]. However, a single currency was not even on the mind of the authors of the Treaties of Rome. At that time, all EEC countries were part of the reasonably well-functioning Bretton Woods system in which exchange rates were fixed but adjustable. This system remained relatively stable until the late 1960s when greater price and cost divergences between the EEC Member States led to several exchange rate and balance of payments crises. This in turn threatened to disrupt the created customs union and the common market for agricultural goods, which had been functioning quite successfully up to then. Even though monetary integration was tried in 1973^[3], it took until 1979 when the European Monetary System (EMS) was created. The EMS became an instrument for further monetary integration, mainly with the European Currency Unit (ECU) which was defined as a basket of fixed quantities of the currencies of the Member States. Monetary stability increased among the EMS’ participants while capital controls were gradually relaxed. Since uncertainty about exchange rate development was reduced, intra-European trade was also protected from excessive exchange rate volatility.

A further impetus for economic and monetary union was provided by the adoption of the Single European Act (SEA) which was signed in order to introduce a Single Market for all its participants. The Single Market was not expected to be able to exploit its full potential without a single currency. The supporters of the Single Market pointed out that a single currency could create greater price transparency for consumers and investors, eliminate exchange rate risks within the Single Market, reduce transaction costs and, as a result, significantly increase economic welfare in the Community.

In 1989, the Delors Report^[4] recommended that economic and monetary union should be achieved in three stages. The first stage was to focus on completing the internal market, reducing disparities between Member States’ economic policies, removing all obstacles to financial integration and intensifying monetary cooperation. The second stage would serve as a transition period, setting up the basic organs and organizational structure of EMU and strengthening economic convergence. The third and final stage would see the exchange rates locked irrevocably and the various Community institutions and bodies would be assigned their full monetary and economic responsibilities.

Finally, the Maastricht Treaty was signed in 1992, the biggest step towards the euro. While supporters of the euro argue that this was a logical step in line with the early goals to “promote throughout the Community a harmonious development of economic activities, a continuous and balanced expansion, an increase in stability, an accelerated raising of the standard of living, and closer relations between the States belonging to it [the EEC]”^[5], others saw it less enthusiastically. Hans Albin Larsson put the signing of the Maastricht Treaty into the historical context with the German reunification and argued that the French saw it as an opportunity to get a share of the German economic power while the Germans under Chancellor Kohl saw the EMU as an instrument to make the other EC member states accept the German reunion and consequently a larger and stronger Germany in the heart of Europe. Thus, in Larsson’s opinion, it was the national interests of the dominating EC countries which resulted in the EMU, not necessarily any belief that the European economy would improve^[6].

However, the Maastricht Treaty is probably the most important step that was taken on the way to the introduction of the euro. The so called Maastricht Criteria will be discussed below. On 1January 1994, the European Monetary Institute (EMI) was created, a transitory institution to perform the preparatory work for the third stage of EMU as outlined in the Delors Report. In December 1995 the Madrid European Council confirmed that the third stage of EMU would start on 1 January 1999 and named the new currency to be established the “euro”. In June 1997 the European Council adopted the Stability and Growth Pact, which complements the Treaty provisions and aims to ensure budgetary discipline within EMU (and which will be discussed below, too). Finally, on 2 May 1998 the EU Council voted unanimously that 11 Member States had fulfilled the conditions necessary to adopt the new single currency on 1 January 1999. Denmark and the UK “opted out”, i.e. they used their right not to participate which was granted them earlier. Greece and Sweden were not deemed to have met the conditions for adopting the euro even though Sweden probably could have fulfilled them but didn’t do so for political domestic-Swedish reasons . The ECB was established with effect from 1 June 1998 as liquidator of the EMI which had completed the tasks it had been created for.

1.2. The Stability and Growth Pact

The so called Maastricht Criteria that are reinforced by the Stability and Growth Pact were set up to maintain the stability of the euro and to create a currency area that would be seen as reliable and stable. The Maastricht Criteria consist of five points:

- An inflation rate that is no more than 1.5 percentage points above the average of the three countries with the lowest inflation rates
- Nominal long-term rates not exceeding by no more than 2 percentage points those for the three countries with the lowest inflation rates
- No exchange rate realignment for at least two years
- A government budget deficit not in excess of 3% of each country’s GDP
- A gross debt ratio to GDP debt that does not exceed 60%

Of these five points, the 3% budget deficit criteria is considered being the most important one, especially since some of the EMU Member States were admitted to the Union with gross debt ratios exceeding not only 60% but 100% (Belgium and Italy). The reinforcement of the Maastricht Criteria through the SGP rest primarily on two pillars: the principle of multilateral surveillance of budgetary positions and the excessive deficit procedure. Any fiscal slippage may form the subject matter of a Council recommendation, which may be made public. The excessive deficit procedure is the core of the SGP. This procedure is triggered if a Member State exceeds the public deficit criterion. If the existence of an excessive deficit is established by the Council, it issues recommendations to the Member State concerned, calling on it to take steps to put an end to the excessive deficit. If the Member State does not comply with these recommendations or does not take steps to remedy the situation, the Council may impose sanctions on it, initially in the form of a non-interest-bearing deposit with the Community. The deposit will, as a rule, be converted into a fine if, within the next two years, the excessive deficit has not been corrected^[7].

[...]

^[1] These countries are: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain

^[2] That was the European Economic Union (EEC), founded in Rome by Belgium, France, Italy, Luxembourg, the Netherlands and West-Germany

^[3] The European Monetary Cooperation Fund (EMCF) was set up as a nucleus of a future community organization of central banks which proved to be inefficient.

^[4] Named after that time’s President of the European Commission

^[5] Article 2 of the Treaty of Rome, 1957

^[6] Page 163; National Policy in Disguise: A Historical Interpretation of the EMU; Hans Albin Larsson in “The Price of the Euro”

^[7] http://europa.eu.int/scadplus/leg/en/lvb/l25057.htm