eu - introduction and monetary union

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Introduction

Fostering stability, growth and prosperity across Europe

The euro is a familiar feature of everyday life, used by over 333 million EU citizens for their daily requirements, tosave for tomorrow and to invest in the future. Indeed, by 2020 there will be a new generation of young adults whowill have known only the euro as their national currency. A well-functioning economic and monetary union and astrong and stable euro are the foundation for a growth-friendly economic environment for the euro area and thesingle market.

Economic and Monetary Union (EMU) represents a major step in the integration of EU economies. It involves thecoordination of economic and fiscal policies, a common monetary policy, and a common currency, the euro. Whilstall 27 EU Member States take part in the economic union, some countries have taken integration further andadopted the euro. Together, these countries make up the euro area. EMU officially stands for Economic andMonetary Union among the European States. Other countries also use EMU to refer generally to the EuropeanMonetary Union. The initial members were Austria, Germany, Belgium, Spain, France, Ireland, Italy, Luxemburg,Finland, Portugal and Netherlands. As part of the EMU, these eleven countries make up the worlds second largest

economy after the United States. Greece and Sweden failed to meet the convergence requirements in time to jointhe EMU in the first round. Sweden failed to fulfill two of the conditions. The conditions were laws governingSwedens central bank were not compatible with the Maastricht treaty and the currency exchange rates in Swedenwere not sufficiently stable for the previous two years. Greece failed to meet all the requirements. The tworemaining members of the EU, the United Kingdom and the Denmark chose not to join the EMU immediately.

There are currently 27 member-states involve integration with the European Monetary Union. Eighteen countrieshave adopted the euro. They are Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,the Netherlands, Portugal, Slovenia, Spain, Cyprus, Malta, Slovakia, Estonia and from 2014 the newest EMUmember Latvia. Plans for a single European currency began in 1969 with the Barre report. Currently participatingEuropean countries can be integrated in to three different economic stages, which correspond to the historicalstages of European Monetary Union development. This paper initially points out the origin of EMU and then its

historical development, current situation, benefits and challenges, euro system.

Origin of the European Monetary Union

At the end of the Second World War, in 1945, the political leaders of Europe believed that the way to avoid futuremilitary conflict was to create a high degree of economic integration between existing nation states. This belieforiginated the unification process of Europe, which has made a considerable progress over the last five decades.

In 1952 France, Belgium, West Germany, Italy, Luxembourg, and Holland formed the European coal and steelcommunity (ECSC) and agreed to remove the trade restriction on coal, steel and iron. In 1957, the same countriessigned the Treaty of Rome that created the European Economic Commission (EEC). The main achievements of theEEC were the elimination of internal tariff among member countries, the establishment of common external tariffand the establishment of the common agricultural policy. The EEC later became European Community (EC) andafter 1993 European Union. The single European Act, signed in 1986, was the next big step forward after theTreaty of Rome. Its intention was to remove remaining obstacles to trade within the European Union leading tocreating a fully integrated single market. The common European Union policies in the areas of taxation, researchand technological development, product standardization, and environment were adopted. In 1992 EU countriessigned the Maastricht treaty, named after the town in the Netherlands where it was signed that furtherstrengthened the unification process. The proposals for the introduction of the European Monetary Union (EMU)are contained in this treaty. Some countries approved the Maastricht treaty by a public vote and other countries


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ratified the treaty through a legislative vote. The treaty set up the conditions which each country in the EuropeanUnion must meet before it could join the EMU. These requirements for EMU membership were considerednecessary because when the member states join the EMU, domestic economic crises in one member state willaffect all of the other member states. To join the EMUs initial formation, each member states had to meet the fiveconvergence criteria:

The country had to achieve a rate of inflation within 1.5% of the rates in the three participating countrieswith the lowest rates.

The national legislation governing the countrys financial system had to be compatible with the treatyprovisions controlling the European system of central banks.

The country had to reduce its government deficit to below 3% of its gross national product. The country had to keep its currency exchange rates with the limits defined by the ERM for at least two

years. The country had to keep its interest rates within 2% of the rates in the three participating countries with

the lowest rates.

Objectives of the EMU

The European Monetary Union (EMU) is an agreement between participating European nations to share a singlecurrency and a single economic policy with set conditions of fiscal responsibility. The three main objectives of theEMU can be identified:

A common currencyThe main purpose of establishing EMU is maintaining a single European currency for member states. In the wake ofthe Second World War, most currencies of the industrialized world were tied closely to the US dollar. Therefore,Plans for a single European currency began in 1969 with the Barre report. As a result, in 1999 the euro wasadopted in non-physical form with the exchange rates for 11 of the 15 member countries. Then, euro is the singlecurrency of the European Monetary Union which was adopted by 11 member states on January 1999. The eurowas a virtual currency for euro zone. The initial members were Austria, Germany, Belgium, Spain, France, Ireland,Italy, Luxemburg, Finland, Portugal and Netherlands. Denmark, Sweden, Greece and the UK opted out initially fromthe euro. It was used in accounting and firms could conduct euro denominated transactions safe in the knowledgethat the exchange rates among the member states were fixed.

A European central bankWith the creation of EMU the member countries lost their freedom of implementing independent monetary policysince there will be a uniform exchange rate within the Euro area. The responsibility for monetary policies istransferred to a supra national body, the European system of central bank located in Frankfurt. The Europeancentral bank (ECB) was established in June 1, 1998 and consists European central bank and European Unionmember countries. A governing council consisting an executive board and the governors of the central banks in theparticipating countries controls the ECB. The primary objective of the ECB is to maintain price stability. Further, inpursuing its objectives, the ECB shall act in accordance with the principle of an open economy with free

competition, favoring in efficient allocation of resources. The basic task to be carried out by the ECB are definingand implementing the monetary policy for the euro area, conducting foreign exchange operations and holding andmanaging the official foreign reserves of the member states, promoting the smooth operations of paymentsystems and contributing to the work of the relevant national authorities in supervising credit institutions and thestability of the financial system.

A centralized monetary policy for all the countries within the Union


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The primary objective of the single monetary policy is the maintenance of price stability. However, the euro systemlike all central banks cannot control the price level directly by using the monetary policy instruments at its disposal.Instead, central banks face a complex transmission process from their own monetary policy actions to changes inthe general price level. The transmission mechanism of monetary policy is characterized by the existence of severaldistinct channels, each with long, variable and not fully predictable lags. The monetary policy strategy fulfils twocrucial tasks. First, the strategy imposes a clear structure on the policy making process itself. The strategy mustensure that the governing council has the information and analysis it requires to take effective monetary policydecisions that will maintain price stability. Second, the Euro systems monetary policy strategy is a vehicle for communicating with the public. Monetary policy is most effective when it is credible that is when the public iscompletely confident that monetary policy is fully committed to the objective of price stability and is beingimplemented in a manner that will effectively achieve this goal.

Implementation Stages of the EMUIn June 1988, an ad hoc committee (Delors Committee) of the central bank governors of the twelve memberstates, was asked to propose a new timetable with clear, practical and realistic steps for creating an economic andmonetary union. The European Council confirmed the objective of the progressive realization of Economic andMonetary Union (EMU). It mandated a committee chaired by Jacques Delors, the then President of the European

Commission, to study and propose concrete stages leading to this union. The governors of the then EuropeanCommunity (EC) national central banks; Alexandre Lamfalussy, the then General Manager of the Bank forInternational Settlements (BIS); Niels Thygesen, professor of economics, Denmark; and Miguel Boyer, the thenPresident of the Banco Exterior de Espaa composed the committee. The resulting Delors Report proposed thateconomic and monetary union should be achieved in three discrete but evolutionary steps, as given below.

Stage one of the EMU (1990 to 1993)Considering the Delors Report as the basis, the European Council decided in June 1989 that the first stage of therealisation of economic and monetary union should begin on 1 July 1990. Therefore as decided, in principle, allrestrictions on the movement of capital between Member States were abolished and it was completely liberalized.Additional responsibilities were given to the Committee of Governors of the central banks of the Member States ofthe European Economic Community, which had played an increasingly important role in monetary cooperation

since its creation in May 1964. The new tasks included holding consultations on, and promoting the coordinationof, the monetary policies of the Member States, with the aim of achieving price stability. In order to implementStages Two and Three, it was necessary to revise the Treaty establishing the European Economic Community (theTreaty of Rome) in order to establish the required institutional structure. For this purpose, an IntergovernmentalConference on EMU was held in 1991. Negotiations at the conference resulted in the Treaty on European Unionwhich was agreed in December 1991 and signed in Maastricht on 7 February 1992.This was called, the Treaty ofMaastrict. The Treaty establishes the completion of the EMU as a formal objective. It sets a number of economicconvergence criteria, regarding the inflation rate, public finances, interest rates and exchange rate stability.However, owing to delays in the ratification process, the Treaty did not come into force until 1 November 1993.

Stage two of the EMU (1994 to 1998)

The start of the second stage of EMU was marked by the establishment of the European Monetary Institute (EMI)on 1 January 1994, and with this the Committee of Governors ceased to exist. The existence of EMI also mirroredthe state of monetary integration within the Community. The two main tasks of the EMI were; I. To strengthencentral bank cooperation and monetary policy co-ordination II. To make the preparations for the establishment ofthe European System of Central Banks (ESCB), for the conduct of the single monetary policy and for the creation ofa single currency in the third stage.

Preparatory works undertaken by the EMI are pointed put below;


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A name for the currency unit to be introduced in the third stage was agreed on as Euro by the European Councilin December 1995. It was confirmed that Stage Three of EMU would start on 1 January 1999. The European Council, on June 1997 decides to adopt the stability and growth pact, designed to ensure budgetarydiscipline after the creation of Euro and a new exchange rate mechanism is set up to provide stability among euroand the national currencies of countries not yet entered into the euro zone. The selected design series for the euro banknotes to be put into circulation on 1 January 2002, was presented tothe European Council, and subsequently to the public by the EMI in December 1996. In the composition of Headsof State or Government, 11 Member States had fulfilled the conditions necessary for the participation in the thirdstage of EMU as unanimously decided by the Council of the European Union on 2nd May 1998. The initial participants were Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands,Austria, Portugal and Finland. As agreed by the ministers of finance of the Member States with the governors of the national central banks ofthese Member States, the European Commission and the EMI in May 1998, the current ERM bilateral central ratesof the currencies of the participating Members would be used in determining the irrevocable conversion rates forthe euro. The 11 participating Member States appointed the President, the Vice-President and the four other members ofthe Executive Board of the ECB on 25th May 1998. Their appointment took effect from 1 June 1998 and marked

the establishment of the ECB The ECB and the national central banks of the participating Member States constitute the Eurosystem, whichformulates and defines the single monetary policy in Stage Three of EMU. With the establishment of the ECB on 1 June 1998, the conversion rates among the 11 participants currenciesand the euro were established.

Stage three of the EMU (1999 and continuing)The third and final stage of EMU commenced on 1 January 1999 with the irrevocable fixing of the exchange ratesof the currencies of the 11 Member States and with the conduct of a single monetary policy under theresponsibility of the ECB. A three year transition period begins before the introduction of actual euro notes andcoins, however on legal terms the national currencies have already ceased to exist.

The Euro notes and coins are finally introduced in January 2000. On 1st of January 2001, Greece enters the thirdstage of EMU, increasing the number of participating Member States to 12. On 1 January 2007, Slovenia becamethe 13th member of the euro area, followed one year later by Cyprus and Malta, by Slovakia on 1 January 2009and by Estonia on 1 January 2011. On the day each country joined the euro area, its central bank automaticallybecame part of the Eurosystem. The three stages of the implementation which were discussed in detail above arepresented as a summary in the below diagram.

Economic and Financial situation of the EMUEconomic and Financial development of the Countries which represent European Union is one objective ofestablishment of this union. To grow the interdependence of national economies and in order to guard against anyresulting undesirable effects they establish economic policies. There are two main instruments for monitoring theeconomic policies. These are general guidelines on economic policy and stability and convergence programmers.The main objectives of the Union's economic policy are ensure a high degree of sustainable economic growth thatis non-inflationary and supported by investment, create jobs by means of a consistent, global strategy and provideMember States, the Council and the Commission with clear policy indications for enactment of the stability andgrowth pact by means of precisely outlined measures.

The framework for cooperation on economic policy is the economic and monetary union (EMU), of which all EUcountries are part. It is the context within which they agree common guidelines for questions of importance for theeconomy. The overall result is more growth, more jobs and a higher level of social welfare for all. In addition, this


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cooperation enables the EU to react to global economic and financial challenges in a coordinated way. It makes theEU as a trading block more resilient to shocks from the outside and enables the bloc to deal with economic andfinancial problems more effectively. The union is coordinating the economic policy in each year by adopting theguideline. These guidelines define a framework for the entire European Union, as well as for each Member State.They specify the medium and long-term structural reforms required to increase the competitiveness of the EUcountries. For many countries, the guidelines highlight the need to allow market mechanisms to function moreeffectively: more market will make the economy more flexible, favor growth and speed up the transition towards aknowledge-based economy. Another aspect of European Monetary Union is to permit competitive forces tooperate to their fullest extent throughout Europe. Competitive forces act to provide the best goods at the lowestpossible price. The ultimate beneficiary of increased competition is the consumer, since he or she maximizes theamount of goods and services that can be purchased with the given disposable income. Those producers whosurvive the competition also benefit in the long run, as they achieve cost effectiveness and acquire competitiveadvantages in both home and foreign markets.

By establishing European Monetary Union this is a huge advantage that can be gained. This European MonetaryUnion effect several ways for the competition and firm size, competition and labor markets and the financialintegration of the European market. Competition and firm size:-One aspect of the monopolistic competition.

Increased economies of scale might well prove to be the source of the largest benefits, as European firms willreach the size of their U.S and Japanese competitors. This will enhance productivity gains, allow for greaterproduct variation and probably result in lower production costs. European labor markets are notorious for theirlack of flexibility. The major concern is on high and well-protected levels of employment, along with the highestpossible wage. Large firms and powerful trade unions share the prices that are being extracted from the ultimateconsumers.

Enhance competition will design preciously cut these prices. If a single European succeeds in increasingcompetition, it will reduce prices, forcing both capital and labor to accept a smaller share unless they manage toincrease productivity. By establishing Europium Monetary Union they get advantage of labor market.

Financing of the European Monetary Union

Their finance forecasts are done on an annual basis and included in a single community budget. Since 1978 theCommunity budget no longer depends on the financial contributions of Member states but is entirely financed byits own resources, subject to maximum of 1.24% of Community GDP. These resources are a combination ofagricultural duties, customs duties derived from common customs tariffs and a uniform VAT rate applied to eachMember States taxable base.

Current financial planning is done on the basis of 7-year cycles. A new agreement was approved in May 2006 inassociation with the Unions 200 7-2013 financial perspectives. This agreement went in to force in January 2007.The overall expenditures ceiling for the 7-year period 2007-2013 is set at 864.3 billion euro.

Euro System

Current situation of EMUThe euro is the single currency shared by (currently) 18 of the European Union's Member States, which togethermake up the euro area. The introduction of the euro in 1999 was a major step in European integration. It has alsobeen one of its major successes: more than 333 million EU citizens now use it as their currency and enjoy itsbenefits, which will spread even more widely as other EU countries adopt the euro. European monetary unioncomprises 18 countries in European region presently facing a fiscal crisis. Situation started with the fiscal crisis ofGreece which finally ended up with a higher bailout. This bailout and fiscal crisis again led to a worsen situation inEMU. With the beginning of the financial crisis, peripheral sovereigns of the European monetary union left with


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large fiscal deficits and increasing levels of public debt. Specific rules that apply to the EU member states stipulatethat states deficit must not exceed 3% of GDP and debt should not exceed 60% of GDP.

- European Commission, Economic and Monetary policy , October, 1992 [ONLINE]:

eu - introduction and monetary union

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