European Economic and Monetary Union (EMU)

The basis of the European Economic and Monetary Union (EMU) was the American desire to see a united Western Europe after the World War II. This desire started taking shape when the Europeans created the European Coal and Steel Community, with a view to freeing trade in these two sectors. The pricing policies and commercial practices of the member nations of this community were regulated by a supranational agency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxembourg and the Netherlands to form the European Economic Community (EEC), whereby they agreed to make Europe a common market. While they agreed to lift restrictions on movements of all factors of production and to harmonize domestic policies (economic, social and other policies which were likely to have an effect on the said integration), the ultimate aim was economic integration. The European countries desired to make their firms more competitive than their American counterparts by exposing them to internal competition and giving them a chance to enjoy economies of scale by enlarging the market for all of them.

European Economic and Monetary Union (EMU)

The EEC achieved the status of a customs union by 1968. In the same year, it adopted a Common Agricultural Policy (CAP), under which uniform prices were set for farm products in the member countries, and levies were imposed on imports from non-member countries to protect the regional industry from lower external prices. An important roadblock in the European unification was the power given under the treaty to all the member countries, by which they could veto any decision taken by other members. This hindrance was removed when the members approved the Single European Act in 1986, making it possible for a lot of proposals to be passed by weighted majority voting. This paved the way for the unification of the markets for capital and labor, which converted the EEC into a common market on January 1, 1993. Meanwhile, a number of countries joined EEC. Denmark, Ireland and the United Kingdom joined in 1973. By 1995, Austria, Finland, Greece, Portugal, Spain and Sweden had also joined, thus bringing the membership to 15.

The structure of the EEC consists of the European Commission, a Council of Ministers and a European Parliament. The Commission’s members are appointed by the member countries’ governments and its decisions are subject to the approval of the Council, where, by convention, either the Finance Ministers or the heads of the central bank represent their respective countries. The members of the Parliament are directly elected by the voters of the member countries. In December 1991, the Treaty of Rome was revised drastically and the group was converted into the European Community by extending its realm to the areas of foreign and defense policies. The members also agreed to convert it into a monetary union by 1999.

As the Bretton Woods system was breaking down in 1973, six out of the nine members of the EEC jointly floated their currencies against the dollar. While Britain and Italy did not participate in the joint float, France joined and dropped out repeatedly. The currencies of the participating countries were allowed to fluctuate in a narrow band with respect to each other (1.125% on either side of the parity exchange rate), and the permissible joint float against other currencies was also limited (to 2.5% on either side of the parity, by the Smithsonian agreement). This gave the currency movements the look of a ‘snake’, with the narrow internal band forming the girth and the movements against other currencies giving the upward and downward wriggle. The external band restricting the movement of these European currencies on either side, gave the impression of a ‘tunnel’ thus giving rise to the term ‘snake in the tunnel’. The idea of creating a monetarily stable zone started taking shape in 1978, which resulted in the creation of the European Monetary System in 1979. The system was quite similar to the Bretton Woods system, with the exception that instead of the currencies being pegged to the currency of one of the participating nations, a new currency was created for the purpose. It was named the European Currency Unit (ECU) and was defined as a weighted average of the various European currencies. Each member had to fix the value of its currency in terms of the ECU. This had the effect of pegging these currencies with each other. Since each currency could vary against the ECU and against other currencies within a certain band on either side of the parity rate (2.25% for others and 6% for pound sterling, Spanish peseta and Portuguese escudo), a certain grid was formed which gave the limits within which these currencies could vary against each other. Whenever the exchange rate between two of the member currencies went beyond the permissible limit, both the countries had to intervene in the forex markets. This co-operation between the countries was expected to make the system more effective. Another important feature of this system was that the members could borrow unlimited amounts of other countries currencies from the European Monetary Cooperation Fund in order to defend their exchange rates. This was expected to ward off any speculative activities against a member currency. Though the countries involved were also expected to simultaneously adjust their monetary policies, this burden was put more on the erring country. It was easier to fix the blame, as at the time of the fluctuation in the exchange rate of two members, the erring country’s exchange rate would also be breaching its limits with respect to the ECU and other member currencies. When these parity rates became indefensible, they could be realigned by mutual agreement. The system was, thus, much more flexible than the Bretton Woods system.

The ECU also served as the unit of account for the EMS countries. It served another important purpose in that loans among EMS countries (including private loans) could be denominated in the ECU. The ECU’s value being the weighted average of a basket of currencies, it was more stable than the individual currencies. This made it more suitable for international transactions.

A number of realignments took place in the first few years of the system. However, the 1980s saw the system becoming more rigid. The German central bank, the Bundesbank, was committed to a low inflation rate, and hence to a tighter monetary policy. Some other countries (specially France and Italy, who had meanwhile joined the EMS) tried to control their domestic inflation by not realigning their currency’s exchange rate with the DM and instead following the same monetary policy as the Bundesbank. The UK, which joined the EMS in 1990, also followed the same policy. This resulted in a high unemployment rate in such countries. This cost was acceptable to these countries, till the situation changed drastically with the effects of the 1990 German unification slowly becoming visible. As the erstwhile West Germany bore the expenses of the unification, its budget deficit started rising, increasing the German prices and wages. To keep inflation under control, the Bundesbank had to increase the interest rates to an even higher level. If the DM was allowed to appreciate at that time, the Bundesbank would not have had to increase the interest rates too much, as German prices would have reduced in response to the higher DM. But as some other member countries of the EMS refused to let the DM appreciate, they had to increase their domestic interest rates in response. This happened at a time when many of the European countries were experiencing very high unemployment rates, and Britain was going through a recession.

The situation became worse with the decision of the EC countries to go ahead with monetary union. In 1989, the report of a committee chaired by the president of the European Commission, Jacques Delor, was published. It recommended that the members of the EC abolish all capital controls and follow one common monetary policy. This monetary policy was proposed to be formulated by a European Central Bank (ECB), and followed by the central banks of all the member countries, which would become a part of the European System of Central Banks (ESCB). It also recommended the irrevocable locking of the EC exchange rates and the introduction of a common currency for the member nations. In the same year, the first stage of the process of economic integration began, and most of the recommendations of the Delor Committee report were accepted. However, it was decided that to make the integration long-lasting, member countries were to achieve a high degree of economic convergence before being allowed to merge their economies with the rest of the group.

In December 1991, as a follow up to the Delor’s report, the Treaty of Rome was revised extensively to provide for the monetary union. As these revisions were adopted in the Dutch town of Maastricht, they collectively came to be known as the Maastricht Treaty. The treaty laid down the timetable for the monetary union. According to the timetable, the union was to be completed by 1999, and the qualifying countries had to fulfill criteria regarding inflation rates, exchange rates, interest rates and budget deficits. As the markets believed these criteria to be too hard for some countries to achieve, speculative pressure against the currencies of these countries started building up. By September 1992, the pressure reached its peak. The first country to bear the brunt of the speculative attacks was Italy. Even as its government announced a set of fiscal reforms to be able to meet the convergence criteria, pressures against the lira continued. Finally, Germany and Italy entered into a deal under which Italy devalued the lira and Germany reduced its interest rates. The UK was also facing a similar attack on its currency, and had to withdraw from the EMS soon after the Italian devaluation. Despite having already devalued its currency, Italy followed Britain and pulled its currency out of the EMS. Immediately afterwards, French voters approved the Maastricht treaty. Yet, this approval could not stop an attack against the French franc. Even Bundesbank and the Banque de France (the French central bank) together could not postpone the inevitable for long. In July 1993, there was another attack on the franc as it became clear that the French and German interest rates would not converge. The French unemployment rates being very high and continuing to rise, it could be foreseen that a further possibility of interest rates rising there did not exist. At the same time, the German government could not be expected to reduce the interest rates as inflation was still not totally under control. It became clear that the franc had to be devalued vis-à-vis the DM, but neither of the countries was ready to adjust the parity rates of their currency. Finally, the EMS countries decided to change the band from 2.25% to 15%. Germany and the Netherlands kept the band between their currencies at 2.25%. The band for peseta and the escudo continued at 6%. Though this change in the band successfully warded off the speculative attacks against the franc, the monetary convergence got a severe setback as there was no more need for countries to converge their monetary policies. With the band becoming so wide, there was no real fixed exchange rate system left to talk about.

Despite these developments, the desire of the European countries to form a monetary union did not fade. After being ratified by all member countries, the Maastricht Treaty came into effect from November 1, 1993. Thus, the European and Monetary Union came into being. The first stage of the union continued up to the end of 1993. During this stage, capital flows and the financial sector were fully liberalized. The members were also required to keep their currencies within a 2.25% band of the parity rates. The second stage began in January 1994, with the establishment of the European Monetary Institute (EMI) in Frankfurt, which was the precursor to the ECB. Its job was to manage the EMS, co-ordinate national monetary policies, and to prepare for the creation of the ESCB. Its most important function was to monitor economic convergence among the member countries, a job to be shared by the EC, the Bundesbank and the Banque de France. In this stage, the governments were not allowed to borrow from their central banks at concessional rates and had to do so at market determined rates. They were required to systematically reduce their fiscal deficits and bring other economic indicators in line. In December 1995, a summit was held in Madrid, where the single European currency was named the euro, and a strict timetable for the EMU was finalized. In December 1996, the Dublin summit was held and it was decided to give full autonomy to the ECB. The rules which the ECB would have to follow for regulating monetary policy and to ensure exchange rate stability were also formulated. In May 1998, the heads of the member governments met in Brussels and were presented the reports of the various agencies responsible for monitoring the convergence of the various members. In accordance with the Maastricht Treaty, the member countries were required to fulfill the following criteria by the end of 1997:

  • Fiscal deficit should be within 3% of GDP.
  • Public debt should not exceed 60% of GDP.
  • The inflation rate should not be more than 1.5% higher than that of three countries having the lowest inflation.
  • The long-term interest rates should not be exceeding the long-term interest rates of the above-mentioned 3 countries by more than 2%.
  • The currency should have stayed within the ERM band for a minimum period of two years without any realignment.
  • The central banks should be autonomous.

In line with the reports prepared by these agencies, the heads of states voted for selecting the countries, which were eligible to join the EMU. 11 countries were allowed entry into the union, they being Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Britain, Denmark and Sweden opted out of choice despite being eligible and Greece was found ineligible. At the same time, the ECB was established. The day-to-day management of the ECB is the responsibility of an executive board. The board has a total of six members including a president and a vice-president. These members are appointed by consensus and enjoy an eight-year, non-renewable term. The managing body of the ECB is the governing council, which consists of the executive board and the governors of the central banks of the EMU countries. The main functions of the ECB are to

  • Determine the monetary policy and to implement it.
  • Support the member countries in implementing their economic policies, if that does not entail going against its main aim of maintaining price stability.
  • Help the member countries in managing their forex reserves and to conduct forex operations.
  • Ensure a smoothly operating interbank payments system..

The most significant development was the introduction of a single currency for the participants of the European Economic and Monetary Union (EMU) – the Euro. On January 1, 1999, the euro came into being. On this date, the exchange rates of the currencies of the participating nations with the euro were irrevocably fixed. There will be a transition period of three years during which these currencies will exist along with euro. However, from this date, all interbank payments will be in euros, there will be no interbank quotes between the dollar and local currencies, all new government debt will be denominated in euros, the ECB will conduct repo transactions only in euros, and all stock exchange quotations for equities and trades and settlements of government debt and equity will be in euro. On the retail level, the bank statements and the credit card bills will be giving the euro equivalents of the national currency figure. Above all, from the same date, the ECB started formulating a common economic policy for the participating nations. Between January 1, 1999, and December 31, 2002, all retail transactions will be settled in the national currencies. As planned euro notes and coins was introduced on January 1, 2002. The next 6 months will be the dual currency period in which both euro and the national currencies can be used for retail transactions. However, the use of the national currencies will be phased out and from July 2002, euro will be the only legal tender. As there will be a single European currency and hence no fluctuation of exchange rates, the introduction of euro is expected to result in a more efficient single market, and stimulate trade, growth and employment in the region. The single currency results in elimination of transaction costs, which result from the need to convert one currency into another.

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