1. Europe’s Economic and Monetary Union Juyeon Lee

2. European Central Bank  Central bank for the EU’s currency (Euro)  The ECB’s main task is “to maintain the euro's purchasing power and thus price stability in the euro area.”  Mission Statement: “The main objective of the Eurosystem is to maintain price stability: safeguarding the value of the euro.”  Also: “Without prejudice to the objective of price stability, the ESCB (European System of Central Banks) shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2." (Treaty article 105.1)

3. The Euro Zone

4. European Monetary System (EMS)  Established in March 1979  Components  European Currency Unit (ECU): nominal currency made up of a basket of all EC currencies. Later replaced with Euro.  The European Monetary Institute (EMI: Formerly the European Monetary Co-operation Fund): to facilitate currency transactions between member states.  The Exchange Rate Mechanisms (ERM): established in 1979 as a mechanism for reducing fluctuations in the relative values of member currencies.

5. The Exchange Rate Mechanism (ERM)  Based on a Parity Grind System  Before the crisis of ’92 and 93, set margin of fluctuation against a central rate for each currency: +/- 2.25% within the normal (narrow) band, +/- 6% within the wide band.  Fluctuation within the wide band is provisional.  UK: Seeing the benefit of ERM in stabilizing currencies and keeping inflation low, the UK later joined the ERM in 1990.

6. The Crises of ‘92-93 and Weaknesses of the ERM  Ended the 12 years of relative stability  Sterling and lira forced out of the ERM  Big devaluation of Spanish, Irish, and Danish currencies  Causes 1. Germany’s monetary policies during 1992 and ’93 (borrowing rather than raising taxes or revaluing Deutche Mark, which forced other governments to keep their interest rate high). 2. Insufficient cooperation between member states and inflexibility 3. “Eurosceptics” argued the ERM is fundamentally flawed.

7. Toward a Single Currency  Steps for the single currency according to the Maastricht Treaty Stage 1(July 1, 1990 to Dec. 31 1993): in 1990, a convergence framework was established, which included the adoption of an annual economic report and multilateral surveillance over member states’ economic policies. State 2(From Jan. 1, 1994): the EMI was established to strengthen coordination of member states’ central banks and monetary policies. Stage 3: a move toward irrevocably fixed exchange rates and single monetary policy for member states. Sanctions will be imposed on a member states running excessive deficits. The ECB was established to take over the EMI.

8. The Convergence Criteria  Disparities between convergence criteria and the actual economic performance of most member states: raising a doubt of “Can the Maastricht schedule be carried out?”  The European Commission’s Report in 1995 1. Good progress made on price stability (8 out of 12 met the convergence criteria) 2. More progresses needed in governments’ fiscal deficits  Criticism of the Convergence Criteria: Political rather than economical (to motivate countries to join the exclusive, secret club). Poor nations have difficulties meeting the criteria.  Example: the French government’s austerity plan in 1995.

9. Against the Currency Union  Mundell’s Case against the Monetary Union 1. The loss of a major macroeconomic policy called an independent interest rate to deal with “asymmetric shocks,” i.e. varying economic conditions between states. 2. Mundell concluded that if a state cannot handle asymmetric shocks only with wage reductions and more flexible labor, then it should not join a monetary union  Criticisms of Mundell’s Theory 1. Ignoring the benefits of single currency such as low transaction costs, more efficient market, greater economic certainty, lower interest rates, and higher economic growth. 2. The use of exchange rate to deal with asymmetric shocks has limits and has long-term consequences. 3. Ignoring the fact that political considerations often override economic calculations.

10. Maastricht Treaty’s Convergence Criteria 1. Price Stability: an average inflation rate must not exceed that of the three best performing member states by more than 1.5% 2. Interest rates: must not exceed that of three best- performing member states by 2%. 3. Government Budgetary policies: current account deficit must not exceed 3% of GDP, and a gross public debt must not exceed 60% of GDP. 4. Currency Stability: +/- 2.5% for those in the narrow band of the ERM for at least 2 years and with no currency devaluation.

11. The Treaty and Monetary Policy  An Independent Central Bank  A main goal of price stability:  The role of the European Central Bank in monetary policy 1. Define and implement monetary policy 2. Conduct foreign exchange operations 3. Hold and manage the official reserves of the member states. 4. Promote the smooth operations of payments systems.  The Council of Economic and Finance Ministers (EcoFin): can make a final decision in foreign exchange markets (unanimously) and conclude monetary agreements with third countries.

12. Why a single currency?  Krugman’s Theory: benefits of a single currency depend on the level of “economic integration.” Nations depending on intra-trades will try to form a single currency to reduce the transaction costs.  Barriers for the EU to form a single currency 1. High degree of divergence among the 15 EU states. 2. Low level of labor market flexibility (both in the labor mobility between states and in the flexibility regarding wage and regulation)  Interestingly, second-tier nations are keener to join the single currency than more wealthy members – political calculations have been major factors.

13. The Independence of the Central Bank  More power to the Central Bank to discourage a government from using a “surprise inflation” to spur growth. 1. Delegation of monetary policy (setting interest rate) to an independent central bank 2. The central bank should set inflation and money supply targets 3. Goal of price stability should be in constitution, not simply in law (so no more meddling by legislators) 4. Terms of office of the central bank officials can be longer than those of political reps who appoint them. 5. Sanctions if the central bank fails to meet the goal of price stability.

14. The ECB’s Independence and Reputation  The ECB: solely responsible for implementing monetary policy without interference from the Council or national governments.  However, few sanctions if the ECB fails to meet the price stability goal.  To enhance the reputation: any central bank must have a history of stable currency and economic growth as a result of its decisions.  The ECB lacking that history (because of its short tenure): The public might turn against the ECB more easily than it would be against the well-established central banks like Bundesbank and the US Feds.

15. History of Europe’s Monetary Integration  “Bad Luck” interpretation: whenever the process was entering a crucial stage, crises (the collapse of the Bretton Wood System, currency crisis in ’92 and ’93, Collapse of the Soviet Union, etc).  Used to justify the case for EMU (Economic and Monetary Union).

16. The Political process toward the EMU  Key issue: will the costs be shared symmetrically across countries?  Economists (Germany, the Netherlands) vs. Monetarists (France and Italy) 1. Economists argued that if a nation wanted to join the monetary union, it must converge on a common set of real economic structures before locking exchange rates. 2. Monetarists: Locking exchange rates will bring about the convergence of real economic structures. 3. More subtle issue: will France’s economy converge on Germany’s or will the two reach the middle ground?

17. German-French relation and the EMU  First phase of negotiation: Germany made minor concessions (no change in its econ. structures), indicating that the French economy would converge on the German one.  Second phase (1979 – 1988): both countries’ interests in the strong relationship. Germany reaffirmed its own economic structures and others demonstrated willingness and ability to converge on German norms.  Third phase (1988 - ): More modeling from the German economy. Other member states to build a set of institutions patterned on the German model and dedicated to the fulfillment of German econ. objectives.

18. The German Unification and Response  The end of Cold War and German Unification: a “new Germany” with changed economic structures.  It would undo the bargains made previously.  Responding the sudden change in the German economy 1. Locking the previous gains: consolidate the gains in the Maastricht Treaty. But requiring member states to adopt austerity policies 2. German economy after the unification: not good enough to be the reference of a good economy. 3. The goal of Monetary Union: became public issue and led to the rejection of the treaty by the Danish vote.

19. Need for the Monetary Integration  Despite setbacks, the process toward a single currency progressed faster than skeptics expected.  Reorganization of national central banks into a coherent system began.  The EMS’s promise: to “broaden the zone of monetary stability” to shield European businesses from adverse effects of volatile exchange rates on trade and investment.  Concern: “Fixed but justifiable” clause on national exchange rates in the EMS might allow countries to competitively devalue their currencies.  Monetary integration: response to such a concern.

20. Building the Support for Monetary Integration  Lack of understanding on money, exchange rates, etc.  Nationalist attachment to member states’ own currencies vs. Euro.  Easy way-out: hope for a strong economic recovery (maybe good luck): strong economies might help the public to support more monetary integration  Problem: economic recovery and popular support of the European integration not strongly positive.

21. Talking Points: 1. Can the ECB enhance its reputation as much as most well-established central banks have done? 2. Will Britain join the Euro Zone sooner than later? (My guess: yes)