Washington College, Chestertown
International Finance

The EMU and the ECB - How does the Eurosystem work

Simon Oertel

Table of Contents

Introduction ... 3

1. Historical Background ... 4

1.1. The Road to the Euro (until 1999) ... 4
1.2. The Stability and Growth Pact (The Maastricht Criteria) ... 6
1.3. The Experiment Begins (1999-today) ... 9

2. Central Banking in Europe ... 12

2.1. The European Central Bank ... 12
2.2. The ECB’s Monetary Policy ... 15

3. Conclusion ... 17

Bibliography ... 19

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 States¹ including all the countries that founded the predecessor of the European Union in 1957². 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 wellfunctioning 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 1973³, 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.

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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.