The European Monetary Union - Benefits and Potential Risks

THE EUROPEAN MONETARY UNION.

Benefits and potential risks

The European Union is committed to form an economic and monetary union (EMU) by the end of the century. A monetary union is a group of countries or regions that use the same money, so the important step will be the permanent locking of exchange rates between EU currencies. But exchange rates will not remain fixed for long if there are constant differences in the fundamental monetary policies. Therefore EMU will also require the merging of national monetary policies. If this is done, and if the financial markets believe the arrangements to be permanent, the locked currencies will become perfectly interchangeable, and interest rates on similar financial assets will be uniform throughout the monetary union, even if separate national currency denominations continue to exist.¹

Key points of EMU:

- common currency: the Euro · common goal: price stability
- common monetary policy through the independent European Central Bank

The aim of EMU is to promote and advance the ideal of the European Single Market and the political unification of Europe. To this end, the participating countries will be merging such an important sphere of activity as monetary and exchange rate policy.² The future European Central Bank (ECB) and the national central banks will be united in the European System of Central Banks (ESCB).

In order to be a success, the membering countries must be compatible. For this reason, conditions governing participation, a fixed timetable and the structure of EMU were laid down in the 1991 "Treaty on European Union" (Maastricht Treaty). The countries of the European Union (EU) have given a binding undertaking under international law to join EMU by the beginning of 1999 at the latest, provided they fulfil the conditions.³ The single European currency will be a force to calculate with shortly before the turn of the millennium. Under the Maastricht Treaty, the third and final stage of Monetary Union must start on January 1, 1999 at the latest. At this deadline, the parities of the national currencies of the participating EU states will be fixed irrevocably, as well as the conversion rates of the national currencies to the Euro. Responsibility for monetary policy and key interest rates will pass from the national central banks of the participating countries to the European Central Bank.

Historical overview

European countries have played with monetary unions schemes before. In 1834, there was the Zollverein monetary union, which led eventually to the political union between the German states. The success of this monetary union which created a federal Germany was based upon a common language and culture. Between 1861 and 1920, there was the Latin Monetary Union which was fairly successful until socialistic ideas began to take hold and government debts began to rise.⁴ During this century, there was also the Scandinavian Monetary Union which lasted until 1924. England is the only country that never participated in European monetary unions schemes. For this reason, the history of the pound sterling extends back about 1,300 years compared to most European currencies which date back only to the end of the Second World War.

In 1970, the Werner report also set up the goal of achieving a monetary union in three steps, but it did not work out, mainly because countries would not want to cooperate and also because of the oil price shock, which changed the international monetary environment drastically. Today the conditions are entirely different: since 1979 the experience of the European Monetary System has shown that co-operation is mutually beneficial. The aims and instruments of monetary policy are comparable in all member states.

Convergence Criteria

1. a low inflation rate
2. stable exchange rates
3. comparably low interest rates
4. a sustainable level of government debt

EMU candidates must fulfil the following convergence criteria, in order to be able to participate in EMU:

Firstly, the average inflation rate of a country must not exceed that of the three best performing countries in terms of price stability by more than 1.5 percentage points for the period of one year before the examination.

Secondly, a member state's currency must have participated in the Exchange Rate Mechanism (ERM) of the EMS and kept within its normal fluctuation margins without severe tensions for at least the last two years before the examination. When the Maastricht Treaty was concluded in 1991, the ERM was still intact and the normal fluctuation margin was ±2.25%. Today, the exchange rate mechanism of the EMS is nothing more than a shell: in most cases the fluctuation margins are ±15%, major industrial nations such as Italy and the United Kingdom have left the ERM. The convergence examination will, therefore, assess actual exchange rate stability. Formal participation in the exchange rate mechanism is, however, a binding condition of the Treaty.

Thirdly, the average nominal long-term interest rate of a member state, measured in terms of the length on long-dated government bonds, must not exceed the corresponding average rates in the three countries with the lowest inflation rates by more than two percentage points for the period of one year before the examination. This criterion assesses the respective stability policy of the countries on the financial markets: if interest rates in one country are substantially higher than elsewhere, in most cases the basic expectation is for higher inflation rates.

Fourthly, member states must avoid excessive government deficits. The annual government budget deficit may not exceed 3% of the gross domestic product (GDP), which is defined as the total value of all goods and services produced by an economy in one year. Also, the total outstanding government debt may not exceed 60% of GDP.⁵

The recent history of European Monetary Union (EMU) shows the constant search by the Member States of the Union for deeper monetary cooperation as a way of strengthening the single market.

Timetable

February 7th, 1992: Signature of the Maastricht Treaty

January 1st, 1994: Creation of the European Monetary Institute (EMI)

May 31st, 1995: European Commission Green Paper on the practical arrangements for the introduction of the single currency.

November 14th, 1995: EMI report The changeover to the single currency

December 15th & 16th, 1995: European Summit in Madrid. The Council adopts the changeover scenario.

Early 1998: Choice of countries which will initially participate in Economic and Monetary Union

January 1 1999: Irrevocable fixing of conversion rates. The euro becomes a currency in its own right

January 1 2002: Introduction of euro notes and coins.

July 1 2002 at the latest: Withdrawal of national currency notes and coins.

At this point of time there are hardly any countries which meet all the conditions for participation in EMU. Most countries still have very high budget deficits as a result of the slowdown in economic growth and rising social spending. This also applies to France and Germany, both of which would have to be members of EMU. Consequently, the EMU timetable is at risk.

It is, however, overlooked here that the timetable should also be seen as an incentive to qualify for EMU. So as long as the 1999 deadline is still possible to reach there is no justifiable reason to call it into question. Last but not least, the EU heads of state and government explicitly confirmed the timetable for EMU at their summit in Madrid at the end of 1995.

Benefits of EMU

I begin with the realistic expectation that EMU will ensure price stability. Price stability is laid down in the Maastricht Treaty as the primary objective of the single monetary policy, to be explicitly incorporated in the statutes of participating national central banks. The European System of Central Banks (ESCB) will enjoy full independence to determine the appropriate level of interest rates in order to satisfy this requirement of the Treaty.

Moreover, the members of the ECB's Executive Board and the Governors of the participating national central banks, who will together form the ECB Governing Council, will have long terms of office and will only be dismissible for serious misbehaviour or inability to perform their duties. These provisions imply that the concept of monetary stability will benefit from explicit legal protection. The ECB should also get reputational benefits, inherited from its constituent central banks.⁶

It is important to notice, that as a result of generally conservative monetary policies for a number of years, the average rate of inflation in the EU is now just a little above two percent. Europe is experiencing high unemployment after there has been economic recession and every country is trying to solve this problem in a different way. European Monetary Union is part of the solution, but it looks like if the public is more concerned with the development of a single currency rather that it can see the benefits of such kind of union. The benefits of price stability are increasingly appreciated. There is growing awareness that inflation, and inflation uncertainty, lead to a misallocation of resources, and therefore the maintenance of price stability is associated with significant efficiency gains, and longer-term benefits to growth.⁷ In this context, EMU will be a tool to consolidate the progress towards price stability already made and to firmly fix inflation expectations. For some countries, where inflation expectations may still be higher due to their shorter track record in terms of monetary stability, EMU will also bring lower interest rates, thus providing a stimulus to investment and to growth in the whole European area .

There should also be benefits from EMU in terms of a reduction in the costs of disinflation following inflationary "shocks".⁸ If the EMU would not exist, maintenance of the option to alter the exchange rate may be taken as leaving open the possibility to devalue, thus giving credence to agents' expectations of higher future inflation.⁹

A further important benefit of EMU is that it will remove the risk of serious real exchange rate variations. These may not only hinder economic growth and give rise to a misallocation of resources; they may also enable protectionism and, therefore, pose a threat to free trade. Such variations are particularly devastating in Europe given the level of economic integration; it was proven that sudden sharp falls in currencies such as the lira and sterling some time ago immediately led to - rather isolated - calls for protection and compensation.¹⁰ Such pressures, if unchecked, could put the survival of the Single Market, and all the benefits it brings to producers and consumers, at risk.¹¹

Two facts are important here: Inside Europe there was a spectacular downward convergence of inflation rates achieved. And at the same time, the Single Market implies generalised competition and constant pressure on profit margins. In such a surrounding even relatively small nominal exchange rate movements turn into bad proportion , with large effects on trade flows and business planning.

Short-term exchange rate volatility inside the EU will also be eliminated. Such volatility can again have a direct effect on trade and investment, as is shown by most empirical studies. In any event, the argument that the increased use of hedging instruments makes such volatility a matter of indifference seems exaggerated.¹² Such instruments are not available to all economic agents and they are fairly expensive. It may not even be optimal to fully protect against a single type of risk, since it may leave the firm more exposed to other types of risk.¹³ Furthermore, the benefits of economic integration afforded by the Single Market process will be enhanced once the transactions costs of exchanging different currencies are eliminated. These costs, which include commissions, the bid/offer spread and overall cash management costs, otherwise constitute a dead-weight loss for society as a whole and are not as insignificant as they might seem.¹⁴

Equally, those costs form an additional layer of protection for national producers; a single currency will make prices across the European area more transparent and directly comparable, which should increase competition and therefore efficiency and strengthen the progress towards a Single Market.

Many more positive effects on growth will flow from the elimination of separate currencies. There is also the potential for the reduction of the risk premium built into real interest rates, which in turn will stimulate productive investment. By facilitating the development of deep and integrated securities markets, the single currency should further reduce long-term rates via the elimination of an illiquidity premium.¹⁵

In addition, a wider and deeper capital market will improve the relationship between savers and investors. At a macroeconomic level, the savings and investment balance will become a smaller force within the individual participating economies.

An EMU country that shows valuable and attractive investment opportunities will be able to attract more capital . Foreign direct investment is also sensitive to exchange rate volatility and to the risk of lasting real exchange rate antiproportions, and therefore it should benefit from EMU.

A number of the benefits enumerated above increase with the existing degree of integration. In this context, it is important to stress that the integration of the real economies and financial markets of the Member States has already reached a high level. According to a recent estimate, around two-thirds of EU trade is intra-EU, an unparalleled degree of real integration.¹⁶ But equally, the single currency should stimulate further economic integration, with efficiency gains. Such further integration will be beneficial also in that it may reduce the possibility of so-called asymmetric shocks, one of the arguments used in the debate about the dangers of EMU, to which I will turn now.

Criticisms of EMU

Although there are various reasons stated that are in favour of the EMU, the arguments stated by the opponents should not be disregarded and should be considered seriously not at least because they contain useful warnings about potential problems.

The main policy or even "political" argument often stated against EMU is that it includes the loss of monetary sovereignty, for example the ability to use monetary policy to achieve domestic objectives. However, this argument only becomes of value if countries would disagree on the final objective of monetary policy; instead, there has been a growing consensus over the last decade or more that monetary policy cannot influence economic activity and unemployment beyond the short term.¹⁷ This has been the result of the experience of the 1970s, both in Europe and in the United States, which demonstrated the falseness of the attempts to trade inflation off against unemployment, as well as the awareness that inflation reduces growth potential.¹⁸ This has led to an intellectual and political shift to the cause of price stability and to world-wide acceptance of it as the primary objective of monetary policy. At the EU level, since monetary policies have a common objective, and given the potential for effects of national policy decisions in this area, it is hard to see what is lost by sharing responsibility for the authority of a single monetary policy - which is, in short, what EMU means. It is also important to know that the degree to which countries may adopt total independent national monetary policies is itself limited by the power of the international financial markets, whose ability to punish perceived monetary laxity with rising bond yields and a falling currency has strengthened in recent years.¹⁹

There are, however, other arguments which might be even more important.

Simply producing the new notes and coins and getting them into circulation will be a hard task for the governments. Apart from currency production and distribution, the main financial problems will be noticed by banks, whose information and accounting systems will need to be changed since they have to operate with two different currencies in the first three years. First, there will clearly be costs to the changeover, such as training, updating computer systems, and adjustments to cash dispensers and vending machines. These are, however, costs, which should be weighed against certain permanently developing benefits. Second, there may be differential effects of a single monetary policy on national economies, owing to differences in the monetary transmission process. However, such differences can be exaggerated. Moreover, the market forces created by EMU should themselves promote convergence in this area, as, for example, sustained low inflation makes long-term fixed rate mortgage finance attractive.²⁰

Perhaps the strongest argument put forward against establishing EMU is that individual countries should retain the ability to change their exchange rates as a means of responding to so-called "adverse asymmetric shocks" - shocks which affect the domestic economy but not the European area as a whole.²¹ But asymmetric shocks are not likely to be frequent events in western Europe. First, the economies remain rather similar in structure and are relatively diversified, at least in comparison with the United States.

To take an example, the automobile industry plays an important role in practically all our countries. It is heavily concentrated in some areas of the United States. Second, whenever we had a real asymmetric shock in the past - German unification or, to a lesser extent, the oil shock - what really mattered was not so much the asymmetric nature of the shock, but the asymmetry of the policy reactions.²² For many Scientists and EMU optimists, the German reunification was a uniquely disruptive shock, which is not likely to recur. There are various hypothesises of what might happen, and it is obvious that market rigidities in most EU countries are a source of concern. There is no doubt that labour and also some goods and services markets show insufficient flexibility. However, I disagree with the view that this is an argument against EMU. The source of the problem lies in structural rigidities that prevent fast at time adjustment in domestic prices and wages. The reduction of such rigidities, especially in labour markets, is an objective which has to be worked on. In an environment of real labour market rigidities, changing the nominal exchange rate may not be effective against shocks. If real wage decline is needed to prevent a negative shock from raising unemployment, it has to be the case that wage setters are prepared to allow it through a depreciation of the national currency but at the same time are not willing to accept it through nominal wage restraint.²³ This presupposes a degree of "money illusion", which is present at most in the very short run.

What role might fiscal policy play in this context? As critics of EMU note, there is no provision under current fiscal arrangements for transfers between Member States of a magnitude sufficient to offset differences in labour market rigidities.²⁴ Moreover, to minimise the risk of an adverse policy mix and an excessive burden on monetary policy, the countries participating in EMU have agreed to exercise a concerted discipline in the conduct of their fiscal management, with accepted sanctions in the case of excessive deficits. But even if such discipline reduces the scope for increasing fiscal deficits and public debts, the operation of automatic stabilisers should still be available to stabilise the economy, provided the structural deficit is close to zero. This is a beneficial objective with or without EMU.

Conclusion

It is not only my personal opinion, that the EMU is offering more benefits rather than creating potential risks. I tried to give an overall view on current state of establishing the Single Currency, pointing out the major criteria which are relevant.

The failure of EMU would be a severe setback for European integration.

LITERATURVERZEICHNIS

1. "Pros and cons of EMU", D. Currie
2. EMU Explained, R. Pitchford
3. EMU's alternatives. B. Kriegel
4. Euromoney, D. Shirreff;5/98
5. Europa 2000 Die Europäische Union
6. International Economics # 9208, W. Fuhrmann
7. Macroeconomics, Hanusch;ISBN 3-540-53801-1
8. WWW:Introducing the Euro
9. Monetary history . WWW
10. Newsweek ,,Euroland"; 11/98
11. Spiegelartikel, special, C. Pauly;#2/98
12. Süddeutsche Zeitung Nr. 47 S.24
13. The information action for the Single Currency, WWW
14. Time;
15.http://www.pei-intl.com/Research/EMU/EURO1097.HTM(theEuro(the Euro)
16.http://www.sachverstaendigenrat-wirtschaft.de/jg97/firstcha.htm (German Council)
17. http://www.itw.ie/exporter/emu.htm (EMU - THREATS AND OPPORTUNITIES)
18. http://www.bi.go.id/pidato/speech.htm (The European Single Currency)
19. various newspaper articles

COINS AND NOTES

Euro notes and coins will not be available until the beginning of 2002. The Euro will, however, be used as book money when Monetary Union starts in 1999.

[...]

¹ EMU Explained, R. Pitchford

² Europa 2000 Die Europäische Union

³ International Economics # 9208, W. Fuhrmann

⁴ Monetary history . WWW

⁵ EMU explained, R. Pitchford

⁶ The information action for the Single Currency, WWW

⁷ "Pros and cons of EMU", D. Currie

⁸ International Economics # 9208, W. Fuhrmann

⁹ EMU's alternatives. B. Kriegel

¹⁰ Monetary history . WWW

¹¹ Newsweek ,,Euroland"

¹² EMU explained, R. Pitchford

¹³ "Pros and cons of EMU", D. Currie

¹⁴ EMU explained, R. Pitchford

¹⁵ Macroeconomics, Hanusch

¹⁶ Spiegelartikel, special, C. Pauly

¹⁷ s.o.

¹⁸ Macroeconomics, Hanusch

¹⁹ Time

²⁰ Süddeutsche Zeitung Nr. 47 S.24

²¹ Macroeconomics, Hanusch/WWW:Introducing the Euro

²² EMU Explained, R. Pitchford

²³ Euromoney, D. Shirreff

²⁴ Spiegelartikel, special, C. Pauly