Economic and Monetary Union

Economic and Monetary Union (EMU), process of establishing a single currency and a single monetary authority in the European Union (EU). The EMU is a cardinal aspect of the project of European political and economic integration.

The idea of EMU was first clearly articulated in the Werner Report (1970), which proposed monetary integration by 1980. Further progress was halted by the oil shocks and worldwide inflation of the mid-1970s and the almost inevitable divergence of exchange rates in response to these developments.

The European Monetary System (EMS) and the Exchange Rate Mechanism (ERM) were established in 1979, but they were not closely related to the EMU proposal since they envisaged, at least initially, frequent readjustments of exchange rates. Monetary union proposals were revived in 1988 and moved forward rapidly. The Delors Report (1989), masterminded by Jacques Delors, produced a detailed plan for monetary union. The Delors plan was adopted, with some modifications, in the Treaty of Maastricht, which was signed by all 12 members of the then European Community in February 1992. Denmark and the United Kingdom, however, obtained opt-outs which enabled them to postpone their final agreement to the principle of monetary union.

The Treaty of Maastricht envisaged a commitment to a gradual three-stage progress towards monetary union, with progressively greater convergence of the economic performance of member countries as an essential part of the process. Stage 1 comprised closer economic and monetary cooperation between member states within the existing institutional framework. Stage 2, which commenced on January 1, 1994, involved reinforcement of economic convergence beyond Stage 1, especially through the establishment of a European Monetary Institute, which served as the European Central Bank (ECB) in embryo, building on the established policy-consultative activities of the governors of EU central banks, while still leaving responsibility clearly in national hands. Stage 3 involved the irrevocable locking of exchange rates between participating currencies and the assumption by the ECB of its full powers of managing the single currency that would replace national currencies in due course, and of executing the common monetary policy of the EU.

The principal mandate of the ECB is price stability, and it is an independent body free of day-to-day political interference. (The governing council of the ECB comprises the national central bank governors from participating states, along with an executive board appointed by these states.) The ECB, however, shares responsibility for the EU’s external exchange rate policy with the Economic and Financial Council of Ministers. Since monetary and exchange rate policy are intimately linked, some observers see here a source of potential tension. A notable feature of the treaty is that it provides not only for a common monetary policy but also for limits on and surveillance of national fiscal policies. The three basic fiscal principles that underlie the provisions are “no excessive fiscal deficits”, “no monetary financing of fiscal deficits”, and “no bailouts of member governments or national public bodies”.

It is notable that the transition to Stage 3 was not automatic. The treaty set out clear and quantified “convergence criteria” for a country’s participation in Stage 3 as follows: (1) for at least two years before entry, the country must have adhered to the normal fluctuation margins of the ERM, without devaluing its bilateral central rate against any other member state’s currency; (2) its average rate of consumer price inflation must not have exceeded by more than 1.5 percentage points the rates observed in the three member countries with the best inflation performance over the preceding year; (3) its average long-term interest rate must not have exceeded by more than 2 percentage points those of the same three best-performing member states over the preceding year; (4) while some allowances can be made for temporary fiscal deficits and for a temporarily high but diminishing debt ratio, the government fiscal deficit should not exceed 3 per cent of gross domestic product (GDP) and the ratio of government debt to GDP should not exceed 60 per cent.

It was agreed at Maastricht that full EMU—in other words Stage 3—should begin for those member states judged eligible to participate no later than January 1, 1999, although dramatic speculative crises from mid-1992 to mid-1993, which resulted in the widening of the exchange margins of the ERM to 15 per cent, initially cast serious doubts on the likelihood of this.

The desirability of monetary union is a controversial matter. Proponents are impressed by the advantages of complete exchange rate stability and certainty, which they see as conducive to trade, investment, and capital flows. The main benefit that is claimed, however, is that a fixed exchange rate would act as an anchor against inflation. Countries such as Italy and the United Kingdom have seen this as an effective way to break inflationary expectations in the labour market, in part by the implied reduction in the discretion of national policymakers. Low-inflation countries such as Germany, however, are concerned about whether the ECB would continue to follow the conservative monetary policies of their national central banks.

Opponents of monetary union focus on the principal cost of a monetary union, namely the loss of national autonomy with regard to monetary and exchange rate policy. This may matter when the positions of national economies are not cyclically synchronized or when they are differentially affected by real shocks in the global economy. An economy in recession or one facing an adverse exogenous shock would then have to adjust by lowering money wages and prices. If wages and prices are inflexible, the adjustment process may be long and painful and involve substantial unemployment. In such circumstances, a change in the exchange rate could ease the adjustment to a new equilibrium. Implicit in this view is some optimism regarding the possibility of a domestic anchor against inflation.

There was controversy also about the transition to EMU. Some thought that the approach should be gradual, as in the Maastricht process, and that it was foolhardy to link economies whose economic performance was widely divergent. Others thought that the gradual approach involved a large risk of speculative crises during the transition; and, moreover, that a rapid move to monetary union would itself have a dramatic effect on expectations and lead quickly to convergence in inflation performance. Despite the above reservations, the governments of most member states, especially France and Germany, continued moves towards monetary union, and designs for the new common currency were issued in 1996.

In January 1999 the EU states participating in the project introduced the single European currency, or Euro, a move seen as the most important creation in world currency since the advent of the United States dollar. Denmark, Greece, Sweden, and the United Kingdom did not participate; Greece for economic reasons, and the other states from choice. Simultaneously, the ECB was created to manage the currency. The EMU timetable envisaged the replacement of all national currencies of the founder states by the Euro three years after its launch. The United Kingdom, while keeping its options open, published a draft plan for British participation in the single European currency in February 1999. In a referendum in September 2000, Denmark voted against joining the Euro; Greece had its subsequent application to join accepted and entered the EMU in January 2001. A year later, on January 1, 2002, the Euro officially became legal tender in 12 EU states: Austria, Belgium, Finland, France, Germany, Greece, Italy, Ireland, Luxembourg, Netherlands, Portugal, and Spain.