Monetary Union
Monetary Union
Economic and Monetary Union (EMU) is an important stage in the process of economic integration.
The main features of European Economic and Monetary Union (EMU) include:
A single European currency
The Euro (€) was first introduced in 2000, and national currencies were finally scrapped in 2002. The framework of rules for entry into the Eurozone was laid down in the Maastricht Treaty in 1992. This treaty also created the rules for membership of the European Union (EU) in general.
The euro-system
The euro-system has two elements – the European Central Bank (ECB), which is responsible for all monetary policy in the eurozone (euro area), and the National Central Banks (CBs) of the 19 member countries. Other European countries are free to join the euro area if they meet the criteria laid down in various treaties. The two most important criteria for entry are that the applicant country has demonstrated price stability, and that its public finances are well managed.
Co-ordination of macro-economic policies
Co-ordination of policy was designed to enable the original 12 economies of the euro-area to converge. A key feature of this was the Stability Pact, which involved members agreeing to keep their economies stable, and keeping their budget deficits under control. The agreed limit for a deficit was that it must be no more than 3% of GDP. This restriction was designed to prevent any unnecessary fiscal stimulus which might de-stabilise the economy, even in the face of high unemployment. However, several countries, including Germany, France, and most notably, Greece, have broken this rule, and this has cast serious doubts about the ability of the euro area to maintain this rule.
The European Financial Stability Facility
The EFSF was formed to help stabilise the European economies after the financial crisis, recession and sovereign debt crisis, and now forms a key element of the reformulated euro-system.
The fiscal compact
In attempt to prevent EU countries from running up further debts, the majority of the EU states signed a fiscal compact which opened up their domestic budgets to collective scrutiny. It remains to be see how successful this measure will be, and whether its leads to a full fiscal union.
Single interest rate
The ECB sets interest rates across the whole Euro-area (EA-19*), and no single National Central Bank has the ability to alter interest rates itself.
Asymmetric inflation target
The ECB sets an asymmetric target rate for inflation of 2% – in other words, the inflation target is not symmetrical, as in the UK, where intervention should occur at rates 1% above and 1% below the target rate.
The advantages of the Euro
There are several significant benefits of having a single currency area. These are primarily derived from the benefits of fixed exchange rates, and include the following:
Transparency
Producers and tourists can more easily compare the prices of international goods, services and resources.
Lower transaction costs
Transaction costs are reduced because there are no commission payments to financial intermediaries.
Certainty and investment
The Euro creates certainty because firms can predict the cost of imported raw materials and can set the price of their exports, which means they can plan, and are more likely to invest.
Trade creation
Trade between members of a single currency area is likely to increase because of the benefits of sharing a currency.
Job creation
Increased trade is likely to generate jobs in those industries that experience increased exports.
Discipline against inflation
Members cannot take the easy option (devaluation) to get out of economic difficulty.
The disadvantages of the Euro
Loss of economic sovereignty
Once a country become a member of the euro area, National Central Banks, including the Bank of England, lose their ability to use interest rate policy to achieve independent macro-economic objectives. Following the financial crisis and global recession, recession-hit countries like Greece were not able to reduce interest rates unilaterally.
Difficulty of conversion
Many European countries, including the UK, may never be able to converge fully with the euro area. In the UK in particular, convergence is difficult because of the uniqueness of its housing market and financial services sector, and because of the closeness of the UK’s trade cycle to that of the USA. In addition, the UK labour market is highly flexible in comparison with France, Germany, and Spain and this also makes convergence difficult.
One cap does not fit all
Having only one interest rate is not sensible when dealing with a diverse range of economies and economic circumstances. Even within a single currency area, great diversity can exist, suggesting that a common economic policy might be unproductive.
Dealing with asymmetric shocks
Asymmetric shocks are external shocks that have an unequal impact on an economy or, in this case, the EU area. The following recent shocks did not have an equal effect across Europe: the handover of Hong Kong to China by the UK in 1997 led to an exodus from Hong Kong to the UK, and not to the rest of Europe, and helped fuel a mini-housing boom in parts of London; the September 11th2001 attacks on New York did not affect all euro area countries evenly; and the collapse of the Argentinean peso in 2002 mainly affected Spain.
The growing imbalance between the more affluent northern euro members, including Germany, and the increasingly indebted southern ones, including Greece, Italy and Portugal, has also raised the issue of the inadequaces of having a single monetary policy.
In these types of circumstance it is argued that a single interest rate will not be appropriate. A member experiencing a negative (perhaps domestically originating) shock would require lower interest rates and looser monetary policy in comparison with those members less affected.
The weakness of an asymmetrical monetary target
Having an asymmetrical inflation target means that the ECB must only intervene if the rate is exceeded, and not if inflation falls below the target rate. Critics argue that, as a result, there is a built-in deflationary bias. The euro area has certainly experienced deflationary pressures in recent years.
Membership tests
In 2003 the UK government laid down five conditions for the UK to join the euro area. These were:
Economic convergence
The trade cycles of the UK and euro area should be in alignment.
Flexibility
Joining should not harm the highly flexible product and labour markets of the UK.
Investment
Joining should not discourage domestic investment and FDI.
Financial services
The City (the financial centre) should not suffer as a result of membership of the euro area.
Growth and jobs
Membership should be good for growth and job creation.
The future?
Given the strength of the case against joining the euro area, even before Brexit, it was increasingly doubtful whether the UK would every scrap the pound. Indeed, the financial crisis re-opened a wider debate about the benefits of enlarging the euro-area.
Brexit impact
This debate has, clearly, been overshadowed Brexit. When, on June 23rd 2016, the UK voted to leave the EU it finally put to rest any thought that the UK would ever adopt the euro. With the future of the EU itself now uncertain, there is the increased risk that some members of the euro-area, notably Greece and italy, might wish to revert back to their previous currencies.
Have prices converged?
The single currency does not appear to have led to any great reduction in price differences across Europe. It was thought that price transparency would have brought prices much closer together, but, without perfectly free trade and tax harmonisation, price differences are still likely. For example, considerable price differences in many basic products, such as cigarettes, chocolate, and water, still persist, as indicated below:
|
|
Paris |
Rome |
Madrid |
|
Big Mac |
€3.00 |
€2.70 |
€2.00 |
|
Mars Bar |
€0.69 |
€0.87 |
€0.57 |
|
Cigarettes |
€5.00 |
€3.50 |
€3.55 |
|
Bottled water |
€0.83 |
€0.68 |
€0.91 |
*Source -Dresdner Kleinwort Wasserstein – Pricing Survey
*Euro-area 19:
Austria
Belgium
Cyprus
Estonia
Finland
France
Germany
Greece
Ireland
Italy
Latvia
Lithuania
Luxembourg
Malta
the Netherlands
Portugal
Slovakia
Slovenia
Spain
Scottish independence, Sterling and the UK
