European Monetary System

UNIVERSITY of BREMEN



Department of economic sciences
European economic policy (07-MIER 32)
Prof. Jörg Huffschmid



European Monetary System and European Monetary Union




Done by Olha Kovalchuk
Matriculation number 1697751
WS 2002/2003








Bremen 2002

2

Plan

Introduction ..........................................................................................................3

1. The development of European monetary integration before the
Maastricht Treaty…………………………………………………………4
1.1 The idea and beginnings of the European Monetary Union………………4
1.2 The European Monetary System and its main instrument – Exchange Rate
Mechanism……………………………………………………………………..6

2. The creation of the EMU as a next and deeper phase of European
integration…………………………………………………………………...10
2.1 The Delors Report………………………………………………………...10
2.2 Maastricht Treaty as a milestone in the development of the EMU idea….11


3. Costs and Benefits of the European Monetary Union………………….14


Summary…………………………………………………………………….17


Literature…………………………………………………………………….19







3
Introduction
The foundation of the European Monetary Union, in my opinion, was one of the most
important steps on the way of European integration. Because now every citizen of those 12
countries which entered the EMU has really something common with all the others – the euro.
It’s really difficult to say, if Europeans are very much interested in the European agreements,
principles, institutions but I can surely say that everybody of them has heard something about
the EMU and ECB.
The aim of my report is to highlight the main stages of European monetary integration
with the focus on European Monetary System and European Monetary Union. EMS appeared in
1979 as an agreement between central banks of most countries of the EC by which they linked
their currencies to prevent large fluctuations relative one another. In the early 1990s the
European Monetary system was strained by the differing economic policies and conditions of
its members, especially the newly reunified Germany, and Britain permanently withdrew from
the system. EMU was established according to the Maastricht Treaty and meant that national
currencies of the EU members were abolished and replaced by a single European currency.
Besides EMU replaced the national, mutually independent central banks by a single European
one (European Central Bank) that is in charge for all member countries. So it seems now, that
the declaration in the preamble to the Treaty of Rome proclaiming the intention to create “an
ever closer union…” (Hansen, 2001: 503, 5) speedily comes into life.
The main theses and points of my paper will be the following:
1. The launch of the EMU in the 1970s was abandoned because of the economic instability
(unequal inflation rates between EEC members) but nevertheless that project
contributed a lot to the understanding of the preconditions for the future European
Monetary Union.
2. A new attempt at establishing monetary stability was launched in March 1979 with the
European Monetary System replacing the “snake”.
3. Exchange Rate Mechanism was a main instrument for fulfilment the objectives of the
EMS
4. The main reason for the ERM (fixed exchange rate system) weakness was its operating
without coordination of monetary policy
5. The efficiencies and benefits from a single market (economic union) will only be
maximized when the costs and risks of currency exchange are eliminated (monetary
union).
6. ERM 2 is an asymmetric system centred around the euro
7. If comparing the costs and benefits of the EMU, it must be decided whether greater
income and price stability is worth the loss of an autonomous monetary and exchange
rate policies
While writing this paper I worked with different sources of information: textbooks,
monographs, articles. But nevertheless, the complete understanding and research of the topic
wouldn’t be possible without Internet resources as they are very helpful while looking for new
and updated information. The only problem was a fair evaluation of costs and benefits of the
EU. Only very few economists try to sum up now the results of the EMU introduction as really
very little time has passed. But nevertheless I tried to do my best and reflect the topic as full and
interesting as possible.
4
1.The development of European monetary integration before the
Maastricht Treaty
The development of European monetary integration started already in 1960s. Though at
that time it was rather slow and couldn’t be fully put into practice as there didn’t exist all the
necessary preconditions. The EEC members were not ready for full monetary integration. But
nevertheless the main events such as Barre, Werner reports, substitution of “the snake in the
tunnel” with European Monetary System based on ERM, creation of European Monetary
Cooperation Fund etc made the basis for further explicit monetary integration after Maastricht
Treaty.

1.1 The idea and beginnings of the European Monetary Union
If to consider the history and beginnings of the European Monetary Union it can be said
that the idea appeared already at the beginning of 1960s while Monnet’s Action Committee
talking about the United States of Europe called for monetary integration. Also in 1962 the
EEC commission in ‘The Action Programme of the Community for the Second Stage’ proposed
to establish an adjustable peg exchange rate system and a reserve currency by the end of the
decade (Arestis, McCauley & Sawyer, 2001, 1).
But nevertheless those suggestions were not accepted because at that time exchange rate
stability and a framework for macroeconomic policy coordination were provided externally by
the Bretton-Woods system. And only the collapse of the international system of fixed exchange
rates fostered the community toward monetary integration. It is important to mention several
reasons which pushed the EEC to the idea of monetary integration. First of all, at the time
Common Agricultural Policy and its price system were threatened by the exchange rate
fluctuation and that’s why a stabilization by safeguarding of fixed exchange rates was needed
(Arestis, McCauley & Sawyer, 2001, 1). Also Germany was in a need of so called
“Westpolitik”. Moreover it was important to adopt a common policy towards the USA, and to
have a strong currency to oppose dollar.
The speedy implementation of the custom’s union together with the erosion of the
stability of the dollar-centred Bretton-Woods system resulted in the necessity of monetary
union to protect the EC from break-up. The increased monetary instability of the 1960s lead to
the Barré Report in 1969. In that report in order to overcome currency instability, it was
proposed to improve macroeconomic co-ordination and to eliminate fluctuation margins around
the currencies of the six members of the EEC with their further fusing into a single currency.
That objective was confirmed by the decision of the EEC heads of states and governments, at
the Hague summit of December 1969, to proceed gradually to EMU (Arestis, McCauley &
Sawyer, 2001, 1).
In that connection a special study group under the guidance of Pierre Werner was
established to review EMU more closely and to propose a concrete plan for moving ahead. The
Werner Report 1971 very optimistically, I must say, planned the movement toward economic
and monetary union by 1980. Like the Delors Report which it preceded, it proposed an EMU in
three stages. The first stage, which was intended to last from 1971 to 1973, was directed at
getting economic support and preparing the ground for any institutional development in order to
facilitate coordinated policy-making. The second stage consolidated economic and institutional
progress of the previous stage. At that stage exchange rate changes could only be made with the
explicit agreement of members. The first two stages foresaw increased policy co-ordination
leading to convergence, a common policy on government budgeting, and a progressive
narrowing of currency fluctuation bands.
5
According to the report the European Monetary Cooperation Fund (EMCF) had to be
created in stage 2 to manage a proportion of the member states reserves and to provide short-
and medium-term finance for intervention. The EMCF was responsible to the Committee of
Central Bank Governors, which itself was charged with co-ordinating monetary and exchange
rate policy. And in stage 3 exchange rates would be irrevocably fixed and a community central
bank would be created to centralise monetary policy.
According to the Werner Report, “monetary union . . . may be accompanied by the
maintenance of national monetary symbols or the establishment of a sole Community currency.
From the technical point of view the choice between these two solutions may seem immaterial,
but consideration of a psychological and political nature militate in favour of the adoption of a
sole currency which would confirm the irreversibility of the venture" (Werner Report, 1970: 5)
(Arestis, McCauley & Sawyer, 2001, 1).
The Werner Report caused a lot of disputes between the members of the EEC. One group,
represented by France, Belgium and Luxembourg, wanted to turn to irrevocably fixed exchange
rate parities as soon as possible, even before the effectiveness of economic policy co-ordination
had been established. (And in my opinion, that was fully unreasonable as these two things are
interdependent and it is very difficult to fulfil one without having another).Another group
though, represented by West Germany and the Netherlands, wished to establish a system of
economic policy co-ordination before eventually progressing to a fixed exchange rate. In the
end, the Werner Report reached a compromise between both positions by developing a strategy
of parallelism for economic policy co-ordination and for monetary union.
In March 1971 the EcoFin Council agreed on EMU, although only stage 1 was elaborated.
There were agreed mechanisms for closer co-operation among central banks. Moreover, a
special clause was included, where it was told that if agreement on the second and more
substantive stage of EMU had not been reached by January 1976, then monetary co-operation
measures should be abandoned. Intra-EEC exchanges were confined to a narrower band of
fluctuation than was permitted in respect of EEC currencies against the dollar (the ‘snake in the
tunnel’). This attempt to limit intra-European exchange rates had to advance the objective of
EMU by promoting trade in goods and services and capital flows within Europe.
But in spite of the concrete steps to create EMU according to Werner Report, the situation
in the world economy in 1970s didn’t foster that objective. The USA, faced with rising
unemployment and slow economic growth, pursued an easy monetary policy which was the
converse of that desired by the authorities in European countries. There took place an expansive
world economic crisis, oil price shocks etc. On the whole, the launch of EMU in 1970s was
abandoned because of the economic instability. Besides, a great role played also conflicting
national objectives and unwillingness to surrender national sovereignty in pursuit of a
Community objective.
But the main drawback of the Werner Report, in my opinion was, that it wanted to
establish fixed exchange rates, without previous reaching of equal inflation rates between EEC
members. But, “unless countries inflate at constant rates it is virtually impossible to keep
exchange rates fixed”. (Overturf, 1986: 55, 11). If Italy, for example, increases its monetary
supply and inflates its price level at 15 percent per year while Germany limits its inflation to 3
percent, then fixed exchange rates will result in severe balance-of-payments deficits for Italy, as
it loses price competitiveness with Germany. The devaluation is the necessary result. That’s
why Werner plan had no chance to be put into life.
With the collapse of the Bretton Woods system and the floating dollar, the process of
EMU halted. When the Commission eventually came round to consider proceeding to stage 2,
no agreement could be reached at the Ecofin Council and EMU was abandoned in December
1974.
6
A lot of economists were against speedy monetary union. The Marjolin Report (1975)
argued that monetary union should be postponed until after the achievement of a high degree of
economic integration in the EC. It advocated that a single unified market would provide a sound
basis on which to launch monetary union. From another standpoint, the MacDougall Report
(1977) stressed the role of a unified fiscal system in a monetary union and concluded that a
monetary union would not be viable without a sufficiently large community budget for fiscal
policy (Arestis, McCauley & Sawyer, 2001, 1). From its point of view the ‘snake’ exchange
rate placed the burden of adjustment on the weak-currency countries and was unable to provide
adequate financing for weak-currency central banks when their currency was subject to
currency speculation. By 1979, only Germany, Netherlands, Denmark, Norway, Sweden,
Belgium and Luxembourg remained within the fixed exchange rate system.
Nevertheless the EMU project (1971) did have concrete achievements at that time and it
served as a basis for those proposing EMU in the future. Among these achievements were the
strengthened co-operation among central banks with the creation of the EMCF and the
agreement to maintain a high level of convergence of the economic policies of member states.
Besides, it highlighted the economic and political difficulties associated with such moves
towards EMU. It also demonstrated that a stable currency management was an important
precondition for any serious attempt to adopt a single currency. Moreover, the EMU project
proved that no lasting progress towards EMU could be achieved without appropriate institution
reforms guaranteeing a transfer of responsibility in the macroeconomic field from nation to
European level.

1.2 The European Monetary System and its main instrument – Exchange Rate
Mechanism
In 1977 Roy Jenkins, President of the Commission, reactivated plans for establishing a
monetary union. His plan was supported by Germany and France. In July 1978, the heads of
state of the member countries, the original six plus three new entrants (UK, Ireland and
Denmark), met to discuss closer monetary co-operation (Arestis, McCauley & Sawyer, 2001,
1). Later that year the European Council adopted a resolution establishing the European
Monetary System (EMS) as an agreement between central banks of the EC countries. A new
attempt to establish monetary stability was launched in March 1979 with the EMS replacing the
“snake”. The second stage, the creation of the European Monetary Fund to replace the EMCF
(European Monetary Cooperation Fund) was planned for two years later, however, bad
economic climate postponed this event.
The EMS was established to pursue three main policy objectives:
1. Creation of a “zone of monetary stability” involving both low inflation and stable exchange
rates;
2. Establishment of a framework for improved economic policy co-operation between member
states;
3. Partial prevention of world monetary instability through the adoption of common policies in
relation to third countries.
Finally, it was hoped that the EMS would lead to economic and monetary convergence,
and would be a basis to economic and monetary union. It introduced innovations to overcome
problems that had lead to the collapse of the “snake”. The divergence indicator, as discussed
below, was created to counter excessive German dominance and establish symmetry. Changes
7
of the exchange rate could occur only by unanimous agreement and not according to unilateral
decision as it happened under the “snake”. This procedure was introduced to prevent countries
from harming the system by taking actions only in their self-interest.
In order to fulfil all the three above-mentioned objectives, the EMS was provided with a
tool called the Exchange Rate Mechanism (ERM) which consisted of four components:
European Currency Unit (ECU), the parity grid, the divergence indicator, and credit financing.
First, the ECU had two uses:
monetary unit based on a basket of EU currencies – a fixed quantity of each currency in the
basket with the weights of the currencies varying over time as intra-European exchange
rates fluctuated;
reserve instrument – at least 20 per cent of the gold and dollar reserves of each country must
be held in ecus. (Crawford, 1996: 55, 2)
Second, the fixed exchange rate is defined in terms of a parity grid, in which each
currency has a central rate, a ceiling and a floor, against each other currency. The central rate is
the amount of a country’s currency equal to one ECU and is only revised by unanimous
agreement of participating governments. The central rates were determined the bilateral
exchange rates, with fluctuation bands set at ±2.25% and ±6% for Italy (Arestis, McCauley &
Sawyer, 2001, 1). Intervention is compulsory and symmetrical at the ceiling and the floor. This
means that whenever a pair of currencies fully stretch the maximum band-width between them,
both must intervene; the central bank with the weak currency sells the strong currency (if
necessary borrowing it from that country’s central bank) to purchase its own, while the central
bank with the strong currency sells it, buying the weaker one. But on the whole, it can be said
the countries with strong currencies rarely decided to intervene as they were worried about the
inflationary risk of inlow. Intervention was mostly used by the countries with week currencies
which sold dollars or marks to acquire their own. So ERM experienced asymmetries.
Third, the divergence indicator is used to give a warning when a country is diverging
(moving) from its central rate. The divergence indicator acted as a supplementary intervention
device. When movements in the daily exchange rate pegged against the weighted average
movement of the other EMS currencies exceeded 75% of the maximum possible divergence
range, it signalled the need for a country’s monetary authority to take corrective measures:
diversified intervention (intervention in a range of currencies, rather than in a single currency),
domestic monetary policy (which would have an effect on interest rates), changes in central
parity, or other measures of economic policy (fiscal or incomes policies). The divergence
indicator applies equally to relatively weak and strong currencies with the intention of
introducing symmetry into the EMS.
Fourth, credit facilities which are available to ERM members for intervention in the
foreign exchange market. Three types of finance facility are provided to member countries to
intervene in the foreign exchange markets once their currency approaches the upper or lower
limits of their exchange rate band. Very short term (45 days - 3 months) and short term (3 - 9
months), which are administered by central banks, and medium-term (2 - 5 years) administered
by the Council of Ministers (Arestis, McCauley & Sawyer, 2001, 1). Only the very short-term
facility is unconditional and remains the only one that has been used (Crawford, 1996: 55, 2)
Credits are given by European Monetary Cooperation Fund.
The members of the European Community participating in the ERM (the UK remained
outside the ERM until October 1990) chose to fix their bilateral exchange rates, but did try to
co-ordinate their monetary policy themselves.
8
The optimists argued that the stability of the exchange rates between member countries
would promote economic trade and growth, and the more inflationary economies would have to
move to lower inflation rates. ERM was described as “a fundamental component of a more
comprehensive strategy aimed at lasting growth with stability, a progressive return to full
employment, the harmonization of living standards and the lessening of regional disparities”
(Jovanovic, 1997) (Arestis, McCauley & Sawyer, 2001, 1).
Even at an early stage there were concerns about the viability of the EMS. Countries in
the EEC had different productivity, prices were changing constantly and it was simply
impossible to keep fixed exchange rate. That’s why quite often parity grid was changed to
correspond to the present economic situation. But in the end Italy refused to change exchange
rate and to devaluate the currency, as it caused big damages for Italian investments. Moreover,
countries with strong currencies were not satisfied with the rule that according to parity grid
they had to buy weak currencies and sell their own strong currencies. As it caused so called
imported inflation. Exports of the strong currency country became cheaper and were
increasingly bought abroad. This caused inflow of the inner currency into the country and
that’s why inflation.
In addition, the EMS faced the asymmetry problem of a fixed exchange rate system
caused by the lack of a common policy toward the dollar. Besides, dollar weakened the DM
while placing it as a reserve currency. This caused the appreciation of the DM within the EMS
and further destabilising of the system. So this example shows us the high degree of
interdependence in the world economy - the EMS experienced shocks even though the
developments occurred elsewhere in the world.
On the whole, the introduction of the ERM was forced by large inflation discrepancies
between participating countries. Between 1979 and 1987, there were eleven realignments
within the ERM. These realignments were caused by high inflation countries devaluing their
currencies to remain competitive with the low inflation countries. Countries were forced to
implement capital controls to prevent the destabilising effects of capital flows. This highlighted
the fundamental weakness of the ERM, a fixed exchange rate system operating without the
coordination of monetary and fiscal policies.
When in 1986 the EU amended the Treaty of Rome with the Single European Act, the end
of 1992 was set as a target date for the removal of all remaining barriers to the free flow of
goods, services and resources. A greater degree of macroeconomic co-ordination among
member states was now required. As a result the EMS was strengthened because of the desire to
achieve greater convergence in economic policies (the Basle/Nyborg agreement, 1987).
Between 1987 and 1992 there was only one realignment, a 3.7% technical depreciation of
the Italian Lira to allow for the narrowing of the fluctuation margin. Other countries became
members of the ERM, Spain in June 1989, the UK in October 1990 and Portugal in April 1992:
all the currencies participated in the 6% band. Moreover, the EMS at last appeared to realise its
purpose and variations in the real exchange rates and money supplies among EMS members
(Germany, France and Italy) were smaller than between non-members (Japan, UK and USA)
within 1979-1988 (MacDonald and Taylor, 1991) (Arestis, McCauley & Sawyer, 2001, 1).
Besides, among EMS members there was convergence in inflation rates, interest rates, budget
deficits and government debt as a percentage of GDP between 1987-92 (Arestis, McCauley &
Sawyer, 2001, 1). By July 1990, all restrictions to intra-community capital movements were
removed and by the beginning of 1993 all remaining restrictions to the free flow of goods,
services and labour were eliminated, the single market was in existence. The status quo,
however, could not remain unchanged: a fixed exchange rate system is only compatible with
the free flow of capital if macroeconomic policy is fully coordinated.
9
On the whole ERM lived through many difficulties if to mention only the oil shock of
1979 (a similar event hastened the demise of its predecessor, the “snake”). Besides, Germany
historically had high interest rates to curb inflationary pressure. Tight monetary policy in
Germany acted as a trigger for the ERM crisis.
Faced with the strain of keeping their currencies within their respective bands, the UK and
Italy were forced to abandon the ERM. This was followed by six other devaluations: the Peseta
in September 1992; the Escudo and Peseta in May 1993; the Irish Pound in January 1993, and
again the Peseta and Escudo in May 1993 (Arestis, McCauley & Sawyer, 2001, 1). France
remained within the ERM only after heavy intervention in the foreign currency market by the
Bundesbank and the Bank of France. Pressure was eased a little in the spring of 1993 when the
Bundesbank made three interest rate reductions. Improvement was only temporary as the
Bundesbank failed to lower interest rate in August 1993. This caused abandoning of the narrow
band of 2.25% in favour of 15%. The crisis highlighted the effects of member countries
operating uncoordinated monetary policies. Germany had ignored the warning of other ERM
members and had adopted a high interest rate policy in the face of a growing money supply.
The ERM was a free floating system in all but name and it appeared that the move toward
monetary integration had been permanently spoiled. Although at the end of 1996 all ERM
currencies with the exception of the Irish pound were within the 2.25% band, while sterling and
the drachma remained outside the ERM.
Summing up, the EMS seemed to have succeeded in promoting convergence in inflation
rates, interest rates, budget deficits and government debt as percentage of GDP from 1987 to
1992 (Salvatore, 1996: 605) (Arestis, McCauley & Sawyer, 2001, 1), although Fratianni and
von Hagen (1992: 30-31) (Arestis, McCauley & Sawyer, 2001, 1) point out that “the inflation
performance of EMS countries has been no better than non-EMS countries”. In this regard,
realignments changed from being a passive reaction to inflation to being an instrument to
control inflation and used in conjunction with domestic measures.














10
2. The creation of the EMU as a next and deeper phase of European
integration
At the end of 1980s European monetary integration was in a big crisis. It seemed even that
it would be impossible to create something like European Monetary Union. But Jacques Delors,
President of the Commission, still believed in the idea and decided to combine monetary
integration with single market as it should be more successful. His assumption appeared to be
correct. But the creation of the EMU had to have a legal base and the Treaty of Maastricht
provided this. In order to enter monetary union the EU countries had to fulfil 5 convergence
criteria. Unfortunately at that time only Luxembourg corresponded to the criteria but it was
decided that by any means EMU had to be created until 1999. 12 countries became members of
the EMU (among them Germany, which was very important for other EU members) and in
2002 a common currency euro was fully introduced into circulation.
2.1 The Delors Report
When Jacques Delors took up his position as President of the Commission in 1985, he had
a number of priorities: a single market, institutional reform, new monetary initiative and
extending Community’s competence in the field of foreign policy and defence (Arestis,
McCauley & Sawyer, 2001, 1). Delors would have preferred to concentrate on EMU but
realised that monetary policy lay too close to the core of national sovereignty. If he choose to
follow such a politically sensitive strategy, then it would have provoked hostility from national
governments and created tensions within the community. Instead he decided to look for a
common problem where consensus could be reached on achieving a solution. At the time a
common shared problem was recession hit economies – Europe had experienced the worst
recession since the war. European industry was losing its competitiveness against American
firms. Delors recognized quite quickly that the single market was the obvious option. It was
simply reaffirming an objective that had been agreed by the heads of states under the Treaty of
Rome. Moreover, successful implementation of the Single Market could be a mechanism for
improving decision-making and renewing interest in EMU. The outcome of the Single Market
Programme and the success of the EMS in achieving monetary stability did really focus
attention back onto EMU. And at the European Summit in Hanover on June 1988, the heads of
government agreed to establish a committee with ‘the task of studying and proposing concrete
stages leading towards this union’. The committee delivered its findings in the Delors Report,
the following year, at the Madrid Summit.
The report identified four key elements to achieve economic union. First, the creation of a
single market; second, competition policy to strengthen the market mechanism; third,
macroeconomic policy coordination coupled with binding rules for budget deficits; and, fourth,
common policies to strengthen structural change and regional change. Economic union would
not require a single economic policy. By contrast, monetary union would necessitate a common
monetary policy to be controlled by a central institution, though a single currency was not
mandatory. Prerequisites for monetary union were identified as the total and irreversible
convertibility of currencies, the complete liberalization of capital transactions, elimination of
margins of fluctuation and the irrevocable fixing of exchange rate parities. The central
institution overseeing the Community’s monetary policy would be a European System of
Central Bank (ESCB). Its primary objective would be price stability while it would maintain
total independence from member states.
The report recommended a transition towards full monetary union in three stages:
1. Initiation process towards EMU, which advocated the convergence of economic
performance and cooperation in monetary and fiscal polices. The common market had to be
11
completed by the removal of all restrictions to intra-community capital movements. In
principle all countries should enter the ERM at the narrow band. This stage would see the
expansion of the role of the Committee of Central Bank Governors in coordinating policy.
2. Transitionary period where the procedures established in stage one had to be consolidated
and an institutional framework created. Monetary policy still remained in the hands of
national government, though policy guidelines had to be established by majority voting. A
European System of Central Banks (ESCB) had to coordinate the independent monetary
policies of member states. The ESCB also sought to achieve harmonization of supervisory
and regulatory functions.
3. Irrevocable fixing of participating states’ exchange rates whilst national central banks gave
control of the domestic money supply to the EC institutions. National currencies were
replaced by a single currency (Though “this step has no economic significance. It is a matter
of denomination of objects”, (Läufer, 1998, 8). The ECB is the sole issuing authority for
Euro notes. The ESCB, which replaced EMI and is composed of ECB and national central
banks, would pursue a single monetary policy engaged in foreign exchange market
interventions and union-wide open market operations, formulation and implementation of
monetary policy, and the technical preparation necessary for a single currency.
The first stage was adopted unanimously by the European Council at the Madrid Summit
in June 1989 and began on 1 July 1990, at the same time as capital movements liberalization
which was a part of the Single Market Programme. After agreement at Maastricht on a new
treaty to delegate responsibility for monetary policy to a new common institute, the second
stage began on the 1 January 1994 (Arestis, McCauley & Sawyer, 2001, 1). The European
Monetary Institute (EMI) was created to assume a coordinating role. The EMI was set up as a
precursor to the ECB - the central institution of stage III. The EMI’s role was to strengthen
cooperation between central banks and the coordination of monetary policies of member states,
to monitor the functioning of the EMS, to take over the tasks of the EMCF and to facilitate the
use of the ECU and oversee its development. In addition it had the general responsibility to
make preparations for stage III of EMU. The third stage, the creation of full monetary union,
had to be fulfilled by either 1997, if a majority of the countries meet convergence criteria, or
1999 even if only a minority of countries meet the criteria. As to me, it is really nice statement
of the Treaty. As we know now, the monetary union was created in 1999 when only several
countries met the criteria. This means that the idea of the EMU hasn’t found full acceptance
among member states of the EU. Still national interests were and remain more important than
European one.

2.2 Maastricht Treaty as a milestone in the development of the EMU idea
The period leading up to the Intergovermental Conference on EMU was one of cheerful
optimism, the Single Market was nearing completion, and European economies were
prospering. The Rome Summit in December 1990 launched a year long process of intensive
negotiations. And at last in December 1991 at Maastricht the Treaty on European Union was
signed, establishing a union which consisted of three pillars: the Treaty of Rome, the Common
Foreign and Security Policy, and cooperation on Justice and Home affairs (Arestis, McCauley
& Sawyer, 2001, 1). The Maastricht Treaty was a political compromise where each country
gave up something in order to gain some movement to the common objective.
The Maastricht Treaty complemented the Treaty of Rome and set up a number of new
institutions as well as specified the stages by which EMU was to be achieved. EMU was seen as
a means of securing “economic and social progress” (Article 2 TEU) (Läufer, 2000: 21, 9) and
12
“non-inflationary development” (Article 2 EEC) (Läufer, 2000: 49, 9). This means that the
efficiencies and benefits from a single market (economic union) will only be maximized when
the costs and risks of currency exchange are eliminated (monetary union). The Treaty of
Maastricht foresees coordinating of Member States’ economic policies which aims at
promoting convergence of policies and economic developments, thereby contributing to
exchange rate stability. According to the Treaty exchange rates need to be treated by the
Member States as a matter of common interest. And this should help to avoid the distortions
within the EU created by certain exchange rate developments (Duisenberg, 1997, 3).
The Maastricht Treaty adopted the Delors three stage plan with some important revisions.
At stage II, the EMI would replace the CCBG (Committee of Central Bank Governors) and
inherit the duties of EMCF (European Monetary Cooperation Fund). Agreement was reached to
set strict convergence criteria which would have to be met before a nation had to join the final
stage of monetary union.
1. Average exchange rate was not to deviate by more than 2.25% from its central rate for
the two years prior to membership;
2. Inflation rate was not to exceed the average rate of inflation of the three community
nations with the lowest inflation rate by 1.5 per cent points;
3. Long-term interest rates was not to exceed the average interest rate of the three countries
with the lowest inflation rate by 2 per cent points;
4. Budget deficit not to exceed 3% of its GDP;
5. Overall government debt not to exceed 60% of its GDP.
The European System of Central Banks (ESCB) and European Central Bank (ECB) were
to take responsibility for monetary policy in the Euro zone at the beginning of stage III.
At the insistence of the German government, the Dublin Summit in December 1996
introduced the Stability and Growth Pact, and this Pact ensured the continuation of limits on
budget deficits in member countries. There should be stronger control of budget discipline and
each country yearly has to provide the European Commission with a Program of Budget and
Economic Policy. After the examination there can be introduced some corrections which have
to be kept. The Stability and Growth Pact specified also the procedure to follow in case limits
are exceeded and outlined the sanctions that the deficit country would bear if it breaks the limits
though the Pact did provide automatic and discretion exemptions under certain conditions.
Higher deficits can be allowed by the decrease of economy by more than 2 per cents. If the state
doesn’t follow the recommendations of the Council for reducing its deficit, it has to accept a
credit (interest rate – 0%), which in two years will be transformed into monetary fine.
(Krätschell & Renner, 2000: 29, 7) Maximum fine was fixed at 0,5 per cent of GDP to be paid
to the EU. As there was a big growth of unemployment in the middle of 1990s, a resolution was
added to the Stability Pact concerning employment, as well as a declaration that the issue of
unemployment would constantly be at the top of the agenda of the European Council (Hansen,
2001: 502, 5).
Also at the Dublin Summit meeting, arrangements were made for ERM II, which outlined
the exchange rate system for countries who had refused to enter the third stage and to accept
euro or did not meet the Maastricht criteria.
The creation of ERM2 was guided by 5 main objectives and principles:
13
First, as I already mentioned, Member states are required to treat their exchange rate
policy as a matter of common interest. Second, exchange rate stability is an important element
of economic convergence (no severe fluctuations for at least two years). Third, anchoring the
exchange rate to a stable currency, as the euro will probably be, can be of help for non-euro
Member States in their convergence efforts necessary to enter the euro area. Fourth, exchange
rate stability can be achieved only in the presence of continued convergence of economic
fundamentals – in particular price stability and sound fiscal and structural policies. Fifth, ERM2
should ensure, as far as possible, continuity with the present exchange rate mechanism. Though,
the arrangement must fully take account of the new economic and institutional environment in
Stage 3. And a final that needs to be mentioned is that participation in ERM2 (as in the previous
ERM) is voluntary (Duisenberg, 1997, 3).
What considers the operational features of the ERM 2 it is important to mention the
following. For each participating non-euro area currency, a central rate versus euro is defined.
But unlike ERM, there is no “parity grid”. A new approach puts the euro at the centre of the
system. Around the euro central rates there is established a standard fluctuation band of +/-
15%. This rather wide band reflects the good experience with operation of ERM. ERM 2 allows
temporary deviations from the central rates to set minor asymmetric economic changes. But if
the exchange rate of the non-euro area currency reaches the fluctuation margins there will be
automatic and unlimited foreign exchange intervention and financing. . Though as Wim
Duisenberg, President of the ECB said, “It is understood that intervention will have to be used
to support – not replace – other policy measures, including appropriate fiscal and monetary
policies” (Duisenberg, 1997, 3).
On the whole, one of the main tasks of the ERM2 is to support countries not initially
participating in the euro area to join as soon as possible.
In May 1998, the European Council selected the countries qualified to participate in Stage
III (introducing euro) of EMU. Originally, only Luxembourg corresponded to all convergence
criteria. Other countries had to lower budget deficits and state debts. Thanks to strict economic
policies most of the countries achieved the goal. For Italy and Belgium comparative
improvements (!!!) were considered to be enough (Krätschell & Renner, 2000: 27, 7).
Of the European Union members not adopting the euro (Denmark, Great Britain, and
Sweden), perhaps the most notable is Britain, which continues to regard itself as more or less
separate from Europe. Nonetheless, British Prime Minister Tony Blair announced plans to
consider adopting the euro sometime in 2002-5. (EMS, 4)
















14
3. Costs and Benefits of the European Monetary Union

What considers the benefits and costs of the EMU, it’s rather difficult to judge nowadays
as only very little time has passed. As to me, more evident results will be seen in the long run.
But nevertheless already today I can name several actual and potential pros and cons of the
EMU.
So, main benefits are the following:
The abolishment of intra-European currency crises as a consequence of independent
national monetary policies under high capital mobility
Efficiency improvement and no transaction costs. No exchange rate risks stimulate
investments within EMU. Improvement of the resource allocation.
More intensive international division of labour because of lower transaction costs leads to
comparatively similar production and income growth rates in all countries-members of the
EMU under condition that trade in the above-mentioned group of countries is mostly of
intra-industry type. Because of the similar demand structure in the EMU members, trade
revenues will be divided comparatively equally. All this corresponds already to the EMU.
Though Greece and Portugal show non-proportional part of inter-industry trade. That’s why
the advantages of more intensive international labour division can be lower here.
Though, on the other hand, transaction costs, connected with the existence of different
national currencies, in reality can not be regarded as a decisive obstacle for foreign trade in
the EU. And that's why their disappearance wouldn’t play such a big role in the real
economic development of the EMU members. (Ohr & Theurl, 2001: 440, 10)
Effects which stimulate investments: as soon as we have common currency in the EMU, the
comparability of prices has been improved. Besides we don’t have to compensate exchange
rate risks with high interest rates which certainly have a negative impact on investments.
That’s why interest rate level has been decreased. So Europe (the EU) can become an
attractive place for investors.
Stability effect for previously unstable countries because of the discipline of convergence
criteria. Also for such countries very positive role plays common monetary and currency
policy lead by ECB.
The abolishment of market segmentation due to exchange rates, an increase in market
transparency and a reduction of price discriminations
More important and stronger role of the European currency in the world economy. This will
increase also the political importance of the EU.
Deeper European integration
Higher competition positively influences price stability as it limits the room for price
increases for enterprise – this is a clear advantage for the consumer.

Apart from benefits there is a number of costs which experienced the countries- members
of the EMU. While joining the EMU each of the them simultaneously had to give up its control
over its own monetary policy to the union policy concerning the common currency. These
potential costs involve the reduction in welfare due to different intra-union unemployment,
inflation preferences and the possibility of regional decline.
The potential cost in entering into monetary union concerns different regional growth
rates. The perceived problem is that changes in demand or supply (especially productivity or
wage demand) conditions will create regional unemployment. This, of course, could and would
have happened before union, but then monetary policy could have been used to expand demand
sufficiently to help a region that would have been a larger and more important part of the
country than it would of the entire monetary union. Though these differences in regional growth
are significantly improved since capital and labour mobility is allowed in the EU. But what
considers the problem of non-national monetary policy, it is still very important. Many
countries are afraid that common monetary policy won’t be so effective as national one.
15
Besides, a very big disadvantage especially for the best developed EMU members is that
currency policy is now unified and there is no possibility to use exchange rate instrument if
there are some inequalities between countries-members of the EMU. Instead, if there appear to
be some problems (and as we remember not all countries-members of the EMU has had stable
currencies and corresponded fully to the convergence criteria before entering EMU), there have
to be used either salary, price adjustments or capital movements, or financial transfers between
member states. That’s why currency policy is considered to be an Achilles’ heel in the
construction of the EMU (Hillenbrand, 2002: 464, 6)
Also the shadow side of euro introduction was a clear loss of euro towards dollar. At the
beginning of 1999 one euro was equal 1,17 USA dollar and till the end of the year it was
already equal 1,01 USD. In February 2000 European currency decreased till 0,95 USD. (Sandte,
2002: 57, 12) But it can be explained by the fact that American economy was growing more
dynamically than European one and US dollar was more attractive for investors than euro. But
during the last year the situation has changed and euro appreciated. In my opinion, one of the
reasons is deflation crisis in USA:
If to consider, the attitude of population to the EMU, it can be said that in June 2001,
according to a survey, only 28 per cents of those asked supported the introduction of euro
(Hillenbrand, 2002: 471, 6) But it really difficult to judge now, after such a short period of time
about pros and cons of the EMU, and which of them outweigh. As to me, it would be clearly
seen only in the long run.

But on the whole, if comparing the costs and benefits of the EMU, it must be decided
whether greater income and price stability is worth the loss of an autonomous monetary and
exchange rate policies. An optimistic note in favour of the EMU is the fact that the costs may
be less than previously estimated.























16
Summary

European Monetary Union is a very substantial part of the EU. It established coordinated
monetary policy for 12 member-states and a common currency – euro. The idea to found EMU
appeared already in 1970s. But at that time Bretton-Woods system still existed and that’s why it
was not possible to put that idea into life. Though the crash of the above-mentioned system
moved European countries to the idea that it would be more profitable and secure to create a
regional system of fixed exchange rates.
In 1971 came out Werner report which very optimistically planned to created monetary
union by 1980. At that time it was decided to fix exchange rates of the EEC countries by so
called “snake in the tunnel”, which meant that currencies could be changed within a certain
band around central rate, which also could fluctuate. At that time central rate could be changed
by each member of the EEC and the system of fixed exchange rates wasn’t very effective. On
the whole, the launch of EMU in 1970s was abandoned in the end because of the economic
instability, caused by world economic crisis, oil price shocks etc. As positive outcome of that
time attempts to establish EMU remained European Monetary Cooperation Fund which later
was in charge of credit facilities in EEC.
In 1979 there was established European Monetary System which replaced the “snake” and
had to lower inflation, stabilise exchange rates, improve economic policy cooperation between
member-states and prevent world monetary instability through the adoption of common policies
in relation to third countries. In order to fulfil all these objectives, EMS was provided with
Exchange Rate Mechanism which consisted of four components: European Currency Unit
(ECU), the parity grid, the divergence indicator and credit financing. Nevertheless because of
so called “imported inflation” and negative impact on investments, this mechanism and EMS
were not effective. One of the main drawbacks of the EMS was the fact that the members of the
European Community participating in the ERM chose to fix their bilateral exchange rates, but
did try to coordinate their monetary policy themselves.
When Jacques Delors took up his position as President of the Commission in 1985,
monetary policy was one of his priorities but he realised that it lay too close to the core of
national sovereignty. And according to his plans, only successful implementation of the Single
Market could be a mechanism for renewing interest in EMU. Prerequisites for monetary union
were identified as the total and irreversible convertibility of currencies, the complete
liberalization of capital transactions, elimination of margins of fluctuation and the irrevocable
fixing of exchange rate parities. The central institution overseeing the Community’s monetary
policy would be a European System of Central Banks (ESCB). Its primary objective would be
price stability while it would maintain total independence from member states.
Maastricht Treaty, signed in December 2001, was a milestone in the development of the
EMU idea. It complemented the Treaty of Rome and set up a number of new institutions as well
as specified the stages by which EMU was to be achieved. If a nation wanted to join the final
stage of monetary union, it had to fulfil the five convergence criteria. It was stated also that EU
countries should create EMU before 1997 if at least half of them corresponded to the
convergence criteria or by any means until 1999. To speak frankly, only Luxembourg
corresponded to Copenhagen criteria and for most of other EU countries the state of these
requirements was recognized as satisfactory. And that’s why full EMU was created in 1999,
though 3 EU members – Great Britain, Sweden and Denmark – didn’t join it Towards them
ERM II was arranged, which fixed exchange rates between euro and non-euro area members of
the EU. Around the euro central rates there is established a standard fluctuation band of +/-
15%. In December 1996 there was introduced also the Stability and Growth Pact which ensures
limits on budget deficits in member countries.
17
If to consider benefits and costs of the EMU, it’s rather difficult to say now what
outweighs. But the main benefits are or should be the following: abolishment of intra-European
currency risks, no transaction costs, higher competition, no need to compensate exchange rate
risks with high interest rates which stimulates investment, stability effect for previously
unstable countries by common monetary policy, stronger role of the European currency in the
world economy, deeper European integration. Main drawback is that it’s not possible now for
member-states of the EMU to lead their own monetary and currency policies. And because
there still exists different regional growth rates it could cause problems for national economies.
Besides, some economists are afraid that common monetary policy would be much slower and
not so effective as national one.
So it’s really very difficult to state if the introduction of EMU has more positive or
negative sides. On one hand we have price stability, but on the other – loss of autonomous
monetary and exchange rate policies. Besides, it is still unclear what will be the effects of EU
enlargement on EMU. It is obvious that enlargement would be a serious difficulty for effective
and consistent work of EMU and ECB as candidate countries still have rather unstable prices
and exchange-rates. And if the convergence criteria were observed the same way as it was in
1997-1999, we couldn’t be sure of the bright future for the EMU.





























18
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