By Max Larrain
The full implementation of the European Monetary Union by putting into circulation the notes and coins of a single currency in twelve of the fifteen member states of the EU is perhaps the greatest symbolic achievement of an international organization.
What is unique with EMU is the determination of a group of independent nations deliberately to relinquish de jure monetary autonomy by creating an EU central bank, the European Central Bank (ECB), which is independent of national and supranational governments in order to pursue price stability.
However, this grand-scale experiment not only has an economic significance but it is a major step towards the deepening of European political integration. The fact that these countries have been willing to replace one of their national symbols indicates that they expect that the economic and political benefits surpass the costs of switching over to a new currency not yet sufficiently proven.
The introduction of the euro was a move that pointed to at least two aims: to consolidate the single internal market in goods and services and to forge closer political union following the spillover theory.
Nevertheless, some member states of the EU have opted to stay out of the euro zone, namely the United Kingdom, Sweden and Denmark.
Our main subject in this paper will be a description of the EMU, its origins, its institutions and the costs and benefits of the introduction of the single currency.
However, we would like to complement this work with a short review of the situation of Denmark as the possible next EU member state to join the common European currency.
II. FOUNDING OF THE EUROPEAN MONETARY UNION
Ever since the creation of the European Economic Community in 1957 by six European nations, the idea of achieving economic coordination through stability of exchange rate has been present. Moreover, this objective had been an aim for Europe already at the end of the 19th century.
The first international system was the Gold Standard, developed around the British pound, which flourished from 1880 until 1914.
In 1944 a new system was agreed at Bretton Woods between the US, the UK and 43 other nations. This system, which pegged major currencies to gold and the dollar, functioned well until the American currency suffered chronic weakness in the late 1960s. However, the success of Bretton Woods in the post-war years prevented to pursue a closer currency arrangement in the early years of the EEC. It was only when serious strains emerged in the Bretton Woods system that European political ambitions turned definitively to monetary union.
2.1 The Werner Report
In 1969 a study group commissioned by the European Council and lead by the
Prime Minister of Luxembourg Pierre Werner investigated the possibility of a
European economic and monetary union. In 1971 the study group issued a report,
known as Werner Report, which envisaged such union in three stages. Its main
(1) The permanent fixing of exchange rates. (2) A single monetary authority to run monetary policy. (3) Unified capital markets. (4) Centralization of fiscal policy at the Community level. (5) Strengthening and coordination of structural and regional policies and (6) a closer cooperation between the ‘social partners’: industry, trade unions and governments.
The first major step towards implementation was the European currency ‘snake’ in 1972, as an attempt to restore stability to Europe’s currencies following the Smithsonian Agreement in December 1971, which had severed the close link between the dollar and gold, and widened the margins of fluctuation around the American currency, permitting large movements between EEC’s currencies. A variant of this arrangement was the so-called ‘snake in the tunnel’, that limited margins between the six EEC currencies to 2.25%. It was joined by UK, Ireland and Denmark, but later on it was abandoned by the French franc, the Italian lira and the British pound. Events in the foreign exchange markets overtook economic arrangements: the Smithsonian agreement collapsed in February 1973, and the dollar floated, leaving the ‘snake in the lake’ free to fluctuate against the dollar.
By the second half of the 1970s, the arrangement had shrunk to a ‘minisnake’,
consisting of Germany and its closest trading partners, the Benelux, as permanent
members. Like the Bretton Woods system, the snake arrangement (here with the
D-mark as its anchor) was asymmetrical, as the German central bank’s low-inflation
monetary policy became the pace setter for the EC’s narrow-margins arrangement.
The fragility of the snake was a reflection of the lack of convergence between Europe’s major economies, underscored by the policy conflicts following the first oil crisis in 1973.
In view of the impossibility of its achievement, the Werner Plan was abandoned by 1975. Nevertheless, the initiative left an important legacy of ideas and practical measures.
2.2 European Monetary System (EMS)
Due to the deficit of the US balance of payments by 1977, the dollar fell sharply and the D-mark rose against European currencies, threatening German competitiveness and exports. German Chancellor Helmut Schmidt and French President Valéry Giscard d’Estaing felt they had to act decisively to insulate Europe from the consequences of the unpredictable dollar. In the fall of 1977, Commission president Roy Jenkins suggested that Europe should revive the goal of monetary union. Drawing on Jenkins’ proposal, the Chancellor and the President concluded that the time had come to create a regional but more pliant Bretton Woods-type exchange rate arrangement for the EC.
The result was the European Monetary System (EMS), launched in 1979 with the
declared objective of creating a ‘zone of monetary stability in Europe’.
The main instrument within the EMS was the Exchange Rate Mechanism (ERM), which
focused on the exchange-rate stabilization during the 1980s. With this system,
as with the Bretton Woods, the ERM members could let their currencies float
within a predetermined margin, ±2.25 percent, or ±6 percent if
they were not in the snake at the start of the EMS. Italy opted for the wider
margin while Britain joined the EMS from the beginning but stayed out of the
ERM until October 1990. However, unlike Bretton Woods system and the snake arrangements,
the ERM was to operate symmetrically for all members. A carefully crafted EMS/ERM
was to ensure this symmetry by making the European Currency Unit (ECU) -a composite
of participating currencies- the center of the system.
The ECU became the reference currency against which the member currencies would establish their central rates, rather than maintaining the bilateral grid of national currencies as the preceding systems. Any currency that moved either to the upper limit or to the lower limit had to take corrective actions, thus the burden of adjustment would no longer fall exclusively on the weaker currencies. An alarm mechanism (‘rattlesnake’) allowed currencies to be corrected each time they reached a 75 percent of the permissible divergence from their parity to the ECU. However, an error in the formula permitted a currency to reach the outer limits before making contact with the divergence indicator. A corrected reference system became a hybrid between the ECU and the bilateral grid.
With the time the ERM evolved to promoting convergence on inflation performance, taking Germany as reference, by virtue of its low-inflation record. The success of the ERM was demonstrated by the large and sustained fall in inflation among its participants, and by 1990 the system seemed to offer a powerful convergence discipline.
The new phase of stability in the EMS that started in 1987 lasted until the summer of 1992. During that period many investors considered that a kind of fixed rate was prevailing, thus high-interest countries became attractive.
2.3 Commissioner Delors Report
The progress on inflation and the coming into force of the Single European Act in January 1987 that included an agreement to complete the Single Market by 1992 provided the conditions and incentives for a further push to the EMU.
Political events at the end of the decade moved the process decisively forward. The collapse of the Soviet Union and its lost influence in Eastern Europe and the reunification of Germany after 1989 raised new anxieties about Germany’s place in Europe. French President Miterrand and German Chancellor Kohl thought it vital to cement Germany in a united Europe with its centre of gravity in the west, and both saw EMU as crucial to that objective. The Hanover summit in 1988 appointed a committee under Commission President Jacques Delors, and comprising mainly EC central bank governors, to devise a blueprint for EMU
The Report on Economic and Monetary Union in the European Community (Commission, 1989) was written under different assumptions and circumstances than the Werner Report, for example, the Delors Report shows a disbelief in the employment/inflation trade-off. Nevertheless, the Commissioner’s Report harked back to the Werner Plan and envisioned the implementation of EMU in three stages:
Stage 1 envisaged the completion of the internal market, the creation of a single financial area and the consolidation of the ERM, with all states joining the narrow band.
Stage 2 would comprise the transition to EMU, via a progressive hardening of the ERM, closer cooperation on economic policies, and the establishment of an embryo central bank to make the technical preparations for EMU.
Stage 3 would see the start of EMU proper, with permanently locked exchange rates, an independent central bank in charge of monetary policy, and in due course a single currency.
The Delors Report was endorsed by the Madrid summit in June 1989, which decided to start Stage 1 in July 1990 and convene an early Intergovernmental Conference on EMU.
III. THE TREATY ON EUROPEAN UNION (MAASTRICHT TREATY)
3.1 Stage 1 of EMU
The Delors committee recommended mandatory limits on fiscal deficits, but warned against fixed deadlines and, unlike the Werner Report, avoided controversial calls for centralization of fiscal and structural policies.
After a year of intensive negotiation, the Treaty on European Union (TEU) was agreed by the Maastricht European Council in December 1991. Its ratification by national parliaments ran into unexpected difficulties and took nearly two years to complete, with Germany the last to ratify. On 1st of November 1993 the TEU came into force.
The treaty is essentially a set of amendments to the Rome Treaty. The EMU provisions are the most concrete, although two new policy areas –‘defense and foreign affairs’ and ‘justice and home affairs’- are also covered.
3.2 Stage 2: the transition
The provisions for Stage 2 incorporate much of the proposals made by Delors, with some important additional features: (1) an elaborate selection process for EMU membership (2) a new body, the European Monetary Institute (EMI) (3) a deadline for the start of Stage 3.
(1) Selection process for EMU membership
The selection process for EMU membership was based on a set of quantitative convergence criteria measuring how far countries have converged in key financial respects. These main criteria were:
a. Price stability: a rate of consumer price inflation over the previous year
no more than 1.5 percentage points above that of the three best-performing states.
b. An interest rate not 2 percent greater than the average of the three best-performing countries (the assumption being that the countries with the lowest inflation would have the lowest interest rate).
c. Membership in the ERM, without devaluation during the two years before entry into EMU.
d. A deficit-to-GDP ratio not to exceed 3 percent.
e. A debt-to-GDP ratio (of all levels of government) not to exceed 60 percent.
Account must also be taken of certain other factors, including progress in completing the Single Market, countries’ external payment balances, the development of labor costs and countries must have made their central banks independent of political interference as required by Stage 3.
(2) The European Monetary Institute (EMI)
The EMI was intended to be the forerunner of the European Central Bank (ECB), with a remit to make the technical preparations for the single currency, but only an advisory capacity in the policy field. This limitation reflected German concern to keep monetary policy in national hands right up to the moment of exchange-rate locking. The EMI had the tasks of coordinating member states’ monetary policies and supervising the proper functioning of the EMS.
(3) A deadline for start of Stage 3
The Delors Report did not specify how long Stage 2 would last, and a debate on the issue ensued at the IGC. Some member states wanted Stage 2 to be as short as possible or to be eliminated entirely, arguing that it was neither necessary nor desirable to prepare for the single currency. The outcome was a deadline fixed by the TEU designing 1st January 1999 for the start of Stage 3, in case it could not start at the first opportunity (1997). The deadline applies regardless of the number of states qualifying and on whether the economic conditions are appropriate. It was inserted at the last minute under a special deal between President Miterrand and Chancellor Kohl, to the surprise of other governments. EU ministers fell back on the deadline when it became clear in 1995 that the 1997 start could not be realized.
3.3 Stage 3: the completion of EMU
The Maastricht design for this stage also contains key features beyond the
(1) Constitution of a European Central bank
The constitution of the ECB is based on a draft produced by the EC governor’s committee in Basle. The ECB is the apex of the European System of Central Banks (ESCB), to which all EU central banks belong. It has most of the customary powers of central banks to conduct monetary policy. Its primary objective is to maintain price stability, to which its support for the Community’s other economic policies must be ‘without prejudice’. In monetary matters the ECB and ESCB must be totally independent of outside interference, especially from governments.
The strength of the ECB’s price stability mandate, and its political autonomy, mean that it is likely to be more single-minded in controlling inflation than any existing central bank –even the Bundesbank. Whereas the latter’s basic objectives and powers are subject to amendment by the German parliament, in the ECB’s case they could be changed only by amending the treaty, which would require the consent of all member states, a notably difficult hurdle.
(2) Exchange-rate strategy
While the main features of the ECB show the dominance of German ‘monetarist’ thinking in its design, in the exchange-rate strategy this thinking did not prevail. It was decided that exchange-rate strategy for the single currency will be determined by EMU finance ministers, under the ECOFIN umbrella, not by the ECB. Ministers will thus keep responsibility for choosing the ‘exchange rate regime’, or for setting ‘general orientation’ for the euro. But in doing so they will have to consult with the ECB and respect the objective of price stability. Thus although in principle there is scope for conflict between ministers and the central bank over the exchange rate, in practice the ECB is in a strong position to discourage ministers from choosing policies which cut across its monetary objectives.
(3) The Stability and Growth Pact
Under this Pact, agreed at the Dublin summit (December 1996), governments participating in EMU will be committed to balancing their budgets in the medium term, in order to give them headroom to operate within the treaty limit of 3% in any particular year. A government which exceeds that limit will be subject to financial penalties if it does not take appropriate corrective action, unless it is specifically exempted.
In setting limits to fiscal deficits, the treaty followed the advice of the Delors Committee, but it did little to strengthen the machinery of policy cooperation in EMU, which Delors had been keen to promote.
In insisting on the 3% limit for deficits except in very unusual circumstances, the Pact leaves little scope for discretionary use of fiscal policy to stabilize economies. This conservative approach to fiscal policy, as on monetary policy, represents largely a victory for German thinking in the design of EMU.
3.4 From the Ecu to the Euro
Initially, the treaty had called for the rapid introduction of the European
Currency Unit (ECU) as the single currency, but that proved unacceptable to
the German government, whose view had long been that the ECU was an insufficiently
strong currency to assume that challenge. Instead, the Council decided in 1995
that the single currency will be called the ‘euro’. It would have
the same value as the ECU, bound to disappear at the start of Stage 3.
The Council endorsed plans for the phased introduction of the euro in the EMU area over a period of up to three and a half years after the start of Stage 3. From January 1999 to December 2001, the euro existed only as deposit money at banks, alongside national moneys, with which it was interchangeable at the permanently fixed conversion rates set for the start of Stage 3. Then in the first six months of 2002 national notes and coin were replaced by euro currency, and households and the government sector switched to euros for all purposes. Finally, on 1st July 2002, the old currencies ceased to be legal tender and the changeover was formally completed. In the case of Germany most of the households D-marks were already changed in the first two months of 2002.
3.5 Costs and Benefits of the EMU
For many member states one crucial, potential economic benefit of the EMU is the improvement in inflation performance. This is valid for governments which have political difficulties to control inflation via domestic policies. It will be easier for them to resist political pressure that might conduce to price instability by arguing compliance with a legally-binding treaty.
Another important benefit would result from eliminating exchange rate uncertainty
in cross-border trade and investment. The exchange stability is a desirable
but not easy feature to attain in the European trading environment, without
which the full advantages of the Single Market cannot be achieved. Sure enough,
there are some mechanisms to counteract exchange rate swings but a long period
of unpredictable swings can destroy the profitability of export facilities or
foreign manufacturing operations.
The differentials in interest rates that existed between strong and weak EU currencies are now eliminated. For former weak-currency economies it means a substantial and permanent reduction in their cost of capital by reducing real long-term interest rates associated to exchange-risk premiums.
There are economic benefits in saving transaction costs from removing the need to convert currencies in cross-border transactions within the EMU area. This is specially applicable for individual travelers using credit cards and other electronically-based money transfer systems.
The euro is already emerging as a global trading and investment currency comparable with the dollar and yen, thus it could have all the benefits associated with an international reserve currency. To the extent that the new currency is held more widely abroad than those it replaces, extra income will accrue to the governments that own the new central bank.
Further gains might arise from the possibly greater attractiveness to international investors of European securities denominated in euros, as compared with those in existing currencies. But this will also depend on the stability and credibility of the euro.
Last but not least, the trading markets become more transparent in that prices can be compared from country to country in the same currency.
Many of the costs that can be associated to the EMU are of political nature,
therefore they may be hard to quantify. Nevertheless, some economic costs can
be named like the expenses and dislocation involved in replacing national currencies
or the ones related to the production of new notes and coins and getting them
The main financial costs will be incurred by commercial banks, whose information and accounting systems need to be adjusted. The overall cost for EU banks has been estimated at around Ecu 10 billion, if the conversion occurred once and for all as it did the 1st of January 2002. Major cash handlers and inventory holders have also incurred in heavy costs.
The cost of abandoning exchange-rate as a tool to cope with major economic disturbances or deep-rooted international differences in economic structures and performance is something which has to be considered as both a political and economic limitation for individual countries. It has been feared that locking exchange rates could lead to heavy unemployment in countries hit by adverse shocks or experiencing below-average productivity growth.
Another major cost invoked by the skeptics is loss of sovereignty, coupled with the so- called ‘democratic deficit’ involved in regulation by ‘bureaucrats’ in Brussels or Frankfurt. But this is a subject difficult to assess which goes far beyond economics.
IV. DENMARK, THE EURO AND THE EMU
4.1 Rejection to adopt the euro
Denmark has not yet introduced the euro. This is a consequence of the Edinburgh
Decision which was drawn up after the rejection of the Maastricht Treaty at
the referendum held in Denmark in June 1992. Nevertheless, the Edinburgh Decision
was endorsed, together with the Maastricht Treaty, by a new Danish referendum
held in May 1993.
However, on 28 September 2000 a majority of the Danish electorate (53.1 %) rejected the adoption of the euro.
During the campaign that preceded the referendum, there were several arguments in favor and against the adoption of the European currency.
One of the prominent public figures that supported the idea of integrating Denmark to the common currency was the former president of the Danish Central Bank (Danmarks Nationalbank) Erik Hoffmeyer. He argued that Denmark’s economic fate is closely linked to the European Union, whether it formally joins the European Monetary Union or not, and that to stay out of the single currency dooms Copenhagen to a diminished voice in Brussels.
The then Prime Minister Poul Nyrup Rasmussen expressed that a yes could dramatically boost confidence in hard-pressed euro and ultimately would bring Britain and Sweden in as well. “The Danes, for once, have all Europe watching”, he said.
Other arguments have pointed out that a two speed Europe, the ‘ins’ and the ‘outs’ could lead to some members to move ahead faster and deeper into European integration, while leaving others behind, a fate not desirable for Denmark.
The “no” campaign, led by a coalition of opposition parties and non-political groups argued that “It is a myth that Denmark will have influence in the EU if we join the EMU”, as expressed by the Socialist MP Knud Erik Hansen.
Many feared that under EMU Denmark would lose the freedom to set its own policies in such areas as labor and social welfare.
4.2 The Exchange Rate Mechanism II (ERM II).
As a consequence of the referendum of September 2000 Denmark remains outside the Eurosystem along with Sweden and the United Kingdom. However, the Danish krone is linked closely to the euro via ERM II. In fact, since the 1st of January 1999 Denmark has participated in the ERM II.
The purpose of this mechanism is to ensure exchange-rate stability between the euro area and the EU member states which have not introduced the single currency. Participation in ERM II is voluntary. After Greece’s full entry into the Eurosystem on 1 January 2001 Denmark is the only participant in this mechanism.
ERM II is a fixed-exchange-rate system. For each participating country’s currency a central rate vis-à-vis the euro is fixed. The fluctuation band around the central rate allows the exchange rate to fluctuate against the central rate. Should a participating country’s exchange rate reach one of the margins, the ECB and the central bank of the country in question are obliged to hold the exchange rate within the fluctuation band. This is ensured through intervention in the foreign-exchange market. In the event of acute speculative pressure against the Danish krone the ECB can provide liquidity support. This consists of short-term credit facilities in euro, to supplement Denmark’s own foreign-exchange reserve. The intervention obligation may be suspended, however, should intervention be in conflict with the ECB’s or the relevant central bank’s primary object of price stability.
The standard fluctuation band in ERM II is +/- 15 percent. Should a country show a high degree of convergence, a narrower band may be agreed, as in Denmark’s case. The Danish fluctuation band is +/- 2.25 percent. The central rate of the Danish krone is 746.038 per 100 euro. The upper and lower fluctuation limits are thereby respectively 762.824 per 100 euro and 729.252 per 100 euro. In practice Danmarks Nationalbank has chosen to stabilize the Danish krone close to the central rate, and the fluctuation band can therefore be regarded as a safety net.
4.3 Danish Foreign-exchange Policy
The foreign-exchange policy objective is to maintain a stable krone vis-à-vis the euro. It is determined by the government after negotiation with the Danmarks Nationalbank.
Participation in ERM II is a continuation of Denmark’s longstanding tradition for the adoption of fixed-exchange-rate systems. This is related to the country’s relatively small size and its considerable foreign trade. In this situation it is important that excessive fluctuation in the exchange rate vis-à-vis the country’s most important trading partners’ currencies is avoided. The exchange rate is kept stable by intervention in the foreign-exchange market, or by adjusting the official short-term interest rate.
As from 1979 up to the introduction of the euro on 1 January 1999 Denmark participated in the ERM of the EMS. Since 1982 adjustment of the exchange rate has not been used actively in economic policy, and the central rate with reference to the D-mark and other key European currencies was unchanged from January 1987 to the1st of January 1999.
V. TO CONCLUDE
The EMU is now a reality that will change life in most of the EU member states.
The framework for the joint monetary policy negotiated at Maastricht focused on medium-term price stability, which is to be assured by the ESCB –the Eurosystem- made as independent as possible from national and European political authorities.
However, there are elements that might undermine this framework, namely three potential sources of friction: national deviation in budgetary policies, obligations to intervene in defense of particular levels for the euro in external currency markets and prudential supervision of financial institutions. The first is addressed by upper limits of budget deficits. The second source is in the hands of the ESCB. The third, in change, remains as prerogative of national regulators.
Despite the Eurosystem’s clear assignment of responsibilities, in opinion of some experts, this framework remains somewhat flawed. The euro area’s cyclical weakness since early 2001, the external weakness of the euro, and the ongoing difficulties in harmonizing the framework for financial markets, might proof how problematic could be to establish pro-growth policies while keeping inflation down at the same time.
As for the Danish situation; boasting one of the highest incomes per capita the economic readiness of Denmark to join the euro zone is not the issue. It has a long standing tradition in maintaining price stability and has debt and deficit to GDP ratio well inside the allowed limits.
Danes have seen most of the benefits of euro-membership already, due to the Danish krone’s unchanged link first to the deutsche mark, then to the euro, over the past 15 years. The close link to the euro through ERM II allows Denmark to enjoy all the benefits of the EMU without having to relinquish its own monetary policy.
Now, when twelve of the fifteen member states of the EU have joined the euro, the feared two speeds Europe with “ins” and “outs” countries will probably not occur since Denmark exercises a tight control over its own currency through the ERM II; Sweden and the United Kingdom are unlikely to let their monetary policies to escape out of control; and candidate countries of Eastern and Central Europe have to accept EMU as part of the EU’s body of existing law, the acquis communautaire.
In my opinion, the Danish electorate has been reluctant to come into a closer union -that could be a step on the road to federalism- because they resist a possible dismantling of a complex net of social securities and collective benefits. However, this sentiment may be surpassed by the fear of isolation. In other words, the joining of Denmark to the euro area is only a matter of time.
Santiago, October 2.002
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