Lecture 11 - Economic and monetary union in Europe
1. What EMU Involves
The lecture provides a structured overview of the Economic and Monetary Union (EMU), highlighting the institutional, monetary and economic foundations of the Eurozone.
Key elements:
- Single currency (the Euro)
- National currencies are replaced, eliminating intra-EMU exchange rates.
- Creates a single exchange rate vis-à-vis external currencies, such as the US dollar.
- A unified monetary authority: the ECB
- The European Central Bank administers and implements monetary policy.
- Monetary policy becomes supranational rather than national.
- Single monetary policy (EMP)
- One policy interest rate for all member states.
- Coordinated money supply.
- Unified exchange rate management for the Euro.
- Free movement of capital
- Already part of the EU Single Market’s “four freedoms”.
- EMU reinforces capital mobility due to currency elimination.
- Tax policy coordination
- Needed because one country’s fiscal stance affects the entire monetary union.
- Motivates mechanisms of surveillance (e.g. the Stability and Growth Pact).
Interpretation:
EMU represents the most advanced stage of European integration, eliminating monetary sovereignty in favour of collective stability. It provides efficiency gains but imposes strict convergence and discipline to prevent destabilising spillovers.
2. Why Countries Chose the Euro €
Several political and economic motivations explain why member states opted into EMU:
(a) Fixed ER vs Monetary Autonomy
Member states faced the “inconsistent trinity”: with free capital movement and trade, they could not simultaneously maintain:
- Fixed exchange rates
- Independent monetary policy
- Capital mobility
Choosing fixed ER necessitated giving up monetary autonomy.
(b) Gains from completing the Single European Market
Separate currencies create transaction costs and nominal exchange rate uncertainty.
Slide commentary:
The Commission (1990) estimated that removing currency-changing costs would raise GDP by 0.25–0.5%. Eliminating currency conversion:
- Enhances transparency
- Reduces risk premia
- Boosts trade (evidence from Rose’s currency-union estimations)
(c) Ending EMS asymmetry
Under the pre-EMU Exchange Rate Mechanism (ERM), only Germany could pursue truly independent monetary policy. Others were forced to align with the Bundesbank to maintain ER stability.
Monetary union eliminated this hierarchy.
(d) Political motivations
Germany’s deeper commitment to the EU was important, especially after reunification and geopolitical shifts post-communism.
3. Step One: Meeting the Maastricht Convergence Criteria
The Maastricht Treaty set five convergence criteria to ensure macroeconomic stability before joining the Euro.
3.1 Inflation Convergence
Inflation rate must be no more than 1.5 percentage points above the average of the three lowest-inflation EU members.
Commentary:
High inflation erodes competitiveness inside a fixed-exchange-rate zone. In monetary union, real depreciation through nominal devaluation is impossible, putting high-inflation countries at risk of factory closures and unemployment.
In 1993, only four countries met this criterion, though by 1997 nearly all (except Greece) had converged.
3.2 Interest Rate Convergence
Long-term interest rates must be no more than 2 percentage points above those of the three lowest-inflation members.
Commentary:
Long-term rates capture market expectations of inflation and fiscal credibility. Higher inflation or unstable fiscal behaviour increases sovereign borrowing costs, which could destabilise the monetary union.
3.3 Budget Deficit Rule
Annual government deficit must be below 3% of GDP.
Commentary:
- High deficits create incentives for governments to inflate away debt (not possible under EMU).
- Other members fear contagion risks if one state faces default.
- This criterion was flexible, and several countries used creative accounting (e.g., Italy’s use of swaps) to appear compliant.
3.4 Public Debt Criterion
Public debt should be below 60% of GDP, or “diminishing sufficiently” towards the target.
Commentary:
Only three countries met this strictly. The 60% figure approximated EU averages and was consistent with stable debt under 3% deficit assuming ~5% nominal GDP growth.
3.5 Exchange Rate Stability (“No Devaluation Rule”)
Countries must remain within ERM II without devaluation for two years.
Commentary:
This criterion ensures markets perceive the existing exchange rate as credible and avoids “competitive devaluations” prior to joining EMU.
Shortcomings of the Maastricht Approach
- Criteria are judged over a short period, not structural sustainability.
- They ignore unemployment, growth, and convergence of business cycles (criticised by the Mundell OCA framework).
- Fiscal rules proved politically malleable and insufficient to prevent later crises.
4. Step Two: Adopting the Euro
By 1998, 11 of 15 EU countries met the conditions sufficiently to join the Euro (confirmed by Council in May 1998).
- Greece failed initially.
- Sweden did not join ERM II.
- The UK and Denmark exercised opt-outs.
The Euro moved from:
- 1999 — used for accounting; ERs fixed irrevocably.
- 2002 — physical notes and coins introduced.
5. Step Three: Eurozone Monetary Policy — The European Central Bank (ECB)
The ECB is among the most independent central banks in the world.
5.1 Governance Structure
- Monetary policy is set by the Governing Council:
- 6 Executive Board members
- National central bank governors (20 today, 17 at the time of the slide)
- “One member, one vote” — decisions should reflect Eurozone-wide interests, not national positions.
ECB Independence
- Executive Board members serve single non-renewable terms.
- Independence aims to enhance credibility, reducing inflation expectations without creating unemployment.
- Reflects central-bank theory: politicians face short-term incentives; independent CBs anchor long-run stability.
Accountability Concerns
- ECB is not democratically elected.
- Limited obligation to justify specific decisions publicly, raising legitimacy debates.
5.2 Operational Structure — The Eurosystem
- National central banks act as ECB agents, maintaining their operational roles.
- The Eurogroup provides informal political oversight (Finance Ministers).
6. ECB Monetary Policy Objectives and Strategy
The Treaty mandates that the ECB’s primary objective is price stability.
6.1 Definition of Price Stability
Originally:
- (1998) Below 2% HICP
Revised:
- (2003) Below, but close to 2% over the medium term
Commentary:
- Pre-2008 inflation record was strong.
- Post-2008 saw deviations due to the financial crisis, deflation risks, and later inflationary spikes.
7. How ECB Implements Monetary Policy
The ECB uses interest-rate policy transmitted through commercial banks.
7.1 Lending Operations
Main Refinancing Operations (MROs)
- Provide 7-day liquidity to commercial banks at a fixed rate.
- Full allotment means banks can access as much liquidity as they can provide collateral for.
Longer-Term Refinancing Operations (LTROs)
During crises:
- 1-month, 3-month, and 3-year liquidity injections.
- Designed to stabilise the banking system when interbank markets collapsed.
Transmission mechanism:
More ECB liquidity → higher bond prices → lower yields → reduced borrowing costs for governments and firms.
7.2 Open Market Operations
- ECB buys or lends against collateral (government bonds).
- Influences short-term interest rates.
- Aims at controlling medium-term inflation prospects.
8. Summary of EMP Implementation
Monetary policy is:
- Centralised in the ECB
- Based on controlling inflation expectations
- Executed via interest rates and liquidity operations
- Coordinated with national CBs under the Eurosystem
9. Conclusions
(1) Euro Eligibility
Determined by Maastricht criteria (inflation, interest rates, deficit, debt, ER stability).
Initially strict, but politically flexible in practice.
(2) Who Sets Monetary Policy?
A highly independent ECB with a clear mandate for price stability.
(3) How Monetary Policy Is Implemented?
Primarily through interest-rate setting and open-market operations, guided by inflation forecasts.
References
Baldwin, R. and Wyplosz, C. (2013) The economics of European integration. 4th edn. Maidenhead: McGraw-Hill.
Commission of the European Communities (1990) One market, one money: an evaluation of the potential benefits and costs of forming an economic and monetary union. European Economy No. 44.
De Grauwe, P. (2012) Economics of monetary union. 9th edn. Oxford: Oxford University Press.
El-Agraa, A.M. (2011) The European Union: economics and policies. 9th edn. Cambridge: Cambridge University Press.
International Securities Market Association (2001) ‘Government deficit accounting practices in the EU’, Financial Times, 5 November.
Levitt, M. and Lord, C. (2000) The political economy of monetary union. Basingstoke: Macmillan.
Rose, A.K. (2000) ‘One money, one market: estimating the effect of common currencies on trade’, Economic Policy, 15(30), pp. 7–45.
Senior Nello, S. (2012) The European Union: economics, policies and history. 3rd edn. Maidenhead: McGraw-Hill.