CHP 1 : EVOLUTION OF THE SINGLE CURRENCY

1.1 ) European Currency Reform Initiatives, 1969-1978

The Werner report (1969)

It set out a blueprint for the stage-by stage realization of Economic and Monetary Union by

proposing a three-phase program to:

Eliminate intra-European exchange rate movements

Centralize EU monetary policy decisions

Lower remaining trade barriers within Europe

Two major reasons for adopting the Euro:

To enhance Europe’s role in the world monetary system.

To turn the European Union into a truly unified market

1.2 ) The European Monetary System, 1979-1998

Germany, the Netherlands, Belgium, Luxemburg, France, Italy, and Britain participated in an

informal joint float against the dollar known as the “snake.” Most exchange rates could fluctuate

up or down by as much as 2.25% relative to an assigned par value.

The snake served as a prologue to the more comprehensive European Monetary System (EMS).

Eight original participants in the EMS’s exchange rate mechanism began operating a formal

network of mutually pegged exchange rates in March 1979.

Capital controls and frequent realignments were essential ingredients in maintaining the system

until the mid-1980s. After the mid-1980s, these controls have been abolished as part of the EU’s

wider “1992” program of market unification. During the currency crisis that broke out in

September 1992, Britain and Italy allowed their currencies to float. In August 1993 most EMS

currency bands were widened to ± 15% in the face of continuing speculative attacks.

1.3 ) German Monetary Dominance and the Credibility Theory of the EMS

Germany has low inflation and an independent central bank. It also has the reputation for tough

anti-inflation policies.

1.4 ) Credibility theory of the EMS

By fixing their currencies to the DM, the other EMS countries in effect imported the German

Bundes bank’s credibility as an inflation fighter. Inflation rates in EMS countries tended to

converge around Germany’s generally low inflation rate.

1.5 ) The EU “1992” Initiative

The EU countries have tried to achieve greater internal economic unity by:

1. Fixing mutual exchange rates

2. Direct measures to encourage the free flow of goods, services, and factors of production

The process of market unification began when the original EU members formed their customs

union in 1957.The Single European Act of 1986 provided for a free movement of people, goods,

services, and capital and established many new policies.

1.6 ) European Economic and Monetary Union

In 1989, the Delors report laid the foundations for the single currency, the euro.

1.7 ) Economic and monetary union (EMU)

A European Union in which national currencies are replaced by a single EU currency managed

by a sole central bank that operates on behalf of all EU members.

Three stages of the Delors plan:

1. All EU members were to join the EMS exchange rate mechanism (ERM)

2. Exchange rate margins were to be narrowed and certain macroeconomic policy decisions

placed under more centralized EU control

3. Replacement of national currencies by a single European currency and vesting all monetary

policy decisions in a ESCB.

1.8 ) Maastricht Treaty (1991)

It set out a blueprint for the transition process from the EMS fixed exchange rate system to

EMU. It specified a set of macroeconomic convergence criteria that EU countries need to satisfy

for admission to EMU. It included steps toward harmonizing social policy within the EU and

toward centralizing foreign and defense policy decision.

EU countries moved away from the EMS and toward the single shared currency for four

reasons:

1. Greater degree of European market integration

2. Same opportunity as Germany to participate in system-wide monetary decisions

3. Complete freedom of capital movements

4. Political stability of Europe

1.9 ) The Maastricht Convergence Criteria and the Stability and Growth Pact

The Maastricht Treaty specifies that EU member countries must satisfy several convergence

criteria:

1. Price stability

2. Maximum inflation rate 1.5% above the average of the three EU member states with lowest

inflation

3. Exchange rate stability

4. Stable exchange rate within the ERM without devaluing on its own initiative

5. Budget discipline

6. Maximum public-sector deficit 3% of the country’s GDP

7. Maximum public debt 60% of the country’s GDP

A Stability and Growth Pact (SGP) in 1997 sets up:

1. The medium-term budgetary objective of positions close to balance or in surplus

2. A timetable for the imposition of financial penalties on counties that fail to correct situations

of “excessive” deficits and debt promptly enough.

1.10 ) The European System of Central Banks

It consists of the European Central Bank in Frankfurt plus 12 national central banks. It conducts

monetary policy for the euro zone. It is dependent on politicians in two respects:

1. The ESCB’s members are political appointments.

2. The Maastricht Treaty leaves exchange rate policy for the euro zone ultimately in the hands

of the political authorities.

CHP.2 : 'EUROPEAN UNION - EU'

DEFINITION

A group of European countries that participates in the world economy as one economic unit and

operates under one official currency, the euro. The EU's goal is to create a barrier-free trade zone

and to enhance economic wealth by creating more efficiency within its marketplace.

The current formalized incarnation of the European Union was created in 1993 with 12 initial

members. Since then, many additional countries have since joined. The EU has become one of

the largest producers in the world, in terms of GDP, and the euro has maintained a competitive

value against the U.S. dollar.

EU and non-EU members must agree to many legal requirements in order to trade with the EU

member states.

The European Union (EU) is a unification of 27 member states united to create a political and

economic community throughout Europe. Though the idea of the EU might sound simple at the

outset, the European Union has a rich history and a unique organization, both of which aid in its

current success and its ability to fulfill its mission for the 21st Century.

2.1 ) History Of EU

The precursor to the European Union was established after World War II in the late 1940s in an

effort to unite the countries of Europe and end the period of wars between neighboring countries.

These nations began to officially unite in 1949 with the Council of Europe. In 1950 the creation

of the European Coal and Steel Community expanded the cooperation. The six nations involved

in this initial treaty were Belgium, France, Germany, Italy, Luxembourg, and the Netherlands.

Today these countries are referred to as the "founding members."

During the 1950s, the Cold War, protests, and divisions between Eastern and Western Europe

showed the need for further European unification. In order to do this, the Treaty of Rome was

signed on March 25, 1957, thus creating the European Economic Community and allowing

people and products to move throughout Europe. Throughout the decades additional countries

joined the community.

In order to further unify Europe, the Single European Act was signed in 1987 with the aim of

eventually creating a "single market" for trade. Europe was further unified in 1989 with the

elimination of the boundary between Eastern and Western Europe - the Berlin Wall.

2.2 ) The Modern-Day EU

Throughout the 1990s, the "single market" idea allowed easier trade, more citizen interaction on

issues such as the environment and security, and easier travel through the different countries.

Even though the countries of Europe had various treaties in place prior to the early 1990s, this

time is generally recognized as the period when the modern day European Union arose due to the

Treaty of Maastricht on European Union which was signed on February 7, 1992 and put into

action on November 1, 1993.

The Treaty of Maastricht identified five goals designed to unify Europe in more ways than just

economically. The goals are:

1) To strengthen the democratic governing of participating nations.

2) To improve the efficiency of the nations.

3) To establish an economic and financial unification.

4) To develop the "Community social dimension."

5) To establish a security policy for involved nations.

In order to reach these goals, the Treaty of Maastricht has various policies dealing with issues

such as industry, education, and youth. In addition, the Treaty put a single European currency,

the euro, in the works to establish fiscal unification in 1999. In 2004 and 2007, the EU expanded,

bringing the total number of member states as of 2008 to 27.

In December 2007, all of the member nations signed the Treaty of Lisbon in hopes of making the

EU more democratic and efficient to deal with climate change, national security, and sustainable

development.

2.3 ) How A Country Joins The EU

For countries interested in joining the EU, there are several requirements that they must meet in

order to proceed to accession and become a member state.

The first requirement has to do with the political aspect. All countries in the EU are required to

have a government that guarantees democracy, human rights, and the rule of law, as well as

protects the rights of minorities.

In addition to these political areas, each country must have a market economy that is strong

enough to stand on its own within the competitive EU marketplace.

Finally, the candidate country must be willing to follow the objectives of the EU that deal

politics, the economy, and monetary issues. This also requires that they be prepared to be a part

of the administrative and judicial structures of the EU.

After it is believed that the candidate nation has met each of these requirements, the country is

screened, and if approved the Council of the European Union and the country draft a Treaty of

Accession which then goes to the European Commission and European Parliament ratification

and approval. If successful after this process, the nation is able to become a member state.

2.4 ) How The EU Works

With so many different nations participating, the governance of the EU is challenging, however,

it is a structure that continually changes to become the most effective for the conditions of the

time. Today, treaties and laws are created by the "institutional triangle" that is composed of the

Council representing national governments, the European Parliament representing the people,

and the European Commission that is responsible for holding up Europe's main interests.

The European Council

It consists of the Heads of State or Government of the Member States, together with its President

and the President of the Commission. The High Representative of the Union for Foreign Affairs

and Security Policy takes part in its work. The European Council defines the general political

direction and priorities of the European Union. It does not exercise legislative functions. The

European Council meets twice every six months, convened by its President. When the situation

so requires, the President will convene a special meeting. The President's term of office is two

and a half years, renewable once. The European Council usually meets in Brussels.

The European Parliament

It is elected every five years by the people of the European Union to represent their interests. The

main job of the European Parliament (EP) is to pass European laws on the basis of proposals

presented by the European Commission. The EP shares this responsibility with the Council of

the European Union. The Parliament and the Council also share joint authority for approving the

EU’s annual budget. The main meetings of the Parliament are held in Strasbourg (France), others

in Brussels (Belgium).

The Council of the European Union

It is the EU’s principal decision-taking body. It shares with the European Parliament the

responsibility for passing EU laws. The Council of the EU consists of ministers from the national

governments of all the EU countries. Meetings are attended by whichever ministers are

responsible for the items to be discussed. Every six months, a different member state assumes the

so-called Presidency of the EU, meaning that it chairs these meetings and sets the overall

political agenda. The rotating presidency does not apply to the Foreign Affairs Council, which is

chaired by the EU's High Representative for Foreign Affairs and Security Policy.

The European Commission

It is the EU’s executive body and represents the interests of the EU as a whole. It drafts

proposals for new European laws, which it presents to the European Parliament and the Council.

It puts into practice the EU's common policies and manages the EU's funds and programmes.

The Commission also plays its role as "guardian of the treaties" making sure that everyone

abides by the EU treaties and laws. It can act against rule-breakers, taking them to the European

Court of Justice if necessary.

The Commission consists of 28 Commissioners — one from each EU country. The president of

the Commission is chosen by the 28 EU governments and endorsed by the European Parliament.

The other commissioners are nominated by their national governments in consultation with the

incoming president, and must be approved by the European Parliament. They do not represent

the governments of their home countries. Instead, each of them has responsibility for a particular

EU policy area. They are all appointed for a period of five years.

In addition to these three main divisions, the EU also has courts, committees, and banks which

participate on certain issues and aid in successful management.

The EU Mission

As in 1949 when it was founded with the creation of the Council of Europe, the European

Union's mission for today is to continue prosperity, freedom, communication and ease of travel

and commerce for its citizens. The EU is able to maintain this mission through the various

treaties making it function, cooperation from member states, and its unique governmental

structure.

CHP.3 : EUROPEAN CENTRAL BANK

The central bank responsible for the monetary system of the European Union (EU) and the euro

currency. The bank was formed in Germany in June 1998 and works with the other national

banks of each of the EU members to formulate monetary policy that helps maintain price

stability in the European Union.

The European Central Bank (ECB, based in Frankfurt, Germany) manages the euro – the EU's

single currency – and safeguards price stability in the EU.

The ECB is also responsible for framing and implementing the EU’s economic and monetary

policy.

Purpose

The European Central Bank (ECB) is one of the EU institutions. Its main purpose is to:

keep prices stable (keep inflation under control), especially in countries that use the euro.

keep the financial system stable – by making sure financial markets and institutions are properly

supervised.

The Bank works with the central banks in all 28 EU countries. Together they form the European

System of Central Banks (ESCB).

It also leads the close cooperation between central banks in the euro area – the 17 EU countries

that have adopted the euro, also known as the eurozone. The cooperation between this smaller,

tighter group of banks is referred to as the ‘Eurosystem’.

Tasks

The ECB's role includes: setting key interest rates for the eurozone and controlling the money

supply managing the eurozone's foreign-currency reserves and buying or selling currencies when

necessary to keep exchange rates in balance helping to ensure financial markets and institutions

are adequately supervised by national authorities, and that payment systems function smoothly

authorising central banks in eurozone countries to issue euro banknotes monitoring price trends

and assessing the risk they pose to price stability.

Structure

The ECB has the following decision-making bodies:

Executive Board – oversees day-to-day management. It has 6 members (1 president, 1 vice-

president and 4 other members) appointed for 8 years by the leaders of the eurozone countries.

Governing Council – defines eurozone monetary policy and fixes the interest rates at which

commercial banks can obtain money from the Bank. It consists of the Executive Board plus the

governors of the 17 national central banks in the eurozone.

General Council – contributes to the ECB's advisory and coordination work and helps prepare

for new countries joining the euro. It consists of the ECB president and vice-president and the

governors of the national central banks of all 28 EU countries.

The ECB is completely independent. Neither the ECB, the national central banks in the Euro

system, nor any member of their decision-making bodies can ask for or accept instructions from

any other body. All EU institutions and governments must also respect this principle.

CHP.4 ) MONETARY AND FISCAL POLICY INTERACTIONS IN A

MONETARY UNION

In EMU, responsibility for monetary policy is assigned to the ECB, while fiscal policy remains

the remit of each individual EU Member State. The Treaty on the Functioning of the European

Union (hereinafter referred to as the “Treaty”), as well as additional provisions on monetary and

fiscal policy interactions, aim to safeguard the value of the single currency and lay down

requirements for national fiscal policies.

The financial crisis has highlighted that threats to financial stability can have a tremendous

influence on both monetary policy and fiscal policy. In particular, financial instability and weak

public finances can have a negative impact on each other. This adverse financial-fiscal feedback

loop poses severe challenges to monetary policy, as volatile and illiquid sovereign bond markets,

as well as a struggling banking system, put the smooth functioning of the monetary policy

transmission mechanism at risk. In order to counter the adverse impact of fiscal and financial

instability on the monetary policy transmission mechanism, the Euro system resorted to a set of

non-standard monetary policy measures during the crisis. Several weaknesses in the national

fiscal policies and economic governance of EMU have come to light in the course of the crisis.

First, the incentives and rules for sound fiscal, financial stability and macroeconomic policies

proved to be insufficient. Second, the absence of a framework for the prevention, identification

and correction of macroeconomic imbalances was a clear flaw in the

EMU framework. Third, the lack of an explicit framework for euro area-wide financial stability

and crisis management made it difficult to contain cross-market contagion quickly and

efficiently.

Together with a stability-oriented monetary policy, sound fiscal and financial stability policies

are an important foundation for sustainable growth and employment in the euro area. Hence, an

improved policy framework is needed to address the identified shortcomings and thus ensure the

smooth functioning of EMU. Such a framework must:

i) maintain a price stability-oriented monetary policy;

ii) provide stronger safeguards for sustainable public finances and economic policies; and

iii) include explicit provisions for ensuring financial stability and crisis management. The

first steps have been taken to overhaul the framework for economic governance in EMU,

as well as the framework for financial supervision and regulation. The fast

implementation and efficient enforcement of the new rules are essential

EMU is based on a unique institutional framework, comprising a single monetary policy and

several fiscal policies, each of which has clearly specified objectives and functions. With regard

to monetary policy, the Treaty tasks the Euro system with the clear, primary objective of

maintaining price stability in the euro area as a whole. With regard to fiscal policy, it is the

responsibility of the national authorities to ensure a commitment to sound public finances,

despite there being a formal framework for coordinating and laying down requirements for fiscal

policies across countries.

The single monetary policy and national fiscal policies interact in various ways. For instance, a

reliable and stability-oriented monetary policy fosters stable inflation expectations and low

inflation risk premia, both of which help to limit the level and volatility of long-term interest

rates. This, in turn, is beneficial to governments’ financing costs. Conversely, fiscal policy has an

impact on monetary policy, not only through demand-side effects, which may have a direct

impact on the inflation outlook, but also by shaping the supply side of the economy, e.g. via tax

regimes, or by influencing long-term interest rates via the issuance of public debt.

While fiscal and monetary policies should ideally be mutually reinforcing, the euro area

sovereign debt crisis has exemplified the opposite, namely that unsustainable public finances and

high levels of debt can impede the conduct of a stability oriented monetary policy. In fact, the

experience of recent years has unfortunately highlighted hat weak public finances can trigger a

vicious circle that puts the financial system under strain. Deteriorating fiscal positions induce a

repricing of sovereign debt, which has an adverse impact on the financial system via banks’

exposure to government bonds. This, in turn, has negative repercussions for the macro economy,

weakening public finances and financial markets even further. Such an adverse feedback loop

then has an impact on monetary policy, in that volatile and illiquid sovereign bond markets, as

well as instabilities in the banking system, put the smooth functioning of the monetary policy

transmission mechanism at risk.

4.1 ) The Institutional Framework Of EMU

The institutional setting for Economic and Monetary Union (EMU) is based on a dual structure.

The competences for monetary policy and for exchange rate policy have been transferred to the

euro area level with the introduction of the euro, while the competences for economic policy

have largely remained the responsibility of national policy makers.

The reason for this arrangement, which dates back to the Treaty of Maastricht of 1992, is that

economic policies – such as fiscal and structural policies – frequently need to take into account

national characteristics and institutional settings and are often the very essence of national public

and political debates. This framework was also expected to introduce a certain degree of policy

competition among national policy makers, thereby contributing to the emergence of best

practices that would be shared among and emulated by governments (see the Monthly Bulletin

articles the Institutional setting and workings of the euro area from 2008 and The economic

policy framework in EMU from 2001).

At the same time, the EU’s Single Market has made Europe’s economies highly interdependent.

In the euro area, economic and financial integration has increased even further as a result of the

single currency. To take account of these interdependencies (in particular in the form of

spillovers, i.e. when policy decisions in one country affect others), economic policies need to be

subject to a European coordination and surveillance framework. Also, uncoordinated national

economic policy responses may be less effective in the context of a large common shock which

affect most or all European countries in broadly similar ways, such as the economic and financial

crisis. Moreover, a European framework is also necessary because national economic policies

must be geared towards stability to ensure compatibility with the single monetary policy and its

primary objective of price stability, as required by the Treaty.

However, the financial and economic crisis has revealed fundamental weaknesses in the

economic governance framework. Economic governance relied on the assumption that countries

would have sufficient incentives to “keep their house in order” and thereby, quasi-automatically,

contribute to the euro area common good. Economic policy decisions were, in practice, only

subject to soft constraints at the European level, even in those areas where hard rules were

supposed to apply (essentially fiscal policy – see below). Peer pressure, i.e. pressure exercised by

Member States on each other to follow sound economic policies, was largely absent in European

policy debates. Moreover, financial markets failed to exercise their disciplinary role properly.

The experience gained since the introduction of the euro suggests that the limits of what soft

policy coordination can achieve have been reached, both as regards the formulation and the

implementation of European rules and recommendations. The existence of substantial policy

spillovers among euro area countries clearly justifies deeper integration in fiscal, structural and

financial policies, leading ultimately to a fully fledged economic union to ensure the smooth

functioning of EMU. Against this background, the ECB has called for a quantum leap towards

strengthening the institutional foundations of EMU, and thus towards a deeper economic union

that is commensurate with the degree of economic integration and interdependency already

achieved through monetary union (see Reinforcing Economic Governance in the euro area).

4.2 ) Overview of economic policy coordination and surveillance instruments in EMU

Integrated Guidelines

In view of the increased interconnectedness of EU – and in particular euro area – economies, the

Treaty requires Member States to regard their economic policies as a matter of common concern

and to coordinate them within the EU Council (Art. 121 TFEU). More specifically, the Treaty

(Art. 120 TFEU) foresees the adoption of Broad Economic Policy Guidelines (BEPG) which set

out recommendations to policy-makers on macroeconomic and structural policies. The BEPG,

which have been adopted by the EU Council, upon a recommendation from the Commission,

were one of the key policy coordination tools during the first decade of EMU.

Since 2005, the BEPG have been merged with the so-called Employment Guidelines (Art. 148

TFEU) to become the Integrated Guidelines. They are endorsed at the highest political level, EU

leaders, at the spring European Council meetings and updated as required.

4.3 ) The Europe 2020 Strategy

Economic reforms in product and labour markets to increase market flexibility and foster

competition are crucial for the smooth functioning of EMU. Such reforms enable Member States

to raise potential growth and employment. Moreover, such reforms help Member States to

improve their productivity and competitiveness while, at the same time, making their economies

more resilient to economic shocks. The case for structural reforms is reinforced within the euro

area, since Member States can no longer use monetary and exchange rate policies as national

policy instruments. Therefore, structural reforms are also crucial to avoid imbalances emerging

within the euro area.

Against this background, the EU leaders adopted, at the European Council meeting in June 2010,

the “Europe 2020 Strategy” – the Union’s strategy for creating jobs and promoting growth

through economic and social reforms, while paying due respect to environmental considerations.

Under the three headings of smart, sustainable and inclusive growth, the strategy covers policy

actions at both national and EU level aimed at enhancing the welfare of the people of European.

The ambitions of the Europe 2020 Strategy are expressed through five EU-level headline targets,

covering employment, research & development, climate change, education and poverty.

Under the Strategy, Member States present annual National Reform Programmes, consistent with

the Integrated Guidelines, which aim to overcome country-specific bottlenecks to growth and

employment. Member States’ efforts are supported at EU level by “flagship initiatives” and

flanking policies which pertain, for instance to completing the Single Market, financing research

and innovation and improving access for EU companies to global markets

ec.europa.eu/europe2020/ .

The Europe 2020 Strategy is a follow-up to the Lisbon Strategy, which has been only moderately

successful, mainly on account of weak governance arrangements, a lack of clear focus and

deficiencies in communication. (Monthly Bulletin article July 2005: The Lisbon strategy – five

years on). The Europe 2020 Strategy tries to correct these weaknesses, mainly by giving the

European Council a strong role in steering the implementation of the reform agenda and by re-

enforcing surveillance of Member States’ reform policies.

The reformed framework for economic governance

As a response to the financial and economic crisis, the Council and the European Parliament

adopted in 2011 a legislative package to strengthen the EU’s economic governance framework

(for an overall ECB assessment see the Monthly Bulletin March 2011 article The reform of

economic governance in the euro area – essential elements).

4.4 ) The Stability and Growth Pact

Sound public finances help to achieve other important policy objectives such as strong and

sustainable growth, and thereby support employment creation. Fiscal discipline also facilitates

the central bank’s task of maintaining price stability (see the Monthly Bulletin article July 2008

One monetary policy and many fiscal policies: ensuring a smooth functioning of EMU).

For these reasons the Treaty requires Member States to avoid excessive deficits (Art. 126

TFEU). The Stability and Growth Pact (SGP), which was adopted in 1997, enhances the Treaty

provisions on fiscal discipline by establishing a procedure of multilateral surveillance consisting

of a preventive and a corrective arm (see Ten years of the Stability and Growth Pact).

The preventive arm is based on the regular surveillance of national public finances. The

Commission and the EU Council assess annually the stability programmes submitted by euro

area members and the convergence programmes submitted by non-euro area members. These

programmes present an overview of the economic and fiscal developments in each country and

set out a medium-term objective for fiscal policy, and an adjustment path towards this objective.

The Commission can issue an early warning to a Member State at risk of non-compliance with

its commitments under the SGP.

The corrective mechanism of the SGP implies that when a Member State fails to comply with its

obligations, an excessive deficit procedure is triggered. The EU Council adopts

recommendations for the Member State concerned, establishing in particular a deadline for the

correction of its deficits. The EU Council monitors implementation of its recommendations and

abrogates the decision of the existence of an excessive deficit when the latter is corrected. If the

Member State fails to comply, a series of further steps is foreseen, ranging from enhanced

surveillance and disclosure to the imposition of financial sanctions. The Member State concerned

is allowed to take part in the discussions on the necessary recommendations in the EU Council

but, in line with the Lisbon Treaty, can no longer vote.

Experience since the introduction of the euro reveals that the provisions of the SGP have failed

to instil a sufficient degree of fiscal discipline in a number of Member States. Nevertheless, and

against the advice of the ECB, Member States agreed, in 2005, on a reform of the SGP which

introduced further flexibility into the procedures. Regarding the preventive arm, the reform

allowed more discretion in the setting and progress towards the medium term objective for fiscal

stability (see below). As for the corrective arm, the new rules widened the use of discretion in

determining an excessive deficit and extended procedural deadlines (see the Monthly Bulletin

article

The Reform of the Stability and Growth Pact).

In 2011, drawing lessons from the financial and economic crisis, the SGP was again reformed as

part of an overall reform to improve economic governance. One notable innovation to strengthen

the Pact is that decision-making procedures have been made more automatic through the

introduction of reverse qualified majority: certain recommendations of the Commission will be

deemed adopted unless the Council rejects them by qualified majority within a certain period of

time. Moreover, more emphasis has been placed on the public debt criterion and the long-term

sustainability of public finances. Moreover, earlier and more graduated financial as well as

political sanctions have been introduced to encourage Member States’ compliance.

While these measures are a step in the right direction, the reform should have gone still further.

In particular, the ECB regrets that one of the key aspects of such a quantum leap – greater

automaticity in decision-making through the use of reverse qualified majority voting to the

maximum extent possible – was only partly achieved.

The macroeconomic surveillance framework

As part of the 2011 reform to strengthen economic governance, a new macroeconomic

surveillance framework was adopted by the Council and the European Parliament. This new

surveillance procedure aims to identify and address macroeconomic imbalances and declining

competitiveness. It will therefore complement the existing country surveillance process foreseen

under the Europe 2020 Strategy, which focuses on fostering sustainable and socially inclusive

growth and employment. The new mechanism, which has a preventive and a corrective arm, will

apply to all EU-27 Member States.

The preventive arm is based on an alert mechanism that is designed to identify imbalances at an

early stage. More specifically, at the start of each European Semester (see below), the

Commission will assess Member States performance against a scoreboard of macroeconomic

indicators in order to detect the existence, or the risk, of macroeconomic imbalances. The results

of the scoreboard and the analysis will be published in a report. If the Commission finds that

there are Member States with indications of significant macroeconomic imbalances, it will carry

out an in-depth review of economic, financial as well as public finance developments in the

Member States concerned. On this basis, the Council can address the necessary

recommendations to the Member State concerned.

If during its review the Commission identifies excessive macroeconomic imbalances, it can

propose to trigger the so-called “Macroeconomic Imbalances Procedure” (MIP) under the

corrective arm of the macroeconomic surveillance procedure. The Council will address policy

recommendation to a country subject to an EIP, which in turn needs to submit a corrective action

plan (CAP) setting out its national policies in response to the Council recommendation. The

implementation of the CAP by the Member State in question will then be subject to close

monitoring by the Commission and the Council, a process which will include progress reports

and surveillance missions. In case of non-compliance with the recommendations, a sanction

mechanism, inspired by the EDP for fiscal surveillance, is foreseen.

The ECB very much welcomes the creation of a new macroeconomic surveillance framework,

which closes an important loophole in the EMU governance framework. The effectiveness of the

new mechanism must not however be weakened by its broad scope, also in terms of indicators

used, so that it can correct imbalances and vulnerabilities at an early stage.

The European Semester

Since 2011, EU surveillance of the economic policies of its Member States has been organised

on an annual basis through the European Semester. This process, which takes place during the

first half of the year, was set up to better align EU surveillance of fiscal and economic policies,

which remain legally separate. It allows fiscal and macroeconomic policies to be assessed

simultaneously against the Integrated Guidelines, a step which is expected to ensure greater

consistency, in terms of policy direction and reporting, among the different surveillance

processes. Moreover, under the European Semester, country-surveillance is complemented by

thematic surveillance, which covers progress in the area of broader structural reforms agreed

under the Europe 2020 strategy.

The so-called “national semester” takes place in the second half of the year. This is when

Member States finalise national budgets and implement policy measures agreed during the

European semester.

Although it is too early to fully assess the effectiveness of the European Semester in improving

the conduct of fiscal and structural policies in Member States, the framework can contribute to a

more integrated and consistent approach to economic policy making.

4.5 ) The Euro Plus Pact

At their summit on 11 March 2011, euro area leaders adopted a Pact for the Euro. The Pact aims

to strengthen the economic pillar of EMU by further extending economic policy coordination to

areas falling under national competence, in particular with regard to competitiveness,

employment and the long-term sustainability of public finances. The Pact is also open to non-

euro area Member States and has been joined by Bulgaria, Denmark, Latvia, Lithuania, Poland

and Romania, so the Pact was re-named “Euro Plus Pact”.

The Pact builds on existing economic policy coordination instruments, in particular the Europe

2020 Strategy, and is consistent with the Single Market. The participating Member States are

committed to making a special effort and to undertaking concrete actions that are more ambitious

than those already agreed. The Pact forms part of the European Semester and national

commitments are reviewed on a yearly basis by the Heads of State or Government.

The euro area dimension in economic policy coordination

The potentially substantial spill-over effects in a monetary union (see above) require euro area

countries to coordinate their economic policies particularly closely. This specific euro area

dimension is recognised in the Lisbon Treaty, which contains a new chapter dedicated to

“provisions specific to Member States whose currency is the euro”. The Protocol on the

Eurogroup, which is annexed to the Treaty, refers explicitly to the need “to develop ever-closer

coordination of economic policies within the euro area”, so as to promote conditions for stronger

economic growth in the EU as a whole.

In keeping with this specific euro area dimension, the Lisbon Treaty has also revised the voting

procedures for decisions to be taken in the field of the BEPG and the SGP. As already

mentioned, only euro area countries participate in EU Council votes on decisions concerning

euro area countries. The need for euro area countries to be particularly stringent in respecting

agreed rules is also reflected in the corrective arms of the SGP and the EIP, with financial

sanctions only foreseen for euro area countries.

Another example of the euro area dimension in the field of economic policy coordination exists

in the field of fiscal policies, where the euro area countries have agreed to enhance their

surveillance in the framework of the Eurogroup. More specifically, the Eurogroup conducts an

annual mid-term review on the appropriateness of budgetary policies in euro area countries

ahead of the submission of draft national budgets for debate in national parliaments.

As one of the main lessons from the first decade of the euro, the ECOFIN Council concluded in

October 2008 that competitiveness in the euro area should be monitored more comprehensively.

The Eurogroup regularly reviews labour markets, competitiveness developments and macro

economic imbalances within the euro area. Moreover, the new Integrated Guidelines adopted

under the Europe 2020 strategy include a detailed guideline for euro area members focusing on

macro-economic imbalances.

Further progress in strengthening the euro area dimension in economic policy coordination was

made at the summit meeting on 26 October 2011, when the euro area leaders agreed to meet at

least twice a year in the form of “Euro Summits“ to provide strategic orientations on economic

and fiscal policies in the euro area, so that the euro area dimension can be taken better into

account in domestic policies. They also committed to number of additional measures, above and

beyond existing requirements, such as the adoption of balanced budget rules (in structural terms)

translating the SGP into national legislation, preferably at constitutional level or equivalent and

the consultation of the Commission and other euro area countries before the adoption of any

major fiscal or economic policy reform plans with potential spillover effects. (Euro Summit

statement )

Moreover, reflecting the core role of the Eurogroup, the Commission and the ECB in the daily

management of the euro area, there will be at least monthly meetings of the President of the Euro

Summit, the President of the Commission, and the President of the Eurogroup in which the

President of the ECB may participate. The Presidents of the three supervisory agencies (see The

ECB´s role in the reformed financial supervisory architecture) and the Head of the EFSF/ESM

may participate on an ad hoc basis.

Moreover, in a new provision introduced by the Lisbon Treaty (Art. 136.1 TFEU), euro area

countries may adopt measures to strengthen the coordination and surveillance of their budgetary

discipline and to set out economic policy guidelines in order to ensure the proper functioning of

EMU. Such measures, which would be legally binding on euro area countries, need to be

consistent with other policy instruments (such as the Integrated Guidelines and the SGP).

CHP.5 : THE SHORTCOMINGS OF EMU.

The economics profession has in general been sceptical of a European monetary union.

Economists have pointed to a large number of pitfalls on the road to a common European

currency. Indeed, the road so far has been a rocky one.

The ERM crisis in the early 1990s severely threatened the EMU-project. The last minute effort in

May 1998 to put a Frenchman in charge of the ECB as well as various attempts in the early

spring of 1999 by the German minister of finance to press for a lowering of the euro-rate

damaged credibility. The transition from stage two to stage three, when the exchange rates of the

first set of countries to join EMU were permanently fixed, was once regarded as highly risky,

potentially provoking speculative attacks. No such attacks materialised, however. The transition

went smoothly at the turn of the new year of 1999. Now after January 1st, 1999, the creation of

EMU and the ECB has triggered a discussion of the future of EMU since it seems to have passed

the major hurdles of the long transition stage that started in the 1970s.

Economists have pointed to a number of shortcomings, also termed "deficiencies", "flaws" or

"potential fault lines" in the construction of EMU. There are by now about half a dozen such

"hazard areas".4 We list the most common ones below, focusing on those pertaining to the euro-

area once it was established but ignore "deficiencies" pertaining to the transition stages before

the common currency is introduced into circulation within Euroland. We thus concentrate our

discussion on the long run "steady-state" of EMU, assuming that it will successfully pass through

the remaining transition.

1. EMU lacks a central lender of last resort. The ECB has not been granted power by the

Maastricht treaty to serve this function. This stands in sharp contrast with modern central

banks, which exercise lender of last resort responsibilities to guarantee the liquidity and

functioning of the payments system.6 In the face of a liquidity crisis, the absence of a lender

of last resort may undermine the existence of EMU.

2. EMU lacks a central authority to supervise the financial systems, including the commercial

banks, of Euroland. The Maastricht treaty gives the ECB some supervisory functions but they

are primarily the task of the union members. This state of affairs portends that a future pan-

European financial crisis may not be efficiently resolved, consequently threatening the

stability of the Eurosystem.

3. The ECB lacks democratic control and accountability. The ECB will be subject to political

attacks and controversies that damage the legitimacy of EMU and erode popular support for

the Euro. The role of the European parliament in monitoring the ECB is unclear at this point

as well. Should major economic problems arise within a single member of EMU, populist

political movements may use them to attack EMU and the ECB.

4. The policy directives for the ECB are inconsistent, unclear, and badly designed. Although

the ECB is to carry out "domestic" monetary policy within Euroland, according to the

Maastricht Treaty, exchange rate policy for EMU is set by the Council of the European

Union, that is by the Council of finance ministers of EMU.9 This will result in political

discussion, tensions and political pressure on the monetary policy of the ECB.

5. The absence of central co-ordination of fiscal policies within EMU in combination with

unduly strict criteria for domestic debt and deficits, as set out in the Maastricht rules and the

Stability Pact implies that EMU will not be able to respond to asymmetric shocks and

disturbances in a satisfactory way.10 For example, presently (summer 1999) the booming

Irish economy is in need of a tighter monetary policy yet the ECB has lowered interest rates

in Euroland making monetary policy in Ireland more expansionary.

6. Europe is too large a geographical area to form a well-functioning monetary union. In other

words, Euroland with its present eleven member states is not an optimal currency area

(OCA). This point, which dates from the analysis of optimal currency areas initiated by

Mundell (1961), has been debated continuously since the announcement of the plans for a

monetary union in Europe. Most empirical work on this issue reaches the conclusion that

EMU is not an optimal monetary union, at least it is less optimal than the US monetary

union. The efficiency gains from increased trade do not outweigh the costs of surrendering

control over national monetary policies.

The costs of that surrender will depend on the incidence of asymmetric or idiosyncratic

macroeconomic disturbances across Euroland, the degree of flexibility of wages and prices,

the mobility of factors of production within Euroland, and the extent to which fiscal policies,

either on a national or on a pan-European level, can serve as a substitute for changes in the

exchange rate and the interest rate of the domestic currency.

European labour markets are commonly described as rigid and labour mobility within the

EMU members as limited. Under these circumstances an asymmetric shock will set off an

adjustment process that will be more slowly and costly within EMU than otherwise.

Rising unemployment, requests for fiscal transfers, and for protection will undermine the

credibility of EMU and the political cohesion required for a well functioning monetary union.

This point is probably the major objection to EMU. The abolition of domestic currencies and

thus of the ability to adjust nominal exchange rates and domestic interest rates when faced

with asymmetric or country-specific shocks, in the opinion of most economists, threatens the

stability of EMU.

5.1 ) Crisis management and the European Stability Mechanism

The European Council on 28-29 October 2010 agreed to establish a permanent crisis

management mechanism to safeguard financial stability in the euro area as a whole. The

establishment of the future European Stability Mechanism (ESM) was formally adopted at the

meeting of the European Council on 24-25 March 2011 as part of a comprehensive package of

measures to respond to the crisis. This adoption followed a limited Treaty change to Article 136

TFEU to allow euro area countries to establish a stability mechanism which is to be activated, if

need be, to safeguard the stability of the euro area as a whole, with any financial assistance

granted under strict conditionality.

The ESM is expected to enter into force at the latest in July 2012 with a lending capacity of €

500 billion and is expected to replace temporary measures such the European Financial Stability

Facility (EFSF ) and the European Financial Stabilisation Mechanism (EFSM), which were

established following the ECOFIN decisions of 9 May 2010 to provide financial support to

Member States in financial difficulties.

The EFSM was established as an EU mechanism with its legal basis in Article 122 TFEU while

the EFSF was established as a euro area mechanism on the basis of Article 122 TFEU together

with an intergovernmental agreement among the euro area countries. The two mechanisms

together have a potential lending capacity of € 500 billion.

At their summit meetings of 11 March 2011and 21 July 2011, the euro area leaders agreed to

increase the flexibility of the EFSF and the future ESM by allowing them to act on the basis of a

precautionary programme, finance recapitalisation of financial institutions, and interventions in

the primary and secondary bond markets.

On 26 October, euro area Heads of State or Government agreed to maximise the available

resources of the EFSF, without extending the guarantees underpinning the facilities, by (i)

providing credit enhancement to new debt issued by Member States and/or (ii) through a

combination of resources from private and public financial institutions and investors, which can

be arranged through Special Purpose Vehicles. In addition, further enhancement of the EFSF

resources can be achieved by cooperating even more closely with the IMF.

5.2 ) The ECB is involved in parts of the operations of the EFSM, EFSF and the future

ESM.

First, it will liaise with the European Commission and the IMF and assess whether there is risk to

the financial stability of the euro area as a whole, and ECB staff will undertake a rigorous debt

sustainability analysis. EFSF and ESM interventions in the secondary bond market will be on the

basis of an ECB report.

ECB staff will also provide technical experts along with the European Commission and the IMF

for the negotiation on a macroeconomic adjustment programme with the Member State

requesting financial support and for monitoring the programme implementation (see the Monthly

Bulletin article July 2011 The European Stability Mechanism).

Moreover, in December 2011 the ECB agreed to act as an agent for the secondary market

activities of the EFSF.

CHP.6 : THE FUTURE OF THE EMU

EMU will be a flexible monetary union.

First of all, the history of monetary unification suggests that national monetary unions are

permanent and flexible. They evolve over time in response to political and economic events.

Their durability and flexibility is a consequence of the political process that once established

monetary unity. EMU has been created by a strong will for political unity, despite a number

of primarily "economic" objections to the project. This political determination will likely

design mechanisms and institutions to overcome the shortcomings of EMU that the initial set

of rules and treaties embodied in the Eurosystem impose.

EMU will be hit by major shocks.

Second, history shows that exceptional shocks and crises will eventually hit any monetary

area. Countries like the US, Canada and Italy have been the subjects of asymmetric or

region-specific shocks and structural shifts that have left permanent scars. The maritime

provinces of Canada and Southern Italy have been struggling for long with comparative

stagnation. In spite of transfers to these poor regions, their problems have not been solved.

However, they have not led to the breakdown of political unity, splitting up the nation state,

and thus the monetary union.

EMU will be based on political unity.

Third, monetary unions of the past were in two important respects different from the present

process leading to the common European currency. First, the national monetary unification of

the 18th and 19th century followed after political unification and, second, they were based on

specie. Consequently, monetary unification was a much simpler process than in the case of

Euroland, thus also politically easier to carry through.

Countries that have joined the EMU today are on a fiat - not a specie - standard. Present

European monetary unification is based on a commonly accepted politically decided

commitment mechanism as opposed to the metallic standard of yesterday that had gold

convertibility as a common focal point and commitment mechanism. The statues of the EC

set out price stability as its "principal objective". A precondition for the EMU to succeed and

be stable in the future is that the individual members of the EMU must display forever a

similar commitment to this common goal, as did the advanced nations to the gold standard

rule more than a century ago. This is most likely the major challenge facing EMU.

EMU will not be an "optimal" currency area.

A major objection of the economics profession to EMU is that it is not now and will not be

an optimal currency area. History shows that the creation, reign and dissolution of national

monetary unions have hardly any connection with the criteria spelled out in the literature on

optimal currency area (OCA) inspired by the work of Mundell, McKinnon and Kenen.

Instead, they have developed in a historical context as a result of the political process. The

historical record suggests that the OCA-theory is not well suited to analyze the evolution of

monetary unions as it lacks important political and historical dimensions. Thus it is not a

promising concept for considering the future of EMU either.

CONCLUSIONS

EMU is a unique construction without any clear precedent in monetary history. This suggests

great caution when forecasting the future of EMU. However, we know that EMU will

function as a national monetary union with one central bank and one common currency

circulating within the union.

The major driving forces behind the establishment of national monetary unions as well as

behind their dissolution are political ones. The “economic” shortcomings noted by

economists concerning the workings of the EMU need not spell disaster. They can be

overcome by political forces as well as by market-based adjustment mechanisms.

The EMU and the ECB will be subject to major shocks in the future - just as the case is with

any monetary area and its central bank. Monetary deficiencies or monetary problems that can

be solved within the nation state should be solvable in a monetary union covering many

nation states, given that the union is organized as a national monetary union with one type of

money circulating within the whole union and with one central bank.

A major lesson from history is that monetary unification is an evolutionary process. EMU

will evolve in the future in a way different from the existing plans for the EMU. This

process, allowing the EMU to adapt and adjust to future disturbances, should properly be

regarded as a policy learning process, where policy makers learn to cope with the

shortcomings that emerge.66 This process will continue as long as the political will to

maintain the union is present. Once it disappears, the EMU may break apart. Judging from

the history of national monetary unions such an outcome appears likely only under extreme

circumstances.