Economic and Monetary Union

  • On January 1, 1999, 11 European countries adopted a common currency, the euro.
  • The nations' individual currencies will continue to circulate until 2002, but their values are fixed in terms of the euro.
  • The Economic and Monetary Union is expected to bring a variety of benefits to its members, such as increased international trade and the higher living standards that trade makes possible.

In order to enjoy the benefits of increased economic integration, 11 European countries formed the Economic and Monetary Union (EMU) and began using a common currency, the euro, on January 1, 1999. At the same time, each of the countries yielded its ability to conduct its own monetary policy to the European Central Bank (ECB), located in Frankfurt, Germany, which now conducts monetary policy for the EMU. The primary objective of the ECB is to "maintain price stability," and the Bank is instructed not to "seek or take instructions from . . . any government of a Member State or from any other body."

The 11 countries in the EMU are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. These countries have a combined population of about 300 million people—about 10 percent more than that of the United States—and a combined gross domestic product about one-third that of the United States. Greece joined the EMU as of January 1, 2001, while the citizens of Denmark voted in 2000 not to join.

By agreement, the EMU countries' individual currencies will continue to circulate until 2002, but during this transition each currency has a fixed value in relation to the euro—and, consequently, in relation to the currency of each of the other EMU members, too. Thus, each participating nation has given up, in addition to its monetary policy power, its ability to influence the foreign exchange (FX) value of its country's currency. (The FX value of the euro may vary against other currencies, however.)

Currently, the euro can be used only for non-cash transactions, although anyone can have a euro-denominated bank account. Euro notes and coins will be brought into circulation by January 1, 2002. The euro is divided into 100 cents, and there will be coins of one, two, five, 10, 20, and 50 cents, and one and two euros, and notes of five, 10, 20, 50, 100, 200, and 500 euros. As of July 1, 2002, the individual countries' notes and coins will no longer be legal tender.

Background
The creation of the Economic and Monetary Union marks the culmination of decades of movement toward European economic integration. In 1951, Belgium, France, Germany, Italy, Luxembourg, and the Netherlands formed the European Coal and Steel Community, creating a common market for coal and steel. In 1957, the same six countries signed the Treaty of Rome, creating the European Economic Community (EEC), or Common Market. (Ireland, Denmark, and the United Kingdom joined in 1972.) The Werner Report, which proposed a European monetary union, was adopted by the heads of state of the EEC members in 1971. In 1979, the nine EEC members formed the European Monetary System, and eight of the countries agreed to maintain the foreign exchange value of their currencies within a stipulated range against the currencies of the other members; the ninth country, the United Kingdom, joined the agreement in 1990. The Maastricht Treaty of 1992 set a timetable for the creation of the EMU, as well as limits on inflation rates, interest rate levels, government deficits, and government debt that countries had to meet in order to join the Union.

Benefits
The most obvious benefit of the common currency is that it reduces the cost and difficulty of completing international transactions within the EMU. For example, a German importer of French wine will no longer have to convert German marks into French francs in order to pay for the wine; both the importer and the French wine company will be using the euro. Thus, the cost of conducting transactions will be reduced, and the savings can be passed along to consumers in the form of lower prices.

The common currency will promote trade among the EMU countries not only by reducing transaction costs, but also by eliminating both exchange-rate uncertainty within the EMU and the costs of protecting against foreign-exchange risk. Thus, the German wine importer will not have to worry about what might happen to the mark/franc exchange rate from when it places the order to when it has to pay for the wine, and neither will it have to go to the expense of a forward contract to protect against possible adverse changes in the exchange rate.

The reduced costs of international trade will force firms to compete to a greater extent than previously against firms in other EMU countries. Moreover, because firms will be producing for larger market areas, they will be able to enjoy increased economies of scale. The increased competition and increased economies of scale, should, in turn, lower prices and raise the standard of living of the residents of EMU countries. The use of a single currency is generally regarded as a factor that has contributed to the success of the U.S. economy over the years, and Europeans hope that their use of a single currency will bring them similar benefits.

Costs
The conversion to a single currency brings the members of the EMU costs, as well as benefits. The individual countries in the EMU can no longer conduct monetary policy or have any control over the foreign exchange value of a national currency. That means that they will have to resort to other methods to combat the problems of recession and inflation within their own countries. However, the EMU limits the ability of a member country to employ expansionary fiscal policy in a recession, as it prohibits a country's annual government deficit from exceeding 3 percent of the country's GDP. There are financial penalties for exceeding this limit, although the penalties may be waived for countries experiencing sizable declines in GDP.

Labor mobility within the EMU is another factor. In a large single-currency area such as the United States, labor mobility plays a major role in solving the problem of high regional unemployment. If the economy is weak in one part of the country, while labor shortages exist elsewhere in the country, workers can move from the high-unemployment area to the regions where jobs are plentiful. However, because of differences in culture, language, etc., labor mobility has been much lower among EMU countries than it is between regions of the United States. With unemployment in the EMU running around 9%, and with the individual EMU countries having yielded much of their ability to conduct macroeconomic policy, the EMU faces the challenge of trying to increase international labor mobility.

The advent of the euro also creates adjustment problems for the average citizen. Europeans must adjust to coins and notes with values different from those with which they have become familiar. Under the euro, for example, people in both France and Belgium will be using the same coins, but France currently has nine coin denominations, while Belgium has just five.

Implications for the United States
The creation of an economic entity whose size rivals the US economy creates challenges and opportunities for the United States. For example, the euro may pose a challenge to the position of the US dollar as a foreign exchange vehicle and as a global "store of value." (While the United States accounts for about one-quarter of world production and about one-fifth of the world's international trade, the dollar is involved in over 80 percent of all foreign exchange transactions and represents about 60 percent of world currency reserves.) A decline in the world's demand for the dollar—should it occur—could reduce the dollar's foreign exchange value, thereby putting upward pressure on import prices in the United States. However, a country's economic success depends far more on other factors that determine the country's ability to provide its citizens with a high standard of living than it does on the extent to which the country's currency is used in international transactions. Moreover, because the euro will promote European economic growth and a more efficient international monetary system, all countries—including the United States—will benefit from the increased demand and from having a stronger trading partner.

The Euro's First Two Years
At this point, two years after its introduction, the euro is an accepted currency in world markets, and the creation of a more integrated financial market in the EMU has reduced the cost of capital and made investments easier to finance. During its first 22 months, the euro fell almost 30 percent against the dollar, at least partly because of the strength of the US economy. In late 2000, when the US economic outlook worsened, the euro rose against the dollar.

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