conomic and Monetary nion y Verdun apter Contents Introduction 344 ■ What is economic and monetary policy? 344 I From The Hague to Maastricht (1969-91) 346 . From treaty to reality (1992-2002) 348 ■ Explaining economic and monetary union 350 ■ Criticisms of economic and monetary union 352 • The global financial crisis and the sovereign debt crisis 354 • Conclusion 356 Reader's Guide This chapter provides an introduction to economic and monetary union (EMU), it describes the key components of EMU and what happens when countries join, EMU was the result of decades of collaboration and learning, which have been subdivided here into three periods: 1969-91, taking us from the European Council's first agreement to set up EMU to Maastricht, when the European Council included EMU in the Treaty on European Union (TEU); 1992-2002, from when plans for EMU were being developed to the irrevocable fixing of exchange rates; and 2002 onwards, once EMU had been established, and euro banknotes and coins were circulating in member states. Next, the chapter reviews various theoretical explanations, both economic and political, accounting for why EMU was created and looks at some criticisms of EMU. Finally, the chapter discusses how EMU has fared under the global financial crisis and the sovereign debt crisis. These crises brought to the fore various imperfections in the design of EMU. This section discusses what changes have been made since 2009 to address those flaws and at what we may expect in the years to come. 344 Amy Verdun Economic and Monetary Union 345 Introduction Euro banknotes and coins were introduced on 1 January 2002. On that date, the euro became legal tender in 12 EU member states, among a total of more than 300 million people. Except Denmark, Sweden, and the UK, all 12 participated. It signalled the start of a new era in the history of the EU not least because, from this point on, the majority of EU citizens were, on a daily basis, in contact with a concrete symbol of European inlegration. What was the path that led to the euro? The goal to create an economic and monetary union (EMU) has been an integral part of European integration since the early 1970s, although those early plans were derailed. Once back on track in the late 1980s and 1990s, supporters of the idea of economic and monetary union wanted to make sure that the process was done properly. Member states agreed that there should be economic and monetary convergence prior to starting EMU. But at the same time, some member stales (such as the UK) did not want to join EMU. What is economic and monetary policy? Having a common currency among distinct nations has occurred for centuries in different settings: the Roman Empire had a single currency. More recently Belgium, France, Italy, Switzerland, and others were part of a Latin monetary union (LMU) from 1865 to 1927. They minted francs that were of equal value across their union. In 1872, the Danes, Norwegians, and Swedes launched a single currency, the Scandinavian krona, used until the outbreak of the First World War in 1914. Although the nineteenth -century European monetary unions were significant, the scale and scope of economic and monetary union in the EU is further reaching, because these earlier unions only harmonized coinage and did not introduce a single monetary policy or a central bank. Furthermore, the financial system has undergone a major transformation in the past century and the role of the state as expanded enormously over the past century. Thus EMU is without doubt the most spectacular and ambitious monetary union of all time. The component parts of EMU EMU, as it was first conceptualized and set out ;n ^ Treaty Maastricht, refers to the union of participaf countries which have agreed to a single monetary p0| icy, a single monetary authority, a single currency an(j coordinated macroeconomic policies. Let us Ha A these features. First, what is monetary policy? Central banks for mulate and implement monetary policy, in SOni cases in collaboration with the government—that is with the ministry of finance and sometimes also with the economics ministry. Monetary policy aims at in fluencing the money supply and credit conditions Central banks set a key interest rate. In EMU, man-ctary policy is no longer formulated at the national level, but decided upon at the European level by a single monetary authority: the European Central Bank (ECB). In December 1991, the Maastricht European Council agreed to create a European System of Central Banks (ESCB). This consists of the ECB and the already existing national central banks of all 28 EU member states (27 after Brexit). Only 19 EU member states have actually adopted the euro: the collection of national central banks of countries that have adopted the euro plus the ECB is called the Eurosystem. Those national central banks are merely 'branches' of the new ECB. The ECB Governing Council is responsible for formulation of the monetary policy for the 'eurozone' or 'euro area'. The ECB is responsible for the new single currency, sets a key short-term interest rate, and monitors the money supply. To facilitate coordination of economic and financial policies, an informal ministerial group has been set up: the so-called 'Eurogroup'. It consists of the ministers of finance, and sometimes economics, who get together to coordinate policies. The group typically convenes before the meeting of the EU Council on Economic and Financial Affairs (ECOFIN). Strictly speaking, EMU could still have been possible without the introduction of a single currency. There were two alternatives: participating countries could have kept their national currencies and fixed their exchange rates irrevocably; or they could have introduced a common currency in parallel to the existing national currencies—something that the British government suggested in 1990 (the 'hard European currency unit (ecu)' proposal), but which did not receive support. While a parallel currency is introduced j^sitle existing national currencies, a single currency laces them. A single currency would reduce the ' ansacti°ns costs that banks charge when currencies exchanged. It was also politically more attractive ause it would signal a full commitment to EMU. In order to have a successful mix between monetary Dolicv and fiscal policy (taxing and spending), EMU envisages the coordination of economic policies (Article 121 TFEU). To secure the euro as a low-inflation currency, there are rules on public debts and budgetary deficits. Article 126 TFEU states that member states must avoid budget deficits in excess of a reference value—set in a protocol annexed to the Treaty at 3% of gross domestic product (GDP)—and general government debt should be at or below a reference value (60% of GDP). Furthermore, monetary financing of the debts and deficits would not be permitted: countries could no longer use the printing press to create money to service their debt. This so-called 'no bailout clause' was put in place to reduce the likelihood of one member state assuming the debt of another or for the EU as a whole (for example through the ECB) to take over some of the debt of a member state should it be unable to pay its debts (Article 125 TFEU). Prior to EMU, a member state that ran high budget deficits with inflationary consequences would have been 'punished' by the market, because it would have needed to set higher short-term interest rates as a consequence. In EMU this mechanism was expected to disappear (which indeed occurred as long-term interest rates of EMU countries converged right after the start of EMU until the sovereign debt crisis). The rules on debts and deficits and the no-bailout clause were to be put in its place to ensure that no country would take advantage of the situation and issue too much debt. Finally; a central bank may aim to target a particular value of the currency vis-a-vis other currencies. The ECB has mostly considered the external value of the | euro as subordinate to its primary aim, which is to achieve price stability (set as close to, but not more than, 2% inflation). Furthermore, because of a situation dubbed by Tomasso Padoa-Schioppa as an 'inconsistent quartet', the euro has typically been left to market forces and thus floats freely against other major currencies. The inconsistent quartet means •hat under conditions of free trade, with liberal capital markets, and fixed exchange rates one cannot also ■ have autonomous monetary policy. Thus, seen that the ECB is most concerned about internal monetary stability (securing the inflation target of about 2% or just below) the exchange rate becomes subordinate to that goal. The acronym 'EMU' consists of two components, 'economic' and 'monetary', with the latter the most prominent component. The term 'economic and monetary union' can be traced back to the discussions in the late 1960s and early 1970s. The policy-makers at the time were not sure how best to create EMU. To have fixed exchange rates—and ultimately a single currency—required some coordination of economic policies. Some countries—Belgium, Luxembourg, and France—thought that, by fixing the exchange rate, the necessary cooperation of the adjacent economic policies would naturally start to occur (the 'Monetarists'). Two other countries—West Germany and the Netherlands—held the opposite position. In their view, economic policies needed to be coordinated before fixing exchange rates or introducing a single currency (the 'Economists'). This debate is referred to as the dispute between the 'Monetarists and the Economists'. (Note that the term 'Monetarists' used in this context does not have the same meaning as the term monetarists' referring to the followers of the ideas of Milton Friedman.) The question of how to reach EMU had already been discussed in some detail by economic thinkers of the 1960s such as Bela Balassa and Jan Tinbergen. According to these and others, economic integration can be subdivided into a number of stages (see also Chapter 20) that range from more minimal to more extensive integration. The least far-reaching form of integration is a free trade area (FTA). In an FTA, participating members remove barriers to trade among themselves, but maintain the right to levy tariffs on third countries. The next stage of integration is a customs union. In addition to the free trade among mem bers, a customs union has common external tariffs on goods and services from third countries. A common market since 1985, renamed Single Market— is characterized by free movement of goods, services, labour, and capital among the participating states, and common rules, tariffs, and so on vis-a-vis third countries. An economic union implies not only a common or Single Market, but also a high degree of coordination of the most important areas of economic policy and market regulation, as well as monetary policies and income redistribution policies. A monetary union contains a common or Single Market, but also further integration in the area of currency cooperation. However, historically deeper integration has not always 346 Amy Verdun Econom.c and Monetary Union 347 been part of a monetary union: the Scandinavian monetary union did not contain a customs union. A monetary union either has irrevocably fixed exchange rates and full convertibility of currencies, or a common or single currency circulating within the monetary union. It also requires integration of budgetary and monetary policies. An economic and monetary union (EMU) combines the features of the economic union and the monetary union. This combination is what European leaders had in mind when they discussed EMU in 1969 and again in 1988. A full economic union (FEU) implies the complete unification of the economies of the participating member states and common policies for most economic matters. A full political union (FPU) is the term used when, in addition to the FEU, much of the political governance and policy-making have moved to the supranational level. Effectively, political unification occurs when the final stage of integration has taken place and a new confederation or federation has been created. The eventual institutional design of EMU in the 1980s and 1990s was an asymmetrical one (Verdun, 1996, 2000). It featured a relatively well-developed monetary union, but a much less developed economic union. Monetary policy was to be transferred to a new European supranational institution (the European Central Bank (ECB)), whereas in the area of economic policy-making decisions remained the full responsibility of national governments. To some extent, one observes here the difference between positive and negative integration. Positive integration refers to the creation of common rules, norms, and policies. Negative integration is all about taking away obstacles, and eliminating rules and procedures that are an obstruction to integration. KEY POINTS • Economic and monetary union consists of a single monetary policy, a single monetary authority, a single currency, a Single Market (including free movement of capital), and coordinated macroeconomic policies. • The 'Monetarists' and the Economists' differed in opinion as to how best to create EMU • There are various stages of integration, ranging from a free trade area to a full political union. The stages are an analytical device • EMU can be characterized as asymmetrical From The Hague to Maastricht (1969-91) At the 1969 Hague Summit, the heads of state government decided to explore a path to econonv' and monetary union. A group of experts, headed h" Pierre Werner, prime minister and finance minist of Luxembourg, drafted the blueprint. The 197Q Werner Plan proposed three stages to reach EMlj by 1980. On the institutional side, it recommended setting up two supranational bodies: a Community System for the Central Banks and a Centre of Deci sion for Economic Policy. The former would pursue monetary policies, while the latter would coordinate macroeconomic policies (including some tax poli. cies). Although most of the recommendations of the Werner Plan were adopted, the plans for EMU stalled in the 1970s because the circumstances changed dramatically and member states had different ideas about how to deal with them and how it should affect the policies that needed to be pursued. For example, the so-called Bretton Woods agreement, ended in August 1971. This agreement had facilitated stable exchange rates in Western Europe since 1945. West European countries responded to its demise by setting up their own exchange rate mechanism (ERM), the so-called 'snake'. However, it only functioned with moderate success throughout the 1970s, and not all EEC member states participated, although several non-EEC members were involved. Developments leading to the relaunch of EMU in the late 1980s In 1979, the European Monetary System (EMS) was set up, in which all European Community (EC) member states were to participate. Not all were immediately part of its most important feature, the exchange rate mechanism or 'ERM'—a system of fixed, but adjustable, exchange rates. For instance, the UK was not part of the ERM during the 1980s, but its currency was part of the European currency unit (ecu)—the unit of account at the heart of the EMS. In 1991, the British pound sterling did join the ERM, but it was forced to leave on 16 September 1992 ('Black Wednesday') following a period of intense selling of sterling in tne financial markets, which the British government was unable to bring to a halt. Italy participated in the ERM from the outset, but was initially given more leeway. I fUjes stipulated that most currencies could not ^tuate more than + 2.25% from an agreed parity, ^hereaS the bandwidth for those who needed more eway (f°r exarnP'e> Ita'y) was set at - 6' constitute a so-called 'op-creat currency area' (OCA). Countries should adopt [e currency only when they are sufficiently in-8 ted economically, when they have mechanisms ^1 ce that can deal with transfer payments if one ^ f tne currency union is affected by an economic J"wflturn and the other part is not, and when they longer need the exchange rate instrument to make diose adjustments. Most analysts claim, however, that £U is not an OCA, although a few think that a jmall number of its members come close to it. OCA theory states that if countries do not form an OCA, n^ev should not give up their exchange rate instrument but use it to make adjustments as the economic situation dictates. These analysts argue that the EU should not have moved to EMU. Others who judge that the EU does indeed constitute an OCA are less critical of this situation. They see the current group of countries as being well integrated. Furthermore, thev use a broader definition of an OCA, claiming that original OCA theory is too rigid and pointing out that, following the original definition, no federation (including Canada, Germany, or the United States (US)) would constitute an OCA. Finally, some argue, following Frankel and Rose (1998), that once countries join EMU, they could become an OCA over time ('endogenous' OCA theory). Other developments that have influenced recent thinking about the role of exchange rates are the effects of financial markets on exchange rate policies—particularly on smaller open economies. Foreign exchange markets can create their own disturbances, which can be irrational. This effect is worse for smaller open economies than for larger established countries. The original OCA theorists did not take the destabilizing effects of exchange rate freedom into consideration. I Asecond school of thought focuses on central bank credibility, ft argues that the EU witnessed long periods of collaboration in central banking prior to EMU. Central banks can be effective only if financial markets have confidence in their policies. In the case of the exchange rate mechanism, participating countries tad to keep their exchange rates stable. They focused "n the monetary policy of the strongest currency, the German Deutschmark. Many individual central banks, % choice, followed the policies of the leader (the Bun-flttfe). The most credible way in which to secure Monetary policy is to commit firmly to it in a treaty. Economic and Monetary Union 35 I That is, in fact, what happened with the Maastricht Treaty. A regime was set up that envisaged full central bank independence and gave the ECB a clear single mandate to maintain price stability. A political science perspective Political science has drawn on European integration theories (see Chapters 4-6) to explain EMU. It is noteworthy that scholars from opposing schools of thought have argued that EMU can be explained using different theoretical approaches. For reasons of simplicity, this section focuses on the two opposing schools in order to capture a larger set of arguments. A neo-functionalist explanation (see Chapter 4) claims that EMU can best be explained as the result of spillover and incremental policy-making. The success of the exchange rate mechanism and the completion of the Single Market necessitated further collaboration in the area of monetary integration. EMU was needed to maximize the benefits of these developments. Significant monetary policy convergence had occurred, arising out of the collaboration within the framework of the ERM and the tracking of German policies by other member states. I Ience EMU couldbe seen as a natural step forward. Moreover, it is argued that supranational actors were instrumental in creating EMU—which is another characteristic of the neo-functionalist explanation of European integration. Not only were the Commission President and the services of the Commission (such as the Directorate-General for Economic and Financial Affairs) involved, but also various committees, such as the EC Monetary Committee (created by the Treaty of Rome), and they each proved influential. An intergovernmentalist explanation (see Chapter 5) argues that EMU can best be understood by examining the interests and bargaining behaviour of the largest member states. This approach sees the European Council meetings and meetings of the EU Council as crucial for decisions such as the creation of EMU and for follow up regulations. By examining the interests of the largest member states, one is able to see why EMU happened. France was in favour of EMU as a way of containing German hegemony. Germany, in turn, was able to secure a monetary policy regime that was sufficiently close to its domestic regime. Some argue that Germany was in favour of EMU in the early 1990s to signal its full commitment 352 Amy Verdun to European integration, following German unification. The UK was not in favour of EMU, but was aware that it was likely to happen. The UK wanted to be involved in agenda-setting, in shaping the process, and in ensuring EMU would not create a more federal political union at the same time. It has also been ar gued that EMU served the economic interests of the business communities within these countries, which subsequently led governments to be more supportive of the project. KEY POINTS • tt is Dnssihle to explain economic and monetary union from different perspectives. • Economists and political scientists have tried tc explain economic and monetary union. ■ Economists often use optimum currency area theory to assess EMU • Political scientists use theories of European integration to explain EMU. Criticisms of economic and monetary union Economic and monetary union is not without its critics, however. Criticisms may involve distinctive national perspectives, but can also rest on institutional grounds. Countries outside the euro area The Danes and Swedes are very proud of their political, social, and economic achievements, and many of them doubt that joiningEMU will benefit their respective countries. A majority of their populations have been relatively sceptical about the euro and see joining the euro area as unnecessary or undesirable. In both countries, a referendum on EMU was held (in Denmark, in 2000; in Sweden, in 2003) and in both cases the majority of those who voted were against joining EMU. Denmark has an opt out agreed at Maastricht and thus can choose to stay outside the euro area; although the Swedish government does not have an opt-out, it pursues policies that guarantee that it does not qualify for EMU. The UK reflects an even more Eurosceptic lation. For many years a large segment of trT1"1" population has had doubts about European ^ tion altogether (see Chapter 27). These [eeli"1^' Euroscepticism have been expressed in several^ °' and particularly in the increasing success of the ^ Independence Party (UKIP) in European Parity ^ elections. In a referendum on 23 June 2016 52»/ ' the voters supported leaving the EU whereas 48»/ ^ invoked Ar- voted to 'remain'. In March 2017, the UK tide 50 of the Lisbon Treaty which stipul; ates the two pro-years. cess of leaving the EU within a period of At the time of writing, the UK is expected to exit the EU by 29 March 2019 but it is unclear what the exact future relationship between the UK and the EU will be post-Brexit (see Chapter 27). The global finandal crisis, the economic recession, and the sovereign debt crisis have had varying effects on member state per. ception of EMU. initially, in 2007 until summer 2008 various currencies of EU member states that had remained outside the euro area did betlcr than the euro Yet, in the autumn of 2008 and the first months of 2009 the euro strengthened against other European currencies such as the Czech koruna, the Polish zlotj; or the Hungarian forint. But as currencies weakened, this benefited the export sector and was regarded as a factor that could assist in a speedier recover)' following the economic downturn or recession after the onset of the financial crisis. Some have criticized the design of the euro as being too much focused on price stability; meaning that the mandate of the ECB is to consider first and foremost the internal management of the euro (to ensure price stability) rather than, for example, at what exchange rate the euro area might be more competitive at the global level. Especially in the early 2000s, when the euro area countries were growing less than countries outside the euro area (and again during the sovereign debt crisis), the criticism was often that the ECB could only consider growth as a secondary consideration. All in all, support for the euro has been varied. Over the past years, the Danish Prime Minister has indicated having more interest than before in joining the euro, while a majority of citizens in Sweden (68%) reject adopting the euro a their national currency (Eurobarometer, 2016).The ten member states that joined the EU in 2004 have also had varying attitudes to euro adoption. The seven that have joined to date (Slovenia, Cyprus, Malta, Slovakia, Estonia, Latvia, and Lithuania) have been keen to do so. Those that have remained outside have done variety of reasons. The three CEE member that atc ST'" outside the euro area have a govern-and population that are reluctant to join even I •"they are current'y not eyen t0° ^ removec' from I nu the criteria for entry, which focus on infla-I I deficit, debt, and long-term interest rates. None °f "hem, however, participate in the exchange rate chanism and will mostly likely only start doing so I . anj when they are more favourable to the idea of oining EMU In all cases, these countries have the formal requirement that they are obliged to join EMU