The European Monetary System, The Maastricht Treaty, Birth of the Euro and its Future

Group Members 516 Tulika Gurung 537 Sharon Nunes 552 Bhavana Sonawane 555 Shivangi Tarai

A Brief History of European Economic Integration

The euro was already envisaged as a goal back at the start of European integration in 1950s It was always seen as the next logical step after the single market The idea gained academic attention through the work of economist like Robert Mundell (Optimal Currency Areas) Break-up of the gold standard in the 1970s led to creation of the forerunners of the euro, European Monetary System (EMS) and Exchange Rate Mechanism (ERM) German reunification (1990) and currency crisis of 1992 as catalysts for push toward the euro leading to Maastricht Treaty in 1992/93.

A Brief Glossary of Euronyms

What Is the EU?

The European Union is a system of international institutions, the first of which originated in 1957, which now represents 27 European countries through the following bodies:
European Parliament: elected by citizens of member countries Council of the European Union: appointed by governments of the member countries European Commission: executive body Court of Justice: interprets EU law European Central Bank, which conducts monetary policy through a system of member country banks called the European System of Central Banks

20-4

What Is the EMS?

The European Monetary System was originally a system of fixed exchange rates implemented in 1979 through an exchange rate mechanism (ERM). The EMS has since developed into an economic and monetary union (EMU), a more extensive system of coordinated economic and monetary policies.
The EMS has replaced the exchange rate mechanism for most members with a common currency under the economic and monetary union.

20-5

The EMS 19791998

From 1979 to 1993, the EMS defined the exchange rate mechanism to allow most currencies to fluctuate +/ 2.25% around target exchange rates.
The exchange rate mechanism allowed larger fluctuations (+/ 6%) for currencies of Portugal, Spain, Britain (until 1992) and Italy (until 1990).
These countries wanted greater flexibility with monetary policy.

The wider bands were also intended to prevent speculation caused by differing monetary and fiscal policies.

20-6

The EMS 19791998 (cont.)

To prevent speculation,

early in the EMS some exchange controls were also enforced to limit trading of currencies.
But from 1987 to 1990 these controls were lifted in order to make the EU a common market for financial assets.

A credit system was also developed among EMS members to lend to countries that needed assets and currencies that were in high demand in the foreign exchange markets.

20-7

The EMS 19791998 (cont.)

But because of differences in monetary and fiscal policies across the EMS, market participants began buying German assets (because of high German interest rates) and selling other EMS assets. As a result, Britain left the EMS in 1992 and allowed the pound to float against other European currencies. As a result, the exchange rate mechanism was redefined in 1993 to allow for bands of +/15% of the target value in order devalue many currencies relative to the deutschemark.

20-8

The EMS 19791998 (cont.)

But eventually, each EMS member adopted similarly restrained fiscal and monetary policies, and the inflation rates in the EMS eventually converged (and speculation slowed or stopped).
In effect, EMS members were following the restrained monetary policies of Germany, which has traditionally had low inflation. Under the EMS exchange rate mechanism of fixed bands, Germany was exporting its monetary policy.

20-9

Membership of the EU
To be a member of the EU, a country must, among other things,
1. have low barriers that limit trade and flows of financial assets 2. adopt common rules for emigration and immigration to ease the movement of people

3. establish common workplace safety and consumer protection rules

4. establish certain political and legal institutions that are consistent with the EUs definition of liberal democracy.
20-10

Snake in the tunnel: Commitment to keeping European rates within narrower band compared with Breton Woods System +4.50%
+2.25%

Exchange rate

- 2.25%

-4.50%

No intervention

Central bank buys domestic currency

No intervention

Central bank sells domestic currency

No intervention

Time

EUROPEAN CURRENCY UNIT(ECU)

European Currency Unit (ECU) is a composite currency unit that consists of fixed amounts of ten currencies. The quantity of each countrys currency in the ECU reflects that countries relative economic strength in the European community. The ECU functions as a unit of account ,as a means of settlement and a reserve assets for the members of EMS.

What is Monetary Union?

Weak version Fixed bilateral exchange rates (rigidly or within a band) Each member undertakes monetary policies to defend the rates Strong version Individual currencies are replaced by a single currency Individual monetary authorities are replaced by a single authority

The Maastricht Treaty (1991)

The European Monetary Institute (EMI) was a precursor to the European Central Bank (ECB) and was created to Coordinate monetary policies and ensure price stability. Prepare the establishment of the European System of Central Banks (ESCB) overseen by the European Central Bank (ECB). Prepare the introduction of a single currency in stage 3. Examine the achievement of economic convergence among EU states as established by the Maastricht Treaty (1992).

The Maastricht Treaty (1991)

Defines three stages in the process towards monetary union. First Stage (from 1 July 1990 to 31 December 1993): The EMS countries abolished all remaining capital controls (Free movement of capital). The degree of monetary cooperation among the EMS central banks were strengthened. Realignments were possible. Member states undertake programs that make possible fixed exchange rates. Second Stage (from 1 January 1994 to 31 December 1998): A new institution, the European Monetary Institute (EMI) was created.

The Maastricht Treaty (1991)

Third (Final) Stage (from 1 January 1999 to 31 June 2002): The exchange rates were irrevocably fixed. Establishment of the European Central Bank in charge of the European monetary policy. The ECB issued the euro. The transition to this final stage was made conditional on a number of convergence criteria. Third Stage was divided into three sub-stages: From 1 January 1999 until 31 December 2001, the national currencies continued to circulate alongside the euro, albeit at irrevocably fixed exchange rates. Commercial banks used the euro in interbank transactions. Individuals had the choice of opening euro accounts. Note that during this period the euro did not exist in the form of banknotes and coins. All transactions between the ECB and commercial banks were in euros. New issues of government bonds were also in euros.

1.

The Maastricht Treaty (1991)

2. 3. During the period 1 January to 1 July 2002, the euro would replace the national currencies which would lose their legal-tender status. From 1 July 2002 on, a true monetary union would come to existence in which the euro would be the single currency managed by one central bank, ECB.

The Maastricht Treaty was finally ratified in the fall of 1993 and 12 countries (except UK, Sweden and Denmark) began to implement Stage 2 of EMU- the convergence phase in which states were required to cut their deficits and lower inflation to qualify for Stage 3.

What is EMU?

 What is EMU & description

What are the three parts of EMU?

1) The euro countries give up their own currency when they join the euro area. The ECB sets interest rates for the euro area (16) 2) The single market all countries participate in the single market, with free movement of goods, services, capital and people (27)

3) Enhanced policy coordination countries retain sovereignty over other economic policies but commit to coordinate more closely at the European level (27/16)

Membership of the Economic and Monetary Union

To be part of the economic and monetary union, EMS members must
1. 2. 3. adhere to the ERM: exchange rates were fixed in specified bands around a target exchange rate. follow restrained fiscal and monetary policies as determined by Council of the European Union and the European Central Bank. replace the national currency with the euro, whose circulation is determined by the European System of Central Banks.

20-21

The Euro

Jan. 1, 1999: The euro became an official currency; 1999-2002: Existing national currencies and the euro operate side by side at fixed rates. The euro is not imposed as currency, but interbank transfers can be made in Euros.

Jan. 2002:New euro notes and coins circulate; July 2002: Local currencies are completely phased out and no longer

allowed. Only euro transactions (cash or transfer) are possible.

Which countries are in the euro area?

Euro area: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, Spain. EU Member States obliged to adopt the euro eventually: Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Sweden. EU Member States with an opt out from adopting the euro: Denmark, United Kingdom.

NON MEMBERS OF EUROZONE

Of the members of the European Union, to which participation in this innovation was restricted, Denmark, Sweden, and the UK chose not to introduce the euro in place of their existing currencies. The UK withdrew from the EMS. One of the causes of this was the substantial flow of shortterm capital from the UK, where interest rates were relatively low, to Germany, which was implementing a very tight monetary policy and hence had very high interest rates.

How does a country join the euro?

A Member State must fulfill the convergence criteria laid down by the Maastricht Treaty: Low inflation Low interest rates Low government deficit Low government debt Stable exchange rate (ERM II)

What are the benefits of the euro?

CITIZENS benefit from greater price transparency, which should stimulate competition and reduce prices and from the elimination of currency exchange costs For BUSINESSES it is easier to make investment decisions (no exchange rate risk) The ECONOMY benefits from price stability, and lack of exchange rate risk

Countries that adopt the euro can no longer change their INTEREST RATE or their EXCHANGE RATE. In a monetary union, you cannot have an INDEPENDENT MONETARY POLICY.

Costs and benefits of the Euro

Benefits:
Reduction in transaction costs. Elimination of the exchange rate risk. Greater competition leading to greater efficiency. Greater integration among the European financial markets and greater investment efficiency. Inflation discipline guaranteed by the independence of the European Central Bank. Fiscal discipline as a requirement to enter and stay in the system.

Increase the urgency of structural reforms in Europe.

The euro and the single market

The euro eliminates currency transactions costs

Leads to greater price transparency price convergence

One market, one money

Eliminates exchange rate uncertainty stimulates investment Euro leads to increased trade and investment flows

FACTORS AFFECTING EXCHANGE RATES

Four factors are identified as fundamental determinants of the real euro to dollar exchange rate: The international real interest rate differential Relative prices in the traded and non-traded goods sectors The real oil price The relative fiscal position

Economic policy making - the euro area and the US

Monetary policy
Federal Reserve Chairman Ben S. Bernanke

ECB President
Jean-Claude Trichet

Fiscal policy
Treasury Secretary Timothy Geithner Eurogroup Finance Ministers

Economic policy co-ordination more difficult?

The Euro Area Economic Situation: Not Good!

Real annual % change unless otherwise stated

2008

2009

2010

Real GDP growth

Inflation Unemployment rate
(percentage of labor force)

0.8
3.3 7.5

-4.0
0.4 9.9

-0.1
1.2 11.5

Source: European Commission Spring Forecast May 2009

Why is the euro area so affected?

US and euro area economies are closely connected Many European banks bought securities tied to US subprime loans German exports have fallen sharply Spanish and Irish housing bubbles have burst Euro area economy is less flexible, has lower productivity growth Toto, I dont think were in Exposure to Eastern Europe? Kansas anymore

GREEK CRISIS
Before one to could even think of the end of great recession of 2008, Greece gave birth to another crisis. Greece debt crisis is actually an evolution of the global crisis. Greece allowed deficits from Central bank and government bonds to pile up.` Greece debt came to light in 2009

CURRENT CRISIS
The European debt crisis came into limelight with Greece. This was done by the new government who took charge after the general elections.

Shocking role of Goldman Sachs in the fraud.

New government revealed the facts which actually happened in which the previous government had overspent and also reported a debt which ballooned to 12.7% of the GDP.

GREECE DATA
Greece has the highest deficit of 13.6% of GDP or euro 32.4bn(as of April 2010). Budget deficit highest in the world. Debt to GDP ratio 113%. Debt GDP ratio 2nd highest in EU. Debt of euro 216bn (as on jan 2010)

Europes response to the crisis

The ECB reduces interest rates to historically low levels (1.25%) and begun quantitative easing

Oct 08: euro area governments adopt concerted action plan to support their financial systems

Dec 08: EU governments adopt European Economic Recovery Plan - a coordinated fiscal stimulus

BAILOUT PACKAGE
Greece was in urgent requirement of funds and on April 23rdit approached IMF and EUROZONES assistance in form of Bailout package. Condition for funds from IMF was that the economy must implement Austerity measures. EU &IMF agreed to 110bn Euros(80bn Euros from EU & 30bn Euros from IMF)

CONTROVERSIES
Public protest in Greece due to implementation of austerity measures. Protests and pressure from other European nations mainly Germany(4.6% in EU)because the debt load is hitting the mark of 121% of GDP. Downgrading of Greece bonds to junk status By S&P

EFFECTS
Stock markets plummeted. Short term borrowing rates had hit levels of 38% Yield premium widens owing to increased cost of borrowing for Greece. Depreciation of currency

RESCUERS
Germany, the largest euro member, because of the feeling that it could lead to worsening of situation to the other Europe nations. IMF by funding the bailout package.EU for providing SPECI AL PURPOSEVEHICLES(SPV)of euro 440bn + 60bn(for emergencies)

CONCLUSION
Failure of Greek financial system will benefit the US treasuries. Help US to correct its own financials. Greek govt. targets public debt to a limit of 60%and deficit to 3% Greece announces increase in taxes and spending cuts to control deficit. EURO countries will fund Greece with terms set by ECB. IMF can provide more funds, if at all required