Essay, Research Paper: European Economic And Monetary Union (EMU)

On January 1, 1999 11 countries agreed that 2002 would mark the year that the Euro replaces the national currencies. Here we have another year for an absolute. By 2002 a single currency will exist in all the EMU countries. This is defined as the third and final stage of the EMU.

The roots of the Economic and Monetary Union go back to the Treaty of Rome. Although the treaty was vague on monetary policy and had few binding constraints in macroeconomic policy, articles 104-109, now 102 to 130 contain a section called "Balance of Payments" and establishes the Monetary Committee to "Keep under review the monetary and financial situation." This committee consists of two representatives from each member state and the commission. A chair was elected by the membership.

There was very little interest at this time in establishing a single currency bloc. The book gives several reasons for this:
1. The Breton Woods system was the reigning idea of the time
2. The U.S. dollar was the undisputed standard
3. Keynesianism was the popular idea of the time and local governments wanted control over their fiscal and monetary policies.

The need for a supranational monetary system became realized during the 1960's with increased instability throughout Europe in regards to the vagaries of the U.S. dollar. France was especially hit by this and did not want to take on the U.S. alone in these matters. The Breton Woods system promised stability through a controlled exchange rate mechanism. This system was referred to as a "˜snake' metaphorically since it was a temporary system that could shed its skin and change, or grow by being added to, but mainly because it was a system of linked exchange rates. During the 1960's there was a long period of exchange rate stability, which brought a false sense of security. In response to this stability, the EMU set up the Common Agricultural Policy, which was described in the book as "˜putting the cart before the horse' since other policies in support of this would have been necessary.

The Hague Summit in 1969 brought a change to the Breton Woods ideal. The topic of discussion at this meeting was the target of a full EMU. The deepening of the EU at this time was attributed to the Hague Summit. This was a Franco-German initiative and involved President Pompidou and Chancellor Brandt. This was designed to allow for major future policy development. It was somewhat uneventful, however, but it brought initial ideas about the 3rd stage of the EMU.

In 1964 the Committee of Central Bankers was founded to manage the collaboration among central bankers in the EU. This committee was a "˜tight knit circle for transnational policy.' In 1970 this committee, along with some national finance officials issued the Werner Report in response to the demise of the snake system. This report was designed to hide the truth about what was going on with the ERM behind the cloak of a strategy called parallelism. "This presumed the complementary development of monetary alignment and macroeconomic policy coordination."

The snake bit itself and the EMU began to beak down in 1971. The system for holding together the exchange rates did not account for or prevent increasing divergence among member nations' economic policies and inflation. By 1974 the EMU was only an idea. Many countries were forced to leave and the rest were reliant on some of the more dominant currencies. The German Deutschmark's dominance became recognizable during this period. After sorting through the rubble it was discovered that some good came out of this failed system. Increased cooperation among central bankers paved the way for better relationships and eventually agreement when working on the development of the single currency.

In 1979 Chancellor Schmidt, against the advice of his central bank, decided to make another go at an exchange rate mechanism. This time it was called the European Monetary System. The idea behind it was to have fixed, but periodically adjustable exchange rates among EU countries, with a narrow margin of adjustment. Some of the reasons for the induction of the EMS were increased dialogue on the topic of a semi-fixed exchange rate system, some of which came from the United States, some from businessmen, who stressed the advantages of such a system. The desire to preserve common agriculture prices was another main motive. The EMS was also designed as a defense against U.S. "˜benign neglect' regarding the valuation of the dollar. Some supporters of the EMS used this opportunity for political gains.

The EMS was based on the original snake with some differences:
1. It was designed to help widen membership
2. It was designed to allow for smoother functioning of the ERM
3. The European Currency Unit, which contained fixed amounts of each EU currency.
4. The divergence indicator, which provided symmetry in calculating exchange rates.
5. Similarities with the German anti-inflation policy

The German anti-inflation policy and the divergence indicator contradicted each other since the divergence indicator calculated based on inflation and deflation while the German system was designed to reduce inflation.

Germany feared constant revaluation of the DM, France and Italy saw this as an opportunity to combat inflation. Countries with more volatile exchange rates saw this as an opportunity to broaden their area, thereby stabilizing this factor. The result was that the divergence indicator would never come to pass.

From 1979 to 1992, stable exchange rates were experienced at an increasing rate. The mechanism for this was "˜gradually accelerating convergence of inflation rates downwards.' When France began to accept this mechanism by dropping its expansionistic policies in 1983, leaps and bounds towards stable inflation rates were achieved throughout the EMS. Widening of the EMS was also achieved during this time period. The UK, who originally declined to enter the EMS, joined up in 1990. Spain Joined in 1989, and Portugal in 1992.

Price convergence and ERM stability relied on short-term interest rates, since long-term interest rates would have been difficult to accomplish with a more volatile exchange rate. Adjustments became smaller and less frequent. Eventually, long-term interest rates were possible with increased exchange stability.