European Central Bank

The European Union (EU) was founded as the European Economic Community (EEC) by the Treaty of Rome in 1957 to promote economic and political integration in Europe. The beginning of the EEC followed the creation of the European Coal and Steel Community, created after World War II as a means of promoting integration among former enemies. The EEC has expanded from its original six members (Belgium, France, Germany, Italy, Luxembourg, and Netherlands) to include United Kingdom, Ireland, and Denmark in 1973; Greece in 1981; Spain and Portugal in 1986; and Austria, Finland, and Sweden in 1995.

All 15-member states hand over some control to the EU’s network of institutions. National governments are represented in the Council of the European Union, whilst citizens of the member states are elected to the European Parliament. In 1993, the Maastricht Treaty (which renamed the EEC as the European Union), created European citizenship. It strengthened the power of the European Parliament, laid out plans for the Economic and Monetary Union, as well as for committed members to negotiate for expansion of the EU to include Central and Eastern European countries.

As part of the EMU, 12 EU member countries (Belgium, France, Germany, Greece, Italy, Spain, Portugal, Finland, Austria, Netherlands, Ireland and Luxembourg) adopted a new common European currency, called the “Euro”. The Euro currency entered into general circulation in January 2002. The monetary policy is managed by the European Central Bank (ECB), which works in collaboration with the national central banks of the 12 Euro zone countries.

The treaty on European Union (often called the Maastricht Treaty) founded the EU and was intended to increase political, economic, and social integration among member states. It is worth noting that the treaty committed the EU to Economic and Monetary Union (EMU). Under the EMU, member nations would combine their economies and adopt a single currency by 1999. A single currency was a natural complement to the European Union’s single market, allowing it to function more efficiently and making it more favorable to growth.

Several benefits would be derived through the main policies of the EMU, which are as follows: ? Elimination of exchange rate fluctuations: this provides a more stable environment for trade within the Euro area by reducing risks and uncertainties for both importers and exporters, who previously had to consider currency movements into their costs. Businesses are better able to plan their investment decisions because of reduced uncertainties. Independent research suggests that the euro has already promoted significant growth in trade within the Euro area.

?Elimination of the various transaction costs related to the exchange and the management of different currencies due to elimination of exchange rate fluctuations. For instance, the costs resulting from: -Foreign exchange operations themselves by buying and selling foreign currencies. -Hedging operations intended to protect companies from adverse exchange rate movements. -Cross-border payments in foreign currencies, which are normally more costly and slower than domestic operations. -Management of several currency accounts, which cause difficulties in currency management and internal accounting systems.

?Price transparency: consumers and businesses can compare prices of goods and services more easily when always expressed in the same currency. Easier price comparisons encourage competition and hence lead to lower prices in the short to medium run. Consumers, wholesalers and traders can buy from the cheapest source, thus putting pressure on companies trying to charge a higher price. ?More opportunities for consumers: the single currency makes it simpler for consumers to travel and to buy goods and services abroad, particularly when coupled with the progress of e-commerce.

?More attractive opportunities for foreign investors: a large single market with a single currency means investors can do business throughout the euro area with minimal interference and can also take advantage of a more stable economic environment. INTRODUCTION The introduction in 1999 of the euro – the single currency of the European Union – marked the beginning of the final stage of Economic and Monetary Union (EMU) and the start of a new era in Europe. This historic achievement was the conclusion of a lengthy process that began in 1957 about forty-two years before the achievement of this project.

It all started somewhere around the year 1957 when a treaty was signed in Rome and bears the name of its host country namely the Treaty of Rome. This treaty gave birth to the EEC, which was made up of six member countries namely Belgium, Germany, France, Italy, Luxembourg and the Netherlands. It has as main objective to pull Europe together. One year later (i. e. in 1958), the European Community was established to promote trade and cooperation between its members. The first six members were Belgium, Luxembourg, France, Netherlands, Italy and West Germany.

They were joined in 1973 by the UK, Ireland, and Denmark. Six years later, i. e. in 1979, the European Monetary System was formed and during the following ten years three more countries joined the European Community namely Greece in 1981, Portugal and Spain in 1986. In 1991, another treaty was signed in the city of Maastricht in Netherlands, which was concerned mainly with the harmonization of all currencies into one single common currency. The treaty of Maastricht also had concerns to the environment, public health and education with regards to Europe but the main object was the adoption of a single currency.

They had already set the January 1 1999 date as deadline for this treaty. This treaty also became the effective constitution of the EMU providing the criteria for judging macroeconomic convergence and laying down the groundwork for eventual establishment of the European Central Bank (ECB). In 1992, the EMU was introduced by the treaty on European Union, which is an agreement for participating countries allowing pooling of currency reserves and the introduction of a common currency. One more year elapsed and another union was created in 1993, i.e. the European Union. It was established by the EC and is a political and economic union.

This brings us to the year 1994 whereby a European Monetary Institute was founded as a step towards establishing the European Central Bank and a common currency. In 1995, a group named the European Council of Madrid in Spain decided to call this new currency the Euro and said it should be divided into cents. In that same year, three more countries joined the EC namely Finland, Austria and Sweden.

A meeting in Amsterdam in June 1997 initiated the designs for the Euro by the European Council. In 1998, the European Central Bank was established having as responsibility the setting of a single money policy and interest rate for the countries who would use the new currency. The ECB worked with the Central Banks of all fifteen countries. And on January 1 1999, the Euro was adopted by eleven of the fifteen countries forming the EU i. e. Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.

On that day, the money from these countries that were in the EU had the value of their money set that means they could not change it anymore. For financial firms, in each of these countries, the creation of the Euro required conversion of numerous existing accounts and systems for trading, risk, analysis, and liquidity management to the new currency. Although development of these systems had been going on for several years, the actual switchover took place over the long “conversion week-end” from the close of business on December 31 1998, through the opening of business on January 4 1999.

Big efforts in major financial centres were necessary for handling the difficulties of re-dominating Euro-area government bonds to the new currency and doing final testing of the system of interbank payments. The establishment of the single monetary area and the removal of currency risk among member countries are expected to provide many opportunities for cross-border trading, portfolio expansion and mergers and acquisitions among European companies. Things did not stop there. Greece decided to join the Euro family two years later i. e. in 2001.

It became the twelfth country to form part of the “Euro era”. In 2002, the Euro became officially the common currency for twelve countries in the EU. This was the biggest money change the world has ever seen! The Spanish government took over the EU’s rotating presidency and postage stamps with the Euro were validated. This caused existing stamps with old currencies’ value to become invalid as from June 30, 2002. However, even though Euro was introduced with a main view to harmonize currency valuations, there are other advantages and some drawbacks linked to that change. ELIGIBILITY CRITERIA.

The treaty on European union (EU) offered the participating countries a chance to become a political and economic world superpower. The treaty provides for a single European currency, common citizenship, common foreign and security policy, a more well-organized and competent European Parliament and a common labour policy. In order that EMU countries benefit, developed and succeed, it is necessary that certain conditions have to be met by the individuals’ nation states. Maastricht treaty developed several criterions of standard that ensure there is economic compatibility with the member nations.

The criteria were as follows: ? The first criterion is the price stability in the member countries. One effective way of determining price stability is by analysing the inflation rate of each nation. In order to calculate a fair level of inflation, an average of the three member states with the best behaviour in price matters are taken into consideration. Thus a country’s inflation must not exceed 1. 5%. ?The second criterion is the long-term interest rates of the countries. Long-term interest rates can have an adverse effect on the economy.

Therefore, it was decided at the treaty that countries that attempt to adopt the Euro would have an average rate of nominal interest in the long term inferior or equal to 2% points on the long term average rate of the three member states of lowest inflation. ?Moreover, a stable currency is considered to be important. So as to ensure there is economic compatibility within the sates, the different currencies of the countries that had adopted Euro had to remain during a minimum period of 2 years with the ? normal’ fluctuation margins of Europe’s exchange rate mechanism.

?Furthermore, it was decided that public deficit, that is, the amount of money owed by the government should not be able to exceed 3% of GDP at market rates. ?Finally, it was resolved that the public debt of the aspiring countries should not be superior to 60% of the GDP. If, this was not possible, then exceptions can be made with countries that have diminishing dept and are achieving a rhythm that will bring them close to the established percentage. However, recently France and Germany have repeatedly broken the rule for limiting deficit to 3 percent of overall budgets.

They have promised to bring their deficits down, but also want the Euro areas stability and growth Pact to be more flexible. On one side Trichet, the president of European Central Bank, said that proposals to loosen the rules do not contribute to the soundness and solidity of Economic and Monetary Union. However, on the other side, Beres the chairwoman of European parliament’s influential economic and monetary affairs committee forwarded that there must be a kind of flexibility in these criteria as this is acting as an obstacles in the growth of the larger domestic market.

Therefore, this new treaty settled the numerous conditions for member states to join the EMU. However, it also aroused much opposition from EU member states. Members sole concern was that a single European currency would replace national currencies. Because of this, Denmark, Sweden and the United Kingdom are reluctant to adopt the Euro. Also Greece was not able to adopt Euro, as it had not the initial criteria for membership. Because of these difficulties, EU was not formally inaugurated until November 1993.

Before and during the transition period of three years, many political and economic benefits were expected from adopting the Euro. The introduction to Euro has been a significant step in the integration of the economies of the countries that form the European Union. ?It was believed that the single currency would be a stable currency and stronger than national currencies. A single authority European Central Bank (ECB) would be responsible for a securing a single monetary union. A stable currency would mean a stable economic environment leading to low inflation and low interest rates.

?Greater safety and rapidity in trade and international relations was perceived. Risks that provoked fluctuations in the exchange rates will be reduced greatly. ?Tourism industry would receive many benefits from the Euro. Certain countries will become cheaper and this could promote the tourism industry. Travellers would not have to pay exchange charges. ?Member countries would benefit from greater price transparency, reduction in foreign exchange transaction costs, currency conversion costs and in the cost of maintaining transaction balances.

However, there were also some political and economic drawbacks: ? Each participating countries had to incur various costs. This was because all prices, bills, coin computer programs had to change. Costs are still expected to increase because as from 1 January 2005, all listed companies in the European Union had to prepare their consolidated accounts according to International Financial Reporting Standard (IFRS). ?The individual countries could no longer conduct monetary policy on its own behalf as the European Central Bank makes all monetary decisions.

?A single European Currency would not allow participating country to adjust their currencies to a shock or economic development specific to that country. ?There was the chance that some member countries could promote economic activities by adopting an undisciplined fiscal policy. However, it has often been argued by various academics that the driving force behind European monetary unification has been strictly political and not economic. According to them Euro has always been considered to be a useful instrument for the creation of the European political union.

Also, it is argued that the assumed benefits as reduction in transaction costs and exchange risk will be small in reality. Transactions cost are saved only in the tourism industry and not in other fields. Therefore the economic advantages of being able to travel within the euro-zone without having to change currency and of being able to compare prices more easily between euro-zone countries are small compared to the economic disadvantages. THE INTEGRATION PROCESS TOWARDS THE EUROPEAN UNIFICATION The possibility of a single currency in Europe aroused many opposing as well as favouring views.

According to Milton Friedman, a Nobel Price winning economist and Father of modern monetary theory, in an interview in 1996, did not think that there could exist a single currency in Europe. According to him one cannot have economic unity without political integration and if European Central bank is to impose its authority, the euro-zone will have to be politically unified. Moreover, according to him the single currency is an infringement of sovereignty and it will lead to failure. On the other side of the coin, Robert Mundell (1998) was in the favour of European unification.

According to him, if dollar can exists, so will the euro and the euro will also stimulate competition within the euro zone. Elie Cohen (1999) in this article on euro and its impact offered economic arguments as well as political arguments in favour of EMU. The economic arguments were that euro would deepen the single market by lowering transaction costs and eliminate the internal rate risk. According to estimates made by the European commission, the Euro zone will gain 0. 4% a year in GDP growth due to this transaction cost.

The political reasons were to win back monetary sovereignty by “demarkizing” Europe. Cohen also talks about the various levels of European integration. The first integration was in year 1957 with the building of a customs Union. There was the free movement of goods, market integration and each country was free to pursue its own recessionary or expansionary policies, leading to parity adjustment. The second integration was the creation of single European act in which free provisions of services, harmonisation of economic legislation, technical standard was possible.

The third integration process was from 1989 to 1998, which was the creation of EMU. Between 1992 and 1997, all member countries worked steadily towards pursuing anti-inflationary prices, fiscal consolidation and tight monetary policies. TRANSITION TO MONETARY UNION Each member of the European Union worked progressively for the establishment of the European Monetary Union (EMU). The integration process was divided into two parts namely: ? Economic integration ? Political integration a. Economic Integration.

In order to meet the convergence requirements as outlined in the Maastricht Treaty, most participating EMU countries were forced to undergo a period of fiscal tightening. The effect of such fiscal tightening has certainly had a short-term unfavourable outcome on the economies of those EMU countries. For instance, in a study made by Nikolaus Keis in 1998 on the subject of EMU convergence effects, it was mentioned that German growth might have been reduced by up to 1% in 1997, the year in which the costs were most evident.

As required by the Maastricht Treaty, member countries must cut budget deficits to 3% or less of Gross Domestic Product (GDP). In order to realize this, Germany as well as the majority of other EMU countries employed a constricted fiscal policy that requested for a reduction in government spending along with considerable increases in federal taxes. It has been estimated that Germany cut nearly DM40bn from its government expenditures in 1997. Though the early 1997 reduction in expenditure pushed Germany closer to the Maastricht basics, it was clear in the second half of the year that Germany would fall short of the 3% requirement.

As a result of that, the finance ministry proposed to use the profit from revaluating the gold reserves to decrease the budget deficit. But this plan was dropped following Bundesbank opposition. Further tax increases and spending cuts were therefore implemented in the second half of 1997 and the outcome was that the budget deficit amounted to 2. 7% in the year. The direct effect of the fiscal tightening, according to Keis’ estimates, was to cut GDP growth by around 0. 7%. Germany was not the only EMU countries to suffer from severe fiscal tightening leading up to the beginning of the Euro.

Most European countries that were striving to meet the criteria of the Maastricht Treaty for EMU membership in the first round had undertaken significant fiscal tightening in 1997. With the exception of Luxembourg, all potential EMU countries were in the position in early 1997 of having to reduce their public deficits, sometimes considerably, in order to meet the deficit and debt criteria in the Maastricht. All of the prospective EMU countries followed a similar scheme of tax increases along with spending decreases with the outcome of a fall in deficit.

Although the end result was similar, the fiscal tightening affected GDP within EMU countries in different ways. The losses in GDP for the core countries (Germany, France and Italy) amounted to the sum of 1. 5% of GDP in 1997. For some of the non-core countries the effects were even larger, as these countries had further to go to meet the convergence criteria. With Europe as a whole suffering from decreased growth, the many export driven economies of the EU further compressed, resulting in an additional multi-nation decrease of GDP that some economists estimate around 0. 4% of GDP.

Despite the fact that the net effect of convergence was a decreased GDP (in the short term), other growth causing agents existed within this period. Massive amounts of investment were used to implement a dual-currency accounting system as well as to provide training. Investments in hardware, software, and employee training programs accounted for what has been estimated to be ECU20bn between 1996 and 1999. The majority of this spending took place within the banking system and the large national and multi-national firms. Most of the mid-size and smaller companies are waiting until the change over is most cost effective.

In the last quarter of 1998, the period in which final preparations for the launch of the euro were being made, the fiscal tightening coupled with the negative effects of the Asian and Latin American crises of foreign trade brought early signs of a slow down in Europe. Thus given the strong pace of activity across the Atlantic, differences in cyclical economic picture, economic activity in some countries, such as Germany and Italy, grew at only moderate pace in 1998, while the economies of some other countries, especially Finland and Ireland, expand rapidly.

These differences could be seen in the increasing divergence in output gaps, a measure of unused capacity in the economy (Fig 1). Figure 1 Source: http://www. 2ideas. repec. org/a/fip/fedgrb/y1999ioctp655-666 The differences became all the more relevant for the setting of monetary policy in light of the lower nominal interest rates brought about by convergence of official interest rates to levels prevailing in Belgium, France, Germany, and the Netherlands in the months leading up to January 1999 (Fig 2). Figure 2 Source: http://www. 2ideas. repec. org/a/fip/fedgrb/y1999ioctp655-666

For short-term interest rates, convergence was less apparent until recently. The main concern was about the difficult choice the ECB would have to make in January 1999 in setting interest rates. Setting a low interest rate would benefit the low-inflation countries like Germany, France, and Belgium. Alternatively, setting a high rate would accommodate countries with higher inflation rates like Italy and Ireland. Long term interest rates had largely converged by early 1998, bringing forward some of the benefit of EMU (Fig3).

Figure 3 Source: http://www. 2ideas.repec. org/a/fip/fedgrb/y1999ioctp655-666 The degree of convergence of long-term interest rates among the 11 participating nations suggests that the loss of independence is not a major concern. After all, a common monetary policy does not leave individual nations completely powerless to fight macroeconomic cycles. Countries still have complete control over their fiscal policy to react independently to lighten shocks. On the other hand, the ability to conduct independent fiscal policy could bring with it an incentive to overspend or under tax and run huge deficits.

No inflation need appear as long as the ECB were committed to price stability. In countries in which activity was already robust such as Ireland, the convergence provided some additional marginal status. Convergence has already taken place in long-term interest rates. In 1995 the yield spreads for 10-year bonds among the 11-euro nations were as great as 600 basis points. In 1998, they had converged to spreads of less than 100 basis points.

This rate setting difficulty has been exaggerated for two reasons: 1. The importance and size of the German and French economies relative to the other nine members meant that initial ECB policy would have to reflect the large economies of theses two countries. 2. It is not expected that a successful monetary policy will maintain uniform price levels in all areas within a single currency. Almost certainly, prices will rise more rapidly in some areas and less rapidly in other areas depending on demand and supply conditions. The aim of the European Central Bank is to achieve an objective inflation rate for the entire 11-nation economy, a rate that represents a weighted average of price levels across many markets.

This kind of averaging is similar to a single currency area like the United States. However, the euro nations have a standard deviation that is approximately five times larger than the U. S. regions. Overall we can say that leaving an independent monetary policy may represent the biggest cost of adopting the euro, but participating members understand this fact. These countries believe the benefits of a single currency, as well as the ECB’s commitment to price stability, will more than offset any potential loss of independence. However, it is quite uncertain how member countries will behave when the going gets tough. b.

Political Integration Since EMU is the institution that has set policies for the introduction of Euro, nearly all countries of the Euro family adopted the currency economically in the same light. However, on political grounds, each country had to make use of different strategies to meet with the requirements of the EMU. ?Germany Germany had been at the forefront of moves towards European political and economic integration. Chancellor Kohl in Germany regarded any delay in introducing EMU as politically damaging, not just for Germany but also for the whole of Europe. In fact, there is a strong emotional attachment in Germany to its national currency (the Deutschmark) because the introduction of D-mark in June 1948 was the first ray of hope amidst deep despair in a Germany in ruins at the end of the war. Germans had been questioning the motives for giving up the D-mark.

For this reason, Germany had urged the European partners to make the future ECB as independent as the German Bundesbank and it vehemently supported maintaining the stability criteria of the Maastricht Treaty. In September 1997, the German cabinet approved a bill to speed up the introduction of the Euro in businesses after 1st January 1999.

Under the terms of the Bill, companies would be able to denominate their capital and shares and draw up balance sheets in Euros from 1999. New and existing government bonds and securities would be denominated in Euros from 1st January 1999 and stock exchanges would be able to carry out most of their activities on a euro basis. The Finance Minister at that time Theo Waigel had tried to encourage more positive attitude towards Euro. The Foreign Minister was afraid that a delay could bring about a sudden appreciation of the D-mark that would damage German exports, stifle growth and endanger jobs.

The pressure on the Government to insist on political stability was increased during the period of election of September 1998. The German Federal Bank, the Bundesbank, officially supported EMU, although some of its members have been concerned that potential members such as Italy might not be ready to join. By February 1999, in spite of an unusually low level of interest rates, hence reduced costs of debt service, and in spite of numerous example of creative accounting, Germany had not succeeded in reducing deficits marketedly and sustain ably below the 3% reference value.

However, despite mixed feelings for the acceptance of Euro, Germany adopted the Euro by January 1999. Public support for the EMU: Standard Euro barometer poll: 40% in favour 45% against ? France The Gaullist President, Jacques Chirac, and the Socialist Prime Minister, Lionel Jospin, had tried to present a common front on EMU. The Finance minister, Dominique Strauss-Khan, supported the initiative of asking the Bank of France to prepare reports on finance’s readiness for the EMU.

The Bank of France, which was in favour of the report, had supported a narrow core EMU membership and had expressed doubts about Italy’s ability to sustain the Maastricht criteria. The Jospin government was not in favour of referendums on either the Treaty or EMU on the grounds that the French people had already voted on Europe in the referendum on the Maastricht Treaty. The European Commission and the European Monetary Institute (EMI) had warned the French government to tighten legislation safeguarding the independence of the Bank of France in order to comply with Treaty requirements.

Public support for EMU: Standard Euro barometer poll: 56% in favour 36% against ? Italy The Italian government’s efforts to prove that its economy was sound enough to make it a candidate for the first wave to join EMU did not initially impress some other EU Member States, notably Germany and the Netherlands, which expressed doubts about Italy joining the first round. Some economists had been concerned that the centre-left government of Romano Prodi’s relying too much on one-off spending cuts, Euro tax: a one-off surcharge on income tax.

The fall in inflation and interest rates had led the EU commission and financial markets to give Italy the benefit of the doubt. Germany’s opposition to Italy joining was weakened by the fact that its own budget deficit looked as if it could turn out to be higher in 1997 than Italy’s. Public support for EMU: Standard Euro barometer poll: 74% in favour 15% against ? Spain The Prime Minister of Spain, Jose Maria Aznar, was determined to take his country into the single currency in 1999. His predecessor was also a firm supporter of the Euro family.

At first Aznar thought it would be better if Spain entered the second wave; however, he has proved to be as keen on entry as his predecessor, and his government’s harsh economic reforms have put Spain in a good position to qualify. Public support for EMU: Standard Euro barometer poll: 58% in favour 23% against ? Austria The Austrian government decided to take its country into the European Union (EU) in 1995. However, its opposition party was against this political integration as they thought that this would increase the level of taxation.

In spite of poor public support, the Austrian government went ahead with the political integration of its country. Public support for EMU: Standard Euro barometer poll: 40% in favour 47% against ? Belgium The Belgian government encouraged the political transition towards the European Monetary Union (EMU) from the start. They started with technical controversies by the Belgian banks, and also advertised and publicized their euro capabilities. Belgium was thus able to offer euro-denominated services to corporate customers as well as retail customers. Public support for EMU:

Standard Euro barometer poll: 58% in favour 32% against ? Denmark Denm