EURO SYSTEM

PRESENTED BY: Arindam Mallick 10 Shaunak Vats 50

A Brief History of European Economic Integration

The original goal behind the integration of Europe was to prevent the devastating wars of the first half of the twentieth century from ever happening again

Dresden, Germany, 1945.

European Economic Integration

Political end by (mainly) economic means
European Coal and Steel Community 1951; European Economic Community 1957 (Treaty of Rome) Customs Union (1968): Free trade area + common external tariff Single (or Internal) Market (launched 1986, completed in1992): breakdown of all tariff and non-tariff barriers to trade and business Single currency (approved1993 Maastricht Treaty, euro launched 1999, notes and coins 2002): eliminated exchange rate transaction costs and risk

The Four Incarnations of the EMS

1979-82: ERM-1 with narrow bands of fluctuation (2.25%) and symmetric. 1982-93: ERM-1 centered on the DM, shunning realignments. 1993-99: ERM-1 with wide bands (15%). 1999- : ERM-2, asymmetric, on the way to euro area.
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Snake in the Tunnel

Fluctuation band against the dollar 2.25%

Bilateral band among European currencies 1%

Exchange Rate Mechanism:

ERM was the institutional mechanism for stability between EC currencies while floating them against all others, including the dollar. Creation of a cocktail currency, : ECU (European Currency Unit) consisted of weighted values of EC currencies based on their GDP and trade. Just as the dollar was at the center of the BW system and was its de facto numraire and reserve asset (the dollar was as good as gold), the ECU was the reserve asset of the EMS (used for settlement of accounts between Central Banks) and its unit of account.

ERM A Semi-Pegged System

1.380 1.375 1.370 1.365 1.360 1.355 1.350 1.345 1.340 1.335 1.330 Banks intervene

Exchange rate vs. ECU

ECU Components

Precursors of the ERM Crisis

West East

DM 350MM 1DM = 1.8M

George Soros

GBP/DEM X-Rate, 1992

3.116

2.776

September 16,1992 Black Wednesday

UK Treasury Response
Raising interest rates to 10% - 12% - 15% Spent 27B of foreign reserves in propping up (buying) the pound

3.4 BILLION
Estimated total cost of Black Wednesday [1997]

800 MILLION
Estimated Black Wednesday trading losses [1997]

Currency Devaluation by Country

0% Britain -10% -20% -30% Spain Italy

Annualized GDP Growth, 1992-2005

3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% France Italy Germany Eurozone UK

Aftermath
Conservative Party blamed for crisis; loses 1997 election, Prime Minister John Major succeeded by Tony Blair UK leaves ERM Italy and Spain widen ERM bands ECU replaced by euro in 1998 ERM-II established in 1999

What is EMU?

What does EMU stand for?

Does EMU stand for:

European Monetary Union?

Or:

Economic and Monetary Union?

EMU vs. the euro area

EMU is a Treaty objective shared by all 27 EU Member States The euro is a reality for 17 Member States (the euro area) What about the E in EMU?

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)

1. What was the start date of Economic and Monetary Union?

a) Jan 1980 The first major monetary policy initiative (1970 Werner Plan) called for EMU by Jan 1980, but adverse economic conditions doomed the initiative. b) Jan 1999 Correct. EMU officially started on Jan 1, 1999. Conversion rates were irrevocably fixed and legislation related to introduction of the euro came into force. c) Jan 2002 Circulation of euro banknotes began.

Designing the Euro Sign

Inspiration

for the symbol itself came from the Greek epsilon () a reference to the cradle of European civilization and the first letter of the word Europe, crossed by two parallel lines to certify the stability of the euro.
European Commission

2. How many countries are currently in the euro area?

a) 27 Number of current EU member states. b) 16 Number of countries in 2010 c) 17 Correct. As of 2011, 17 EU member states are part of the euro area

EUROZONE
17 Member States Use EUROasLuxembourg their currency Belgium Malta Germany The Netherlands Ireland Austria Greece Portugal Spain Slovenia France Slovakia Italy Finland Cyprus Estonia- 2011

1999

Belgium, Ireland, Spain, France, Luxembourg, the Netherlands, Austria, Portugal, Finland Greece Slovenia Cyprus, Malta Slovakia

2001 2007 2008 2009

The Outs
Britain, Denmark, Sweden, and most of Eastern Europe remain outside of euro To join would need popular support and low budget deficits Britain and Sweden unlikely to join unless economy tanks Eastern European countries perhaps more likely to join as they meet criteria

A fine distinction: EMS vs. ERM

EMS = European Monetary System
all EU members are part of it

ERM = Exchange Rate Mechanism

Grid of agreed bilateral exchange rates, mutual support, joint realignment decisions, ECU

The UK and Sweden do not want ERM membership

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What were the set of rules set out for entry into the European Monetary Union?

a) Copenhagen Criteria
The political, economic, and legislative requirements that countries must meet to join the EU.

b) Stability and Growth Pact

Pact enacted in 1997 to ensure that fiscal discipline would be maintained and enforced in the EMU.

c) Convergence Criteria
Correct. The 1992 Maastricht Treaty set out 5 criteria that countries needed to meet prior to joining the EMU.

The so-called Maastricht Criteria

Inflation rates: No more than 1.5 percentage points higher than the average of the 3 best performing (lowest inflation) member states of the EU. Government finance: Annual government deficit: Ratio of the annual government deficit to GDP must not exceed 3% at the end of the preceding fiscal year. Government debt: Ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Exchange rate: Applicant countries should have joined the exchangerate mechanism (ERM II) under the European Monetary System (EMS) for 2 consecutive years and should not have devalued its currency during the period. Long-term interest rates: The nominal long-term interest rate must not be more than 2 percentage points higher than in the 3 lowest inflation member states.

How the European Single Currency Evolved

Maastricht Treaty (1991) Blueprint for the transition process from the EMS fixed exchange rate system to EMU. Macroeconomic convergence criteria for admission to EMU. Harmonize social policy within the EU Centralize EU foreign and defense policy

Who sets interest rates in the EMU?

a) The European Council Determines membership in the eurozone. b) Member States Manage national fiscal policies within EU limits. . c) The European Central Bank Correct. ECB controls interest rates for euro. Independent of political authorities; goal is low inflation. d) The European Parliament Not important here.

The European Central Bank

Established under the Amsterdam Treaty (1998) Modeled after the German Bundesbank Headquartered in Frankfurt Current president Jean-Claude Trichet The ECB has the exclusive right to authorise issuance of banknotes The primary objective of the ECB is to maintain price stability within the Eurozone, or in other words to keep inflation low!!

Economic policy in EMU

5. What is the current dollar-euro exchange rate? a) 86 cents

January 2002

b) $1.59 July 2008 . c) $1.36

Correct.

A Single Currency - Competing Models

Technocratic Priority of monetary integration should be to maintain low inflation. Authority over monetary policy should be invested in a political independent central bank directed to keep inflation low. EU should have strict rules limiting size of budget deficits. Politicized Priority of monetary integration should be to promote growth and employment. Governments need to coordinate all tools of economic policy fiscal, monetary, excha nge rate to achieve these goals.

And the winner is.

Outcomes of negotiations for the Maastricht Treaty favored the technocratic German view: Politically independent ECB tasked with keeping inflation low Convergence criteria Only Britain and Denmark allowed not to participate Deadline for creation of single currency

Transition to Monetary Union

Rough Seas or Smooth Sailing?

The backlash begins

1992/93 marks end of publics permissive consensus European project finally starts to hit home for citizens (i.e. touches their daily lives) react by objecting to technocratic, elitedriven nature of integration process Ratification problems: the Danish no the French petit oui German constitutional woes

2009: Happy 10th Birthday, euro!

The euro has helped to bring Europeans together It has fostered greater economic integration (reinforcing the Single Market) It has contributed to macroeconomic stability (e.g. lower inflation) But now the euro area is confronted by a very dire economic situation

Was It Really Happy?

The Euro Area Economic Situation: Not Good!

Real annual % change unless otherwise stated

2008 0.8 3.3 7.5

2009 -4.0 0.4 9.9

2010 -0.1 1.2 11.5

Real GDP growth Inflation Unemployment rate

(percentage of labor force)

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 Toto, I dont think were in growth Kansas anymore Exposure to Eastern Europe

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

The financial crisis: Other ways Europe should respond?

Speed up economic reforms (Lisbon Strategy)
http://ec.europa.eu/growthandjobs/index_en.htm

Make the single market work better (especially for Services)

EMU and the financial crisis

Crisis exposes persistent divergences in the euro area One size fits all monetary policy problematic Countries need to use fiscal stimulus, just as in US, but difficult to coordinate fiscal response of 16 Member States Break-up of EMU?

Conclusions
The launch of the euro was a tremendous achievement for the EU But EMU is still a work in progress (especially for the E part) The euro area is in its first recession; how will it cope? Will the crisis lead to further divergence in EMU, or will it encourage countries to speed up reforms? Can you have a monetary union without a complete economic union and/or Political union?

Designing the Currency

Designing the Currency