The European Monetary Union came into existence in the year 1979, based on a Resolution that was passed on 5th December 1978 by the European Council. The European council is made up of the Government Heads and State heads of 9 countries which were the members of the EC (European Community) in 1978. The objective was to develop a monetary stability in Europe comprising a bigger financial stability both at abroad and home (Collignon S. 1994). The founding fathers of the European Monetary Union intended that after two years the system should proceed to a second final phase in which it would be given a more definite institutional framework in particular through the development of EMF (European Monetary Fund). This timetable proved un-achievable for economic, legal as well as political reasons. At present there appears to be a broad consensus that significant further institutional development of the European Monetary Union would require a major political initiative and necessitate an amendment of the Treaty that established the European Economic Community. Recent efforts to modify the operational procedures of the European Monetary Union and to increase its efficiency resulted in some changes but did not affect its basic institutional structure.
While the hopers of the optimists have been realized only in part after more than seven years of European Monetary Union existence it has nevertheless become clear that the fears and predictions of the skeptics have not been justified. The widespread expectations that a system of fixed, though adjustable, exchange rates would not hold together for long or conversely that it would degenerate into a system of frequent small exchange rate adjustments, akin to a crawling peg have not materialized. The countries participating in the exchange rate mechanism (ERM) of theEuropean Monetary Union have shown political determination to keep the system in operation. On a practical level the participating central banks have demonstrated an unprecedented ability to work together in securing a smooth functioning of the system.
After some disappointing developments in more recent years economic policies in the European Monetary Union countries have been increasingly oriented toward domestic stability and thus have facilitated a growing convergence in prices, costs and monetary aggregates. While it may be debated whether the European Monetary Union and its constraints have been the main cause for this convergence there is a consensus that the existence of the system has encouraged and contributed to the convergence of economic policies and developments. At the same time the exchange rate variability of currencies participating in the ERM has significantly diminished since the establishment of the European Monetary Union compared with earlier years and with other major currencies.
Formation of the monetary union
The formation of Monetary Union in Europe can be seen as part of the wider drive to increased integration and in many ways it was inevitable once competition policies had made the economic space virtually barrier free. A monetary union involves more than an Optimal Currency area, because it requires a degree of harmonization of fiscal and microeconomic policies across members of EMU. As a result of these policies as Frenkel and Rose (1997) argue the union may endogenously become more of an Optimal Currency Area (OCA) than it was with differences in products and institutions gradually disappearing. OCAs early literature summarized by Mundell (1997) suggested that related countries with same small on big output tradeoffs of inflation must be integrated to coordinate policy of monetary by leaving them with policy of fiscal for independent stabilization. Responses to external events and to policy changes in such a world could be described as symmetrical making policy discussion even handed across the Union.
If economies are similar then the shocks will affect them in the same ways. Hence it is commonly easy for them to have a similar policy of monetary. These differences can make responses vary across the area. For instance in the spring of 1999 the European central bank cut interest rates for the first time. The economies of Europe were in different cyclical positions and hence reacted. The Germans and Italians faced falling output and the cut and the associated fall in the exchange rate stimulated output. The Spanish and the Irish were above full capacity and the cut in interest rates could only increase inflation pressures.
However differences in cyclical positions are not only the reason for asymmetrical responses to a symmetrical shock. Interest rate shocks are propagated by the banking system and by the structure of housing finance, and as MacLennan et al. (1998) argue, there are significant differences in these institutions which will take some period of time to vanish. There are other differences that can only be removed slowly such as differences in the structure of government debt or the nature and effects of private sector wealth. German firms have attachments to banks and a great deal of investment is financed by borrowing whereas Scandinavian and British firms rely more on equity markets for finance. Hence shocks to the economy will have different effects through these institutions. Finally as we stress below labor market institutions differ within Europe at least as much as they did between first and West Germany and hence the speed of response to shock differs.
Germany and European Monetary Union
In a widely quoted and controversial statement before the European Parliament a former president of the German Bundesbank argued that German monetary union contains important lessons for European monetary union. Most important among these is the prospect that the region specific structural changes triggered by monetary unions cannot be controlled or mitigated by monetary policies. A minimum of harmonization with respect to both economic developments and economic and financial policy is needed before taking the irrevocable step toward monetary union with a single currency and a European central bank. The underlying controversy is as old as the EC itself. Should monetary union be an instrument of integration forcing monetary discipline as well as necessary structural changes upon member states? Or should an economic union based upon integration and harmonization of national policies goes before monetary union? If there are lessons to be learned from the present German experience they concern the far reaching implications of monetary union when the union contains an economically backward region. The necessary and inevitable structural changes are such that for both economic and political reasons they cannot be left to work themselves out through private initiative and market forces alone. Regional unemployment, poor infrastructure and different standards of environmental protection create irresistible pressures for financial burden sharing. The community’s present constitutional structures are ill equipped to cope with those demands. It is highly doubtful whether the member states are prepared to confer the power to tax upon the Community or to participate on a meaningful scale, in the necessary financial equalization among them. Even the West German Lander are extremely reluctant to let their East German counterparts participate in the established system of financial equalization.
Under those circumstances a European central bank would have a formidable task in adhering to a policy of tight money. This applies even if we assume a European central bank to be endowed with full political independence an assumption that can hardly be taken for granted. There are quite different traditions and attitudes among the member states with respect to the uses of monetary policies and the acceptable degree of inflation. A European central bank its independence not withstanding could not isolate itself from economic and political processes and expectations in the member states. It would be unrealistic to expect from the European central bank to have the kind of public support that has made it possible for the German Bundesbank to be steadfast during these difficult times in the implementation of its mandate to preserve price stability.
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