Economic and monetary
union (EMU)
EMU involves …
• Policy harmonisation to remove obstacles to factor
mobility
• A more marked and wider range of common policies,
especially in relation to macroeconomic policy
• Irrevocably fixed exchange rates or, as in the case of the
EU, a single currency
• A common monetary policy – that is, one interest rate
and exchange rate policy determined by a single Central
Bank
• Some pooling of foreign exchange reserves
• Possible inter-state transfers to offset economic
distortions arising from EMU
A bit of theory
• To be an EMU the EU needs to be an
Optimal Currency Area
• This means that there has to be:
o an absence of asymmetric shocks
o a high degree of labour mobility and wage flexibility
o a centralised fiscal policy that can redistribute
resources to member countries performing poorly
The road to EMU
• EMU is long standing objective
• Starting in 1970s
• Evolved from European Monetary System (EMS)
(a semi-fixed exchange rate system)
• EMS often unstable but was platform for EMU
• Led to Maastricht Treaty – three stage approach
Three stage approach
• Stage One (from 1 July 1990) the removal of all remaining obstacles
to capital flows the participation of all member states’ currencies in
the ERM and greater policy co-ordination and convergence of
economic performance
• Stage Two (from 1 January 1994) creation of the European
Monetary Institute (EMI), a transitional institution intended to be
replaced by the European Central Bank (ECB). During this stage,
any central bank that was not already independent of its national
government, was to become independent
• Stage Three (from1 January 1999) the irrevocable fixing of
participating currencies. The European System of Central Banks
(ESCB), composed of the European Central Bank and independent
national banks, took over responsibility for monetary and exchange
rate policy
Convergence is key
• Nominal convergence
• Real convergence
• Institutional convergence
Costs and benefits of EMU
Benefits
• elimination of intra-EU transaction
costs lower interest rates
• uniform interest rates
• removal of exchange rate
uncertainty in intra-EMU trade
• aids development of a genuine
SEM
• removes the option of competitive
devaluations between EU states
• financial integration
• economic cushioning from
domestic political instability
• creates a new international
currency to represent the EU’s
combined economic weight
Costs
• short term deflation
• loss of the exchange rate as a tool
of national economic policy
• loss of power to set interest rates
and control the supply of money
• potential problems related to a
lack of ‘real’ convergence and
potential policy conflicts
• the inappropriateness of one
monetary policy for so many
states
EMU – the first decade
• A mixed record due to:
o The ineffectiveness of the Stability and Growth
Pact (SGP) as a bulwark against fiscal
profligacy
o The unwillingness of some member states to
take the necessary micro-economic reform
The Euro crisis (from 2009)
• Failure to reform and inadequate convergence
was core to crisis
• As was ill-designed system
• Deterioration of public and current account
balances Portugal, Greece, Ireland and Spain
• Contagion in system as banking crisis turned
into public debt crisis
The Euro crisis (from 2009)
• Expose fault lines in Euro
• Austerity vs. growth
• Application of German ordo-liberalism – not
easily transferable
• EU growth fell and unemployment rose sharply
Main problems of EU as an OCA
• Labour mobility is limited across the EU
• There is a home bias in capital markets
• Wage and prices tend to be inflexible
downwards
• There is no substantive internal fiscal transfer
mechanism
• Business cycles are not fully synchronised
across the eurozone
• Economic structures across the EU are still
divergent
EU had co-ordination problem
This led to:
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Excessive borrowing
Conflict over responsibility over bail outs
Divergent macro-economic policies
Divergent economic growth patterns
The implications of trade imbalances
Solutions
• Short term
o Quantitative easing
o Bail out
o Financial assistance
• Long term
o Economic reforms
o Reform of EMU
o Fiscal centralisation