EMU and the euro – guide

The euro is a resounding success, says the European Commission today. The protection provided by an international currency with a market of nearly 320 million people, supported by sound public finances and stable macroeconomic policies, is particularly welcome in these times of uncertainty and worrying increases in the prices of energy and food. But as we complete 10 years of Economic and Monetary Union (EMU), the Commission says we must acknowledge that there is still work to be done. The euro area’s governance and coordination of economic policies must be improved. This will involve both deepening and broadening economic surveillance arrangements to guide fiscal policy over the cycle and in the long term and, at the same time, address divergences in growth, inflation and competitiveness. We also need to better project our voice in the global arena, to reflect the euro’s weight as an international currency used well beyond its borders. Only then will the benefits of the single currency become fully apparent to the citizens of the euro area.

May 2008 marks ten years since Europe’s leaders took the political decisions to move ahead with stage III of EMU, i.e. the creation of the euro, on 1 January 1999, in a first wave of eleven countries.

EMU, or Economic and Monetary Union, is the official name for the process of monetary unification in Europe. It includes three stages: I – freedom of capital movement (achieved in 1990): II – Establishment of a European Monetary Institute (the predecessor of the European Central Bank), legal convergence and increased monetary policy cooperation (1994); III – irrevocable fixing of the conversion rates against the single currency (1999 for a first group of 11 countries – Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland). The Maastricht Treaty in 1992 established a number of nominal convergence (“Maastricht”) criteria with regard to price stability, public finances, exchange rate stability and long-term interest rates that countries must comply with before they can adopt the euro. At present 15 EU countries participate in the euro area (Greece joined in 2001, Slovenia in 2007 and Cyprus and Malta in 2008). If approved by the Council of EU finance ministers, Slovakia will become the 16^th member in 2009.

Under the EU Treaty, Member States are required to ” (Articles 98 and 99). This coordination is ensured, through a variety of instruments, by the Commission and the Council of EU finance ministers (ECOFIN). Increasingly important is the Eurogroup that came into being in June 1998 and which will be given formal recognition in the upcoming Lisbon Treaty. The Eurogroup brings together the euro area finance ministers to discuss issues related to the single currency and policy coordination in the euro area. It has a stable president since 2005 (Jean-Claude Juncker, Prime-Minister and Finance Minister of Luxembourg). The Commission and the European Central Bank (ECB) take part in Eurogroup meetings.

The euro area has one currency with one entrusted to an independent, centralised, decision making body. The ECB and the central banks of all EU Member States form the European System of Central Banks (ESCB). Decisions on monetary policy in the euro area are taken by the Governing Council of the ECB, which comprises the governors of the national central banks of those Member States that have adopted the euro and the members of the Executive Board of the ECB.

The euro is a political project as much as an economic one. The main economic motivations were to provide macro-economic stability, putting an end to currency crisis, and to complete the single market launched in 1992. This, in turn, was expected to increase growth and jobs thanks to a reduction of transaction costs and risks that would boost intra-area trade and finance and this has indeed happened although the record can and must be improved with regard to growth.

EMU has succeeded in its core mission of securing macro-economic stability, by delivering low and stable inflation to euro area countries. It has led to lower interest rates, boosted trade, investment and financial market integration, fostered huge job creation and seen an increase in fiscal discipline as euro-area budget deficits have decreased. However, output and productivity growth have not been as strong as hoped. More progress on structural reforms is needed to further improve the euro area’s economic performance and increase its capacity to respond to adverse economic developments.

Economic growth has on average been around 2 per cent per year since the inception of the single currency, broadly the same rate as in the 10 preceding years. Extensive research yields overwhelming evidence that the single currency has strongly stimulated trade, investment (including foreign direct investment), better functioning financial markets, stability and growth. In fact, most of the smaller countries have fared remarkably well, also in comparison with their non-EMU neighbours. But at the same time growth has been weak in countries where structural reforms in product and labour markets have been lagging. Such slow pace of reform perhaps reflects the fact that the single currency has provided a shield against adverse shocks, which generally act as a stimulus to reform. This paradox can only be resolved by strengthening the co-ordination of structural reform in the euro area – one of the key recommendations in the EMU@10 Communication and Report.

The euro area is set to expand further in the coming decade as more EU Member States adopt the euro. This heightens the need for further progress on structural reforms to ensure that all countries in a larger and more diverse euro area can adapt to economic developments and raise their growth and productivity performance. The report also highlights several major trends that EMU must face. Ongoing globalisation can stimulate efficiency in the production processes, reduce prices through greater competition and enhance consumer choice. However, less-efficient sectors of the euro-area economy need to continue to adapt to the external pressures. Population ageing will also kick in as the “baby boom” generation born after the Second World War moves into retirement. The relative size of the working age population will decrease markedly and, without policy changes, social welfare costs are likely to rise at the same time that potential output is falling. Finally, food and energy supply constraints and climate change issues are already causing price rises in the food and fuel sectors. Without an adequate policy response they could imply further inflationary pressures and thereby cause particular problems for the poorest in society who are disproportionately affected by increases in the price of essential goods.

The proposed policy agenda is based on three pillars, which concern domestic, international and governance issues.

• The domestic agenda aims to deepen fiscal policy co-ordination and surveillance, to broaden macroeconomic surveillance beyond fiscal policy and to better integrate structural reforms in the overall policy co-ordination within EMU.
• The external agenda aims to strengthen the euro area’s international strategy enhance its external representation.
• Both agendas will require a more effective system of economic governance.

• The euro area has a proven track record of maintaining price stability. Before the euro, it was not rare for Member States to have very volatile inflation rates with levels well above 10% or 20%. As euro area inflation has remained only just above 2% in the last 10 years, EMU’s culture of economic stability should help maintain stable price expectations.
• Membership of EMU means a stable economy that supports business, boosts trade and inspires the confidence of domestic and foreign investors. In the euro area, unemployment is currently at its lowest since euro area records began in 1993 and job creation has been significantly higher in the euro area since the introduction of the euro; 16 million jobs have been created since the start of EMU.
• Interest rates started to fall in the run up to the launch of the euro from 9% on average in the 1990s to around 5% since 1999. This allows citizens and businesses to borrow money cheaply and with more security, e.g. when taking a mortgage loan for buying a house. Membership of the euro area helps shield its members against economic turbulence and significant interest increases.
• With the disappearance of transaction costs, citizens have been able to travel in the euro area for leisure or business at lower expense. They have not only been relieved of the hassle of changing money at borders but can expect to make considerable savings. This is best illustrated by the famous example of the tourist who, travelling in the EU in the 90s with DM 1,000 in his pocket and changing money in each country, would be left with DM 500 on returning home – without having made a single purchase! While abroad, and thanks to the euro, citizens can now send money home to friends and family at a fraction of the cost. Before the euro, the average bank fee to transfer the equivalent of €100 to another country was €24. Now cross-border money transfers are treated in the same was as domestic operations.
• The euro saves money for enterprises and supports a dynamic business environment. Following the introduction of the euro and the disappearance of transaction costs, businesses in the European Union have been relieved of an estimated €20-25 billion in costs. This allows companies to invest more in job creation and to be more competitive.
• The elimination of exchange rate risks and costs has made it more attractive to trade with other euro area countries. It is estimated that intra-euro area trade has increased 5-10% to nearly 60% of total euro area trade. Today, half of the euro area external trade is also invoiced in €, a percentage that rises to 60% for the trade of other EU countries.
• Cross-border direct investment flows (FDI) within the euro area are also estimated to have increased from 20 to 35% of total FDI. This shows that the euro-area is an attractive business location, where companies have increased their investment in recent years to consolidate their presence in one of the world’s biggest and richest markets.
• With the euro, Member States have a world-class currency. The role of the euro in international trade, the global bond market and as an official reserve currency has increased substantially and continues to grow in importance. On some measures, the euro has even overtaken the dollar. This is the case for the international bond market with the euro accounting for 49% of outstanding bonds as opposed to 35% for the dollar at the end of 2007. Moreover, the value of euro coins and bills in circulation recently overtook that of US dollars, with 1,075.8 billion US dollar worth of euro coins and bills in circulation versus 816.9 US dollar coins and bills in March 2008. Euro cash is also increasingly used outside the euro area, with 10-20% of the total value of euro banknotes in circulation currently held outside the euro area, versus 60% for the US dollar. The attractiveness of the euro as a world currency means that tourists can increasingly travel all over the world with euros in their pockets while businesses are increasingly able to trade in euros beyond the borders of the euro area.

We are aware of this perception but that’s simply not borne out by the facts. Notwithstanding the recent spurt in inflation caused by soaring global food and energy prices, inflation had never been so low in so many countries and for such a long period of time! During the first decade of EMU it fell to around 2% from 8 to 10% in the 1970s and 1980s on average.

The changeover process in 2002 and more recently, when Slovenia, Malta and Cyprus became members of the euro area is estimated to have increased prices by an additional 0.1 to 0.3 percentage points, according to national statistics offices and Eurostat. To keeps things in perspective, this means an additional increase of thirty euro cents to the annual increase of about €2on a €100 basket of purchases!

Many economists and national central banks have tried to come up with an answer and, although there is no single or very clear response, a number of factors appear to have played a role:

• No matter how small the impact, the abusive increases that occurred in some countries – not all of them – left a lasting impression especially when they concerned every day purchases that consumers notice most. Many, more expensive, items have seen their price decrease thanks to more competition (e.g. telephone services), technological progress (e.g. flat-screen TV sets) or globalisation (e.g. clothing items). But consumers do not notice this as much because they buy them less frequently or, alternatively, may buy more of them than before which weigh on overall household expenditure (mobile phones are a key example with nearly one per family member in many countries…). Steep increases in house prices in some countries – a side effect of unprecedented low interest rates – may also contribute to inflation perceptions.
• The studies show that the citizens in countries that have recorded a below-average growth performance are also more likely to blame the euro.
• But people also, quite simply, need time to get used to a new currency and to re-create themselves and in € (i.e. prices below certain thresholds such as 0.99 cents). In some cases they still tend to compare prices with 2001 levels ‘forgetting’ that even at around 2% a year (more in certain countries) cumulated inflation can be significant. The same goes with psychological prices/values.
• The fact that the advent of the euro banknotes and coins coincided with the ascent of oil prices from around $20 in 2002/2003 to more than $100 presently also played a role. In this respect, however, it is important to know and to note that the euro has partly protected us. The price of oil increased nearly five times, in dollars, in the last five years but nowhere as much at the pump, in euro.

Typically every citizen consumes a number of articles partly daily and partly on a less frequent basis (weekly, monthly or even annually). This includes different goods such as food and beverages, clothing, furniture, electronic articles (like TV sets, telephones and computer), cars etc. It also includes services like hair-cutting, cafés, financial services, rent, holidays etc. It is the role of national statistical authorities to determine the consumption behaviour and pattern of citizens and establish so-called consumption baskets. Such baskets are updated regularly to reflect new products (e.g. flat screen TVs did not exist 20 years ago) or quality improvements (e.g. cars and computer today perform very much different from 3 or 5 years ago). The prices of these baskets are checked every month to calculate increases/decreases from one month to the other and from the year before. .

Yes and no. First of all, from a trade point of view let’s remember that although the euro-dollar is the most traded currency pair in the world’s foreign exchange markets, more than half of the euro area trade is carried out within the euro area itself (in 2007, for example, more than 60% of French exports went to Germany). On top of this, the main external export market for the euro area is the United Kingdom and only afterwards the United States, followed by China and Switzerland. So although there is concern about the current exchange rate of the euro and sharp currency fluctuations it is better to compare against the basket of currencies of our main trading partners.

The euro’s appreciation is also a sign of the relative strength of the euro-area economy compared to that of the other trading partners, in particular of the United States. The euro area has no external or internal imbalances – at 0.6% in 2007, its average public deficit was the lowest in decades; the current account position is also in balance.

For the consumer a strong euro provides a shield against the global surge in energy and food prices which are still largely denominated in dollars. It increases the terms of trade of both consumers and companies and allows containing imported inflation thereby permitting lower domestic interest rates which are beneficial for investment and growth. It also makes travel and holidays outside the euro area cheaper. On the other hand, industries that compete internationally see their competitiveness adversely affected, which requires continued efforts to improve it not only through cost containment, but also by focusing on increasing the quality of euro area products.

Slovakia aims to introduce the euro as of 1 January 2009. The Commission assessed today that it fulfils all the criteria and proposed to the Council that Slovakia adopts the euro next January.

All EU countries have a right, and are welcome, to adopt the euro if they meet the convergence criteria in a sustainable way. Denmark and the United Kingdom have an opt-out. In order to plan ahead and focus the minds of the business community as well as the public they may set themselves a target date. The Commission, nevertheless, cannot and does not endorse national target dates or pronounce itself on their credibility.

In order to adopt the euro, national currencies are also expected to spend at least two years in the Exchange Rate Mechanism (ERM II) (see below) to test the stability of their exchange rate. The currencies of the Baltic countries do participate in the ERMII, but they do not presently meet the inflation criterion. Bulgaria, the Czech Republic, Hungary, Poland, Romania and Sweden do not participate yet in ERM II. Except Sweden, they also do not yet all fully respect the criteria for public finances, inflation and interest rates (see today’s Convergence Report cited above).

The ERM II is a mechanism for the currencies of EU countries which have not yet adopted the euro. It is based on stable but adjustable central rates to the euro, with standard fluctuation bands of +/-15% around the central rate. Exchange rate policy co-operation may be further strengthened, as is the case with Denmark, which has an agreed fluctuation band of +/- 2.25%.