International economics

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Monetary Union

Economic and Monetary Union (EMU) is an important stage in the process of economic integration.

The main features of European Economic and Monetary Union (EMU) include:

A single European currency

The Euro (€) was first introduced in 2000, and national currencies were finally scrapped in 2002. The framework of rules for entry into the Eurozone was laid down in the Maastricht Treaty in 1992. This treaty also created the rules for membership of the European Union (EU) in general.

The euro-system

The euro-system has two elements - the European Central Bank(ECB), which is responsible for all monetary policy in the eurozone (euro area), and the National Central Banks (CBs) of the 16 member countries. Other European countries are free to join the euro area if they meet the criteria laid down in various treaties. The two most important criteria for entry are that the applicant country has demonstrated price stability, and that its public finances are well managed.

Co-ordination of macro-economic policies

Co-ordination of policy was designed to enable the original 12 economies of the euro area to converge. A key feature of this was the Stability Pact, which involved members agreeing to keep their economies stable, and keeping their budget deficits under control. The agreed limit for a deficit was that it must be no more than 3% of GDP. This restriction was designed to prevent any unnecessary fiscal stimulus which might de-stabilise the economy, even in the face of high unemployment. However, several countries, including Germany, France, and most notably, Greece, have broken this rule, and this has cast serious doubts about the ability of the euro area to maintain this rule.

The European Financial Stability Facility

The EFSF was formed to help stabilise the European economies after the financial crisis, recession and sovereign debt crisis, and now forms a key element of the reformulated euro-system.

The fiscal compact

In attempt to prevent EU countries from running up further debts, the majority of the EU states signed a fiscal compact which opened up their domestic budgets to collective scrutiny. It remains to be see how successful this measure will be, and whether its leads to a full fiscal union.

Single interest rate

The ECB sets interest rates across the whole Euro-area (EA-19), and no single National Central Bank has the ability to alter interest rates itself.

Asymmetric inflation target

The ECB sets an asymmetric target rate for inflation of 2% - in other words, the inflation target is not symmetrical, as in the UK, where intervention should occur at rates 1% above and 1% below the target rate.

The advantages of the Euro

There are several significant benefits of having a single currency area. These are primarily derived from the benefits of fixed exchange rates, and include the following:

Transparency

Producers and tourists can more easily compare the prices of international goods, services and resources.

Lower transaction costs

Transaction costs are reduced because there are no commission payments to financial intermediaries.

Certainty and investment

The Euro creates certainty because firms can predict the cost of imported raw materials and can set the price of their exports, which means they can plan, and are more likely to invest.

Trade creation

Trade between members of a single currency area is likely to increase because of the benefits of sharing a currency.

Job creation

Increased trade is likely to generate jobs in those industries that experience increased exports.

Discipline against inflation

Members cannot take the easy option (devaluation) to get out of economic difficulty.

The disadvantages of the Euro

Loss of economic sovereignty

Once a country become a member of the euro area, National Central Banks, including the Bank of England, lose their ability to use interest rate policy to achieve independent macro-economic objectives. Following the financial crisis and global recession, recession-hit countries like Greece were not able to reduce interest rates unilaterally.

Difficulty of conversion

Many European countries, including the UK, may never be able to converge fully with the euro area. In the UK in particular, convergence is difficult because of the uniqueness of its housing market and financial services sector, and because of the closeness of the UK's trade cycle to that of the USA. In addition, the UK labour market is highly flexible in comparison with France, Germany, and Spain and this also makes convergence difficult.

One cap does not fit all

Having only one interest rate is not sensible when dealing with a diverse range of economies and economic circumstances. Even within a single currency area, great diversity can exist, suggesting that a common economic policy might be unproductive.

Dealing with asymmetric shocks

Asymmetric shocks are external shocks that have an unequal impact on an economy or, in this case, the EU area. The following recent shocks did not have an equal effect across Europe: the handover of Hong Kong to China by the UK in 1997 led to an exodus from Hong Kong to the UK, and not to the rest of Europe, and helped fuel a mini-housing boom in parts of London; the September 11^th2001 attacks on New York did not affect all euro area countries evenly; and the collapse of the Argentinean peso in 2002 mainly affected Spain.

The growing imbalance between the more affluent northern euro members, including Germany, and the increasingly indebted southern ones, including Greece, Italy and Portugal, has also raised the issue of the inadequaces of having a single monetary policy.

In these types of circumstance it is argued that a single interest rate will not be appropriate. A member experiencing a negative (perhaps domestically originating) shock would require lower interest rates and looser monetary policy in comparison with those members less affected.

The weakness of an asymmetrical monetary target

Having an asymmetrical inflation target means that the ECB must only intervene if the rate is exceeded, and not if inflation falls below the target rate. Critics argue that, as a result, there is a built-in deflationary bias. The euro area has certainly experienceddeflationary pressures in recent years.

Membership tests

In 2003 the UK government laid down five conditions for the UK to join the euro area. These were:

1.       Economic convergence

The trade cycles of the UK and euro area should be in alignment.

2.       Flexibility

Joining should not harm the highly flexible product and labour markets of the UK.

3.       Investment

Joining should not discourage domestic investment and FDI.

4.       Financial services

The City (the financial centre) should not suffer as a result of membership of the euro area.

5.       Growth and jobs

Membership should be good for growth and job creation.