The Euro By Rami Elkhoury How the European

The Euro By Rami Elkhoury

How the European Single Currency Evolved • The Bretton Woods system (which fell apart in 1973) fixed every member country’s exchange rate against the U. S dollar and as a result fixed the exchange rate between every pair of nondollar currency. • EU countries tried progressively to narrow the extent to which they let their currencies fluctuate against each other. • These efforts lead to the birth of the euro on January 1, 1999 • Bretton woods system – first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. 730 delegates from all 44 Allied Nations gathered in Bretton woods, New Hampshire and deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944.

Why The Euro? EU members adopted the euro for 4 main reasons: 1. Unified market: the belief that greater market integration and economic growth would occur. 2. Political stability: the belief that a common currency would make political interests more uniform. 3. The belief that German influence under the EMS would be moderated under a European System of Central Banks. 4. Eliminate the possibility of devaluations/revaluations: with free flows of financial assets, capital flight and speculation could occur in an EMS with separate currencies, but would be more difficult with a single currency.

What is EMS? • The European Monetary System was originally a system of fixed exchange rates implemented in 1979 through an exchange rate mechanism (EMR). • The EMS has since developed into an economic and monetary union (EMU), a more extensive system of coordinated economic and monetary policies.

What Has Driven European Monetary Cooperation? • Countries that established the EU and EMS had several goals. 1. To enhance Europe’s power in international affairs: able to represent more economic and political power in the world. 2. To make Europe a unified market: Believed with free trade, free flows of financial assets and fixed exchange rates, will increase economic growth and economic well being. 3. To make Europe politically stable and peaceful.

The EMS from 1979– 1998 • From 1979– 1993, the EMS defined the exchange rate mechanism to allow most currencies to fluctuate +/2. 25% around target exchange rates. • The exchange rate mechanism allowed larger fluctuations (+/6%) for currencies of Portugal, Spain, Britain (until 1992) and Italy (until 1990). – These countries wanted greater flexibility with monetary policy. – The wider bands were also intended to prevent speculation caused by differing monetary and fiscal policies.

The EMS from 1979– 1998 cont. To prevent speculation, • early in the EMS some exchange controls were also enforced to limit trading of currencies. – But from 1987– 1990 these controls were lifted in order to make the EU a common market for financial assets. • a credit system was also developed among EMS members to lend to countries that needed assets and currencies that were in high demand in the foreign exchange markets.

The EMS from 1979– 1998 cont. • But because of differences in monetary and fiscal policies across the EMS, markets participants began buying German assets (because of high German interest rates) and selling other EMS assets. • As a result, Britain left the EMS in 1992 and allowed the pound to float against other European currencies. • As a result, exchange rate mechanism was redefined in 1993 to allow for bands of +/-15% of the target value in order devalue many currencies relative to the deutschemark.

The EMS from 1979– 1998 cont. • But eventually, each EMS member adopted similarly restrained fiscal and monetary policies, and the inflation rates in the EMS eventually converged (and speculation slowed or stopped)

Inflation Convergence for Six Original EMS Members, 1978– 2006 Source: CPI inflation rates from International Monetary Fund, International Financial Statistics. 20 -10

European Economic Monetary Union • In 1989, a committee headed by Jacques Delors, president of the European Commission had a goal, (EMU), economic and monetary union, which would replace national currencies by a single EU currency managed by a sole central bank operating on behalf of all EU members.

The Maastricht Convergence Criteria and the Stability and Growth Pact • The Maastricht Treaty specifies that EU member countries must satisfy several macroeconomic convergence before they can be admitted to EMU 1. 2. 3. 4. The country’s inflation rate in the year before must be no more than 1. 5 percent above the average rate of the 3 EU member states with lowest inflation. Must have maintained a stable exchange rate within the ERM without devaluating on its own initiative Must have a public-sector deficit no higher than 3 percent of its GDP Must have a public debt that is below or approaching a reference level of 60 percent of its GDP

The Maastricht Convergence Criteria and the Stability and Growth Pact cont. • Stability and Growth Pact (SGP) – Negotiated by European leaders in 1977. – Sets out “the medium-term budgetary objective of positions close to balance or in surplus – Sets out a timetable for the imposition of financial penalties on countries that fail to correct situations of excessive deficit and debt promptly enough

The Maastricht Convergence Criteria and the Stability and Growth Pact cont. • Before signing the Maastricht Treaty, low inflation countries such as Germany wanted assurance that their EMU partners had learned to prefer an environment of low inflation and fiscal restraints. • They feared that the EURO might be a weak currency, falling prey to the types of policies that fueled other countries inflation at various points in time. • By May 1998, 11 EU countries had satisfied the convergence criteria and would be founders of the EMU: Australia, Belgiun, Finland, France, Germany, Ireland, Italy, Luxenbourg, Netherlands, Portugal, and Spain.

The European System of Central Banks • Conducts monetary policy for the European Central Bank in Frankfurt plus the 15 national central banks. • Decisions of the ESCB are made by votes from the president of the ECB and the heads of the national central banks.

The European System of Central Banks cont. • The authors of the Maastricht treaty hoped to create an independent central bank free of the political influences that might lead to inflation. • The ESCB is required to brief the European Parliament regularly on its activities, but the European Parliament has no power to alter the ESCB’s statute.

The Revised Exchange Rate Mechanism • For EU countries that are not yet members of EMU, a revised exchange rate mechanism defines broad exchange rate zones againts the euro and specifies reciprocal intervention arrangements to support these target zones. • It was viewed as necessary to discourage competitive devaluations against the euro by EU members outside the euro zone and to give would-be EMU entrants a way of satisfying the Maastricht Treaty’s Exchange rate stability convergence criterion.