The Treaty of Rome creating the EC in 1957 focused on eliminating trade barriers, but a series of events starting in the 1960s also gave concrete form to the idea of a European monetary union. In January 1999, 11 EU members formed an EMU and agreed to adopt the euro in place of their national currencies: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Greece, Slovenia, Cyprus, Malta, and Slovakia joined later, and the EMU now has 16 members. The following discussion examines the challenges in creating and maintaining the EMU, and the implications of the EMU for European and global monetary relations.
From 1958 to the late 1960s, the Bretton Woods pegged exchange rate regime provided the EC with some stability. However, two changes in the 1960s caused the EC to consider regional monetary integration: Growing U.S. balance-of-payments deficits decreased confidence in the U.S. dollar and threatened exchange-rate stability; and Europe’s rapid progress in developing a customs union and a common agricultural policy increased the need for exchange-rate stability among EC members. At a 1969 summit, the six EC members asked Pierre Werner, the Luxembourg prime minister, to develop a proposal for an EMU. The 1970 Werner plan recommended that the EC countries adopt similar fiscal and monetary policies and reduce fluctuations in their currency exchange rates; one element of the plan was a “snake agreement” that limited exchange-rate fluctuations among EC currencies to a
narrow band of percent. Because France, Ireland, Italy, and
Britain had weaker currencies, they could not adhere to the band, and they soon left the snake agreement. Other factors contributing to the failure of the snake agreement were the increase in capital mobility, the divergent
European Monetary Relations 153 macroeconomic policies of EC members, and global events such as the 1973–1974 oil price rise and the 1975 global recession. As discussed, states can attain only two of the three “Unholy Trinity” goals (exchange-rate stabil- ity, capital mobility, and monetary policy autonomy). Because capital mobility was increasing, the EC members could stabilize their currency exchange rates only by sacrificing monetary policy autonomy. However, the EC members’ divergent economic policies led to differential inflation rates, and speculative capital flows against the weaker currencies split the “snake” apart.
After the “snake” agreement failed, the EC launched a European Monetary System (EMS) and this time they were more successful. Kathleen McNamara argues from a constructivist perspective that a neoliberal policy consensus among EC leaders in the late 1970s induced them to give up autonomous monetary policies to achieve exchange-rate stability. To become more competitive internationally, the EMS members gave priority to exchange-rate stability and inflation control over social issues and were “willing to rule out the use of monetary policy as a weapon against broader societal problems, such as unemployment and slow growth.”51The EMS had
an exchange-rate mechanism (ERM) and a European currency unit (ECU). The ERM limited exchange-rate fluctuations to a percent band, and central banks intervened to keep the exchange rates within these levels. If this effort failed, a state could realign its currency after consultations with other EMS members. The ECU was a new currency based on a weighted basket of EMS currencies; it was used in cross-border banking and as a common unit of account, but not in commercial transactions. Although the EMS helped stabilize exchange rates, some EC members could not keep their exchange rates within the narrow ERM band because of increased financial flows, and they were permitted to move to a broader band of +6 to -6 percent.52
The problems of the EMS stemmed from the fact that it was only a partial monetary union, and the need for monetary stability increased as EC integration progressed. Hence, there were pressures for a full monetary union that would create a single European currency and give Europe a greater voice in international economic negotiations. In 1989, the Delors Committee proposed a three-stage process toward monetary union, involving a coordination of monetary policies, a realignment of currency exchange rates, and the creation of a single currency under a European central bank. This plan was included in the 1992 Treaty on European Union or Maastricht Treaty.53 However, the steps toward monetary union were
difficult because the Maastricht agreement (at Germany’s insistence) had rigid requirements for developing a single currency. To join the EMU, a country’s budget deficit had to be no greater than 3 percent of its GDP and its public debt no greater than 60 percent of its GDP. Some EU countries did not meet these criteria, and the budgetary cuts required caused considerable discontent. For example, French workers staged massive strikes in 1995 to protest planned cutbacks in social programs. Many Germans also did not want to sacrifice the deutsche mark, which reflected the country’s economic strength, for what could be a weaker euro; but Germany’s chancellor
Helmut Kohl strongly supported the EMU. Other countries had different concerns. For example, Britain wanted to preserve its monetary sovereignty, and Britain and France opposed the decision to locate the new European Central Bank (ECB) in Frankfurt, Germany. Britain, Sweden, and Denmark decided not to join the EMU, and Greece was too weak economically to be a founding member. Despite the obstacles, 11 EU members formed the
Economic and Monetary Union (EMU) in 1999 and agreed to replace their
national currencies with the euro. Greece was admitted to the EMU in 2001, Slovenia joined in 2007, Cyprus and Malta joined in 2008, and Slovakia joined in 2009.
Debate has continued over the costs and benefits of the EMU. The benefits of a monetary union include reduced exchange-rate volatility, lower transaction costs, greater price transparency, and a better functioning internal market. The costs of a monetary union result mainly from the loss of the exchange rate as a policy instrument; that is, an EMU member can no longer pursue an independent monetary policy by altering its exchange rate. The Nobel laureate Robert Mundell framed this debate on costs versus benefits many years earlier. Mundell argued that an optimum currency area, which maximizes the benefits of using a common currency, has certain characteristics: It is subject to common economic shocks, has a high degree of labor mobility, and has a tax system that transfers resources from strong to weak economic areas. Mundell’s ideas have been highly influential (albeit controversial), and he has been called the “Father of the Euro.”54When the
EMU was created, there were serious questions as to whether countries with such different characteristics should be forming a common currency. Whereas more competitive countries such as Austria, Finland, and Germany had currencies that persistently appreciated, less competitive countries such as Portugal, Spain, Italy, and Greece (which joined the EMU later) had currencies that persistently depreciated. “Euro-optimists” hoped that the common currency would make the poorer countries more competitive. However, low interest rates within the EMU lured governments and households in these countries to engage in unwise budgetary policies and excessive consumption.
Greece, Portugal, and Spain could also rely on large inflows of foreign capital, because it was believed that membership of these countries in the eurozone made their bonds safe investments. However, the 2008 global financial crisis caused revenues to plunge, and capital inflows to countries where fiscal discipline was inadequate precipitously declined. Greece was the country hit hardest, and by April 2010 it was in danger of defaulting on its sovereign debt. Whereas EMU members were to incur budget deficits and public debts of no more than 3 percent and 60 percent of their GDPs respec- tively, Greece had a budget deficit of 13.6 percent and a debt of 115 percent of its GDP. If Greece were outside the eurozone, it could devalue its currency and become more competitive; but its use of the euro has precluded that possibility. Fears that Greece’s deficit and debt problems would spread to other countries such as Portugal, Ireland, Spain, and even Italy sparked efforts by the IMF and EMU to provide Greece with an economic rescue package.
What Is the Future of the U.S. Dollar as the Key Currency? 155 However, political as well as economic factors will determine the outcome of this crisis in the eurozone. For example, there is political opposition in Germany (the strongest EMU member) to bail out euro countries because of their overspending habits, and there is opposition in the deficit countries to the stringent terms (e.g., cutbacks in wages and other economic benefits) the IMF and EMU would require for economic assistance. An examination of these economic-political linkages is critical to an understanding of the crisis facing the EMU.55
To this point, we have looked mainly at the regional implications of the EMU. However, many have raised questions about the future of the U.S. dollar and whether the euro might replace it as the key international currency. The next section addresses this issue.