purpose of creating the conditions for greater economic efficiency so that more goods and services can be produced at a lower cost through increased competition and productivity. In a single market there is free movement of factors of production. The demand for, and availability of, these fac-tors varies between countries and the resulting variation in prices provides incentives for factors to move between countries.
To achieve the benefits of a single market, the Single European Act includes a commitment to: (a) free movements of goods and services whereby all customs duties, quantitative restrictions on imports and exports, and restrictions on the provision of services by citizens of member states across national borders are eliminated; (b) free movement of people whereby all obstacles to people’s right to move between member countries for the pur-pose of employments and the right of establishment of self-employed per-sons are abolished; (c) free movement of capital whereby restrictions on the movement of capital between member states are prohibited.
To make a reality of these freedoms and to enable market forces to operate freely, the Community has developed a framework of rules regard-ing the removal of capital controls, the facilitation of labor mobility, the liberalization of road transport, the harmonization of technical standards, and a reduction in customs formalities. Important changes were introduced such as the mutual recognition of national norms under which products and services sold in one member country may be sold freely throughout the Community, legislation securing harmonization of policies in order to avoid discrimination through technical standards, a faster decision-making process through majority voting thus restricting the blocking of a decision by a single member state, and an increased role of the European Parliament.
Most of the legal framework for integrating the market for goods, services, labor, and capital was completed in December 1992. A major study, the Cecchini Report, estimated that the development of the single market would lead to acceleration of economic growth and increased prosperity for all European citizens.28The Report was also subject to criticism because it pre-sented a favorable view of the benefits while it underestimated the costs of economic integration.29 Nevertheless, the truth remains that integration of national economies into a single market also involves painful structural adjustments in the face of increased competition. The Community, through the Community Support Framework and the establishment of the Cohesion Fund, has provided financial resources to facilitate the adjustment process and improve the competitive position of the less developed regions.
Economic and Monetary Union Historical Background
The principle of the Economic and Monetary Union (EMU) became for-mally a Community target at the Hague Summit in 1969 where the EEC
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leaders agreed to proceed gradually toward economic and monetary union.
However, important differences emerged regarding the manner in which EMU was to be achieved. A group of countries (Belgium, France, Italy, and Luxembourg), called the “monetarists,” supported the view that monetary discipline was the first step toward EMU by keeping exchange rate fluctua-tions between the currencies of member countries within narrow limits and rendering policy cooperation and economic convergence inevitable. Another group of countries (Germany and the Netherlands), called the “economists,”
argued that the coordination of economic policies and economic convergence should be achieved first before moving toward EMU. The Werner Report in 1970, taking into account these differences, recommended establishment of EMU in stages by 1980.30 The first step toward that end was taken in 1972 by establishing an adjustable-peg exchange rate system, the “Snake,”
whereby participating currencies were allowed a ±225 percent margin of fluctuation against the central US dollar rate. However, the 1973 oil crisis and the free fluctuation of the dollar affected European currencies and the goal of achieving EMU by 1980 was abandoned.
A new initiative, the EMS, was launched on March 13, 1979, with the aim of stabilizing exchange rates and promoting closer monetary coopera-tion leading to a zone of monetary stability. The basic feature of the EMS was fixed exchange rates between the participating currencies and floating exchange rates between participating and nonparticipating currencies.31The institutional arrangements included three central features: (1) fixed exchange rates; (2) a new unit of account, the European Currency Unit (ECU) whose value was determined in terms of a basket of currencies weighted according to their relative strengths; (3) borrowing facilities for member countries fac-ing balance of payments problems. The system provided for fixed exchange rates with compulsory intervention limits of±225 percent around the ECU central parity (or ±6 percent in the case of weaker currencies). National governments would take all the necessary steps, such as adjusting domestic interest rates, to keep their currencies within the prescribed limits. However, the system was flexible as it allowed realignments by mutual agreement (i.e., adjustment of central parities) if economic conditions caused a currency to become fundamentally overvalued or undervalued.32
The German mark assumed a central role as the currency with the best inflation performance. The remaining members used the fixed exchange rate against the German mark as a means of increasing their own anti-inflationary credibility. Germany pursued a monetary policy defined by the Bundesbank, the German central bank, while the monetary policies of other EMS partic-ipants followed that of Germany by limiting money supply growth so that inflation rates were in line with the German inflation rate. The EMS did help stabilize exchange rates despite numerous realignments. In the period between January 1987 and September 1992 there were no realignments.
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The stability signified the system’s evolution into an instrument of economic policy as participating countries sought economic convergence with low inflation rates.
Strains in the EMS began at the beginning of the 1990s following the German unification. Inflationary pressures in Germany forced the Bundesbank to raise interest rates and this created instability in the system as the other participating countries had to raise their own interest rates in order to keep their exchange rates within the prescribed bands. The instability was reinforced by currency speculation, which reached a peak in September 1992 as markets realized that certain participating currencies could not maintain high interest rates and eventually would have to devalue. The pound sterling and the Italian lira came under heavy pressure and the two currencies were forced to leave the exchange rate mechanism (ERM) as they were no longer able to maintain the prescribed margins. In the following months other cur-rencies also came under attack such as the Spanish peseta, the Danish krone, the Irish punt, and the Portuguese escudo. These currencies remained in the ERM but were devalued in contrast to the French franc, which, although it came under strong speculative attack, resisted devaluation following mas-sive intervention. In August 1993 the EMS countries decided to widen the permitted fluctuation margins to±15 percent and this gave countries more room to gear monetary policy toward domestic conditions and allowed them to reduce their interest rates below Germany’s rate.
The Single Market Act of 1986, which created the single European mar-ket in 1992, made the creation of the Economic and Monetary Union (EMU) a Community objective and obliged member countries to work toward economic convergence for the achievement of EMU. The President of the European Commission, Jacques Delors, and the governors of the Commu-nity central banks presented the “Delors Report” in April 1989, a decisive step for full unification and the signing of a new treaty.33The Delors Report defined EMU as a currency zone where the conduct of economic policy is the result of collective effort for achieving common objectives and set three prerequisites:
1. Total and irreversible convertibility of the currencies of member states 2. Complete removal of restrictions on capital movements and the
inte-gration of financial markets
3. The irrevocable fixing of parity rates.
The Report underlined that the fulfillment of the above three precondi-tions will bring about perfect substitutability of the currencies of member states and full convergence of interest rates. This way, the road was open for the adoption of a common currency, a development that the Report considered desirable but not necessary. Also, the report mentioned the need
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for a single monetary policy under the auspices of a “federal” System of Central Banks (SCB) whose Board would be appointed by the Council of Ministers and would be independent from national governments.
The Report included a list of four basic parameters that were considered a necessary condition for the achievement of economic growth. These were:
1. The Single Market with complete liberalization in the movement of goods, services, and factors of production
2. The existence of an effective competition policy and other market strengthening measures
3. The existence of common policies aimed at structural changes and regional development
4. The coordination of macroeconomic policies with special emphasis on fiscal policy.
The European Union Treaty (the Maastricht Treaty), which amended the Rome Treaty, was signed on February 7, 1992, and came into force on November 1, 1993 (European Commission, 1992). At a later stage, the Amsterdam Treaty, which was signed on October 2, 1997, and came into force on May 1, 1999, amended both the European Union and the Rome Treaties.
The Treaty adopted the proposals of the Delors Report and decided on the strategy and implementation schedule of the EMU. The strategy was a gradual implementation (the European Commission was against a “two-speed” Europe), that is, in stages as economic convergence and economic policy coordination progressed. The timetable and content of each stage are set out in Articles 105–109 of the Treaty and are described below:34
There was a three-stage process to EMU. In Stage 1 (1990–1993), all member state currencies were to join the ERM of the EMS on equal terms.
Periodic exchange rate realignments were possible. The 1992–1993 exchange rate crisis described above set Stage 1 behind schedule as some countries did not join at all or were forced to leave the ERM. All member countries were to lift all restrictions on capital movements and improve economic policy coordination. Toward this end, member states would submit Convergence Programs containing specific targets regarding inflation rates and budget deficits.
Stage 2 (1994–1998) began in 1994 with the establishment of the Euro-pean Monetary Institute (EMI). Monetary policy remained in the hands of national central banks and the EMI defined the framework within which the ECB was to operate in Stage 3. Stage 2 also made provisions so that governments would no longer resort to central bank lending in order to finance budget deficits.
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Exhibit 5.4
Official Currency Conversion Rates of the Euro (national currency units/euro)
Country Currency Conversion rate
Austria Schilling 137603
Belgium Belgian franc 403399
Finland Markka 594573
France French franc 655957
Germany Deutsche mark 195583
Greece∗ Drachma 340750
Ireland Punt 0787564
Italy Italian lira 193627
Luxembourg Luxembourg franc 403399
The Netherlands Guilder 220371
Portugal Escudo 200482
Spain Peseta 166386
∗Except Greece, which joined the euro zone on January 1, 2001 Source: European Central Bank (1998), Press Release, 31 December.
Stage 3 began in 1998 with the introduction of the common currency (the euro), the irrevocable locking of exchange rates (Exhibit 5.4), and the formulation of a common monetary policy according to the provisions of the Treaty by the European System of Central Banks (ESCB) and the ECB. The Exchange Rate Mechanism II (ERM II) was also set up to ensure a smooth transition to the common currency and to reinforce the convergence efforts not only of those countries that did not join the euro zone but also of can-didate countries. The 12 countries that fulfilled the Maastricht criteria (see below) and were qualified to join the single currency in 1999 were Austria, Belgium, Finland, France, Germany, Greece (in January 2001), Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Sweden did not fulfill the convergence criteria since the Swedish currency had remained outside the ERM II and also because its legislation was not compatible with the European Union Treaty and the ESCB Statute. Denmark and the United Kingdom decided not to take part in Stage 3 and remained outside the euro zone. On January 1, 2002, the euro was introduced in note and coin form.
A period of six months was given for national currencies to withdraw from circulation and as from July 1, 2002, only the euro is a legal tender in EMU member countries.
Benefits and Costs of EMU. Technically, the single market does not require a common currency but many economists argue that the existence of a common currency is desirable. The relevant economic theory examining whether a region benefits from the existence of a common currency is the
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theory of optimum currency areas.35 A region is considered an optimum currency area when the markets of goods, services, capital, and labor within a group of countries are unified to such an extent that it would render the existence of a common currency more effective than several national curren-cies. Obviously, regions of the same nation sharing a common currency are optimum currency areas. This theory gave rise to an extensive international academic literature where the evaluation of EMU is made under the light of the theory of optimum currency areas. As a general conclusion, the pos-sibility that the benefits from EMU will exceed costs is dependent on four factors: (a) the degree of country interdependence; (b) the degree of capital and labor mobility; (c) the degree of convergence of the economies of the member states so that exogenous disturbances will have a symmetrical effect on all members, and (d) the degree of price and wage flexibility.
The higher the degree of the first two factors, the closer the convergence of the economies, and the greater the flexibility of prices and wages, the higher the possibility that EMU will be successful. This conclusion explains the special emphasis given to the convergence criteria by the European Commis-sion. The benefits from the adoption of a common currency are significant.
According to a Commission study, the savings from the elimination of trans-action costs amount to 13–19 billion euros (or 0.3–0.4 percent of the EU GDP).36The same study estimates that production in the EU will increase by 5 percent of the EU GDP as a result of increased investor confidence because of the absence of exchange rate risk. An additional benefit is the saving of approximately 160 billion euros of foreign exchange reserves. A more recent study estimated that exchange rate variability during the 1995–1996 period caused the loss of 1.5 million jobs and slowed EU GDP growth by 2 percent.37
Long-run benefits include the increased convergence of the economies of the member states, increased competition, and downward convergence of interest rates, which results in higher investment levels in a stable environ-ment and an efficient allocation of resources. The main costs associated with the EMU are the loss of the exchange rate and monetary policy as an instru-ment of national sovereign economic policy and the restricted effectiveness of fiscal and income policies.
According to the theory of optimum currency areas, participating coun-tries are affected symmetrically by exogenous disturbances, as long as there is perfect capital and labor mobility. If an external disturbance is asym-metrical, capital and labor mobility will tend to offset the disturbance. For example, if Greece and Italy are affected asymmetrically by an exogenous shock so that Greece experiences recession and Italy an economic boom, then wages will fall in Greece so that lower prices and production costs will restore competitiveness and will increase in Italy. In addition, unemployed
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labor will migrate to Italy so that equilibrium can be achieved through the convergence of wages and production costs.
Problems arise when there is no downward price and wage flexibility or when capital and labor mobility is low. In this case, equilibrium can be achieved only through a higher price level (inflation) and a subsequent loss of competitiveness in Italy and a simultaneous competitiveness gain in Greece. However, if Italy is not willing to suffer the consequences of inflation and Greece the consequences of recession, equilibrium can be attained by a change in the exchange rate without the negative effects of recession. If the two countries are members of a monetary union, the use of the exchange rate instrument is no longer an option. The only solution for Greece is to suffer the consequences of long-term recession, unemployment, and chronic current account deficits. Consequently, if the members of a monetary union are affected asymmetrically by an exogenous disturbance and there is no sufficient price and wage flexibility, then it is preferable to retain their interdependence rather than become members of a monetary union.
The European monetary union has the ability to reduce disturbances originating from policy intervention and to mitigate the effects from asym-metrical exogenous shocks. The fact that the ECB follows a policy often called “one size fits all” cannot be interpreted as a weakness of the com-mon currency because the long-term success of the euro depends on the appropriate integration of member countries, which, as the above discussion implies, should behave as one economy in the long run.38 In general, mon-etary integration requires high factor mobility and symmetrical effects from exogenous disturbances. Countries fulfilling these conditions will certainly benefit from participation in a monetary union. If, however, there are differ-ences with regard to economic structures, levels of economic development, preferences, and economic policy instruments, at least some participating members will suffer short-term adjustment costs.
The Maastricht Convergence Criteria. A successful transition to a mone-tary union requires a high degree of convergence among member countries with respect to a low rate of inflation, sound fiscal finance, and exchange rate stability. On the basis of the above preconditions, member countries wishing to adopt the common currency must fulfill four convergence criteria set out in the European Union Treaty (Maastricht Treaty).39 These are the following:
• Inflation—According to Article 109 (j) and Article 1 of the Protocol Agreement, a high degree of price stability is required. Such a devel-opment is evident from a rate of inflation close to that of the three best-performing member states in terms of price stability. The infla-tion rate in the previous year must be at most 1.5 percent above those in the three member states with the lowest inflation as measured by
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the consumer price index (CPI), taking into account the difference in national definitions. The index used for comparison purposes is the harmonized index of consumer prices (HICP) constructed by the Com-mission’s Statistical Service (EUROSTAT), the EMI, and the ECB. The low inflation criterion makes it evident that the member state is ready for a smooth transition to the new common currency system together with the remaining member states that have achieved price stability.
• Fiscal discipline—Article 109 (j) requires fiscal discipline position with-out excessive budget deficits. Article 104 defines the excessive deficit procedure. The European Commission will prepare a report if a mem-ber state does not fulfill the requirements of fiscal discipline, which are (a) the ratio of planned or actual government deficit to GDP should not be greater than a reference value of 3 percent and (b) the ratio
• Fiscal discipline—Article 109 (j) requires fiscal discipline position with-out excessive budget deficits. Article 104 defines the excessive deficit procedure. The European Commission will prepare a report if a mem-ber state does not fulfill the requirements of fiscal discipline, which are (a) the ratio of planned or actual government deficit to GDP should not be greater than a reference value of 3 percent and (b) the ratio