What is the European Monetary Union?

By Amity Stauffer

Among the European states, EMU officially stands for Economic and Monetary Union. Other countries also use EMU to refer generally to the European Monetary Union. EMU is the agreement among the participating member states of the European Union to adopt a single hard currency and monetary system. The European Council agreed to name this single European currency the Euro. The European states decided that the EMU and a single European market were essential to the implementation of the European Union, which was created to advance economic and social unity among the peoples of Europe and to propel Europe to greater prominence in the international community.

History of the EMU

In 1979, the European Council adopted the European Monetary System, known as EMS, which employed an exchange rate mechanism, or ERM, to encourage participating countries to keep the fluctuations of their currency exchange rates within an acceptable band. The permissible limits of the ERM were derived from the European Currency Unit, or ECU, a referential currency calculated from an average of the participating countries' national currencies. In 1988, Jacques Delors, the president of the European Commission, chaired a committee which proposed a three-stage plan to reach full economic union, including the establishment of a European Central Bank and a single currency which would replace any existing national currencies. With each stage, the monetary policies of the participating countries would become more closely entwined, culminating in full convergence in the EMU.

The Maastricht Treaty: Founding Document for the EMU

Plans for the EMU were formalized in provisions within the Maastricht Treaty, which founded the European Union. The Maastricht Treaty was signed in 1992, and subsequently ratified by all of the member states. Some countries approved the treaty by a public vote, while other countries ratified the treaty through a legislative vote. The Treaty set up the conditions, or "convergence criteria," which each member state in the European Union must meet before it could join the EMU. These conditions for EMU membership were considered necessary because when the member states join the EMU, domestic economic crises in one member state will effect all of the other member states. To participate in the initial formation of the EMU, each member state had to meet the following five convergence criteria by 1998: (1) the national legislation governing the country's financial system had to be compatible with the treaty provisions controlling the European System of Central Banks; (2) the country had to achieve a rate of inflation within 1.5% of the rates in the three participating countries with the lowest rates; (3) the country had to reduce its government deficits to below 3% of its gross national product; (4) the country had to keep its currency exchange rates with the limits defined by the ERM for at least two years; and (5) the country had to keep its interest rates within 2% of the rates in the three participating countries with the lowest rates.

The Founding Member States of the EMU

Eleven of the fifteen European Union member states initially qualified to join the EMU in 1998. Those states were: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. As part of the EMU, these eleven countries now make up the world's second-largest economy, after the United States. Some analysts have suggested that only by using flexible definitions did Belgium and Italy meet the deficit-related criteria. Two countries, Greece and Sweden, failed to meet the convergence requirements in time to join the EMU in the first round. Sweden failed to satisfy two of the conditions: laws governing Sweden's central bank were not compatible with the Maastricht Treaty and the currency exchange rates in Sweden were not sufficiently stable for the previous two years. Greece failed to meet all of the requirements. These countries will be reevaluated every two years to determine if they meet the requirements for joining the EMU. The two remaining members of the European Union, the United Kingdom and Denmark, chose not to join the EMU immediately. Both of these countries made provisions in the Maastricht Treaty that preserved their right not to join the EMU. To ensure stable currency exchange rates among all of the European Union member states, the currencies of those states that did not qualify to join the EMU or that chose not to participate in the EMU initially were linked to the single European currency of the EMU, the euro, by a new currency exchange rate mechanism, known as ERM2.

The Launch of the Euro

On January 1, 1999, the currency exchange rates of the eleven participating member states became permanently fixed, marking the beginning of the third and final phase of the EMU. On this date, the euro became a legal currency. Citizens in participating countries now can write checks, use credit cards, and write traveler's checks denominated in euros. Banks and businesses now have the option of using euros to transact business. The production of the first euro coins and banknotes began on January 1, 1999. An estimated 12 billion banknotes and 80 billion coins will be minted initially. On the first of January, 2002, the participating countries must begin to remove their national currencies from circulation. By the first of July 2002, the old national currencies will no longer be legal tender, and all transactions from that date forward in the participating EMU states must be conducted in euros. Once they are retrieved from circulation, the old national coins and banknotes will be destroyed.

As an integral part of the EMU, a new monetary institution was founded in Frankfurt, Germany-the European Central Bank, or ECB. The ECB sets monetary policy for the EMU independently from the influence of any of the national governments or any other outside influence. The ECB together with the central banks of all of the states in the European Union form the European System of Central Banks, or ESCB, which is charged by statute with maintaining price stability. The ESCB implements the monetary policy of the ECB, and administers the foreign exchange reserves of the participating member states, among other tasks.

Advantages of the Euro

The conversion to a single European currency provides a number of advantages. Use of the common euro eliminates the currency exchange fees from the cost of doing business between the European states. Companies will be able to quickly compare prices with their competitors, which may encourage competition and may result in lower prices for consumers. By encouraging stability and efficiency, proponents of the EMU hope that the use of the euro will stimulate economic growth and may reduce the unemployment rates in the participating member states. International investors will likely diversify their portfolios with euros, encouraging more investment in the European continent. The European states want the euro to become one of the premier currencies in the international financial market, alongside the dollar and the yen.

Criticisms of the EMU

Concerns about the EMU center around loss of national sovereignty for each of the individual participating states. Some fear that the participating states may not be able to pull out of a national economic crisis without the ability to devalue its national currency and encourage exports. Others worry that the participating European states will be forced to give tax breaks to compete with each other and that companies may have to lower wages for their employees and to lower prices on goods that they produce. Because taxes continue to be levied at the national level and not by the EMU, tax policy cannot be used as a tool to help individual states that may be experiencing an economic downturn. In this way, the EMU differs from the United States which has both a single federal monetary policy and a primarily centralized tax system. In the United States, the residents of an individual state with a lagging economy can pay less tax and the residents of another state with a soaring economy can make up some of the tax deficit. In the EMU, because tax policy is not centralized, the other states cannot help out an individual participating state that is economically troubled by shouldering a greater proportion of the tax burden. Also, because the participating EMU countries vary so much culturally, the labor force in these countries is not nearly as mobile as between the states of the United States. Because the labor force is fairly stationary, problems of high unemployment may persist in certain individual EMU states while other countries may not be able to fill positions with qualified employees. Finally, some countries (like the United Kingdom) may fear that joining the EMU may pull their country down to the economic equivalent of the least common denominator, saddling them with the economic problems of countries with a less successful economy.