The European Union (EU) is an “intergovernmental and supranational union of 25 democratic member states from the European continent. The European Union was established under that name in 1992 by the Maastricht Treaty” . However, some of the aspects of the European Union have existed for over 50 years. After WWII, an organization was formed by European countries to reduce trade barriers and increase cooperation among them, known as the European Coal and Steel Community. In 1957, the European Economic Community was formed and it was the first full customs union to be created. It was later changed to European Community and is now the first pillar of the European Union.
As of May 2004, the European Union has twenty five members: Austria, Belgium, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden, United Kingdom. Bulgaria and Romania are expected to become members in 2007, given that they fulfill all the requirements of membership. Moreover, Turkey, Croatia and the Republic of Macedonia (under the name “former Yugoslav Republic of Macedonia") have been given official candidate status. Finally, Iceland, Liechtenstein and Norway can participate almost fully in the single market of the European Union but will not join it and, Switzerland rejected such participation altogether.
The de facto capital of the European Union is Brussels and there is a number of institutions that support the functioning of the European Union. These are namely the European Parliament, the Council of the European Union, the European Commission, the European Court of Justice, the European Court of Auditors, the European Central Bank, the European Investment Bank, the advisory committees (e.g. Economic and Social Committee) and the agencies of the European Union. This paper is about the financial aspects of the European Union and as a result, the analysis will concentrate only on the development and significance of its financial bodies.
According to the CIA World Factbook, the 2005 estimate for the European Union’s GDP (based on PPP) should be around $12.18 trillion and if it is considered as a single unit, it has the largest economy in the world. As more members are expected to join, the economy will grow even further. Currently, the currencies that are in circulation are fourteen in total and include the euro, the British pound, the Cypriot pound, the Czech koruna, the Danish krone, the Estonian kroon, the Hungarian forint, the Latvian lat, the Lithuanian litas, the Maltese lira, the Polish zloty, the Slovak koruna, the Slovenian tolar and the Swedish krona.
Many of the policies of the European Union relate to some extent to the development and growth of an effective single market. In 1979, the European Monetary System (EMS) was created, according to which the eight original participants began “operating a formal network of mutually pegged exchange rates” . It was adopted in order to prevent large fluctuations relative to one another. However, it was abandoned in 1998 when the European Economic and Monetary Union (EMU) was created. National currencies were replaced by a single European Union currency, the euro. There were mainly five reasons for this conversion. First of all, EU countries wanted to “enhance Europe’s role in the world monetary system” . In addition, EU countries wanted to create a truly unified market; it was believed that a single currency will bring about greater market integration. Also, some thought that Germany’s management of the EMS had mainly promoted Germany’s interests at the expense of other countries’ macroeconomic goals. Moreover, there could be speculative attacks and the best way to combine a fixed exchange rate with freedom of capital movements was to adopt a single currency. Finally, there was reason to believe that political stability would be guaranteed in this way.
As mentioned before, the currency that was selected to replace the national currencies was the euro. In late 2004, following the demands of individual countries to modify the name in order to be meaningful in their own language, it was decided that the “o” was dispensable but all names had to begin with “eur”. There are seven different banknotes (5, 10, 20, 50, 100, 200, and 500) and their design is symbolic of Europe’s architectural heritage. On the one side there are windows and gateways to represent the spirit of openness and cooperation and on the other side there is a bridge that represents the communication of the people. The coins on the other hand have an identical, “European” side and a “national” one. The currency finally went in circulation in January 2002.
In order to be admitted to the EMU, there are four criteria that have to be met by each country. First, the country’s inflation rate should not be more than 1.5 percent higher than the average inflation rate of the three countries with the lowest rate. Second, the country must have maintained a stable exchange rate for at least two years. Third, the public sector debt of a country should not exceed three percent of its GDP (Gross Domestic Product). Finally, the public debt should be below sixty percent of the country’s GDP. Currently, there are twelve countries that have adopted the euro and, three countries (UK, Denmark and Sweden) have no clear roadmap for adopting it. As for the remaining ten countries, they have to adopt it in the near future.
As mentioned above, there are three countries that are not expected to join the eurozone in the near future. Sweden has no official op-out clause from the Maastricht treaty and is therefore required to join the eurozone at some point. In 2003, a referendum was held on the adoption of the euro and it resulted in the rejection of adopting a single currency. Since every country needs to participate for at least two year in the ERM II before adopting the single currency, the government of Sweden has found a legal loophole for avoiding the conversion to the euro simply by staying outside the exchange rate mechanism. United Kingdom and Denmark, on the other hand, have such opt-out clauses. The UK believes that not being able to set its own interest rates will have a detrimental effect on the country’s economy and is concerned about the unfunded pension liabilities which could depress the euro in the future. Denmark has held two referendums and both of them rejected the euro. However, this as not stopped the country from pegging its currency to the euro as it remains in the ERM II.
The European System of Central Banks (ESBC) is composed of the European Central Bank (ECB) and the national central banks (NBCs) of all twenty five member states. The Eurosystem or Eurozone is the subset of the European Union member states that have adopted the euro and it will coexist with the ESBC for as long as there are countries that have not adopted the euro. The decisions of the ESBC are made by votes of the governing council of the ECB and the authors of the Maastricht Treaty designed this system in order to insulate the central bank’s decisions from political influences. As a result, the ECB operates beyond the reach of any single government. The ESBC has to report regularly to the European Parliament but the European Parliament does not have the power to alter any decisions.
The ECB building is in Frankfurt, Germany and is modeled on that of the German Bundesbank and Landesbanken. Its basic tasks are the following: “a) definition and implementation of monetary policy for the euro area, b) conduct foreign exchange operations, c) hold and manage the official foreign reserves of the member states (portfolio management), d) promote the smooth operation of payment systems” . Some of its further tasks regard the financial stability and supervision, the issuance of banknotes, collection of statistical information and maintaining and developing international and European cooperation.
The primary objective of the ECB’s monetary policy is to maintain price stability because it primarily leads to economic growth and job creation. The definition of price stability for the ECB means “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area below 2%” . There are three main reasons why the ECB is aiming at below but close to 2%. First of all, this rate provides a sufficient margin that reduces to a minimum the risk of deflation. In addition, as with all indices, the HICP may be slightly overstating the actual inflation rate. Finally, it provides an adequate margin for countries to operate under inflation differentials.
The ECB, as is the case with most central banks, considers transparency as crucial. “Transparency means that the central bank provides the general public and the markets with all relevant information on its strategy, assessments and policy decisions as well as its procedures in an open, clear and timely manner.” It plays a very important role because on the one hand it enhances its credibility with the public, it imposes self-discipline on its policymakers and becomes more predictable and thus less prone to economic shocks.
The ECB is the sole supplier of euro banknotes and bank reserves in the euro area. As a result, it has a monopoly in the supply of the monetary base which consists of the money in circulation and the reserves that are being held. Since the ECB is a monopolist, it can control the liquidity in the money market as well as its interest rates. In order to promote the smooth operation of payment systems, the ECB provides regular financing to its counterparts, namely the NCBs. It also provides standards for securities clearing and settlement payments, it oversees the whole system and finally, it acts as a “catalyst for change” .
Moreover, the ECB manages three portfolios: the foreign reserves portfolio, the own funds portfolio and the pension fund portfolio. Even though each portfolio has a distinct management strategy, they all follow the same philosophy. Firstly, all of them are managed in a way that brings about higher returns and secondly, the ECB invests only in very liquid markets in order to avoid market distortions. Furthermore, the ECB is also involved in the risk management of these portfolios and the ECB has three main responsibilities which can be summarized as follows: “compliance, measurement and reporting of performance and strategic asset allocation” .
Coming to the last part of the ECB’s main tasks concerning the foreign exchange operations, the ECB conducts foreign exchange interventions, sales foreign currency interest income and commercial transactions. Such interventions can be carried out either directly by the ECB or by the NCBs acting as agents of the ECB. “Interventions may also take place within the framework of the exchange rate mechanism II (ERM II)” . The ERM II is in fact the third stage of the EMU and the currencies in this exchange rate system are allowed to float within a range of plus/minus fifteen percent against the euro. It replaced the European Exchange Rate Mechanism (ERM), which was adopted in 1979 by the European Community as part of the European Monetary System and was based on the concept of fixed currency exchange rate margins. In the beginning the allowed margin was plus/minus 2.5 percent (the Italian lira was allowed a margin of six percent) and in 1993 it was expanded to fifteen percent (because of speculation against the French franc). The exchange rates were based on the ECU, the European unit of account, whose value was determined by the weighted average of the participating countries. Nowadays, all the countries that have not adopted the euro have to take part in the ERM II before joining the Eurozone. It is asymmetric, and peripheral countries peg their currency to the euro and adjust passively to the decisions of the ECB.
Coming to the issue of whether the Eurozone is an Optimal Currency Area, we first need to define what it is. An OCA “is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency” and there are some criteria that have to be met. First of all, there needs to be perfect labor mobility across the region. Then, there should be openness with capital mobility and price and wage flexibility across this region. Finally, there should be “an automatic fiscal transfer mechanism to redistribute money to areas/sectors which have been adversely affected by the first two characteristics” .
In the European Union, labor mobility is relatively low. Even though there are no physical boundaries to traveling, there are government regulations and a number of cultural obstacles that are related to the fact that there is no single language (every country has its own), and also the fact that traditions, mentality and social norms differ across countries (they can also vary within the country’s regions as well). Moreover, capital mobility is high and there is high trade intensity between the member countries. There is data confirming that intra-Europe trade has doubled after the introduction of the euro. Finally, the last criterion refers to the transfer of money between areas. Despite the fact that Stability and Growth Pact (SPG) has not been enforced, in reality it eliminates the possibility of such transfers because there is a no “bail-out” clause in the SPG. Looking closely to all the aspects of the European economy, there is evidence that the markets have become better integrated but it is impossible to say whether the eurozone members benefit from the currency area since there are both advantages and disadvantages and since not all of the criteria are being met.
There are several problems that the EMU may face in the coming years. First of all, asymmetric economic development of the member countries may be hard to handle through a single monetary policy. Moreover, one of the reasons why the EMU was created was to create a political union. As countries may have different macroeconomic needs, it might be difficult to sustain this political harmony that was initially envisioned because of the economic disputes that may arise. A third potential problem may be that the eurozone countries will have a hard time adjusting to economic shocks because of low labor mobility and high unemployment. In addition, even though the Stability and Growth Pact has not been enforced yet, it is possible that in the future constraints on national fiscal policy due to the SGP could be quite “painful due to the absence of fiscal federalism within the European Union” . Finally, due to the expansion of the European Union in 2004 into Eastern Europe and the Mediterranean an agreement has to be reached regarding the ESBC’s governing council. This will be especially tricky because it will be a scheme of rotational representation will have to be adopted and it is difficult to imagine that a country like Germany would be willing to give its place to a significantly smaller one like for example Cyprus.
The ECB has chosen monetary autonomy and the European Union has liberalized its capital markets. As a result, a floating or flexible exchange rate had to be adopted according to the impossible trinity and this accounts for the large fluctuations of the euro against other currencies in general and specifically against the US dollar. Currently, the exchange rate is 1.264 €/$. The lowest exchange rate since its introduction has been 0.8344 €/$ (in 2001) and the highest was reached in 2003 and was 1.3668 €/$. As mentioned earlier, there is a number of currencies pegged to the euro (22 in total). Part of the euro’s strength in the period 2001-2004 was the more attractive interest rates in Europe than in the US and its continuing ascent against the US dollar could be due to the concern over the huge US Current Account deficit. Europe, on the other hand, is in “approximate current account balance” and in 2004 exports amounted to $1.318 trillion while imports amounted to $1.402 trillion (excluding intra-EU trade).
In conclusion, apart from the three countries mentioned earlier, once the conversion period is over the euro will adopted by twenty two member states. The single currency removes the risk associated with exchange rate fluctuations and increases the appeal of investing outside the firm’s or individual’s borders and therefore increases profits. It also removes conversion fees which may seem minimal but when multiplied millions of times, the reduction in transaction costs is enormous. Moreover, deeper financial markets are created, which means that the markets are more liquid and flexible. Since the ECB is solely responsible for the eurozone’s monetary policy, price stability may be maintained and this is a big advantage since much of Europe has been susceptible to economic problems throughout the years. Even though the US dollar is the most important reserve currency, followed by the euro and the Japanese Yen, the euro is rising in importance. One implication of this concerns oil prices. Europe consumes more imported petroleum than the US and there have been discussions about pricing oil in euros. This would mean that nations will be required to hold stores of euros to buy oil instead of US dollars and also that European oil prices will not be dependent on the US/EUR exchange rate any more (the price of oil in the eurozone will follow more closely the world oil price). As previously noted, the eurozone is not an optimal currency area and in the future the EMU will most likely encounter the aforementioned problems.