Economic and Monetary Union EU

Economic and monetary union was a recurring ambition for the European Union from the late 1960s onwards because it promised stability and an environment for higher growth and employment.

However, a variety of political and economic obstacles barred the way. Weak political commitment, divisions over economic priorities and turbulence in international markets all played their role in frustrating progress towards EMU.

Despite these obstacles, the second half of the 20th century saw a constant search by the growing number of EU Member States for deeper economic integration as a means of strengthening the political bonds between them and protecting the common market.

The road towards today’s Economic and Monetary Union and the euro area can be divided into four phases: Phase 1: From the Treaty of Rome to the Werner Report, 1957 to 1970

The international currency stability that reigned in the immediate post-war period did not last. Turmoil on international currency markets between 1968 and 1969 threatened the common price system of the common agricultural policy, a main pillar of what was then the European Economic Community. In response to this troubling background, Europe’s leaders set up a high-level group led by Pierre Werner, the Luxembourg Prime Minister at the time, to report on how EMU could be achieved by 1980. Phase 2: From the Werner Report to the European Monetary System, 1970 to 1979

The Werner group set out a three-stage process to achieve EMU within ten years, including the possibility of a single currency. The Member States agreed in principle in 1971 and began the first stage – narrowing currency fluctuations. However, a fresh wave of currency instability on international markets squashed any hopes of tying the Community’s currencies closer together. Subsequent attempts at achieving stable exchange rates were hit by oil crises and other shocks until, in 1979, the European Monetary System (EMS) was launched. Phase 3: From the start of EMS to Maastricht, 1979 to 1991

The EMS was built on exchange rates defined with reference to a newly created ECU (European Currency Unit), a weighted average of EMS currencies. An exchange rate mechanism (ERM) was used to keep participating currencies within a narrow band. The EMS represented a new and unprecedented coordination of monetary policies between the Member States, and operated successfully for over a decade.

This success provided the impetus for further discussions between the Member States on achieving economic and monetary union. At the request of the European leaders, the European Commission President, Jacques Delors, and the central bank governors of the EU Member States produced the ‘Delors Report’ on how EMU could be achieved. Phase 4: From Maastricht to the euro and the euro area, 1991 to 2002

The Delors Report proposed a three-stage preparatory period for economic and monetary union and the euro area, spanning the period 1990 to 1999. Preparations involved: Stage 1: completing the internal market (1990-1994), namely through the introduction of the free movement of capital; Stage 2: preparing for the European Central Bank (ECB) and the European System of Central Banks (ESCB), and achieving economic convergence (1994-1999); and Stage 3: fixing exchange rates and launching the euro (1999 onwards).

European leaders accepted the recommendations in the Delors Report. The new Treaty on European Union, which contained the provisions needed to implement EMU, was agreed at the European Council held at Maastricht, the Netherlands, in December 1991. This Council also agreed the ‘Maastricht convergence criteria’ that each Member State would have to meet to participate in the euro area.

After a decade of preparations, the euro was launched on 1 January 1999. At the same time, the euro area came into operation, and monetary policy passed to the European Central Bank (ECB), established a few months previously – 1 June 1998 – in preparation for the third stage of EMU. After three years of working with the euro as ‘book money’ alongside national currencies, euro coins and banknotes were launched on 1 January 2002 and the biggest cash changeover in history took place.

Phase 1: the Werner Report
The 1957 Treaty of Rome has little to say about money. This is because the post-war order for the market economies of Europe, North America and Japan was founded on the Bretton Woods system which provided the international framework for currency stability, with gold and the US dollar as the predominant monetary standards. From the Treaty of Rome to the Werner Report, 1957 to 1970

The authors of the Treaty of Rome therefore assumed that stable currencies would remain the norm, and that Europe’s construction could be securely based on achieving a customs union and common market allowing the free movement of goods, services, people and capital.

Currency turmoil strikes in the late 1960s

The Bretton Woods system had already begun to show signs of strain in the late 1950s, and by 1968-69, a new era of currency instability threatened when market turbulence forced a revaluation of the German mark and devaluation of the French franc. This endangered the stability of other currencies and the common price system of the common agricultural policy – which was, at that time, the main achievement of the European Community.

The Community seeks economic prosperity and political development in EMU

Against this troubling background, and with the customs union largely achieved, the Community was anxious to set itself new goals for political development during the next decade. The 1969 Barre Report, which proposed greater economic coordination, brought new impetus, and Economic and Monetary Union became a formal goal at a summit in The Hague in 1969. Europe’s leaders set up a High Level Group under the then Luxembourg Prime Minister Pierre Werner to report on how EMU could be achieved by 1980.

The Werner Report – EMU in three stages

The Werner group submitted its final report in October 1970, setting out a three-stage process to achieve EMU within a ten-year period. The final objective would be the irreversible convertibility of currencies, free movement of capital, and the permanent locking of exchange rates – or possibly a single currency. To achieve this, the report called for closer economic policy coordination, with interest rates and management of reserves decided at Community level, as well as agreed frameworks for national budgetary policies.

Phase 2: the European Monetary System
While the Member States were divided over some of the Werner Report’s main recommendations, in March 1971, they agreed in principle on a three-stage approach to European Monetary Union. The creation of the European Monetary System in 1979 laid the foundations for a new era of monetary co-operation. From the Werner Report to the European Monetary System, 1970 to 1979

The first stage, narrowing of exchange-rate fluctuations, was to be tried on an experimental basis without any commitment to the other stages. Unfortunately, the Werner strategy took for granted fixed exchange rates against the dollar. When the USA effectively floated the dollar from August 1971, the ensuing wave of market instability put upward pressure on the Deutschmark and squashed hopes of tying the Community’s currencies more closely together.

Snake in the tunnel

To retrieve the situation, in March 1972, the Member States created the ‘snake in the tunnel’. This was a mechanism for managing fluctuations of their currencies (the snake) inside narrow limits against the dollar (the tunnel). Hit by oil crises, policy divergence and dollar weakness, within two years the snake had lost many of its component parts and was little more than a German-mark zone comprising Germany, Denmark and the Benelux countries.

Interest remained strong

The quick ‘death’ of the snake did not diminish interest in trying to create an area of currency stability. A new proposal for EMU was put forward in 1977 by the then president of the European Commission, Roy Jenkins. It was taken up in a more limited form and launched as the European Monetary System (EMS) in March 1979, with the participation of all Member States’ currencies except the British pound, which joined later in 1990 but only stayed for two years.

The European Monetary System was built on the concept of stable but adjustable exchange rates defined in relation to the newly created European Currency Unit (ECU) – a currency basket based on a weighted average of EMS currencies. Within the EMS, currency fluctuations were controlled through the Exchange Rate Mechanism (ERM) and kept within ±2.25% of the central rates, with the exception of the Italian lira, the Spanish peseta, the Portuguese escudo and the pound sterling, which were allowed to fluctuate by ±6%. In August 1993, these bands were widened to 15% in order to counter speculative pressures, but by 1996 all currencies had moved back to their original fluctuation margins.

The system included an intervention mechanism and a preventive tool – once the exchange rate of a currency reached 75% of the maximum fluctuation margin authorised, the currency was considered as ‘divergent’ and the country had to take remedial action through interest rates and fiscal policy adjustments. In the event of the maximum fluctuation margin being reached, central banks had to intervene by buying or selling the currency to avoid the margin being exceeded.

The EMS was a radical new departure because exchange rates could only be changed by mutual agreement between participating Member States and the Commission – an unprecedented pooling of monetary sovereignty.

Phase 3: the Delors Report
While the European Monetary System’s main goal was to reduce exchange-rate instability – which damages trade, investment and economic growth – its creation was helped by a new consensus among Member States that controlling and reducing inflation had to become an economic priority. From the start of the European Monetary System to Maastricht – a decade of success

In the first few years, there were many currency realignments in the European Monetary System (EMS). But by the time of the negotiations on the Maastricht Treaty in 1990-91, it had proved a success. Short-term volatility of exchange rates between European Community currencies was substantially reduced, thanks to a mixture of converging inflation rates, and interest rate management which targeted the exchange rate.

This success formed an encouraging backdrop to the discussions on EMU, as did the valuable experience in the joint management of exchange rates gained by the Community’s central banks.

The single currency would complete the single market

The case for EMU turned on the need to complete the single market, the programme adopted in 1985 for removing all remaining barriers to the free movement of goods, services, people and capital. It was clear that the full benefits of the internal market would be difficult to achieve with the relatively high business costs created by the existence of several currencies and unstable exchange rates.

In addition, many economists and central bankers took the view that national monetary autonomy was inconsistent with the Community’s objectives of free trade, free capital movements and fixed exchange rates. For many, this view was later confirmed by the turmoil which hit the ERM in 1992-93, causing the withdrawal of the Italian lira and the pound sterling, and the widening of the fluctuation bands to 15%.

The Delors Report recommended EMU in three stages

In June 1988, the European Council meeting in Hanover, Germany, set up the Committee for the Study of Economic and Monetary Union, chaired by the then President of the Commission, Jacques Delors, and including all EC central bank governors. Their unanimous report, submitted in April 1989, defined the monetary union objective as a complete liberalisation of capital movements, full integration of financial markets, irreversible convertibility of currencies, irrevocable fixing of exchange rates, and the possible replacement of national currencies with a single currency.

The report indicated that this could be achieved in three stages, moving from closer economic and monetary coordination to a single currency with an independent European Central Bank and rules to govern the size and financing of national budget deficits.

The three stages towards EMU
Stage 1 (1990-1994)
Complete the internal market and remove restrictions on further financial integration.

Stage 2 (1994-1999)
Establish the European Monetary Institute to strengthen central bank co-operation and prepare for the European System of Central Banks (ESCB). Plan the transition to the euro. Define the future governance of the euro area (the Stability and Growth Pact). Achieve economic convergence between Member States.

Stage 3 (1999 onwards)
Fix final exchange rates and transition to the euro. Establish the ECB and ESCB with independent monetary policy-making. Implement binding budgetary rules in Member States.

And so to Maastricht

On the basis of the Delors Report, the Madrid European Council of June 1989 decided to proceed to the first stage of EMU in July 1990, and the 1989 Strasbourg European Council called for an intergovernmental conference to determine the Treaty revisions that would be needed to move to the second and third stages and implement EMU.

The first stage of EMU involved completing the internal market, starting with the coordination of economic policies and removing obstacles to financial integration. For the following stages, substantial preparatory work by central bank governors greatly eased the work of revising the Treaty.

The heads of state and government at the European Council at Maastricht in December 1991 approved the Treaty on European Union in which it was decided that Europe would have a stable single currency by the end of the century.