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History of the Euro

by J. Orlin Grabbe

"I just want to be good."--Little Alex (Malcolm McDowell) in Stanley Kubrick's A Clockwork Orange.
The "euro" is the name of the proposed single currency of the European Community. Essentially the euro is simply the ECU renamed, since ECUs will be exchangeable one-for-one for new euros. The ECU is currently the basis for the European Monetary System.

ECU stands for European Currency Unit, but is pronounced "EK-you", after the name of an old French coin with an equivalent spelling. The ECU is defined in terms of pieces of European currencies, making it a composite, or basket, currency in origination. Since its creation it has become a currency of denomination for eurobonds and bank certificates of deposit, among many other uses.

It is not yet decided whether the conversion of ECUs to euros will take place at the market ECU value, or at the ECU value fixed on paper (calculated from "ECU central rates"). Logically market rates would be used for the conversion. But if central rates are used the conversion is still straight forward. Suppose at conversion time the ECU trades for $1.10 in the market, while the value of the component currencies at ECU central rates is $1.08. Then it is obvious that 1 market ECU = 1.10/1.08 = 1.0185 central rate ECUs. And a euro would cost $1.10 if euros were exchangeable one-for-one with market ECUs, or $1.08 if euros were exchangeable one-for-one for central rate ECUs. The net effect is that "ECUs" will have been replaced with "euros".

When the European Monetary System was launched on March 13, 1979, the system was based on average behavior of the participant countries of the European Community. Average was good; too much departure from average was bad. If the community average was 5 percent inflation, then a country with either 0 percent inflation or 10 percent inflation would cause strains in the system. All this economic coordination took place through a country's exchange rate. A country was on track just as long as its exchange rate with respect to the ECU did not depart too much from a fixed value--the ECU central rate. (Details of this mechanism may be found in Chapter 2 and Chapter 22, International Financial Markets, 3rd edition, by J. Orlin Grabbe.) The Maastricht Treaty added additional criteria other than exchange rates.

The Maastricht Treaty was finally approved (through a subterfuge) by the remaining holdout, Denmark, in May 1993. The Treaty set out three stages of further transition to monetary union between participant countries of the European Community. The first stage was to have been completed by Jan. 1, 1994, and involved the elimination of "all restrictions on the movement of capital between Member States, and between Member States and third countries". This goal was not actually achieved.

The second stage began on Jan. 1, 1994, with the creation of the European Monetary Institute (EMI) in Frankfurt, Germany. The EMI was a precursor to a proposed European Central Bank, which in the future is supposed to implement a common European monetary policy, conduct foreign exchange operations, hold reserves of member countries, and promote smooth payment mechanisms. The goals of the EMI itself were more modest. The EMI was supposed to hold the gold and foreign exchange reserves, and oversee the operation, of the European Monetary System, and to promote the use of the ECU and an ECU clearing system.

How to Be Good

Meanwhile, the EMI is also supposed to monitor some other economic convergence criteria among member countries, which included not only exchange rates, but also inflation, government debt, and interest rates. To be "good", and thus to be allowed to joined the new monetary union in 1999, countries need to have done the following by end 1997:

  • to have kept its currency within the normal margins around its fixed value in terms of the ECU and to have not devalued against any other member country for two years;

  • to have "price stability", which is defined as having a rate of inflation of the consumer price index not more than 1.5 percent points about the three member countries with the lowest inflation rates;

  • to have a government deficit that is not "excessive", which is defined as a) a government deficit that doesn't exceed 3 percent of yearly gross domestic product; and b) the value of outstanding government debt doesn't exceed 60 percent of yearly gross domestic product;

  • to have long-term interest rates (ten-year government bond rates) not more than 2 percent above the three member countries with the lowest rates of inflation.
  • Except for the criteria on government debt, each of these again rests on the concept of an average. But meeting the criteria has led to considerable activity in the area of government statistics fudging. How much fudging is allowed is up to the EMI and the European Commission to decide.

    For example, France (much like the U.S. in another context) counted a current pension fund "surplus" as government income, thus reducing the calculated government deficit. Of course, just as in the U.S., the current year's "surplus" did not take account of future obligations (on which basis the flow of pension funds was actually insufficient--that is, in deficit). But this hardly matters, since both France and Germany have to be in the union, if it is to take place at all (see history in International Financial Markets). Germany envisions that the new European Central Bank will conduct policy much like the Bundesbank, but the French have other ideas.

    The third stage is supposed to come about on Jan. 1, 1999, at which time countries will irrevocably fix their currencies to the euro (=ECU), after which national currencies will be phased out during a transition period. During transition, the euro and the national currency will circulate side by side. The EMI will be dissolved into a European Central Bank (ECB), which will determine a common monetary policy. Government bonds will be denominated in euros, and some countries, like France, will convert existing debt to euros. The current head of the central bank of the Netherlands, Wim Duisenberg, is expected to become the first president of the ECB.

    During a three-year transition period, 1999-2002, European companies will convert their accounts to euros. Then, in 2002, euro notes and coins will be circulated in the different countries. There will, of course, be much bickering over the use of national symbols (should the queen's head be conjoined with the body of a bird?), or whether coin sizes will fit into national telephones and vending machines.

    Will all this actually happen? The answer is not clear, even this close to the scheduled date. A critical mass of participants is required for anything significant to take place. Luxembourg, for example, fits the bill for monetary union with no problem. But there is strong political opposition to the move in countries like the UK and Denmark. And it will be a cold day in hell before either Italy or Greece meets the convergence criteria.

    Recent years have witnessed a period of unprecedented good will between nations: the fall of the Berlin Wall, the dissolution of the Soviet Union, relative Middle East peace, and so on. One senses, however, that this era of good will is rapidly coming to a close. Looming over the horizon are conflicts between the U.S., China, and Japan, turmoil in Russia, and another war in the Middle East. All these will exert their strains on the European Community and on monetary union.

    The movement toward European unification began with a post-World War II desire of people like Jean Monnet and Robert Schuman to so integrate the economies of Germany and France that they could never go to war again. Early trade agreements led to exchange rate agreements, and these have evolved into agreements on broad economic convergence criteria. The final process of unification, of course, would be integrated defense departments- -a step not currently in the offing.

    Natural Disasters

    One recent focus of attention has been the nature of punishments to be meted out to bad countries. At the European Union (EU) meeting in Dublin in Dec. 1996, it was decided that countries with government deficits too large would not be punished in the event of a "natural disaster" or if gross domestic product (GDP) had a negative growth rate of more than 2 percent. It was observed that among the 15 EU countries, there had only been negative growth rates that large in 13 instances in the last 30 years (i.e. in 13 observations out of 450).

    If negative GDP rates are between negative .75 and negative 2.00, then European finance ministers will decide whether a country is to be punished. (There was no determination of what the punishment will be, but public flogging of the finance minister or penalty payments of central bank gold come to mind.)

    A combination of a government deficit larger than 3 percent of GDP combined with a positive GDP growth rate, or a negative growth rate not exceeding .75 in absolute value, would result in automatic punishments. This agreement is seen as a victory for Germany, as France wanted maximum political discretion to punish or not to punish.

    Coming Soon: "The End of Ordinary Money, Part III: Anonymous Digital Cash in Theory and Practice".

    February 1, 1997
    Web Page: http://www.aci.net/kalliste/