In January 2002, euro notes and coinsentered circulation and the single currencybecame a reality. This event represented thefinal stage in a long journey and the realisa-tion of one of the ‘big ideas’ of Europeanintegration. The journey has not beenwithout incident. It got off to a false start viathe thwarted plans of the 1970 WernerReport which had envisaged full EMU by1980. Attempts to forge closer monetarylinks subsequently encountered severe diffi-culties in the early 1990s with the crises inthe ERM, EMU’s predecessor. Although its

launch has largely been successful, EMU andthe single currency continue to face manychallenges, including the need for eurozonemembers to undertake economic reforms to enable the currency to operate smoothly;the management of relations with EUmembers outside the eurozone and theabsorption of new members, especially from2004 accession states.

This chapter addresses the above chal-lenges by first exploring the nature of EMUand the single currency and the conditionsthat need to be met for it to succeed. Second,

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Economic and monetary unionAn unfinished project

I want the whole of Europe to have one currency; it will make trading much easier.Napoleon, in a letter to his brother, Louis, dated 6 May 1807

This chapter will help you understand:

■ how and why the single currency came into existence;

■ the nature of EMU and the risks and benefits associated with it;

■ the conditions which EMU requires to work and why these require fundamental reforms

by eurozone members;

■ the impact of the eurozone on the European business environment;

■ why the UK, Denmark and Sweden remain outside the eurozone;

■ the status and strategy of the 2004 accession states in relation to EMU.

the chapter briefly sets out how the EUarrived at its advanced stage of monetaryintegration, followed by an explanation ofwhy it embarked upon such an ambitiouspath and of the risks attached to such a courseof action. This process also reveals how EMU and the single currency have changedthe business environment. The chapter then discusses the challenges facing the single currency. It concludes by drawing togetherthe various strands in a tentative outlook for the project.

WHAT IS EMU?

A key part of the Treaty of Rome was thecreation of a common market but it con-tained no explicit commitment to the objec-tive of economic and monetary union.However, EMU is the possible, albeit notinevitable, next stage of integration after acommon or single market (see Chapter 2).Indeed, the existence of separate nationalcurrencies is regarded by some as one of the remaining barriers to the attainment of a barrier-free single market. Moreover, as interdependence increases with the freemovement of goods, services, capital andlabour so the logic of increased commonrules in areas such as competition policy andgreater economic coordination and coopera-tion increases to the extent that separateeconomies and markets are melded together.Furthermore, in a highly interdependentmarket, the logic for monetary union in-creases to ward off the possibility of diver-gent monetary policies distorting andundermining the benefits of interdependenceor of competitive policies setting off infla-tionary pressure.

EMU, therefore, embraces the followingcharacteristics:

■ policy harmonisation to remove obstaclesto factor mobility. This corresponds tothe achievement of the four freedoms(mobility of capital, services, goods andlabour) – the heart of the SEM and ofStage one of EMU (see below);

■ a more marked and wider range ofcommon policies, especially in relation tomacro-economic policy;

■ irrevocably fixed exchange rates or, as inthe case of the EU, a single currency;

■ a common monetary policy – that is, oneinterest rate and exchange rate policydetermined by a single central bank;

■ some pooling of foreign exchangereserves;

■ possible inter-state transfers to offseteconomic distortions arising from EMU.

The above characteristics are essentiallytechnocratic and economic in nature butEMU also has a highly controversial politicaldimension. At a minimum, EMU implies asurrendering, or pooling, of sovereignty incertain areas of policy making, namely thenational determination of interest rates andof exchange rate policies and the acceptanceof constraints in the exercise of macro-economic policy. It also requires politiciansto undertake the frequently unpopularpolicies needed to qualify for membership ofEMU and, in the longer term, to introducethe structural reforms needed to ensure thattheir economies can thrive within EMU and that EMU itself runs smoothly. Althoughmany current eurozone members showedtremendous political commitment in meet-ing the eligibility criteria for eurozonemembership by restraining public spendingand other deflationary measures, for exam-ple, it is the reluctance of some of the largermember states, in particular, to embark uponmore fundamental structural reforms in their

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economies that is potentially building up seri-ous problems for EMU (see below). More-over, EMU inevitably gives rise to a broaderpolitical debate about how far economic andmonetary union spills over into the need forgreater political unity among its members,the future role and nature of the EU in generalor, indeed, whether political union shouldprecede monetary union for EMU to work.These questions underpin some of the Britishpopulation’s concerns about the euro –despite the efforts of pro-euro campaigners atleast to keep it as an essentially economicissue (see Case Study 8.1, p. 180).

The above factors may characterise EMUbut they do not in themselves determinewhether the EU is a suitable grouping forlaunching EMU. The theory of optimum cur-rency areas (OCAs) sets out the conditionsthat should prevail if two or more countriesare to give up their separate currencies andreplace them with a single currency. A highlevel of interdependence through trade andcapital flows is clearly necessary but accordingto Robert Mundell, the originator of OCAtheory, three further conditions must be sat-isfied for a common currency to be beneficial:

1 There should be an absence, as far aspossible, of asymmetric shocks – that is,external economic shocks that affect indi-vidual members of the EMU in a differen-tial manner. The greater the degree of economic convergence among participat-ing states, so the likelihood of asymmetricshocks diminishes. Such shocks become aproblem within EMU systems because ofthe centralisation of interest rate andexchange rate policies.

2 A high degree of labour mobility andwage flexibility is needed. so that whenshocks do occur, individual economieswithin the union are able to adjust vialabour migration or changes in wages

given they can no longer rely on changesin autonomous national monetary policyto correct for economic imbalancesbetween countries.

3 A centralised fiscal policy which can re-distribute resources to member countriesperforming poorly should be in place.

This raises the question of whether theeurozone meets the criteria of an OCA. Theprocess of European integration prior toEMU has increased cultural, economic andpolitical links among European countries butsignificant differences remain (see Chapter1). There are strong regional sub-groupingswithin the EU: Finland, for example, hasmore in common and greater linkages withits Nordic and Baltic neighbours than withthe countries of Southern Europe and viceversa. The 2004 generation of member states that are striving to meet the eligibilitycriteria of EMU may also find themselves inan asymmetric conundrum. Their long-termmajor economic objective is to ensuremacro-economic convergence with oldermember states. In order to achieve this, theireconomies must grow substantially morequickly than those already in the eurozone. Inorder to meet the Maastricht convergencecriteria (see below), deflationary measuresmay be necessary to contain their budgetarydeficits and the inflation their buoyant econ-omies may unleash but which is not neces-sarily a serious problem at their stage ofdevelopment. Once in the eurozone, theseconstraints will persist. Despite this potentialfor asymmetries among EMU members, themore closely the countries integrate, throughthe SEM and other policies, including EMU,the greater the level of interdependence andsynchronisation of business cycles which,although not totally removing the possibilityof asymmetric shocks, significantly reducestheir power to undermine EMU.

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The eurozone scores less well in terms of labour mobility and wage flexibility.Although the SEM has played its part inreducing barriers, obstacles to the freemovement of labour, including high culturaland language barriers, remain. Labour mar-kets in some member states remain highlyregulated and generally inhibit the ability of labour markets to adjust to compensatefor the absence of differentiated monetarypolicy. Moreover, although OCA theoryemphasises the need for labour market flexi-bility as an adjustment tool, the mobility ofgoods, service and capital plus the SEM alsogenerally facilitate the workings of EMU.Capital is highly mobile throughout the EU and the single market in most goods andservices, although far from perfect (seeChapter 4), has made significant progress inthe 1990s.

The EU also lacks any strong centralredistributive element to compensate fortensions within the eurozone. Its budget istiny compared to those of member statesand, although the Cohesion and StructuralFunds are intended to bring about somedegree of redistribution, member state resist-ance to increasing the EU budget and to itstax-raising powers means the prospect of theEU taking on this role in any meaningful wayremains distant.

In short, on a theoretical level at least, theprospects for EMU within Europe do notappear bright. However, the political com-mitment of member states to launch EMUwas underestimated by many and, havingmade that commitment, presumably the willto make it work should not be underesti-mated either. However, there are signs thatsome member states are shying away fromthe unpopular reforms needed in their econ-omies to make EMU work, potentiallycausing problems for the project in the longterm (see below).

THE ROAD TO EMU

The final realisation of the single currency in2002 – when euro notes and coins came intocirculation – was the third modern-day at-tempt at European monetary integration. Thefirst began in 1969 when the Hague Summitstrove to relaunch the process of Europeanintegration by, among other things, introduc-ing EMU by 1980. This objective was rein-forced by the Werner Report, adopted by the EU in 1971, and resulted, in 1972, in the‘snake in the tunnel’ – an adjustable fixedexchange rate system in which member cur-rencies fluctuated within a margin of ±2.25per cent against the US dollar in a systemadministered by the European MonetaryCooperation Fund (EMCF). The upheaval ininternational financial markets that led to theend of the post-war Bretton Woods financialagreement and to inflation and high unem-ployment in the industrial world dealt a fatalblow to any serious attempts to meet the 1980EMU deadline.

The second attempt at European mone-tary integration was the EMS, which wasestablished in 1979 and formed the back-bone of European monetary arrangementsuntil the creation of EMU. The EMS was notintended to lead to EMU but to create a‘zone of monetary stability’ – that is, to actas an anti-inflationary anchor in a worldincreasingly beset by inflationary problems.The ERM was a key part of the EMS: partici-pation in the ERM required members tomaintain their currency within specified fluc-tuation margins of ±2.25 per cent either sideof the ecu central rates. Higher inflationcountries such as Italy were permittedfluctuations of ±15 per cent. The ecu, orEuropean currency unit, was a basket of cur-rencies participating in the ERM, with eachcurrency weighted according to its role inintra-EU trade.

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MILESTONES IN THE DEVELOPMENT OF THE SINGLE CURRENCY

1969 Hague Council calls for EMU by 1980

1970 Werner Report endorses the goal of EMU by 1980

Mar. 1972 Currency snake launched

April 1973 European Monetary Cooperation Fund (EMCF) established to provide

financial support to maintain stable exchange rates

1979 EMS, including the ERM, founded to create a ‘zone of monetary stability’

within Europe

1989 Delors Report proposes a three-stage approach to EMU and is adopted by the

Madrid Council in June

July 1990 Stage one of EMU begins

Oct. 1990 UK joins ERM

Dec. 1991 European Council approves the Maastricht Treaty which establishes a three-

stage timetable to achieve EMU. The UK and Denmark secure an ‘opt-out’

from Stage three

Sept. 1992 ‘Black Wednesday’ – UK sterling and the Italian lira suspend membership of

the ERM following massive speculation

Aug. 1993 Normal fluctuation band widened from 2.25 per cent to 15 per cent either side

of the central parity of currencies within the ERM

Jan. 1994 Stage two of EMU begins with the establishment of the European Monetary

Institute (EMI) – successor to the EMCF and forerunner of the ECB

Dec. 1995 Madrid Council confirms 1 January 1999 as the start of Stage three of EMU

Dec. 1996 Dublin Council agrees the terms of the Stability and Growth Pact

Oct. 1997 UK Chancellor of the Exchequer, Gordon Brown, commits the UK ‘in principle’

to eurozone membership and sets out five economic tests that must be

satisfied before Britain joins

May 1998 Brussels Council decides 11 member states (Belgium, Germany, Spain,

France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and

Finland) are eligible for adoption of the euro

Jan. 1999 Stage three of EMU begins with the ‘irrevocable fixing’ of the conversion

rates between participating currencies. The European System of Central Banks

(ESCB) starts to conduct a single monetary and foreign exchange policy and

electronic trading in euros begins

Sept. 2000 The Danish people vote against joining the euro by 53.1 to 46.9 per cent

Jan. 2001 Greece joins the euro

Jan. 2002 Euro notes and coins enter circulation in 12 member states. Initially in ‘dual

circulation’ alongside national currencies, the euro becomes the sole

currency by the end of February

June 2003 Gordon Brown announces that the UK only passes one of his five economic

tests and rules out UK membership for the foreseeable future

Sept. 2003 Sweden votes in referendum against joining the euro by 56.2 per cent to 41.8

per cent

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Currency realignments were permitted toreduce tension in the system. In the ERM’sinitial phase, states persistently devaluedwithin the system and its ability to act as adisciplinary device to promote convergencein terms of key monetary indicators (that is,inflation and interest rates) was severely cur-tailed. By the mid- to late 1980s, the ERMhad become more credible as a means ofdelivering convergence as member statesshowed a greater commitment to its rulesand procedures. Consequently, inflation andinterest rates converged and membership ofthe ERM expanded to include all EU statesbar Greece. However, as the ERM expanded,tensions within the system grew: as theeffects of the early 1990s’ recession andGerman reunification took hold, the policyrequirements and preferences of statesstarted to diverge. Typically, some states hadunemployment problems whereas others hadinflationary difficulties. Such differencescould not be sustained within the ERMframework and, in September 1992, the UKand Italy left the ERM. Instability continuedwith the Spanish, Portuguese, Irish andFrench currencies proving particularly vul-nerable and in August 1993, the fluctuationbands were widened to ±15 per cent wherethey have remained.

The timing of the crisis was unfortunate asthe EU had just committed itself in theMaastricht Treaty to a progressive move toEMU by the end of the decade. For the more

sceptical states, the crisis reinforced a beliefthat moves towards EMU were prematurewhereas, for the more Europhile states, thecrisis confirmed their view that, in a world offree capital movements, a single currencywas the best way to achieve the desiredcurrency stability. Economic problems werecompounded by political uncertainty arisingfrom the rejection of the treaty by the Danishreferendum and the unwillingness of theBritish to sign. The upshot was opt-outclauses for both the UK and Denmark whichallowed both countries to refrain indefinitelyfrom adoption of the single currency.

The Maastricht Treaty resulted from theresurgence of the integration begun by theSEM campaign. By 1988, a committee hadbeen established under Commission Presi-dent Jacques Delors to consider the issue ofEMU and the steps needed to achieve it. Theresult was the 1989 Delors Report which fed directly into the Maastricht Treaty. Thetreaty, among other things, set out thetimetable, the eligibility criteria for EMUmembership and details of the institutionsand framework of rules for EMU. Thetimetable comprised three stages:

■ Stage one, which began on 1 July 1990,required the removal of all remainingobstacles to capital flows; the participationof all member states’ currencies in theERM and greater policy coordination andconvergence of economic performance.

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Nov. 2003 Effective suspension of the Stability and Growth Pact (SGP) following

persistent breaches of the budget rules by France and Germany

June 2004 Estonia, Lithuania and Slovenia join ERM II

Mar. 2005 Terms of the revised SGP agreed

April 2005 Cyprus, Latvia and Malta join ERM II

Nov. 2005 Slovakia joins ERM II

■ Stage two, which began on 1 January 1994,involved the creation of the EMI, a transitional institution intended toprepare the EU for Stage three when itwould be replaced by the ECB. Duringthis stage, any central bank that was notalready independent of its national gov-ernment, was to become independent.

■ Stage three (to begin either on 1 January1997 or 1 January 1999) began with theirrevocable fixing of participating curren-cies. The ESCB, composed of the ECBand independent national banks, tookover responsibility for monetary andexchange rate policy.

In practice, insufficient member stateswere adjudged to be ready for EMU by1997. In May 1998, amid some degree ofcynicism and accusations of creative account-ing, the European Commission declared that11 states met the necessary conditions toadopt the euro on 1 January 1999. It wasclear that not all states would meet a strictinterpretation of the nominal criteria out-lined within the treaty. However, theCommission decided that as long as the cri-teria, especially those for public finances,were moving in the right direction, thenmembership could go ahead. Only Greecewas excluded for economic reasons. Theothers – Denmark, the UK and Sweden –remained outside EMU, largely for politicalreasons.

The decision to maximise the number ofstates within the initial moves towards EMU,despite their apparent deviation from theMaastricht targets, derives largely frompolitical expediency (notably so in the case of Italy) and recognition that the level of benefits from EMU are directly linked to thesize of membership. In addition, an improv-ing general economic environment would,according to the Commission, eventually

eliminate deviations from the targets. More-over, Greece made strenuous efforts toreduce inflation and its budget deficit andjoined the eurozone in 2001 – in time for theentry of notes and coins into circulation.Within three years, it became apparent thatGreece’s last-minute qualification for euro-zone membership was due more to an imag-inative interpretation of key economicstatistics rather than a sudden conversion tomonetary and fiscal discipline. This disclo-sure, although overshadowed by the SGPcontroversies (see below), could become anembarrassment when it comes to assessingthe preparedness of the 2004 accession statesfor eurozone membership.

In addition to establishing a timetable forEMU, the Maastricht Treaty set out the con-ditions (generally known as the ‘convergencecriteria’) with which member states mustcomply to be considered eligible for eurozonemembership. The ultimate success of EMUdepends upon convergence between memberstates in terms of economic development and performance. The endpoint of the con-vergence process is a state of ‘cohesion’between states. This does not imply uniformeconomic development and performance –merely harmonious economic conditions.Convergence comprises three distinct, yetultimately related, processes – nominal, realand institutional convergence:

1 Nominal convergence. This is convergence interms of macro-economic performance asindicated by core fiscal and monetary vari-ables and is the form of convergence referredto within the Maastricht Treaty. In practice,there is little economic rationale for theMaastricht criteria other than to prove thatstates can live with, and are committed to,what are essentially criteria for sustainingprice stability. Thus entry into EMU requiresstates to meet the following criteria:

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■ budget deficits must be no more than 3per cent of GDP;

■ government debt must be no more than60 per cent of GDP;

■ interest rates must be no more than twopercentage points above the average ofthe three ‘best’ performing states;

■ inflation rates must be no more than 1.5percentage points above the average ofthe three best performing states;

■ states must demonstrate exchange ratestability by maintaining their currencywithin the normal band of the ERM for atleast two years prior to entry.

Although Stage three has been launched,these convergence criteria remain importantfor two reasons. First, the budget and debtcriteria remain at the heart of the SGP whichis intended to provide the framework forcontinued fiscal discipline once EMU is oper-ational. Second, EU members outside theeurozone wishing to become members of theeurozone must also meet the convergencecriteria. Given that the first incarnation ofthe ERM effectively disappeared upon thelaunch of Stage three, ERM II was set up asan exchange rate waiting room for prospec-tive EMU entrants. Within one year of acces-sion, six out of the ten new member stateshad become members of ERM II, raising thepossibility of adoption of the euro by 2007 bysome of them at least.

2 Real convergence. Eligibility for EMU mem-bership rests entirely on compliance with the conditions for nominal convergence.However, in the longer term, it is the degreeof real convergence that will determine thesuccess of the eurozone. Real convergenceimplies that levels of unemployment andindustrial and economic developmentbetween states should broadly approximate.While there are no set criteria, certain coreindicators need to converge to ensure that

harmony can be established within the man-agement of a single currency. For example,vast differences in unemployment betweenstates could imply differing policy prioritiesbetween constituent parts of EMU. The EUsought to strengthen real convergence byincluding provisions for a Cohesion Fundwithin the Treaty upon European Union butthe burden for achieving real convergencefalls mainly on the willingness of individualmember states to undertake often unpopularstructural reforms, particularly in the field oflabour market flexibility.

3 Institutional convergence. The move towardsEMU also implies increasing uniformity interms of economic management. The mostobvious form is to achieve a consensusbetween states around the priorities of eco-nomic policy (namely, low and stable infla-tion). As part of the commitment towardsthis policy objective, potential members alsohave to guarantee the independence of thenational central bank.

Achieving nominal convergence by 1999 wasa core political objective for many memberstates. The monetary criteria did not posemuch of a problem as they had been providedfor within the existing framework pro-vided by the ERM. The fiscal policy criteriaproved more problematic. In the short term, the fiscal retrenchment necessitated by efforts to meet the criteria magnifiedEurope’s unemployment problem and cre-ated a fear that the nominal convergencecriteria could lock Europe into permanentmass unemployment.

BENEFITS AND RISKS OF EMU

Given the difficulties involved in establishingeligibility for eurozone membership, it ispertinent to ask why 12 EU members went

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ahead with the project and why the ten 2004accession states are striving to follow suit.The potential benefits of eurozone member-ship and the potential costs/risks associatedwith the eurozone are set out in Box 8.2.Many of these are difficult to quantify.Where they have been assessed, the gains donot appear to be particularly great. In thecase of transactions costs, for example, it isestimated that EMU saves some 0.5 per centof the EU’s GDP. These relatively small ben-efits are also unevenly spread: smaller stateswith a higher dependence upon intra-EUtrade will benefit the most. In practice, manyof the gains from EMU will only be realisedover the medium to long term (for example,through greater price stability stimulatinghigher levels of investment).

These effects are also unevenly spreadacross businesses. The biggest beneficia-ries are those enterprises that derive thehighest proportion of their revenues fromforeign markets. Thus, larger enterprises are expected to benefit more from EMU.

These benefits will extend to large non-EUcompanies with extensive investmentsthroughout the EU. However, not all largecompanies will benefit. Enterprises with astrong domestic market (such as utilities) willseemingly gain little until their markets startto exhibit a greater degree of international-isation. For SMEs, the impact is difficult topredict. Although many SMEs have a strongtendency to serve local markets, there are anumber with a high export focus (such as ITcompanies) which can expect to benefit fromthe introduction of the euro.

Despite nearly a decade of the SEM, therestill remain large price differentials for manyproducts between states (see Chapter 4). Formany businesses, EMU should speed up priceconvergence through enabling consumers tocompare prices across member states moreeasily because of enhanced price transpar-ency. This transparency will extend to wagesand other labour costs which some tradeunions hope will lead to EU-wide collectivebargaining – a hope which, as yet, remains

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THE COSTS AND BENEFITS OF EMU

Costs Benefits■ short-term deflation ■ elimination of transaction costs in

■ loss of the exchange rate as a tool of intra-EU trade

national economic policy ■ lower interest rates

■ potential problems related to a lack of ■ removal of exchange rate uncertainty

‘real’ convergence and potential policy in intra-EMU trade

conflicts ■ aids development of a genuine SEM by

■ the inappropriateness of one monetary increasing price transparency and

policy for so many states promoting international specialisation

■ removes the option of competitive

devaluations between EU states

■ creates a new international currency to

represent the EU’s combined economic

weight

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largely unfulfilled. Price transparency couldalso change supply patterns as the eliminationof exchange risk and greater transparencywithin the euro area will make it easier forfirms to optimise their sourcing. Price trans-parency should also lead to price conver-gence within sectors such as banking,financial services, cars, chemicals and phar-maceuticals. However, complete price con-vergence will not occur because of continu-ing differences in transport costs, spatialvariations in tastes and preferences, the costsof cross-border shopping, local cost differ-ences and different competitive situations.Overall, however, the EU market shouldexhibit less fragmentation with international-isation of markets affecting an increasingnumber of enterprises (regardless of size) aseach is more able to sell its goods to a moregeographically dispersed market. This processwill be enhanced as inter-state direct mail ande-commerce become more widespread.

In practice, many of the positive and neg-ative aspects of EMU will only manifestthemselves over the medium to long term.Advocates of the process play up the fact thatthe benefits of EMU are directly linked to itssize. As EMU membership expands, so thebenefits to European business will grow.Opponents regard EMU as primarily a political exercise with negligible economicbenefits. However, the core concern has tocome down to whether the states are suffi-ciently similar for them to co-exist with acommon currency.

Further problems could limit the abilityto sustain convergence, including the per-ception that not all EMU states are at thesame stage of the trade cycle – a major reasongiven for the UK’s delayed entry into theEMU (see Case Study 8.1). A classic exampleis Ireland. At the time of its accession in1973, Ireland was the poorest of all Com-munity members in per capita terms.

However, its dynamic growth in the 1990sand beyond has meant that its GDP per headis among the highest in Europe in the mid-2000s and, in the early years of the singlecurrency, a more restrictive monetary policyand higher interest rates than those preferredby Italy and Germany, both struggling withdisappointing growth and unemployment,would have been more suitable for Ireland.In short, it is a legitimate question to askwhether one monetary policy can fit all. Theimplication of a single monetary policy isthat, unless economies are perfectly aligned(which does not happen within let alonebetween states) some countries will have aninappropriate interest rate. Thus, attentionneeds to be paid to how economies can boosttheir factor mobility to balance out such differences and to whether closer integra-tion will help bring these cycles into closeralignment.

A lack of real convergence between statesrepresents the most potentially seriousproblem facing the fledgling EMU. If there is insufficient real convergence, EMU will be subject to asymmetric shocks wherebydifferent parts of the zone will be affected byexternal shocks in markedly different ways(for example, some states could see unem-ployment rise, others could see inflationincrease). If this is the case, a single monetaryand exchange rate policy becomes difficult, ifnot impossible, to sustain. Only if shocks aresymmetric or if there is an adequate responsemechanism (in terms of fiscal transfers orresource mobility and flexibility) to compen-sate for such effects will an EMU work. As none of these conditions exists in the EU,EMU should, in theory, be a non-starter for this group of states. Despite this being a theoretical extreme (all states are them-selves subject to asymmetric shocks or haveinadequate resource mobility or flexibility tocompensate for such effects: for example,

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most states have regional variations in unem-ployment), it does imply that EMU needs tobe accompanied by structural reform oflabour markets.

The move towards EMU highlighted new challenges for policy makers in comple-menting the competitiveness of indigenousenterprises. The option of a competitive de-valuation to secure competitiveness in for-eign markets is explicitly ruled out in termsof trade with other EU states. This placesemphasis upon firms to alter costs and exhibitgreater flexibility if they are to compete suc-cessfully in both European and global mar-kets. Flexibility requires governments to freeup market forces within the European econ-omy in both factor and product markets (see Chapter 13).

THE EARLY YEARS OF EMUAND LOOMING CHALLENGES

The introduction of the euro went rela-tively smoothly. There were complaints

from consumers in some countries that busi-nesses took advantage of the changeover toround up prices (see Chapter 15). Althoughthis undoubtedly took place in someinstances, there was no overall significantimpact on inflation in the eurozone.

When the euro was introduced in January1999, the trend was for a weakening of thecurrency against the dollar (see Figure 8.1)and other currencies. This gave some ammu-nition to Euro sceptics who dismissed theeuro as a weak currency. However, this wasmissing the point. During the first three yearsof its existence, the euro did not have the fullfunctionality of a currency, given that notesand coins did not come into circulation untilJanuary 2002, and was therefore unlikely tooperate as a full-blown currency. Moreover,the euro is a floating currency and its valuecan be expected to fluctuate in line withunderlying economic fundamentals. Fromthe beginning of 2002, the euro steadilystrengthened to reach levels against the dollarthat were above those prevailing at the timeof the euro’s launch. This pattern stemmed

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1.4

1.3

1.2

1.1

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0.9

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Jan.

99 A J O

Jan.

00 A J O

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Figure 8.1 €/US$ exchange rate, January 1999 to May 2005

Source: European Central Bank.

from an inherent weakness in the dollar.However, there is nothing inherently desir-able about having either a weak or a strongcurrency: the former can foment inflationand the latter makes life more difficult forexporters. From the trade and investmentperspective, the best that can be hoped forfrom a currency is that it is neither seriouslyover- nor under-valued and that it remainsrelatively stable. It is excessive volatility thatcreates unpredictability and uncertainty andinhibits trade and investment. This uncer-tainty has so far been removed in the euro-zone and there is no evidence that the floatingeuro is any more volatile than the predeces-sor national currencies.

. . . within the Eurozone

In terms of the transition to the euro and theperformance of the currency since its intro-duction, there is nothing untoward to worryabout. However, fundamental problems arearising from two linked factors:

1 the ineffectiveness of the SGP as abulwark against fiscal profligacy;

2 the unwillingness of some member statesto take the necessary reform measures toensure they can compensate for the loss ofnational monetary policy as the mainpolicy instrument used to correct com-petitiveness problems. In other words,some key economies are putting offunpopular reforms that would help theirmarkets operate more efficiently in linewith the OCA criteria outlined above.

The Stability and Growth Pact(SGP)The move to EMU was based around a con-sensus that low inflation is the primary goalof economic policy. To ensure this priority

is not diluted within EMU (and thus thatstates keep to pre-EMU commitments), inDecember 1996, upon the insistence of the German government, agreement wasreached to sustain the Maastricht fiscal con-vergence criteria after the launch of EMU.That is, budget deficits should remain below3 per cent of GDP and the national debtshould be below 60 per cent of GDP after thelaunch of the single currency. Persistentfailure to comply with the SGP could resultin heavy financial penalties, including finesup to 0.5 per cent of GDP.

The SGP was considered necessarybecause if countries within a monetary unionrun large fiscal deficits, the single capital mar-ket means that financing of this debt will leadto higher interest rates for the whole union.Indeed, monetary union may even encourageexpansionary fiscal policies if member statesperceive that the cost of financing their debtis spread over more countries (this would, ofcourse, only be a rational course of action, ifother countries did not behave in a similarfashion). Moreover, large fiscal deficits cantempt politicians to place pressure on mone-tary authorities, even supposedly indepen-dent monetary authorities, to keep interestrates low – a strategy that would ultimatelythreaten the price stability goal of monetaryunion.

That fiscal discipline is needed in mone-tary union is uncontroversial. Some arguedthat the political capital locked up by respec-tive member states in EMU would be suffi-cient to sustain convergence but experienceand the dangers of free riders resulted inrejection of this option and adoption of the SGP. However, the SGP regime wasregarded by many as too inflexible from thebeginning. For example, the choice of 3 percent and 60 per cent for the budget deficitand debt limits respectively was purely arbitrary. The SGP required member states

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to keep their spending within limits at alltimes despite the strong case for allowingmembers to vary government borrowing as apercentage of GDP throughout the stages ofthe trade cycle. In EMU, fiscal policy is theone macro-economic weapon left to states to manage their economies. If constraints are imposed upon this, then the automaticstabilisers could be severely affected. That is,it is part of the normal corrective process fordeficits to increase during economic slow-downs in line with decreasing tax revenueand increasing expenditure on unemploy-ment and other social benefits, whereasbudget deficits fall when economies prospergiven rising tax revenues and falling socialspending. In other words, to try to keepdeficits below an arbitrary 3 per cent of GDPwhen the economy is in trouble will onlyincrease deflationary pressure. The imposi-tion of fines in such circumstances will alsoonly exacerbate the problems. Such prob-lems could be countered by a strongercentral fiscal and redistributive policy butthis is something that member states willclearly not countenance.

The above concerns about the potentialfor problems with the SGP were quicklyborne out, even causing the then Commis-sion President Romano Prodi to call the pact‘stupid’. Fiscal deficits in Portugal, Franceand, ironically, Germany, the architect of theSGP, rapidly breached the 3 per cent limit.The imposition of penalties on the twobiggest countries in the eurozone was politi-cally difficult and, indeed, the SGP was effec-tively suspended in November 2003 whensufficient members (excluding Spain, theNetherlands, Austria and Belgium) agreednot to proceed further against France andGermany. Despite the European Commis-sion’s victory in July 2004 in its subsequentcase at the ECJ against the finance ministers,the SGP’s shortcomings had been exposed.

The problems with the SGP underminedthe general credibility of EMU. It createdtension within the eurozone itself by em-phasising the small–large country divide. TheNetherlands and Austria, for example, wereangry that they had taken difficult decisions in their attempts to comply with the terms of the SGP whereas France and Germanyappeared to get away with ignoring it. It alsosent contradictory signals to the new memberstates striving to comply with the Maastrichtcriteria ahead of adoption of the euro andwho will thereafter be subject to the SGP.

In March 2005, the heads of governmentreached agreement on revisions to the SGP(see Box 8.3). In general, the changes resultin greater flexibility in the system. The juryis out, however, on whether the relaxation has gone too far and undermined confidencein the fiscal framework of EMU and thesustainability of public finances in eurozonecountries. It is the lack of clarity and theextensive range of ‘relevant factors’ thatmember states can invoke to avoid the excessive deficit procedure that brings in the greatest flexibility – or, in the view of its critics, significantly weakens the pactthrough its numerous exceptions, greatercomplexity and reduced transparency, all ofwhich will make the pact harder to imple-ment. In the short term, the agreementshould reduce the embarrassing politicalrows surrounding the deficits of key EMUmembers like France and Germany but in thelonger term, it remains unclear whether therevised SGP has become so ‘flexible’ that ithas effectively become meaningless.

Economic reform within theeurozone

One of the conditions for a successful EMUis flexible labour and product markets. In theabsence of the devaluation option as the,

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albeit temporary, solution to competitivepressures, flexible markets should be able totake the burden of adjustment. However, therecord of European countries in reducingstructural rigidities in their economies ismixed. Unfortunately for EMU, its threebiggest members – Italy, Germany andFrance – suffer from excessive labour andproduct market inflexibilities and costly,swollen pension, welfare and health systemswhich make it difficult to meet both the fiscalrequirements of EMU and the need for freelyfunctioning markets. In all three cases, polit-ical leaders have attempted to push throughreforms to address these issues but thereforms have not gone far enough and/orhave been amended in the face of theirgeneral unpopularity or looming local ornational elections.

Each of the big three has its own prob-lems. Italy, for example, depends dispropor-tionately on small, specialist manufacturingfirms in sectors such as textiles, furniture,

machine tools, food processing and whitegoods. These industries are relatively lowtech and low skilled, need a low cost base tosustain their competitiveness and, as such,are particularly vulnerable to competitionfrom CEE and Asia, notably China. Othercompetitiveness problems stem from poorinfrastructure in the south, relatively highenergy costs, low levels of R&D spending, a lack of large companies and a preponder-ance of small, family-owned companies with limited tendencies to merge. Italy tradi-tionally maintained its competitiveness bydevaluing the lira. Since 1999, this option hasno longer been available and the need forstructural reform was no longer hidden.

Political pressures have made reformdifficult and they will not become any easier.Nevertheless, the government has madesome reform efforts. In July 2004, parlia-ment passed some pension reforms. Italy hasa particularly acute problem in relation to itsageing population given its low fertility rates,

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THE REVISED STABILITY AND GROWTH PACT

The revisions in the SGP agreed by heads of government in March 2005 were intended to

make the pact more flexible. The main conditions of the agreement were:

■ Thresholds: the 3 per cent ceiling for the budget deficit and the 60 per cent limit for

national debt remained unchanged.

■ ‘Relevant factors’ enabling countries to avoid an excessive deficit procedure: member

states in danger of breaching the deficit will be able to invoke a range of ‘relevant

factors’ to avoid the imposition of penalties. Such factors include potential growth, the

economic cycle, structural reforms (for example, in social security and pensions), R&D

policies, public investment etc. The agreement does not establish an exhaustive list of

factors but rather sets out chapter headings that establish general principles around

which member states will be able to argue their case.

■ Extension of deadlines: instead of one year, countries will have two in which to correct

an excessive deficit. This can be extended further in the case of ‘unexpected and adverse

economic events’.

BO

X 8

.3

increasing life expectancy and low labourforce participation (see Chapter 13). The2004 reforms included an increase in thecontribution period for entitlement to retireon full pension, incentives to workers toextend their working lives and measures topromote private pensions. In May 2005,competitiveness reforms, including incen-tives to encourage mergers among SMEs,bankruptcy reforms and some welfarestreamlining, were pushed through parlia-ment. Although welcome, these reformsneed to be taken much further to achieve sus-tained competitiveness.

Indeed, Italy could become a test case forthe revised SGP. The European Commissionhas also made known its intention to holdItaly to account for failure to meet the termsof the revised SGP. Such a move, importantto the Commission to preserve any lingeringcredibility of the SGP, could bolster calls byItaly’s Welfare Minister, Roberto Maroni,immediately after the French and Dutch referendum rejections of the constitutionaltreaty in May/June 2005 to reintroduce thelira. Although not a proposition to be takenseriously at the time it was made, particu-larly as the reintroduction of a depreciatinglira would cause Italy’s debt service pay-ments to spiral, there remains the possibilitythat such calls could gain momentum if moresubstantial reforms are not taken to addressItaly’s deep-rooted economic problems andthe eurozone becomes a scapegoat for theseproblems.

Germany, too, has its structural problemswhich, by exacerbating the country’s unem-ployment problems also make its budgetaryproblems worse, and inhibit its ability toadjust to increased competitive pressures inthe absence of national monetary policy.Germany’s problems stem, in large part,from its high wage and non-wage costs (seeFigure 16.7), high taxes and generous

welfare state (see Chapter 13). In 2003, thegovernment brought forward Agenda 2010,a moderately ambitious set of proposals forstructural reforms in public pensions, health-care and social benefits and the so-calledHartz labour market reforms which, amongother things, were designed to end generousbenefits for the long-term unemployed, tomake it less easy for the unemployed to reject job offers, to put shorter limits onentitlements to unemployment benefit andto rein in the trend to earlier retirements.

Again, domestic political constraints andpressures caused a softening of the proposalsand complaints by some that the reformsbring hardship without any benefits, whereasothers say the reforms do not go far enough.The 2005 general election brought the moreliberal-minded Angela Merkel to power. Thefull extent of her liberalism will not becomeclear until she has been in power for sometime and she will have to work within theconstraints imposed upon her by her coali-tion partners. Meanwhile, against the back-ground of the threat of possible relocationabroad, several large German companieshave negotiated deals with unions that havecut wage costs by forcing wages down, freez-ing wages or by persuading workers to worklonger hours for the same pay.

France, one of the most enthusiastic pro-ponents of the single currency, has alsoshown an unwillingness to free up its marketsand generally deregulate its labour and prod-ucts markets as implied by the logic of thesingle currency. Workers, for example, areprotected by a high minimum wage, securityfrom lay-offs and a short working week.Consequently, France has also been doggedby fiscal problems and stubbornly high ratesof unemployment. The government has partially addressed some of the issues butoverall there is an unwillingness to tackle theissues head on and raise the possibility of

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social conflict. This became apparent inspring 2006 when government attempts tomake it easier for employers to hire and fireyounger workers met with fierce oppositionincluding large-scale street demonstrations.Indeed, the negative result of the 2005French referendum on the constitutionaltreaty has been interpreted by many com-mentators as a rejection by the French popu-lation of the deregulation and liberalisationthat has marked the latest phase of Europeanintegration and a preference for more pro-tectionism – or ‘economic nationalism’ – apreference that is at odds with the marketintegration ideology of the single currency(see Chapter 2).

That reform is possible has been shown bythe UK and the Netherlands in the 1980s and by Denmark and Sweden in the 1990s.The short-term impact is frequently painfuland consequently carries political risks forthe political party introducing reform.However, reform does hold out the possibil-ity for longer term gains. Without reform,the rigidities in the eurozone’s biggest econ-omies will get worse, putting greater strainon the system. The danger is that the singlecurrency gets the blame for these problemswhen, in fact, they have been building up fora number of years and would have come tothe forefront even without the existence of the single currency, albeit probably not soquickly. Moreover, the absence of a singlecurrency would not remove the need forreform in a world economy that is rapidlybecoming more interdependent and global-ised and nor would any attempt to insulatethese economies from globalisation result in anything but deteriorating prosperity. Inshort, the eurozone is suffering from a political failure to implement the policiesneeded to make it work and needs nationalpoliticians with the courage to take thesemeasures.

. . . within EU outsiders

Old outsiders

Three of the EU-15 – Denmark, Sweden andthe UK – did not participate in the launch ofthe single currency. Denmark and the UKhave a legal right to opt out of EMU underthe TEU. Sweden, which acceded to the EUafter the signing of the TEU and thereforewas required to accept the acquis communau-taire at the time, including a commitment toEMU, has no such right but was excludedfrom the euro on the technical grounds thatit was not a member of the ERM. This waspolitically expedient as the Swedish govern-ment felt its population was not ready forEMU.

In all three cases, as Figure 8.2 demon-strates, levels of popular support for the euroare much lower than in the eurozone mem-bers. This helps to explain both why thecountries were reluctant to join and whytheir adoption of the euro is not imminent. InSeptember 2000, Denmark held a referen-dum in which 53 per cent voted againstDenmark adopting the euro. In September2003, 56 per cent of the votes in a Swedishreferendum on the single currency wereagainst membership. Consequently, euromembership is off the agenda in both coun-tries for some time. Even though euroapproval ratings in Denmark in particularhave increased since the referendum, furtherefforts by the generally pro-euro politicalelites to take Denmark into the single cur-rency are not likely for some time as theprevious referendum itself showed that thepossibility of gain was outweighed by the riskof failure.

Each country has its own reasons for notjoining but, in general, public debate aboutthe euro in these three countries has expres-sed concerns about loss of sovereignty,

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especially in relation to the loss of monetarypolicy as a major economic policy instru-ment, loss of identity and doubts aboutwhether it is possible for one interest rate tosuit so many countries. On the other side, inaddition to the usual general pro-euro argu-ments, the outsider countries also have toconsider whether their continuing standingaside from the final stage of EMU will ulti-mately lead to their increasing marginalisa-tion from core EU business.

However, even if the governments ofDenmark, Sweden and the UK chose to tryto take their countries into the eurozone,they would find it difficult to sell it to theirrespective populations given the poorer per-formance of the eurozone economies relativeto their own. As the graphs in Figure 8.3show, GDP growth in the outsider countries

has outstripped that of the eurozone; GDPper head in the outsider countries is abovethe average for most eurozone countries; theoutsiders’ unemployment performance isgenerally much better and inflation is belowthat of the eurozone. In these circumstances,especially given the tendency of the politicalelites in the outsider countries to talk up theeconomic side of the euro and downplay itspolitical dimension, it would be difficult toconvince the electorate that there is anythingto gain by voting for the euro. There is a viewthat a sustained period of economic perform-ance significantly below that of the eurozonecountries is needed before euro referendumscan be won in the outsider countries. Giventhe problems inherent in the eurozone area(see above), this scenario is unlikely in theshort to medium term.

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80

70

60

50

40%

30

20

10

0Aut.98

Spr.99

Aut.99

Spr.00

Aut.00

Spr.01

Aut.01

Spr.02

Aut.02

Spr.03

Aut.03

Spr.04

Aut.04

Eurozone Denmark Sweden UK

Figure 8.2 Support for the single currency, 1998–2004

Source: Eurobarometer.

New outsiders

On 1 May 2004, ten countries joined theEU. All new members accepted the acquiscommunautaire, including participation in the third stage of EMU with a derogationregarding adoption of the single currency.Moreover, the populations of the newmember states have implicitly given theirconsent to eurozone membership by virtueof their ‘yes’ votes in the 2003 accession ref-erendums as commitment to join the singlecurrency was part of the bargain for joining.Opinion polls confirmed this: as accessionapproached, according to Eurobarometer,58 per cent of the population of the newmember states were in favour of single cur-rency membership, ranging from 46 per centin Estonia to 81 per cent in Slovenia.

The new member states have announcedtheir intention to join the single currency as

soon as possible. The key issue for them isnot if they join but when. In order to join, thenew members must meet the Maastrichtconvergence criteria, including a minimumof two years in ERM II. It is likely there willbe two waves of eurozone entry. The firstwill involve the smaller new members:Estonia, Lithuania and Slovenia joined ERMII in June 2004 and Cyprus, Latvia and Maltafollowed suit in April 2005. Assuming theabsence of any major currency upheavals inthe two years following their ERM entry, thefirst new member states could adopt the euroby 2007.

The second wave of new country entrantswill comprise the larger new member states– Poland, Hungary and the Czech and SlovakRepublics. These countries are bedevilled by persistent fiscal problems and the associ-ated social welfare costs and political prob-lems arising from attempts to resolve these

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Eurozone UK

GDP growth GDP per head, 2005 (EU15=100)

Inflation (%) – annual average rate 2004/12

Sweden Denmark

150100500

6

4

2

0

%

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

FinlandPortualAustria

NetherlandsItaly

IrelandFranceSpain

GreeceGermanyBelgium

EurozoneSweden

DenmarkUK

15

10

5

01995

Denmark

2000

Unemployment (%)

2005

3.5

3

2.5

2

1.5

1

0.5

0Sweden UK Eurozone

Germany France ItalyUK

Sweden

Denm

ark

Euroz

one

Germ

any

Fran

ce Italy

Spain

Figure 8.3 Comparative economic performance inside and outside the eurozone

Source: Eurostat.

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Case Study 8.1

OPTING OUT OF EMU: THE CASE OF THE UK

The UK’s decision to opt out of the initial moves to EMU is significant given that it is the

world’s fourth largest economy and the EU’s second largest. Moreover, the UK is not only

the headquarters and primary EU location for many major multinational companies but is

also, through the City of London, Europe’s major European financial centre. In addition to

the standard arguments made against single currency membership (loss of sovereignty, one

monetary policy cannot fit all, etc.), several arguments specific to the UK are often made

against UK membership. These include:

■ Trade: the UK has a lower level of intra-EU trade than other member states so is more

vulnerable to external shocks. While it is certainly true that the UK has the lowest level

of intra-EU trade in the EU, the majority of its trade (56 per cent) is still with other EU

members, only three percentage points behind Italy and eight behind Germany. In short,

this argument can be overstated.

■ Personal sector: the UK has one of the highest percentages of home owners in the EU

and British mortgage holders are more dependent on variable rate mortgages than in

other EU countries, making UK interest rates much more responsive to housing markets

than is the case elsewhere in the EU.

■ Oil: the UK’s position as an oil producer and exporter means the UK is affected

differently by oil price movements, making asymmetric shocks more probable in a

eurozone including the EU. The power of this argument is declining in line with the

depletion of North Sea oil and the gradual transition of the UK from being a net energy

exporter to a net energy importer.

That the UK opted out of EMU came as no surprise given the lack of public and political

support for the project. The low level of public support is demonstrated in Figure 8.2.

However, it is worth noting that for the majority of the British public, the single currency

does not rank very highly as an important issue, raising questions about the depth of anti-

euro feeling among the UK populace.

Business in the UK has tended to hold less polarised views. Foreign investors are the most

‘pro-euro’, especially if they view their investment as a platform for access to the SEM.

Indeed, several foreign investors in the UK have warned that the UK’s continuing absence

from the eurozone will lead to mainland Europe rather than the UK being the first choice

destination for future investment. Figure 8.4 shows the trend of inward investment in the EU

since the early 1990s when the UK, along with France, was the main destination for inward

FDI. The UK was even more dominant towards the end of the 1990s. Since then, the UK

has been overtaken as a source of FDI by several EU countries. Although this is far from

conclusive evidence that concerns about inward FDI if the UK stayed outside the eurozone

were justified, the early indications are that the UK has lost its position as the major

destination for inward investment in the EU, and it is likely that a major part of this loss is

down to non-participation in the eurozone.

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Larger UK companies, on the whole, have tended to be pro- rather than anti-euro,

although there are several high-profile contrary examples. Smaller UK companies have a

greater tendency to be anti-euro but, again, there are many exceptions to this.

Even with the UK outside the single currency area, British business cannot ignore the

euro. A number of big EU groups active in the UK, as well as major UK enterprises, shifted

their accounting to the euro from 1999. Once multinationals alter their business processes

to account for the euro so the pressures upon SMEs to alter their processes grow. Despite

the fact that operating dual currency systems is expensive, this cost is more than out-

weighed by potential losses from ignoring the euro. Whatever their opinions upon EMU,

UK businesses cannot ignore it as non-membership can act as a constraint upon their

competitiveness within core EU markets.

Concerns have also been highlighted about the potential relative decline of the City of

London as Europe’s main financial centre if the UK decides to sustain its exclusion from the

euro. The impact upon employment within the City depends upon its ability to capture a share

of the market for euro securities. The fear is that new investment and the focus of banks

could shift towards Frankfurt at the expense of London. Others doubt this, noting that the

UK is a centre for international, not just European, business. Thus global, rather than intra-

European, competition is more of a threat. Some feel that the presence of skilled workers

and the ability of the City of London to be innovative and exist in ‘unofficial markets’ as well

as global markets means that EMU may deliver more benefits than costs.

140,000

120,000

100,000

80,000

60,000

40,000

20,000

01992–97

(avge)1998 1999 2000 2001 2002 2003

UK France Germany Netherlands Spain Ireland

Figure 8.4 Inward FDI (US$m)

Source: UNCTAD, World Investment Report.

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British political parties are also divided. The Liberal Democrats are the most enthusias-

tic Europeans and single currency supporters. The Conservative Party, torn apart by its

divisions on Europe during its final years in government in the 1990s, contains a wide range

of Euro sceptics, from a minority advocating total withdrawal to those arguing that integra-

tion should go as far as the SEM and no further. A small, but nonetheless deeply committed,

minority support euro membership. The ruling Labour Party equally provides a home for all

sides of the euro debate but European divisions have not inflicted fundamental damage on the

party as is the case with the Conservatives. However, the overwhelming stance of Labour is

supportive of Europe and the euro, a major turnaround from the early 1980s when the official

policy was withdrawal. The official position of the government is that it is ‘in principle’

supportive of the idea of UK adoption of the euro but it will not entertain UK membership

until the time is right economically. In order to determine when this will be, and in addition

to the Maastricht criteria, the UK government has set out the following five economic tests

or questions that must be satisfactorily answered before it takes the UK into the eurozone:

1 Convergence: are business cycles and economic structures compatible with European

interest rates on a permanent basis?

2 Flexibility: if problems emerge, is there sufficient flexibility to deal with them?

3 Investment: would membership of the eurozone create better conditions for firms

making long-term decisions to invest in the UK?

4 Financial services: what impact does joining the eurozone have on the UK’s financial

services industry?

5 Growth, stability and employment: will joining the euro promote higher growth, stability

and a lasting increase in jobs?

In June 2003, Chancellor Gordon Brown concluded that, although progress had been

made towards satisfying the five tests, only the test on financial services had been passed and

therefore it was not in the economic interests for the UK to join at that point. During the

2005 election campaign, Prime Minister Tony Blair appeared to rule out UK adoption

of the euro for the foreseeable future. Indeed, given the UK’s better all-round economic

performance than the eurozone (see Figure 8.3) and the problems in the eurozone, business

pressure to join has eased off and in the mid-2000s, UK membership of the single currency

appears much lower on the political agenda than it has been for some time. In short, for now

at least, the euro has become a non-issue in Britain.

Case questions

1 In the mid-2000s, UK adoption of the euro is further away than ever. Why might thisbe the case?

2 How might UK business be damaged by continuing exclusion from the eurozone?

3 What benefits might continuing exclusion from the eurozone bring to UK business?

4 Discuss the political and economic role of the ‘five tests’ in determining whether theUK should join the eurozone.

5 To what extent does the ‘distinctiveness’ of the UK economy justify its continuingabsence from the eurozone?

problems. Accordingly, their dates forpotential euro membership have beenretreating. In mid-May 2004, for example,Hungary announced postponement of thetarget date of euro entry from 2008 to 2010as a result of its higher than forecast inflationand budget deficit. The Czech and SlovakRepublics are looking at 2009–10 and2008–10 respectively as their target entrydates, and Poland is unlikely to be readybefore then.

In short, there will be a minimum of fiveto six years for the larger countries betweenEU accession and adoption of the single cur-rency. This period could be longer if thesecountries shy away from difficult politicaldecisions regarding fiscal reform. In theinterim, there is sufficient time for any gapbetween expectations of EU membershipand the reality to become apparent to thepopulace of these countries, thereby creatingthe conditions for a backlash against euro-zone membership and a divergence betweenelite and popular support for eurozone mem-bership. Moreover, the longer the gapbetween accession referendum and a seriousattempt to join the single currency, the morethe euro legitimacy of the accession refer-enda will fade, possibly leading to demandsfor a euro-specific poll.

In terms of the nominal Maastricht con-vergence criteria, the new member states aredifferentially placed. As stated above, thelarger states have greater problems meetingthe fiscal criteria and, in general, inflationaccelerated somewhat in 2004, creatingproblems for some countries where previ-ously there was none. However, the infla-tion problems were created by higher oilprices (which affect all European countries to a degree and thus do not necessarily represent a deterioration in the relative posi-tion of the new member states vis-à-viscurrent eurozone members) and by one-off

accession-related tax reforms and other priceincreases that will drop out of the inflationfigures within a year.

With regard to real convergence, the newmember states are growing significantlymore quickly than the older member states(see Chapter 16) and, indeed, need to do sofor many years before their economic levelsare broadly comparable. Given the massiveeconomic reform processes that the majorityof new member states have gone throughsince 1989, several of them have better cre-dentials regarding product market flexibilityand liberalisation and deregulation gen-erally than older member states. They dotend to suffer from labour market inflexi-bility and high levels of unemployment. Theformer have not been helped by the transi-tion periods imposed on free movement bymost old member states. By the mid-2000s,unemployment remained high in many cases despite rapid economic growth. This isbecause growth has taken place within acontext of ongoing structural reform withthe result that job creation was often offsetby the loss of jobs in sectors undergoingreform. Moreover, growth has been accom-panied by productivity improvements origi-nating from restructuring. Although bad foremployment in the short term, improvedproductivity performance is essential for thelong-term competitiveness of these countriesand will ultimately help them compete in theeurozone and beyond.

The entry of the new member states intothe eurozone depends on their compliancewith the convergence criteria but it may alsobe affected by factors such as how the exist-ing eurozone members respond to theircurrent challenges. For example, how mean-ingful will the revised SGP be? Will euro-zone growth remain fitful and below that ofits main economic competitors? If it does,will the attractiveness of the eurozone as a

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way of boosting growth, trade and invest-ment diminish and undermine efforts to takethe countries into the area? Will the pre-dominantly pro-European government coali-tions in the new member states be replacedby governments with less enthusiasm for theEuropean project? So, although the prospectsfor these countries to become eurozonemembers looked promising at the time oftheir accession, there are several factors thatcould derail euro adoption for at least someof them.

OUTLOOK

The early years of the single currency werelargely successful. However, fiscal indisci-pline, the persistent poor performance of theeurozone’s biggest economies and theirslowness/failure to undertake the necessarystructural reforms to improve their compet-itiveness and to create the optimal environ-ment for EMU coupled with the blow dealtto the whole European project by the Frenchand Dutch rejection of the constitutionaltreaty in mid-2005 have raised a questionmark, albeit as yet a small one, over the long-term health of the eurozone.

The ratification failure of the constitu-tional treaty should not, in itself, damageEMU. The business of the EU will continueas usual. The threat from the rejection of thetreaty stems from doubts and differences

about the long-term future of the EU andfrom the interpretation of the treaty rebuff asa revolt, at least on the part of France, againstthe liberalising, open market approach ofmuch EU policy to date. This links to themost urgent challenge to EMU – the resolu-tion of the competitive problems of keyeurozone economies via painful but neededmicro-economic reform in terms of labourand product markets. Failure to do this will, eventually, put intolerable strains onthe single currency area. Appropriate actionby the member states concerned is certainlyprobable: they showed tremendous politicalcommitment to get EMU off the ground inthe first place and failure to carry the projectthrough would carry extremely high costs aswell.

In the shorter to more medium term, it isunlikely that the ‘old’ EMU outsiders –Denmark, Sweden and the UK – will takeany significant steps to adopt the single cur-rency. There is no immediate incentive forthem to do so. In the longer term, if theirrelative economic positions vis-à-vis thecurrent EMU members change, or if theyfind themselves increasingly marginalisedfrom EU business, their single currencymembership cannot be ruled out. The ‘new’outsiders (that is, the ten 2004 accessionstates) have, without exception, expressedtheir intention to join the eurozone as soonas possible and their commitment remainsstrong.

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KEY POINTS

■ From a business perspective, EMU facilitates trade and investment and generallyreinforces the market integration theme of earlier integration initiatives.

■ Reform of the SGP has taken place but the jury is out on whether its credibility hasbeen irreversibly undermined.

■ Improvements in labour and product market flexibility are required in several euromembers if EMU is to succeed. Some of the bigger states, in particular, are finding itpolitically difficult to introduce the needed reforms.

■ In the mid-2000s, adoption of the single currency does not appear to be an option inthe short to medium term for Denmark, Sweden and the UK.

■ Adoption of the euro looks a real possibility within two to three years of accession forthe smaller 2004 accession states whereas the larger new member states will have towait longer.

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ACTIVITIES

1 Choose one of the ten 2004 accession states and research their preparations for, andpotential gains from, EMU membership. Also identify the risks that EU membership exposesthem to.

2 In a classroom, organise a debate in which one side puts forward the case for UK adoption of the euro and the other puts the case against.

3 Choose France, Italy or Germany and research their efforts to pursue key economic reforms.Although it can be argued, the need for economic reforms existed before the euro and areneeded for broader competitiveness reasons, consider how and why the reforms are alsolinked to the success of EMU.

4 Research a European company and consider how the existence of the euro might have aninfluence upon its strategy and operations. Companies ranging from global multinationalsto SMEs based either in or outside the eurozone are suitable for this exercise as they willall be affected in some way, albeit differently. In a classroom context, individual studentsor groups of students can be allocated a different company and asked to present theirfindings to the class. Their findings can then be compared and contrasted to pull out thesimilarities and differences. Note: issues to look at include location in or out of theeurozone; location of suppliers and markets; characteristics of the sector; relative shareof activities in the eurozone. For non-eurozone companies, to what extent do they utilisethe euro? etc., etc.

Ardy, B., Begg, I., Hodson, D., Mahe, I. and Mayes,D. (eds) (2005) Adjustment to EMU: One Europeor Several?, Basingstoke: Palgrave Macmillan.

Backé, P., Thimann, C., Arratibel, O., Calvo-Gonzalez, O., Mehl A. and Nehrlich, C. (2004)‘The Acceding Countries’ Strategies towardsERM II and the Adoption of the Euro: AnAnalytical Review’, ECB Occasional Paper Series,No. 10. Frankfurt: European Central Bank, http://www.ecb.int/pub/.

Brown, B. (2004) ‘Exiting EMU’, The InternationalEconomy, 18 (2), pp. 57–60.

Commission of the European Communities (2004)‘EMU after Five Years’, European Economy,Special Report, Number 1/2004, http://europa.eu.int/comm/economy_finance/publications/european_economy/2004/eesp104en.pdf.

De Grauwe, P. (2002) ‘Challenges for MonetaryPolicy in Euroland’, Journal of Common MarketStudies, 40 (4), pp. 693–718.

De Grauwe, P. (2005) The Economics of MonetaryUnion, 6th edn, Oxford: Oxford University Press.

De Grauwe, P. and Kouretos, G. (2004) ‘EMU:Current State and Future Prospects’, Journal ofCommon Market Studies, 42 (4), pp. 679–89.

De Grauwe, P. and Schnabl, G. (2004) ‘EMU EntryStrategies for the New Member States’, Inter-economics, 39 (5), pp. 241–7.

Duckenfield, M. (2006) Business and the Euro:Business Groups and the Politics of EMU inBritain and Germany, Basingstoke: PalgraveMacmillan.

European Central Bank (2004) European CentralBanks: History, Role and Functions, http://www.ecb.int/pub/pdf/other/ecbhistoryrolefunctions2004en.pdf.

Feuerstein, S. and Grimm, O. (2004) ‘The Road to Adopting the Euro’, Intereconomics, 39 (2),pp. 76–83.

Gabel, M. and Hix, S. (2005) ‘Understanding Public Support for British Membership of theSingle Currency’, Political Studies, 53 (1), pp. 65–81.

Hayo, B. (2003) ‘European Monetary Policy:Institutional Design and Policy Experience’,Intereconomics, 38 (4), pp. 209–18.

Hermann, S. and Jochem, A. (2003) ‘Real andNominal Convergence in the Central and EastEuropean Accession Countries’, Intereconomics,38 (6), pp. 323–7.

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QUESTIONS FOR DISCUSSION

1 ‘Present policies, institutional arrangements and political attitudes are incompatible with asustainable economic and monetary union in the long run’ (FT 8 June 2005, p. 17).

Explain and comment upon this statement in the light of the challenges currently facing theeurozone.

2 ‘The reform of the Stability and Growth Pact has rendered it useless as a mechanism forfiscal discipline within the single currency area.’ Explain why this statement may have beenmade. Do you agree with it (make sure you justify your answer)? What do events since the2005 reform tell us about its success or failure?

3 In what way has EMU changed Europe’s business environment?

4 What are the main dangers to the long-term success of the single currency?

5 ‘EMU is as much a political as an economic project.’ Do you agree? Explain your answer.

SUGGESTIONS FOR FURTHER READING

Intereconomics (2003) 38 (1) – four articles on theStability and Growth Pact.

Intereconomics (2004) 39 (5) – three articles on theeastwards enlargement of the eurozone.

Intereconomics (2005) 40 (1) – four articles onreform of the Stability and Growth Pact.

Journal of Common Market Studies (2000) TakingStock of EMU, whole issue, 38 (4).

Journal of European Integration (2005) 27 (1) –whole issue on EU members outside the eurozone.

Louis, J. (2004) ‘The Economic and MonetaryUnion: Law and Institutions’, Common MarketLaw Review, 4 (2), pp. 575–608.

Schwartz, A. (2004) ‘Risks to the Long TermStability of the Euro’, Atlantic Economic Journal,32 (1), pp. 1–10.

Tanzi, V. (2004) ‘The Stability and Growth Pact: Its Role and Future’, Cato Journal, 24 (1/2), pp. 57–69.

Tavlas, G. (2004) ‘Benefits and Costs of Entering the Eurozone’, Cato Journal, 24 (1/2), pp. 89–106.

Trichet, J.-C. (2001) ‘The Euro after Two Years’,Journal of Common Market Studies, 39 (1), pp. 1–13.

Yeager, L. (2004) ‘The Euro Facing Other Moneys’,Cato Journal, 24 (1/2), pp. 27–40.

Key websites

There are many sites on EMU – the following ismerely a selection.

The Commission’s EMU website: http://europa.eu.int/comm/economy_finance/index_en.htm

The European Central Bank’s website: www.ecb.int

The website of the Financial Times: http://specials.ft.com/euro/index.html

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