Transition to Monetary Union

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Transitional arrangements of the Maastricht Treaty

• gradual, conditional (convergence criteria) transition to EMU

Criteria

1. Low inflation rate < 1.5% above the average of the lowest 3 in EU
2. LR interest rates < 2% higher than the average of the 3 lowest
3. Exchange rates stable i.e. membership of ERM without devaluation for 2 years
4. Government budget deficit < 3% of GDP or if higher then it should be ‘declining continuously & substantially becoming closer to the 3% target’
5. Accumulation of deficits – debt < 60% of GDP or ‘diminish sufficiently & approach 60% at a satisfactory pace’

(4 is the flow variable, 5 is the stock variable)

In order to meet these criteria debt has been one of the important factors – in France there were privatisations in order to bring the PSBR down.

• primary debt = budget deficit (G-T)
• interest = r on existing debt rB
• 
• change in debt = change in budget deficit plus change in outstanding debt times interest rate minus growth
• to pay off debts, growth has to be greater than the interest rate!
• 

The EMS crises of 1992-3

• with no capital controls, credibility & liquidity problems started to have their full destabilising effects
• inflation rising in Spain & Italy – they became uncompetitive
• UK & France needed low interest rates to pull out of recession, Germany needed high interest rates due to reunification pushing up inflation
• Speculators realised this and forced £ out in 1992
• When France tried to support the Franc it did so by buying Francs for DMs which it borrowed from the Bundesbank this was in turn sterilised by the Bundesbank, and eventually Bundesbank refused to lend any more DM for fear of expanding money supply too much
• Outcome was excessively deflationary monetary policy and intensifies recession

3-Stage process to move to EMU

1. July 1990 all EU members (except Sweden, Greece, UK, Italy) entered EMS and liberalised capital markets
2. January 1994 European Monetary Institute set up as precursor to European Central Bank (ECB)
3. January 1999 euro launched with fixed exchange rates with the old currencies & ECB established in Frankfurt
4. 2002 Euro notes and coins introduced for 300 million people