The creation of the euro and European Central Bank

The Treaty on European Union

The concept of a united Europe arose following the Second World War as a way for Europe to eventually regain competitiveness in the global marketplace.  Leaders dreamt that a single market would allow the region’s economy to rise like a phoenix from the ashes, though in reality it was exceedingly complicated and time-consuming to bring this idea to fruition.  It was more than 40 years from the end of the war until the signing of the Maastricht Treaty, or The Treaty on European Union, in 1992.

The Treaty on European Union, or TEU, articulates its primary aims and purposes in Article 3.  Included in that Article is the intention to create an internal market for the “sustainable development of Europe based on balanced economic growth and price stability” through “an economic and monetary union whose currency is the euro” (TEU, Article 3).

Founding Member States largely commenced monetary integration as early as in 1979 with the European Monetary System, or EMS, which was a resolution of the European Council.  This served to “keep most Community currencies in a single exchange rate system” while also producing the European Currency Unit, or ECU, “which was defined as a ‘basket’ of fixed quantities of the currencies of the Member States” (Scheller 19).  In 1987, the adoption of the Single European Act, or SEA, furthered the region’s goals of economic union, but also made it apparent that progress would be limited without full monetary union.  Two years later, the Delors Report unveiled three stages for complete economic and monetary union:  1) cohesion of economic policies to complete the internal market, 2) build institutional infrastructure, and 3) fix exchange rates and coordinate institutional obligations.  The fulfillment of these stages entailed the creation of the Statute of the European System of Central Banks and of the European Central Bank and ultimately concluded with the completion of the euro transition on 1 January 2002.

Protocol 4 to the TEU and the Treaty on the Functioning of the European Union, or TFEU, contains the Statute of the European System of Central Banks, or ESCB, and of the European Central Bank, or ECB.  Article 3 defines its primary tasks as “to define and implement the monetary policy of the Union; to conduct foreign-exchange operations; to hold and manage the official foreign reserves of the Member States; and to promote the smooth operation of payment systems.” 

The Governing Council holds the primary decision-making power of the ECB and it is comprised of an Executive Board and the Governors of the national central banks.  The Governing Council dictates monetary policy of the euro zone, while daily, operational tasks and policy implementation is left to the Executive Board.  The six Executive Board members are appointed by euro area heads of state on a “recommendation from the EU Council, after consulting the European Parliament and the Governing Council” (Scheller 59).  “As [a] member of the Executive Board, the President of the ECB [plays] a prominent role [as:] the chair of all three decision-making bodies of the ECB, the casting vote in the Governing Council and on the Executive Board, [and] the external representation of the ECB (for instance at the international level)” (Scheller 61).

In terms of money creation, the European Central Bank has the “exclusive right to authorize the issue of euro banknotes within the Union” and only these notes “have the status of legal tender” (TFEU, Article 128).  Legacy currencies ceased to be of value in the euro area by the end of February 2002.

Economic and legal implications of a common currency

The principle costs of monetary union are immediately apparent:  the elimination of Member State monetary sovereignty and thus the severe restriction of economic policy tools.  This inhibits or abolishes the ability of nations to independently influence domestic trends in labor, wages, and consumption.  “Monetary sovereignty has been transferred to the supranational level under the terms and conditions” of the TEU, TFEU and Protocol No. 4 (Scheller 28).  Consequently, exchange rate authority is likewise allotted to the ECB. Member States retain some degree of economic dominion since the Treaties only require Member States’ “close coordination” of their fiscal policies,” which results in varying tax rates, social security programs, etc. (TFEU, Article 119).  However, Member States are encouraged to adhere to the Broad Economic Policy Guidelines.  Other principles of the European Union intend to partially mitigate or compensate for the effects of monetary subjugation such as the promotion of the free movement of labor.  The current crisis in the euro zone unfortunately reveals the potentially fatal costs of monetary integration.  However, as with any new and optimistic enterprise, costs were generally overlooked in favor of the anticipated benefits of currency union.

The perceived benefits of a single currency to accompany the Single Market are to increase price stability and transparency, “eliminate exchange rate risks, reduce transaction costs and, as a result, significantly increase economic welfare in the Community” (Scheller 20).

Price stability is a fundamental goal of the European Union and is achieved via monetary union due to the centralization of monetary policy and creation.  The most widely accepted gauge of price stability is inflation, while the most common measure of inflation is the consumer price index.  From an economic standpoint, the benefits of controlled inflation are obvious: if the inflation rate remains fairly low, it encourages an efficient level of consumption for goods and capital and thus contributes to economic growth.  

The relative success of price stability via inflationary control is apparent through a comparison of historical consumer price data and the present harmonized rate of inflation among euro zone countries.  Greece, for example, experienced severe volatility in its inflation[1] with levels exceeding 30% in the early seventies. 

Chart:  Long-term Greek CPI

Source:  Global-Rates.com[2]

Even Germany, which some may consider the epitome of fiscal restraint, experienced inflation levels above the typical target range of 2 to 3% throughout its history preceding the euro.

Chart:  Long-term German CPI

Source:  Global-Rates.com

The harmonized consumer price index, or HICP according to Global-Rate’s terminology, chart below indicates that monetary union succeeded in maintaining a low inflation rate for most of its duration.  There is a downturn at the onset and throughout the escalation of the debt crisis, but inflation nevertheless has stayed within a narrow range.

Chart:  Long-term HICP within the euro zone

Source:  Global-Rates.com

In addition to price stability, a common currency allows for price transparency.  This is directly beneficial to consumers, businesses, and investors and it enhances the competitiveness of the Single Market.  Typically considered a prerequisite for a competitive market, full disclosure in price composition creates better-informed consumers and promotes seller honesty. 

Finally, the elimination of exchange rate risk is also directly beneficial to consumers, businesses, and investors as it diminishes transaction costs.  In this context, a common currency particularly aids the tourism industry within the EU, businesses with international sales and operations, and European investors.

Subjective benefits of monetary union may include the perception that it lends credibility to the EU and visibility to the euro in the global marketplace.  

The legal implications of monetary union are less straightforward than an economic cost-benefit analysis and permeate numerous facets of national law.  Member States and their central bank charters cannot have conflicting legislation.  However, there is not enough precedent or homogeneity in some areas of national financial market regulation, such as mortgage valuation, lending practices, or capital raising techniques, to ensure that Union monetary policy will impact each Member State in relatively similar fashions.  The result is that the “way in which the same interest rate increase is transmitted into consumption and investment spending will be very different across Union members” (De Grauwe 22).  Case rulings constantly prove that Union law is superior to national law and it seems that the legal implications directly applicable to euro unity remain under development in courtrooms.

Procedural aspects

While the longer-term consequences of monetary integration continue to develop, the immediate requirements for inclusion are explicit.  Title VIII of the TFEU outlines the general economic and monetary policy framework of the EU and Article 119.3 obliges Member States to comply “with the following guiding principles: stable prices, sound public finances and monetary conditions, and a sustainable balance of payments.”  Coinciding with the TFEU’s guiding principles, there are four economic components, or transitional provisions, for current and future inclusion in the euro area.  Protocol No. 4 delineates specificities relating to these provisions and those of the ESCB and ECB.

Price stability is determined by inflation, which is measured by the nation’s consumer price index.  A state’s rate of inflation should be closely aligned to the inflation rates of “the three best-performing Member States in terms of price stability,” which is typically between 2 and 3% (TFEU, Article 140).

Secondly, Member States must have a healthy fiscal position thereby avoiding excessive government debt levels.  Debt is gauged in proportion to gross domestic product and the Protocol creates a reference value for this ratio, which is a maximum of 60%.  Exceptions to the reference value may be given to states with declining or temporarily inflated debt levels.  Fiscal position is also measured by the government budget and an annual deficit should not exceed 3% of GDP.

The third component of economic integration is exchange-rate developments.  Aspiring euro zone members must adhere to the current exchange rate mechanism for a minimum of two years, which, at present, allows a currency’s central rate to fluctuate ±15% against the euro.

The final, general criterion is “the durability of convergence achieved by the Member State with a derogation and of its participation in the exchange rate mechanism being reflected in the long-term interest rate levels” (TFEU, Article 140).  Participation in the exchange rate mechanism, or ERM, entails fixing the domestic currency to the euro for a minimum of 2 years.  As with inflation, interest rates should be in-line with those of the three best-performing Member States.  Interest rates are measured “on the basis of long- term government bonds or comparable securities” (Scheller 37).

Article 131 of the TFEU requires all Member States to “ensure that its national legislation including the statutes of its national central bank is compatible with the Treaties and the Statute of the ESCB and of the ECB.”  Compatibility must particularly be addressed in the areas of national central bank independence, money issuance, foreign reserve holding, and exchange rate policy.

Once these economic and legal admission requirements for transition have been met according to the satisfaction of the ECB and European Commission, the two bodies will consult with the European Parliament, discuss with the European Council, and the Council will vote on the Commission’s proposal.  Upon Council approval, the currency will be “irrevocably” fixed to the euro ERM and subsequently exchanged.