Portal to the Economy of the Euro

IN THIS SECTION:

"European" Monetary Union: a short history
Will it survive 1 ?: severe test of 2008 financial crisis passed well
Will it survive 2 ?: 2010-11 debt crisis brings a much ruder test
Divergent economies: under a single roof
When the pressure is on change takes off
EMU institutions: the "Europeanised" Bundesbank
Trichet's succession

ECB's crusade: against inflation and political interference:

euro group
stability & growth pact
Greece
exchange rate policy
ERM II
10th anniversary

During its first decade the ECB could be seen as a "Europeanised Bundesbank", having adopted the institutions and the philosophy of the Bundesbank, running monetary policy much as the Bundesbank before. The emphasis was on containing inflation. It cherished its independence and attempts to introduce a "political counterweight" failed. It is widely considered to have dealt competently with the 2008-09 financial crisis, boosting its stature and its prospects of longevity. After ten successful years Germany in particular was pleased with the way things turned out, some other euro zone countries less so.

The second decade started with the unfolding sovereign debt crisis, presenting the ECB with formidable new challenges. It laid bare the absence of a common fiscal policy and the heterogeneousness of the member countries. The Stability and Growth Pact aimed to ensure fiscal discipline, but failed to do so and will be reinforced. Other aspects of the EMU's architecture is changing. A period of flux lies ahead. The ECB may not remain a "Europeanised Bundesbank". Germany is no longer pleased with the way things are evolving.

The latest setbacks have even bolstered the view often heard in the UK and the US that the single currency may not survive in its current form. Among the euro zone countries, however, there is considerable determination to make the necessary changes to ensure its survival, but a unified vision of which direction to go is proving difficult to find. Also, in view of the lack of competitiveness of some south European countries, it has become conceivable that not all the current members may stay the course.

Long time in the making: A reference to a common European currency can be found in the 1957 Rome Treaty which established the European Economic Community (EEC). The first plan for the creation of a monetary union was elaborated by the European Commission in 1962, but was not taken any further. The 1970 Werner Report envisaged the creation of a monetary union in 1980 but became victim of the breakdown of the Bretton Woods system of fixed exchange rates.

Kicking off with the “snake”: A European currency system (“currency snake”) was introduced in 1972 to limit the fluctuations of the currencies of the European Community (as the EU was then known) against each other to 4.5% (+/- 2.25%). This was replaced in 1979 by the European Monetary System (EMS), consisting of the European Currency Unit (ECU), exchange rate and intervention mechanism (ERM) and various credit mechanisms. The “snake” band of +/- 2.25% was maintained for most currencies (+/- 6% for Italy), but allowed occasional exchange rate adjustments to be made.

Maastricht settles it: The 1992 Maastricht Treaty finally settled the form monetary union was to take. The exchange rate turbulence of 1992-93, during which the British pound and the Italian lira left the EMS and the fluctuation bands had to be widened to +/- 15%, enhanced scepticism about the project. But the political leaders of the time, notably German Chancellor Helmut Kohl and French President Francois Mitterrand relentlessly drove the project forward.

Final agreement was reached by the European heads of state 2nd/3rd May 1998 and the monetary union started life on the 1st January 1999. The existing ERM came to an end and was replaced by the ERM II.

Will it fly? Various economic difficulties were envisaged. Many argued that EMU would, even could, not work. But its motivation was never primarily economic. EMU was conceived as another stepping stone to the ultimate goal of European political union. It involved member countries relinquishing their national monetary policy.

In a more limited way this was already the case in the EMS where maintaining the fixed exchange rate parities implied following the monetary policies of the Bundesbank for Germany, the economically strongest of the EMS countries. France in particular called for a monetary union where monetary policy is set by all the member countries.

A political animal: At the time of German reunification there was also the desire to bind Germany firmly into a European system. Some saw monetary union as a bargain: France would accept German unification if Germany abandoned its renowned DM. Initially reluctant, the German government subsequently became an enthusiastic supporter of EMU as a means of bringing European political union closer. The German people were, however, never consulted and, judging by the surveys carried out at the time, would have refused to jettison the DM.

It is probably incorrect to see Germany giving up the DM as a quid pro quo for others accepting unification. Unification would have happened in any case. It is nonetheless true that a unified Germany, retaining the powerful DM, would have been intolerable for the other European countries. This Germany's political leaders understood. Some even doubt that EMU could have been achieved without the potential threat to the established European order posed by German unification.

Clone of the Bundesbank: After much soul searching the Bundesbank was won over by the undertaking to model the ECB on the Bundesbank, particularly in its strict monetary policy aimed at tightly controlling inflation. This explains much of the restrictive stance the ECB has pursued through much of its short life.

Not to the liking of all: Of the then 15 EU countries, eleven became enthusiastic participants on 1 January 1999. The UK, Sweden and Denmark felt little enthusiasm for membership while the Greek economy was deemed not quite ready and joined only in 2001. Followed by (each time on 1 January) Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009 and Estonia in 2011. (also see Prospective members) For a blow-by-blow account of the formation of EMU see David Marsh, The Euro, 2009, Yale University Press

EMU aroused widespread scepticism, particularly in Anglo-Saxon countries. The former British PM Margaret Thatcher famously proclaimed in her 2002 book “Statecraft” that the “European single currency is bound to fail, economically, politically and indeed socially, though the timing, occasion and full consequences are necessarily still unclear”. During the worst of the 2008 financial crisis many thought that the time had come, that this was the occasion.

Similarly, Milton Friedman forecast that, because of its "internal contradictions", the euro area would splinter as soon as the world economy hit a real bump. In the autumn of 2008 a "real bump" arrived. Doubts were expressed that the then Euro 15 would still be fifteen by year-end. This was reflected in the financial markets by the extraordinary widening of the yield gap between German government bonds and those of various other euro zone members.

In fact rather than splinter when hitting a bump, the monetary union has tended to advance when hitting a barrier by adopting measures to overcome the difficulty ("avoiding catastrophe and muddling through").

Widening bond yield spreads: The importance of liquidity in a crisis explained some of the widening of the spreads: the German bond market is the most liquid. But previously there was only a modest yield gap to account for differences in liquidity in the markets. The widening gap implied that the markets considered that there was a risk that some countries may default and/or leave the euro zone. It would be a daunting task for a country to leave the euro zone (see Eichengreen). Yet as the crisis deepened, and some euro zone countries faced intimidating budget deficits, fears of a break-up mounted.

Support to be forthcoming: In spite of EMU's "no bail out clause" (see below), Germany in Feb'09, at the height of the crisis, found it necessary to proclaim that it would support the stability of the euro and that aid would be forthcoming for a euro zone country which hit major trouble. The European Commission added that measures were in place (without specifying what they were). At the time Ireland was in the firing line. In the end assistance was not necessary as Ireland introduced a drastic austerity regime which calmed the markets.

Talk soon became about more countries joining rather than any existing members leaving. For instance two EU countries outside the euro zone, Hungary and Denmark, saw their currencies come under attack late in 2008 and had to raise interest rates. The higher interest rates were seen as” the cost of staying outside”. Early in 2009 the currencies of the Baltic states came under intense pressure and severe austerity measures had to be imposed. (more at Prospective members)

Size matters: In the crisis situation size mattered. The scale of the 2008 financial crisis was such that the central banks of small countries, especially ones with a large banking sector, were in danger of lacking resources to stabilise the situation. This was dramatically illustrated by the collapse of the Iceland economy. It may have avoided the melt-down of its financial sector if it had the ECB as a lender of last resort. Some even wondered whether the central banks of the UK and Switzerland, with their large banking sectors, could cope (see Buiter)

2008/09 Crisis boosts ECB's stature: The 2008 financial crisis indeed provided a stiff test of the single currency’s endurance. By the spring of 2009 fears of damage to the monetary union started to fade. In the bond markets the yield gaps narrowed again and talk of one or the other country quitting ceased.

Though the ECB was widely criticised for not cutting interest rates fast enough and low enough, it did in particular flood the banking system with liquidity and accepted an exceptionally wide range of securities as collateral. All in all the ECB's response may be judged by posterity as "appropriate" or even as "good".

There were obstacles. The sixteen member countries retain important powers. This complicated the task of rapidly finding a unified and broadly based response. The depth of the crisis demanded that all levers of policy be used. Still, in the course of H2'09, as the euro zone economy tentatively started to grow again and financial markets gradually began to normalise, the view grew that the ECB was successfully steering the region towards calmer waters. The monetary union survived with its reputation boosted. There was widespread agreement that the ECB dealt competently with the crisis. It appeared all the stronger for that. It was not to last.

"Internal" crisis questions EMU architecture: A crisis internal to the euro zone erupted early in 2010. Fears arose in the financial markets that deeply indebted Greece may default on its bonds, even leave the euro zone. Disquiet spread to other deeply indebted euro zone countries. Once more bond yields widened dramatically and the EUR came under intense pressure.

Being an internal crisis, rather than the 2008 financial crisis which originated in the US, the 2010 debt crisis posed questions more directly about the euro zone's architecture. These events exposed as a major weakness the euro zone's lack of a common fiscal policy, to complement the common monetary policy.

It was expressly stipulated in the Maastricht Treaty that neither the ECB nor individual euro zone countries could bail out a member country which ran into financial difficulties. Yet the difficulties experienced by Greece soon spread to other countries and undermined the euro zone as a whole.

For a thorough review of how the euro zone got into the sovereign debt crisis see the Introduction to Completing the euro zone rescue by Richard Baldwin and Daniel Gros, Centre for Economic Policy research, June 2010.

Unrealistic "no bail" out clause: The underlying premise of EMU's no bail out clause was that if a country was unable to finance its budget deficit in the markets, it is on its own and has no option but to default. This was shown to be untenable.

Firstly, for the members of the monetary union not to come to the aid of a member is against the spirit of a monetary union even if expressly prohibited by the rules. In the Greek case, as in the earlier Irish case, even Germany felt obliged to express solidarity, saying that it was inadmissible for the union to allow a member to default. "No bail out" may be the law of Europe's monetary union (and there is even doubt about this, see below), but is against the ethos of a monetary union.

Contagion: Secondly, now equally apparent is that default (real or potential) by one member raises fears of default by other members. In the recent episode Greece was by no means the only deeply indebted country (see fiscal policy).

The bonds of other deeply indebted countries rapidly also came under attack. The euro zone could be dumped into a financial crisis if the government bonds of a rising number of countries come under attack in the financial markets. According to the rules the response of the governments whose bonds are under attack has to be fiscal austerity. If an increasing number of countries resort to austerity the euro zone may be dumped into recession. Or, in the situation in the spring of 2010, dumped back into recession.

It also became evident that euro zone banks, already weakened by America's sub-prime mortgage crisis, were major holders of the bonds of the euro zone countries considered in danger of defaulting. A default would hit these banks hard. It became as much a matter of saving the banks as saving Greece.

Ineffective Stability & Growth Pact: The fact that so many countries found themselves in 2010 with such deep budget deficits and mountains of debt could be seen as a failure of the Stability & Growth Pact which is the mechanism which was supposed to prevent excessive deficit from arising in the first place (see below).

The Pact was already difficult to implement in the 2001-03 period of low growth and the provisions then had to be made more elastic. In reality the euro zone did not have a workable mechanism to enforce fiscal restrictions. As a mitigating factor it should be born in mind that the recession of 2008-09 was exceptionally deep, aggravating the fiscal imbalances. Without this deep recession the euro zone may have muddled through.

More fundamentally: divergent economic developments within euro area: More fundamental than the non-operation of the Pact is the divergent developments within the euro area with some countries improving their economy's competitiveness while other countries saw theirs deteriorate. In the absence of countervailing devaluations/revaluations this has lead to wide discrepancies in current account balances. It also contributes to the budget deficit and indebtedness as a country lacking in competitiveness finds it difficult to grow, leading to a vicious circle of inadequate growth curtailing tax inflows and raising welfare and support payments. Employment deteriorates.

Divergent economies under a single monetary roof

One-size-fits-all monetary policy: again increasingly questioned

Whether the euro area formed an optimal currency union was intensely debated at the time of its conception. Many academic economists saw major impediments in the lack of labour mobility across member countries’ borders and rigidities in product markets. The absence of a common fiscal policy was seen by many as an important shortcoming. With no problems encountered during the first ten years, these concerns faded.

Inflation differentials between the first group of euro area members, which had declined steeply in the run-up to EMU’s start in 1999, stayed roughly the same in the ten years to 2008. For instance inflation in Spain and Ireland was consistently above the euro area average, resulting in very low or negative real interest rates. Both countries also experienced strong growth and soaring property prices (which have since gone sharply into reverse).

Germany, in contrast, consistently experienced below average inflation and growth rates as well as stable property prices, leading to talk that the common monetary policy was too lax for Spain and Ireland, but too tight for Germany. Elsewhere the results were mixed. For example Finland experienced low inflation and high growth while Portugal experienced high inflation and slow growth.

Troublingly wide divergence in unit labour costs ....

Though inflation rates have now largely converged for the major countries, this remains to be achieved for unit labour cost. Already in its Nov'08 Monthly Bulletin the ECB warned that persistent differences in wage growth (not offset by differences in productivity growth) could undermine growth and jobs in the countries experiencing rapid wage increases.

The cumulative growth in unit labour costs over the 1999-2009 period amounted to 22% for the euro zone. But this average resulted from very divergent country developments: a 9% rise in Germany contrasts with a rise of 22% for France and rises above 30% in the other countries bordering the Mediterranean. Greece, at 36.5%, experienced the steepest rise of all.

Before monetary union such divergences were typically corrected through exchange rate adjustments.

Since 2009 the divergence in unit labour costs have narrowed somewhat. See inflation

... and in current account and budget balances

The divergences in current account balances and budget balances among the euro zone countries have also widened, especially after the financial crisis of 2007-09. A loss of competitiveness is anyway usually associated with a deepening current account deficit as well as with a deepening budget deficit.

In 2009 Germany sported a current account surplus of 4% of GDP. At the other extreme Greece and Portugal recorded deficits of 13% and 10% respectively. Whereas a current account deficit in a euro zone country can not lead to a foreign exchange crisis, it can lead to a credit crisis if foreign capital ceases to flow into the country. (see Martin Wolf)

Budget balances also diverged substantially in the euro area in 2009. Finland, Germany and Austria had budget deficits of around 3% of GDP. In Ireland, Spain and Greece the deficits were in the 11% to 14% range.

The divergences between current account balances and the budget balances of the euro zone countries in 2009 were much wider than in 1999, as indicated by the chart below.

(Source: European Commission, European Economy Spring 2010, Statistical Annex)

Background: Unit labour costs (ULC) measure the average cost of labour per unit of output. If total labour costs in an economy in a year rise by 4% and real GDP rises by 4%, ULC are unchanged. But if labour costs rise by 6% and GDP by 4% ULC rise by 2%.

If ULC in a year rise by 5% in (say) Spain and only by 1% in (say) Germany, Spain loses competitiveness vis-à-vis Germany (this is speaking very generally: competitiveness is affected by other factors, also there are different ways of measuring ULC).

For annual development of unit labour costs 1999 to 2013 see debt

The chart plots the current account balance and the budget balance for each country in 1999 and again in 2009. For each country the two years are connected by an arrow. All arrows point upwards, indicating that, between 1999 and 2009, budget balances deteriorated in all countries. Most arrows also slope to the right, indicating that in most countries current account balances also deteriorated (two exceptions: Germany and Austria)

In 1999, the starting point of the arrows, balances were much more closely grouped together than in 2009, the end point of the arrows, indicating the widening divergence in the euro zone.

Ireland, Spain, Greece and Portugal stand out as the countries with the deepest current account and budget deficits in 2009.

The 2009 deficits were also much deeper than in 1999 (Ireland even had a budget surplus in that year). France and Italy also show significant twin deficits in 2009, a marked deterioration from 1999. The other five countries still had current account surpluses in 2009 and the budget deficits were relatively contained. These countries, with the addition of France, are usually referred to as core Europe.

(Source of data: European Commission, European Economy Spring 2010, Statistical Annex)

... as well as in real effective exchange rates

The European Commission itself has expressed grave concern about these divergences within the euro zone. Already in a report dated Jan'10 it estimated that the real effective exchange rates for Greece, Spain and Portugal were overvalued by 10%, Germany's undervalued by 5%. Such large and persistent differences across the euro zone, the Commission warned, was of serious concern as it undermined confidence in the currency and may hamper the functioning of EMU. The differences in competitiveness is reflected in diverging current account positions. Large current account deficits entail deepening indebtedness.

The evident danger is that some countries may find it too difficult to adapt. Correcting a deep budget deficit (without the boost to exports from devaluation) may bring a long period of austerity, rising unemployment, little or negative growth and deteriorating living standards, a situation some deeply indebted countries now face.

"Race to the top"

A country may consider that it will be better off outside the monetary union. Though exiting from the single currency appears a near impossible task (see Eichengreen). Above all the absence of the previously "easy" option of devaluation forces a country to make the structural changes required to raise productivity and improve the performance of the economy.

Thereby the standard of living in the previously lagging economy may be raised towards the level in the best performing country in the monetary union (a sort of "race to the top"). A devaluation merely perpetuates the gap between a productive country and a less productive country and hence in living standards.

See Buiter about the difficulties Greece would face if it left the euro zone which may even imply leaving the EU.

EMU to survive?

Many in the Anglo-Saxon world believe that the problems starkly illustrated by Greece, Ireland and others may spell the end of the EMU "experiment", or at least the end of the EMU as currently constituted. The EMU has indeed come to a T junction, i.e. continuing along the previous trajectory was no longer possible because the divergent economic developments in the member countries were not compatible with a common monetary policy.

One change of direction may indeed be into a cul-de-sac, bringing an end to the single currency. More likely though is a revamping of the monetary union's structure to allow it to function better.~

It is proving difficult to find solutions acceptable to all. But however big these difficulties, they pale in comparison to the difficulties posed by a break-up and a return to a fragmented Europe. However, the departure of one or other country has become a possibility.

A political creation

EMU is above all a political creation, meant as a major stepping stone towards a "United States of Europe". The plunge into monetary union is now seen as hasty and ill prepared. In mitigation, the unexpected reunification of Germany in 1989, which upset the balance of power in Europe, called for a rapid response.

The period ahead will demonstrate whether the political will is there to adapt the current architecture of the monetary union sufficiently to make it function.

Fragile banks: hard hit by sovereign debt crisis

The euro zone's banks emerged from the 2008-09 recession fragile and undercapitalised. Whereas America's banking system was restructured and recapitalised in 2009, little was done in Europe. Because of how the banks are embedded in the financial and political structures of their home countries change is proving difficult.

The sovereign debt crisis is proving particularly hazardous for the banks because of their substantial holdings of the debt of the over indebted countries. The large size of banks' holdings was encouraged by their zero risk rating in regulatory capital calculations. Also the ECB accepts sovereign bonds with no haircuts as collateral for the provision of liquidity.

The capital of most euro zone banks would be inadequate if their portfolios of foreign debt were valued at market prices. This makes a restructuring of, for instance, Greek debt problematic. As banks find it difficult to obtain capital in the markets or sell unsecured bonds, they may have to be recapitalised by public funds, itself problematic.

One way to boost their capital ratios would be to stop lending. This would in turn undermine growth.

For detailed discussion see:   Nicolas Veron, Testimony on the European Debt
                                            and Financial Crisis, Bruegel Policy Contribution,
                                            September 2011

When Greece got into trouble early in 2010, unable to borrow in the financial markets at a bearable interest rate, all were unanimous: no bailout. It is not allowed under the Maastricht Treaty.

Fourteen months on, in Mar'11, the EU agreed on a EUR500bn European Stability Mechanism to bail out, from 2013, countries unable to borrow in the financial markets.

The path has been a tortuous one, easy to ridicule. The financial markets remain sceptical. Yet it testifies to the ability of the EU to innovate (and its readiness to slaughter some sacred cows).

It testifies to the political determination to advance along the path of European integration. Euro zone governments have pledged to do whatever it takes to save the euro. "Avoiding catastrophe and muddling through".

Measures taken: (see details)

Apr'10: Greece granted EUR110bn loan from member countries and IMF
May'10: creation of European Financial Stability Facility (EFSF) and European Financial Stability Mechanism (EFSM), ECB sets up Security Markets Programme (SMP)
Nov'10: Ireland bailed out
Mar'11: creation of European Stability Mechanism, Pact for the euro
May'11: Portugal bailed out
Jul'11: Lending capacity of EFSF extended; second bailout for Greece
Sep'11: Agreement to tighten fiscal discipline, including sanctions
Oct'11: EFSF bailout fund to be leveraged, Greece granted new EUR130bn aid package.
Dec'11: Agreement on fiscal compact, Commission to vet budgets.

What we have learned:

The political will to advance towards deeper European integration is strong, apparently not to be derailed by fiscal laxity of some member countries.
Lack of decisive decision making, European Commission sidelined, German-France duo taking lead, measures always "too little, too late".
Financially the euro zone is extensively interwoven: bailing out countries equals bailing out banks as banks are major holders of sovereign debt.
European banks are severely undercapitalised, requiring extensive capital injections if a sovereign defaults.
The measures taken so far have not sufficed to put an end to the crisis. The euro zone is still muddling but not yet through. Possibility of one or other country leaving the euro zone has risen.

The “Europeanised Bundesbank”: Without the approval of the prestigious Bundesbank, Chancellor Helmut Kohl would never have succeeded in ramming through his unpopular policy of ditching the DM and creating monetary union. To obtain approval the ECB had to be cast in the image of the Bundesbank.

The ECB is located in Frankfurt and its institutions mirror those of the Bundesbank. Above all the primacy of price stability and political independence was writ large into the ECB’s constitution. Hence the “europeanisation of the Bundesbank.”

27 members of the European System of Central Banks (ESCB): The ESCB is composed of the ECB and all the national central banks of the member countries of the EU. But, as not all the EU countries are part of the euro zone, the ESCB could not function as the monetary authority of the euro zone.

Instead the Eurosystem is entrusted with this task. It consists of the ECB and the central banks of the member states which have adopted the euro (17 as of 2011). The ESCB and the Eurosystem will coexist until all EU member countries have adopted the euro. Thereafter the Eurosystem will disappear.

Moving to Frankfurt’s historic vegetable market: as a further concession to Germany for relinquishing its trusted DM, the ECB is domiciled in Frankfurt, seat of the Bundesbank. (Address: Kaiserstrasse 29, D-60311 Frankfurt-am-Main, Germany; Tel (switchboard): +49 69 13 44 0); web site ECB: European Central Bank home page.

The ECB is scheduled to move to its own purpose built premises in 2014 (originally already in 2011). Located on the grounds of the old Frankfurt wholesale vegetable market on the banks of the Main, the futuristic building is now under construction. The foundation stone was laid 19 May'10 by Jean-Claude Trichet. The old market hall, a listed building, will be preserved and form part of the ECB’s space.

The building, designed by the Austrian firm COOP HIMMELB(L)AU, will be dominated by two futuristic towers (connected by an atrium). It is, according to the ECB, to become a landmark building for the entire world (pictured below). Building is scheduled for completion end-2013 with the ECB moving in in 2014.

Six man executive board: The ECB is headed by a six member Executive Board appointed (for non-renewable eight-year terms) by common accord by the governments of the member states which have adopted the euro:

-President (since 2011) Mario Draghi (Italy, born 1948), retires 31 Oct'19
-Vice-President (since 2010) Vitor Constancio (Portugal, 1943), retires 31 May'18
-Member (since 2012) Benoit Coeure (France, 1969), retires 31 Dec'19
-Member (since 2004) Jose Manuel Gonzalaz-Paramo (Spain, 1958), retires May'12
-Member (since 2012) Jorg Amussen (Germany, 1966), retires 31 Dec'19
-Member (since 2011) Peter Praet (Belgium, 1949), retires 31 May'19

Peter Praet has been given the economics portfolio. After the departure of Gonzalaz-Paramo end-May'12 the executive board will consist entirely of new members.

The Executive Board prepares meetings of the Governing Council and implements monetary policy. Some whisper this is where the vital decisions are forged.

23 member Governing Council: The ECB Governing Council sets the monetary policy of the euro zone. It consists of the Executive Board and the governors of the central banks of the countries which have adopted the euro (see current members). Each has one vote and is not to vote as a national representative but in a fully independent personal capacity.

Originally decisions were to be taken by simple majority. The president of the EU’s Council of Ministers and a Commissioner from the European Commission can attend the Governing Council meetings but have no vote. The Governing Council has in practice adopted a consensus seeking approach, rather than taking decisions by simple majority as is the case at America's Federal Reserve and Bank of England.

Reportedly the ECB had never had a formal vote on interest rates up to 2010. Consensus ruled. The consensus principle does not mean unanimity, but that most members are in broad agreement with the decision and that those who are not can nonetheless "live with" it. (see Otmar Issing, The Birth of the Euro, 2008, Cambridge University Press, p154)

From the beginning of 2009 when the number of euro zone countries rose from 15 to 16, a rotating voting scheme was to apply. But in Dec'08 it was decided to postpone the move until the number of euro zone countries reaches 18 (probably only in 2014, see Prospective Member Countries).

New voting system: The previous system of one country, one vote was considered not sustainable because it would give considerable voting power to the smaller countries at the expense of the bigger countries. Also, once more members join, the meetings, it was felt, would have too many participants to be an efficient policy-making body.

Considerable attention was given to devising the new voting system. A rotation system was devised by the ECB and approved by heads of state of the EU member countries in March 2003. The new system combines elements of rotation (on the lines of the US Federal Reserve Board's FOMC) and the formation of country groups with group representatives (on the lines of the IMF and the World Bank).

The Executive Board members will continue to have one vote each. All central bank governors will attend all meetings, but not all will have a vote all the time. It was subsequently decided that governors will rotate in and out of the voting right after one month. A governor will thus be without a vote for only a short period.

First Thursday of every month: The Governing Council usually meets in Frankfurt on the first Thursday of every month to assess the economic and monetary conditions in the euro zone and to take its monetary policy decisions.

These are announced at a press conference just after the meeting, followed by a Q & A session (can be viewed live on the ECB web site).

Two Governing Council meetings per year are held elsewhere in the euro area (2012: Madrid 3 May, Ljubljana 4 Oct).

In the week prior to the meeting all ECB officials are expected to refrain from commenting on monetary policy ("purdah"). This is to avoid undermining the ECB's message which could, it was felt, spread confusion. The ECB lays great score on speaking with on voice. The deliberations of the Governing Council are not made public, an aspect much criticised. (Minutes of the rate setting meetings of America's Fed and the Bank of England are published with a delay.)

A change in policy is often pre-announced through coded words. When during the press conference President Trichet pledges "vigilance" over inflation, a rate hike is a possibility. When this changes to "strong vigilance" a rate hike becomes very likely. The term "appropriate" to describe its policy stance usually signals that a change is unlikely in the near term. But the ECB also stresses that it is never pre-committed.

A second monthly meeting is held later in the month and deals with other, mostly administrative, matters.

Little known General Council: consists of the president and vice-president of the ECB and the governors of the central banks of all the EU member states. It will disappear once all EU members are part of the euro zone. Among its tasks is to strengthen the coordination of monetary policies in the EU and the necessary preparations for the irrevocable fixing of the exchange rates of the member countries which have not yet adopted the euro. It meets once a quarter: 2011: 17Mar, 22Jun, 22Sep, 22Dec.

Trichet's succession

President Trichet retired in 31 Oct'11. There was much speculation about who might succeed him. Bundesbank President Axel Weber (53) was the front runner, but he stepped down Apr'11 from the presidency of the Bundesbank. He explained that his vision of how monetary policy should be conducted was not shared by the majority of the ECB's Governing Council.

After receiving the endorsements of France, Spain and Germany, Italy's central bank governor Mario Draghi (63) took over from J-C Trichet 1 Nov'11.

Draghi's hat had for long been in the ring as the best qualified (he was also chairman of the Financial Stability Board, the global body looking at financial market regulations) But two south Europeans at the ECB's helm (Vice-president is Portugal's Constancio) is surprising due to these countries' reputation of fiscal and monetary laxity.

Some consider that, because of the need to counter past laxity by Italy, Draghi may pursue a particularly strict Bundesbank type monetary policy. In view of the sovereign debt crisis which is undermining the single currency, he takes over at a particular delicate time.

A note on ECB's bank supervisory role: In spite of the substantial increase in cross-border banking and financial integration, banking supervision remained a national task. Much was, however, done over the years to advance cross-border supervisory cooperation and convergence, for instance by the Committee of European Banking Supervisors. The ECB was closely involved in a consultative role. The Maastricht Treaty does allow for specific supervisory tasks to be entrusted to the ECB and the ECB has indicated that it sought a wider role in bank supervision, particularly of large banks operating across euro area borders ("cross border banking groups").

EU governments, however, decided (19 Jun'09) that national supervisors would retain their role, though supported by a "European Systemic Risk Board" (ESRB) and a "European System of Financial Supervisors".

The 65-member Risk Board met for the first time 20 Jan'11. It is staffed mostly by the ECB and national central banks and is located in Frankfurt ("hosted by the ECB"). It monitors and warns of a build up of risk in the economy. It has no legal powers to enforce action and has been criticised as being a "talking shop".

The European Parliament approved the risk board 27 Sep'10. At the same time it approved three new EU authorities to supervise the banking sector (European Banking Authority), financial markets (European Securities and Markets Authority) and the pension & insurance industry (European Insurance and Occupational Pensions Authority).

ECB independence: politicians keep off: The ECB lays great store on its independence which it considers to be unique in the world of central banks. It is independent of political influence in order to avoid politically motivated measures diverting it from its central task, assuring price stability. The Bundesbank was instrumental in making this aspect clear in the Maastricht Treaty.

The ECB and the national central banks are prohibited from seeking or taking instructions from any government of the member states or from any of the European Community institutions. Nor are member states or community institutions to seek to influence members of the decision-making bodies of the ECB. Moreover any changes in the constitution of the ESCB have to be unanimous and approved by all the member countries.

The ECB provides an annual report to the European Parliament and other EU institutions and its president appears before the Parliament’s committees. The Parliament has the right to be informed, but not to take decisions.

Primary objective: to maintain price stability: As laid down in the treaty establishing the ESCB, the primary task of the ECB is to maintain price stability. This has subsequently been clarified by the ECB to mean inflation rates of below, but close to, 2% over the medium term. Inflation refers to a general increase in consumer prices as measured by the Harmonised Index of Consumer Prices (HICP). This is the weighted average of the (harmonised) consumer price indices of the euro zone countries.

The treaty also stipulates that “without prejudice to the objective of price stability”, the ESCB is to support a high level of employment, sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic performance.

Political counterweight sought: creation of Euro Group: The emphasis and priority given to price stability and central bank independence was not to everyone’s taste. The French in particular sought a “political counterweight” to the ECB in order to co-ordinate the economic policies of the euro zone, to ensure the competitiveness of the euro and to deal with general economic and social aspects. It was seen as sort of “economic government”, filling what some saw as a void in the monetary union construct.

This was emphatically opposed by Germany who feared that the independence of the ECB would be compromised.

This discussion eventually led to the creation of the Euro Group, an informal meeting of euro zone finance ministers held on the eve of the monthly ECOFIN meeting (the EU Council of Finance and Economic Ministers). Calls to strengthen the Euro Group continued to be heard but continued to be met with German resistance.

There was a feeling that Germany may have given up the DM, but was more than ever in control of the euro zone's monetary policy. The ECB was perceived as implementing Bundesbank style monetary policies on a European scale.

The Luxembourg PM Jean-Claude Juncker (56) is chairman of the Euro Group (but will shortly be replaced). An Economic and Financial Committee (EFC) prepares the agenda for these monthly meetings of the euro zone finance ministers. It comprises senior officials from member states, the Commission and the ECB.

Change is in the air: The sovereign debt crisis is of such severity that discussions are underway of how to adapt the monetary union to better cope. Some fundamental change may take place. There is as yet little agreement about what they may be.

Fiscal policy remained in the hands of national governments: The lack of a common fiscal policy to complement the common monetary policy was seen as a negative feature of the currency union right from the start. This lack was up to 2008 not the hindrance the critics foresaw. But early in 2010 it moved centre stage.

Fiscal policy is particularly important in Europe. Expenditure by the general government sector (central, state and local government as well as social security) amounts to around 48% of GDP in the euro area, only 34% in US and 40% in Japan.

“Matter of common concern”: Though in the hands of the member countries, fiscal policy is hemmed by the Maastricht Treaty. The Treaty states that the economic policies of member countries are “a matter of common concern”. Moreover the “excessive deficit procedure” defines the requirement of a sound budget position.

Also, on the recommendation of the European Commission, the EU Council adopts Broad Economic Policy Guidelines (BEPGs) which are to provide the general economic policy objectives of the EU member states. Country specific recommendations can also be included in the BEPGs.

Fiscal laxity of one member could impose costs on all through various channels:

excessive spending by a member country could drive up inflation, bringing in its wake a tightening of monetary policy by the ECB, burdening all euro zone members with higher interest rates
at the extreme rising inflation could lead the ECB to monetise public debts
an excessive budget deficit in one country which can no longer be finance by borrowing in the markets could force the other member countries to bail it out

Stability and Growth Pact: imposing a measure of fiscal discipline: Mainly on the insistence of Germany, the Stability and Growth Pact was adopted at the Amsterdam summit of EU heads of states in 1997. Its provisions call for member countries to pursue a medium term budget position “close to balance or in surplus”. This in order to provide room for budgets to slip into deficits in times of weak or negative growth while, however, keeping the budget deficits below the reference value of 3% of GDP. The reference value of the government debt-to-GDP ratio is 60%.

Should the 3% budget deficit limit be exceeded, the excessive deficit procedure is invoked which calls on the offending member to rectify the position. In theory exceeding the 3% limit could lead to the offending member being fined (except in the case of a deep recession, defined as an annual fall of real GDP of at least 2%). The fine, it has been pointed out, would further deepen the deficit.

In practice no country overstepping the 3% mark has been fined and the provisions were subsequently made more elastic. In reality the euro zone did not appear to have an effective mechanisms to enforce fiscal restrictions.

Annual stability programmes: rectifying excessive deficits: Annual stability programmes are submitted to the European Commission by each country. They contain the measures which are to bring the country’s fiscal position into balance. Towards the middle of the last decade a majority of countries failed to respect the 3% limit (including Germany over the 2002-05 years) and the restrictions of the Stability & Growth Pact were eased in 2003-04.

The Pact has nonetheless had a restraining impact on fiscal policy, though its weakness only fully came to light at the start of 2010 when Greece's excessive budget deficit set in motion the sovereign debt crisis.

No bail-out clause: A further measure to promote fiscal rectitude was the “no bail-out” clause which aimed to ensure that the repaying of public debt remains national. It was felt that the possibility of a bail out by others would encourage lax fiscal policies ("moral hazard"). Moreover the ECB and national central banks were forbidden to lend directly to a national government or to buy its securities directly. But there are no restrictions on buying government securities in the secondary market. (Also the ECB of course accepts government bonds as collateral in its refinancing operations with banks. This can be seen as an indirect way of lending to governments.)

Also, according to the treaty, the "no bail-out clause" allowed bail-outs of a member country following "natural disasters or other exceptional occurrences beyond its control." Moreover the wording of the clause appears not to exclude ways for member countries to assist other member countries in financial difficulties, even making loans. The treaty permits the financing of "specific projects". As these are left undefined, anything can be declared a "specific project".

Greece bailed out: Early in 2010 Greece started what soon became the euro zone's sovereign debt crisis. A newly elected government announced that Greece's budget deficit was twice as deep as stated by the former government. The yield on Greece's government bonds soared.

Initially the ECB and the other euro zone countries declared explicitly and forcefully that there would be no "bail-out". But this line had subsequently to be abandoned. Not only did the sovereign debt of other heavily indebted euro zone countries come under pressure, but it also transpired that German, French and other euro zone banks were major holders of Greek government bonds.

Greek banks suffered substantial loss of deposits and became dependent on the ECB for liquidity. Greece's credit rating was reduced to junk by Standard & Poor's.
For a detailed review of Greece's recent budget difficulties see: Economist.

Intense pressure was brought on Greece, which ran deep deficits even in good times, to bring the deficit back down to below 3% within a few years (from a finally reported 15.4% in 2009) and to implement structural reforms. The country faces an unprecedented intrusion in its domestic finances which is particularly problematic because of national pride and a history of social revolts, strikes and street protests.

Euro zone finance ministers eventually elaborated a bail-out framework for Greece which sidesteps the "no bailout" clause and involves the IMF. A 3-year EUR110bn bailout was finally approved by euro zone finance ministers 2 May'10, coupled with a severe austerity programme for Greece. The financial markets saw the bail-out package as a short term solution only.

It became evident early in 2011 that Greece's planned return to financing itself in the markets in 2012 was not feasible as its bond yields have risen to prohibitive levels and the austerity measures were behind schedule and the budget reduction targets were not being met.

A second bailout was agreed but faces difficulties. A "voluntary" debt restructuring, in which bond holders exchange maturing bonds for longer dated bonds, is part of the agreement. An eventual Greek default on its debts is expected. Even its exit from the euro zone can no longer be excluded.

The bailout of Greece was followed in Nov'10 by the bailout of Ireland and in May'11 by the bailout of Portugal.

Pact for the euro: At the Mar'11 summits of EU leaders outline agreement was reached on a "pact for the euro", previously "competitiveness pact", which aims to prevent future debt crises by harmonising budgetary, tax and social policies. The measures to be taken are voluntary (there are no sanctions) and are to be supervised by the European Commission. It is a general appeal for wage restraint, raising the retirement age, commitment to rigorous budget and labour market reforms as well as harmonisation of the corporate tax rate.

The member countries have also committed themselves to translate the provisions of the Stability & Growth Pact into national legislation and put in place national legislation for banking resolution. The debt stock is to be reduced by 1/20th annually where the existing debt stock exceeds 60% of GDP.

The euro zone heads of government are to meet once a year to verify progress. But all other EU countries are invited to join. This can conceivably be seen as a form of "economic government".

The Pact for the euro is widely seen as inadequate and far ranging discussions are underway on more substantial changes to the construct of the monetary union. So far little agreement exists.

Exchange rate policy: shared with ECOFIN, ECB has final say: Decisions on foreign exchange rate policy is a shared responsibility of the EU Council of Finance and Economic Ministers (ECOFIN) and the ECB. But according to the Treaty any decisions regarding foreign exchange policy are to be fully consistent with the ECB’s primary objective of price stability. Also the sole competence for deciding and carrying out foreign exchange operations lies with the Eurosystem.

Policy of benign neglect adopted: As the ECB has as prime task the maintenance of price stability it does not have specific measures regarding the foreign exchange rate of the EUR. The exchange rate regime is generally characterised as “benign neglect”. Officially the ECB intervenes in the foreign exchange market only to iron out excessive short term fluctuations or imbalances.

The considerable movements of the EUR against the USD has nonetheless been at times of considerable concern and has often resulted in “verbal intervention”. As far as it is known there have been only two instances late in 2000 when the ECB has openly intervened in the foreign exchange market (both times to support the euro and with little effect).

Exchange Rate Mechanism II (ERM II): currently three members: With the launching of the euro at the start of 1999 the then existing ERM came to an end and was replaced by the ERM II. Its aim is to promote exchange rate stability in the EU. But on the insistence of the UK membership was voluntary. Membership is mandatory only as a precursor to full euro zone membership. Only two countries initially became members: Denmark and Greece. Greece joined the euro area in 2001.

Currently there are three currencies in ERM II, the most prominent and enduring being the Danish Krone. As a prelude to joining EMU, the Danish krone was joined at various times by Lithuania’s litas, Estonia’s kroon, Latvia’s lats, Cypriot pound, Maltese lira, Slovenia’s tolar and Slovakia’s koruna. Most were temporary members before being replaced by the euro. Besides Denmark's krone, still remaining in the "waiting room" are Lithuania's litas and Latvia's lats. (see also prospective members)

Currencies in the ERM II float within a range of +/- 15% against the central euro rate, but most countries impose a much tighter band of +/- 1% or less. In the case of turbulence, ECB foreign exchange intervention and financing at the margin of the standard or narrow intervention bands are, in principle, automatic and unlimited, with very short term financing available. This can, however, be suspended if it conflicts with the ECB’s primary objective of price stability.

High credibility achieved, initial doubts overcome: In June 2008 the ESCB celebrated its tenth anniversary. On the 1st of January 2009 the euro itself celebrated its tenth anniversary.

Contrary to the initial widespread scepticism, the euro had, over those ten years grown in stature. It had become a fact of life. Until the turmoil which engulfed the financial world in Sep’08, it was hard to imagine that the single currency could still fail. In terms of its exchange rate against the USD the early years were difficult as the currency devalued steadily. But since 2002 it appreciated and reached early in 2008 a level which few thought possible.

The euro also steadily raised its share of world official foreign exchange reserves: in Q3'09 its share of global central bank reserves stood at 27.9%, up from 17% in 2000. Since it has slipped to 25.7% in Q3'11 as the debt crisis weighs. The dollar still dominates.

From 2003 until the financial crisis struck the euro zone economy prospered. Unemployment fell sharply. But early claims, some extravagant, that monetary union would raise overall growth and boost internal trade were not realised. Intra euro area trade grew, but less rapidly than world trade.

The euro area's underlying growth rate had shown no improvement. Per capita income remained at around 70% of that of the US. EMU had thus neither fulfilled the prophesies of its doomsayers nor the feats of its champions.

Inflation remained moderate. In most years it fell into the 2% to 2.5% range. Over the 1999-2009 inflation averaged 2.1%, slightly above the target. The ECB gained credibility for its low inflation monetary policy.

ECB acquired reputation for efficiency: The ECB was also satisfied that the operational framework of the single monetary policy was functioning smoothly, as was its clearing and settlements system. Its provision of liquidity in crises (9/11, sub-prime mortgages) was quick and generally deemed to have been commensurate.

The smooth introduction of euro coins and notes in Jan'02, a gigantic logistic exercise, enhanced the ECB's reputation for efficiency.

Its response to the Sep'08 financial crisis was also deemed sure footed, quick and efficient, preventing a meltdown of the financial system by showering it with liquidity and accepting a broad range of collateral from the banks.

The current President, Jean-Claude Trichet, who took over from Wim Duisenberg in 2003, was widely admired. He fully embraced the stability ethos of the Bundesbank. The euro zone's sovereign debt crisis brought an end to this happy state of affairs.

Monetary union comes under severe strain: 2010-11 are proving exceptionally difficult years for the ECB. It is attempting to cope, breaking many of the principles on which it was founded. It can no longer be excluded that a country may leave the monetary union.

Various policies are being put into place to cope with the sovereign debt crisis. The ECB and the EU are showing flexibility. Yet the measures to finally end the crisis have so far eluded the policy makers. But it still appears more likely than not that the sovereign debt crisis will find a solution, leaving the monetary union stronger for having muddled through.