European Monetary Union (EMU)

The European Monetary Union is an economic entity and not a political one. As such, it is not one country, but rather is a group of 12 European countries, all members of the European Union, that have banded together to form a currency bloc for economic gain. Recently most news has been focused on the common currency - the euro - as it went from a virtual currency used in international transactions to one used by the citizenry of the EMU. The Deutschmark, French franc, Italian lira and others were phased out of existence and euro currency and coins took their place January 1, 2002.

The original idea was developed shortly after the end of World War II as a political move (and it remains a political move even though the impact is economic). The goal was to link the European countries so closely that another war would be impossible. But political unity proved to be difficult with countries refusing to give up their national sovereignty. Political union would have meant a common government budget, foreign affairs and social policy. However, monetary union allows countries to have control over their national budgets. At the same time, the countries acknowledge that under monetary union it will be more difficult to solve long term internal problems such as unemployment under the European Economic and Monetary Union (EMU) constraints.

In a way, the euro's birth can be looked upon as a solution to the problem caused by the breakdown of the Bretton Woods system of fixed exchange rates in 1971-73. Because of the high level of trade between European countries, it was felt that freely floating exchange rates would be disruptive to commerce and economic growth. Countries attempted to peg their currencies to one another to limit fluctuations. However, because of the lack of economic convergence, periodic realignments were necessary and the countries drifted into two blocks - one with low inflation and low interest rates and another that required higher interest rates to maintain stable exchange. There were still disruptions.

The European Economic and Monetary Union has had a major impact on the world economy, international trade relations and global financial markets. The eurozone includes 12 European nations and will eventually rival the size of the U.S. economy as well as U.S. trade volumes. The twelve countries are Germany, France, Belgium, Luxembourg, Finland, Italy, Spain, Portugal, Ireland, Netherlands, Greece and Austria. Three members of the Economic Union (EU) chose not to participate in EMU. Denmark, Sweden, and the United Kingdom did not join at this time because of strong domestic and political opposition. Many eastern European countries, however, looking to join the EU took the first step towards membership in December 2002.

In the absence of independent monetary and exchange rate policy, the only tool left to individual countries is fiscal policy. A Stability and Growth Pact, which puts tight limits on public borrowing, is part of the EMU plan. The logic behind the Pact was to prevent the use of fiscal policy to undermine monetary policy. But if the complicated Pact rules are followed, fiscal policy could become dangerously tight, especially in times of an economic slowdown. It should be noted that one of the criteria for entrance into the EMU was that the government deficit should be no more than three percent of GDP per year and the debt level be not more than 60 percent of GDP. It should be noted that the euro governments taken together breached the three percent ceiling every year between 1982 and 1996.