Economic Report President

EUROPEAN ECONOMIC AND MONETARY UNIONThe European response during the 1990s to the challengespresented by financial globalization has been to continue the processof economic and financial integration of the continent. As part of thisprocess, 11 members of the European Union embarked on a projectof monetary unification, which took effect on January 1, 1999, withthe third stage of European Economic and Monetary Union (EMU).European integration raises some of the same analytical issues andpolicy challenges as the integration of the emerging market countriesinto the world financial system.THE EMU SCHEDULEIn a summit meeting in the spring of 1998, the heads of the EU governmentsdecided that EMU should proceed as envisioned in theMaastricht Treaty of 1991 to its third stage, monetary unification. Thefounding members of EMU were selected on the basis of assessments,made by the European Monetary Institute (the forerunner of the EuropeanCentral Bank) and the European Commission, as to whether theyhad met the Maastricht Treaty’s economic convergence criteria in1997. Members were required to have had government deficits andtotal debt that were no greater than 3 percent and 60 percent of grossdomestic product (GDP), respectively. In addition, their inflation ratesand long-term interest rates had to have been within 1.5 and 2 percentagepoints, respectively, of the average of the three EU countries withthe lowest inflation and interest rates. Finally, members’ currenciesmust also have stayed within the EU Exchange Rate Mechanismbands for 2 years.Twelve of the 15 EU members wished to participate in EMU from itsinception, and 11 of these were found to satisfy the criteria (onlyGreece was not). This, in part, reflected remarkable progress towardfiscal consolidation, since the targets had seemed out of reach formembers such as Italy a mere year or two before. Of the other threeEU countries, Denmark and the United Kingdom had opted not to joinEMU for the time being, whereas Sweden had chosen not to qualify byremaining out of the Exchange Rate Mechanism.The remarkable convergence of financial conditions in the Europeancountries is clear from data on the 11 EMU countries’ short-term andlong-term interest rates (Charts 7-1 and 7-2), which show a sharp convergenceafter 1996. Differences in interest rates across countries canbe due to two major factors: a currency premium related to the risk ofdevaluation, and a country premium related to the possibility ofdefault on the public debt. With monetary union to start in January1999, short-term interest rates had converged by late 1998, as currencyrisk was eliminated (default risk is already close to zero for very291