The EU (as constituted in the 1980s) had a population that was bigger than that of the United States and three times larger than Japan’s.

The basic performance measures described below show that by the 1980s the economies of Europe had lost the vigour that had been apparent during the 1960s.

For the purpose of making a like-for-like comparison, Europe is represented in Tables 16.1-16.3 by the 15 countries which constituted the EU at the time the single currency was launched, albeit that three chose not to join.

The term ‘Eurosclerosis’ was coined during the 1980s to describe Europe’s economic malaise, and it was against this background that policymakers put forward proposals to reverse the trend by enhancing economic integration among EU members.

In terms of economic growth, Japan remained the most dynamic of the advanced economies during the 1980s, having enjoyed three decades of spectacular expansion as it established itself as a world-class manufacturer and exporter.

The big difference from the 1970s was that Europe’s growth rate began to fall behind that of the USA.

By the 1990s Japan had fallen by the economic wayside, and was enduring what became known as the ‘lost decade’. Meanwhile, the differential between Europe and the USA widened further as the latter’s growth was boosted by the onset of the dotcom boom.

In the years from 2000 to 2008, during which 12 of the EU-15 were in the euro, their economic growth performance remained lacklustre. The best that can be said is that it remained ahead of Japan’s, while the gap versus the US was narrower than in the 1990s.

Table 16.1: GDP growth 1961-2009

Table 16.2: GDP per head 1960-2007

Table 16.2: GDP per head 1960-2007 shows trends in GDP per head in relation to the figure for the EU-15 over the period since 1960. The comparison is made in terms of purchasing power parities (PPPs), which avoids the vagaries and volatility of exchange rates and gives a better guide to living standards

Europe closed the income per head gap with the US between 1960 and the late 1980s. But it widened again during the 1990s before stabilising in this decade.

Nonetheless, the average American still has a standard of living that is more than a third higher than that of the average citizen of the EU-15. After overtaking the EU-15 during the 1980s, Japan has since lost ground, so that the two are now on a par.

The most obvious consequence of this relatively poor performance has been slower growth of employment and higher rates of unemployment. Although unemployment rates tended to rise in all major economies from the end of the 1960s, the increase was most marked in the EU.

The European average, moreover, masks the fact that in several member countries such as Germany, Spain, France and Italy, the rate of unemployment among the civilian labour force has been in double figures at times during the past decade.

Even after nearly two decades of economic stagnation, Japan’s unemployment rate is still well below the EU-15 level.

Table 16.3: Unemployment rates 1961-2008
(% of civilain labour force)

Table 16.4: Intra-European trade in 1990
(% of trade with other EU members)

As Table 16.4: Intra-European trade in 1990 shows, during the period when the single currency was being considered, the principal customer of, and supplier to, EU member states was other EU countries.

It follows from this that if cross-border trade between members could be increased, it ought to provide a spring-board for faster growth and an opportunity to combat ‘Eurosclerosis’.

The first step in this process was the Single European Act, which came into effect in 1987. Better known as the 1992 programme, it included provisions to remove the physical, fiscal and technical barriers to trade between members of the EU in order to create a single market.

Even then, it was clear that trading with another EU member was still both more expensive and riskier for a business than buying or selling within its own borders. The additional cost was the foreign currency transaction and the extra risk was the instability of the exchange rate, which together made pricing difficult and could reduce a company’s export profit margins.

The logical next step after the creation of the single market was a single currency which, by cutting costs and removing exchange risks, would stimulate trade.

Stage One pre-dated Maastricht, starting in 1990. It consisted of the final removal of exchange controls in eight of the then 12 participating members of the ERM, and measures to encourage convergence.

Stage Two started in 1994 and gave the newly created European Monetary Institute (EMI) responsibility for preparing for monetary union.

Stage Three began with the irrevocable locking of currencies and the start of the euro in January 1999.

For a single currency to succeed, a high degree of economic convergence is essential.

Within the euro area there is only one interest rate which is set by the European Central Bank (ECB), the successor to the EMI which is charged with maintaining a low inflation environment.

Convergence was defined in terms of four criteria which the initial participants were expected to meet by the end of 1997. These criteria are still applied to applicants, while the Stability and Growth Pact (SGP) is meant to keep countries on the path of fiscal discipline once they’ve joined the Euro Area.

The convergence criteria are:

• price stability - a rate of inflation no more than 1.5 percentage points above the average of the three member states with the lowest rates of annual inflation;
• durability of convergence - long-term interest rates not exceeding the average rates of these low inflation states by more than two percentage points for the previous 12 months;
• exchange rate stability - exchange rates which have fluctuated within normal ERM margins for at least two years;
• a sound government financial position, as determined by the Excessive Deficits Procedure. Whether a country is subject to this procedure is judged in terms of its annual general government deficit, which should not exceed 3% of GDP, and its total outstanding borrowings, which should not be more than 60% of GDP.

In May 1998, when it came to making the formal decisions about which countries qualified for the third stage of EMU, some latitude was shown in respect of the public finances criteria.

Simultaneous with the summit meeting, it was decided that seven of the 11 applicants should no longer be subject to the Excessive Deficits Procedure. The authorities made allowances for the fact that there was clear evidence of improvement in government fiscal positions.

Only Greece and Sweden were rejected, the latter on the grounds that it had not joined the ERM. This was a good example of the EU’s penchant for diplomatic window-dressing, as in reality Sweden did not wish to join, but unlike the UK and Denmark it did not have a formal opt-out.

As from 1 January 1999, the exchange rates of the participating member states with the euro were irrevocably fixed.

From that date the euro became the legal currency of the 11 participating member states, with the national currencies existing only as subdivisions of the euro. Foreign exchange markets between participating countries therefore ceased to exist.

During the transition, companies had the choice as to whether to use the euro and when to make the switch.

Finally, from 1 January 2002, euro notes and coins were introduced and became legal tender. The production of 70 billion coins weighing 300,000 tonnes had begun in 1998.

Legacy national notes and coins were withdrawn from all member countries by the end of February 2002, so completing the process.

Common monetary policy

Responsibility for achieving price stability and therefore control of interest rates has been vested in the European Central Bank, which has its headquarters in Frankfurt.

The ECB is independent of any national government and of other European institutions.

The first President, Wim Duisenburg, was appointed for a fixed term by the Council of Ministers. The President heads a six-man Executive Board, all of whom sit with the Governors of the national central banks to form the Governing Council.

The present holder of the title is Jean-Claude Trichet who was appointed in 2003.

EBC Strategy

In its ten-year existence, the ECB has shown itself to be both aggressively anti-inflationary and stubbornly independent.

Its strategy for achieving price stability involves a combination of direct inflation targeting and monitoring of monetary aggregates. Monetary policy is geared to keeping inflation close to, but not above, 2% over the medium term.

In its determination to meet this target, the ECB has tended to adopt a more rigorous interest rate stance than either the Bank of England or the Federal Reserve in the US.

Source: Thomson Financial Datastream

The second pillar of the Euro Area’s architecture is the Stability and Growth Pact. This was agreed by heads of government at the Amsterdam summit in June 1997.

Given the efforts made to achieve convergence of fiscal positions in the run-up to Stage Three, it was thought vital to establish a new mechanism which built on the Excessive Deficits Procedure to ensure that members did not jeopardise the eurozone’s economic stability by lax fiscal management.

The Pact maintained the 3% of GDP ceiling for annual government deficits, and set in place a more rigorous system of medium-term objectives, surveillance, and penalties. Sustained breaches of the Pact could, ultimately, lead to a country paying substantial fines.

From the start, doubts were expressed about whether the Pact was enforceable, especially when large countries commit breaches. When tested by France and Germany in the wake of a modest economic downturn in 2004 and 2005, the sanctions proved worthless.

These two large countries justified their ‘excessive’ deficits by the downturn in their domestic economies, characterised by slow growth and high unemployment. Denied the option of reducing interest rates to stimulate activity, a looser fiscal stance was the alternative.

Rather than punish the errant nations, the Council of Ministers renegotiated the Pact in 2005. Although the basic parameters of the Pact (3% deficit and 60% public debt limits, as shares of GDP) remain unchanged, the list of mitigating circumstances has been widened.

Yet despite concerns that this might prelude a further rash of breaches, fiscal discipline has been good in the past few years, albeit against the background of relatively strong economic growth. By 2008 the aggregate deficit for the EU was just under 2% of GDP.

British critics have certainly had to hold their tongues as the fiscal position in the UK has been allowed to deteriorate, with the deficit in 2008, measured on the EU harmonised basis, reaching over 5%.

Source: European Commission, Government Finance Statistics

When it was launched in January 1999, one euro was worth £0.70 and US$1.18. From there it fell consistently in value.

While there was a degree of scepticism about the credibility of the euro’s institutional framework, the main cause of the new currency’s weakness was the dotcom boom and the enthusiasm of investors for all things American.

The euro’s low-point against sterling, at £0.57, was reached in October 2000, while around the same time the euro fell to just US$0.81.

Source: Thomson Financial Datastream

Since 2002, however, the single currency’s fortunes have turned around to a remarkable extent. The launch of the euro has created large pan-European markets for equities and bonds.

The returns on these assets may not always be spectacular, but for investors in the eurozone at least there is no currency risk to worry about.

Indeed, at various points in recent years the euro’s strength has become a problem for the region’s exporters, and could be a factor that will inhibit economic recovery. In early 2008, the euro peaked at around $1.60, and later the same year nearly achieved parity with sterling.

For all the doubts about whether the Euro Area makes economic sense as a single currency zone, the fact remains that the euro has become a strong and credible currency.

It is now believed to represent around a fifth of holdings of foreign exchange reserves by the world’s central banks, making it a clear second choice after the dollar, but well ahead of the yen.

To date, four of the new EU members have joined the eurozone: Slovenia in 2007; Cyprus and Malta in 2008; and Slovakia in 2009.

Unlike the UK and Denmark, which negotiated opt-outs, new members do not (in theory at least) have any choice about joining the single currency once they have met the convergence criteria. But some of the new members have been distinctly lukewarm (especially Poland and the Czech Republic).

Becoming a member of ERM2, which is a reformatted version of the original Exchange Rate Mechanism for aspirant single currency members, is mandatory for a period of two years. As yet, Hungary, Poland, and the Czech Republic have not joined ERM2, so that their currencies still float relatively freely.

The upside

Membership of the euro is especially attractive to small economies. Not only does participation in its institutions give them a seat at the top tables of decision-making, but it also avoids the perils of extreme volatility at times of international financial turbulence, of the sort experienced in 2008 by Iceland.

This is a particularly pertinent issue given the economic meltdown that beset the three tiny Baltic states of Estonia, Lithuania, and Latvia during 2009. Having joined ERM2 several years ago they are all keen to preserve their exchange rate parities, for otherwise the two-year clock would be reset, thus delaying their chances of joining the single currency.

The downside

Yet it is also abundantly clear that they are paying a high price, with the adjustment process being worked out through falls in domestic prices and wages. They are all in the grip of extremely severe recessions, with GDP likely to decline on an annual basis by around a fifth in 2009.

In September 2008, the newly-elected Polish government announced a timetable for joining the single currency in 2012. But with the effects of the global economic recession pushing up public spending, and the government still unwilling to lock the zloty into ERM2, it was admitted in July 2009 that this timetable would be missed. It now looks unlikely that anybody new will join the euro before 2013.