European Economic and Monetary Union (EMU)

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What is the 'European Economic and Monetary Union (EMU)'

The European Economic and Monetary Union (EMU) is the successor to the European Monetary System (EMS), the combination of European Union member states into a cohesive economic system, most notably represented with the adoption of the euro as the national currency of participating members.

BREAKING DOWN 'European Economic and Monetary Union (EMU)'

The EMU's succession over the EMS occurred through a three phase process, with the third and final phase initiating the adoption of the euro currency in place of former national currencies. This has been completed by all initial EU members except for the United Kingdom and Denmark, who have opted out of adopting the euro.

History of the European Monetary Union

The first efforts to create a European Economic and Monetary Union began after World War I. On September 9, 1929 Gustav Stresemann, at an assembly of the League of Nations, asked, "Where are the European currency, the European stamp that we need?" Stresemann's lofty rhetoric became irrelevant, however, when a little more than a month later the Wall Street crash of 1929 became the symbolic beginning of the Great Depression, which not only derailed talk of a common currency, it also split Europe politically and paved the way for the Second World War.

The modern history of the European Economic and Monetary Union started with speech given by Robert Schuman, the French Foreign Minister, on May 9, 1950 that later came to be called The Schuman Declaration. Schuman argued that the only way to ensure peace in Europe, which had been torn apart twice in thirty years by devastating wars, was to bind Europe as a single economic entity: "The pooling of coal and steel production ... will change the destinies of those regions which have long been devoted to the manufacture of munitions of war, of which they have been the most constant victims." His speech led to the Treaty of Paris in 1951 that created the European Coal and Steel Community (ECSC) between treaty signers Belgium, France, Germany, Italy, Luxembourg and the Netherlands.

The ECSC was consolidated under the Treaties of Rome into the European Economic Community (EEC). The Treaty of Paris was not a permanent treaty, and was set to expire in 2002. To ensure a more permanent union, European politicians proposed plans in the 1960s and 1970s, including the Werner Plan, but world-wide, destabilizing economic events, like the end of the Bretton Woods currency agreement and the oil and inflation shocks of the 1970s, delayed concrete steps to European integration.

In 1988, Jacques Delors, the President of the European Commission, was asked to convene an ad hoc committee of member states' central bank governors to propose a concrete plan to further economic integration. Delors's report led to the creation of the Maastricht Treaty in 1992 that established a timeline for the creation and implementation of the EMU.

In 1998, the European Central Bank (ECB) was created, and at the end of the year conversion rates between member states' currencies were fixed, a prelude to the creation of the euro currency, which began circulation in 2002.

European Monetary Union and the European Sovereign Debt Crisis 

Adoption of the euro forbids monetary flexibility, so that no committed country may print its own money to pay off government debt or deficit, or compete with other European currencies. On the other hand, Europe's monetary union is not a fiscal union, which means that different countries have different tax structures and spending priorities. Consequently, all member states were able to borrow in euros at low interest rates during the period before the global financial crisis, but bond yields did not reflect the different credit-worthiness of member countries.

Greece and the Flaws in the EMU

Greece represents the most high-profile example of the flaws in the EMU. Greece revealed in 2009 that it had been understating the severity of its deficit since adopting the euro in 2001, and the country suffered one of the worst economic crises in recent history. Greece accepted two bailouts from the EU in five years, and short of leaving the EMU, future bailouts will be necessary for Greece to continue to pay its creditors. Greece's initial deficit was caused by its failure to collect adequate tax revenue, coupled with a rising unemployment rate. The current unemployment rate in Greece is 25 percent; for people under age 25, it is 50 percent. In July 2015, Greek officials announced capital controls and a bank holiday and restricted the number of euros that could be removed per day.

The EU has given Greece an ultimatum: accept strict austerity measures, which many Greeks believe caused the crisis in the first place, or leave the EMU. On July 5, 2015, Greece voted to reject EU austerity measures, prompting speculation that Greece might exit the EMU. The country now risks either economic collapse or forceful exit from the EMU and a return to its former currency, the drachma.

The downsides of Greece returning to the drachma include the possibility of capital flight and a distrust of the new currency outside of Greece. The cost of imports, on which Greece is very dependent, would increase dramatically as the buying power of the drachma declines relative to the euro. The new Greek central bank might be tempted to print money to maintain basic services, which could lead to severe inflation or, in the worst case scenario, hyperinflation. Black markets and other signs of a failed economy would appear. The risk of contagion, on the other hand, may be limited because the Greek economy accounts for only two percent of the Eurozone economy. On the other hand, if the Greek recovers or thrives after leaving the EMU and European imposed austerity, other countries, such as Italy, Spain and Portugal, may question the tight austerity of the euro and also be moved to leave the EMU.

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