Foundations of the European Union

The European Monetary System and Policy
By Maarten Solinger
International Business Program

i. Executive Summary
The European Monetary System and Policy dates back to 1959 when the first step towards monetary union was made with the treaty of Rome. Right now, 47 years later, the euro is a fact, with a monetary system that prevails over all the countries of the euro-zone, with a policy that was originally based on satisfying growth, low to no inflation, low unemployment and lower and more stable prices, as well as elimination of conversion fees, deeper financial markets, and lower volatility therein. It has been successful in accomplishing most of those objectives, even though some are openly disputed. Whether the euro as a whole is successful remains to be seen, since the question if the euro-zone in itself is suitable for monetary union is left largely unanswered. Two criteria are met with, and two are not.
The key success factor now and in the future will be the policy of the ECB, which is dual; fight of inflation at the expense of economic growth or vice versa. How long the policy of the ECB can count on the trust of its members depends largely on movements in the world economy, the financial markets and the ability of policy makers to shroud the efforts in political correctness.

ii. Table of contents

i. Executive Summary p. 2 ii. Table of Contents p. 3 iii. Preface p. 4 1. Euro History p. 6 2. The European Monetary System p. 7 3. The early nineties currency crisis p. 8 4. Convergence program p. 10 5. Launch of the euro as a currency p. 12 6. The benefits of the euro p. 16 7. European Central Bank Policy and promises p. 23 8. The future of the European Monetary System p. 25 9. Conclusion p. 27 10. Bibliography p. 30

iii. Preface

The European Union has a monetary system because it is not only a free trade alliance, but it also has a its own currency which is now used as currency in 12 of its member states. This system works as follows: There is one central bank, which independently of the political and legislative system defines and executes the European monetary policy for as far as money and intervention rates are concerned, this being a major macro economic power in the world economy, it is carefully monitored and advised by the brightest people the EU could entice for public service. Of course, I could very well explain how it works and thereby show that I have a clear understanding of the workings of the European Union’s monetary system, as I said, I would fly through that, however, everything is so closely related to one another that that is simply impossible. Therefore, I have carefully sought out how it works, what mechanisms are at play and made a critical extrapolation towards the future. I will answer the question how it happened and how it works in the body of the paper and if it works now and in the future in the conclusion. I have taken a semi-scientific approach, it cannot be the purpose to confuse anyone reading this.

A few weeks later, I have indeed been able to contact an official within the European Central Bank, at first, most of my introductory questions were answered by a public relations officer, but as my questions got more complicated I got hold of a more or less senior official within the ECB, however, it became increasingly more difficult to get answers from the ECB even through informal channels as the e-mails I sent possessed a critical tone, myself being a strong opponent of the European Monetary System and fearful of its future implications (more about this later) which was hard to keep out, some were answered with a proverbial ‘no comment’, the last three I sent, namely when I asked whether the Euro was not in fact a suicide pact for the participating economies since I assumed there was no contingency plan for when the Euro was being left by a number of leading economies like France and Germany which question was in turn based on another assumption if there was a contingency plan for when countries in fact leave the Euro-zone and there might be a run on the Euro causing economic regression in the Euro-zone, were downright ignored. One time-stamped (very informal) e-mail I received contained more factual information on contingency though.

1. Euro-history
In other words, how did this happen, how did it get this far, with this I do not want to say things like: Has everyone gone raving mad? This is the stupidest idea ever.
For instance, it seemed a very good idea for the United States of America’s dollar in 1785; replacing every state’s respective pound and so to have one currency that was accepted in every state, it lead to price stability, and no more discrepancies in exchange rates within the United States, which in term gave a greater sense of freedom to its citizens, who now could pay in all states with one currency, on the other hand, all the state-owned currencies had a great deal of cultural heritage, they all told a unique story of history, coupled with honour, religion, patriotism and beliefs and ideals, why give them up for one coin and note, for cold green cash?
The answer to this seems a simple equation: advantages – disadvantages = benefits or drawbacks and in this case the drawbacks were less than the advantages.
But was it actually the same case for the euro? Or was it all covered by great dreams and desires and let us not forget political correctness?
Before these questions can be answered we should first look at the history of the euro, which shows the following • 1959: Treaty of Rome: The first political step towards a monetary union • 1979: Central banks agree on the European Monetary System • In the same year the Central banks agree to affix their currencies’ exchange rates to the European Currency Unit, limiting the volatility of the inter-euro zone Foreign Exchange-market • 1989: Fall of the Berlin wall • 1992: Treaty of Maastricht: deciding on open markets for goods, services and people and with currencies being seen as assets on the Foreign Exchange market, also money. And also setting the criteria for joining the euro-club • 1994: Convergence Program • 1998: Choice of currencies joining the Euro-zone • 1999-2002: The launch of the euro, irrevocably fixing the exchange rates

2. The European Monetary System

The European Monetary System or EMS came into being in 1979. The topics that were decided on were the structure of the monetary system, in other words a less or more specific monetary policy – intervention rates for more zones of countries with more or less the same industry life cycles or one intervention rate for all euro-countries, chosen was for the latter, other topics that were agreed on were the location of the central bank, power of the body and foreign monetary policies. With the central banks of the participating European countries agreeing to fight volatility of the exchange rates on the Foreign Exchange Market, the Central banks agreed to peg or fix their currency to the European Currency Unit or ECU with an allowance for difference of plus or minus 2.25%, this meant that the exchange rate of the respective currencies could still fluctuate and that the value of the ECU was not completely fixed yet and could fluctuate with the values of the currency fluctuations of the other currencies. The European Currency Unit was an accounting unit used by the European Union, based on the currencies of the member states; it was not a currency in its own right.

3. The early nineties currency crisis (1992)

The limitations of the single monetary policy agreed upon in 1979 became visible with the fall of the Berlin wall and the collapse of the Soviet Union. Germany was reunited and in the former East-Germany the West-German Mark became the official currency. Because of all the East Germans wanting to taste their freedom and the new possibilities of one Germany and the Government acknowledging this, the government issued that each former East-German citizen received one hundred Deutsch Mark to spend (I was nine at the time, funny and sometimes amazing what one can remember), also because of this, demand for commodities in Germany rose sharply and the German economy was booming to the point that there was a risk of inflation due to a surplus of money in the economy. Germany having a history of sometimes almost comical fear of inflation and trying to keep its currency strong at all cost (historically seen not too comical if one looks at what happened during a time of hyper-inflation in Germany in the 1930’s and the twenty years that followed that). The normal thing a central bank does to fight off the risk of inflation is to raise the intervention rate or Refinance Rate, and so did the German Central Bank or DCB, however, by doing so, Germany created a paradox that is depicted by Mundell’s triangle: If Germany raised its Interest rate (Intervention Rate or for the European Central Bank REFI-rate) , and the rest of Europe would not follow that hike, there would be the impossible situation that the same currency would be valued differently within the same currency area.

[pic] To break this triangle there were essentially two options: 1. The European Central Bank would impose the new Intervention Rates (IR’s) on all European countries, regardless of it was the right thing for the other countries or not. 2. Abandon the euro as a currency.

Since committing abortion on the euro after so many years of such hard work was hardly taken into consideration, it was decided that every country had to adopt the German set Intervention Rate as to maintain equality in the value of the euro. However, the thing was that at the moment the German economy was booming, none of the other euro-zone countries were in a state of economic growth, quite to the contrary, most were only just beginning to recover from the 1987 stock exchange crash and the recession that followed. As a result therefore, the other economies were pushed back into recession. Whether this was or was not the right decision to take, we will never know since arguments pro and contra are arbitrary, euro-sceptics like myself say we should have abandoned the euro at that early stage, others refer to the period of unprecedented economical growth following that period of recession.

4. Convergence Program

Initiated in 1994 the convergence program was part of the Maastricht treaty that was signed in 1992 and contained the criteria that the countries joining the euro-club had to comply with. It was reasoned that, if countries would want to join (economic) forces, they would have to have similar fundamentals, these fundamentals are: • Low inflation • Low long term rates; these are a clear indicator of anticipated inflation levels and confidence of the financial market in that country • Public deficits had to be below or equal to three percent of GDP • Accumulated public debt or public income below or equal to 60 percent of GDP

4.1 Europe as an Optimum Currency Area (OCA)?

With the convergence program, the euro-zone countries tried to create similar economic fundamentals, with that trying to mimic or create an Optimum Currency Area, which is an area highly suitable for monetary union. For being that, the area has to score high on several criteria, a high score signifies that the area (in this case the euro-zone would be able to minimise the effect and probability of an asymmetric shock, an asymmetric shock is a market change within the area that impacts the economics of that area, for instance a change in the oil price, it affects all the industries within the area, but all in a different way, if it were to affect the industries in the same way it would be a symmetric shock. The first two or actually three (bullet two represents two criteria) are economical and the last is political: • Economic integration also called product diversification and openness in terms of export, business life cycles and industrial features, which all have to be more or less equal • Flexibility In terms of capital mobility and mobility of the labour force • Fiscal transfer within the prospected currency area

The first point holds integrally, there is a high level of economic integration between the countries of the European Union, European countries export heavily towards one another and the industrial life cycles are more or less equal.
As far as the second point is concerned; capital mobility, this comes along with imports and exports but also with investment, and this holds as well, with the high level of imports and exports (which reportedly have doubled since the founding of the monetary union) there is a large flow of capital between the European countries, also because the older Euro countries seek to invest in the new European countries because of the lower wages there, but at the same time the tariffs on exports are abolished and these countries are part of the free trade alliance, therefore, with reduced labour cost and a significant economy of scale, this could mean a capital gain for industries of high labour intensive goods shifting their production facilities to new-European countries. On the other hand, labour-force flow is relatively low, especially when compared to the United States or Japan. In the future, when all countries implement EU directives into their national law, the free transfer of people may intensify. Whereas in the same future, taxes and wages of new-European countries may increase as well, in that case both criteria reverse position and the big picture will not change all that much.
Fiscal transfer may be the biggest ‘fly in the ointment’ because as of the stability and growth pack fiscal policy and public spending are not part of European Monetary Policy and therefore, will never be intra-European.

With this, there are two criteria that suggest that the European Union is fit for a Optimum Currency Area – namely Economic Integration and Capital Movement – and two criteria contradicting it being – Labour Movement and Fiscal Transfer. Even though this list is far from complete, it is seen by many experts as a sufficient way to reason whether an area is suitable for a monetary union.

5. The launch of the euro as a currency

The first of January 1999 saw the launch of the Euro as the official currency of the Euro countries. At this date, the euro came into being as a paper currency, which means that it was used as the currency of transactions and on cheques.

The value of the euro was set as one, and the exchange rates of the currencies joining the euro were determined by triangulating the exchange rates of those respective currencies to the Dollar, Pound Sterling and Yen on the close of the Foreign Exchange markets on December 31 1998.
With the introduction of the euro as a paper means of transaction came the necessary controversy, Sweden, Denmark and the United Kingdom found it undesirable to join the euro-community and Denmark appealed to the opt-out clauses the Danish had negotiated in the Maastricht treaty after two separate referenda were held in order to poll the feasibility of the euro under the Danish population, since both outcomes were negative, Denmark did not become part of the euro-zone. However, Denmark has pegged its Krone to the euro and it is said that it will publicly discuss the opt-out clauses somewhere in 2006.
The United Kingdom argued that the introduction of the euro as a currency would merely be a stepping stone towards the creation of a European super-state, and that it would be an economic disaster to take away the UK’s own monetary policy, beside that there was major concern for Europe’s pension liabilities that would not be funded.
Sweden also held a referendum to poll its citizens’ opinion towards joining the euro-club, as the outcome of the referendum was negative, Sweden did not join on the legal clause that prior to joining the euro-zone, an at least two year membership or adherence to the European exchange rate mechanism was required, which it had avoided. Therefore Sweden was not required to join the euro as a currency.

The countries that did join the euro are depicted on the map below, please not that beside Austria, Belgium, France, Finland, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain the euro is also legal currency in the eurozone overseas territories of French Guiana, Réunion, Saint-Pierre et Miquelon, Guadeloupe, Martinique and Mayotte.

[pic]
██ Eurozone countries
██ ERM II countries
██ other EU countries
██ unilaterally adopted euro

By virtue of some bilateral agreements the European mini states of Monaco, San Marino, and Vatican City produce their own euro coins on behalf of the European Central Bank. Andorra, Montenegro and Kosovo adopted the euro as their legal currency for movement of capital and payments, but without the right to mint coins. Andorra is in the process of entering a monetary agreement similar to Monaco, San Marino, and Vatican City
Below table shows the exchange rate of the currencies joining the euro against the euro on 31 December 1998.

|Currency |Abbr. |Rate |
|[pic]Austrian schillings |(ATS) |13.760300 |
|[pic]Belgian francs |(BEF) |40.339900 |
|[pic]Dutch gulden |(NLG) |2.203710 |
|[pic]Finnish markkaa |(FIM) |5.945730 |
|[pic]French francs |(FRF) |6.559570 |
|[pic]German mark |(DEM) |1.955830 |
|[pic]Irish pounds |(IEP) |0.787564 |
|[pic]Italian lire |(ITL) |1936.270000 |
|[pic]Luxembourg francs |(LUF) |40.339900 |
|[pic]Portuguese escudos |(PTE) |200.482000 |
|[pic]Spanish pesetas |(ESP) |166.386000 |

6. The Benefits of the Euro
With the introduction of the euro, there were a number of prospected benefits for the participating economies, these benefits would help the economies retain their growth as well as making it easier for them to trade on the intra-European markets, additional legislation would ensure a greater freedom of movement of goods people and services.
There would also be a number of macro-economic direct and indirect benefits: • No more volatility of euro-currencies at Foreign Exchange markets and removal of Exchange rate risk • No transaction costs for firms dealing in the intra-European environment • One reserve asset • One single monetary policy and intervention rate

Indirect benefits • Lower (difference in) prices (Eurostat data confirms this, nevertheless many citizens perceive it not to be the case) • Lower Inflation • Lower risk premium on interest rates • Public account policy should lead to higher public discipline (balance between public savings and expenditure • A larger financial market and capitalisation

6.1 No more volatility of the currencies of the European countries
With the removal of all those currencies and replacing them with one it has become increasingly easy and cheap to invest across borders and import and export, on which the European Union depends heavily for growth. Easier because all transactions now take place in one currency and cheaper because there is no longer an exchange rate risk because of fluctuations of exchange rates on the Foreign Exchange market.

6.2 No transaction cost for companies
Because the currencies have been replaced with one currency, companies no longer have to go to their bank and buy foreign currency in the want to make a transaction within Europe, eliminating the costs of bank fees for those transactions. Also international cash (debit and credit)-withdrawals will cost the same as domestic withdrawals. Only France has found a way around this, by charging for every withdrawal and charging relatively more for international or draughts abroad.

6.3 One reserve asset
A very sensitive point, in theory, this would have been the case, all the central banks would be able to get rid of their foreign capital reserve since the European Central Bank would have taken that over, to back its own currency with other currencies. In practice however, the ECB does not hold a foreign capital reserve for the euros issued, it does not hold a foreign capital reserve at all. For other Central Banks however, it is much easier, because instead of holding separate Guilder-, Mark- and Franc-accounts, they only have to have one single euro-account.

6.4 One monetary policy and interest rate for all of Europe
When introduced this was seen as the major advantage as far as monetary mechanisms are concerned, since it was reasoned that Europe has the same economic principles in al its economies, a single monetary policy would work well, truth of the matter is however, that even though it has made the financial markets more flexible and liquid, as the early 90’s currency crisis showed us, a less-specific monetary policy may work better than a single very specific.

6.5 Lower prices
Another sensitive issue, it is the opinion of many citizens of Europe that prices of everyday commodities have increased sharply since the introduction of the euro, but critically seen, if I would compare the prices of one kilo of tomatoes, Dutch “wasserbomben” (water-bombs) which, before the euro cost fl. 1.69 and after the euro € 0.69 and a glass of beer in a bar which before the euro was fl. 3.20 and after the euro €2.00, I would say we are still true to the original exchange rate if we were to single out factors such as inflation and hikes in taxes and excises, which are not part of European Monetary Policy. Beside that, the Purchasing Power Parity (the amount of similar goods one can buy in one economy, relative to in another economy for the same amount of money – both real and nominal – does not show a big drop.
What actually happened, is that prices within the European union levelled, the differences between the different countries decreased, a little… but still.

6.6 Lower Inflation
An important issue, since it represents the amount of money inside an economy, if more money is flowing in than out, the economy is inflating, if more money is flowing out than in, the economy is deflating, think of air flowing into a rubber boat or mattress, while money flowing into the economy is seen as a good thing, if money is floating out as well, too much inflow is not a good thing, if there is too much money in an economy, or air in a rubber boat, the thing can burst, resulting in very little tension of the material, in a boat’s case rubber or in an economy’s case currency, relative to the tension of the water or in an economy’s case demand of a currency. As a result of too much inflation, a boat would sink and the demand for a currency would sink as well. There are some leaks of course, that prevent the economy from inflating too much, the first is export, we receive goods from another country, as a result, we have to pay them, this means that money from us flows out of our economy and into the other, the other is the central bank, which sets an interest rate that banks have to pay over their capital. This is also a major outflow and the instrument used by the central bank to control the in or deflation of an economy.
For the Euro-zone, inflation has not dropped significantly.
Reason for this is the ECB’s aggressive policy towards keeping the euro a strong currency, thus decreasing exports because it is too expensive. In some parts, especially the northern part of the EU, inflation has increased rather than decreased. The inflation for 2006 is forecasted at around two percent, for the west-European countries, the average inflation would have been forecasted at 1.2 percent, while for the southern countries it would have been closer to three percent. Again this is a sign of stabilisation between countries rather than a decrease.

6.7 Lower risk premium on interest rates
Not really sensitive but more a complicated issue, which can be best described by an example: Say I would be importing wine from Australia, I would have to pay 100,000 Australian dollars, and I would have to pay it on delivery, the delivery of my wine is three months after I signed the contract for so many wine for 100,000 dollar, in the mean time, the dollar could appreciate or depreciate against the guilder, in other terms, the dollar could become worth more or less, in the former case, I would need more guilders to pay 100,000 dollars than in the latter case, in which I would need less guilders. In order to protect myself from this risk (or exchange rate exposure) I can do a couple of things: a) nothing, which is very risky, b) forward contract the bank for delivering me 100,000 euros at a fixed rate, regardless of whether the Australian dollar has appreciated or depreciated, or c) buy a call-option: I buy a 100,000 dollars when I need them in three months, however, should it turn out negative for me, I can call it off, for this additional service of being able to call it off, I pay a risk-premium, so that the bank makes some money on it even if I call it off. (I will spare you the calculation of at which point it would be positive or negative for me () This risk premium is exactly what it is about; the risk premium will be significantly lower if you pay in American dollars than when you pay in Argentinean pesos, and at the same time it will be lower if you pay in European euros, a currency that everyone knows and trusts thank when you pay in Italian Lira’s.

6.8 Public account policy should have lead to higher public discipline (balance between public savings and expenditure
Why do I not just skip this point? They failed… big time
Since the convergence program, public debt should be no more than three percent of GDP and the accumulated debt no more than 60 percent, however, public expenditure being part of national political policy rather than European monetary, the Union could have done nothing more than encourage the political systems to allocate less or equal than that. However, because there are three approaches to maintaining a macro-economic policy and one is not feasible, with the other being held by the European Central Bank (Keynesian policy is not feasible, and the financial is being held by the ECB) national economies basically still want to hold on to their own monetarist policy the countries seek a monetarist approach: keeping public expenditures up to retain economical growth and counting on the multiplier effect. This is a big “fly in the ointment” (a disturbing factor where all other factors are completely satisfactory) The result of this so-called multiplier effect (see Mankiw: Macro economics, chapter 5, 2002 edition) will show in the long run, where there will (if the effect holds and much to the disadvantage of the euro-zone it most likely will) probably be a tremendous inflow of money into the economy, which in turn will lead to a higher intervention rate of the ECB, which in turn will lead to higher public expenditure, just to keep the economies growing (marginally) in the long term. How to explain this? Economic growth has always been a topic on political agendas and will remain so well into the future.
Every political party is willing to disregard long run economic consequences and sacrifice economic position for a few parliamentary seats in the short term, thus frustrating every good willing policy of the European Monetary Union.
Therefore, as most countries saw economic growth declining over the last five years, upped their public expenditure and failed to make the limit of three percent.
The solution is double, either we take public away from the individual countries or we let the euro go as a currency and only use it as a accounting currency. Which will be best? Only time can tell, but it is unlikely that any country will want to give up its fiscal and public spending policy…

6.9 A larger financial market and capitalisation
In all honesty, yes, the financial market has deepened, especially within the euro-zone, the financial market and especially the Foreign Exchange markets have become more flexible and liquid. Is this necessarily a function of the introduction of the euro? That is extremely hard, if not impossible to tell. If we look at the Euronext 50 index, it would certainly suggest that the stock market has deepened, with a rate of almost €3400 billion it is hard to deny, on the other hand, who would deny it to be a response to a slowly recovering economy, making traders give a higher appreciation for the blue chip funds? If we look at the construction of the indexes, mostly worldwide, it is an accumulation of a number of funds, in the Euronext index the number is 50, of various sort and origin that form an index, or indicator of the state of the economy. Therefore it is arbitrary to the trade to tell if it is good or bad or mediocre. Sceptics might say that we need 50 funds to give a proper rating whereas the Dow Jones only needs 30, opponents may respond that the United States economy is much more homogeneous than the European and that the NASDAQ is left out of that equation.
Fact is however that, because of the high appreciation of the Euronext, it is likely that European stock markets have deepened and become more efficient.
7. European Central Bank Policy and Promises

The ECB made some promises that would be beneficial to the economies participating in the euro. These promises were further underlined by the Lisbon Agenda in 2000, where it was stated that Europe would be the worlds leading economy by 2010. Quickly thereafter this agenda was abandoned on account of infeasibility. Notwithstanding the abandoned Lisbon Agenda, promises were made concerning: • No inflation • Satisfying growth rate • Low unemployment • Independence of ECB of US Federal Bank

7.1 No inflation
Inflation being forecasted at two percent over 2006, it is actually higher than western Europe, which was forecasted at 1.2 percent and for the southern-European countries it is forecasted at three percent.
Only the existence of inflation is a tell tale sign of mission failure.

7.2 Satisfying growth rate
This point is really what ECB policy is all about, since by setting the intervention rates, it controls the exchange rate of the euro against the dollar, by doing over the last five years, the euro has become increasingly overvalued against the dollar.

Concretely, this means that because it takes American companies relatively more dollars to buy euros, it is more expensive to import from the euro-zone than to seek resources elsewhere. This has its impact on the growth of the European economies, which was stagnating at the first aggressive approach of strengthening the euro, to the point of overvaluation of the currency. This has lead to a decrease in competitiveness against the rest of the world, increasing the trade surplus and decreasing the growth potential. Therefore, reform is necessary to catch up with the rest of the world, even though productivity in Europe is soaring.
But to answer the question whether a growth rate of 1.2 percent over 2006 is satisfying we must say no.
This because the ECB has taken a dual approach, on one side fight inflation risk and keep the euro strong and on the other trying to keep the economy growing, this requires an extreme fine tuning of the REFI-rates which, so far, the ECB has shown itself incapable of.
The best strategy would be to take the inflation as it is, lower the intervention rates and allow the economy to inflate to pick up some growth. Over time, as it becomes more interesting to export to the US again because the Americans can afford to again, the level of the euro will probably balance, because more money is flowing to other countries in the form of payments for imports into the euro-zone, in this way countering inflation risk.

7.3 Low unemployment
With the stagnating growth of the exports of the euro-zone, and with that also the difficulty for foreign firms to invest in the euro-zone, because it is more expensive, it has been unfeasible to retain the employment level that was maintained during the years before the euro. In other words, the current growth and inflation level make it impossible to at the same time keep unemployment low, therefore it is forecasted at nine percent over 2006.
Beside export being expensive for importing countries, it is also expensive for companies inside the euro-zone to retain production, because of the high minimum wages within the European Union, it has become increasingly cheap to outsource production and research and development.

7.4 Independent ECB of US Federal Bank
This is hard to tell, the Financial Times may make us believe that there is a causal link between ECB and the US federal bank, however, there is no way to prove it, it is true that the ECB is always increasing its REFI-rate more or less than a month after the US federal bank. Whether that is of an inflation risk or because the Fed did is hard to tell. I would give the ECB the benefit of the doubt and say their policy is strongly influence by the Fed but that it is still largely independent.

8. The future of the European monetary system

Over the least few chapters, I have made some references to future strategies and what I would feel are best practices, or at least better practices than the monetary policy that the ECB pursuits now. The most important thing it has to do in the near foreseeable future is getting the euro to a more credible level against the dollar, Europe still depends heavily on the United States as a trade partner, even though the neo-European countries, China and South-America to a lesser extend become increasingly important. Europe is an expensive area to import from or invest in, this has its effect on a lot of industries, that despite of their high productivity do not show much growth. In order to safely do that, the European Union will have to get its fiscal policy and public expenditure under a much tighter control, as we have seen in the classes provided by Mr. Russell, that central European expenditure tends to be overdone, sometimes unfounded and wasteful, such as the Common Agricultural Policy. The decentralised public expenditure seems to be focussed on retaining growth within the national economies making up the European union and specifically the euro-zone.
Beside that, the ECB should be creating a foreign capital reserve, to be able to protect the euro in case of a run on the euro. The way it is now, if the financial trade would start to speculate against the euro and there would be a collapse of trust in the currency, the euro is extremely exposed. The ECB would be able to do nothing more than raising the REFI-rate to avoid hyper-inflation, this would have its reflection on prices and competitive level of the European economy. Which reflection , in this extreme case is, mildly understated, not very positive, it would possibly be the worst economic recession in decades, and beside that, would involve every economy in the euro-zone.

9. Conclusion
9.1 Does the EU’s monetary system work?

The answer to that is yes, it works, but was it as successful as it was planned or even promised to be, or is the success in fact mainly the result of political correctness?
No, it is not as successful as planned or promised and yes, its success is mainly based on political correctness, but the promises made were largely to its citizens, of which promises only price stability has been reached.
However, it is very successful for companies, because it reached the goals, those of Europe as a truly free trade area, the introduction of the euro has taken care of the abolishment of conversion fees, lower cost for intra-European trade, has brought along a currency that is strong and stable, convertible to any other currency and it has given a deeper and larger stock market as well as a more liquid and flexible as well as more efficient financial markets.

2. Will the EU’s Monetary System work in the future?
The answer to that is probably yes as well, the scary point is what will happen when it stops working. If the ECB continues with its current aggressive approach of keeping the euro at its current level against the dollar, thus undermining Europe’s growth potential and competitive position, it might not work anymore. If the European monetary system is not willing to reform, there may come a time when economies lose their trust in the euro as their currency, and they may subsequently leave the euro. On the other hand, economies that are now the neo-European countries may be reluctant to actually join the euro-zone, especially if they compare the estate of the euro-zone economy with those of Denmark, Sweden and the United Kingdom. In which case they will probably not join the euro. This will beyond any reasonable doubt have its effect on the confidence the international financial trade has in the euro, and the euro may depreciate. As the worst case scenario, traders may start to speculate against the euro, which, at a certain time will yank the bottom out under the euro, leaving it in a freefall. At that time, the ECB can do very little more than raise its intervention rate, which will have a negative effect on the confidence of euro-zone countries in the euro. Because the ECB does not have a foreign cash reserve, it can not sell if off for euros and thereby accelerating the deflation of the economy, in fact, the ECB’s current policy would lead to hyper-inflation and a highly exposed euro in such a case.
Question remains of course, how realistic this scenario is, and for the answer I would like to refer to Murphy’s Law; anything that can go wrong, will go wrong simultaneously at the worst possible time.
At that moment, when Murphy’s law kicks in, countries will undoubtedly leave the euro-zone as not to be surged into a black economic hole with the euro. At that point, as there is most likely no contingency plan for that scenario, countries will have to reinvent their economy, currency and central bank policy.

11. Bibliography
International Financial Environment Classes given by M. Griette www.wikipedia.org European Central Bank website (don’t know the url by heart)
Mankiw – Macroeconomics 2002 version, chapters 1-8
Robert A. Mundell, Peter Kenen, Ronald McKinnon, several articles about OCA’s (also to be found on wikipedia though)
Robbins & Coulter – Management and Organisation