Functioning of the Economic and Monetary Union

The Euro Zone: A Growing Monetary Union

Phase III of the monetary union commenced on January 1, 1999, with a three-year adaptation period. Monetary policy responsibility was transferred to the European System of Central Banks, and new public debt began to be issued in euros from day one.

Upon completion of the adaptation phase, the second part of phase III began on January 1, 2002. During this period, euro banknotes and coins were introduced alongside national currencies. Within six months, national currencies were entirely replaced by the euro in the member states of the Monetary Union.

The European Monetary System (EMS) was also updated to link the currencies of EU Member States not part of the euro area with the euro, facilitating their future incorporation. It’s important to note that all EU Member States are part of the Economic and Monetary Union (EMU), but only those countries adopting the euro constitute the euro zone.

The euro area initially consisted of 11 EU member states when introduced in 1999. Over time, more countries joined, and currently, the euro area includes 19 EU member states. Additionally, the euro is the official currency in several European states and territories through specific agreements. However, certain countries, such as Denmark, have an opt-out clause, while others, like Sweden, may join in the future.

How Does EMU Work?: The Government of the Euro 1.0

The general economic policy framework of the euro zone was established in the EU Treaty signed in Maastricht. Under this framework, monetary policy is centralized, while fiscal and structural policies remain under the jurisdiction of national governments. Close coordination among countries is crucial to ensure optimal policy mix and avoid sub-optimal outcomes.

Supervision instruments were established within the Council of Ministers, further supported by the creation of the Eurogroup where finance ministers of euro area member countries discuss matters related to the single currency. However, deficiencies in the design of the eurozone’s economic governance were revealed during the 2007-08 crisis, prompting an ongoing reform process.

The division of economic policies between European institutions and Member States is as follows:

• Monetary and exchange policies, as well as regulations related to the Single Market, fall under the responsibility of community authorities.
• Fiscal, employment, and most structural policies concerning national product, labor, and capital markets remain the responsibility of Member States or regional and local authorities.
• The European Central Bank (ECB) plays a vital role in the general economic policy framework, maintaining channels of information exchange with other economic policy makers.

The EU introduced long-term strategies such as the Lisbon Agenda (later updated as Europe 2020) to align with short and medium-term mechanisms. The European Commission analyzes fiscal policies and economic and structural reform programs of Member States annually, providing recommendations for the following months.

The ECB and Centralized Monetary Policy

The euro area has a single currency and centralized decision-making for monetary policy. The European Central Bank (ECB), an institution with its own legal personality, manages the monetary policy of the euro. It forms the Eurosystem along with the central banks of euro area countries, collectively known as the European System of Central Banks (ESCB).

The ESCB is governed by the Executive Board, the Governing Council of the ECB, and the General Council. The Governing Council, consisting of governors of national central banks of euro area countries and members of the ECB Executive Committee, is the sole decision-making body for monetary policy in the euro area.

The ECB’s primary objective is price stability, aiming for an inflation rate below 2% in the medium term. It operates with a high degree of independence from political power but can be a source of institutional conflict during crises.

General principles guiding monetary policy include a medium-term and non-activist orientation, preventive measures considering time lags, reliance on aggregate indicators for the euro area as a whole, and no specific exchange rate targets.