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The European Union and central banks

EUROPE – A SINGLE ECONOMY AND A SINGLE CURRENCY

Throughout history European countries have differed from one another in terms of language, religion, culture, economy and politics. At the same time, and for many decades, there has been a common understanding that cooperation serving joint interests is beneficial to everybody. The integration of Europe started as early as 1951 with the signing of the Treaty of Paris, which united the coal and steel industries of six European countries. In 1992, when the Maastricht Treaty was signed and the European Union was established, cooperation became closer and even more European countries were involved in activities. This also laid the foundation for the European Economic and Monetary Union (EMU).

The Member States of the European Union collaborate in many areas. Joint activities are essential in the field of economy and finance, because goods, services, capital and people move freely from one Member State to another in the European Union, and the economic decisions of one Member State can affect other states as well. Thus, common principles are agreed on and some decisions are taken together.

The single currency – the euro – grew out of the single economy in 1999. It was first introduced as an account currency and in 2002 as cash. This can be deemed one of the most significant achievements in the integration of the European Union. Today, 18 of the 28 Member States of the European Union have introduced the single currency. This means that some Member States have not wished to join the euro area or have not been able to meet the requirements for new members.

The single currency has made the lives of people and companies easier, because they do not have to consider the costs or risks of currency exchange. Therefore, we as citizens of a small country need not be afraid that the exchange rate of our national currency will decline in respect of other currencies. Stable finance also contributes to economic development. Thanks to the single currency, it is easier to compare prices with those of other states.

Membership of the European Union and the introduction of the euro mean an increase in international reliability and economic security for a small country like Estonia. Estonia joined the European Union and the European System of Central Banks in 2004 and the euro area in 2011. Eesti Pank has been a member of the Eurosystem since then. As such, we can now make decisions related to the euro jointly with other central banks in the euro area and the European Central Bank.

A SINGLE CURRENCY MEANS JOINT DECISIONS

ECB and the Eurosystem explained in 3 min.

Central banks roughly cooperate on two levels:
1) at the level of the European Union formed by the European Central Bank and the central banks of all of the Member States of the European Union, called the European System of Central Banks (ESCB); and
2) at the level of the euro area formed by the European Central Bank and national central banks of all states using the euro, called the Eurosystem.
 
At the level of the European Union, i.e. within the framework of the European System of Central Banks, all central banks actively cooperate in each area of the central bank, but decisions directly related to the euro and monetary policy are made in a narrower circle. Only the central banks belonging to the euro area or using the euro as a functional currency in their country participate in adopting decisions.
 
The main function of the Eurosystem or, in other words, the European Central Bank and national central banks of the euro area, is to ensure price stability. To be more specific, central banks in the euro area must maintain inflation (the increase in consumer prices) at slightly below 2% per year. This function is performed by the Eurosystem by making and implementing single monetary policy.
 
The monetary policy and other decisions of the Eurosystem are made by the Governing Council of the European Central Bank. The Governing Council comprises the Executive Board of the European Central Bank and the governors of all of the national central banks in the euro area. The Governor of Eesti Pank is one of the members of the Governing Council of the European Central Bank and, thus, a monetary policy decision-maker. Just like the governors of the German, Italian or Finnish central banks, the Governor of Eesti Pank also has a vote.
 
In addition to the regular meetings and decision-making processes of the governors of central banks, there are also committees and working parties that operate in order to implement the decisions of the Governing Council. The committees and working parties include representatives of all of the central banks in the euro area. They are professional experts exchanging experience, trying to find solutions to problems, developing project implementation possibilities and, thereby, closely cooperating with one another. This ensures that the best experts in the euro area are involved in all processes, and upon adopting decisions the experience of all countries is followed.
 
The European Central Bank directs the cooperation of the central banks of 18 countries belonging to the euro area. All decisions are taken jointly in the euro area, but the central banks implement them within their states themselves. For instance, the Governing Council of the European Central Bank decides on the basis of the judgments of cash experts from all countries how many banknotes will be manufactured and put into circulation, but in Estonia Eesti Pank gives money to banks.

DEVELOPING THE SINGLE CURRENCY

The Member States of the European Union enjoy considerable freedom in shaping their economic policy. The economies of various states need not always develop at the same pace. For example, the economy of one country may be in a growth stage, while that of another country is in decline. This makes it complicated to implement single monetary policy.

Economic development cannot be spontaneous, but it must be directed. If the economy of a state grows too fast, the growth must be slowed to avoid long-term problems for the state as well as indirectly for other states. On the other hand, if any country in the euro area is in deep recession, the economy of that state must be fostered. Central banks can do this by setting interest rates. For instance, if banks receive money from the central bank at a lower interest rate or less expensively, the cost of money is less expensive for companies and this encourages them to take out bigger loans, which helps the economy recover. And, of course, vice versa – higher interest rates or more expensive money cools the economy.

Unlike countries that use the euro and where decisions concerning interest rates are taken together, states outside the euro area can shape their monetary policy independently. This means that the state can set interest rates for banks and companies itself, taking into account whether the economy needs to be cooled or fostered. As there is no such possibility in the euro area, other operational levers of the economy must function. For instance, in the event of a declining economy, prices and salaries may be reduced and, thereby, the competitiveness of the country is strengthened. The amount of available budgetary funds can also be increased (in other words, the more active fiscal policy can be applied) to direct more money into the economy and to try to overcome the crisis in this way. That is why it is important in the European Union to ensure the free movement of workers, goods and capital.

Critics of the monetary union have considered the clumsy nature of these decision-making mechanisms to be one of its major problems. The more Members States there are of the European Union, the more complicated it is to reach joint decisions. Conflicts of interest may paralyse the decision-making ability of the European Central Bank. Critics often imply that the interests of small countries may be overshadowed by those of larger states.

These examples show that belonging to the single currency area limits the possibilities of states to directly influence their own economy through monetary policy. Why then do countries seek to be members of the euro area? One of the reasons is that membership of the Economic and Monetary Union increases the reliability of a country, which makes borrowing less expensive for companies and people. Thus, we pay less for our apartment or home loans and companies have more finances with which to carry out their objective. Belonging to the euro area is especially important for smaller countries, because we can affect processes in the euro area that would have an impact on us in any case.

However, some problems also arise with the use of the single currency, because the risky behaviour of one country may affect all users of the single currency. As there were previously no strict criteria under which violators of euro area rules could be disciplined, some countries found that belonging to the euro area would ensure them lower interest rates in the future, allowing them to leave their monetary affairs unattended. The expenditure of such states exceeded revenue and the missing funds were borrowed from outside of the state, thereby increasing public debt. Within a certain period of time market participants also trusted the single currency to the extent that such behaviour was not seen as a problem. But during the global financial crisis of 2008, the situation changed and attention was again paid to the behaviour of single states in the euro area. The countries that had fostered negligent fiscal policy got into trouble, because borrowing from outside of the country became very expensive. Moreover, the problems of these states caused tension throughout the euro area and called into question the reliability of the monetary union. Some market participants even talked about the possible collapse of the euro area during the recession.

The crisis has shown that strict budgetary and banking rules must be established over countries using the single currency and that crisis resolution must be made more efficient. This is the only thing that enables the stability and reliability of the euro area as a whole to be ensured. Thus, in recent years the states in the euro area have agreed upon new and stricter budgetary rules and created joint crisis resolution funds. A completely new banking supervision process has also been initiated. Within the framework of this process a single supervisory mechanism will be created under the European Central Bank. The crisis has proven that all states must be involved in solving problems, because we are all together in the Economic and Monetary Union.

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