Maastricht Treaty convergence criteria and eurozone monetary union

Eurozone Maastricht Treaty

Euro zone Treaty

The European Community established the convergence criteria. These criteria was established in order to allow its EU Member states to take part in the Euro Zone, and using the Euro, as an official currency. The members of the European Union formed the Maastricht Treaty in 1992. The principle goals of the treaty were to establish an economic and monetary union, strengthen the democratic legitimacy of its institutions, better the effectiveness of its institutions, come up with the community social dimension, and also establish a unified foreign and security policy (Charles 1998).

The criteria contain several principles governing inflation rates, government finance, exchange rate, and long-term interest rates. The percentage points for inflation rates should not be 1.5 higher than the average the top three members states in performance of the EU. Government finance covers both the annual government deficit and the government debt. Under the annual government deficit, the criteria talks about the proportion of annual government deficit to gross domestic product (GDP). This proportion, at the close of the leading fiscal year, must not get past 3%. It can, however, reach close to 3%, and it is only exceptional and temporary excesses that can be granted for such case of exceptionality (David 1999).

The criteria discuss the government debt under terms that the proportion of the gross government debt to GDP, at the close of the leading fiscal year, must not go beyond 60%. If specific conditions make this unachievable, then the proportion must have significantly reduced at a satisfactory pace to approaching the reference value. For applicant countries, they must have joined, for two consecutive years, the exchange-rate mechanism (ERM II) as set in European Monetary System (EMS). Also, during this period, the applicant country must not have devalued its currency. In the case of long-term interest rates, the criteria holds they must not go exceed the last three inflation member states by 2 percentage points (Emil 2009).

In March 2005, the Maastricht criterion was flexed more, under the great influence of Germany and France. This was for the purpose of taking into consideration both the economic and structural reforms. Thus, this paved way for authorization of exceptional and temporary excesses.

The European Central Bank (ECB) was created in June 1988. The currency rates for the 11 member states were fixed and the euro got brought in as the single currency. In 2001, Greece joined the euro area, Slovenia joined as the 13th member in January 2007, Cyprus and Malta joined in January 2008, and Slovakia on January 2009. The inflation convergence and introduction of single inflation targeting across Eurozone have encouraged investors to have homogenous inflation expectations across core and periphery and drove the borrowing yields down.

Current interest rates

Potential risks and solutions

Euro zone experienced a financial decline in 2008 following global financial crises by then. This made Europe to be a verge of collapse. In the Euro zone, there are many sovereign financial crises that emerge as a result of financial melt-down. Banks are hit after allowing excessive credit to EU customers. For instance, during the financial melt-down of 2008, Greece experienced an unsustainable budget deficit, and a debt that could no longer financed. The Irish banks were on the verge of collapse too after lending excessively for real estate. This resulted to real estate impracticability in the Irish Republic.

For individual in financial difficulties, and cannot pay their mortgage, the banks repossess their homes. For companies with insufficient sales to pay the operation costs and services, they go bankrupt, and the company owners lose their ownership capital. Also notable is that all governments borrow. They issue bonds, which are bought by local and foreign banks, citizens, foreign banks, and at times by foreign countries. The borrowing helps them be able to deal with lumpiness of expenditure as compared to income. Income is mostly taxes. It also helps it deal with the differences between the expenditure and the benefits that add up to the economy. For example, big infrastructure business projects such as a motorway require a lot of outlay to start. The benefits later flow back to the economy when we experience decreased cost of transport and increased productivity. The later results to increase output levels in a country and increased tax revenues. The treasury can use this revenue to pay back its loans with interests. However, if a country's spending gets out of hand or revenue declines, it starts to borrow in order to settle its current expenditure rather than use it to support productive-enhancing investments. This yields to unsustainable budget deficit. The debt burden begins to creep up (Stephan 2008).

When a country's debts increase, the leaders also get increasingly suspicious about lending. In order for them to lend, they require a higher interest rate to convince them to continue purchasing government bonds. These rates of interest give a very powerful signal to the government to rule its budget deficit. This it does by either cutting its expenditure or by improving taxes or both. A toll that governments have at their disposal is that if they have their own currency they can devalue. This lowers the labour costs as compared to other counties and gives a boost to exports. However, this can cause higher inflation.

In the Euro zone, the rates of interest for the bonds of each member country converged after the Euro got introduced in 2002. The rates for different countries in the area stood similar to one another till the end of 2009. But there were wide differences in the production levels, budget and even trade deficits. There were debt burdens in each of the Euro countries despite these similarities shown in interest rates.

Off course having a common currency for all EU countries is, all together, a wonderful idea. It would mean no foreign exchange problem to travellers. This promotes intra-Euro zone trade by making it simpler for importers and exporters. Like the dollar, the Euro has become a global financial force with which to reckon. However, a common currency comes with a few challenges. For one, there should to be a lender of last resort for all the banks, and sovereigns in the currency zone. This role, within a country, is played by the central bank. There should be interconnected fiscal and budgetary policies across the entire zone. This would imply that it is impossible for politicians have final say on tax, and spending levels within their own countries, and borrowing is carried out by the Euro zone through issuance of Eurobonds. Also, having a common currency would mean having a single pan-Euro zone banking regulator to monitor and enforce common prudential regulations for all banks in the zone. Therefore, all banks will function within the same risk model and will have the same capital requirements to backstop their loan portfolios (Robin 2008).

In mitigating some of the drawbacks of the common euro currency, the Maastricht criteria were proposed. The criteria stipulates that for a country to become a Euro zone member yet it has a budget deficit of less than 3% of GDP and a proportion of public debt to GDP below 60%, then inflation had to be less and the interest rates be close to EU average. At the time of introduction of the European currency, most countries hugely flouted the criteria. The countries that greatly flouted the criteria include countries like France (David 1999).

Another risk that faces the Euro zone concerned the European decision makers. Notably German and France, at first denied there were problems with the Euro. In February 2010, the IMF specialist in bailing out bankrupts countries would never operate within the Euro zone. The IMF, ECB, and the European Commission put together an initial bail-out package for Greece. This includes the Greek government commitments to raise taxes and reduce spending. This forced the rioters to take to the streets, and living standards got plummeted.

Another solution to the weakness of the Euro was the introduction of the Financial Stability Fund (EFSF). The EFSF was recently granted a lot of financial resources. This would make it a permanent EMF to handle financial crisis in the member countries. This will also need clear rules of governance. The Euro zone would also need a greater control over it profligate spending by wayward member countries.

In addition, the Euro zone needs greater control over profligate spending by stubborn member countries, as well a pan-Euro zone banking system of surveillance, possibly as component of the future EMF. President Nicolas Sarkozy and Chancellor Angela Merkel announced in August 2011 the introduction of the Euro zone Economic Council. This body is not believable as it will have only fixed authority and will only meet twice a year.

A lot cannot also be learned from the Greeks. Their decades of experience with the IMF program show that they will not be able to implement the IMF program as it is presently designed. It is simply too dreadful and will collapse the country's economy. The income per head has decreased to a level below that of 1980, when Greece got to be a full member of the EU. Therefore, for Greece to rise, it must get some relief, both in reform program terms and debt relief terms. This reform program has to focus much on recovering competitiveness than on raising taxes, and cutting costs. Some technocrats have discussed an exit from the Euro zone for Greece. This is a highly scary option with totally unforeseen consequences (Robin 2008).

In sum, monetary policy has increased its impact on all retail lending rates except

Longer-term corporate loans while cost of funds influences show similar improvements

Only for medium and long-term corporate loans, implying that the cost of funds as a determinant of longer-term borrowing cost for SME have increased in relevance. With the possible exception of short-term corporate loans the long run pass-through is imperfect, eventually pointing to credit rationing phenomena (Felix 2008).

Conclusion

The financial crisis affecting the euro zone countries appears unbelievably complex. Although the reasons for the crisis are simple, the answer will not be easy. In order for the euro zone to resolve this crisis, it demands the political will to attempt painful measures, with severe distributional impacts. As long as some groups attempt to avoid those costs, the crisis resolution will be elusive.

The crisis, and the resulting recession are of vital importance. The euro zone is the world's largest economy, and its trajectory has great effects on the effect of the fortunes the United States, and Asia. This impact is even firmer at a period when the world economy fragile. The euro zone crisis is a consequence of at least two main weaknesses in the master project of the European monetary integration. First, the euro, and its monetary policy were employed to specific economies that were different one from the other. The countries were subject to too diverse a set of economic shocks.

They were not sufficiently integrated, and they lacked a fiscal union that could smooth out those shocks, compensating hard-hit economies with transfers from better-performing economies. Further, vital with the euro in place, the monetary policy of the new European Central Bank proved to be too loose for some countries and too tight for others. Second, investors understood the creation of the treaty as an unquestioning guarantee of government debt for members. It was clear that if a severe financial crisis came up in one euro zone member state, the perils of infection to the rest of the zone and of a negative impact on the common currency would force other states to bail out a member in crisis. Investors conceived this interpretation yet there were no such formal guarantees made.