How the Euro Works


National currencies are vitally important to the way modern economies operate. They allow us to consistently express the value of an item across borders of countries, oceans, and cultures. Wealth can be easily stored or transported as currency.

­Currencies are also deeply embedded in our cultures and our psyche. Think about how familiar you are with the price of things. If you've grown up in the United States, you think of everything in "dollars," just like you think about distances in inches and miles.

On January 1, 2002, the euro became the single currency of 12 memb­er states of the European Union. This will make it the second largest currency in the world (the U.S. dollar being the largest). It will also be the largest currency event in the history of the world. Twelve national currencies will evaporate and be replaced by the euro.

In this article, we'll look at the monumental task of changing 12 countries' entire monetary systems to a new, single system, and why this change was implemented.

 

 

 

Designing the Euro

The European Commission (EC) was given the task of creating the euro symbol as part of its communications work. There were three things the design had to accomplish:

  • It had to be easily recognized.
  • It had to be easily written by hand.
  • It had to be pleasing to look at.

The EC had more than 30 designs drawn up. They selected 10 from those and let the public vote, which narrowed those 10 down to two. From there they made their final selection. The design that was selected is based on the Greek letter epsilon, and also resembles the "e" as the first letter of the word "Europe." The two parallel lines through the center of the "c" represent stability.

The euro is abbreviated as EUR. This was established through the International Organization for Standardization (ISO).

Bank-note Designs

There are seven euro bank notes. Their design was also the result of a contest. Designers were nominated by the national central banks, and the competitors turned out designs for the seven bank notes based on either the theme of "Ages and Styles of Europe" or an abstract modern theme.

Robert Kalina of the Oesterreichische Nationalbank won the competition. His designs were selected at the Dublin European Council in December of 1996. He based his designs on the theme of seven important architectural periods in Europe's cultural history.

The seven bank notes are printed in different sizes and shapes for easier identification. Here is what they look like:

Coin Designs

There are eight euro coins ranging in value from 1 cent to 2 euros. They also vary in size and thickness according to their values to promote easier identification. As with the bank notes, there was a Europe-wide competition for the coin design. Luc Luycx of the Royal Belgium Mint had the winning designs for the side of the coins that is common to all 12 member states.

The design features one of three maps of Europe surrounded by the 12 stars representing the Euro member states. The opposite side of the coins has designs specific to each country, also surrounded by the 12 stars. Although each country has its own coin design, each coin is accepted in any member state.

Here is what the common side of the coins looks like:

To see each of the member states' designs, click here (then click on the map for the country whose coin you wish to see).

The European central banks paid for the initial supply of currency to be produced -- a staggering 50 billion euro coins and 14.5 billion euro bank notes!

Where Did the Idea Come From?

The original seed was planted in 1946 when Winston Churchill suggested the creation of the "United States of Europe." His goals were primarily political, in that he hoped a unified government would bring about peace for a continent that had been torn apart by two world wars.

Then, in 1952, six west-European countries took Churchill's suggestion and created the European Coal and Steel Community (ECSC). These resources were quite strategic to the power of each country, so a requirement of the ECSC was that each country allow their resources to be controlled by an independent authority. Their goal, just as Churchill had intended, was to help prevent military conflict between France and Germany.

In 1957, the Treaty of Rome was signed, declaring the goal of creating a common European market. It was signed by France, Germany, Italy, Belgium, the Netherlands, and Luxembourg.

After many false starts, the process of creating the Euro got its real start in 1989, when the Delors Report was published by Jacques Delors, president of the European Commission. This important report outlined a three-stage transition plan that would create a single European currency. In the next section, we'll look at the stages.

Planning the Transition

As outlined in the Delors Report, the transition to a single European currency followed a three-stage plan:

  • Stage one began on July 1, 1990, and immediately abolished (at least in principle) all restrictions on the movement of capital between the member states. It also began the identification of issues that needed to be dealt with and the development of a working program to implement the upcoming changes.
  • Stage two began on January 1, 1994, and marked the establishment of the European Monetary Institute (EMI). The EMI was responsible for coordinating the monetary policy and strengthening the cooperation of the central banks, as well as making preparations for the establishment of the European System of Central Banks, which included the single monetary policy and single currency. In December 1995, the European Heads of State or Government at the European Council meeting in Madrid voted on the name "euro" for the single currency of the European Monetary Union.
  • Stage three began on January 1, 1999, with the establishment of "irrevocably fixed exchange rates" of the currencies of the current 11 member states. At this point, the euro was the official currency of those countries, but could only be used in non-cash transactions such as electronic transfers, credit, etc. Greece joined the EMU in January 2001, raising the number of member states to 12.

For more details on the events occurring between 1957 and 1989, see the More Euro History section.

Participating Countries

There are currently 13 member states of the European Union utilizing the euro:

  • Belgium
  • Germany
  • Greece
  • Spain
  • France
  • Ireland
  • Italy
  • Luxembourg
  • The Netherlands
  • Austria
  • Portugal
  • Finland
  • Slovenia

Additionally, six non-EU countries and territories use the euro as a form of payment:

  • Monaco
  • Vatican City
  • San Marino
  • Andorra
  • Kosovo
  • Montenegro

To participate, countries must meet the requirements that were set up in the Maastricht Treaty, drafted in 1991.

Countries that meet the criteria but did not wish to participate include Great Britain, Denmark and Sweden.

Economic Requirements for Participation

In addition to the membership requirements of the EU, countries who wished to participate in the euro and be a part of "Euroland" had to pass some economic tests referred to as convergence criteria:

  • The country's annual government budget deficit (the amount of money it owes) cannot exceed 3 percent of gross domestic product (GDP, the total output of the economy).
  • The total outstanding government debt (the cumulative total of each year's budget deficit) cannot exceed 60 percent of GDP.
  • In order to push down inflation rates and encourage more stable prices, the country's rate of inflation must be within 1.5 percent of the three best performing EU countries.
  • The average nominal long-term interest rate must be within 2 percent of the average rate in the three countries with the lowest inflation rates. (Interest rates are measured on the basis of long-term government bonds and/or comparable securities.)
  • The country's exchange rates must stay within "normal" fluctuation margins of the European Exchange Rate Mechanism (ERM) for at least two years.

While there was much debate over how strictly these requirements must be upheld, it was finally determined that participating countries must show that they are at least "on course" to meet the requirements.

Meeting the initial requirements, however, is not a one-time thing. The Stability and Growth Pact, which was drafted in 1996, established an agreement stating that fines would be charged to countries who have excessive deficits. Member states cannot run a budget deficit that is greater than 3.0 percent of the GDP. If they do, they will be charged 0.2 percent of their GDP, plus 0.1 percent of the GDP for every percentage point of deficit above 3.0 percent. The Pact does not automatically impose these fines, however. Countries that are in recession, which is defined as a fall by at least 2.0 percent for four fiscal quarters, may automatically be exempt. A fall by any amount from 0.75 to 2.0 percent requires a vote by the EU to impose the fine.

While the Pact is structured as a stabilizer for the economy, there are still those who argue that it can be damaging to economies in that governments can adopt a loose fiscal stance during times of fast growth, but put the brakes on excessively during slowdowns.

Setting the Value of the Euro

The European Central Bank (ECB) was established in 1998. Its job is to make sure that the European System of Central Banks (ESCB) implemented the changeover required by the euro statutes and generally carries out its duties. The General Council of the ECB was responsible for setting the conversion rate for the euro for each participating country. Those rates were established in January 1999, and are "irrevocably fixed." The conversion was based on the existing currency so that the euro is simply an expression of the previous national currency.

The ECB used guidelines established in a Joint Communique that was issued on May 2, 1998, by the ministers of the member states who were adopting the euro. In order not to modify the external value of the European Currency Unit (ECU), they used the bilateral rates of the Exchange Rate Mechanism (ERM) to establish the fixed conversion rate for each national currency. The calculation of the exchange rates followed the regular daily concertation procedure, which used the representative exchange rate for each nation's currency against the U.S. dollar as of December 31, 1998.

Here are the established values. One euro equals:

  • 40.3399 Belgian franc
  • 340.750 Greek drachma
  • 6.55957 French franc
  • 1936.27 Italian lira
  • 2.20371 Dutch guilder
  • 200.482 Portuguese escudo
  • 1.95583 Deutsche mark
  • 166.386 Spanish peseta
  • 0.787564 Irish punt
  • 40.3399 Luxembourg franc
  • 13.7603 Austrian schilling
  • 5.94573 Finnish markka

Implementing the Changeover

On January 1, 1999, the euro was established as the official currency of the 12 participating member states of the European Union. The conversion rates were "irrevocably fixed," and the euro officially "existed." At that point, the euro could be used for non-cash transactions, such as making electronic payments, writing checks, or credit transactions. Although this sounds confusing, in most cases the balances were shown both in the national currency as well as in the converted euro amounts. The currency changed, but because of the established conversion rate, the value remained the same.

The euro currency was introduced on January 1, 2002. Some countries had slightly different schedules for the end of circulation of their existing national currency. This is the schedule for the euro introduction and endings for national currencies:

  • December 31, 2001 was the last day for electronic payments in the old currencies.
  • December 31, 2001 was the last day that the German mark could be legal tender; however, cash was accepted until February 28, 2002.
  • January 28, 2002 was the last day for the Dutch guilder.
  • February 9, 2002 was the last day for the Irish punt.
  • February 17, 2002 was the last day for the French franc.
  • February 28, 2002 was the last day for all other national currencies, including the Belgian franc, Luxembourg franc, Italian lira, Greek drachma, Finnish markka, Spanish peseta, Portuguese escudo, and Austrian schilling.

When items were purchased with national currency, the change was given in euros. Exchange of cash was also done in banks. Automated teller machines (ATMs) began distributing only euros on January 1, 2002. During the "dual circulation period," until the final deadlines were reached for changeover, both national currencies and the euro were accepted, but after that point only the euro was acceptable legal tender. Banks will still be able to exchange old currency for new currency until approximately 2012.

Advantages of the Euro

The euro is fundamentally a tool to enhance political solidarity. This political motivation began when the idea of the European Union and a single currency was first conceived. While it also has the economic effect of unifying the economies of participating countries, it ultimately does much more for the European Union.

Economically, the euro's advantages include:

  • Elimination of exchange-rate fluctuations - Any time either a consumer or a business made a commitment to buy something in a different country in the future (at future prices), they stood the chance of paying much more (or less) than they had planned. The euro eliminates the fluctuations of currency values across certain borders.
  • Price transparency - Being able to easily tell if a price in one country is better than the price in another is also a big benefit, both for consumers and businesses. With price equalization across borders, businesses have to be more competitive. Pricing still varies, but consumers can more easily spot a good deal -- or a bad one.
  • Transaction costs - This is particularly helpful for tourists and others who cross several borders during the course of a trip. Before, they had to exchange their money as they entered each new country. The costs of all of these exchanges added up significantly. With the euro, no exchanges are necessary within the Euroland countries.
  • Increased trade across borders - The price transparency, elimination of exchange-rate fluctuations, and the elimination of exchange-transaction costs all contribute to an increase in trade across borders of all the Euroland countries.
  • Increased cross-border employment - Not only can business be conducted across borders more easily, but people are more easily employable across borders. With a single currency, it is less cumbersome for people to cross into the next country to work, because their salary is paid in the same currency they use in their own country.
  • Simplified billing - Billing for services, products, or other types of payments are simplified with the euro.
  • Expanding markets for business - Business can expand more easily into neighboring countries. Rather than having to set up separate accounting systems, banks, etc. for transactions in countries other than their native one, the euro makes it simple to operate from a single central accounting office and use a single bank.
  • Financial market stability - On a larger scale, the financial and stock exchanges can list every financial instrument in euros rather than in each nation's denomination. This has further ramifications in that it promotes trade with less restriction internationally, as well as strengthens the European financial markets. Banks can offer financial products (loans, CDs, etc.) to countries throughout Euroland.
  • Macroeconomic stability - Because of the European Central Bank (ECB), introduction of the euro also helps to lower (and control) inflation among the EU countries.
  • Lower interest rate - Because of the decreased exchange-rate risk, the euro encourages lower interest rates. In the past, additional interest was charged to cover the risk of the exchange-rate fluctuation. This risk is gone with the introduction of the euro.
  • Structural reform for European economies - The participation requirements of the euro pushed many EU member states who wanted to participate to get their economies in shape and improve their economic growth. With the requirements of the Stability and Growth Pact, they will also have to maintain that control in the future, or face fines.

Disadvantages and Risks of the Euro

While there are many advantages to the euro, there are also some disadvantages. The cost of transitioning 12 countries' currencies over to a single currency could in itself be considered a disadvantage. Billions were spent not only producing the new currency, but in changing over accounting systems, software, printed materials, signs, vending machines, parking meters, phone booths, and every other type of machine that accepts currency.

In addition, there were hours of training necessary for employees, managers, and even consumers. Every government from national to local had impact costs of the transition. This enormous task required many hours of organization, planning, and implementation, which fell on the shoulders of government agencies.

The chance of economic shock is another risk that comes along with the introduction of a single currency. On a macroeconomic level, fluctuations have in the past been controllable by each country.

  • With their own national currencies, countries could adjust interest rates to encourage investments and large consumer purchases. The euro makes interest-rate adjustments by individual countries impossible, so this form of recovery is lost. Interest rates for all of Euroland are controlled by the European Central Bank.
  • They could also devalue their currency in an economic downturn by adjusting their exchange rate. This devaluation would encourage foreign purchases of their goods, which would then help bring the economy back to where it needed to be. Since there is no longer an individual national currency, this method of economic recovery is also lost. There is no exchange-rate fluctuation for individual euro countries.
  • A third way they could adjust to economic shocks was through adjustments in government spending, such as unemployment and social welfare programs. In times of economic difficulty, when lay-offs increase and more citizens need unemployment benefits and other welfare funding, the government's spending increases to make these payments. This puts money back into the economy and encourages spending, which helps bring the country out of its recession. Because of the Stability and Growth Pact, governments are restricted to keeping their budget deficits within the requirements of the pact. This limits their freedom in spending during economically difficult times, and limits their effectiveness in pulling the country out of a recession.

In addition to the chance of economic shock within Euroland countries, there is also the chance of political shock. The lack of a single voice to speak for all euro countries could cause problems and tension among participants. There will always be the potential risk that a member country could collapse financially and adversely affect the entire system.

More Euro History

The Treaty of Rome was ratified in 1958, establishing the European Economic Community (EEC). The goal of the EEC was to reduce trade barriers, streamline economic policies, coordinate transportation and agriculture policies, remove measures restricting free competition, and promote the mobility of labor and capital among member nations. It was very successful, but just as with the ECSC, it served more of a peacemaking role between the European nations than an economic role.

At this time, the monetary exchange rate between countries was controlled by the Bretton Woods system, which connected currencies to the U.S. dollar, allowing for only a one point fluctuation around designated values. This was referred to as the "pegged rate" and was based partly on the gold backing of the dollar. This system worked well for 20 years, helping to stabilize exchange rates and restore economic growth in the postwar period. By 1960, however, the system began to fail, and exchange-rate agreements became the prevalent topic among European political and economic leaders.

By December 1969, Luxembourg's Prime Minister, Pierre Werner, was asked to write an EC (European Community) report covering the need for a complete monetary union among the European economies. The Werner Report came out in 1970 and specifically brought up the idea of a single European currency as part of a cooperative monetary effort. The report was the first to use the term Economic and Monetary Union.

Although this plan seemed promising, it lost momentum when President Nixon's 1971 policy of "benign neglect" ended U.S. backing (by its gold reserves) of the predefined exchange rates against the dollar, collapsing the Bretton Woods system. Other foreign central banks were not willing to support the dollar, which would have provided the equivalent of deposit insurance.

So where did that leave the European countries when it came to the stability of their currencies? It brought about the development in 1979 of the European Monetary System (EMS), which locked exchange rates among the participating countries into predefined trading zones. This was known as the Exchange Rate Mechanism (EMS). This move, in itself, stabilized the economy by creating predictable trading zones.

The next move toward a unified European economy came with the 1987 Single European Act. This act called for the systematic removal of barriers and restrictions that hampered trade between European countries. As a result, border checks, tariffs, customs, labor restrictions and other barriers to free trade were dismantled.

For more information on the euro and related topics, check out the links on the next page.

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