Monetary Policy in Unknown Territory the European Central Bank in the Early Years

The creation of a monetary union in Europe on 1 January 1999 is undoubtedly one of the largest macro and politico-economic experiments in modern history. It was the cap stone of the so-called 'Maastricht Process' designed to achieve macro economic convergence, which had shaped monetary and fiscal policies in the countries striving for membership in European Monetary Union (EMU) over much of the 1990s. 1 The start of EMU was marked by the conversion of the national currencies of the member states into euros and the beginning of the operations of the new Euro System, the new European Central Bank (ECB) and the national central banks of the participating states (NCBs). 2 While euro cash rested in the form of the previous national currencies for the first three years, interbank and most non-cash payments have been denominated in euros since the start and European financial markets quickly adopted the euro as of account. The replacement of the national currency signs by euro cash at the start of 2002 will complete the introduction of EMU. The new EMU has a combined population 11 percent larger than that of the US, and a combined GDP of 61 percent of US GDP. 3 Like the US, and in sharp contrast to the individual member states, it a fairly closed economy, whose trade with third countries is about 20 percent of GDP. EMU has created a large financial area with a combined stock market capitalization initially of 28 percent of that of the US and a securities market with an initial value of about 60 percent of the US market. 4 By 2000, the combined stock market valuation of the euro economy had risen to about 37 percent of that of the US, and its securities market value to about 69 percent of the US market, suggesting that EMU has stimulated financial market growth. Due to institutional and regulatory differences, financial market integration is still less than perfect, but market-driven integration proceeds rapidly. 5 Despite the large degree of nominal convergence achieved at the end of the 1990s, the start of EMU was surrounded by many uncertainties. Little was known (and is) about the properties and the stability of basic macroeconomic relations in the new monetary area such 1 For a review of fiscal policies in the EMU member states during the 1990s see Hughes-Hallett, Strauch and von Hagen (2001). 2 In addition to …