Maastricht Treaty

• Signed in 1991 in the city of Maastricht in the Netherlands, this treaty created the European Union and laid out the plans for the formation of a monetary union by 1999.
• It was understood that in order for the monetary union to be successful, its members needed to be part of an “optimal currency area”, and that stability among members was extremely important. In order to meet these requirements, the Maastricht Treaty set out convergence and stability criteria that had to be met before a country could become a member of the EMU. The criteria were as follows (see here):
  • Inflation was to be no more than 1.5 percentage points above that of the 3 lowest inflation rates in EMU members.
• This was to insure that monetary policies were similar across countries as well as to gauge whether a country was susceptible to asymmetric shocks.
• Government deficits were limited to be no larger than 3 percent of GDP.
• This was to promote stability by overcoming Europe’s deficit bias.
• Government debt was limited to be no larger than 60 percent of GDP.
• This rule was not enforced, as most EMU members were unable to meet this criterion before 1999. As long as a potential member was reducing debt levels (through good management of deficit positions) they were allowed to enter the EMU.
• The potential member had to demonstrate exchange rate stability by being a member in the exchange rate mechanism (ERM) for at least 2 years prior to joining the EMU.  In the ERM a country’s central bank is required to keep exchange rate fluctuations within a specified rage.
• This was again used to align monetary policy before joining the union, as well ensures a proper exchange rate once the local currency was exchanged for euros.
• The long-term interest rate is not to exceed the lowest 3 rates among EMU members (or potential members) by more than 2 percentage points.
• This was to ensure that the fundamentals of the economy were similar across potential members.
• Each new member of the EU must meet these criteria before they can enter the EMU.
• Once a country becomes a member of the EMU, it no longer must abide by the Maastricht treaty (in the case of exchange rates, inflation, and the long-term interest rate, it really doesn’t have the control to maintain these economic variables).
• Once in the EMU, a country must abide by the Stability and Growth Pact.

Results:

• Inflation convergence:  Inflation rates dramatically improved and converged in the run up to joining the EMU in 1999.

• Deficits: Every member (with the exception of Greece who met the criteria by 2000) was able to bring their deficit to GDP ratio within 3 percent by 1999.

• Debt: Very few members met the 60 percent debt to GDP ratio, but authorities are pleased to see the general decline in the debt levels.

• Exchange rates: Each member was able to stay within the ERM within 2 years of joining the EMU.
• Long-run interest rates: Every member was successful in bringing long-term interest rates into line.