European Economic Integration

Contents I

• The Definitions of FTA, CU, CM, and EU, the European Monetary Union (EMU)

• Current State: The European Union (EU) and the Euro-zone: 15 members in EU and 12 members in the euro-zone excluding U.K., Sweden and Denmark

• Hence, there are currently 12 EMU members, Denmark and the UK negotiated opt-out clauses while Sweden postponed entry.

• 13 countries in the pre-accession state: These are Czech Rep., Estonia, Hungary, Poland, Slovenia, Latvia, Lithuania, Slovak Rep., Cyprus, Malta, Bulgaria (2007), Romania (2007)and Turkey (???: Did not fulfill the 1993 Copenhagen criteria).

Alternative Strategy: Unilateral Euroization

• Attractive for countries with little prospect for EU entry in near future.

• A country can adopt the Euro unilaterally (even without ECB’s consent (European Central Bank) as the sole or parallel legal tender (Bosnia, Kosovo, Monte Negro)

Alternative Strategy II

• This brings benefits of single currency (exchange-rate stability, low inflation and interest rates, higher trade) even before the country qualifies for full EMU membership (or even before it gains EU membership)

• No influence on ECB policy making• Feasibility? The central bank must have

sufficient stock of foreign exchange to replace currency in circulation.

Contents II• Treaty of Rome (1957)• Single European White

Paper(1985)• Single European Act (1987)• History of the EuropeanIntegration-- European Payment Union (1950-

1958)

-- European Monetary Agreement (1958-1972)

-- Bretton Woods Agreement (1959-1971)

-- Basle Agreement (Snake in the Tunnel ) (1972)

-- European Monetary System (1979)

-- The Delors Report (1989) and the Plan for the realization of European Monetary Union (EMU)

-- The Maastricht Treaty (1992)-- The Euro Area: Costs and

benefits

• The European Institutions-- Legislative-- Jurisdictional-- Executive-- Economic

Main notions of economic integration

• Free trade area – Eliminates tariffs within the area only. Each country retains

its own policy towards non-members.

• Custom union – Add a common external policy to the free trade area.

• Common market– Factors of production can flow freely within a custom union.

Free movement of capital, labor and goods/services.

• Economic union– Common market with common determination of some

structural and macroeconomic policies.

Weak version

• Fixed bilateral exchange rates (rigidly or within a band)

• Each member undertakes monetary policies to defend the rates

Strong version

• Individual currencies are replaced by a single currency• Individual monetary authorities are replaced by a

single authority

What is Monetary Union?

SpainPortugal

France

Germany

EnglandIreland

Sweden

Finland

Denmark

Italy

Greece

Austria

BelgiumNetherlands

• Establishes European Economic Community (EEC)

– Belgium, France, Germany, Italy, Luxembourg, Netherlands.

• The EEC was a “Custom Union”.

– Elimination of internal tariffs.

– Common external tariffs of 15 percent (members’ average).

• Institutionalize the virtuous circle of export-led growth.

– The elimination of tariffs would create trade (trade creation).

– The imposition of external tariffs would reduce dependence from the

United States, Soviet Union, etc. (trade diversion).

Treaty of Rome (1957)

Intra-EC trade as a percentage of total trade

25

30

35

40

45

50

55

60

65

70

75

80

1958 1963 1968 1973 1978 1983 1988 1993

Per

cent

age

of t

otal

tra

de

Belgium, Luxembourg France Germany Italy Netherlands

• Government procurement

– Government units purchase their supplies from domestic

companies as much as possible.

• Technical standards

– Countries require different standards for the

commercialization of some products. Also, some products

do not work in other countries (e.g. Electrical plugs).

Non-tariff barriers

• Local content and rules of origin

– Local laws require foreign firms to buy fixed percentages of

their production supplies from domestic firms.

• Physical barriers

– Internal customs stations slow down communication and

impose bureaucratic burdens.

• Fiscal frontiers

– VAT, excise taxes, corporate taxes, are very different among

countries.

• The European White Paper was a proposal of legislation to eliminate the existing non-tariff barriers.

• The Single European Act (SEA) formally approved most of the legislation proposed in the White Paper and other legislation promoting the liberalization of capital.

Single European White Paper (1985)Single European Act (1986)

• Government procurement – The SEA requires member governments to open up their

purchases from firms of other member countries.

• Technical standard – The SEA adopts the principle of Mutual Recognition: if a

product is legal in one country, it can access all other countries’ markets, given no security or safety problems.

• Physical barriers – Simplification of export-import documentation and custom

checkpoints procedures.

• Fiscal barriers – Homogenization of VAT and corporate taxation. Countries

could choose, for each product, to eliminate the VAT or impose a minimum VAT of 15 percent.

Single European Act (1986)

Labor mobility

• Workers move from areas with low wages to areas of high wages.

• The movement of workers to areas with high wages tends to reduce the wages of existing workers.

• The redistribution effects motivates conservative resistance.

• However, intrinsic labor immobility prevented this mechanism from working in the EU.

Liberalization of factors of production

MPLI

WG

MPLG

LaborG,I

WI

Wages in Germany

Wages in Italy

LGLI

Equilibrium wages with and w/o labor mobility

MPLI

WG

MPLG

LaborG,I

WI

Wages in Germany

Wages in Italy

LGLI

Equilibrium wages with and w/o labor mobility

WG WI

Capital mobility

• Capital moves from areas where the return on capital (interest rate) is low to areas where the return is high.

• The movement of capital to areas with high interest rate tends to reduce the interest rate in these areas and increases the interest rate in the areas with law rates.

• As for labor there are significant redistribution effects that motivate conservative resistance.

Capital mobility (continue)

• During 1980s there were extensive capital controls in the EU. Individuals and firms were not allowed to open bank deposits in other EU countries.

• In July 1990 these controls were eliminated and it was one of the causes of the 1992 collapse of EMS.

• In 1993 there has been a major liberalization of the banking system

• In anticipation of the SEA, there has been an increase in merger and acquisition activities. In particular in the service and banking sectors.

The Single Market Act (I) 1986

• Goods Trade Liberalization1. Streamline or eliminate border

formalities2. Liberalize government procurement3. Harmonization and mutual recognition of

technical standards in production, packaging and marketing.

4. Harmonization of VAT rates.

SEA (II)

• Factor Trade Liberalization

1. Increased capital market integration

2. Liberalization of cross-border market-entry policies, including mutual recognition of approval by national regulatory agencies

SEA (III)

• General Deregulation

1. Reduction in subsidies and anti-competitive regulation

2. More active enforcement of competition policy

SEA (IV)

• Procedural and Transfer Policies

1. Qualified majority voting in the Council of Ministers on most single market issues

2. Substantial Increase in Structural Funds

European Payment Union (1950-1958)

• Facilitated multilateral clearing of payment

imbalances. The Bank of International Settlements

acted as a clearing house.

European Monetary Agreement (1958-1972)

• Many European currencies became convertible. The

Agreements facilitated central banks in making

settlements in gold and dollars.

History of the European Monetary Integration

Bretton Woods Agreement (1959-1971)

• Currencies were allowed to fluctuate by 1% with

respect to the dollar.• European currencies could fluctuate as much as 4%

with each other.• With the Smithsonian Agreement on December 1971,

the band was enlarged to 2.25%

Basle Agreement (Snake in the Tunnel ) (1972)

• EC currencies jointly moving within a dollar tunnel.– Bilateral exchange rates with respect the dollar 2.25%.

– Bilateral exchange rates among European currencies 1%.

• Intervention mechanism and monetary support for member countries.

Snake in the Tunnel

Bilateral band among European currencies

1%

Fluctuation band against the dollar

2.25%

EU exchange rates with the dollar in the 60s and 70s

0.000

0.200

0.400

0.600

0.800

1.000

1.200

1.400

1.600

1.800

2.000

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980

EU

cur

ency

for

1 d

olla

r

GERMANY FRANCE ITALY

NETHERLANDS BELGIUM UNITED KINGDOM

EU exchange rates with the dollar in the 60s and 70s

0.000

0.200

0.400

0.600

0.800

1.000

1.200

1.400

1.600

1.800

2.000

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980

EU

cur

ency

for

1 d

olla

r

IRELAND DENMARK SPAIN

SWEDEN FINLAND AUSTRIA

European Monetary System (1979)

• Currencies were allowed to fluctuate by 2.25% with

each other (Italy and UK 6%).

• Possibility of realignments allowed within the EMS.

• Financing facilities were provided.

• Creation of the European Currency Unit (ECU)

ECU composition in November 1996

National currency Units

Belgium francDanish kroneFrench francGerman markItalian liraIrish poundLuxembourg francNetherlands guilderBritish poundGreek drachmaSpanish pesetaPortuguese escudoAustrian schillingFinnish markkaSwedish krone

3.3010.19761.332

0.6242151.8

0.0085520.13

0.21980.08784

1.446.8851.393

Composition of ECU in November 1996

0 5 10 15 20 25 30 35

Belgium franc

Danish krone

French franc

German mark

Italian lira

Irish pound

Luxembourg franc

Netherlands guilder

British pound

Greek drachma

Spanish peseta

Portuguese escudo

Percentage

• Stage 1 (July 1990)– Free movement of capital. Member states undertake programs

that make possible fixed exchange rates.

• Stage 2 (January 1994)

– Creation of the European Monetary Institute (EMI) to:• Coordinate monetary policies and ensure price stability.

• Prepare the establishment of the European System of Central Banks (ESCB) overseen by the European Central Bank (ECB).

• Prepare the introduction of a single currency in stage 3.

• Examine the achievement of economic convergence among EU states as established by the Maastricht Treaty (1992).

Delors Report (1989)Plan for the realization of EMU

• Stage 3 (January 1999) – Introduction of the single currency “EURO”.

– Establishment of the European Central Bank in charge of the

European monetary policy.

• Price stability– For the preceding year the average inflation rate must not

exceed that of the three best-performing states by more

than 1.5%.

• Interest rate convergence– For the preceding year the average long-term interest rate

must not exceed that of the best three states (in terms of

inflation) by more than 2%.

• Budget discipline– Government budget deficit must be less than 3% of GDP.

– Government (Public) debt cannot exceed 60% of GDP.

Maastricht Treaty (1991)

• Exchange rate stability– For the preceding two years no exchange rate realignments. This means

two years membership in the ERM without devaluation.

• Independent CB with price stability as its primary objective.

• Motivation for the Maastricht Criteria:– Impose fiscal prudence and prevent free riding (e.g. on low interest rates)

– Eliminate threat of national governments seeking bail-outs from the ECB.

– Increase stability of the EMU and the common currency.

– Stability and Growth Pact (1996)

Maastricht Treaty (1991) II

• Economic Union– Customs Union: Free movement of goods and services,

mutual recognition of norms and standards (i.e. no non-tariff barriers), common external tariff.

– Free mobility of capital and labor

– EU-wide competition policy

– Coordination of macroeconomic policies

– Economic and social cohesion (solidarity) and regional development.

Implications of EMU

• Monetary Union– Irrevocably fixed exchange rates

– Replacement of national currencies by the euro.

– Single monetary policy determined by an independent ECB

– Restrictions on and coordination of national fiscal policies

Implications of EMU (II)

• Single Interest Rate set by the ECB• Exchange rates can not be readjusted to correct for

changes in “fundamentals” (e.g. inflation differential between two countries)

• Single Monetary Policy ECB is nominally independent although representatives of national CBs sit on ECB council.

• Monetary policy can not respond to country specific shocks.

• Use of Fiscal Policy as an adjustment policy is limited by the Maastricht Criteria Prices may need to be more flexible (micro flexibility), labor mobility may need to bear a greater share of adjustment to shocks,

Increased need for “fiscal risk sharing”, case for fiscal federalism?

Implications for Macroeconomic Policy

EU exchange rates with the dollar in the 80s and 90s

0.000

0.250

0.500

0.750

1.000

1.250

1.500

1.750

2.000

2.250

2.500

1980 1982 1984 1986 1988 1990 1992 1994 1996

EU

cur

ency

for

1 d

olla

r

GERMANY FRANCE ITALY

NETHERLANDS BELGIUM UNITED KINGDOM

EU exchange rates with the dollar in the 80s and 90s

0.000

0.250

0.500

0.750

1.000

1.250

1.500

1.750

2.000

2.250

2.500

1980 1982 1984 1986 1988 1990 1992 1994 1996

EU

cur

ency

for

1 d

olla

r

IRELAND DENMARK SPAIN

SWEDEN FINLAND AUSTRIA

The ‘EURO’ area

• Benefits:

– Reduction in transaction costs.

– Elimination of the exchange rate risk.

– Greater competition leading to greater efficiency.

– Greater integration among the European financial markets and greater investment efficiency.

– Inflation discipline guaranteed by the independence of the European Central Bank.

– Fiscal discipline as a requirement to enter and stay in the system.

– Increase the urgency of structural reforms in Europe.

Costs and benefits of the Euro

• Costs:

– The system of fixed exchange rates eliminate the possibility of using exchange rate adjustments as a policy tool in the presence of asymmetric shocks.

– Individual countries cannot use monetary policy to face country-specific shocks.

– Europe may not be an optimal currency area due to:• Likelihood of asymmetric or country-specific shocks.

• Limited labor mobility.

• Structural labor market rigidities.

– Limited ability to use fiscal policy as a stabilization tool in absence of monetary independence.

– Absence of a system of fiscal redistribution to insure against regional/national shocks.

Legislative Institutions - European parliament

- Council of Ministers

Executive Institutions

- European Commission

- European Council

Jurisdictional Institutions

- European Court of Justice

- Court of First Instance

Economic Institutions

- European System of Central Banks

European Institutions

• European Parliament– Functionalist version of the legislative branch.

– Composed of 626 members.

– Elected every five years.

• Council of the European Union or Council of Ministers– Important legislative organism.

– Formed by the 15 ministers responsible for the matter being decided.

– Votes are distributed taking into account the size of the country members.

– Deliberations are directives that are applied by each individual country.

Legislative Institutions

• European Commission

– Functionalist version of the executive branch.

– Composed of 20 members (one official from each country).

– Initiate legislation for the Council of Ministers (and the Parliament).

Identifies European problems and studies possible solutions.

– Once the legislation is passed, it oversees its implementation by

monitoring individual governments in passing the necessary national

legislation.

• European Council

– Realistic version of the executive branch.

– Formed by the heads of the government of each country plus the

president of the European Commission.

– Proposes initiatives to the Commission.

Executive Institutions

• European Court of Justice– Composed of 16 judges.

– Each member is elected for 6 years by a member state. The sixteenth member is the Chief Justice and it is elected by the other members.

– Suits may be brought by member states, corporations, or individuals

on issues related to the interpretation of Community law.

• Court of First Instance– Similar composition of the Court of Justice.

– Deals with most of the actions undertaken by individuals and companies.

– Appeal can be made with the Court of Justice.

Justice Institutions

• European System of Central Banks

– It is composed of the European Central Bank and the central banks

of the member states.

– Similar to the Federal Reserve System in the United States.

– The executive body is the ESCB Board appointed by the European

Council.

– The ESCB Board and the Governors of the countries’ central banks

form the Council of the ESCB.

Economic Institutions