European Economic Integration

• Among 15 European countries there is:

– Free trade– Free mobility of labor – Free mobility of capital

• Among 12 of the 15 European countries:– Since July 2002, national currencies are completely

replaced by the new European currency, the “EURO’’.

The current state of European integration

• Europe is economically important– The economic size of the European Union is similar to the

economic size of the United States.

• Possibility of imitation– Other areas in the world are undertaking similar steps to

integrate national economies. Examples are:• ASEAN for some East Asian countries.

• MERCOSUR for some Latin American countries.

• SAARC for some South Asian countries.

Why should we be interested in the process of economic and monetary integration in Europe?

EUROPEAN FIRMS

• Opportunities - Larger market to target– In the immediate because formal trade barriers are eliminated.

– In the long-run trade and business expansion will make the European market more homogeneous.

• Challenges - Stronger competition– Local firms are facing the increasing competition of foreign

firms. Foreign firms may be more competitive in technology, management and financially.

Why should firms be interested in the process of economic and monetary integration in Europe?

NON-EUROPEAN FIRMS

• Opportunities– The European market is no longer a fragmented

combination of local markets, but rather a large uniform market.

– This will reduce the cost of market penetration.

• Challenges– The within-union increase in competition will reinforce the

competitiveness of European firms. – The increased efficiency and size of European firms imply

that they will be more competitive also in non-European markets. This may be of concern also for firms that are not directly interested in the European market.

ALL FIRMS (EUROPEAN AND NON-EUROPEAN)

• The investment and location strategies will be only driven by:– Local regulations.– Availability of qualified labor.– Vicinity to the final market.

• Exchange rates uncertainty will no longer play a role

for intra-European investments.

ALL FIRMS (continue)

• The faster way to take advantage of the new market opportunities and to face the competition is through:– Cooperative agreements with other firms.– Mergers.– Acquisition of local firms.

• These are the dominant strategies as they combine managerial and organizational experience of the foreign firm with the knowledge and market position of the local firm.

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.

• 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 (1987)

• 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 (1987)

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 allow 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.

Foreign direct investment in EU countries

0

10,000

20,000

30,000

40,000

50,000

60,000

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993

Mill

ions

of

1994

US

dol

lars

France, Germany, Italy and UK Benelux, Denmark Greece, Ireland, Portugal, Spain

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 best three 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 term of

inflation) by more than 2%.

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

– Government debt cannot exceed 60% of GDP.

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

Maastricht Treaty (1992)

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