1 The Economics of European Integration

2 Table Of Contents 1. History Facts, law, institutions and the budget Decision making 4. Essential microeconomic tools The essential economics of preferential liberalisation  Market size and scale economics  Growth effects and capital market integration  Economic integration, labour markets and migration The common agricultural policy  Location effects, economic geography and regional policy  EU competition and state aids policy EU trade policy

3 13. A monetary history of Europe 1413. A monetary history of Europe 14. The choice of an exchange rate regime The European monetary system 16. Optimum currency area 17. The European Monetary Union 18. Fiscal policy and the stability pact 19. The financial markets and the Euro

4 Chapter 1 History

5 Early Post War Period A Climate for Radical Change: Facts:

6 A Climate for Radical Change:Images Reichstag, 1945 Frankfurter Allee, 1945

7 A Climate for Radical Change:Images Brandenburg Gate

8 A Climate for Radical Change:Images Unter der Linden, 1945 Unter der Linden, 1997

9 A Climate for Radical Change:Images Berlin Cathedral, 1945 Berlin Cathedral, 1997

10 A Climate for Radical Change:Images

11 A Climate for Radical Change:Images Rotterdam, 1940

12 A Climate for Radical Change:Images Verona 1945

13 A Climate for Radical Change:Images London 1940

14 A Climate for Radical Change:Images London 1940

15 A Climate for Radical Change:Images East London, 1940

16 The prime question in 1945 “How can Europe avoid another war?”What caused the war? 3 answers Blame the loser Capitalism Destructive nationalism These implied 3 post-war solutions ‘Neuter’ Germany , Morgenthau Plan, 1944 Adopt communism Pursue European integration European integration ultimately prevailed, but this was far from clear in the late 1940s.

17 Emergence of a divided EuropeGermany & Berlin divided into 4 zones Cold War begins. USSR pushes communism in the East. UK, French and US zones merged by 1948 Moves towards creation of West German government. Berlin blockade, 1948. “Neuter Germany” solution abandoned for strong West Germany + European integration. Berlin blockade

18 A divided Europe

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21 East German Guard Towers

22 Checkpoint Charlie, 1961

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24 First Steps First Steps: the OEEC and EPUOEEC and EPU set up in conjunction with Marshal Plan, 1948. OEEC coordinated aid distribution and prompted trade liberalisation. EPU facilitated payments and fostered trade liberalisation.

25 Need for deeper European integrationAs Cold War got more war-like, West Germany rearmament became necessary. 1949, Fed’l Rep. of Germany established. But strong and independent Germany was a scary thought to many , including many Germans. Wide-spread feeling: best to embed an economically and militarily strong W. Germany in European superstructure. Problem: OEEC was too loose to avoid future war among Western European powers.

26 Two strands of European integrationFederalism and intergovernmentalism Immediate disagreement about depth of European integration Federalism – supranational institutions Intergovernmentalism – nations retain all sovereignty Intergovernmental initiatives OEEC (1948), Council of Europe (1949), EFTA (1960) Federal initiative ECSC (1951), EEC (1958)

27 1960-1973, two non-overlapping circlesIS EFTA-7 NL B D L N S FIN F I DK EEC-6 UK A P IRL CH West European Trade Arrangements in 1960s : The EFTA-7 and the EEC-6 form two E GR non-overlapping circles.

28 Evolution to Two Concentric CirclesPreferential liberalisation in EEC and EFTA proceeded (EEC’s customs union and EFTA’s FTAs completed by 1968) Discriminatory effects emerge, leading to new political pressures for EFTAs to join EEC Trade diversion creates force for inclusion As EEC enlarges, force for inclusion strengthens When UK decides to apply for EEC (1961), 3 other EFTAns also change their minds. De Gaulle’s ‘non’ (twice)

29 Evolution to Two Concentric CirclesFirst enlargement, 1973 UK, Denmark, Ireland & Norway admitted (Norwegians say no in referendum) Enlargement of EEC reinforces ‘force for inclusion’ on remaining EFTAs Remaining EFTAs sign FTA agreements with EEC-9 Why weren’t the FTA’s signed before? Domino-like affect of lowering barriers 1st within EEC6 → enlargement → EEC-EFTA FTAs

30 Two concentric circlesGR West Europe's Trade Arrangement in mid-1970s : I D F B L NL IRL P UK CH A FIN N S IS DK EEC-9 EFTA-7

31 Euro-pessimism, 1975-1986 Political shocks: Economic shocks:‘Luxembourg Compromise’ (1966) + enlargement leads to decision-making jam. Economic shocks: Bretton Woods falls apart, Failed monetary integration schemes (except within DM bloc). 1973 and 1979 oil shocks with stagflation. Failure of Deeper Trade Integration. Growing cost of Common Agricultural Policy creates frictions over budget.

32 Bright spots Democracy in Spain, Portugal and GreeceGreece joins in 1981 Spain and Portugal join in 1986 after long a difficult accession talks EMS set up in 1979 works well Budget Treaties 1979 Cassis de Dijon decision built on 1974 Dassonville ruling Challenged validity of national rules that introduce non-tariff barriers to trade. Mutual Recognition Principle introduced.

33 Deeper circles: single market programmeMutual recognition as threat to national regulatory control; race to bottom? How to put member gov’t back in charge? Delors launches completion of the internal market with Single European Act create "an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured". Important institutional changes, especially move to majority voting on Single Market issues. Mutual recognition is disciplined by minimum harmonisation More efficient decision making procedures allow agreement on min. standards “New Approach” Directives.

34 Single Market Programme, EC92Basic elements Goods Trade Liberalisation Streamlining or elimination of border formalities, Harmonisation of VAT rates within wide bands Liberalisation of government procurement Harmonisation and mutual recognition of technical standards in production, packaging and marketing Factor Trade Liberalisation Removal of all capital controls (!!!), and deeper capital market integration Liberalisation of cross-border market-entry policies,

35 Domino effect, part II Deeper integration in EC-12 strengthened the ‘force for inclusion’ in remaining EFTAns. End of Cold War loosened EFTAns’ resistance to EC membership. Result of ‘force for inclusion’ EEA – initiative to extend single market to EFTAs. Membership applications by all EFTAns except Iceland. Concentric circles, but both deeper.

36 Fourth enlargement 1994, Austria, Finland, Norway and Sweden admitted (Norwegians again vote no). 1994 1973 2004 1958 Cyprus 1973 Malta 1981

37 Communism’s creeping failure and spectacular collapseBy the 1980s, Western European system clearly superior due to the creeping failure of planned economies. Up to 1980s, Soviets thwarted reform efforts (economic & military pressure). Changes in USSR due to inadequacy economic system. timid pro-market reforms (perestroika). openness (glasnost).

38 Velvet revolutions in CEECsJune Polish labour movement ‘Solidarity’ forced free parliamentary elections & communists lost Moscow accepted new Polish government. Moscow’s hands-off approach to the Polish election triggered a chain of events. Reformist in Hungarian communist party pressed for democracy & Hungary opened its border with Austria, 1000s East Germans moved to West Germany via Hungary and Austria. Mass protests in East Germany; Wall falls 9th November 1989. End of 1989: democracy in Poland, Hungary, Czechoslovakia and East Germany (unification in 1990).

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40 USSR collapses 1990, Estonia, Latvia and Lithuania – declared their independence from the USSR. End of 1991, the Soviet Union itself breaks up. Cold War ends without a shot. Military division of Europe ended.

41 EU reacts The European Union reacted swiftly to this geopolitical earthquake by providing emergency aid and loans to the fledgling democracies. Signing of ‘Europe Agreements’ with newly free nations in Central and Eastern Europe These are free trade agreements with promises of deeper integration and some aid

42 From Copenhagen to CopenhagenEU says CEECs can join the EU (June 1993). Set out famous Copenhagen criteria for membership. stability of institutions guaranteeing democracy, the rule of law, human rights and respect for and, protection of minorities, the existence of a functioning market economy as well as the capacity to cope with competitive pressure and market forces within the Union. Copenhagen summit December 2002 says 10 CEECs can join in 2004. 5th enlargement in May 2004

43 German unification and MaastrichtPending 1990 unification of Germany opens door to a ‘grand bargain’ (Mitterrand, Kohl). Germany gives up DM for European Monetary Union & East Germany joins the EU without negotiation. Jacques Delors proposes 2nd radical increase in European economic integration. the formation of a monetary union. Idea championed by French President Francois Mitterrand and German Chancellor Helmut Kohl. Maastricht Treaty, signed 1992 a monetary union by 1999, single currency by 2002. Also, sets up EU’s ‘three pillar’ structure to reduce EU’s ‘competency creep;’ ERM exchange rate crises,

44 Preparing for Eastern EnlargementImpending enlargement required EU to reform its institutions Four tries: Amsterdam Treaty, 1997 Nice treaty, 2000 draft Constitutional Treaty, 2003 Reconsidered by IGC 2003 Constitutional Treaty, June 2004.

45 Amsterdam Treaty Failed to reform main institutionsTidied up of the Maastricht Treaty More social policy, Parliament powers modestly boosted, flexible integration, ‘closer cooperation introduced Amsterdam leftovers voting rules in the Council of Ministers, number of Commissioners, Extension of issue covered by majority voting

46 Nice Treaty Reforms of main institutions agreed, but poorly doneCouncil voting rules highly complex and reduce EU’s ability to act with more members No important extension of majority voting Make shift solution for Commissioners No reform of decision making in ECB Generally viewed as a failure Main changes re-visited in draft Constitutional Treaty, 2003

47 Constitutional TreatyImproved decision-making rules for Council of Ministers and slightly more majority voting. Inclusion of Charter of Fundamental Rights. Other things where CT not strictly required: Many ‘gestures’ and tidying up. Moves towards more coherent foreign policy decision making. Many de facto points turned into de jure.

48 Constitutional Treaty’s ProblemsFrance and Netherlands reject the Constitutional Treaty in referendums in Summer 2005. EU leaders suspend the ratification deadline. Next steps uncertain as of early 2006.

49 The Economics of European Integration

50 Chapter 2 Facts, law, institutions and the budget

51 Facts: Population

52 Facts: Population 6 big nations:> 35 million (Germany, the UK, France, Italy, Spain and Poland). Netherlands: 16 million people. 8 ‘small’ nations (size of a big city): 8 to 11 million: (Greece, Belgium, Portugal, Sweden, Austria, Czech Republic and Hungary). 11 ‘tiny’ nations: (size of a moderate to small city) together make up less than 5 per cent of EU25 population (Slovak Republic, Denmark, Finland, Ireland, Lithuania, Latvia, Slovenia, Estonia, Cyprus, Luxembourg and Malta.)

53 Facts: Income per capita

54 Facts: Income per capita11 high income – over €20,000 Denmark, Ireland, Austria, Netherlands, Belgium, Finland, Italy, Germany, France, UK and Sweden. 9 medium income category – from €10,000 to €20,000 Spain, Greece, Portugal, Cyprus, Hungary, Slovenia, the Czech Republic, Malta and the Slovak Republic. 6 low income nations, less than €10,000 Estonia, Poland, Lithuania, Latvia, Bulgaria, Romania, and Turkey NB: Turkey’s income is half that of the richest-of-the-poor, Estonia. Luxembourg is in the super-high income category by itself. per capita income is almost twice that of France about 40% of Luxembourgers work so the average worker earns over €100,000 a year!

55 Facts: Size of Economies

56 Facts: Size of EconomiesEconomic size distribution is VERY uneven. Six nations (Germany, the UK, France, Italy, Spain and the Netherlands) account for more than 80% of EU25’s economy. Other nations are small, tiny or miniscule. ‘Small’ is an economy that accounts for between 1% and 3% of the EU25’s output: Sweden, Belgium, Austria, Denmark, Poland, Finland, Greece, Portugal and Ireland. ‘Tiny’ is one that accounts for less than 1% of the total: Czech Republic, Hungary, Slovak Republic, Luxembourg, Slovenia, Lithuania, and Cyprus. Miniscule is one that accounts for less than one-tenth of 1%: Latvia, Estonia and Malta.

57 Facts: EU15’s Global Trade Pattern

58 Facts: EU15’s Global Trade PatternThe EU trades mainly with Europe, especially with itself: about two-thirds of EU exports and imports are to or from other Western European nations the EU’s exports to North America amount to only 10 per cent of its exports Asia’s share is only 8 per cent. About 80 per cent of EU exports consist of industrial goods (‘intraindustry’ trade).

59 Facts: EU15’s Global Trade Pattern

60 Facts: EU15’s Global Trade PatternEU25 members are all comparatively open economies when it comes to trade in goods: openness ratio for the EU15 ranges from 17 per cent for Greece up to 75 per cent for the Belgium-Luxembourg figures for the 10 newcomers are higher than Greece’s figures for Japan and the US are 10 per cent and 8 per cent respectively. EU15 market is very important for all EU25: share of exports going to the EU15 ranges between 50 per cent to 80 per cent.

61 Law: ‘Sources’ of EU LawThe EU Court created by the Treaty of Rome: court then established the Community’s legal system two landmark cases in 1963 and 1964. EC law was established on the basis of: the EU institutions ensuring that actions by the EC take account of all members’ interests, i.e. the Community’s interest the transfer of national power to the Community. (Source: Borchardt (1999), p. 24.) Draft Constitutional Treaty may replace this as the source of EU law.

62 Law: Key Principles of EC LawAutonomy: system is independent of members’ legal orders. Direct Applicability: has the force of law in member states so that Community law can be fully and uniformly applicable throughout the EU. Primacy of Community law: community law has the final say, e.g. highest French court can be overruled on a matters pertaining to intra-EC imports Necessary so Community law cannot be altered by national, regional or local laws in any member state. (Source: Borchardt (1999).)

63 Law: Structure

64 Law: Structure The EU’s Three-Pillar Structure:what is the difference between the European Community and the European Union? Three-Pillar Structure: 1st: Economics 2nd: Security and Foreign 3rd: Justice. EC law only applies to first pillar. EU is ‘roof’ over the three pillars.

65 Law: Types of EU legislationPrimary legislation: treaties. Secondary legislation: collection of decisions made by EU institutions.

66 Law: Types of EU legislationFive types of secondary law: Regulation Applies to all member states, companies, authorities and citizens. Regulations apply as they are written, i.e. they are not transposed into other laws or provisions. They apply immediately upon coming into force.

67 Law: Types of EU legislationDirective: May apply to any number of member states, but they only set out the result to be achieved. Member states what needs to be done to comply with the conditions set out in the directive (e.g. new legislation, or change in regulatory practice). Decision: Is a legislative act that applies to a specific member state, company or citizen. Recommendations and opinions: These are not legally binding, but can influence behaviour of, e.g. the European Commission, national regulators.

68 Institutions: The ‘Big Five’There are dozens of EU institutions but only five are really important: European Council Council of Ministers Commission Parliament EU Court. Others matter in specific areas or at particular moments.

69 Institutions: European CouncilConsists of the leader (prime minister or president) of each EU member plus the President of the European Commission. By far the most influential institution: its members are the leaders of their respective nations. Provides broad guidelines for EU policy.

70 Institutions: European CouncilThrashes out compromises on sensitive issues: reforms of the major EU policies the EU’s multiyear budget plan Treaty changes final terms of enlargements, etc.

71 Institutions: European CouncilMeets at least twice a year (June and December): meets more frequently when the EU faces major political problems highest profile meetings at the end of each six-month term of the EU Presidency these meetings are important political and media events determine all of the EU’s major moves

72 Institutions: European Councilmost important decisions of each Presidency are contained in a document, known as the ‘Conclusions of the Presidency’, or just the ‘Conclusions. Strangely, the European Council has no formal role in EU law-making: its political decisions must be translated into action via Treaty changes or secondary legislation.

73 Institutions: European CouncilConfusingly, the European Council and the Council of the EU are often both called the Council. The 2003 draft Constitution proposes to make the European Council a form part of the EU institutional structure.

74 Institutions: Council of MinistersUsually called by old name Council of Ministers (formal name is now ‘Council of the EU’). Consists representatives at ministerial level from each Member State, empowered to commit his/her Government:

75 Institutions: Council of Ministerstypically minister for relevant area: e.g finance ministers on budget issues confusingly, Council uses different names according to the issue discussed. Famous ones include EcoFin (for financial and budget issues), the Agriculture Council (for CAP issues), General Affairs Council (foreign policy issues).

76 Institutions: Council of MinistersIs EU’s main decision-making body (almost every EU legislation must be approved by it). Main task to adopt new EU laws: measures necessary to implement the Treaties also measures concerning the EU budget and international agreements involving the EU is also supposed to coordinate the general economic policies of the Member States in the context of the Economic and Monetary Union (EMU), e.g. famous 3 per cent deficit rule.

77 Institutions: Council of MinistersCouncil also decides on: 2nd and 3rd pillar issue, i.e. Common Foreign and Security Policies (2nd), police and judicial cooperation in criminal matters (3rd). two main decision-making rules: on the most important issues, unanimity, e.g. Treaty changes, enlargement, multi-year budget plan, Council decisions are by on most issues (about 80 per cent of all Council decisions), majority voting qualified majority voting (QMV).

78 Institutions: QMV QMV is complex and is changing. Three sets of rules:Procedure that applies until mid 2004: basic form unchanged since 1958 Treaty of Rome. Procedure post-2004 (from Nice Treaty) unless Constitutional Treaty supersedes them: political agreement in Nice Treaty; implemented by Accession Treaty for 2004 enlargement. Procedure from Constitutional Treaty draft endorsed by European Council at June 2003 meeting.

79 Institutions: QMV Procedure that applies until mid 2004:each member’s minister casts a certain number of votes more populous members have more votes: many fewer than population-proportionality suggests e.g. France (60 million citizens) has 10 votes; Denmark (5 million citizens) has 3

80 Institutions: QMV total number of votes in the EU15 is 87the threshold for a winning majority is 62 votes: this is called a ‘qualified majority’, i.e. the majority rule is that about 71 per cent of all votes are required to adopt a proposal.

81 Institutions: QMV The implications of this system are complex:since bigger members have more votes, 71 per cent of the votes does not mean 71 per cent of members (three large members voting ‘no’ could block adoption even if the other 12 voted ‘yes’)

82 Institutions: QMV since small nations get far more votes than strict population-proportionality would suggest, 71 per cent of the votes does not mean 71 per cent of the EU population: 71 per cent threshold can theoretically be reached, e.g. by a coalition of just eight members representing 58 per cent of the EU population.

83 Institutions: QMV Even though QMV is the basis of most Council decisions, the Council rarely votes: they usual decide things by ‘consensus’. Shadow voting: despite this, QMV and voting weights are important if nations know they would be outvoted, were a vote were to recorded, they usually join the consensus to be collegial

84 Institutions: QMV nations go through a mental process of ‘shadow voting’ before deciding to join the consensus: figure out what the outcome would be, if a vote were held majority rule and votes matter to mental calculation.

85 QMV: Nice/Accession Treaty ReformsReforms change QMV in two main ways (note: changes scheduled to take effect in November 2004): 1. Makes QMV more complex; two new criteria in addition to votes proposition passes the Council when coalition of yes-voters meets three criteria:

86 QMV: Nice/Accession Treaty Reformsvotes: 72 per cent of the Council votes (232 votes of the 321 Council votes in the EU25) number of members: 50 per cent of the member states population: 62 per cent of the EU population.

87 QMV: Nice/Accession Treaty Reforms2. Votes reallocated to favour big nations

88 QMV: Nice/Accession Treaty ReformsTo see this another way, look at percentage increase by member: members ranked by population. Poland, Spain are relative biggest winners. Tiny members biggest relative losers.

89 QMV: draft Constitutional TreatyVoting rules in the Nice and Accession Treaties widely viewed as failing to meet the goal of maintaining the Council’s ability to act. European Convention (2002–3) proposed a radical reform: embodied in 2003 draft Constitutional Treaty (CT). Note: Endorsed by European Council at June Summit.

90 QMV: draft Constitutional TreatyUnder CT rules, qualified majority needs yes votes from: member states with at least 60 per cent EU population at least half members.

91 QMV: draft Constitutional TreatyDraft CT says the new rules take effect in 2009: Nice rules could be in place for several years. Voting rules among the most controversial changes in the CT: the 2003 IGC may change them.

92 QMV: draft Constitutional TreatyPower implications: big nations gain a lot (except Spain and Portugal who lose a lot) intermediate-sized nations lose tiny nations gain slightly. (Source: Baldwin and Widgren (2003) ‘Decision Making and the Constitutional Treaty: Will the IGC discard Giscard?’

93 Institutions: The CommissionEuropean Commission is at the heart of the EU’s institutional structure. Driving force behind deeper and wider European integration.

94 Institutions: The CommissionHas three main roles: propose legislation to the Council and Parliament to administer and implement EU policies to provide surveillance and enforcement of EU law (‘guardian of the Treaties’) it also represents the EU at some international negotiations.

95 Commissioners, Commission’s CompositionBefore the 2004 enlargement: one Commissioner from each member: extra Commissioner from the Big-Five (Germany, UK, France, Italy and Spain in the EU15) this includes the President (Romano Prodi up to 2005), two Vice-Presidents and 17 other Commissioners.

96 Commissioners, Commission’s CompositionUnder Nice Treaty each member in EU25 has one Commissioner. Draft Constitution, only 15 Commissioners: rotating evenly among all members would have non-voting Commissioners from other nations (IGC likely to change this).

97 Commissioners, Commission’s CompositionCommissioners are chosen by their own national governments: subject to political agreement by other members Commission, the Commission President individually, approved by Parliament.

98 Commissioners, Commission’s CompositionCommissioners are not national representatives: should not accept or seek instruction from their country. Appointed together, serve for five years current Commission’s term ends in January 2005.

99 Commissioners, Commission’s CompositionEach Commissioner in charge of a specific area of EU policy: Directorate-Generals (DGs). Executive powers Commission executive in all of the EU’s endeavours power most obvious in competition policy and trade policy.

100 Commissioners, Commission’s CompositionManage the EU budget, subject to EU Court of Auditors. Decision making: decides on basis of a simple majority, if vote taken almost all decisions on consensus basis.

101 Institutions: European ParliamentTwo main tasks: oversees EU institutions, especially Commission it shares legislative powers, including budgetary power, with the Council and the Commission.

102 Institutions: European ParliamentOrganisation: up till the 2004 enlargement, 626 members (MEPs) after 732 directly elected in special elections organised by member nation number per nation varies with population but rises less than proportionally.

103 Institutions: European ParliamentMEPs supposed represent local constituencies, but generally organised along classic European political lines, not national lines as in Coucil: centre left and centre right two main party groupings (together about two-thirds of seats) MEPs seat, physical, left-to-right.

104 Institutions: European ParliamentLocation: parliament is in Strasbourg, in Luxembourg, and in Brussels nationalistic struggles to keep an EU institution local resulted in this. Democratic control.

105 Institutions: European ParliamentThe Parliament and the Council are the primary democratic controls over the EU’s activities. The MEPs are directly elected by EU citizens, so European Parliamentary elections are, in principle, a way for Europeans to have their voices heard on European issues.

106 Institutions: European ParliamentIn practice, however, European Parliamentary elections are often dominated by standard left-versus-right issues rather than by purely EU issues. Indeed, European Parliamentary elections are sometimes influenced by pure national concerns with the voters using the elections as a way of expressing disapproval or approval of the ruling national government’s performance.

107 Institutions: European ParliamentMoreover in many member states, participation in European Parliamentary elections tends to be fairly modest, and MEP absenteeism is a problem. By contrast, the elections by which national governments are chosen have very high levels of popular participation. The national elections, however, involve many issues, so voters may find it difficult to influence their nation’s stance on EU issues via national elections.

108 Institutions: European ParliamentThe 2003 draft Constitutional Treaty proposes few changes for the Parliament, although it does expand its power somewhat by giving the Parliament a voice in almost all legislative activities.

109 Institutions: European ParliamentDemocratic control: Parliament and Council are the primary democratic controls over the EU’s activities MEPs directly elected so in principle a way for Europeans to have a voices in practice, however, European Parliamentary elections dominated by standard left-versus-right, and purely local issues rather than by EU issues.

110 Institutions: European ParliamentThe 2003 draft Constitutional Treaty proposes few changes for the Parliament: does expand its power, giving it equal standing with the Council on almost legislation.

111 Institutions: European Court of JusticeEU laws and decisions open to interpretation that lead to disputes that cannot be settled by negotiation: Court settles these disputes, especially disputes between Member States, between the EU and Member States, between EU institutions, and between individuals and the EU.

112 Institutions: European Court of JusticeEU Court’s supranational power highly unusual in international organisations. Influence. As a result of this power, the Court has had a major impact on European integration. As mentioned above, a 1964 judgment established EC law as an independent legal system that takes precedence over national laws in EC matters, and a 1963 ruling established the principle that EC law was directly applicable in the courts of the members.

113 Institutions: European Court of JusticeIts ruling in the 1970s on non-tariff barriers triggered a sequence of events that eventually led to the Single European Act (see Chapter 4 for details). The Court has also been important in defining the relations between the Member States and the EU, and in the legal protection of individuals (EU citizens can take cases directly to the EU Court without going through their governments). Organisation.

114 Institutions: European Court of JusticeThe Court of Justice, which is located in Luxembourg, consists of one judge from each member state. They are appointed by common accord of the member states' governments and serve for six years. The Court also has eight ‘advocates-general’ whose job is to help the judges by constructing ‘reasoned submissions’ that suggest what conclusions the judges might take. The Court reaches its decisions by majority voting. The Court of First Instance was set up in the late 1980s to help the Court with its ever growing workload.

115 Institutions: European Court of JusticeInfluence: court has had a major impact on European integration via case-law. Organisation: located in Luxembourg one judge from each member appointed by common for six years

116 Institutions: European Court of Justicealso eight ‘advocates-general’ to help judges the Court reaches its decisions by majority voting Court of First Instance set up 1980s to help with ever growing workload.

117 Legislative ProcessesMain procedure, co-decision procedure, gives the Parliament equal standing with the Council after a proposal is made by Commission (used for about 80 per cent of EU legislation).

118 Legislative ProcessesThe co-decision procedure requires: Commission’s proposal to be adopted by the Parliament (deciding by simple majority) and Council (deciding by qualified majority) before it becomes law if the Parliament and/or the Council disagree, proposal only adopted if a Council-Parliament compromise can be reached.

119 Legislative ProcessesThe consultation procedure is used for a few issues, e.g. the Common Agricultural Policy’s periodic price fixing agreements – where the member states wished to keep tight control over politically sensitive decisions. Under this procedure, the Parliament must give its opinion before the Council adopts a Commission proposal. Such opinions, when they have any influence, are intended to influence the Council, or the shape of the Commission’s proposal.

120 Legislative ProcessesAnother procedure in which the Parliament plays a subsidiary role is the assent procedure. For example, on decisions concerning enlargement, international agreements, sanctioning member nations and the coordination of the Structural Funds, the Parliament can veto, but cannot amend a proposal made by the Commission and adopted by the Council.

121 Legislative ProcessesThe final procedure, the cooperation procedure, is a historical hang over from the Parliament’s gradual increase in power. Specifically, before the co-decision procedure was introduced in the Maastricht Treaty, the cooperation procedure was the one that granted the most power to the Parliament. The best way to think of it is as the co-decision procedure where the Parliament’s power to amend the proposal is less explicit. Also, the Council can overrule an EP rejection by voting unanimously.

122 Legislative ProcessesOther procedures: consultation procedure: used for few issues, Parliament only gives opinion. Assent procedure: e.g. decisions concerning enlargement Parliament can veto, but cannot amend proposal.

123 Legislative ProcessesCooperation procedure: historical hang over Quite similar to co-decision procedure Like co-decision procedure but Parliament’s power to amend is less explicit. Draft Constitutional Treaty to make Co-decision apply to almost all decisions.

124 The Budget: Expenditure

125 Evolution of Spending Priorities

126 Evolution of Spending, Level

127 Evolution of Spending, Level

128 Funding of EU Budget EU’s budget must balance every year.Financing sources: four main types: Tariff revenue ‘Agricultural levies’ (tariffs on agricultural goods) ‘VAT resource’ (like a 1 per cent value added tax – reality is complex) GNP based (tax paid by members based on their GNP).

129 Funding of EU Budget Miscellaneous relatively unimportant since 1977taxes paid by eurocrats, fines and earlier surpluses pre-1970s direct member contributions.

130 Evolution of Funding Sources

131 Contribution vs GDP, 1999, 2000

132 Contribution vs GDP, 1999, 2000 Percentage of GDP per member is approximately 1 percent regardless of per-capita income. EU contributions are not ‘progressive’, e.g. richest nation, (L) pays less of its GDP than the poorest nation (P).

133 Net Contribution by Member

134 The Economics of European Integration

135 Chapter 4 Essential Micro Tools

136 Preliminaries I Demand curve shows how much consumers would buy of a particular good at any particular price. It is based on optimisation exercise: Would one more be worth price? Market demand is aggregated over all consumers’ demand curves. Horizontal sum.

137 Preliminaries I Supply curve shows how much firms would offer to the market at a given price. Based on optimisation: Would selling one more unit at price increase profit? Market supply is aggregated over all firms. Horizontal sum. A firm’s supply curve is its marginal cost curve.

138 Welfare analysis: consumer surplusSince demand curve based on marginal utility, it can be used to show how consumers’ well-being (welfare) is affected by changes in the price. Gap between marginal utility of a unit and price paid shows ‘surplus’ from being able to buy c* at p*. = MU

139 Welfare analysis: consumer surplusIf the price falls: Consumers obviously better off. Consumer surplus change quantifies this intuition. Consumer surplus rise, 2 parts: Pay less for units consumed at old price; measure of this = area A. A = Price drop times old consumption. Gain surplus on the new units consumed (those from c* to c’); measure of this = area B. B = sum of all new gaps between marginal utility and price

140 Welfare analysis: producer surplusSince supply curve based on marginal cost, it can be used to show how producers’ well-being (welfare) is affected by changes in the price. Gap between marginal cost of a unit and price received shows ‘surplus’ from being able to sell q* at p*. S=MC

141 Welfare analysis: producer surplusIf the price rises: producers obviously better off. Producer surplus change quantifies this intuition. producer surplus rise, 2 parts: Get more for units sold at old price; measure of this = area A. A = Price rise times old production. Gain surplus on the new units sold (those from q* to q’). measure of this = area B. B= sum of all new gaps between marginal cost and price.

142 Preliminaries II Introduction to Open Economy Supply & Demand Analysis. Start with Import Demand Curve. This tells us how much a nation would import for any given domestic price. Presumes imports and domestic production are perfect substitutes. Imports equal gap between domestic consumption and domestic production.

143 Import demand curve (MD)Home Supply price price 1 P* 2 P” P” 3 P’ P’ Home Demand Home import demand curve, MDH quantity imports Z’ Z” C” C’ M” M’

144 Import supply curve (MS)quantity exports C” X’ X” price Foreign export Supply curve, XSF, or MSH. Foreign Supply Demand 1 3 Z’ Z” 2

145 Welfare & Import demand curveprice Home Supply NB: E=B+D P* P” P’ Z’ C’ quantity imports Z” C” Demand A B C D E import demand curve, MDH M’ M” 1 2 3 ToT effect

146 Welfare & Import supply curvequantity exports C” X’ X” price Foreign export Supply curve, XSF, or MSH. A B C D E F=C+E F Foreign Supply Demand 1 3 Z’ Z” 2 Trade price effect, i.e.ToT effect

147 Trade volume effect & border price effectDecomposing Home loss from price rise, P’ to P”. Area C: Home pays more for units imported at the old price. Area C is the size of this loss. Home loses from importing less at P”. area E measures loss. marginal value of first lost unit is the height of the MD curve at M’, but Home paid P’ for it before, so net loss is gap, P’ to MD. adding up all the gaps gives area E. Home imports MD M M’ P” C E Domestic price P’

148 Trade volume effect & border price effectHome imports MD M M’ P” C E Domestic price Border price effect Trade volume effect P’ Systematic net welfare analysis using the price and quantity effects: “border price effect” (area C), and the “import volume effect” (area E). Very useful in more complex diagrams.

149 Trade volume effect & border price effectCan do same for Foreign gain rise, P’ to P”. Foreign gains from getting a higher price for the goods it sold before at P’ (border price effect), area D. And gains from selling more (trade volume effect), area F.

150 The Workhorse: MD-MS DiagramDiagram very useful. easy identification of price and volume effects of a trade policy change. Welfare change likewise easy. euros imports MS MD Import supply curve demand curve Imports PFT

151 MD-MS + open econ. supply & demandMD-MS diagram can be usefully teamed with open economy supply and demand diagram. Permits tracking domestic & international consequences of a trade policy change. euros imports quantity MS MD Z C Domestic price, euros Import supply curve Domestic demand curve Imports demand curve Sdom Ddom PFT

152 MFN Tariff Analysis 1st step: determine how tariff changes prices and quantities. suppose tariff imposed equals T euros per unit. Small country ‘fiction’. Tariff shifts MS curve up by T. Exporters would need a domestic price that is T higher to offer the same exports. Because they earn the domestic price minus T.

153 MFN Tariff Analysis For example, how high would domestic price have to be in Home for Foreigners to offer to export Ma to Home? Answer is Pa+T, so Foreigners would see a price of Pa. Home imports MD Border price Foreign exports XS=MS MS w/FT MS with T Domestic price T Pa 2 Pa+T Ma Xa=Ma 1

154 MFN Tariff Analysis New equilibrium in Home (MD=MS with T) is with P’ and M’. Domestic price now differs from border price (price exporters receive). P’ vs P’-T. Border price Domestic price MS with T MS XS=MS P’ PFT PFT T P’-T MD Foreign exports Home imports M’ MFT X’=M’ XFT= MFT

155 Positive effects Domestic price rises. Border price falls.Imports fall. Can’t see in diagram: Domestic consumption falls. domestic production rises. Foreign consumption rises. Foreign production falls. Could get this in diagram by adding open economy S & D diagram to right.

156 Welfare effects: Home Drop in imports creates loss equal area C. (Trade volume effect). Drop in border price creates gain equal to area B. (Border price effect, i.e. ToT effect). Net effect on Home = -C+B. ALTERNATIVELY: Private surplus change (sum of change in producer and consumer surplus) equal to minus A+C. Increase in tariff revenue equal to +A+B. Same net effect, B-C (but less intuition).

157 Welfare effects: ForeignDrop in exports creates loss equal area D (Trade volume effect). Drop in border price creates loss equal to area B. (Border price effect, a.k.a., ToT effect). Net effect on Foreign = -D-B. ALTERNATIVELY: Private surplus change (sum of change in producer and consumer surplus) equal to minus -D-B. Same net effect, B-C (but less intuition).

158 Welfare effects: useful compressionIn cases of more complex policy changes useful to do Home and Foreign welfare changes in one diagram. MS-MD diagram allows this: Home net welfare change is –C+B. Foreign net welfare change is –D-B. World welfare change is –D-C. NB: if Home gains (-C+B>0) it is because it exploits foreigners by ‘making’ them to pay part of the tariff (i.e. area B). Notice similarity with standard tax analysis.

159 Distributional consequences: HomeTrade protection imposed mainly due to politically considerations raised by distributional consequences. Thus important for some purposes to see domestic consequences of trade policy change. For this, add the open economy supply & demand diagram to the right of the MD-MS diagram. MD-MS diagram tells us the price and quantity effects of trade policy change. Open-economy S&D tells us the domestic distributional consequences.

160 Distributional consequences: HomeHome consumers lose, area E+C2+A+C1; Home producers gain E, Home tariff revenue rises by A+B. net change = B-C2+-C1 (this equals B-C in left panel). euros imports quantity MS MD C Domestic price, euros Sdom Ddom PFT Z P’ P’-T C’ Z’ A B D E C2 C1

161 A typology for trade barriersMany ways to categorise trade barriers. A useful 3-way categorisation. Focuses on ‘rents’ i.e. who earns the gap between domestic and border price? DCR (domestically captured rents) e.g. tariff, import licence. FCR (foreign captured rents), price undertakings, export taxes. Frictional (no rents since barriers involve real costs of importing/exporting), e.g.. Swedish wipers on headlights, paper recycling for carton boxes.

162 A typology for trade barriersNet Home welfare changes for: DCR = B-C FCR = -A-C Frictional = -A-C Net Foreign welfare changes for: DCR = -B-D FCR = +A-D Frictional = -B-D Note: foreign may gain from FCR. euros MS P’ A C PFT D B P’-T MD M’ MFT Home imports

163 The Economics of European Integration

164 Chapter 5 Essential Economics of Preferential Liberalisation

165 The PTA Diagram Studying European integrations – e.g. EEC’s customs union – which were discriminatory, i.e. preferential requires: at least three countries: at least two integrating nations. at least one excluded nation. Ability to track domestic and international consequences of liberalisation. Must MD-MS diagram to allow for two sources of imports.

166 The PTA Diagram: Free trade eq’mRoW Partner Home Border price Border price Domestic price XSP MS XSR 1 2 PFT MD XR RoW Exports XP Partner Exports Home imports M=XP+XR

167 The PTA Diagram: MFN tariff eq’mDomestic price Home imports MD PFT RoW Exports Partner XSP XSR MS MSMFN P’ M’ M=XP+XR Border price T P’-T 2 1 X’R X’P XP XR

168 Discriminatory, unilateral liberalizationTo build up to analysis of real-world policy changes (e.g. customs union): Consider Home removes T on imports only from Partner. 1st step is to construct the new MS curve. The liberalisation shifts up MS (as with MFN liberalisation) but not as far since only on half of imports. Shifts up MS to half way between MS (free trade) and MS (MFN T), but More complex, kinked MS curve with PTA.

169 Discriminatory, unilateral liberalizationBorder price Border price Domestic price RoW Partner MSMFN Home MSPTA XSR XSP MS P’ P” P” T P’-T P”-T Pa T 1 p* MD RoW Exports Partner Exports Home imports XR” XR’ XP’ XP” M’ M”

170 Domestic price & border price changesdomestic price falls to P’ from P”. Partner-based firms see border price rise, P’-T to P”. RoW firms see border price fall from P’-T to P”-T. Border price Border price Domestic price MSMFN XSR XSP MSPTA MS P’ P” P” T P’-T P’-T P”-T MD XR” XR’ RoW Exports XP’ XP” Partner Exports M’ M” Home imports

171 Quantity changes: supply switchingRoW exports fall. Partner exports rise more than RoW exports fall, so domestic imports rise. Domestic price Home imports MD RoW Exports Partner XSP XSR MS MSMFN M’ Border price MSPTA P’ T P” P’-T P”-T XR” XR’ XP’ XP” M”

172 Impact of customs union formation

173 Welfare effects XSR A XSP D C B MD Home’s net change = A+B-C.Partner’s net change = +D. RoW’s net change = -E. Domestic price Home imports MD RoW Exports Partner XSP XSR M’ Border price P’ P” XR’ XP’ XP” M” C B A XR” P’-T P”-T E D

174 Analysis of a Customs UnionEuropean integration involved a sequence preferential liberalisations but all of these were reciprocal. In example, both Home & Partner drop T on each other’s exports. Need to address the 3-nation trade pattern.

175 Analysis of a Customs UnionFTA vs Customs Unions. Given symmetry 3-nation set up, FTA between Home and Partner is automatically a customs union. Home-Partner CU has Common External Tariff (CET) equal to T in the real world, things are more complicated. Analysis is simply a matter of recombining results from the unilateral preferential case. In market for good 1, analysis is identical. In market for good 2, Home plays the role of Partner. In market for good 2, Partner plays role of Home.

176 Welfare effects of a customs unionIn market for good 1: Home change = A+B-C1-C2. In market for good 2: Home change = +D1+D2. NB: D1=C1. Net Home impact =A+B-C2+D2 . Partner impact identical. RoW loses. euros imports MD Exports XS M’ A D 2 1 C B C2 XP” XP’ XR” P’-T P” P’ P”-T © Baldwin & Wyplosz The Economics of European Integration, 2nd Edition

177 Trade creation & diversionTrade creation & diversion is jargon that is often used. It is imprecise, but widely used. Intuition for why it is so popular, despite its shortcomings. It captures ambiguity of welfare gains in two words. “Discriminatory liberalisation”. Liberalisation = tends to improve welfare ~ trade creation Discrimination -= tends to diminish welfare ~ trade diversion

178 Not just tariffs …

179 Frictional barrier preferential LiberalisationIn market for good 1: Home change = A+F. In market for good 2: Home change = +D. Net Home impact: =A+F+D. Unambiguously positive. Partner gains same. RoW loses. euros euros A XS P’ F P” D MD P’-T P”-T XP’ XP” Exports XR” XP’ M’ imports

180 Customs Union vs FTA FTA like CU but no Common External Tariff.Opens door to ‘tariff cheats’, goods from RoW destined for Home market enter via Partner if Partner has lower external tariff, called ‘trade deflection’. Solution is ‘rules of origin’ meant to establish where a good was made. Problems: Difficult and expensive to administer, especially as world get more integrated. Rules often become vehicle for disguised protection. Despite the origin-problem in FTAs, almost all preferential trade arrangements in world are FTAs. CU’s require some political integration. Must agree on CET and how to change it, including anti-dumping duties, etc.

181 WTO Rules A basic principle of the WTO/GATT is non-discrimination in application of tariffs. FTAs and CUs violate this principle. Article 24 permits FTAs and CUs subject to conditions: Substantially all trade must be covered . Cannot pick and choose products. Intra-bloc tariffs must go to zero within reasonable period. If CU, the CET must not on average be higher than the external tariffs of the CU members were before. In EEC’s CU this meant France and Italy lowered their tariffs, Benelux nations raised theirs (German tariffs were about at the average anyway).

182 Kemp Wan Theorem Possible to alter CET to get Pareto improvement.Form CU and adjust CET to ensure zero external trade effect (thus welfare impact on RoW is zero). Treat external trade vector as part of endowment vector & First Welfare Theorem tells us FT between partners achieves FB and so is better than distorted equilibrium. Not practical, but an intellectual landmark (FTAs need not be bad).

183 The Economics of European Integration

184 Chapter 6 Market Size and Scale Effects

185 Market Size Matters European leaders always viewed integration as compensating small size of European nations. Implicit assumption: market size good for economic performance. Facts: integration associated with mergers, acquisitions, etc. In Europe and more generally, ‘globalisation.’

186 Facts M&A activity is high in EU.much M&A is mergers within member state. about 55% ‘domestic.’ Remaining 45% split between: one is non-EU firm (24%), one firm was located in another EU nation (15%), counterparty’s nationality was not identified (6%).

187 Facts Distribution of M&A quite varied:Big 4: share M&As much lower than share of the EU GDP. I, F, D 36% of the M&As, 59% GDP. Except UK. Small members have disproportionate share of M&A.

188 Facts Why M&A mostly within EU? Why UK’s share so large?Non harmonised takeovers rules. some members have very restrictive takeover practices, makes M&As very difficult. others, UK, very liberal rules. Lack of harmonisation means restructuring effects very impact by member states.

189 Theory: Economic Logic Verballyliberalisation  de-fragmentation  pro-competitive effect  industrial restructuring (M&A, etc.) RESULT: fewer, bigger, more efficient firms facing more effective competition from each other.

190 Economic logic: backgroundMonopoly case Demand Curve Price Price Marginal Revenue Curve Marginal Cost Curve P* Demand Curve P’ A P” B D Marginal Cost C E Q’ Q* Q’+1 Sales Sales

191 Duopoly case, example of non-equilibriumprice price Firm 1’s expectation of sales by firm 2, Q2 Firm 2’s expectation of sales by firm 1, Q1 p1’ Demand Curve (D) Demand Curve (D) p2’ Residual Demand Curve firm 1 (RD1) Residual Demand Curve firm 2 (RD2) A1 MC A2 MC x1’ Firm 1 sales x2’ Firm 2 sales Residual Marginal Revenue Curve firm 1 (RMR1) Residual Marginal Revenue Curve firm 2 (RMR2)

192 Duopoly & oligopoly case, equilibrium outcomeprice Typical firm’s expectation of the other firm’s sales price Typical firm’s expectation of other the other firms’ sales p* D D p** RD RD’ A MC A MC RMR RMR’ sales x* 2x* x** sales 3x** Duopoly Oligopoly

193 BE-COMP diagram mmono mduo m’ n’ BE (break-even) curve COMP curve n=1Mark-up (m) COMP curve BE (break-even) curve m’ n’ mmono mduo n=1 n=2 Number of firms

194 Details of COMP curve p' mmono p" mduo D R-D (duopoly) Marginal costMark-up price p' mmono A’ p" mduo B’ D Monopoly mark-up Duopoly mark-up COMP curve R-D (duopoly) Marginal cost curve MC B A Number of firms n=1 n=2 R-MR MR (monopoly) Typical firm’s sales xduo xmono

195 Details of BE curve BE Home market po=mo+MC Demand curve A AC>poMark-up (i.e., p-MC) euros price Home market po=mo+MC Demand curve BE A AC>po ACo=po B A po mo B AC AC MC n” no n’ Number of firms Sales per firm Co Total sales x”= Co/n” x’= Co/n’ xo= Co/no

196 Equilibrium in BE-COMP diagrameuros Price Mark-up Home market Demand curve BE E’ E’ p’ p’ m' E’ AC COMP MC n’ Number of firms x’ Sales per firm C’ Total sales

197 No-trade-to-free-trade integrationeuros price Mark-up Home market only Demand curve BE BEFT E’ E’ E’ 1 p’ p’ m' C E” E” E” p” p” A A pA mA AC COMP MC n’ n” 2n’ Number of firms x’ x” Sales per firm C’ C” Total sales

198 Economic Logic Integration: no-trade-to-free-trade: BE curve shifts out (to point 1). Defragmentation: PRE typical firm has 100% sales at home, 0% abroad; POST: , Can’t see in diagram. Pro-competitive effect: Equilibrium moves from E’ to A: Firms losing money (below BE). Pro-competitive effect = markup falls. short-run price impact p’ to pA. Industrial Restructuring: A to E”, number of firms, 2n’ to n”. firms enlarge market shares and output, More efficient firms, AC falls from p’ to p”, mark-up rises, profitability is restored. Result: bigger, fewer, more efficient firms facing more effective competition. Welfare: gain is “C”.

199 Competition & Subsidies2 immediate questions: “As the number of firms falls, isn’t there a tendency for the remaining firms to collude in order to keep prices high?” “Since industrial restructuring can be politically painful, isn’t there a danger that governments will try to keep money-losing firms in business via subsidies and other policies?” The answer to both questions is “Yes”. See Chapter 11, 2nd Edition.

200 The Economics of European Integration

201 Chapter 7 Growth Effects & Factor Market Integration

202 Growth Effects European leaders have long emphasised the pro-growth aspects of European integration. These operate in a way that is fundamentally different from the way allocation effects operate; They operate by changing the rate at which new factors of production – mainly capital – are accumulated, Hence the name ‘accumulation effects’.

203 Verbal logic of growth Growth in income per worker requires more output per worker. Nation's labour force can produce more goods and services year after year only if they have more/better 'tools' year after year. 'tools' means capital broadly defined: physical capital (machines, etc.), human capital (skills, training, experience, etc.) and knowledge capital (technology). ERGO, rate of output growth is linked to rate of physical, human and knowledge capital accumulation. Most capital accumulation is intentional and it is called investment. Thus: European integration affects growth mainly via its effect on investment in human capital, physical capital and knowledge capital.

204 Verbal logic of growth: summaryEuropean integration (or any other policy) → allocation effect → improved efficiency → better investment climate → more investment in machines, skills and/or technology → higher output per person. * Medium run effects eventually fade out. Growth returns to its long-run rate. Long run effects raise long-run rate forever.

205 Some facts Table 7‑1: European Growth Phases, 1890-1992 2.6 1.7 1.6Period Real GDP Real GDP per capita Real GDP per hour Belle epoque 2.6 1.7 1.6 2nd 30 yr war 1.4 1.0 1.9 Golden era 4.6 3.8 4.7 Prod’ity slowdown 2.0 2.7 Whole Period 2.5

206 Some facts These nations grew during WWIIGrowth in the WWII Reconstruction Phase. The Set-Back: (Pre-war year when GDP equalled that of 1945) Back-on-Track Year (Year GDP attained highest pre-war level) Reconstruction Growth (rate 1945 to col. 2 year) Austria 1886 1951 15.2% Belgium 1924 1948 6.0% Denmark 1936 1946 13.5% Finland 1938 1945 n.a. France 1891 1949 19.0% Germany 1908 Italy 1909 1950 11.2% Netherlands 1912 1947 39.8% Norway 1937 9.7% Sweden These nations grew during WWII Switzerland UK

207 Some facts EEC average 4,825 8.0 + 1.2 4.2 EFTA average 6,835 3.6 -1.4GDP per capita & Rankings, 1950 and 1973 (1990 international dollars). 1950 GDP (1990 $) European Rank 1950 Change in Rank GDP Growth Rate EEC average 4,825 8.0 + 1.2 4.2 EFTA average 6,835 3.6 -1.4 3.0 France 5,221 7 + 2 4.0 Germany 4,281 9 + 5 5.0 Italy 3,425 13 4.9 UK 6,847 2 -5 2.4

208 Some facts Complete table 1950 GDP (1990 $) European Rank 1950Change in Rank GDP Growth Rate EEC average 4,825 8.0 + 1.2 4.2 Netherlands 5,850 5 -1 3.4 Belgium 5,346 6 -2 3.5 France 5,221 7 + 2 4.0 Germany 4,281 9 + 5 5.0 Italy 3,425 13 4.9 EFTA average 6,835 3.6 -1.4 3.0 Switzerland 8,939 1 3.1 UK 6,847 2 -5 2.4 Sweden 6,738 3 + 1 Denmark 6,683 4 Norway 4,969 8 -4 3.2 Finland 4,131 10 Austria 3,731 11 Others average 2,401 14.3 -0.3 5.2 Ireland 3,518 12 -3 Spain 2,397 14 5.8 Portugal 2,132 15 5.6 Greece 1,558 16 6.2 For Comparison USA 9,573 Japan 1,873

209 Solow diagram Show medium run growth effects in simple diagram.To simplify, start with whole EU as a single, closed economy with fully integrated capital and labour markets and the same technology everywhere.

210 Outflow of capital per L, constant depreciation rate, delta Solow diagram Outflow of capital per L, constant depreciation rate, delta The inflow of new capital and how it varies with K/L A B K/L euros/L GDP/L s(GDP/L) d(K/L) Y/L* K/L* K/Lo Io Do Assume fixed investment rate, s

211 Induced capital formationInduced capital formation effect, i.e. medium-run growth bonus euros/L GDP/L’ E Y/L’ C GDP/L Y/Lc Allocation effect Y/L* d(K/L) B s(GDP/L)’ D s(GDP/L) A K/L* K/L’ K/L

212 Integration induced investment rate riseeuros/L Medium-run growth bonus GDP/L D Y/L’ Y/L* d(K/L) B s’(GDP/L) C s(GDP/L) A K/L* K/L’ K/L

213 Other MR growth effects: investment rateOther MR growth effects: investment rate. Experience of Spain & Portugal

214 Other MR growth effects: investment rate. Experience of Ireland

215 Other MR growth effects: investment rate. Experience of Greece

216 Long-term growth in Solow-like diagrameuros/L GDP/L Y/L* s(GDP/L) A d(K/L) B K/L* K/L =Knowledge/L

217 Long-term growth impact of integrationIntegration improves efficiency → improves investment climate → higher investment rate (s rises to s’) → faster growth (knowledge capital accumulates more rapidly) euros/L GDP/L s’(GDP/L) Y/L* s(GDP/L) C A d(K/L) B K/L* K/L =Knowledge/L

218 The Economics of European Integration

219 Chapter 8 Economic Integration, Labour Markets and Migration

220 Why Labour Markets MatterLabour costs: key for international competitiveness Half of all production costs Set nationally Labour markets are indirectly in competition via goods markets Labour mobility One aspect of this competition Also helps know each other

221 Controversies Abound Economic logic sometimes clashes with social logic Effectiveness sometimes clashes with equity Solidarity clashes with individualism Acquired advantages under threat

222 Plan Unemployment Economic integration and the Labour marketsMigration

223 Unemployment

224 Unemployment: a symptomSome Facts Unemployment: a symptom

225 Labour Market Rigidities: the Simplest InterpretationFlexible wages deliver “full employment”

226 Labour Market Rigidities: the Simplest InterpretationRigid wages result in unemployment Flexible wages deliver “full employment”

227 Why wage rigidity? Labour markets are different Social imperativesDomination by one side Information asymmetries Losing a job is a major vulnerability Human capital and special skills Social imperatives Fairness Need for income stability Need for job security

228 The Standard Response: Collective Negotiationslead to higher wages Individual supply

229 The Standard Response: Collective Negotiationslead to higher wages and to unemployment Individual supply

230 Economic Integration and Labour MarketsA two-way relationship

231 Effects of economic integration on the labour marketsMore competition on the goods market means that labour costs are a strategic issue Goods market integration indirectly leads to labour market integration. It also calls for faster reaction to shocks: flexibility is at a premium

232 Effects of the labour markets on economic integrationEconomic integration creates winners and losers Willingness to undertake economic integration depends on the winners readiness to compensate the losers This calls for safety nets that make labour markets more rigid and less able to face competition

233 The case of social dumpingWages and productivity in 2005 (Germany = 100)

234 Western fears of Eastern HordesMigration Western fears of Eastern Hordes

235 Immigration: Facts

236 Immigration: Facts (cont.)

237 Migration: The Simplest FrameworkInitial situation

238 Migration: The Simplest FrameworkPost-migration situation

239 Migration: The Simplest FrameworkLoss of home workers

240 Migration: The Simplest FrameworkGain of home capital-owners

241 Migration: The Simplest FrameworkLoss of foreign capital-owners

242 Migration: The Simplest FrameworkGain of foreign-workers staying abroad

243 Migration: The Simplest FrameworkGain of migrant workers Gain of foreign-workers staying abroad

244 Migration: The Simplest FrameworkHome gains Foreign gains

245 The Economics of European Integration

246 Chapter 9 Common Agricultural Policy

247 CAP Massively complex, massively expensive policy.Hard to understand without seeing how it developed. CAP started as simple price support policy in 1962. EU was net importer of most food, so could support price via tariff. Technically known as a ‘variable levy.’

248 Simple price support with tariffHome Demand Home Supply Home Demand Home Supply price price pss Price floor (Pw+T, or Pw’+T’) Price floor T’ T A B Pw’ C1 C2 Pw Pw Imports (with floor) Q Q Z Zf Cf C Z Zf Cf C Imports (without price floor)

249 Food tax interpretationPrice floor supported by tariff is like all-in-one package made up of simpler policy measures. (i) free trade in the presence of (ii) a consumption tax equal to T and (iii) a production subsidy equal to T. Price, quantity, revenue and welfare effects are identical. This is insightful: makes plain that consumers are the ones who pay for a price floor enforced with a variable levy. Part of what they pay goes to domestic farmers (area A), part of it goes to the EU budget (area B), part of it wasted (areas C1 and C2). Home Demand Home Supply price Price floor A B C1 C2 Pw Q Z Zf Cf C

250 Farm size distribution in 1987Very skewed ownership: Biggest 7% of farmers owned ½ of the land. Smallest 50% of farmers owned only 7% of the land. Farm size class (hectares) Number of farms (millions) Number of farms as share of total Share of EU12 farm land in size class Average farm size (hectares) 1 to 5 3.411 49.2% 7.1% 2.4 5 to 10 1.163 16.8% 7.0 10 to 20 0.936 13.5% 11.5% 14.1 20 to 50 0.946 13.7% 25.7% 31.2 over 50 0.473 6.8% 48.6% 117.6 total 6.929 100% 115 (mill.ha) 16.5

251 Pw+T Atotal Asmall Abig Pw B price price priceFamily farm supply curve Commercial farm supply curve Total supply curve Pw+T Asmall Atotal Abig Pw B Q Q Zsmall Zbig Ztotal Q

252 CAP problems #1 Problem: The supply problem.‘Green’ revolution technology boom, supply ↑ High guaranteed prices encourage investment & adoption. Output rises much faster than consumption.

253 S’ Pw Cf Zf price price S1 S2 S3 S4 Home Supply Demand p1ss p2ssPrice floor p3ss S’ B A a b c Price floor d e C1 C2 p4ss Pw EU purchase Home Demand Q Q Cf Zf

254 Follow-on problems of oversupplyEU switches from net food import to exporter in most products.

255 Follow-on problems: World market impactImport protection insufficient for price support. CAP becomes major food buyer. Some of this is dumped on world market. CAP protection and dumping depresses prices on world markets. Harms non-EU food exporters.

256 Follow-on problems: BudgetBuy and storing or dumping food becomes increasingly expensive.

257 Other CAP problems #2 Problem: The farm income problem.General problem, inelastic demand means farm sector’s total income falls with prices, so either average farmer income must fall, or then number of farmers must fall. In EU: Average farm incomes fail to keep up despite huge protection and budget costs. Most of money goes to big farms that don’t need it: CAP makes some farmers/landowners rich. Keeps average (i.e. small) farmer on edge of bankruptcy. Farmers continue to exit farming (about 2% per year for last 4 decades).

258 Other CAP problems Factory Farming:Pollution, Animal welfare, Nostalgia. Bad for ‘image’ and thus public support for CAP.

259 CAP Reforms Supply control attempts: 1992: MacSharry Reforms:1980s, experimentation with ad hoc & complex set supply ‘controls’ to discourage production. Generally failed; technological progress & high guaranteed prices overwhelmed supply controls. 1992: MacSharry Reforms: Basic idea: CUT PRICES supports to near world-price level & COMPENSATE farmers with direct payments. Was essential to complete the Uruguay Round. Worked well. June 2003 Reforms; essential to Doha Round. Implementation Similar to MacSharry reforms in spirit. Still might not be enough to allow Doha Round to finish.

260 Evaluation of the today’s CAPSupply problems & food “mountains.” Left figure: massive shift to direct payments. Price cut reduced EU buying of food: right figure shows important drop in EU storage of food. EU dumping of food on world market also dropped.

261 Farm incomes & CAP support inequityReformed CAP (post MacSharry) support still goes mostly to big, rich farmers. payments intended to compensate, so inequity continued. Half the payments to 5% of farms (the largest). Half the farms (smallest) get only 4% of payments. Recent studies show that only about half of these payments go to farmers. Rest to non-farming landowners and suppliers of agricultural inputs (seed, fertilisers, agri-chemicals, etc.) See: “Who Finances the Queen’s CAP payments?”

262 CAP support inequity Size Class Payment per farm% of EU15 farms in size class Number of farms in size class % of EU15 payments to size class Cumulative % of budget (from largest to smallest) Cumulative % of farms (from largest to smallest) 0 to 1.25 €405 53.76% 2,397,630 4.3% 100.0% 99.97% 1.25 to 2 €1,593 8.54% 380,800 2.7% 95.7% 46.21% 2 to 5 €3,296 16.30% 726,730 10.7% 93.0% 37.67% 5 to 10 €7,128 9.17% 409,080 13.0% 82.2% 21.37% 10 to 20 €13,989 6.81% 303,500 19.0% 69.2% 12.20% 20 to 50 €30,098 4.13% 184,100 24.8% 50.2% 5.39% 50 to 100 €67,095 0.94% 41,700 12.5% 25.4% 1.27% 100 to 200 €133,689 0.24% 10,720 6.4% 12.9% 0.33% 200 to 300 €241,157 0.05% 2,130 2.3% 6.5% 0.09% 300 to 500 €376,534 0.03% 1,270 2.1% 4.2% 0.04% over 500 €768,333 0.01% 610 Average, All farms €5,015

263 Future challenges Doha Round: Eastern Enlargement:Completing these WTO talks may require deeper reform of CAP. Eastern Enlargement: Number of farms will rise. Farmland rise from 130 million hectares to 170 million.

264 EU newcomers: Farm facts

265 The Economics of European Integration

266 Chapter 10 Location Effects, Economic Geography and Regional Policy

267 Europe’s regions Concern for Europe’s disadvantaged regions has always been part of EU priorities. In Treaty of Rome preamble. Pre-1986, most spending on regions was national Rural electrification, phones, roads, etc. Entry of Spain & Portugal created voting-bloc in Council (with Ireland and Greece) that induced a major shift in EU spending priorities, away from CAP towards poor-regions. “Structural spending” now about 1/3 EU budget.

268 Europe’s Economic Geography: FactsEurope highly centralised in terms of economic activity. western Germany, Benelux nations, N.E. France and S.E. England have 1/7th land, but 1/3rd of pop. & ½ GDP. Periphery has lower standard of living. More unemployment. Especially among youth. More poverty.

269 Geographic income inequalityVery uneven income distribution, geographically. 1999 income/pop by nation. Luxembourg is 110% richer than average. Bulgaria only 26% of average.

270 Geographic income inequalityIncome distribution even more uneven at regional level. Within nation economic activity is very unevenly distributed Income distribution has become: More even in EU15 Less even within EU15 nations (by region)

271 Geographic income inequalityFrench example Ile de France (Paris) has almost 1/3 of all economic activity. Per capita incomes (not shown) are 158% of EU15 average. Mediterranee has 10% of GDP, 12% of population. GDP/pop only 86% of EU15 average. Outre-Mer are former French colonies (poor islands in Caribbean, etc.).

272 Geographic SpecialisationKrugman index of specialisation shows most EU nations becoming more specialised. EU economies seem to be specialising more in their comparative advantages.

273 Theory 2 major approaches linking economic integration to change in the geographic location of economic activity. Comparative advantage suggests nations specialise in sectors in which they have a comparative advantage. New Economic Geography suggests that integration tends to concentrate economic activity spatially. General idea: Use c.a. approach to explain cross-nation facts. Use NEG to explain within nation facts.

274 Comparative Advantage and Specialisation

275 Agglomeration & NEG When productive factors can cross borders (international or inter-regional) integration may have very different effects. scale economies & trade costs generate forces that encourage geographic clustering of economic activity. "Overall clustering“ = some areas with lots of economic activity, others empty “core-periphery”. "Sectoral clustering" = each sector clusters in one region, but most regions get a cluster.

276 Agglomeration & Dispersion ForcesBasic idea is that lowering trade costs affect both. Agglomeration forces. Tend to lead industry to cluster geographically. Dispersion forces. Tent to encourage industry to disperse geographically.

277 Agglomeration Forces Many agglomeration forces:Technological spillovers (e.g. silicon valley), Labour market pooling (e.g. City of London), Demand linkages (a.k.a backward linkages), Supply linkages (a.k.a foreward linkages). New Economic Geography (NEG) forces on demand & supply links since they are clearly affected by economic integration (lower trade costs).

278 Circular Causality & Demand Linkages1. If some industry moves to big region 4. Production Shifting, Due to trade costs, firms prefer to locate in big market. More industry moves to big region 2. Expenditure Shifting, workers spend incomes in big region instead of in small region 3. Market Size Effects: big market gets bigger, small market gets smaller

279 Circular Causality & Supply Linkages1. If some industry moves to big region 4. Production Shifting Some more firms move from small market to big market, attracted by lower costs 2. Production Shifting, Migrated firms’ output now cheaper in big region & dearer in small region (trade costs) 3. Cost Shifting, Availability of wider range of locally available intermediate goods makes big region cheaper place to produce

280 Dispersion Forces Many forces lead to a tendency of firms to avoid agglomerations of economic activity: Rents and land prices, High cost of other non-traded services, Competition with other firms. The NEG focuses on the last one “local competition” since it is clearly related to trade costs. As trade costs fall, distance provides less protection from distant competitors.

281 EE-KK Diagram Study impact of integration on geographical concentration in EE-KK diagram. Simplifying assumptions: Only 2 regions, north and south, 2 factors, capital (mobile), labour (immobile), 2 sectors, services (L-intensive), industry (K-intensive). Assume one unit of K required per industrial firm. Implies north’s share of K is also its share of industry.

282 EE Curve EE curve shows demand linkage.EE upward sloped; as north gets a larger share of industry its market becomes larger relative to that of the south. EE steeper than 45o; the mobile factor makes up only part of total expenditure. For EE line, trade costs don’t matter. What matters is how much labour and how much capital is in each region. As north’s labour share rises, EE shifts to right.

283 KK Curve KK is upward sloped. Steeper than 45o (home market effect).Trade costs level affects the KK curve. trade costs ↓, KK gets steeper. Share of labour in the two regions has no impact on KK.

284 EE-KK Diagram: locational equilibriumKK shows how production shifting leads to expenditure shifting. EE shows how expenditure shifting leads to production shifting. Intersection of EE and KK show equilibrium sK and sE. If economy starts elsewhere, say A, expenditure and production shifting move it to B.

285 EE-KK Diagram: locational equilibriumEuropean integration lowers trade costs. KK rotates counter clockwise around ½,½ . More industry moves to the bigger market. B to B’ Explains tendency of integration to foster geographic clustering of economic activity. Can be all industry (empty out some regions). Can be clusters by sector.

286 EU Regional Policy EU always had poor regions (Mezzogiorno, etc.).much spending on poor EU regions, but very little by EU (pre 1986). 1973, Ireland (poor at the time joined); 1981, Greece joined but no major reorientation of EU spending priorities. In 1986, Iberian enlargement shifted power in Council and spending priorities changed.

287 EU Regional Policy For historical reasons, EU has five “Funds”,four “Structural Funds”, Spent in any qualified region. “Cohesion Fund”. Spent only in poor-4 (Spain, Portugal, Greece and Ireland). 5 Funds work together under overall strategy. Many programmes, initiatives, and objectives, BUT over 90% is spent on three priority “objectives.”

288 3 Objectives Objective 1 (about 70% of structural spending).spending on basic infrastructure and production subsidies in less developed regions. generally defined: regions with incomes less than 75% of the EU average. Nordic exceptions (low population density). There are about 50 “objective 1 regions”; they have about 20% of the EU population. Objective 2 (about 10% of structural spending). projects in regions whose economies are specialised in declining coal mining, fishing, steel production, etc. spending should support economic and social “conversion.” About 18% of the Union's population lives in ‘Objective 2” regions. Objective 3 (about 10% of the funding). measure to modernise national systems of training and employment promotion.

289 Regions covered by Objectives 1 & 2

290 Impact of 2004 Enlargement New members are much poorer than EU15.Difficulties: Cost of structural spending could rise substantially, NB: budget set, but allocation to new members not yet public. 10 new poor nations make some poor regions in EU15 look relatively rich. Pushes them above 75% of EU25 average. Political power in Council likely to shift spending priorities.

291 Impact of 2004 Enlargement Some regions that will pushed above 75% of average will lose Objective 1 status. Some, like northern Finland and Sweden are unaffected. Low pop density criteria. All of 2004 entrants have less than 75% of EU25 average. Except Cyprus.

292 Allocations for NewcomersEU already allocated structural spending for newcomers up to 2006. Can predict spending/pop based on income using EU15 numbers “linear” line in figure; NB: newcomers get ‘below the line’ treatment

293 The Economics of European Integration

294 Chapter 11 Competition Policy & State Aid

295 EU’s role Exclusive competency of EU; Commission controls.2 aspects: mergers & anti-competitive behaviour. Look at justification for putting competition policy at the EU level. Spillovers (negative effects of one Member’s subsidies on other Members’ industry). Need belief in ‘fair play’ if integration is to maintain its political support. Witness recent ‘protectionist’ tendency of Member States to prevent foreign takeovers.

296 Recall: Economic LogicIntegration: no-trade-to-free-trade: BE curve shifts out (to point 1). Defragmentation: PRE typical firm has 100% sales at home, 0% abroad; POST: Can’t see in diagram. Pro-competitive effect: Equilibrium moves from E’ to A: Firms losing money (below BE), Pro-competitive effect = markup falls, short-run price impact p’ to pA. Industrial Restructuring” A to E”, number of firms, 2n’ to n”, firms enlarge market shares and output, More efficient firms, AC falls from p’ to p”, mark-up rises, profitability is restored. Result: bigger, fewer, more efficient firms facing more effective competition. Welfare: gain is “C”.

297 Competition & State aid (subsidies)2 immediate questions “As the number of firms falls, isn’t there a tendency for the remaining firms to collude in order to keep prices high?” “Since industrial restructuring can be politically painful, isn’t there a danger that governments will try to keep money-losing firms in business via subsidies and other policies?” The answer to both questions is “Yes”. Turn first to the economics of subsidies and EU’s policy

298 Anti-competitive behaviourCollusion is a real concern in Europe. dangers of collusion rise as the number of firms falls. Collusion in the BE-COMP diagram. COMP curve is for ‘normal’, non-collusive competition Firms do not coordinate prices or sales. Other extreme is ‘perfect collusion’. Firms coordinate prices and sales perfectly. Max profit from market is monopoly price & sales. Perfect collusion is where firms charge monopoly price and split the sales among themselves.

299 Economic effects Collusion will not in the end raise firm’s profits to above-normal levels. 2n’ is too high for all firms to break even. Industrial consolidation proceeds as usual, but only to nB. Point B Zero profits earned by all. prices higher, pB> p”, smaller firms, higher average cost. Mark-up BEFT mmono Perfect collusion A B pB E” Partial collusion p” COMP n=1 n” nB 2n’ Number of firms

300 Economic effects The welfare cost of collusion (versus no collusion).four-sided area marked by pB, p”, E” and B. price Demand curve Mark-up BEFT pmono mmono Perfect collusion A B B pB E” Partial collusion E” p” COMP n=1 n” nB Number of firms Total sales CB

301 EU Competition Policy To prevent anti-competitive behavior, EU policy focuses on two main axes: Antitrust and cartels. The Commission tries: to eliminate behaviours that restrict competition (e.g. price-fixing arrangements and cartels), to eliminate abusive behaviour by firms that have a dominant position. Merger control. The Commission seeks: to block mergers that would create firms that would dominate the market.

302 Economics of cartels Suppose price without cartel would be P.euros Quantity C’ C P’ P AC a b c Demand curve Suppose price without cartel would be P. Cartel raises price to P’. DCS=-a-b; ‘ripoff’ DPS=+a-c Net welfare = -b-c ; “technical inefficiency”

303 The vitamin cartels (Box 11‑1)In 2001, Commission fined 8 companies for vitamins cartels vitamins A, E, B1, B2, B5, B6, C, D3, Biotin, Folic acid, Beta Carotene and carotinoids The European vitamins market is worth almost a billion euros a year. The firms fixed prices, allocated sales quotas, agreed on and implemented price increases and issued price announcements in according to agreed procedures. They set up a mechanism to monitor and enforce their agreements and participated in regular meetings to implement their plans. Formal structure with senior managers to ensure the functioning of the cartels: the exchange of sales values, volumes of sales and pricing information on a quarterly or monthly basis at regular meetings, and the preparation, agreement and implementation and monitoring of an annual "budget" followed by the adjustment of actual sales achieved so as to comply with the quotas allocated. Hoffman-La Roche of Switzerland (cartel ringleader) received the largest fine (462m euros); BASF and Merck (Germany), Aventis SA (France), Solvay Pharmaceuticals (the Netherlands), Daiichi Pharmaceutical, Esai and Takeda Chemical Industries (Japan).

304 Exclusive territoriesMore common anti-competitive practice is ‘exclusive territories’. Nintendo example; high prices in Germany vs UK. Germany’s inelastic demand meant Nintendo wanted to charge a higher price than in UK. Normally Single Market limits this sort of price discrimination (arbitrage by firms). Nintendo implemented a system that prevented arbitrage within the EU (illegal). European Commission fined Nintendo and the 7 distributors 168 million euros. euros Quantity PGermany PUK DGermany DUK MC MRGermany MRUK

305 Abuse of dominant positionFirms that are lucky or possess excellent products can establish very strong positions in their market. Not a problem, per se: position may reflect superior products and/or efficiency, e.g. Google’s triumph. However dominance may tempt firm to extract extra profits from suppliers or customers. Or arrange the market to shield itself from future competitors. Illegal under EU law ‘abuse of dominant position.’ e.g. Microsoft with media software: Charge high price of Word, etc. where the competition has been driven out of biz (WordPerfect, etc.), but give for free all software where there is still competition.

306 Merger control DCS=-a-b; ‘ripoff’. Initially P=AC.Merger implies lower AC to AC’, but raises the price to P’. DCS=-a-b; ‘ripoff’. DPS=+a+c. Net welfare = -b+c ; ambiguous, ‘efficiency defence’. Laissez-faire (in US and increasingly in EU); if free entry then eventually P driven down to AC’. As in BE-COMP diagram. euros Quantity C’ C P’ P=AC a b c Demand curve AC’ Williamson diagram

307 State aid economics Look at two cases: Restructuring prevention.Unfair competition.

308 Restructuring preventionConsider subsidies that prevent restructuring. Specifically, each government makes annual payments to all firms exactly equal to their losses: i.e. all 2n’ firms in Figure 6-9 analysis break even, but not new firms. Economy stays at point A. This changes who pays for the inefficiently small firms from consumers to taxpayers. Mark-up BE BEFT E’ 1 m' E” mA A COMP n’ n” 2n’ Number of firms

309 Restructuring prevention: size of subsidyPre-integration: fixed costs = operating profit = area “a+b”. Post-integration: operating profit = b+c. ERGO: Breakeven subsidy = a-c . NB: b+c+a-c=a+b. euros Price Mark-up COMP Demand curve BEFT E’ E’ p’ a AC A A pA pA A b c MC 2n’ Number of firms Sales per firm Total sales x’ C’ CA xA= 2CA/2n’

310 Restructuring prevention: welfare impactChange producer surplus = zero (profit is zero pre & post). Change consumer surplus = a+d. Subsidy cost = a-c. Total impact = d+c. euros Price Mark-up COMP Demand curve BEFT E’ E’ p’ a AC d A A pA pA A b c MC 2n’ Number of firms Sales per firm Total sales x’ C’ CA xA= 2CA/2n’

311 Only some subsidise: unfair competitionIf Foreign pays ‘break even’ subsidies to its firms, All restructuring forced on Home, 2n’ moves to n”, but all the exit is by Home firms. Unfair. Undermines political support for liberalisation.

312 EU policies on ‘State Aids’1957 Treaty of Rome bans state aid that provides firms with an unfair advantage and thus distorts competition. EU founders considered this so important that they empowered the Commission with enforcement.

313 The Economics of European Integration

314 Chapter 14 The Choice of an Exchange Rate Regime

315 Background theory A quick refresher on basic macroeconomic principlesApplication of these principles to the question of exchange rate regimes Europe’s monetary integration is a history of seeking exchange rate stability. Why?

316 The Question and The AnswerThe question: what to do with the exchange rates: viewpoint of an individual country, in contrast with Chapter 13 which looks at systems underlines the principles to evaluate the merits of a monetary union. The answer: there is no best arrangement: a matter of trade-offs.

317 Three Basic PrinciplesLong term: neutrality of money. Short term: non-neutrality of money. Interest parity condition.

318 Long Term: Neutrality of MoneyIn the long run, money, the price level and the exchange rate tend to move proportionately.

319 Long Term: Neutrality of MoneyComparison between France and Switzerland Growth rate in France less growth rate in Switzerland Year to year: Nothing really visible

320 Long Term: Neutrality of MoneyComparison between France and Switzerland Growth rate in France less growth rate in Switzerland Five-year averages: Something emerges

321 Long Term: Neutrality of MoneyComparison between France and Switzerland Growth rate in France less growth rate in Switzerland

322 Long Term Neutrality of Money: TheoryThe aggregate demand and supply framework: the vertical long-run aggregate supply schedule.

323 PPP: An Implication of Long Term NeutralityThe real exchange rate: defined as  = EP/P* PPP: E offsets changes in P/P* so  is constant. Equivalently: Many caveats, though.

324 PPP: An Implication of Long Term NeutralityFrance and Switzerland: averages

325 PPP: An Implication of Long Term NeutralityGermany and the UK ( )

326 Caveat: The Balassa-Samuelson Effect

327 Short Term Non-Neutrality of MoneyFrom AD-AS: the short-run AS schedule. So monetary policy matters in the short run. Channels of monetary policy: the interest rate channel the credit channel the stock market channel the exchange rate channel.

328 Exchange Rate Regimes and Policy EffectivenessFixed exchange rate: no independent monetary policy: money is endogenous.

329 Exchange Rate Regimes and Policy Effectiveness

330 Exchange Rate Regimes and Policy EffectivenessFixed exchange rate: no independent monetary policy. Flexible exchange rate: no effect of fiscal policy: the exchange rate offets fiscal policy effects.

331 Exchange Rate Regimes and Policy Effectiveness

332 When Does the Regime Matter?In the short run, changes in E are mirrored in changes in  = EP/P*: P and P* are sticky. In the long run,  is independent of E: P adjusts.

333 When Does the Regime Matter?In the short run, changes in E are mirrored in changes in  = EP/P*: P and P* are sticky. In the long run,  is independent of E: P adjusts. If P is fully flexible, the long run comes about immediately and the nominal exchange rate does not affect the real economy. Put differently, the choice of an exchange rate regime has mostly short-run effects because prices are sticky.

334 What’s On The Menu? Free floating. Managed floating. Target zones.Crawling pegs. Fixed and adjustable. Currency boards. Dollarization/euroization. Monetary union.

335 The Choice of an Exchange Rate RegimeThe monetary policy instrument: can be useful to deal with cyclical disturbances can be misused (inflation). The fiscal policy instrument: can also deal with cycles but is often politicised can be misused (public debts, political cycles).

336 The Choice of an Exchange Rate RegimeExchange rate stability: freely floating exchange rates move ‘too much’ fixed exchange rates eventually become misaligned.

337 The Old Debate: Fixed vs FloatThe case for flexible rates: with sticky prices, need exchange rate flexibility to deal with shocks remove the exchange rate from politicisation monetary policy is too useful to be jettisoned.

338 The Old Debate: Fixed vs FloatThe case for fixed rates: flexible rates move too much (financial markets are often hectic) exchange rate volatility: a source of uncertainty a way of disciplining monetary policy in presence of shocks, always possible to realign.

339 The New Debate: The Two-Corners SolutionOnly pure floats or hard pegs are robust: intermediate arrangements (soft pegs) invite government manipulations, over or under valuations and speculative attacks pure floats remove the exchange rate from the policy domain hard pegs are unassailable (well, until Argentina’s currency board collapsed…).

340 The New Debate: The Two-Corners SolutionIn line with theory: soft pegs are half-hearted monetary policy commitments, so they ultimately fail.

341 The Two-Corners Solution and The Real WorldFear of floating: many countries officially float but in fact intervene quite a bit. Fear of fixing: many countries declare a peg but let the exchange rate move out of official bounds.

342 Fear of Floating

343 The Two-Corners Solution and The Real WorldFear of floating is deeply ingrained in many European countries. Fear of fixing partly explains the disenchantment with the EMS and some reluctance towards monetary union.

344 Conclusions A menu hard to pick from: trade-offs are everywhere.All of this takes the view from a single country. Systems involve many countries and rest on agreed upon rules, including mutual support. Since the end of Bretton Woods, there is no world monetary system. This leaves room for regional monetary systems. Enters Europe’s experience.