Chapter 8 Outline

Regional Economic Integration in Europe

Europe has two trade blocs--the European Union and the European Free Trade Association. Of the two, the EU is by far the more significant, not just in terms of membership (the EU has 15 members, and EFTA has 4), but also in terms of economic and political influence in the world economy. Many now see the EU as an emerging economic and political superpower of the same order as the United States and Japan. Accordingly, we will concentrate our attention on the EU.⁵

Evolution of the European Union

The EU is the product of two political factors: (1) the devastation of two world wars on Western Europe and the desire for a lasting peace, and (2) the European nations' desire to hold their own on the world's political and economic stage. In addition, many Europeans were aware of the potential economic benefits of closer economic integration of the countries. The original forerunner of the EU, the European Coal and Steel Community, was formed in 1951 by Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands. Its objective was to remove barriers to intragroup shipments of coal, iron, steel, and scrap metal. With the signing of the Treaty of Rome in 1957, the European Community was established. The name changed again in 1994 when the European Community became the European Union following the ratification of the Maastricht Treaty (discussed later).

The Treaty of Rome provided for the creation of a common market. This is apparent in Article 3 of the treaty, which laid down the key objectives of the new community. Article 3 called for the elimination of internal trade barriers and the creation of a common external tariff and required member states to abolish obstacles to the free movement of factors of production among the members. To facilitate the free movement of goods, services, and factors of production, the treaty provided for any necessary harmonization of the member states' laws. Furthermore, the treaty committed the EC to establish common policies in agriculture and transportation.

The community grew in 1973, when Great Britain, Ireland, and Denmark joined. These three were followed in 1981 by Greece, in 1986 by Spain and Portugal, and in 1996 by Austria, Finland, and Sweden (see Map 8.1) bringing the total membership to 15 (East Germany became part of the EC after the reunification of Germany in 1990). With a population of 350 million and a GDP greater than that of the United States, these enlargements made the EU a potential global superpower.

Political Structure of the European Union

The economic policies of the EU are formulated and implemented by a complex and still-evolving political structure. The five main institutions in this structure are the European Council, the Council of Ministers, the European Commission, the European Parliament, and the Court of Justice.⁶

The European Council

The European Council is composed of the heads of state of the EU's member nations and the president of the European Commission. Each head of state is normally accompanied by a foreign minister to these meetings. The European Council meets at least twice a year and often resolves major policy issues and sets policy directions.

Map 8.1 see

The European Union

The European Commission

The European Commission is responsible for proposing EU legislation, implementing it, and monitoring compliance with EU laws by member states. Headquartered in Brussels, Belgium, the commission has more than 10,000 employees. It is run by a group of 20 commissioners appointed by each member country for four-year renewable terms. Most countries appoint only one commissioner, although the most populated states--Britain, France, Germany, Italy, and Spain--appoint two each. A president and six vice presidents are chosen from among these commissioners for two-year renewable terms. Each commissioner is responsible for a portfolio that is typically concerned with a specific policy area. For example, there is a commissioner for agricultural policy and another for competition policy. Although they are appointed by their respective governments, commissioners are meant to act independently and in the best interests of the EU, as opposed to being advocates for a particular national interest.

The commission has a monopoly in proposing European Union legislation. The commission starts the legislative ball rolling by making a proposal, which goes to the Council of Ministers and then to the European Parliament. The Council of Ministers cannot legislate without a commission proposal in front of it. The Treaty of Rome gave the commission this power in an attempt to limit national infighting by taking the right to propose legislation away from nationally elected political representatives, giving it to "independent" commissioners. The commission is also responsible for implementing aspects of EU law, although in practice much of this must be delegated to member states. Another responsibility of the commission is to monitor member states to make sure they are complying with EU laws. In this policing role, the commission will normally ask a state to comply with any EU laws that are being broken. If this persuasion is not sufficient, the commission can refer a case to the Court of Justice.

The Council of Ministers

The interests of member states are represented in the Council of Ministers. It is clearly the ultimate controlling authority within the EU since draft legislation from the commission can become EU law only if the council agrees. The council is composed of one representative from the government of each member state. The membership, however, varies depending on the topic being discussed. When agricultural issues are being discussed, the agriculture ministers from each state attend council meetings; when transportation is being discussed transportation ministers attend, and so on. Before 1993, all council issues had to be decided by unanimous agreement between member states. This often led to marathon council sessions and a failure to make progress or reach agreement on proposals submitted from the commission. In an attempt to clear the resulting logjams, the Single European Act formalized the use of majority voting rules on issues "which have as their object the establishment and functioning of a single market." Most other issues, however, such as tax regulations and immigration policy, still require unanimity among council members if they are to become law.

The European Parliament

The European Parliament, which now has about 630 members, is directly elected by the populations of the member states. The parliament, which meets in Strasbourg, France, is primarily a consultative rather than legislative body. It debates legislation proposed by the commission and forwarded to it by the council. It can propose amendments to that legislation, which the commission (and ultimately the council) are not obliged to take up but often will. The power of the parliament recently has been increasing, although not by as much as parliamentarians would like. The European Parliament now has the right to vote on the appointment of commissioners, as well as veto power over some laws (such as the EU budget and single-market legislation). One major debate now being waged in Europe is whether the council or the parliament should ultimately be the most powerful body in the EU. There is concern in Europe over the democratic accountability of the EU bureaucracy. Some think the answer to this apparent democratic deficit lies in increasing the power of the parliament, while others think that true democratic legitimacy lies with elected governments, acting through the Council of Ministers.⁷

The Court of Justice

The Court of Justice, which is comprised of one judge from each country, is the supreme appeals court for EU law. Like commissioners, the judges are required to act as independent officials, rather than as representative of national interests. The commission or a member country can bring other members to the court for failing to meet treaty obligations. Similarly, member countries, companies, or institutions can bring the commission or council to the court for failure to act according to an EU treaty.

The Single European Act

Two revolutions occurred in Europe in the late 1980s. The first was the collapse of communism in Eastern Europe. The second revolution was much quieter, but its impact on Europe and the world may have been just as profound as the first. It was the adoption of the Single European Act by the member nations of the EC in 1987. This act committed the EC countries to work toward establishment of a single market by December 31, 1992.

The Stimulus for the Single European Act

The Single European Act was born of a frustration among EC members that the community was not living up to its promise. By the early 1980s, it was clear that the EC had fallen short of its objectives to remove barriers to the free flow of trade and investment between member countries and to harmonize the wide range of technical and legal standards for doing business. At the end of 1982, the European Commission found itself inundated with 770 cases of intra-EC protectionism to investigate. In addition, some 20 EC directives setting common technical standards for a variety of products ranging from cars to thermometers were deadlocked.

Many companies considered the EC's main problem was the disharmony of the members' technical, legal, regulatory, and tax standards. The "rules of the game" differed substantially from country to country, which stalled the creation of a true single internal market. Consider the European automobile industry. In the mid-1980s, there was no single EC-wide automobile market analogous to the US automobile market. Instead, the EC market remained fragmented into 12 national markets. There were four main reasons for this:

• Different technical standards required cars to be customized to national requirements (e.g., the headlights and sidelights of cars sold in Great Britain must be wired in a significantly different way than those of cars sold in Italy, and the standards for car windshields in France are very different from those in Germany).

• Different tax regimes created price differentials across countries that would not be found in a single market.

• An agreement to allow automobile companies to sell cars through exclusive dealer networks allowed auto companies and their dealers to adapt their model ranges and prices on a country-by-country basis with little fear that these differences would be undermined by competing retailers.

• In violation of Article 3 of the Treaty of Rome, each country had adopted its own trade policy with regard to automobile imports (e.g., whereas Japanese imports were not restricted in Belgium, they were limited to 11 percent of the car market in Great Britain and to less than 2 percent in France and Italy). These divisions resulted in substantial price differentials between countries. In 1989, the prices of the same model of car were, on average, 31 percent higher in the United Kingdom and 11 percent higher in Germany than in Belgium.⁸

In addition to such considerations, many member countries were subsidizing national firms, thereby distorting competition. For example, the French government in 1990 decided to pump FFr 6 billion into Groupe Bull, a state-owned computer maker, and Thomson, a defense and electronics group. This brought protests from ICL, a British computer maker, on the grounds that such a subsidy would allow Groupe Bull to capture more of the EC computer market.⁹

Against this background, many of the EC's prominent business people mounted an energetic campaign in the early 1980s to end the EC's economic divisions. The EC responded by creating the Delors Commission. Under the chairmanship of Jacques Delors, the former French finance minister and president of the EC Commission, the Delors Commission produced a discussion paper in 1985. This proposed that all impediments to the formation of a single market be eliminated by December 31, 1992. Two more years passed before the EC persuaded all member countries to accept the proposals contained in the discussion paper. The result was the Single European Act, which was independently ratified by the parliaments of each member country and became EC law in 1987.

The Objectives of the Act

The purpose of the Single European Act was to have a single market in place by December 31, 1992. The act proposed the following changes:¹⁰

1. Remove all frontier controls between EC countries, thereby abolishing delays and reducing the resources required for complying with trade bureaucracy.

2. Apply the principle of "mutual recognition" to product standards. A standard developed in one EC country should be accepted in another, provided it meets basic requirements in such matters as health and safety.

3. Open public procurement to nonnational suppliers, reducing costs directly by allowing lower-cost suppliers into national economies and indirectly by forcing national suppliers to compete.

4. Lift barriers to competition in the retail banking and insurance businesses, which should drive down the costs of financial services, including borrowing, throughout the EC.

5. Remove all restrictions on foreign exchange transactions between member countries by the end of 1992.

6. Abolish restrictions on cabotage--the right of foreign truckers to pick up and deliver goods within another member state's borders--by the end of 1992. This could reduce the cost of haulage within the EC by 10 to 15 percent.

7. All those changes should lower the costs of doing business in the EC, but the single-market program was also expected to have more complicated supply-side effects. For example, the expanded market should give EC firms greater opportunities to exploit economies of scale. In addition, the increase in competitive intensity brought about by removing internal barriers to trade and investment should force EC firms to become more efficient.

To signify the importance of the Single European Act, the European Community also decided to change its name to the European Union once the act took effect.

Implications

The implications of the Single European Act are potentially enormous. We discuss the implications for business practice in more detail in the Implications for Business section at the end of the chapter. For now it should be noted that, as long as the EU is successful in establishing a single market, the member countries can expect significant gains from the free flow of trade and investment. These gains may be greater than those predicted by standard trade theory that accrue when regions specialize in producing those goods and services that they produce most efficiently. The lower costs of doing business implied by the Single European Act will benefit EU firms, as will the potential economies of scale inherent in serving a single market of 360 million consumers. On the other hand, as a result of the Single European Act, many EU firms are facing increased competitive pressure. Countries such as France and Italy have long used administrative trade barriers and subsidies to protect their home markets from foreign competition. Removal of these barriers has increased competition, and some firms may go out of business. Ultimately, however, both consumers and EU firms will benefit from this. Consumers will benefit from the lower prices implied by a more competitive market. EU firms will benefit if the increased competitive pressure forces them to become more efficient, thereby transforming them into more effective international competitors capable of going head-to-head with US and Asian rivals in the world marketplace.

But the shift toward a single market has not been as rapid as many would like. Six years after the Single European Act became EU law, there have been a number of delays in applying the act to certain industries, often because countries have appealed to the Council of Ministers for more time. The insurance industry, for example, was exempt until July 1994 (see the opening case for details). Investment services were not liberalized until January 1996, and there was no compulsion to liberalize basic telephone services until 1998 (and until 2003 in poorer countries such as Greece to protect local telephone companies from being "crushed" by the likes of Britain's BT or America's AT&T).¹¹ Also, many European countries have found their dreams of a single market dashed by the realities of deep and enduring cultural and language barriers between countries, which still separate many national markets, although not as effectively as formal barriers to trade once did. Still, the long-run prognosis remains very strong, and despite all the short-term setbacks, the EU will probably have a reasonably well-functioning single market by the early years of the next century.

European Monetary Union (EMU: The Adoption of A Single Currency

In December 1991, leaders of the EC member states met in Maastricht, the Netherlands, to discuss the next steps for the EC. The results of the Maastricht meeting surprised both Europe and the rest of the world. The EC countries had been fighting for months over a common currency. Although many economists believed a common currency was required to cement a closer economic union, deadlock had been predicted. The British in particular had opposed any attempt to establish a common currency. Instead of a deadlock, the 12 members signed a treaty that not only committed them to adopting a common EC currency by January 1, 1999, but also paved the way for closer political cooperation.

The treaty laid down the main elements, if only in embryo, of a future European government: a single currency, the euro; a common foreign and defense policy; a common citizenship; and an EU parliament with teeth. It is now just a matter of waiting, some believe, for history to take its course and a "United States of Europe" to emerge. Of more immediate interest are the implications for business of the plans to establish a single currency.¹²

Benefits of EMU

As with many of the provisions of the Single European Act, the move to a single currency should significantly lower the costs of doing business in the EU. The gains come from reduced exchange costs and reduced risk.¹³ The EU has calculated that EU businesses convert roughly $8 trillion from one EU currency to another every year, which necessitates about $12 billion in exchange costs. A single currency would avoid these costs and help firms in other ways, as fewer resources would be required for accounting, treasury management, and the like. As for reduced risk, a single currency would reduce the risks that arise from currency fluctuations. The values of currencies fluctuate against each other continually. As we will see in Chapter 9, this introduces risks into international transactions. For example, if a British firm builds a factory in Greece, and the value of the Greek currency subsequently declines against the British pound, the value of the British firm's Greek assets will also decline. A single currency would eliminate such risks, thus reducing the cost of capital. Interest rates would fall, and investment and output would increase as a consequence.

In addition to these gains, advocates argue that a single currency will make it difficult for companies to charge different prices in different EU countries.¹⁴ If the price for a car in euros is 20 percent higher in Germany than it is in France, so the argument goes, many German consumers will simply go to France to buy their cars. This will force down the price for cars in Germany until they are equal to the price for the same car in neighboring states, resulting in significant gains for German consumers. The introduction of the euro should result in a significant increase in price competition across a wide range of industries (for another example, see the opening case on the European insurance industry). The resulting fall in prices will give European consumers more money to spend on other items, raising their economic welfare. In addition, the increase in price competition will force business to respond by becoming more efficient. This too should be good for the EU economy.

Costs of EMU

The drawback, for some, of a single currency is that national authorities would lose control over monetary policy. Thus, the EU's monetary policy must be well managed. The Maastricht Treaty called for establishment of an independent European Central Bank (ECB), similar in some respects to the US Federal Reserve, with a clear mandate to manage monetary policy so as to ensure price stability. Like the US Federal Reserve, the ECB, based in Frankfurt, is meant to be independent from political pressure--although critics question this. Among other things, the ECB will set interest rates and determine monetary policy across the euro zone. Critics fear that the ECB will respond to political pressure by pursuing a lax monetary policy, which in turn will raise average inflation rates across the euro zone, hampering economic growth.

Several nations were concerned about the effectiveness of such an arrangement and the implied loss of national sovereignty. Reflecting these concerns, Britain, Denmark, and Sweden won the right from other members to stay out of the monetary union if they chose. According to some critics, European monetary union represents putting the economic cart before the political horse. In their view, a single currency should follow, not precede, political union. They argue that the euro will unleash enormous pressures for tax harmonization and fiscal transfers, both policies that cannot be pursued without the appropriate political structure. Some critics also argue that the EMU will result in the imposition of a single interest rate regime on national economies that are not truly convergent and are experiencing divergent economic growth rates.

The most apolitical vision that flows from these negative views is that the euro will lead to lower economic growth and higher inflation within Europe. To quote one critic:

Imposing a single exchange rate and an inflexible exchange rate on countries that are characterized by different economic shocks, inflexible wages, low labor mobility, and separate national fiscal systems without significant cross-border fiscal transfers will raise the overall level of cyclical unemployment among EMU members. The shift from national monetary policies dominated by the (German) Bundesbank within the European Monetary System to a European Central Bank governed by majority voting with a politically determined exchange rate policy will almost certainly raise the average future rate of inflation.¹⁵

The Road Toward EMU

According to the Maastricht Treaty, to achieve monetary union by 1999, member countries must have achieved low inflation rates, low long-term interest rates, a stable exchange rate, public debt limited to no more than 60 percent of a country's GDP, and current budget deficits of no more than 3 percent of GDP. Initially there was considerable skepticism that this would be possible. However, by mid-1998, of the 12 countries that had singled their intention to join the euro zone, only Greece would not make the criteria. For now three EU countries, Britain, Denmark and Sweden, are still sitting on the sidelines, although there is speculation that Britain and Sweden may join before 2002. Under the current timetable, the 11 countries that made the grade and agreed to EMU locked their exchange rates against each other on January 1, 1999, and the ECB then took over management of monetary policy in those countries. The financial markets began to trade euro-dominated assets on January 4, 1999, effectively creating the world's second largest currency after the US dollar. Notes and coins denominated in euros will go into circulation at the beginning of 2002, and national currencies will be withdrawn in July 2002. Between 1999 and 2002, shops and restaurants in the euro zone will display prices in both euros and the local currency. Prior to its introduction, the theoretical value of the euro was estimated to be around one US dollar. In late January 1999, the euro was trading at 1 euro = $1.17.

Enlargement of the European Union

The other big issue the EU must now grapple with is enlargement. After a bitter dispute among the existing 12 members, they agreed in March 1994 to enlarge the EU to include Austria, Finland, Sweden, and Norway. Most of the opposition to enlargement came from Britain, which worried that enlargement and a subsequent reduction in its voting power in the EU's top decision-making body, the Council of Ministers, would limit its ability to block EU developments that it did not like. Britain backed down in the face of strong opposition from other EU members and agreed to enlargement.

Voters in the four countries went to the polls in late 1994. Austria, Finland, and Sweden all voted to join the EU, but Norway voted to stay out. Thus, the EU of 12 became the EU of 15 on January 1, 1996. Next the EU had to deal with membership applications from Hungary, Poland, the Czech Republic, Estonia, Slovenia, Malta, Cyprus, and Turkey.¹⁶ In 1997, the EU responded by formally inviting five former communist states, Estonia, Poland, the Czech Republic, Slovenia, and Hungary, to join. However, the timetable for this event is uncertain, and any additional expansion unlikely until after completion of EMU in 2002. All these countries still have a long way to go before their economies reach the level enjoyed by current EU members. For example, according to the European Commission, Poland, the country with the largest population among the five, needs to modernize its agricultural sector, speed up its sluggish privatization efforts, and bring its inflation rate down from around 20 percent to about 3 percent.¹⁷

Fortress Europe?

One of the main concerns of the United States and Asian countries is that the EU will at some point impose new barriers on imports from outside the EU. The fear is that the EU might increase external protection as weaker member states attempt to offset their loss of protection against other EU countries by arguing for limitations on outside competition.

In theory, given the free market philosophy that underpins the Single European Act, this should not occur. In October 1988, the European Commission debated external trading policy and published a detailed statement of the EC's trading intentions in the post-1992 era.¹⁸ The commission stressed the EC's interests in vigorous external trade. It noted that exports by EC countries to non-EC countries are equivalent to 20 percent of total world exports, compared to 15 percent for the United States and 9 percent for Japan. These external exports are equivalent to 9 percent of its own GDP, compared to 6.7 percent for the United States and 9.7 percent for Japan. In short, it is not in the EU's interests to adopt a protectionist stance, given the EU's reliance on external trade. The commission has also promised loyalty to GATT and WTO rules on international trade. As for the types of trade not covered by the WTO, the EU states it will push for reciprocal access. The EU has stated that in certain cases it might replace individual national trade barriers with EU protection against imports, but it also has promised that the overall level of protection would not rise.

Despite such reassurances, there is no guarantee that the EU will not adopt a protectionist stance toward external trade, and there are indications that has occurred in two industries, agriculture and automobiles. The EU has continued the Common Market Agricultural Policy, which limits many food imports. In autos, the EU reached an agreement with the Japanese to limit the Japanese market share of the EU auto market. Between 1993 and 1998, those countries that had quotas on Japanese car imports lifted them gradually until the end of 1998, when they were abolished. Meanwhile, Japanese producers committed themselves to voluntarily restraining sales so that by the end of the century they hold no more than 17 percent of the European market. After that, all restrictions are to be abolished. These examples of protectionism, however, are not the norm, and the EU countries generally have adopted a relatively liberal trade policy with regard to third parties, such as Japan and the United States. In a published report on the issue, the WTO has stated that the growth of regional trade groups such as the EU has not impeded the growth of freer world trade, as some fear, and may have helped to promote it.¹⁹