Presentation on the European Union Formation

The European Union

Economic Integration & The European Union

INT 362 Osman Sabri KIRATLI

The European Union

• Since the creation of the EU half a century ago, Europe has enjoyed the longest period of peace in its history.

• EU enlargement has helped overcome the division of Europe – contributing to peace, prosperity, and stability across the continent.

• A single market and a common currency conditions for companies and consumers.

The European Union

What is the European Union?

• Shared values: liberty, democracy, respect for human rights and fundamental freedoms, and the rule of law.

• Largest economic body in the world

• A unique institution – Member States voluntarily cede national sovereignty in many areas to carry out common policies and governance.

• Not a super-state to replace existing states, nor just an organization for international cooperation.

• World’s largest & most open market for goods and commodities from developing countries.

27

7

30

490million

Member States

Combined population of

EU Member States

Percent of world’spopulation

Percent of global GDP

55Percent of combinedworldwide OfficialDevelopment Assistance

The European Union

Stages of Regional Integration

Stage 1 Free Trade Area: the elimination of tariffs

• for goods and services within region (NAFTA)

Stage 2 Customs Union: Free Trade Area with a common

• external tariff (EEC)

Stage 3 Single Market/Economic Union:

• eliminating all tariff and non-tariff barriers

• Freedom of goods, services, labor and capital

• “Harmonization” of regulation

• May also have common currency (euro)

Stage 4 Political Union?

• Common Political Institutions/Constitution

The European Union

The European Union

1951:

• In the aftermath of World War II, the aim was to secure peace among Europe’s victorious and vanquished nations and bring them together as equals, cooperating within shared institutions.

• Based on a plan by French statesman Jean Monnet and Foreign Minister Robert Schuman (to German Chancellor Adenauer)

• Six founding countries – Belgium, the Federal Republic of Germany, France, Italy, Luxembourg and the Netherlands – signed a treaty to run heavy industries (coal and steel) under common management “to make war not only unthinkable but materially impossible”

European Coal and

Steel Community

Jean Monnet and other leaders with the first “European” ingot of steel

The European Union

Treaty of Rome

• The six founding countries expanded cooperation to other economic sectors, creating the European Economic Community (EEC) – or “common market.”

• As a result, people, goods, services, and capital today move freely across the Union.

• Britain left out, formed EFTA instead

• EURATOM: shared nuclear energy research

• 1960s: Common Agricultural Policy

1957:

Signing of the Treaty of Rome

The European Union

Single European Act & Maastricht Treaty

Jacques Delors and the SEA (1986)

• Single Market by 1992

End of Cold War (1989-91) and Maastricht Treaty (1991/3)

• Three pillar structure (left): Euro & economic Policies, CFSP and Justice & Home Affairs

• Extension of Qualified Majority Voting, European citizenship

The European Union

Lisbon Treaty

• Reformulated version of the failed European Constitutional Treaty of 2004

• The ‘No’ of the popular referenda in the Netherlands & France dealt a significant blow to the Constitution and the future of the Union- which found itself in a reflection/crisis period after

• the Reform/Lisbon Treaty, ratified in 12/2009 (in 2nd attempt in Ireland)

• which takes in most aspects of the constitution (minus flag, anthem, constitution-wording, Minister) such as

- Semi-permanent Council President (Herman Van Rompuy)

- High Rep for Common Foreign Affairs & Security

(Catherine Ashton)

Policy (‘EU Foreign Minister’) + Ext. Diplom. Service

- Charter of Fundamental Rights (binding)

- Qual. Majority Voting & Co-decision the rule

- National Parliaments receive more time for review

- 1 Million Citizen’s Initiative

The European Union

Enlargement Waves• 1967: ECSC, EEC, and EuroAtom merged to form the basis of the EC

• 1973: the United Kingdom, Denmark, and Ireland joined the EC

• 1981: Greece joined

• 1986: Spain and Portugal joined

• 1995: Finland, Sweden, and Austria joined

• 2004: Central Europe (eight countries), Cyprus and Malta joined

• 2007: Romania and Bulgaria joined

The European Union

Candidate Countries

Croatia

Former Yugoslav Republic of Macedonia

Turkey

Potential

Candidate Countries

Albania

Bosnia & Herzegovina

Montenegro

Serbia including Kosovo (under UN Security Council

Resolution 1244)

The European Union

EU Institutions• The “Institutional Triangle”: The Commission, The Council of Ministers,

The Parliament

• The Other Two: The Court of Justice, The Central Bank

The European Union

1-European Commission• 27 (College of) Commissioners, representing the European

perspective, each responsible for a specific policy area.

• Supported & represented by ~25,000 Eurocrats in Brussels & the world, divided into departments called Directorates-General

• Reduction to 2/3 planned in 2014

• The Commission is supposed to represent the interests of the EU, not the member states. Thus they aren’t supposed to receive “instructions” from their home country

• Does no directly control taxation, policy or armed forces

• Occasional problems with corruption: The EU parliament can force the entire Commission to resign through a vote of “no confidence.” Almost did in 1999 with Santer Commission, which, instead, resigned en masse.

European Commission President José Manuel Barroso

The European Union

1-European Commission

• EU’s executive branch proposes legislation, manages Union’s day-to-day business, budget, and enforces rules.

• Negotiates trade agreements and manages Europe’s multilateral development cooperation.

• Proposes new laws

• Implements them

• Prepares EU Budget

• Acts with complete political independance

• Acts as guardian of treaties

• Can take offending parties to court

• Answerable to parliament

The European Union

2-Council of Ministers (+ EU Council)• EU’s main decision-making body, comprised of (9

configurations of) ministers of 27 MS, representing their point of view

• After obtaining the draft law from the EC & input from EP, Council votes either by unanimity or QMV

• QMV: majority of member states+73.9 of votes (+62 percent of population)

• Council presidency rotates among MS every six months

• EU Council: regular meeting of Heads of Government

• Not the same as the Council of Europe which is a European organization located in Strasbourg, It was founded in 1949 to protect human rights and foster democracy. Made up of 36 nations

• Meetings held in secret, little media coverage

The European Union

2-Council of Ministers (+ EU Council)

• Decides on foreign policy

• Sets EU political goals

• Co-ordinatetes national policies

• Controls EU budget

• Makes key decisions:economic and political

• Heads of govt meet twice a year at EU summits

The European Union

3-European Parliament

• ‘Voice of Europeans’ – (785/750) members elected across EU for 5-year terms (according to national population)

• Since 1979 directly elected, but low turnout

• Seats are, for the most part, shared proportionally according to size of member state

• These produce distortions: Germany has 99 seats, Malta has 5, but . . .

• This means: Germany has 1 MEP per 800,000; Malta one MEP per 80,000

• Oddity is that EU parliament cannot introduce laws nor raise revenue

• MEPs in the Parliament are currently organized into 8 different political groups

European Parliament in session

The European Union

3-European Parliament

• With the Council, passes EU laws and adopts EU budgets (‘co-decision’ rights)

• Approves/Supervises EU Commissioners. It has the power to dismiss the Commission by censure

• Debates new legislation

• Ammends/approves budget

• Advises council

The European Union

3-European Parliament:Political Parties

• These European parties are themselves composed primarily of national parties

• For example, a member of the British Conservative (Tory) Party would be a member of the European Democrats) and include parties not currently elected or even currently outside the EU

• Hence, European Union parties are more fluid, with national or European parties easily able to switch between groups which often occurs after elections or an enlargement

The European Union

4-European Court of Justice• Highest EU judicial authority – 27 judges (6yr

terms) + Advocates General/Cof First Instance

• Ensures all EU laws are interpreted and applied correctly and uniformly (Preliminary rulings, direct actions against MS, EC)

• Located in Luxembourg

• Primary Law: Treaties & Constitutional Boundaries of MS

• Secondary Law: Rules & Regulations, Directives

• Power of Court seems to be growing; this reflected in tension between Court and member states

• On the other hand, Court of Justice has strengthened courts in member nations by giving it new jurisdiction

• Under new constitution, ECJ power would grow significantly

The European Union

4-European Court of Justice

• Can act as an independent policy maker/over-rules national law

• Determines if national laws are consistent with EU laws

• EU law takes precedence but only in areas of EU “competence,” that is, where the countries have given power to the EU

• Legislates laws, supervise Commission, controls budget allocation

Deals with

• Claims by the EU Commission that a member state has not implemented a legal requirement

• Claims by a member state that the EU Commission has exceeded its authority

• Responds to inquiries from national courts about the meaning or validity of a particular piece of EU law

• General Court (Court of First Instance before 2009) screens issues before they come to Court of Justice

The European Union

Other important EU bodies• The Economic and Social Committee (ESC)

(advisory group on social/econ. issues), a forum for EU civil society, dominated by groups of employers, trade unions and agricultural organizations

• The Committee of the Regions (advisory opinion in regional issues)

• The Court of Auditors monitors the EU budget

• The Eur Ombudsman receives and investigates complaints by citizens

• The European Central Bank (ECB) formulates the EU’s monetary policy (Frankfurt)

• European Investment Bank (EIB) supplies loans for ‘European’ projects

• Specialized Agencies (across EU)

• COREPER: Committee of Permanent Representatives

– Powerful but often overlooked in understanding EU

– Acts as links between Brussels and member states

– Sets agenda for much of Council’s business

The European Union

Major Policies▪ Euro & Monetary Union: Euro removes

transaction costs & is reserve currency

▪ CFSP: Foreign Minister, External Action Service; minimal budget: €170 million (2007)

▪ Common Agricultural Policy (CAP): farm subsidies keystone of integration, accounts for ~ 40% of EU budget

▪ Regional Policy: Structural & Social Funds

▪ JHA: Europol & -just; Counterterrorism & Internal Security; Asylum & Immigration laws, borderless Schengen agreement

▪ Trade, Transport & Competition: Single Market rules (4 freedoms of movement), subsidy control & mergers; External Trade

▪ Culture/Education: Exchange, sister cities

▪ Environmental Policy

▪ Foreign Aid: Cotonou Convention (77 countries)

The European Union

Figures on Transatlantic Economy

• EU and U.S. together account for 40% of total global trade (more than $1.5 billion in transatlantic trade every day).

• The $3 trillion EU-U.S. transatlantic economy employs 14 million workers on both sides of the Atlantic.

• In 2005, Europe accounted for roughly two-thirds of total global investment flows into the U.S. – by far the most significant source of foreign investment in the U.S. economy.

The European Union

The €uroThe euro – Europe's new single currency - represents the consolidation and culmination of European economic integration.

Its introduction on January 1, 1999, marked the final phase of Economic and Monetary Union (EMU), a three-stage process that was launched in 1990 as EU member states prepared for the 1992 single market.

With German reunification 1990, EMU presents opportunity to tie a unified Germany to the EU/EC by creating common ‘bandwidth’ of currency fluctuations & deciding which countries can take part (by 1998) (Stage 1) - single currency instead of common currency!

Jan 1, 1999 =launch of currency at $ 1.18 and ECB creation (Stage 2)

Final money intro/circulation Jan 1,2002 (Stage 3)

Results: Reduces cost of business/transaction costs, reduces exchange rate risks, but also reduces national monetary flexibility

€

€

€

The European Union

Economic Integration: Basics• Definition: The combination of several national economies into a larger

territorial unit

• It implies the elimination of economic boarders between countries.

• Economic borders: any obstacle which limits the mobility of goods services and factors of production between countries.

• All processes of economic integration include two aspects:

– Negative integration: the elimination of obstacles.

– Positive integration: harmonization, coordination of existing instruments.

The European Union

Stages of Regional Integration

Stage 1 Free Trade Area: the elimination of tariffs

• for goods and services within region (NAFTA)

Stage 2 Customs Union: Free Trade Area with a common

• external tariff (EEC)

Stage 3 Single Market/Economic Union:

• eliminating all tariff and non-tariff barriers

• Freedom of goods, services, labor and capital

• “Harmonization” of regulation

• May also have common currency (euro)

Stage 4 Political Union?

• Common Political Institutions/Constitution

The European Union

Number of regional trade agreements, 1948-2002

The European Union

MadagascarZimbabwe

Zambia

Namibia

Angola

ZaireUgandaKenya

Ethiopia

Sudan

Egypt

COMESA

The European Union

Cambodia

Philippines

Malaysia

Indonesia

Indonesia

Indonesia

Malaysia

Indonesia

Thailand

Viet Nam

Lao PDRMyanmar

ASEAN

The European Union

Argentina

Brazil

Bolivia

Peru

Venezuela

Colombia

Mexico

United States

Canada

RTAs in AmericaNAFTA (3)CARICOM (13)CACM (5)ANDEAN (5)MERCOSUR (4)

The European Union

European Economic IntegrationEstablishing a common market (EEC treaty) with four freedoms:

• Free movement of goods (Cassis-de-Dijon case, 1979).

• Free movement of persons

• Free movement of services

• Free movement of capital

The European Union

European Economic Integration1951 ECSC European Coal and Steel Community

Membership Belgium, France, Luxembourg, Netherlands, Italy & W. Germany

1957 EURATOM European Atomic Energy Community

1957 EEC European Economic Community

1967 EC European Communities; combining ECSC, EEC, and EURATOM

1973 Membership + United Kingdom, Ireland, and Denmark

1981 Membership + Greece

1986 Membership + Spain and Portugal

1990 Membership + East Germany (re-unification of West and East Germany)

1993 EU European Union

1995 Membership + Finland, Austria, and Sweden

1999 EMU Economic and Monetary Union

The European Union

Economics of Integration

Starting assumptions:

1. A country whose producers are favored, that is be subjected to preferential tariff treatment will gain economic advantages.

2. Third nations which are excluded from preferential treatment will lose.

3. Such discriminatory liberalization is both liberalization, which removes price barriers and tends to improve economic efficiency and Home welfare, and discrimination, which introduces new price barriers and thus tends to harm efficiency and welfare. (Trade creation vs. trade diversion)

The European Union

Economics of Integration

Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay.

Producer surplus is the difference between its cost and what it actually gets for the good

The European Union

Economics of Integration• If 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.

• Total Consumer surplus: A+B

The European Union

• If 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.

The European Union

The European Union

Neo-classical theory of economic integration

quantity

demand

supply

price

pC

pB

pB+tpC+t

tariff

tariff

q0 q1 q4q3

imports after customs union

imports before customs union

decrease producer surplus

net gain

increase consumer surplus

decrease government revenue

The European Union

quantity

demand

supply

price

pB

pC

pC+t

pB+ttariff

tariff

q0 q1 q4q3

imports after customs union

imports before customs union

decrease producer surplus

net gain; possible loss

increase consumer surplus

decrease government revenue

-/-

Trade diversion

The European Union

• The US is the most efficient producer (Pus)

• Before the CU:

• France imports ru from the US applying a tariff which leads to PF. T = ruhi

• CU: Germany faces no tariffs but the US does: France imports kn from Germ.

• Loss of tariff revenue and reduction of producer surplus: ruhi + PFrkPG (in favour of consumers)

• Trade creation:

• Consumption effect: umn

• Production effect: rkl

• Trade deviation: lmhi (what you don’t import from the US multiplied by PAPUS)

• Net welfare effect: rkl+umn-lmhi

The European Union

Static Benefits of Customs Union

Trade Creation:

• Replace domestic production by cheaper imports from another member of the customs union:

– Production effect: reduce inefficient local production and minimize the inefficient use of resources

– Consumption effect: increase demand since price has fallen

Trade Diversion:

• Replace imports from cheaper 3rd countries by more expensive imports from members of the customs union.

The European Union

Static Benefits of Customs Union• The customs union has a positive welfare effect if trade creation >

trade diversion. This will tend to happen when:

– The more inclusive the customs union (fewer 3rd countries)

– The higher the initial tariff eliminated by the creation of the customs union (PF-P G in the following figure)

– The smaller the difference between the price which emerges from the customs union and the price which could be had from importing from the most efficient producer who by definition is a 3rd country.

The European Union

Indirect and Dynamic Effects of Customs Union

Dynamic Effects (longer term and more difficult to measure)

• Increases productivity and thus potential growth rates due to:

1- Improvement in the allocation and utilization of resources within members

Factor mobility

– Free movement of K and L:

– More efficient allocation of resources

– Convergence of wages and capital incomes within the CM

But:

– K moves easier than L (transport and cultural costs). So not a full equalization

– Factor mobility can also lead to depressed areas within the CU

The European Union


2-Economies of scale effects

Provide conditions for optimum size production and opportunity for cost reductions

Market is enlarged, and the avarage cost of production decreases

3-Specialization according to comparative advantage

Yet a danger: increasing returns can lead to dumping and monopolies. By that, integration can reinforce imperfect competition

The application of an effective competition policy to ensure that firms do not exercise monopoly power or abuse their market power to the detriment of consumers and the efficient allocation of resources in general.

4- Increasing competition

The European Union


Minor effects:

5- Bargaining power

6- Insurance

Small countries may want to join as an insurance for both political and economic events (such as future discrimination on trade –economic- or further consolidation of politica regime –political-)

The European Union

Economic Integration: Final Remarks• National universal tariffs replaced by preferential tariff changes. This is

only a second-best outcome (after universal tariff liberalization) and creates both trade creation and trade diversions.

• RTAs in general increase welfare through trade creation, but the discriminatory nature of an RTA may make the net welfare effect negative. Net effect of CUs (trade creation-trade diversion) should be calculated.

• Different segments within the society gain or lose

• Increased popularity of Regionalism rather than Multilateralism may be bad for the world economy.

• EU is most succesful and powerful economic integration scheme; many CEE countries want to join; EU’s political decision process needs to be revised.

The European Union

Economic Integration: Final Remarks• This process causes externalities for non-members, which may seek to internalize

them by closer cooperation or even participation in it. Hence: enlargement

• Contradicts WTO regulation that countries should impose tariffs on a non-discriminatory basis

• GATT loophole: FTAs and customs unions –it was allowed because some early members wanted to preserve their preferential arrangements (British Commonwealth)

So, GATT Treaty allows preferential liberalization for CUs and FTAs

The European Union

European Single Market: History• Article 3, Treaty of Rome:

‘the elimination, as between member states, of customs duties and quantitative restrictions on the import and export of goods, and all other measures having equivalent effect; the abolition as between member states, of obstacles to freedom of movement for persons, services and capital’

• Programme to create a Common Market (CM) initially proposed in 1969

• Before: Free trade but restrictions to capital movements and mobility

The European Union

European Single Market: History• 1978: the Cassis de Dijon case

– The ECJ ruled that Germany could not ban the importing of Cassis de Dijon on the grounds that it did not conform to German rules governing the sale of alcohol

– It meant mutual recognition of each other’s rules and regulations

• 1979: the introduction of the European Monetary System (EMS): link currencies to prevent large fluctations among exchange rates

• early 1980s

– Lack of global competitiveness

– Lack of progress towards higher level of integration

• 1985 - The Commission’s White Paper “Completing the Internal Market” – contained the legislative blueprint for completing the single market by end 1992

The European Union

European Single Market: History• 1987

• The Single European Act

– to create a Single Market within the European Community by 1992

– Amended the Treaty of Rome to allow majority voting in issues of the Single Market

– Article 13:

• ‘The internal market shall comprise an area without internal frontiers in which the free movement of goods, persons, services and capital is ensured in accordance with the provision of this Treaty’

The European Union

The Single European Act (SEA)• Programme towards a larger market without frontiers

– Economic and social cohesion

– Common policy on technological/scientific development

– EMS strengthening

– Coordinated environment protection

• The elimination of cost increasing barriers between EC states:

– Physical Barriers, associated with frontier inspections;

– Technical Barriers, causing legal and regulatory obstacles;

– Fiscal Barriers, (taxes and subsidies)

New EC approach:

• ‘approximation instead of standardization’

• the removal of internal frontiers

• a binding timetable

The European Union

Expected Benefits of Integration• Cecchini report (1988). Cost saving effects:

– ‘Static trade effect’: benefits from allowing public authorities to buy from the cheapest suppliers

– ‘Competition effect’: Downward pressure on prices as a result of greater competition

– ‘Restructuring effect’: Reorganisation of industrial sectors and individual companies as a result of greater competition

Integration may turn previously segmented markets in to a single integrated market

The European Union

Expected Benefits of Integration

• The emergence of virtuous cycles of innovation and competition

• Lowering of prices for consumers

• Greater job creation

• Reduces firms monopoly power

• Inefficient firms exiting

• Allows for more products to be consumed

• Scale reduces costs of production

• Still: Large variation in average prices: for consumer goods 15.2% around mean

The European Union

Free Movements RevisitedFree Movement of Labour:

• Once labour barriers are reduced, labour will move from low to high wage countries.

• Wages in the former will tend to rise due to a reduced supply of labour, while in the latter they will tend to fall due to a rising labour supply, i.e. wage equalisation.

– But: cultural/language barriers in EU

Free Movement of Capital:

• If the rate of return on investment is higher in one country than in another, investment funds will tend to move to the latter until the rate is equalised.

– But, the capital flows can be influenced by uncertainty and different fiscal policies.

The European Union

Free Movements Revisited

Free Movement of Goods:

Before:

• Segmented markets, with prices independent across countries

• Eliminated (with limited success) policies that raise cost of entering specific market such as:

– Protectionist public procurement

– Different service regulation (banking; insurance)

– Capital controls

– Different legal frameworks

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Allocation effects revisited

• Real world

– perfect competition vs. imperfect competition

– Fact: Intra-EU trade is 70-80% intra-industry, thus not driven by comparative advantage.

We need models with imperfect competition

The European Union

_______________________________________________________ECU (billion) as % of GDP of the EC

_______________________________________________________(a) (b) (a) (b)

Barriers affecting 8 9 0.2 0.3trade (customs)

Barriers affecting 57 71 2.0 2.4production (subsidies)

Barriers affecting the 60 61 2.0 2.1reaping of economies of scale(national procurement)

SEM: Success or Failure?

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_______________________________________________________ECU (billion) as % of GDP of the EC

_______________________________________________________(a) (b) (a) (b)

Barriers which 46 46 1.6 1.6 prevent competition(subsidies, technicalspecifications)

Total benefits 171 187 5.8 6.4

Note: (a) low estimate (b) high estimatebased on Cecchini (1988) and Emerson (1988)

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GDP (%) Prices (%) Employment External Balance

(millions) (%) of GDP

+ 4.5+ 4.5 - 6.1 - 6.1 + 1.8+ 1.8 + 1.0 + 1.0

• Time scale 6 + years from full implementation of programme (1.1.93)

• Estimates subject to a margin of error +/- 30%

The European Union

SEM: Success or Failure?• Review by Commission in 2002

– Effects of SEM between 1992-2002:

• GDP: 1.8% higher (164.5bn Euro higher)

• Employment: 1.46% higher (2.5 million extra jobs)

• FDI: intra-EU 15 times increase between 1995 and 2000 (from third countries 4 times higher)

• Downward price convergence (3.6%)

• Productivity immediately after 1992: up 2%

• Cross-border procurement: increase from 6% (1987) to 10% (1998)

• Export goods price convergence (50% of all in EU)

The European Union

SEM: Success?• Improved supply-side of the EC economy:

– higher aggregate demand by increasing real purchasing power

– increased investment

– improved competitiveness of EC relative to rest of the world

• Improvements in public sector budgets:

– reduction in cost of public procurement

– growth of GDP and tax revenue

– more public expenditure and reduced unemployment through restructuring

The European Union

SEM: Failure?• Location of activities:

– Peripheral location and low productivity trap Difficult to face higher competition

• Income redistribution:

– Pressure on wages through competitionneed for extra social provisions

• Institutional setting:

– Need for policies on social issues - for even distribution of benefits

• Effects on outside world

– Positive growth versus protectionism

– New evaluation needed

• The distinction between what happened and what would be without Single Market

• Political changes: e.g. German unification

• Long term effects!?

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The European Monetary Union• An overriding desire for exchange rate stability:

– initially provided by the Bretton Woods system

– the US dollar as an anchor and the IMF as conductor

• Three attempts by the Europeans for monetary integration:

Attempt 1: the ‘Snake in the tunnel’ arrangement

Attempt 2: the European Monetary System (EMS)

Attempt 3: the Monetary Union

The European Union

The European Monetary Union: First Attempt

• Monetary union in the European Community (EC) was proposed as long ago as 1970 in the Werner Report, which envisaged it being in place by 1980.

• Adjustable fixed XR with US dollar in the centre and permitted margins for fluctuations

• Not supported by France

• However, two key developments in the international sphere derailed this first attempt:

1. The breakdown of the Bretton Woods system of fixed exchange rates in August 1971

2. The 1973 oil crisis Upper limit

Lower limit

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The European Monetary Union: Second Attempt

• The second attempt, the European Monetary System (EMS), created in 1979, proved more durable, although it too was accompanied by a number of major and minor crises.

• EMS = European Monetary System

– A EU arrangement: all EU members are part of it

– Main elements: Exchange Rate Mechanism (ERM) + ECU

• ERM = Exchange Rate Mechanism

– An agreement to fix the exchange rate

• The ECU:

– not a currency, just a unit of account

– took some life on private markets

• ERM jointly managed

– Changes in exchange rates agreed by all members

– Fluctuations between +/-2.25% and +/-15%

– Mutual support to correct exchange rates when needed

– Allows prompt realignments

– Deutschemark gradually emerged as the anchor

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ECU

The European Union


• Full capital mobility established in 1990 as part of the Single Act

– ERM in contradiction with impossible trinity unless all monetary independence relinquished.

• Bad luck:

– German unification: a big shock that called for very tight monetary policy

– the Danish referendum on the Maastricht Treaty

• A wave of speculative attacks in 1992-3:

– the Bundesbank sets limits to unlimited support

• Way out of crisis: wide band of fluctuation (±15%)

– a soft ERM on the way to monetary union

The European Union

The European Monetary Union: Third Attempt

• The Maastricht Treaty did three things to further monetary integration in Europe:

1. It set out a timetable for the establishment of monetary union.

2. It laid down the criteria by which the fitness of countries to join in monetary union would be determined.

3. It established the institutional framework for the conduct of monetary policy under EMU.

Stage One: 1990-1993

• The complete elimination of capital controls among the Member States and increased cooperation between their central banks

Stage Two: 1994-1998

• The real beginning of the transition to EMU with the establishment of the European Monetary Institute (EMI).

• EMI = precursor of the European Central Bank, charged with co-ordinating monetary policy and preparation for the single currency

Stage Three: January 1, 1999

• Eleven countries fixed their exchange rates.

• The national currencies of the eleven were replaced by the euro.

• The ECB took over responsibility for monetary policy in the euro area.

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The European Monetary Union: Third Attempt

• Denmark and the United Kingdom did not participate in the first round, having negotiated “derogations”, even though they satisfied most of the criteria.

• Likewise Sweden did not participate.

• The only country that wished to participate but failed to meet the convergence tests was Greece (joined in 2001)

• New member states need to meet euro acquis and Slovenia, Malta, Cyprus and Slovakia have now joined the EMU, too.

The European Union

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Monetary Policy under EMU• EMU fundamentally changes the way in which monetary policy is

conducted in the participating states.

• Responsibility for monetary policy shifted from national central banks to the ECB on January 1, 1999.

• Monetary union implies a choice between exchange rate stability and monetary policy autonomy

• The impossible trinity: only 2 of the following possible simultaneously:– Full capital mobility– Autonomous monetary policy– Fixed exchange rates

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Optimum Currency Areas• Benefits:

– No transaction costs, no exchange-rate uncertainty, efficiency of single currency as a unit of account and store of value

• Costs:

– Rising interdependence with other members of the union

– Loss of monetary and exchange rate instruments

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Optimum Currency Areas: Benefits of Common Currency

The euro means big changes for business both within these countries and throughout Europe:

1.Cheaper transaction costs – countries in the euro zone do not have to change currencies when doing business with each other.

2.Exchange rate certainty – sharing a single currency means countries in the euro zone are no longer affected by currency fluctuations when trading with each other.

3.Transparent prices– it is more obvious if different euro zone countries charge different prices for the same goods and services.

4.Increased cross-border competition: -Businesses who want to export into the euro zone may be at a disadvantage against competitors within the zone who share the same currency as the importer.

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Optimum Currency Areas: Benefits of Common Currency

5. Cross-border mergers and other joint ventures: Increased competition might make mergers within the euro zone more likely, and sharing the single currency may also make them easier.

6. Raising finance: Firms may have more choice since bond and equity markets may be more attractive in euros.

7. Standardization and lowering of interest rates: Induces investment in a more stable market

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Six criteria for Optimum Currency Areas

Three economic criteria:

– Labor Mobility

– Diversification

– Openness

Three political criteria:

– Fiscal risk-sharing

– Homogeneity of preferences

– Solidarity

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1. Labour mobility

2. Diversification: OCA is beneficial for countries whose production and exports are widely diversified and of similar structure. If production and exports are diversified and similar, there are few asymmetric shocks and each of them is likely to be of small concern.

3. Openness: Countries which are very open to trade and trade heavily with each other. If all goods are traded, domestic goods prices must be flexible and exchange rate does not matter for competitiveness.

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4. Fiscal Transfers: Countries that agree to compensate each other for adverse shocks form an OCA. Transfers can act as an insurance that mitigates the costs of an asymmetric shock

5. Homogeneity of Preferences: Countries that share a wide consensus on the way to deal with shocks form an OCA

Different interest groups enjoy political power in different countries

6. Solidarity: Countries that view themselves as sharing a common destiny better accept the costs of operating an OCA.

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Is EMU an optimal currency area?

• In order to answer to this question there are different parameters to evaluate:

– Intra-EU trade and openness

– Degree of asymmetry of shocks

A. Degree of Openness:

Large differences in openness of EU countries with the rest of the Union

• For countries with a small degree of openness (UK and Greece), it is less clear that they belong to an optimal currency area with the rest of the EU

• Cost-benefit analysis is likely to show net benefits of being in EMU for Benelux, and small central European countries

Belgium/Luxembourg 66,7Slovakia 58,9Czech Republic 54,1Netherlands 51,1Estonia 45,6Hungary 43,7Slovenia 37,3Ireland 34,7Lithuania 30,1Austria 28,1Latvia 24,6Denmark 23,1Poland 23,1Germany 22,0Sweden 21,2Malta 21,0Finland 19,1Portugal 16,6France 13,7Italy 12,2Spain 12,0United Kingdom 9,8Cyprus 6,1Greece 4,0

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Is EMU an optimal currency area?B. Asymmetric shocks

• Not all CE-countries may be part of an optimal currency area with the rest of the European Union

• Despite relatively large openness of the CE-countries vis a vis the EU, many are subjected to relatively large asymmetric shocks, so that it is not obvious that they would gain from entering EMU

• However, for some of these countries entering EMU might be the best possible way to import monetary and price stability

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Is EMU an optimal currency area?B. Asymmetric shocks

• If a country faces economic crisis, real exchange rate, EP/P*, must depreciate to restore competitiveness

• Either prices fall or nominal exchange rate depreciates.• If not: overproduction and unemployment

• Symmetric: Same demand shock in two similar countries that share the same currency and, therefore, exchange rate: No problem. The same real XR adjustment as before.

• Asymmetric: Only one country is affected; countries share common currency: Problem!

• Country A’s (affected one) real exchange rate must depreciate both vis-à-vis ROW and Country B

• Country A wants a depreciation.

• Country B is unhappy: depreciation would lead to excess demand and inflationary pressure.

• Common central bank considers preferences of both countries and allows partial depreciation

• Both countries affected adversely when they share the same currency

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The Maastricht Convergence Criteria1. Inflation:

not to exceed by more than 1.5 per cent the average of the three lowest rates among EU countries.

2. Long-term interest rate:

not to exceed by more than 2 per cent the average interest rate in the three lowest-inflation countries.

3. ERM membership:

at least two years in ERM without being forced to devalue.

4. Budget deficit:

deficit less than 3 per cent of GDP.

5. Public debt:

debt less than 60 per cent of GDP (or diminishing and approaching 60% at satisfactory pace)

Note: Fulfilment of criteria was observed on 1997 performance for decision in 1998.

• The convergence criteria give little regard to standard OCA arguments

• Problem No. 1:

– a few years of budgetary discipline do not guarantee long-term discipline

– excessive deficit procedure once in euro area

• Problem No. 2: deficit and debt ceilings are arbitrary

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How does the EMU work?Actors:

• National Central Banks (NCBs) continue operating but with no monetary policy function.

• A new central bank at the centre: the European Central Bank (ECB).

• The European System of Central Banks (ESCB): the ECB and all EU NCBs (N=27).

• The Eurosystem: the ECB and the NCBs of euro area member countries (N=16)

Objectives:

• fighting inflation close to 2% is the absolute priority

• supporting growth and employment comes next

Means:

Control the very short-term interest rate: European Over Night Index Average (EONIA)

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EMU: Success or Failure?

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EU Competition Policy Why? Competition and open markets put companies under continual pressure to

innovate, improve quality and keep prices low.

• Driven by Treaty of Rome (art.3)

– ..”ensuring that competition in a common market is not distorted”

Aims:

Wider consumer choice

Technological innovation

Effective price competition

These are only possible in an environment where:

Companies compete rather than collude

Dominant companies do not abuse their market power (by restricting entry)

Efficiencies are passed on to the final consumers in the form of lower prices and better products

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EU Competition Policy• Main Components of EU Competition Policy:

– Antitrust and Cartels

– Merger Control

– Market Liberalization

– State Aid Control

• Implemented through rules

– Anti-competitive behaviour & abuse of monopoly power (Articles 81 & 82 in Amsterdam Treaty)

– Merger Policy

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EU Competition Policy• EU is given exclusive competency; why?

– 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

• Note: recent ‘protectionist’ tendency of Member States to prevent foreign takeovers

– Free market v correction of market failure arguments

• Commission controls competition policy. It can

– investigate, declare restrictive agreements by companies or governments void, order parties to terminate them and impose fines and penalties up to 10 percent of the firms worldwide turnover

– ECJ has the power to confirm, cancel, reduce or increase fines and penalties or to annul Commission decisions

• Policy not consistently applied

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Article 101: Anti-Competitive Agreements

• Prohibites collusion: intra firm agreements that distort intra EU trade and prevent, restrict or distort competition as they are incompatible with the common market

• covers horizontal agreements between the firms in the same industry and vertical agreements between companies along the supply chain Horizontal vs vertical co-operation

• Explicit prohibitions include

– price fixing

– output fixing

– market sharing agreements (eg sugar cartel 1970s)

– tied contracts

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Article 101: Anti-Competitive Agreements

• Anti-Cartel instrument

– dangers of collusion and chance of cartels rise as the number of firms falls

• If Commission find against agreement

– firms usually agree to end or modify agreement

– Com. Issue formal decision

– fines upto 10% turnover of each firm

• particularly heavy for cartels

• Covers foreign firms if intra-EU trade affected

• Not all inter-company arrangements are illegal, and the Commission may create block exemptions: e.g. exclusive relationship between carmakers and their official distributors.

If Articles 101 and 102 are violated, a firm may end up paying fines amounting up to 10% of its annual turnover. The Commission imposed fines for anti-competitive behavior totaling almost $2 billion

• But: Co-operation may be beneficial in some areas such as R&D

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Article 102: Monopolies, Abuse of Dominance

• Anti-monopoly instrument

• Prohibits abuse of a dominant market position by one or more firms

• Abuses may take the form of restricting output, price discrimination, unfair pricing and using dominant position in market to limit competition in another market (e.g. Microsoft bundling Windows with Media Player )

• Relatively few cases (compared to Article 101)

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Merger Regulations• A firm may reach a dominant position by acquiring a competitor and

this may benefit consumers in the form of lower prices, better products etc. (especially when economies of scale effects lead to cost reductions).

• But the Commission may block mergers if mergers impede effective competition. Commission wants to ensure SEM gains not eroded by defensive mergers

• Firms need to get Commission approval before merging. This regulation applies to all transactions with a ‘Community dimension’, which in practice typically means those where the combine turnover of the companies exceeds 2.5 billion Euros.

• Large companies outside the EU but generating at least 100 million euros in terms of annual business in the Community are also subject to the EU merger regulation.

• Merger Regulation in force only in 1990

• Critisims: State intervention, eg national security

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Article 106: Public Procurement

• No anti-competitive behaviour in assigning public supply contracts

• Little done until late 1970s

• Reforms aimed at:

– financial transparency

– no discrimination in public procurement allocations

– Harmonization of standards

• SEM: Com. intensified policy in energy, telecommunications, transport

• Difficult to implement

– resistance from States

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Article 107: State Aid• No trade-distorting aid

– to ensure that such measures do not distort competition in the Single Market (e.g. the prohibition of a state grant designed to keep a loss-making firm in business,)

• Exceptions include key sectors like steel

• Aid must be notified by states and authorised by the Comission

• Tougher stance since SEM

• More difficult to investigate

• State aid for steel producers, the coal industry, farming and aviation-all of which are facing long-term structural problems and an uncertain future.

Presentation on the European Union Formation

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