Chapter 4: Economics of European Integration

Basics of Economic Integration

The world economy has been witnessing a remarkable increase within the economic integration since the establishment of the EC in the 1950s. Upon the successful implementations achieved by the EU, various countries from different geographies have attempted new economic integration initiatives. This increase within the establishment of economic integrations has gained a new impetus in 2000s upon the weaknesses of the multilateral trading system. The success of European economic integration under the auspicious of the EU and the apparent increase within the establishment of economic integrations justifies a detailed examination of the theory.

Not all the initiatives have eventuated with a successful and efficient integration. The probable reasons of the failures of the economic integration initiatives might be as follows:

1. High-dependence on trade with the countries that are outside the economic integration,
2. A small domestic market that is far from supporting a higher degree of industrialization and economies of scale,
3. High transportation costs and weak international relations,
4. Addiction to a central planning system, once experienced by CMEA (Council for Mutual Economic Assistance) of the ex- Soviet countries (Jovanovic, 2006, 156).

Stages/Types of Economic Integration

Preferential trade agreement that is at the bottom of the economic integration pyramid constitutes the basic form of economic integration. In other words, it refers to the first stage of economic integration. At the preferential trade agreement, the policies that require common decisions and implementations of the participant countries are minimum. The basic aim within a preferential trade agreement is to enhance international trade among the participant countries in certain industries. In this respect, countries lower the tariffs and restrict the implementation of the non-tariff restrictions on the related industries. Countries might decide to proceed their economic integration initiative if they succeed to liberalize international trade within the scope of the preferential trade agreement. Since it does not require common trade accords except for the related industries, preferential trade agreements are the most preferred type of economic integration.

Free trade area is the next stage within the economic integration. The member countries are entitled to abolish all trade restrictions among themselves but continue to implement their own trade policies toward the countries that are out of the free trade area. In other words, member countries of a free trade area are free to implement their national external trade policy to the third countries .

The third stage/type of economic integration is customs union. Member countries of a customs union abolish all the trade restrictions among themselves and implement a common external trade policy in the third countries. Moreover, the customs union member countries act together as a single entity at the negotiation and conclude the trade agreements with the other countries (third countries). The implementation of the common external tariff avoids the possibility of trade deflection or transshipment. Certainly, it is one step further through a deeper integration. Member countries leave their independence in deciding and implementing their own tariff rates.

The fourth stage/type of economic integration is common market. All the trade restrictions are abolished among the member countries. In addition to the free movement of goods, free movement of services, labor and capital are also achieved. In other words, there are four freedoms within a common market. There is no doubt that common market is a higher level of economic integration. Member countries give up their sovereignty in most of the economic policies related to the four freedoms. Common market also requires additional common economic policies that help to the wellfunctioning of the economic integration, such as common competition policy, common indirect taxation policy, common consumer policy, common environmental policy, common e-commerce policy, etc.

The last stage/type of the economic integration process is the economic and monetary union. Certainly, it is the most comprehensive type of economic integration. Economic and monetary union encompasses all the features of the common market and goes further to unify all the economic institutions. The fiscal policy that is one of the main instruments of the economy policy is managed by a common hand on behalf of the member countries. The other main instrument of the economy policy, the monetary policy is managed by a common central bank, leading to the adoption of a common currency. Definitely, it is quite hard to reach this last stage of economic integration because member countries are usually not very enthusiastic about waiving their sovereignty in national currency. Furthermore, pursuing a common fiscal policy may not fit to the necessities of the member countries that are not homogeneous in economic terms.

Theory of Customs Union and the European Union

Theory of Customs Union

Theory of customs union analyzes the welfare effects of customs union. The welfare effects of customs union are introduced by Jacob Viner in 1950. Viner in his book, titled The Customs Union Issue, examines the static effects of customs union . After Viner, the theory of economic integration has been evolved by taking the long run effects of the customs union into consideration t in particular and economic integrations in general. The long run effects that have been developed upon the static effects are referred to dynamic effects of customs union.

Static Effects of Customs Union

Static effects of customs union are the effects that occur at the time of the establishment of the customs union. Static effects of customs union are called trade creation and trade diversion. Trade creation takes place when customs union leads to a shift in commodity from a high cost domestic producer to the lowest cost customs union member country. In this case, economic efficiency will rise due to the best allocation of resources. Thus, welfare will increase in the commodity market that is subject to examination. On the other hand, trade diversion takes place when customs union leads to a shift in commodity from the lowest cost third country to the relatively higher cost customs union member country.

Essentially, the static effects of a customs union are derived by virtue of the five different economic effects. These effects are production effect, consumption effect, trade effect, revenue effect and distribution of income effect. These five different effects emanate from the increase in consumer surplus.

Dynamic Effects of Customs Union

Dynamic effects are long run effects of customs union. They arise due to increased competition within the customs union, higher level of technology, economies of scale, induce to foreign direct investments and better allocation of economic resources:

1. Increased competition: Before the establishment of the customs union, producers may enjoy the protection behind the trade restrictions. Along with the establishment of the customs union, trade restrictions among the member countries are abolished. Thus, producers have to be more efficient so as to compete with the identical commodities of the other member countries. Due to the increased competition, costs of production will be decreased, leading to a decrease in prices. Consumers will enjoy the lower prices that were the outcomes of increased competition.
2. Higher level of technology: Increased competition will lead to some search of higher level of technology. Since producers would like to rise efficiency in order to meet the increased competition, they would demand higher level of technology within their production. Thus, customs union would stimulate the improvement and utilization of new technologies. At the end, consumers will be better off with decreased prices.
3. Economies of scale: It may result from the enlarged market effect of the customs union. A country that enters into a customs union will begin to produce for the customs union market that is larger than its domestic market. Increased amount of production will lead to economies of scale that will lower the costs and also prices. Like in the previous dynamic effects, consumers will be better off from the economies of scale.
4. Induce to foreign direct investments: Enlarged market that is formed along with the customs union may attract the attention of potential investors. Those investors who would like to meet the advantages of increased competition and economies of scale will invest within the customs union member countries. Increased foreign direct investments will also help to the adjustment of balance of payments deficits of the member countries, if any.
5. Better allocation of economic resources: In a customs union, member countries produce the commodities or services in which they have a comparative advantage. Specialization that arises from comparative advantage will lead to better allocation of economic resources. Not only the member countries but also the world will be better off with the adequate allocation of economic resources that are limited (Salvatore, 2007, pp. 346-347).

Customs Union of the European

Union The establishment of European integration under the auspices of the EU was met within the midst of a very favorable period of economic growth in the previous century. Yet, the customs union of the EU was not achieved immediately after the Treaty of Rome. Although some import tariffs were cut by 1 January 1959, a transitional stage was anticipated so as to abolish them all. Despite the pessimistic anticipations, the customs union of the EU was established in 1968, eighteen months ahead of the schedule.

However, abolishment of the tariffs within the scope of the customs union did not remove all trade restrictions among the founding member countries. Since the EU customs union had mostly covered industrial commodities, member countries had continued to implement trade restrictions on agricultural commodities and services. Due to the trade restrictions in services among the member countries, doing business in banking, finance and insurance sectors were still very troublesome in 1970s and even in the first half of the 1980s. Progress within financial integration was discrete, uneven and simply modest (Micossi, 1988, 217).

Yet, full liberalization of trade on industrial commodities was not fully achieved. In spite of a progressive abolishment of the tariffs, the non-tariff restrictions were still constituting a significant barrier on the free movement of the commodities among the member countries. Essentially, it was one of the main concerns of the 1992 Single Market Program of the EU.

Theory of Common Market and the European Union

The theory of common market is certainly an extended version of the theory of customs union. Due to the free movement of labor and capital within the common market, the economic effects of customs union are enriched.

Theory of Common Market

The theory of common market analyzes how the member countries are affected economically from the establishment of a common market. Certainly, welfare is increased with a more efficient allocation of resources from the less productive and efficient geographies to the higher among the member countries of the common market. The reason of the welfare increase within the common market is not just the free movement of factors of production and thus the better allocation of the resources but also the non-discrimination principle.

Economic Effects of Full Capital Mobility within a Common Market

Economic effects of full capital mobility within a common market are analyzed by the basic one commodity, two factors of production and two countries model. It is assumed that the Factor-Price Equalization Theorem does not hold within the model. If the Factor-Price Equalization Theorem prevails, then there will not be any incentive for the factor mobility within a common market.

Economic Effects of Full Labor Mobility within a Common Market

Economic effects of full labor mobility within a common market is akin to the economic effects of full capital mobility. In order to examine the economic effects of full labor mobility, we continue to assume that country A which is a capital-abundant country and country B which is the labor-abundant country establish a common market, referred to AB Common Market.

Common Market of the European Union

The construction of a big European market was one of the main driving forces of the founding fathers of the EU. They had known the importance of coming together and trading and working altogether while constituting a more efficient, creative, richer and fairer European society.

The EU Common Market, the EU Single Market, the EU Internal Market: the changes within the name over the years reflect the dual prospect of both deepening and enriching of the large European market. It is deepened upon the framework of four freedoms, the free movement of goods, services, labor and capital while it is enriched with the single currency, the Euro and the cohesion policy which ensures that all the European citizens can benefit from and contribute to the prosperity.

Theory of Economic and Monetary Union and the European Union

The theory of economic and monetary union is evidently composed of two parts, the theory of economic union and the theory of monetary union.

Theory of Monetary Union

The monetary union simply refers to the adoption of a common currency by the member countries within the economic integration. Nevertheless, the achievement of it requires a deep enthusiasm and consistency since it induces costs along with numerous benefits both to the member countries and to the economic integration as a whole.

Requirements of Monetary Union

Monetary union has three substantial characteristics: (1) exchange rates within the monetary union must be irrevocably fixed to each other, (2) there must be full convertibility on either currency or capital transactions, (3) a single currency has to replace national currencies.

Costs, Benefits and Optimality of Monetary Union

Essentially, the theory of monetary union rests on the cost and benefit analysis as well as the optimality of monetary union.

Costs and Benefits of Monetary Union: As briefly mentioned before, monetary union limits the national autonomy of member countries in implementing their monetary policy which is one of the main macroeconomic policy instruments. In this respect, monetary union goes beyond a customs union or a common market. Next to the economic costs due to loss of national control and implementation of monetary policy, monetary union is directly related with the concept of national sovereignty.

Optimality of Monetary Union: Traditional approach is frequently used in determining eligibility of a country for entering into a monetary union. In other words, this approach queries whether a country has to participate within a monetary union or has to maintain its national currency. Such a query discloses the optimality of monetary union for prospective participants. Optimality requires that the adoption of a single currency should neither reduce or impede the ability of member countries to adjust economic shocks nor raise their vulnerability to current or future shocks.

Theory of Economic Union

There are two main macroeconomic policy instruments, which are monetary policy instruments and fiscal policy instruments that affect total expenditure of an economy.. The monetary union deals with common implementation of monetary policy instruments by the single monetary authority, the single central bank on behalf of member countries. In addition to the completion of monetary union, economic union refers to common implementation of fiscal policy instruments by the single fiscal authority. In other words, the theory of economic union is closely related with fiscal federalism.

Economic and Monetary Union of the European Union

Monetary Union of the European Union

After a long period of comprehensive preparations and historical achievements based on EMS-1, monetary union of the EU was achieved by the Maastricht Treaty of 1992. The Maastricht Treaty has embraced a broader approach to the monetary union embodying the economic union dimension within the scope. Thus, the EU has been introduced with the aim of establishing an Economic and Monetary Union (EMU) as a whole.

The Maastricht Treaty defined conditions for the member countries to enter the EMU. These conditions which are referred as Maastricht Convergence Criteria are about inflation, long-term nominal interest rate, budget deficit, public debt and EMS membership.

History of Monetary Union of the European Union: Monetary union of the EU rests on the European Monetary System (EMS). It is a bridge between the Bretton-Woods System in which there is the US dollar in the center and the monetary union. In this respect, it is the entry point for the monetary union for the new member countries. The decision to establish a monetary union is not a new initiative for the EU. It was taken in 1978 upon the monetary disorders that had pursuit the end of the Bretton Woods System and impossibility to maintain the system of Snake in the Tunnel.

Economic Union of the European Union

As discussed before, economic union is directly related with fiscal integration. As long as the member countries of EMU go through the further stages of fiscal integration, they approach to constitute an economic union.

The initial status of the EMU’s fiscal framework within the Maastricht Treaty was based upon the view that each member country has to be responsible from its fiscal policy. The main aim of the common fiscal framework was to address the deficit at the national level since the single currency, the Euro was expected to overcome the probable negative spillovers. Monetary policy was considered as the main instrument to manage the business cycle within the Eurozone and discretionary fiscal policy.