International_Economics_Tenth_Edition (1)

preunion economies are quite competitive are likely to benefit from trade creation because the formation of the union offers greater opportunity for specialization in production. Also, the larger the size and the greater the number of nations in the union, the greater the gains are likely to be, because there is a greater possibility that the world's low-cost producers will be union members. In the extreme case in which the union consists of the entire world, there can exist only trade creation, not trade diversion. In addition, the scope for trade diversion is smaller when the customs union's common external tariff is lower rather than higher. Because a lower tariff allows greater trade to take place with nonmember nations, there will be less replacement of cheaper imports from nonmember nations by relatively high-cost imports from partner nations.

Dynamic Effects

Not all welfare consequences of a regional trading arrangement are static in nature. There may also be dynamic gains that influence member-nation growth rates over the long run. These dynamic gains stem from the creation of larger markets by the movement to freer trade under customs unions. The benefits associated with a customs union's dynamic gains may more than offset any unfavorable static effects. Dynamic gains include economies of scale, greater competition, and a stimulus of investment.

Perhaps the most noticeable result of a customs union is market enlargement. Being able to penetrate freely the domestic markets of other member nations, producers can take advantage of economies of scale that would not have occurred in smaller markets limited by trade restrictions. Larger markets may permit efficiencies attributable to greater specialization of workers and machinery, the use of the most efficient equipment, and the more complete use of by-products. There is evidence that significant economies of scale have been achieved by the EU in such products as steel, automobiles, footwear, and copper refining.

The European refrigerator industry provides an example of the dynamic effects of integration. Prior to the formation of the EU, each of the major European nations that produced refrigerators

(Germany, Italy, and France) supported a small number of manufacturers that produced primarily for the domestic market. These manufacturers had production runs of fewer than 100,000 units per year, a level too low to permit the adoption of automated equipment. Short production runs translated into high per-unit cost. The EU's formation resulted in the opening of European markets and paved the way for the adoption of large-scale production methods, including automated press lines and spot welding. By the late 1960s, the typical Italian refrigerator plant manufactured 850,000 refrigerators annually. This volume was more than sufficient to meet the minimum efficient scale of operation, estimated to be 800,000 units per year. The late 1960s also saw German and French manufacturers averaging 570,000 units and 290,000 units per year, respectively,'

Broader markets may also promote greater competition among producers within a customs union. It is often felt that trade restrictions promote monopoly power, whereby a small number of companies dominate a domestic market. Such companies may prefer to lead a quiet life, forming agreements not to compete on the basis of price. But with the movement to more open markets under a customs union, the potential for successful collusion is lessened as the number of competitors expands. With freer trade, domestic producers must compete or face the possibility of financial bankruptcy. To survive in expanded and more competitive markets, producers must undertake investments in new equipment, technologies, and product lines. This will have the effect of holding down costs and permitting expanded levels of output. Capital investment may also rise if nonmember nations decide to establish subsidiary operations inside the customs unions to avoid external tariff barriers.

I European Union

In the years immediately after World War II, the countries of Western Europe suffered balance-of- payments deficits in response to reconstruction

<Nicholas Owen, Economies ('.fScale, Competitiveness, and Trade Patterns within the European Community (New York: Oxford University Press.

1983). pp. 119-139.

260 Regional Trading Arrangements

efforts. To shield its firms and workers from external competitive pressures, they initiated an elaborate network of tariff and exchange restrictions, quantitative controls, and state trading. In the 1950s, however, these trade barriers were generally viewed to be counterproductive. Therefore, Western Europe began to dismantle its trade barriers in response to successful tariff negotiations under the auspices of GATT.

It was against this background of trade liberalization that the European Union (EU), then known as the European Community, was created by the Treaty of Rome in 1957. The EU initially consisted of six nations: Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany. By 1973, the United Kingdom, Ireland, and Denmark had joined the trade bloc. Greece joined the trade bloc 1981, followed by Spain and Portugal in 1987. In 1995, Austria, Finland, and Sweden were admitted into the Ell. In 2004,10 other Central and Eastern European countries joined the EU: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia. This brought the membership of the EU up to 25 countries. Two others, Bulgaria and Romania, hope to join the EU by 2007. The EU views the enlargement process as an opportunity to promote stability in Europe and further the integration of the continent by peaceful means.

EU expansion will produce both winners and losers. Most studies agree that Germany, Italy, Austria, Sweden, and Finland, who have close trade and investment ties with Central and Eastern European nations, will be gainers. France, Spain, Portugal, Greece, and Ireland are likely to be losers, given the sizable funding they receive from EU programsespecially France's agricultural funds-as the money gets stretched over more countries. Clearly, the Central and Eastern European nations stand to the gain the most as their economies become integrated with other European economies.

Pursuing Economic Integration

According to the Treaty of Rome of 1957, the EU agreed in principle to follow the path of economic integration and eventually become an economic union. In pursuing this goal, members of the EU first dismantled tariffs and established a free-trade

area by 1968. This liberalization of trade was accompanied by a fivefold increase in the value of industrial trade-higher than world trade, in general. The success of the free-trade area inspired the EU to continue its process of economic integration. In 1970, the EU became a full-fledged customs union when it adopted a common external tariff system for its members.

Several studies have been conducted on the overall impact of the EU on its members' welfare during the 1960s and 1970s. In terms of static welfare benefits, one study concluded that trade creation was pronounced in machinery, transportation equipment, chemicals, and fuels, whereas trade diversion was apparent in agricultural commodities and raw materials.' The broad conclusion can be drawn that trade creation in the manufacturedgoods sector during the 1960s and 1970s was significant: 10 percent to 30 percent of total EU imports of manufactured goods. Moreover, trade creation exceeded trade diversion by a wide margin, estimated at 2 percent to 15 percent. In addition, analysts also noted that the EU realized dynamic benefits from integration in the form of additional competition and investment and also economies of scale. For instance, it has been determined that many firms in small nations, such as the Netherlands and Belgium, realized economies of scale by producing both for the domestic market and for export. However, after becoming members of the EU, sizable additional economies of scale were gained by individual firms, reducing the range of products manufactured and increasing the output of the remaining products.'

After forming a customs union, the EU made little progress toward becoming a common market until 1985. The hostile economic climate (recession and inflation) of the 1970s led EU members to shield their people from external forces rather than dismantle trade and investment restrictions. By the 1980s, however, EU members were increasingly frustrated with barriers that hindered transactions

'Mordechai E. Kreinin, Trude Relations o[the EEe. An EmpiricalApproach

(New York: Praeger, 1974), Chapter 3.

'Richard Harmsen and Michael Leidy, "Regional Trading Arrangements," in International Trade Policies: The Uruguay Round and Beyond, Volume II, International Monetary Fund, World Economic and Financial Surveys, ] 994, p. 99.

within the bloc. European officials also feared that the EU's competitiveness was lagging behind that of Japan and the United States.

In 1985, the EU announced a detailed program for becoming a common market. This resulted in the elimination of remaining nontariff trade barriers to intra-EU transactions by 1992. Examples of these barriers included border controls and customs red tape, divergent standards and technical regulations, conflicting businesslaws, and protectionist procurement policies of governments. The elimination of these barriers resulted in the formation of a European common market and turned the trade bloc into the second largest economy in the world, almost as large as the U.S. economy.

While the EU was becoming a common market, its heads of government agreed to pursue much deeper levels of integration. Their goal was to begin a process of replacing their central banks with a European Central Bank and replacing their national currencies with a single European currency. The Maastricht Treaty, signed in 1991, set 2002 as the date at which this process would be complete. In 2002, a full-fledged European Monetary Union (EMU) emerged with a single currency, known as the euro.

When the Maastricht Treaty was signed, economic conditions in the various EU members differed substantially. The treaty specified that to be considered ready for monetary union, a country's economic performance would have to be similar to the performance of other members. Countries cannot, of course, pursue different rates of money growth, have different rates of economic growth, and different rates of inflation while having currencies that don't move up or down relative to each other. So the first thing the Europeans had to do was align their economic and monetary policies.

This effort, called convergence, has led to a high degree of uniformity in terms of price inflation, money supply growth, and other key economic factors. The specific convergence criteria as mandated by the Maastricht Treaty are as follows:

•Price stability. Inflation in each prospective member is supposed to be no more than 1.5 percent above the average of the inflation rates in the three countries with lowest inflation rates.

•Low long-term interest rates. Long-term interest rates are to be no more than 2 percent above the average interest rate in those countries.

•Stable exchange rates. The exchange rate is supposed to have been kept within the target bands of the monetary union with no devaluations for at least two years prior to joining the monetary union.

•Sound public finances. One fiscal criterion is that the budget deficit in a prospective member should be at most 3 percent of GDP; the other is that the outstanding amount of government debt should be no more than 60 percent of a year's GDP.

In 1999, 11 of the ED's 15 members fulfilled the economic tests as mandated by the Maastricht Treaty and became the founding members of the European Monetary Union (EMU). These countries included Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, and Finland. In 2001, Greece became the twelfth country to join the EMU.

Recall that in 2004, 10 countries joined the European Union: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia. They are thus obligated to join the EMU and adopt the euro as their national currency. Membership in EMU is not automatic, however, because the accession countries must first satisfy the convergence criteria as mandated by the Maastricht Treaty. However, the candidates see the convergence criteria as a small price to pay for the exchange-rate stability and the low interest rates that come with full entry into the monetary union.

An important motivation for EMU was the momentum it provides for political union, a longstanding goal of many European policy makers. France and Germany took the initiative toward EMU. Monetary union was viewed as an important way to anchor Germany securely in Europe. Moreover, it provided the French a larger role in determining monetary policy for Europe, which they would achieve with a common central bank. Prior to EMU, Europe's monetary policy was mainly determined by the German Bundesbank.

262 Regional Trading Arrangements

The EMU Presents Different ~-fz

Faces to Portugal and Sweden

The year 1999 marked the advent of the historic EMU. European economies had to meet strict monetary and fiscal criteria before joining. Although Portugal and Sweden both met these criteria, only Portugal decided to exercise its option to become a member of the EMU. Consider the differing views of the two countries.'

In Lisbon, businessman Jorge Cruz Morais explains why Portugal supports the European Monetary Union. "We have to be in the first boat," he says. "If monetary union started without us, we'd fall off the map." In Stockholm, however, economist Roland Spant explains why Sweden shouldn't participate. "It is a giant step into the unknown," he says. "It's like jumping from the Empire State Building and inventing the parachute on the way down."

Situated at the opposite extremes of Europe, the countries of Portugal and Sweden were at the opposite ends of the debate over the EMU prior to its inception in 1999. Portugal wanted to be part of the common currency; Sweden wan~ed to stay out. Indeed, depending on whose eyes It was viewed through, EMU either meant Europe's boldest postwar move toward closer units or a major gamble with clear advantages but also significant risks.

It is easy to understand Portugal's preference for further European integration. Until its dictatorship disintegrated in the early 1970s, Portugal was long ostracized by Europe, and it looked for a place in the world. When Portugal joined the European Union in the 1980s, the move was not motivated only by economics: It was also an attempt to gain respectability. By the 1990s, Portugal feared that exclusion from the EMU would cause it to be an outsider once again. Another reason for membership was that prior to 1999, Portugal received a significant portion of funds paid to the European Union by member nations for infrastructure and other projects, far more than it paid in. Also, Portugal's exports to fulfill the strict monetary and fiscal criteria to qualify for the euro brought interest rates down sharply in

'Drawn from "A Tale of Two Nations Shows Europe's Union Has Differing Sides," The WallStreet Journal, July 29, 1997, pp. Al and A2.

the 1990s. This produced a boom rather than the pain felt in other European countries, and Portugal looked to EMU to lock in fiscal discipline.

On the downside, some business leaders felt that Portuguese industry was not fully prepared for the post-EMU onslaught of competition. Although Portugal had relatively low labor costs in 1997, they could boomerang into a big risk: A common currency could unleash a wave of demands by Portuguese workers for wages that would eq~al average European wages. However, the productivity of the average Portuguese was half that of the average German worker. Higher wages would thus result in relatively higher production costs for many Portuguese firms and a loss of competitiveness.

Although Sweden qualified for the common currency with flying colors, it decided not to join. The reason lay partly in Sweden's historic preference for neutrality with regard to the rest of Europe. Also, Sweden's decision to join the European Union in 1995 coincided with budgetary reductions that hurt the country's welfare state. Many Swedes thus associated the European Union with hardship and felt that monetary union could only make things worse by increasing pressure for tax harmonization, thus making it more difficult to finance welfare programs.

Moreover, Swedes maintained that by linking itself into a common currency, Sweden could no longer use a floating exchange to compensate for its high wage costs-and with a jobless rate of more than 12 percent, this might further increase unemployment. Finally, Swedish business leaders felt that such key domestic industries as mining, paper, and pulp were more sensitive to the dollar than to European currencies, so Sweden needed to retain monetary sovereignty to be able to react to events across the Atlantic ocean.

Most important, Swedes argued that Europe simply was not prepared for a monetary union. They contended that Europe, unlike the United States, was not a homogeneous market: Its economic structures and cycles were too different to justify tying the countries into a rigid arrangement. Put simply, it was not workable to have 15 governments and one central bank. If Italy has 6 percent inflation and Germany 1 percent, what should the European Central Bank do?

Indeed, both Portugal and Sweden had good reasons to join the EMU, and good reasons not to join. Their decisions involved balancing things that could not be measured as well as broad political goals. Later in this chapter, we will consider the economic costs and benefits of a common currency as applied to the European Monetary Union. .

Agricultural Policy s'V'{(

Besides providing for free trade in industrial goods among its members, the EU has abolished restrictions on agricultural products traded internally. A common agricultural policy has replaced the agricultural-stabilization policies of individual member nations, which differed widely before the formation of the ED. A substantial element of the common agricultural policy has been the support of prices received by farmers for their produce. Schemesinvolving deficiencypayments, output controls, and direct income payments have been used for this purpose. In addition, the common agricultural policy has supported EU farm prices through a system of variable levies, which applies tariffs to agricultural imports entering the ED. Exports of any surplus quantities of EU produce have been assured through the adoption of export subsidies.

One problem confronting the ED's price-support programs is that agricultural efficiencies differ among EU members. Consider the case of grains. German farmers, being high-cost producers, have sought high support prices to maintain their existence. The more efficient French farmers do not need as high a level of support prices as the Germans do to keep them in operation; nevertheless, French farmers have found it in their interest to lobby for high price supports. In recent years, high price supports have been applied to products such as beef, grains, and butter. The common agricultural policy has thus encouraged inefficient farm production by EU farmers and has restricted food imports from more efficient nonmember producers. Such trade diversion has been a welfaredecreasing effect of the ED.

Variable Levy

Figure 8.2 on page 264 illustrates the operation of a system of variable levies and export subsidies. Assume that SEUo and DEUo represent the EU's sup-

encourage imports. EU consumers would be protected against rising wheat prices.

The variable import levy tends to be more restrictive than a fixed tariff. It discourages foreign producers from absorbing part of the tariff and cutting prices to maintain export sales. This would only trigger higher variable levies. For the same reason, variable levies discourage foreign producers from subsidizing their exports in order to penetrate domestic markets

The completion of the Uruguay Round of trade negotiations in 1994 brought rules to bear on the use of variable levies. It required that all nontariff barriers, including variable levies, be converted to equivalent tariffs. However, the method of conversion used by the EU essentially maintained the variable levy system, except for one difference. The actual tariff applied on agricultural imports can vary, like the previous variable levy, depending on world prices. However, there is now an upper limit applied to how high the tariff can rise.

Export Subsidy

The EU has also used a system of export subsidies to ensure that any surplus agricultural output will be sold overseas. The high price supports of the common agricultural policy have given EU farmers the incentive to increase production, often in surplus quantities. But the world price of agricultural commodities has generally been below the EU price. The EU pays its producers export subsidies so they can sell surplus produce abroad at the low price but still receive the higher, international support price.

In Figure 8.2(b), let the world price of wheat be $3.50 per bushel. Suppose that improving technologies result in a shift in the EU supply schedule from SEUo to SED j ' At the internal support price, $4.50, EU production exceeds EU consumption by 2 million bushels. To facilitate the export of this surplus output, the EU provides its producers an export subsidy of $1 per bushel. EU

wheat would be exported at a price of $3.50, and EU producers would receive a price (including the subsidy) of $4.50. The EU export subsidies are also characterized by a sliding scale. Should the world price of wheat fall to $2.50, the $4.50 support price would be maintained through the imposition of a $2 export subsidy.

The EU'spolicy of assuring a high level of income for its farmers has been costly. Highsupport prices for products including milk, butter, cheese, and meat have led to high internal production and low consumption. The result has often been huge surpluses that must be purchased by the EU to defend the support price. To reduce these costs, the EU has sold surplus produce in world markets at prices well below the cost of acquisition. These subsidized sales have met with resistance from farmers in other countries.

Virtually every industrial country subsidizes its agricultural products. As seen in Table 8.1, gov-

Government Support for Agriculture, 2001

'The producer-subsidy equivalent represents the total assistance to farmers in the form of market price support, direct payments, and transfers that indirectly benefit farmers.

Source: Organization of Economic Cooperation and Development

(OEeD), Agricultural Polides in OECDCountries: Monitoring and Evaluation, 2003. See also World Trade Organization, Annual Report, 2003.

ernment programs accounted for 35 percent of the value of agricultural products in the EU in 2001. This amount is even higher in certain countries such as Japan, but it is much lower in others, including the United States, Australia, and New Zealand. Countries with relatively low agricultural subsidies have criticized the high-subsidy countries as being too protectionist.

Government Procurement

Policies

Another sensitive issue confronting the EU has been government procurement policies. Governments are major purchasers of goods and services, ranging from off-the-shelf items such as paper and pencils to major projects such as nuclear power facilities and defensesystems. Government procurement has been used by EU nations to support national and regional firms and industries for several reasons: (1) national security (for example, aerospace); (2) compensation for local communities near environmentally damaging public industries (such as nuclear fuels); (3) support for emerging high-tech industries (for example, lasers); and (4) politics (as in assistance to highly visible industries, such as automobiles).

some 350,000 additional jobs have been created. The price savings from open competition (trade and competition effects) are estimated at 40 to 50 percent for pharmaceuticals in Germany and the United Kingdom; 60 to 70 percent for telecommunications equipment in Germany and Belgium; and about 10 percent for automobiles in the United Kingdom and Italy. In sectors where companies were too small to compete internationally, additional savings arose from mergers that resulted in a smaller number of EU companies able to exploit economies of scale. Examples included electric locomotives, turbine generators, and boilers, where decreases in units of costs of 12 to 20 percent were possible."

'European Union, Public Procurement: Regional and Social Aspects

(Brussels: Commission of the European Communities. July (989). See also Keith Hartley. "Public Purchasing," in D. Gowland and S. James. eds .. Economic Policy After 1992 (Brookfield. VT: Dartmouth Publishing Co. 1991), pp. 114-125.

Economic Costs and

Benefits of a Common

Currency: The European

Monetary Union

As we have learned, the formation of the EMU in 1999 resulted in the creation of a single currency (the euro) and a European Central Bank. Switching to a new currency is extremely difficult. Just imagine the task if each of the 50 U.S. states had its own currency and its own central bank, and then had to agree with the other 49 states on a single currency and a single financial system. That's exactly what the Europeans have done.

The European Central Bank is located in Frankfurt, Germany, and is responsible for the monetary policy and exchange-rate policy of the EMU. The European Central Bank alone controls the supply of euros, sets the short-term euro interest rate,

1II1l!I111II11II1III1II1

The year 2000 was a momentous one in Europe because it marked the introduction of euro notes and coins into the member economies of the European Monetary Union. What are the characteristics of the euro?

The sign for the new single currency looks likes an E with two horizontal parallel lines across it. It was inspired by the Greek letter epsilon, in reference to the cradle of European civilization and to the first letter of the word "Europe." The parallel lines represent the stability of the euro.

What do euro notes look like? Referring to the above euro note, the designs of euro notes are symbolic and closely related to the historical phases that make up Europe'sarchitectural heritage. Windows and gateways dominate the front side of each banknote as symbols of the spirit of openness and cooperation in the EU. The reverse side of each banknote features a bridge from a particular age, a metaphor for communication among the people of Europe and between Europe and the rest of the world.

Like u.s. currency, euro notes and coinscome in a variety of denominations. There are 7 euro notes

'.

and 8 euro coins. The denominations of the notes range from 500to 5 euro, and the coins range from 2 euro to 1 euro cent. Vending machines and other coinor note-operated automatic machinesin the participating member countries have been adapted for usewith euro notes and coins.

According to the schedule for the changeover to the euro, in 2002 euro notes and coins replaced notes and coins in national currencies, which were withdrawn from circulation. Since then, the national currency is no longer valid for everyday use, but people can exchange their old banknotes for euro banknotes at the national central banks. Also, asof 2002 old national currency units can no longer be used in written form such as checks, contracts, and pay slips.

Why did it take from 1999, when the euro was adopted, to 2002 for the actual introduction of the euro notes and coins? Mainly because it took that long to print and mint them. After all, we are talking about 14.5 billion banknotes and 50 billion coins.

and maintains permanently fixed exchange rates for the member countries. With a common central bank, the central bank of each participating nation performs operations similar to those of the 12 regional Federal Reserve Banks in the United States.

or Burger King anywhere in the United States and

Regional Trading Arrangements

purchase hamburgers with the dollar bills in their purses and wallets. The same was not true in European countries prior to the formation of the EMU. Because each was a distinct nation with its own currency, a French person could not buy something at a German store without first exchanging his French francs for German marks. This would be like someone from St. Louis having to exchange her Missouri currency for lllinois currency each time she visits Chicago. To make matters worse, because marks and francs floated against each other within a range, the number of marks the French traveler receives today would probably differ from the number he would have received yesterday or tomorrow. On top of exchange-rate uncertainty,the traveler also had to pay a fee to exchange the currency, making a trip across the border a costly proposition indeed. Although the costs to individuals can be limited because of the small quantities of money involved, firms can incur much larger costs. By replacing the various European currencies with a single currency, the euro, the EMU can avoid such costs. Simplyput, the euro will lower the costs of goods and services, facilitate a comparison of prices within the EU, and thus promote more uniform prices.

Optimum Currency Area

Much of the analysis of the benefits and costs of a common currency is based on the theory of optimum currency areas.' An optimum currency area

'The theory of "optimum currency areas" was first analyzed by Raben Mundell. who won the 1999 Nobel Prize in Economics. See Raben Mundell."A Theory of Optimum Currency Areas," American Economic Review. Vol. 5I. September 1961. pp. 717-725.

is a region in which it is economically preferable to have a single official currency rather than multiple official currencies. For example, the United States can be considered an optimal currency area. It is inconceivable that the current volume of commerce among the 50 states would occur as efficiently in a monetary environment of 50 different currencies. Table 8.2 highlights some of the advantages and disadvantages of forming a common currency area.

According to the theory of optimum currency areas, there are gains to be had from sharing a currency across countries' boundaries. These gains include more uniform prices, lower transaction costs, greater certainty for investors, and enhanced competition. Also, a single monetary policy, run by an independent central bank, should promote price sta bility.

However, a single policy can also entail costs, especially if interest-rate changes affect different economies in different ways. Also, the broader benefits of a single currency must be compared against the loss of two policy instruments: an independent monetary policy and the option of changing the exchange rate. Losing these is particularly acute if a country or region is likely to suffer from economic disturbances (recession) that affect it differently from the rest of the single-currencyarea, because it will no longer be able to respond by adopting a more expansionary monetary policy or adjusting its currency.

Optimum currency theory then considers various reactions to economic shocks, noting three. The first is the mobility of labor: Workers in the affected country must be able and willing to move

The risks associated with exchange fluctuations are eliminated within a common currency area.

Costs of currency conversion are lessened.

The economies are insulated from monetary disturbances and speculation.

Political pressures for trade protection are reduced .

Absence of individual domestic monetary policy to counter macroeconomic shocks.

Inability of an individual country to use inflation to reduce public debt in real terms.

The transition from individual currencies to a single currency could lead to speculative attacks.