THE ECONOMICS OF EUROPEAN INTEGRATION

THE ECONOMICS OF EUROPEAN INTEGRATION

Fundamental Concepts

A. Purpose and progress of economic integration

The expression 'economic integration' covers a variety of notions. It may refer to the absorption of a company in a larger concern. It may have a spatial aspect, for instance if it refers to the integration of regional economies in a national one. In case of EU, economic integration is always used with respect to international economic relations, to indicate the combination of the economies of several sovereign states in one entity.

Economic integration is not an objective in itself, but serves higher objectives. The immediate, economic, objective is to raise the prosperity of all cooperating units. The farther-reaching objective is one of peace policy; namely, to lessen the chance of armed conflicts among partners. Polacheck (1980), using data for 30 countries in the 1958-1967 period, showed that doubling the trade between two countries leads to a 20 per cent decline in the frequency of hostilities.

Used in a static sense, 'economic integration' represents a situation in which the national components of a larger economy are no longer separated by economic frontiers but function together as an entity. Used in a dynamic sense it indicates the gradual elimination of economic frontiers among member states (that is to say, the abolition of national discrimination), with the formerly separate national economic entities gradually merging into a larger whole. Of course, the static meaning of the expression will apply in full once the integration process has passed through its stages and reached its object.

Objects of integration

Economic integration is basically the integration of markets. Economists make a distinction between markets of goods and services on the one hand, and markets of production factors (labour, capital, entrepreneurship) on the other.

Free movement of goods and services is the basic principle of economic integration. As is well known from classical international trade theory the free exchange of goods promises a positive effect on the prosperity of all concerned. It permits consumers to choose the cheapest good, generally widens the choice, and creates the conditions for further gain through economies of scale, etc.

The obvious welfare gains from the liberalisation of product markets are a good economic reason to start integration with that object. However, integration schemes tend to follow a political logic rather than an economic one. The political reasons to begin integration at the goods market are:

- lasting coalition between sectors demanding protection and sectors and consumers demanding cheap imports is hard to accomplish;

- substitute instruments (such as industrial policy, non- tariff barriers, and administrative procedures) can be used to intervene in the economic process;

- vital political issues like growth policy and income redistribution are guaranteed to remain within national jurisdiction.

Free movement of production factors can be seen as another basic element of economic integration. One argument for it is that it permits optimum allocation of labour and capital. Sometimes, certain production factors are missing from the spot where otherwise production would be most economical. To overcome that problem, entrepreneurs are apt to shift their capital from places of low return to more promising places. The same is true of labour: employees will migrate to regions where their labour is more needed and therefore better rewarded. A second argument is that an enlarged market of production factors favours new production possibilities which in turn permit new, more modern or more efficient uses of production factors (new forms of credit, new occupations, etc.).

The choice of production factors as the object of the second stage in the integration process is partly based on the economic advantages that spring from such integration. But here, too, we have to consider the political logic. The integration of labour markets seems to be the obvious choice in periods of a general shortage of labour A tangle of national regulations for wages, social security, etc. seems to leave politicians sufficient opportunities for practical intervention on the national level for them to accept general principles on the European level. With capital-market integration the issue of direct investments seems straightforward; many politicians may hope to attract new foreign investment in that way. For other capital movements the willingness to integrate is less obvious because integration would imply giving up the control of sensitive macroeconomic instruments.

Policy approximation is the next stage of economic integration. In an economy which leaves production and distribution entirely to the market, the elimination of obstacles to the movement of goods and production factors among countries would suffice to achieve full economic integration. Not so in modern economies, which are almost invariably of the mixed type, the government frequently intervening in the economy. In economies of the mixed type, integration cannot be achieved without harmonising the policies pursued by the governments of the individual states. Policy making is on the whole more difficult to integrate than markets for goods, services and production factors. Politicians are likely to be the more unwilling to give up their intervention power, the more such elements are involved as employment policy or budgetary policies (referring to expenditure on schools, subsidies, as well as revenues from taxes).

Moreover, national civil servants tend to uphold their way of operating interventional schemes as the most efficient, and since their very existence depends on complicated sets of rules, they are hardly inclined, in general, to cooperate towards harmonised policy. Thus, the conditions for a common currency or monetary integration will not readily be met. That is one reason why currency integration is mostly introduced at a late stage of integration. Even later comes the integration of points that touch the very heart of a nation's sovereignty, in particular the acceptance of a common defence policy.

B. Positive and negative integration

With respect to modern mixed economies, Tinbergen (1954) distinguished negative integration (that is, the elimination of obstacles), and positive integration (that is, the creation of equal conditions for the functioning of the integrated parts of the economy). The former's demand on policy will be relatively simple (deregulation, liberalisation), but the latter will always involve more complex forms of government policy (harmonisation, coordination). Let us look somewhat closer at the differences.

Negative-integration measures are often of the simple 'Thou shalt not' type. They can be clearly defined, and once negotiated and laid down in treaties, they are henceforth binding on governments, companies and private persons. There is no need for permanent decision-making machinery. Whether these measures are respected is for the courts to check, to which individuals may appeal if infringements damage their interests.

Positive integration is more involved. It often takes the form of vaguely defined obligations requiring public institutions to take action. Such obligations leave ample room for interpretation as to scope and timing. They may, moreover, be reversed if the policy environment changes. As a consequence, they hold much uncertainty for private economic agents, who cannot derive any legal rights from them. Positive integration is the domain of politics and bureaucracy rather than law. No wonder then that positive integration does not present a built-in stimulus for progress. Because politicians are more likely to opt for positive rather than negative integration, progress is likely to be slower, the higher the

stage of integration, that is the farther integration proceeds on the path towards a Full Economic Union.

C.   Stages of economic integration

As international trade and investment levels continue to rise, the level of economic integration between various groups of nations is also deepening.  The most obvious example of this is the European Union, which has evolved from a collection of autarkical nations to become a fully integrated economic unit.  Although it is rare that relationships between countries follow so precise a pattern, formal economic integration takes place in stages, beginning with the lowering and removal of barriers to trade and culminating in the creation of an economic union.  These stages are summarized below.

A. FREE TRADE AGREEMENTS

The first level of formal economic integration is the establishment of free trade agreements (FTAs) or preferential trade agreements (PTAs).  FTAs eliminate import tariffs as well as import quotas between signatory countries.  These agreements can be limited to a few sectors or can encompass all aspects of international trade.  FTAs can also include formal mechanisms to resolve trade disputes.  The North American Free Trade Agreement (NAFTA) is an example of such an arrangement.

Aside from a commitment to a reciprocal trade liberalization schedule, FTAs place few limitations on member states.  Although FTAs may contain provisions in these areas if the signatory countries agree to do so, no further harmonization of regulations, standards or economic policies is required, nor is the free movement of capital and labour a necessary part of a free trade agreement.  FTA signatory countries also retain independent trade policy with all countries outside the agreement.

However, in order for an FTA to function properly, member countries must establish rules of origin for all third-party goods entering the free trade area.  Goods produced within the free trade area (and subject to the agreement) may cross borders tariff-free, but rules of origin requirements must be met to prove that the good was in fact produced in the exporting country.  In the absence of rules of origin, third-party countries seeking trade access to the FTA area will choose the path of least resistance the country where they face the lowest opposing tariff in order to gain effective entry to the entire FTA region.

B. CUSTOMS UNION

A customs union (CU) builds on a free trade area by, in addition to removing internal barriers to trade, also requiring participating nations to harmonize their external trade policy.  This includes establishing a common external tariff (CET) and import quotas on products entering the region from third-party countries, as well as possibly establishing common trade remedy policies such as anti-dumping and countervail measures.  A customs union may also preclude the use of trade remedy mechanisms within the union.  Members of a CU also typically negotiate any multilateral trade initiative (such as at the World Trade Organization) as a single bloc.  Countries with an established customs union no longer require rules of origin, since any product entering the CU area would be subject to the same tariff rates and/or import quotas regardless of the point of entry.

The elimination of the need for rules of origin is the chief benefit of a customs union over a free trade area.  To maintain rules of origin requires extensive documentation by all FTA member countries as well as enforcement of those rules at borders within the free trade area.  This is a costly process and can lead to disputes over interpretation of the rules as well as other delays.  A CU would result in significant administrative cost savings and efficiency gains.

In order to gain the benefits of a customs union, member countries would have to surrender some degree of policy freedom specifically the ability to set independent trade policy.  By extension, because of the increased importance of trade and economic measures as foreign policy tools, customs unions place some limitations on independent foreign policy as well.

C. COMMON MARKET

A common market represents a major step towards significant economic integration.  In addition to containing the provisions of a customs union, a common market (CM) removes all barriers to the mobility of people, capital and other resources within the area in question, as well as eliminating non‑tariff barriers to trade, such as the regulatory treatment of product standards.

Establishing a common market typically requires significant policy harmonization in a number of areas.  Free movement of labour, for example, necessitates agreement on worker qualifications and certifications.  A common market is also typically associated whether by design or consequence with a broad convergence of fiscal and monetary policies due to the increased economic interdependence within the region and the effect that one member countrys policies can have on other member countries.  This necessarily places more severe limitations on member countries ability to pursue independent economic policies.

The principal advantage of establishing a common market is the expected gains in economic efficiency.  With unfettered mobility, labour and capital can more easily respond to economic signals within the common market, resulting in a more efficient allocation of resources.

D. ECONOMIC UNION (AND MONETARY)

The deepest form of economic integration, an economic union adds to a common market the need to harmonize a number of key policy areas.  Most notably, economic unions require formally coordinated monetary and fiscal policies as well as labour market, regional development, transportation and industrial policies.  Since all countries would essentially share the same economic space, it would be counter-productive to operate divergent policies in those areas.

An economic union frequently includes the use of a common currency and a unified monetary policy.  Eliminating exchange rate uncertainty improves the functioning of an economic union by allowing trade to follow economically efficient paths without being unduly affected by exchange rate considerations.  The same is true of business location decisions.

Supranational institutions would be required to regulate commerce within the union to ensure uniform application of the rules.  These laws would still be administered at the national level, but countries would abdicate individual control in this area.

Full economic union (FEU) implies the complete unification of the economies involved, and a common policy for many important matters. The situation is then virtually the same as that within one country. Given the many areas integrated, political integration (for example, in the form of a confederacy) is often implied.

The transitions between the various stages of integration are fluent and cannot always be clearly defined. The first stages, FTA, CU and CM, seem to refer to market integration in a classical laissez-faire setting, the higher stages (EU, MU, FEU) to policy integration. In practice, however, the former three stages are unlikely to stabilise without some form of policy integration as well (for instance, safety regulations for a FTA, commercial policy for a CU, or social and monetary policies for a CM (Pelkmans, 1980). between a customs union and full integration, a variety of practical solutions for concrete integration problems are likely to occur.

The stages of integration just sketched have two characteristics in common. They abolish discrimination among actors from partner economies (internal goal). They may thereby maintain or introduce some form of discrimination with respect to actors from economies of third countries (external goal).

D. Degrees of policy integration

Because countries are free to negotiate economic integration agreements as they see fit, in practice, formal agreements rarely fall neatly into one of the four stages discussed above.  This can lead to some confusion of terminology and also confusion as to the state of economic integration in some parts of the world.  In the case of Canada, for example, the country is part of a free trade area with the United States and Mexico.  However, the North American Free Trade Agreement also includes provisions that partially liberate the flow of labour and capital in the region an element of a common market.  In addition, Canada has in the past pushed to curtail the use of trade remedy measures within North America.  While this represents a desire to advance one aspect of North American integration, the next formal step a customs union does not appear to be a policy priority at this time.

All forms of integration described above require permanent agreements among participating states with respect to procedures to arrive at resolutions and to the implementation of rules. In other words, they call for partners to agree on the rules of the game. For an efficient policy integration, common institutions (international organisations) are created. However, for the higher forms of integration, such as a common market, the mere creation of an institution is not sufficient: they require transfer of power from national to union institutions.

All forms of integration diminish the freedom of action of the member states' policy-makers.

The higher the form of integration, the greater the restrictions and loss of national competences. The following hierarchy of policy cooperation is usually adopted:

- Information: partners agree to inform one another about the aims and instruments of the policies they (intend to) pursue. This in-formation may be used by partners to change their policy to achieve a more coherent set of policies., However, partners reserve full freedom to act as they think fit, and the national competence is virtually unaltered.

- Consultation: partners agree that they are obliged not only to inform but also to seek the opinion and advice of others about the policies they intend to execute. In mutual analysis and discussion of proposals the coherence is actively promoted. Although formally the sovereignty of national governments remains in-tact, in practice their competences are affected.

- Co-ordination goes beyond this, because it commits partners to agreement on the (sets of) actions needed to accomplish a coherent policy for the group. If common goals are fixed some

authors prefer the term cooperation. Coordination often means the adaptation of regulation to make sure that they are consistent internationally (for example, the social security rights of migrant labour). It may involve the harmonisation (that is, the limitation of the diversity) of national laws and administrative rules. It may lead to convergence of the target variables of policy (for example, the reduction of the differences of national inflation rates). Although agreements reached by coordination may not always be enforceable (no sanctions), they nevertheless limit the scope and type of policy actions nations may undertake, and hence imply limitation of national

competences.

- Unification: either the abolition of national instruments (and their replacement with union instruments for the whole area) or the adoption of identical instruments for all partners. Here the national competence to choose instruments is abolished.

E. Goods markets

Advantages

Fully integrated goods markets imply a situation of free trade among member states. People aim for free trade because they expect economic advantages from it, namely:

- more production and more prosperity through better allocation of production factors, each country specialising in the products for which they have a comparative advantage;

- more efficient production thanks to scale economies and keener competition;

- improved 'terms of trade' (price level of imported goods with respect to exported goods) for the whole group in respect of the rest of the world.

Integration of goods markets implies first of all the removal of (all) impediments to free internal goods trade. In modern mixed economies such negative integration is not sufficient, however. For the market to function adequately there must be common rules for competition on the internal market and for trade with third countries.

Obstacles to free trade

The free-trade area has been defined before as a situation where there are neither customs duties or levies with similar effect, nor quantitative restrictions or indeed any factor impeding the free internal movement of goods (the latter are often taken together under the heading of non-tariff barriers, or NTB).

They can be described as follows:

- Customs duties or import duties are sums levied on imports of goods, making the goods more expensive on the internal market. Such levies may be based on value or quantity. They may be indicated in percentages or vary according to the price level aspired to domestically;

- Levies of similar effect are import levies disguised as administrative costs, storage costs or test costs imposed by the customs;

- Quantitative restrictions (QR) are ceilings put on the volume of imports of a certain good allowed into a country in a certain period (quota), sometimes expressed in money values. A special type is the so-called 'tariff quota', which is the maximum quantity which may be imported at a certain tariff, all quantities beyond that coming under a higher tariff;

- Currency restrictions mean that no foreign currency is made available to enable importers to pay for goods bought abroad;

- Other non-tariff impediments are all those measures or situations (such as fiscal treatment, legal regulations, safety norms, state monopolies, public tenders, etc.) which ensure a country's own products' preferential treatment over foreign products on the domestic market.

Motives for obstacles

Obstacles to free trade are mostly meant to protect a country's own trade and industry against

competition from abroad, and therefore come under the heading of protection. Protection can be combined with free trade. A customs union, for instance, prevents free trade with outside countries by a common external tariff and/or other protectionist measures, while leaving internal trade free.

Like individual countries, a customs union may-hope to benefit from protection against third

countries, that is, from import restrictions. From the extensive literature we have distilled the following arguments in favour of such measures:

- Independence from other countries as far as strategic goods are concerned, a point much stressed in the past and especially in times of war;

- The possibility of nurturing so-called 'infant industries'. The idea is that young companies and sectors which are not yet competitive should be sheltered in infancy in order to develop into adult companies holding their own in international competition;

- Defence against dumping. The healthy industrial structure of an economy may be spoiled when foreign goods are dumped on the market at prices below the cost in the country of origin. Even if the action is temporary, the economy may be weakened beyond resilience;

- Defence against social dumping. If wages in the exporting country remain below productivity, the labour factor is said to be exploited; importation from such a country is held by some to uphold such practices and is therefore not permissible;

- Employment boosting. If the production factors in the union are not fully occupied, protection can turn the demand towards domestic goods, so that more labour is put to work and social costs are avoided;

- Diversification of the economic structure. Countries specialised in one or a few products tend to be very vulnerable; marketing problems of such products lead to instant loss of virtually all income from abroad. That argument applies to small developing countries rather than to large industrialised states;

- Shouldering-off balance-of-payment problems. Import restrictions reduce the amount to be paid abroad, which helps to avoid adjustments of the industrial structure and accompanying social costs and societal friction (caused by wage reduction and a restrictive policy, etc.).

Pleas for export restriction have also been heard. The underlying ideas vary considerably. The arguments most frequently heard are the following:

- Some goods are strategically important and must not fall into the hands of other nations; that is true not only of military goods (weapons) but also of incorporated knowledge (computers) or systems;

- Exportation of raw materials means the consolidation of a colonial situation; a levy on exports will hopefully increase people's inclination to process the materials themselves. If not, then at any rate the revenues can be used to start other productions;

- If too much of a product is exported, the importing country may be induced to take protective measures against a series of other products; rather than that, a nation may accept a 'voluntary' restriction of the exports of that one product.