7.4 Towards a Single European Market
7.4.2 Mechanisms and Means of Economic Integration
To attain the goals set by the Treaty of Rome, the six founding member-states committed to such limits as dates of implementation, general policy guidelines, institutions of political representation, boundaries of competition and permissible state interventions. On all these fronts the treaty laid down the roadmap for a single European market, since after the period of the customs union, which by Articles 8 and 38 was set to last until 1970, the policy framework was expected to include common policies for agriculture, fisheries, transport, telecommunications, energy, social policy and in general arrangements for the convergence of the member-state economies.
The prevailing monetary conditions were based on a system of fixed exchange rates derived from the Bretton Woods agreement, which allowed the price of each currency to vary within certain limits of the dollar, whose price was tied to gold.
Even though this agreement was weak, it provided relatively satisfactory exchange rate stability through the 1960s. But in the meantime the crisis in the international monetary system was deepening and on August 15, 1971, the USA abrogated the dollar’s convertibility to gold. This meant essentially that the system of the “gold standard” had come to an end. Thus, due to the exchange rate volatility that resulted, and on the basis of the Werner report of 1970, the six member-states of EEC decided to move closer towards monetary cooperation by (a) establishing a common community currency, or at the very least, full convertibility and irrevoca- ble fixing of the exchange rates among European currencies and (b) transferring the responsibility for handling monetary and credit policies from national to commu- nity institutions. Yet, for reasons not relevant here, this decision was not implemented until 1978 and the six countries determined the value of their currencies with a mechanism that became known as “the snake of EEC within the Smithsonian tunnel”.
The currency crisis in 1973 made it clear that economic integration necessitated a common monetary policy. The reason was that, with monetary and credit policies conducted independently on the basis of national criteria, each member-state attempted at times to benefit even at the expense of other member-states. Moreover,
9This situation led even socialist governments with a long tradition in the maintenance of large welfare states to renege on their promises. An example in this regard is Sweden where the government that won the elections in 1994 on the promise to extend the welfare benefits was forced to backtrack (Torbio¨rn 2003, 118).
in the absence of a common monetary policy towards the dollar and the yen, speculation in foreign exchange markets against the national European currencies was easy. These weaknesses prompted member-states to revive their plans for monetary integration. After preparatory discussions which started in 1977, the European Council decided in July of 1978 to create the European Monetary System (EMS), and in December of the same year laid down the basic principles of the EMS, which began to operate in March 1979. The reasons that led to the creation of the EMS included:
• The on-going international monetary instability and the problem of the dollar since, due to their effects on intra-community exchange rates, member-states had to take measures to minimise the impact of the disorderly developments in the international money and capital markets on their economies.
• The views that (a) monetary stability would lower inflationary pressures and restore market tranquillity, which was necessary for economic growth and (b) monetary integration would move EEC closer to its initial objectives, i.e. closer to the convergence of their real economies.
• The expectation that the EMS would operate as a self-protection and preparation mechanism in view of the imminent enlargement of EEC with the Mediterranean countries.
Additionally, Germany and France had their own important reasons to support the introduction of the EMS. Germany wished to stop the continuous appreciation of its currency, which reduced the competitiveness of its exports and increased unem- ployment, whereas France viewed the EMS as a means to reduce inflation, which remained at very high levels. EMS evolved through time as follows.10
In the first stage, from its founding in 1979 until January 1987, EMS functioned as a mechanism of almost floating exchange rates. During this period, the exchange rate was adjusted 11 times, averaging more than one adjustment per year due to the differences in the inflation rates that prevailed among member-states.
In the second phase, from 1988 until 1992, a climate of optimism prevailed about the stability of the EMS because no further exchange rate adjustments took place.
Monetary stability resulted from the various controls in the movement of funds among member-states, which were intended to defend EEC currencies from specu- lative attacks. Greece, for example, followed looser monetary and fiscal policies than Germany, and as a result, experienced higher inflation. To preserve the relative competitiveness of its exports to Germany, Greece had to devalue its currency periodically. In anticipation of such events, large amounts of foreign exchange could move from Greece to Germany, reducing the reserves of the Bank of Greece and destabilising the monetary relationship between the two countries. The controls afforded by the EMS led to greater stability because they helped discourage foreign exchange speculation. In 1990, however, these controls were abolished as it became
10For the analysis that follows we relied primarily on the publications of de Grauwe (1992) and Eichengreen (2007b).
clear to all concerned that it was impossible to ensure (a) freedom of capital movements; (b) fixed exchange rates and (c) independent monetary policies, all at the same time [“incompatible trilogy” according to Wyplosz (1997)]. Thus, the move towards a common currency started to be increasingly viewed as inevitable.
The third stage, which began in 1992, was characterised by frequent adjustments to the exchange rate of the member-states’ currencies, most notably the Italian lira and the British pound. The monetary stability that had prevailed during the 5-year period 1988–1992 had come to an end. In the history of the European integration, the year 1992 remains memorable because (a) all legislative procedures for the establishment of the Single European Market were completed, with the exception of the free movement of workers;11 (b) the unification offered huge benefits to European citizens by creating a market of 340 million people and (c) on February 7, 1992, the member-states signed the Treaty of Maastricht. Although the treaty’s effective date was January 1, 1993, the developments that took place that year not only upset its timely implementation and prospects but also challenged seriously the unity of the community.12After several years of negotiations, the EU leaders endorsed the decision to adopt the Euro as the common European currency on December 15, 1995, with effective date January 1, 1999. On March 25, 1998 the European Commission announced the 11 countries that met the criteria for joining the Euro. According to the Treaty of Maastricht, these criteria were (a) inflation would not be higher than 1.5 % points above the average inflation rates in the three member-states with the lowest inflation; (b) the ratio of government deficit to GDP in the previous fiscal year would not exceed 3 % and the ratio of government debt to GDP would not exceed 60 %. Alternatively, if the ratio was over 60 % due to unforeseen events, it ought to be on a downward trend, converging to the prescribed limit; (c) the currency of the country would be integrated in the EMS mechanism in the previous 2 years and it would not have devalued and (d) the nominal long term interest rate would not be higher than 2 % points compared with that of the three countries with the lowest inflation. Austria, Belgium, France, Germany, Ireland, Spain, Italy, Luxembourg, Netherlands, Portugal and Finland met these criteria.
Greece did not, but was expected to enter at a later stage, whereas the UK, Denmark and Sweden met the criteria but chose not to adopt the common currency. On January 1, 1999, the Euro became the common currency of the EU and replaced the currencies of the 11 member-states at predetermined fixed rates. Finally, with the entrance of Greece into the Euro zone in 2002, the EU-12 achieved monetary unification and the Euro emerged as a global reserve currency.
The adoption of the Euro was not easy because benefits and costs among member-states differed significantly. The main cost was that, by adopting the
11Clearly, the complete liberalisation of capital movements raised the issue of the conditions that ought to be met in order to be compatible with the objective of exchange rate stability within the EMS.
12For example, the negative outcome, albeit by a narrow majority (50.7 %), of the Danish referendum held on June 2, 1992, for the ratification of the treaty, sparked great controversy.
common currency, the member-states relinquished their right to conduct indepen- dent monetary policies. According to orthodox economic thinking, this meant that the member-states lost the flexibility to improve their balance of payments through appropriate adjustments in the exchange rate of their national currencies, and hence they lost the ability to improve their domestic economies and to reduce unemploy- ment.13But this cost might not be very large after all because, in the light of the globalisation process that was underway in 1992, the effectiveness of currency devaluation as a means to enhance a country’s competitiveness and trade balance could be challenged. The reason is that, according to more recent research, in such an international environment the results of devaluation don’t last long, whereas any positive benefits in the short-run become negative in the long-run because of the imported inflation. In other words, the more open the economy of a country and the greater the propensity to import, the more quickly any short-term benefits from devaluation vanish, and vice versa. Therefore, given the quest for full integration of the European economies, as well as the advancing globalisation, the potential cost of abandoning the tool of devaluation that member-states absorbed in order to participate in the monetary union was small. Or, at least, it was small relative to their benefits from the lowering of transaction costs and the uncertainty due to deliberate future changes in exchange rates among member-states. In any case, for the countries of Europe that proceeded to monetary unification, on the one hand the cost of foregoing the tool of devaluation was small, whereas on the other the benefits were significant because their economies were already tied together very closely.
Apart from their efforts in the front of monetary unification, EU authorities put in place mechanisms and devised instruments to attain all other objectives. For example, they adopted uniform policies for many sectors of the European economy and enforced their implementation by the various member-states. Under the lead- ership of the European Competition Commission, they strived to keep European markets open to competition, and through the structural funds, they provided large financial assistance to less developed member-states and regions so as to speed up convergence. However, the following references indicate that the adopted policies had serious unintended consequences that demand attention.
13In a monetary union the cost of losing the possibility of an independent monetary policy increases if the following differences among member states prevail: (a) there is no full labour mobility and the wages and prices are not sufficiently flexible; (b) the member-states have different levels of prices and unemployment, i.e. they have different Phillips curves, which would imply that a member-state prefers higher prices and less unemployment than another member-state and (c) a member-state has a high inflation rate, so that issuing bonds instead of printing new money forces it to absorb the interest on bonds.
7.4.2.1 Arrangements That Generated and Promoted Eurosclerosis
EU member-states, in their attempt to break the vicious circle, whereby inflationary expectations fed into nominal wages and in turn increased inflation and worsened recession, introduced a mechanism based on the concept of “corporate social responsibility”. This mechanism constituted essentially a negotiating framework between the so-called social partners, i.e. trade unions and businesses, so as to avoid conflicts harmful to the economy. Parallely, governments in member-states, draw- ing on their concern for low income classes, which was a tradition left over by the economic policies in the aftermath of the Second World War, introduced numerous social programmes that led to the rise of the welfare state.14 From these two institutional arrangements emerged a nexus of serious problems known as Eurosclerosis. In particular, labour markets lost their flexibility; the incentives of individuals to find profitable opportunities and exploit them through entrepreneur- ship were distorted; individuals lost their motivation for hard work and, not surprisingly, state sectors became and continue to be large and unmanageable, since public expenditures exceed on average 45 % of GDP and to a large extent they serve consumption purposes.
7.4.2.2 Arrangements That Distorted Competition
Consider the Common Agricultural Policy (CAP). CAP protected agriculture in the EU from foreign competition. While agriculture contributes to economic growth, this sector has certain peculiarities that are not found in others. The EU was able to maintain independence from food imports, but at the cost of flexibility of agri- culture to respond to changing demand conditions. CAP constrained member- states from developing their comparative advantages in response to advancing globalisation and contributed to market distortions. The reason is that the policies were biased in favour of farmers and against the European consumers, who paid higher than world prices for agricultural foodstuffs. In Greece, for example, researchers have found that after 1981 the transfers of income to Greek farmers from the EU under the Community Support Framework were offset by the amount that Greek consumers paid to the farmers of the community. Moreover, these policies created abroad the impression of “Fortress Europe”, strengthened protec- tionism internationally and hurt poor agricultural countries, and even worse they failed to bring about the convergence of the European agricultural sectors to which they aimed in the first place. The convergence of the economies that the Treaty of Rome set as one of its main objectives became the weak underbelly of the European integration, since it stimulated the implementation of structural policies that are
14For the nature of this state intervention in labour markets and its role in the emergence of the European welfare state, as well as the degree to which it was adopted by the various member states, see Berend (2006, 194–195, 213–222).
inconsistent with the establishment of a competitive European economy based on the harmony derived from the imperative that all European peoples should thrive by developing their comparative advantages. Due to these structural policies, Eurosclerosismay be much broader than is usually acknowledged.