The Economics of European Integration [6 ed.] 9781526847218

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Sixth edition Richard Baldwin & Charles Wyplosz

II

The Economics of European Integration, Sixth edition Richard Baldwin & Charles Wyplosz ISBN-13 9781526847218 ISBN-10 1526847213

II Published by McGraw-Hill Education 8th Floor 338 Euston Road London NWl 3BH Telephone: 44 (0) 20 3429 3400 Website: www.mheducation.co. uk British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data The Library of Congress data for this book has been applied for from the Library of Congress

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Ded ication For Sarah, Ted, Julia and Nicky - R.B. In memory of my parents, whose sufferings inspired my yearning for a

Europe at peace, and who taught me the pleasure of learning - C. W.

Brief Table of C

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About the Authors Preface Acknowledgements Guided Tour Online Learnin g Ce ntre Study Ski ll s

1

2 3

Part I History, Facts and Institutions History Facts, law, institutions and the budget Decision making

xiii xiv xviii xix xx i xxiii

1

3 39 71

Part II The Microeconomics of European Integration Essential microeconomic tools and tariff analysis The essential economics of preferential liberalization Market size and scale effects Growth effects and factor market integration Economic integration, labour markets and migration

143 159 177

9 10 11 12

Part Ill EU Micro Policies The common agricultural policy Location effects, economic geography and regional policy EU competition and state aid policy EU trade policy

203 205 231 255 275

13 14 15

Part IV The Macroeconom ics of Monetary Integration Essential macroeconomic tools The history of European monetary integration Optimum currency areas

287 289 323 347

Part V EU Monetary and Fiscal Pol ic ies The European monetary union Fiscal policy and the Stability Pact The financial markets and the euro The Eurozone in crisis Index

379 381 413 443 475 511

4 5 6 7

8

16

17 18 19

95 97 119

Detailed Table of Content About the Authors Preface Acknowledgements Guided Tour Online Learning Centre Study Skills

xiii xiv xviii xix xxi xxiii

Part I History, Facts and Institutions Chapter 1 History 1.1 Early post-war period 1.2 Two strands of European integration: federalism and intergovernmentalism 1.3 Evolution to two concentric circles: the domino effect part I 1.4 Euro-pessimism 1.5 Deeper circles and the domino effect part II: the Single Market Programme and the EEA 1.6 Communism's creeping failure and spectacular collapse 1. 7 Reuniting East and West Europe 1.8 Preparing for eastern enlargement: a string of new treaties 1.9 Global and Eurozone crises and institutional responses 1.10 The rise of Euroscepticism 1.11 Summary Self-assessment questions References and further reading Chapter 2 Facts, law, institutions and the budget 2.1 Economic integration in the EU 2.2 EU structure pre- and post-Lisbon 2 .3 EU law 2.4 The Big-5' institutions 2.5 Legislative processes · 2.6 Some important facts 2.7 The budget 2.8 Summary Self-assessment questions References and further reading 1

3 4 9 15 17 18 21 23 23 26 29 35 36 37 39 40 46 49 52 58 61 63 67

68 69

Detailed Table of Contents

Annex: Details on the COMP and BE curves A6 .1 COMP curve in detail A6.2 BE curve in detail

155 155 157

Chapter 7 Growth effects and factor market integration 7.1 The logic of growth and the facts 7.2 Medium-term growth effects: induced capital formation 7.3 Long-term growth effects: faster knowledge creation and absorption 7.4 Summary Self-assessment questions Essay questions References and further reading

159 160 164 173 174 175 175 175

Chapter 8 Economic integration, labour markets and migration 8.1 European labour markets: a brief characterization 8.2 Labour markets: the principles 8.3 Effects of trade integration 8.4 Migration 8 .5 Summary Self-assessment questions Essay questions References and further reading

177 178 181 187 190 199 200 201 201

Part Ill EU Micro Policies

203

Chapter 9 The common agricultural policy 9 .1 The old simple logic: price supports 9.2 Changed circumstances and CAP problems 9.3 The simple economic logic of the new CAP 9.4 CAP reform 9.5 Today's CAP 9.6 Remaining problems 9.7 Summary Self-assessment questions References and further reading

205 207 212 219 222 224 226 227 228 229

Chapter 10 Location effects, economic geography and regional policy 10.1 Europe's economic geography: the facts 10.2 Theory part I: comparative advantage 10.3 Theory part II: agglomeration and the new economic geography 10.4 Theory part Ill: putting it all together 10.5 EU regional policy 10.6 Empirical evidence 10.7 Summary Self-assessment questions References and further reading

231 232 237 239 247 249 252 253

253 253

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.- ,. , --------------------

.

Detailed Table of Contents

Chapter 11 EU competition and state aid policy 11.1 The economics of anti-competitive behaviour and state aid 11.2 EU competition policy 11 .3 Summary Self-assessment questions References and further reading

255

256 269 273 274 274

Chapter 12 EU trade policy 12 .1 Pattern of trade and tariffs: facts 12.2 EU institutions for trade policy 12.3 EU trade policy: broad goals and means 12.4 EU trade policy: existing arrangements 12.5 Summary Self-assessment questions References and further reading

275 276 280 283 283 284 285 285

Part IV The Macroeconomics of Monetary Integration

287

Chapter 13 Essential macroeconomic tools 13.1 The closed economy: a refresher 13.2 The open economy 13.3 The impossible trinity principle 13.4 The real exchange rate and the purchasing power parity principle 13.5 Applications: macroeconomic policies and the exchange rate 13.6 Summary Self-assessment questions Essay questions References and further reading Annex: Various exchange rate regimes

289 290 296 301 307

Chapter 14 The history of European monetary integration 14.1 Back to the future: before paper money 14.2 Bretton Woods as an antidote to the inter-war debacle 14.3 After Bretton Woods: Europe's snake in the tunnel 14.4 The European monetary system 14.5 The Maastricht Treaty 14.6 The crisis 14.7 Summary Self-assessment questions Essay questions References and further reading Annex: Hume's mechanism

323 324 331 332 334

Chapter 15 Optimum currency areas 15.1 The question, the problem and the short answer 15 .2 Benefits of a currency area

311

316 317 318 318 320

339 341 341 342 342

343 344 347 348 350

Detailed Table of Contents

~

\.

15 .3 Costs of a currency area 15 .4 The optimum currency area criteria 15.5 Is Europe an optimum currency area? 15.6 Is Europe becoming an optimum currency area? 15.7 Summary Self-assessment questions Essay questions References and further reading Part V EU M onetary and Fiscal Policies

354 358 364 371 373 375 375 376 379

Chapter 16 The European monetary union 16.1 Principles 16.2 The five entry conditions 16.3 The Eurosystem 16.4 The monetary policy strategy 16.5 Independence and accountability 16.6 Instruments 16.7 The first years, until the Great Crisis 16.8 Summary Self-assessment questions Essay questions References and further reading

381 382 383 388 392 396 399 401 408 410 410 411

Chapter 17 Fiscal policy and the Stability Pact 17.1 Fiscal policy in the monetary union 17.2 Fiscal policy externalities 17.3 Principles 17.4 The stability and growth pact 17.5 The macroeconomic imbalance procedure 17.6 Summary Self-assessment questions Essay questions References and further reading

413 414 418 421 427 438 439 440 440 440

Chapter 18 The financial markets and the euro 18.1 Essentials of financial markets 18.2 Effects of a monetary union 18.3 Fragmentation during the crisis 18.4 The Eurozone and its banks 18.5 The international role of the euro 18.6 Summary Self-assessment questions Essay questions References and further reading

443 444 450 457 460 468 472 473 473 473

xi

)

.. Detailed Table of Contents

Chapter 19 The Eurozone in crisis 19.1 Stage one: the global financial crisis 19.2 Stage two: the public debt crisis in the Eurozone 19.3 Policy responses 19.4 Banks and public debt 19.5 What have we learned from the crisis? 19.6 Summary Self-assessment questions Essay questions References and further reading Index

475 476

480 490 497 501 507

508 508 508 511

Prefa

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What's up? When the first edition of this book was published in 2004, European integration was a process under Wal . During that -year, ten cow1tries joined the existing fifteen members of the European Union. Since then thr;e more cow1tries have gained membership. At that time, twelve countries had adopted the euro and seven have done so since then. As we close this edition, integration ma-y sound like a misnomer as negotiations on the withdrawal of the UK are under wa-y . In the mean time, the sovereign debt crisis has come close to triggering a disintegration of the Eurozone. In addition, in many countries, newl-y influential political parties present themselves as Eurosceptics, and some of them are in power. European integration currently seems more like a description of the existing situation than a continuing process, although seven countries have applied to become members of the European Union. Still, excluding the UK, currentl-y 44 7 million people live in the European Union, far more than in the USA. Ever-yda-y, the-y produce and consume goods and services that move freely within the continent and 340 million of them use the euro as their own currency. Furthermore, some 400 million people can travel seamlessly within the Schengen Area without having to show passports or identity cards. Thus Europe exists. It constitutes a uniq,ue historical achievement. After centuries of bitter wars, the continent is peaceful and deeply integrated, in spite of sq,uabbles here and there. It is often said that Rome, its distant and very different predecessor, was not built in one day. Likewise, Europe is still being built. This book describes and explains European integration, and its contents mirror the ever-changing situation. In the first three editions, we noted the many flaws in the integration process, especially those concerning the Eurozone. In the fourth edition, we were lamenting the policy responses to the crisis, pointing out what had to be done. At the time of the fifth edition, the crisis was coming to its end. Since then, much has been done, often along the lines that we mentioned. The European Union has been transformed, and so has this book As always with previous editions, most of the tables, figures and boxes have been updated with the most recent data and events. The most drastic changes of this sixth edition concern both the pedagogy and the content. In terms of pedagogy, we have retained the five-part structure - see below- but: _ Chapter 1 discusses Brexit but, since the manuscript had to be closed before the final 'divorce' deal was settled, the treatment was necessarily somewhat speculative. _ Chapter 8 offers an expanded treatment of migration, which has emerged as a major concern. _ Presentation of the macroeconomic theory in Chapter 13 has been streamlined, better motivated and extended. It now includes a new section that brings the main results together and presents the theory of exchange rate determination. The section on monetary neutrality has been moved in a succinct form to Chapter 15 where it is used to explain different views of monetary policy. - Chapter 14 is now presented as a history of monetary integration in Europe, which makes ft~l us_e of the principles developed in Chapter 13. It is designed as a transition between theory and apphcations developed in subseq,uent chapters. - Chapter 15, which presents the optimum currency area (OCA), has been redesigned. It includes ~e aggregate demand and supply framework that has been req,uested by many instructors, while makmg more use of the theory presented in Chapter 13. It presents a thorough discussion of the insurance role of transfers. . .. d - Chapter 17 has been extended to include new developments, including regarding the Stabihty an Growth Pact and the macroeconomic imbalances procedure. . 1 - A new section has been introduced at the beginning of Chapter 18 to present the explain financia . . Chapter 13. That theory IS . a 1so use d to explain risk and the markets usmg the theory developed m variety of interest rates (maturities and riskiness). . . . d d in context within Obviously, the latest developments are fully covered. The information IS me1u e every chapter.

About the Authors Richard Baldwin is Professor of Internatio'nal Economics at the Graduate Institute, Geneva since 1991 a 1 part-time visiting research professor at the University of Oxford from 2012 to 2015, Director/President of CE_P R from 2~14 to 2018, and Editor-in-Chief of Vax since he founded it in June 2007. He was Co-managing Editor of the Journal Economic Policy from 2000 to 2005, Policy Director of CEPR from 2006 to 2017, and Programme Director of CEPR's International Trade programme from 1991 to 2001. He has previously been a Senior Staff Economist for the President's Council of Economic Advisors in the Bush Administration (1990-1991), on leave from Columbia University Business School where he was Associate Professor. He did his PhD in economics at MIT with Paul Krugman and has collaborated with him on several occasions. He was visiting professor at MIT in 2002/03 and has taught at universities in Australia, Italy, Germany and Norway. He has also worked as consultant for the numerous governments, the Asian Development Bank, the European Commission OECD World Bank EFTA and USAID. The author of numerous books ' include ' international ' trade, globalization, regionalism and European and articles, his research interests integration. Charles Wyplosz is Professor Emeritus of International Economics at the Graduate Institute in Geneva where he also served as Director of the International Centre for Money and Banking Studies. Previously, he has taught at INSEAD and at the Ecole des Hautes Etudes en Sciences Sociales in Paris. He is a Fellow of CEPR and of the European Economic Association. His main research areas include financial crises, European monetary integration, fiscal policy and regional monetary integration. He is the co-author (with Michael Burda) of the leading textbook Macroeconomics, A European View and has published several books and many professional articles. He serves as consultant to many international organizations and governments and is a freq,uent contributor to public media. He was a Founding Managing Editor of Economic Policy. A French national, Charles Wyplosz holds degrees in Engineering and in Statistics from Paris and a PhD in Economics from Harvard University.

Acknowledgem nts Our thanks go to the following reviewers for their comments at vanous · · th e t ext's d eve1opment: s t ages m Benedicta Marzinotto, College of Europe John O'Hagan, Trinity College Dublin Michael Wycherley, Trinity College Dublin Maria-Roxana Radulescu, Newcastle University Yon~em Sonme_~, Manchester Metropolitan University Chns _van Ho01Jdonk, Radboud University Cat~rma Marvao, Dublin Institute of Technology Ennco Marvasi, Politechnic University of Milan Graciela Zevallos, University of East Anglia Liesbeth Dries, Wageningen University & Research Liviu-George Maha, Alexandru loan Cuza University of Iasi Michele Chang, College of Europe Rob Ackrill, Nottingham Trent University Roberto Palacios-Rodriguez, University of Hull Siobhan McCarthy, Dublin Institute of Technology Yves Segers, KU Leuven We would also like to thank Ralf Fendel for the material which he provided for the textbook and its accompanying online resources. We would like to thank Mathias Dolls, Clemens Fuest, Andreas Peichl and Christian Wittneben who accepted to share their latest estimates (on fiscal stabilizers) used in Figure 17.1. Each new edition lengthens our indebtedness to colleagues, former and present students and editors. It also increases our pleasure when the time has finally come to thank them all. In the current and previous editions a number of colleagues have made useful suggestions and identified mistakes. While we alone ' are responsible for the remaining old and new mistakes, we thank our reviewers for their no-holds-barred evaluations, which have been both challenging and most useful. We have tried hard to respond to each and every criticism and to follow the many constructive suggestions that we received. As always, McGraw-Hill has lined up a first-class editing and production team and we would like to thank everyone who was involved. Matt Simmons, the Portfolio Manager who arranged for detailed reports from the reviewers (whose names are revealed above but were anonymous for us), oversaw t11e planning for changes in this new edition, and enforced the unavoidable agenda. Nicola Cupit, the Content Developer, and Ali Davis, the Content Product Manager diligently followed us after Ben King, the Production Manager, taught the essentials of writing a book online. We would also like to thank the students who provided face-to-face feedback while we were teaching the fourth edition material. Richard Baldwin would in particular like to tlmnk the students at the University of Geneva. Every effort has been made to trace and acknowledge ownership of copyright and to clear permission for material reproduced in this book. The publishers will be pleased to make suitable arrangements to clear permission with any copyright holders whom it has not been possible to contact.

Preface

What th is book is This is a tex~book for c~urses on European economic integration. Its emphasis is on economics, covering both th~ _nucroe~onom1cs and macroeconomics of European integration. Understanding European economic mtegrat10n, however, req,uires much more than economics, so the book also covers the essential aspects of European history, institutions, laws, politics and policies. The ?ook is written at a level that should be accessible to second- and third-year undergraduates in econonucs as well as advanced undergraduates and graduate students in business, international affairs, European studies and political science. Some knowledge of economics is needed to absorb all the material with ease - a first-year course in the principles of economics should suffice - but the book is self-contained in that it reviews most essential economics behind the analysis. ·

What is in th is book !he bo~k is organized into five parts: essential background (Part I), the microeconomics of European mtegration (Part II), microeconomic policies (Part III), the macroeconomics of monetary integration (Part IV) and macroeconomic policies (Part V). Part I presents the essential background for studying European integration. An overview of the post-Second World War historical development of European integration is presented in Chapter 1. The chapter should be useful to all students, even those who are familiar with the main historical events, as this chapter stresses the economic and political economy logic behind the events.

A concise presentation of the indispensable background information necessary for the study of European integration is presented in Chapter 2. This includes key facts concerning European economies and a brief review of the EU's legal system and principles (fully updated to reflect the Lisbon Treaty changes). Chapter 2 also presents information on the vital EU institutions and the EU's legislative processes as well as the main features of the EU budget. Chapter 3 presents an economic framework for thinking about EU institutions. The first part explains how the 'theory of fiscal federalism' can be used to consider the appropriateness of the allocation of powers between EU institutions and EU Member States. The second part explains how economic reasoning - game theory in particular - can be used to analyse EU decision-making procedures for their efficiency as well as their implications for the distribution of power among EU members. While these are not classic topics in the study of European integration, they are essential to understanding the current challenges facing the EU, such as the 2004 enlargement and the debates around the Lisbon Treaty. This is more relevant than ever as the Eurozone crisis is almost sure to produce a shifting of some competencies from the national level to the supranational level - or, at the very least, a serious debate over such shifts. Part II presents the microeconomic aspects of European integration. • An introduction to the fundamental methods of trade policy analysis is presented in Chapter 4. The chapter introduces basic supply and demand analysis in an open economy and the key economic welfare concepts of consumer and producer surplus, and then uses them to study the simple economics of tariff protection. An in-depth analysis of European preferential trade liberalization is given in Chapter 5. The focus is on how the formation of a customs union or free trade area affects people, companies and governments inside and outside the integrating nations. • A thorough study of how the market-expanding aspects of European int_egration ~ffect th~ efficie~cy of European firms is presented in Chapter 6. The main line of reasonmg explams how mt~gratwn in the presence of scale economies and imperfect competition can produce fewer, bigger and more efficient firms facing more effective competition from each other. Again, the ongoing enlargement of the European Union makes this sort of logic more relevant than ever.

◄ Preface

Chapter 7 gives a detailed study of the growth effects of E . . I . 1· k" . uropean mtegration Th economic ogic m mg European mtegration to medium-ru d1 · e emphasis is on tl n an ong-run growth ff 1e and endogenous growth theories are covered to the extent th t th e ects. Neoclassical growth-integration linkages. The basic facts and empirical .da ey help students understand the . ev1 ence are also covered. Chapter 8 deals with the labour markets. It recalls the basics f 1 b . . o a our economics m ord t O unemp Ioyment and develop the notion that social renuirements h . er explain . b " may ave senously negative ff t erms o f JO s, wages and growth. The chapter uses these insights to study th ff . e ects in d ea1s WI·th many cont roversial · issues · e e · ects of mtegratio n. It such as social dumpin d · t· th f b . . g an ffilgra ion, trymg hard to stay ab e ray y presentmg economic analysis as one logic, but not the only one. ove Part III presents the main microeconomic policies of the EU. Chapter 9 _looks at the Common Agricultural Policy (CAP), presenting the economics and facts that are essenti~l for understanding its effects. The chapter takes particular care to examine the economic forces behmd recent CAP reform in the light of international trade negotiations (the Doha Round), the eastern enlargement and the reforms that are being discussed for the post-2013 financial period. Chapter 10 presents the economics that link European integration to the location of economic activities. This includes a presentation of the main facts on how the location of economic activity has shifted both within and between nations. To organize thinking about these facts - and to understand how EU regional policy might affect it - the chapter presents the location effects of integration in the light of neoclassical theories (Heckscher-Ohlin), as well as the so-called new economic geographlJ. The chapter also presents the main features of the EU's regional policy and considers the implications of the eastern enlargement. Chapter 11 covers the basic elements of the EU's competition policy and state aid policy (EU jargon for subsidies). Instead of merely describing the policies, the chapter explains them by introducing the basic economic logic of anti-competitive practices. It has been updated to include several recent cases that illustrate the difficulties of applying simple economics to the complex world of international business. Chapter 12 addresses EU trade policy, that is, its commercial relations with the rest of the world. While trade policy is not as central to the EU as are, say, the CAP and cohesion policies, it is important. The EU is the world's largest trader, and trade policy is probably the only EU 'foreign policy' that is consistently effective. The chapter covers EU trade policy by presenting the basic facts on EU trade, covering the EU's institutional arrangements as concerns trade policy, and finally summarizing the EU's policies towards its various trade partners. It has been fully updated to reflect changes introduced by the Lisbon Treaty. Part IV continues the approach of Part II by providing the basic principles behind macroeconomic and monetary integration. • The essential principles needed for the macroeconomic analysis are presented in Chap~er 13. ~his chapter presents the macroeconomic theories and tools needed to analyse 1~10~1etary. mtegra~on. It is organized around the Mundell-Fleming model and establishes three pn~1ciples: mterest iate arity purchasing power parity and the impossible trinity that affects the chmce of _exchang~ rate ~egim~s. This chapter can serve either as a refresher for economics students or a (fast) mtroductwn to economics for others. th The long process of European monetary integration is recounted in Chapter 14. It st~1:ts briefly wi • cient times when Europe was a de facto monetary union under the gold standard, reviews the Bretton an . . . h US d O11 • d then moves to ai an . Woods period when Europe's exchange rates were tied together via t e · · b · fl ev1ewed the European Monetary System, past and present. The process of euro adopt10n is ne Yr · f. k ded to think about the Chapter 15 presents the optimum currency area theory, the ramewor nee . . 13 • working of a monetary union. The basis is provided by the principles developed m ~hapter ti 1 Looking at the costs and benefits resulting from sharing a common currency, th e th ~ory ~ esfse~ha • h E It · used extensively m m L er to understanding what works and does not work m t e urozone. is

i

Preface

Part Vis the counterpart to Part III, as it presents the main macroeconomic policies of the EU. The main features of the European monetary union are laid out in Chapter 16. This includes a description and analysis of the institutions created by the Maastricht Treaty and how they have evolved since, including during the crisis that started at the end of 2009. It explains the importance attached to price stability and the measures adopted to achieve this objective. The chapter also provides a review of the first decade of the euro up until the crisis. Fiscal policy is the last national macroeconomic instrument remaining once national monetary policy has been lost. Chapter 17 looks at the Stability and Growth Pact, designed to deliver just enough budgetary discipline so as not to endanger the overriding price stability objective. Since the first edition of this book, we have underlined the pact's serious shortcomings; the crisis has led to a strengthening of the pact, but fundamental economic and political difficulties remain. Chapter 18 deals with the financial markets. It starts with an analysis of financial markets in general. It then explains how and why the financial services industry was transformed by the Single European Act 1986 and by the adoption of a single currency and how it has been fragmented by the crisis. The measures taken to deal with this unexpected development are presented and evaluated, including the creation of the Banking Union. The chapter concludes by q,uestioning whether the euro can challenge the US dollar as a world currency. Finally, Chapter 19 offers an overview of the Eurozone crisis. It looks at the global crisis that started in the USA and its transmission to Europe. The next step, the sovereign crisis, is then described and analysed, bringing together much of the material presented in earlier chapters. The policy responses are presented and critically evaluated. The chapter ends with a discussion of the remaining challenges and an analysis of what the break-up of the Eurozone would mean.

H ow to use this book The book is suitable for a one-semester course that aims at covering both the microeconomics and macroeconomics of European integration. If the course is long enough, the book can be used seq,uentially for two courses. Shorter courses may focus on the trade and competition aspects; they can use only Parts I, II and III. Conversely, a course dealing only with the macroeconomic aspects can use Parts IV and V, and finish with labour market issues as covered in Chapter 8 (which does not really req,uire the previous microeconomic material). Eclectic courses that focus on theory and cover trade, competition and macroeconomics can use only Chapters 1-8 and 16-19 or just 4-8 and 16-19. Eclectic courses oriented towards policy issues can use, with some additional lecturing if the students are not familiar with basic theory, Chapters 1-2, 9-12 and 16-19. In general, all chapters are self-contained but, inevitably, they often refer to results and facts presented elsewhere. Each chapter includes self-assessment q,uestions designed to help the students check how well they master the material, and some chapters also provide essay q,uestions which can be given as assignments. We also provide additional readings that are easily accessible to undergraduate students. The fifth edition continues our tradition of providing many internet links that should allow students and lecturers alike to gain the latest information on the EU's many fast-developing areas. We have observed that the internet is an excellent way to stimulate students' interest by bringing classroom teaching to real issues they see every day in the media. The links we provide go well beyond journalist treatment in a way that allows students to realize the usefulness of the basics they have learned from the text.

Gu ided our

Introduction

Chapter introduction Each chapter opens with an introduction outlining the ideas and

When this book was being written, in 20 concepts that will be addressed in the following pages. economically and politically. Britain was q,u eveq)\vhere, and explicitly anti-EU parties we1~="::t'al~=~:----~----=~~-=~-'"'."""!:-.-::--~:---:------------ -France, Germany and Poland. The EU, however; wr :· crisis of 2008, the Eurozone crisis of 2010 and then new relevance, or purpose, that goes well beyond i whose aim ·was to avoid war in Europe. EU meml members tluive in a hostile global situation. Authoritarianism and aggressive nationalism , practices and institutions that had long undeqJilme threat. Emerging powers such as China and India a the old order's mai11 architect - the United States decades of peace, Russian tanks were once again Figure 1.2 The four-way division of Germany neighbours. These are trymg times for small pro authoritarian and uncompromismgly nationalistic. nhr:ased it.,..i

1a1 2018- 'Jt~i.s n

aps and diagrams These are provided throughout the text to show the geographical impact of changes in EU integration across the continent.

Most European nations were bankrupt bilateral agreements, often involving ba another type, say food). The EPU 'multi nation's bilateral trade deficits into a sin deficits or surpluses with every other EP

Each chapter contains a number of boxes that provide fmther examples and explanations of key facts, events or economic ideas relating to the European Union.

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to the EPU as a whole. Most members ha~_.,.~,m · wartime damage (which made exporting diffi ,· advantage of this approach was that the need t all that mattered was the nation's overall trade the web of bilateral trade restrictions that had EPU can be thought of as the real start of pos liberalized trade flows inside Europe.

35 30 25

- - Germany Spain Ireland

Figures and tab les Figures and tables feature throughout the text to help illustrate important statistics and data about the European Union and its Member States.

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5.6 Summary This chapter introduced the verbal logi liberalization in an NICNIR setting. Afte1 and welfare effects of the formation of a

Chapter summaries Recaps of the key ideas and discussions are featured at the end of each chapter.

• Formation of a preferential trade an .._""'."""!~r:-:-~-:-~~~ a rea, tends to lower domestic prices and 'f t: liberalizations also produce supply switch member-based suppliers.

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• The welfa re effects of any trade liberali standard public-finance concepts, which , price) effects. • The welfare im act of

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The NICNIR was the backbone of 'customs and provisos were put forth in the NICNIR set exercises illustrate the basic points. Kemp-Wan theorem, 1976) Starting fro~/ hree nations are symmetric in everything, 'fict Partner form a customs union and low

Self-assessment questions

new, post-~ber~lization border p~c~ ~ ' 'lforalization, 1.e. P - T. Show that this K 1 in while Ro W does not lose from th.is CU .Gooper-Massell, 1965, extended) We can

Self-assessment q,uestions are included to allow students to test themselves on the economic concepts and facts featured in each chapter.

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Essay questions Essay q,uestions feature at the end 2 Can you imagine other regions in th 3 You are given the task of designing students to write full answers to Eurozone. Consider both how to coll practice for exams. 4 'Admission of more countries into shocks.' Comment. 5 Are business cycles and economic struc comfortably with euro interest rates on a p 6 If problems emerge, is there sufficien~flex

of some chapters and encourage explor_e ideas in more detail as

Further readin : the aficionado's car

Acharya, R., J.-C. Crawford, M. Maliszewski and - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - . , s) Preferential Trade Agreement Policies for D

;-Chapter 2.

Further reading, useful webs ites and references

~fP. and C.F. Foley (2011) 'PoultnJ in motion:

For students who want to explore key concepts, each chapter contains a list of extra sources to help further research.

':}\Omic Policy Research, London. ·m, R. (2014) 'The impact of mega-regionals: th iiie-changers or Costly Distmcti.011sjor the Wo,

'"ers 17091.

·" 1n, R. (2006) In or 01tt: Does it i\fotter? A n Evi

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.~trand, J. (2008) 'How much has Emopean econ ' VoxEU.org, 6 September, httpJ/www.voxeu.org/ar big-was-boost.

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Chapter 0 1 Chapter 02 Chapter 03

History Facts, law, institutions and the budget Decision making

3 39 71

Chapter Contents 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11

Early post-war period 4 Two strands of European integration: federalism and intergovernmentalism 9 Evolution to two concentric circles: the domino effect part I 15 17 Euro-pessimism Deeper circles and the domino effect part II: the Single Market Programme 18 and the EEA 21 Communism's creeping failure and spectacular collapse 23 Reuniting East and West Europe 23 Preparing for eastern enlargement: a string of new treaties 26 Global and Eurozone crises and institutional responses 29 The rise of Euroscepticism 35 Summary

CHAPTER 1 History

Introduction When this book was being written, in 2018, the European Union (EU) was w1 der enorm . · · 11 B ·t . ·tt· th EU · · ous strain economically and pol~ti_ca y. _n am w~s q,w mg . : , scepti~is~ about the EU was on the rise almos everywhere, and exphcitly anti-EU parties were gammg popularity m several large nations includin t 1 France, Germany and Poland. The EU, however, was showing enormous resilience. It overcame theg 0 crisis of 2008, the Eurozone crisis of 2010 and the migration crisis of 2015-16. The EU was also acq,ui;. al new relevance, or purpose, that goes well beyond its traditional role as the creator of an ever-closer :goa whose aim was to avoid war in Europe. EU membership was increasingly seen as critical to helping i~ members thrive in a hostile global situation. Authoritarianism and aggressive nationalism were on the rise around the world in 2018. The rules practices and institutions that had long underpinned global stability, economic growth and peace are unde; threat. Emerging powers such as China and India are challenging the existing world economic order just as the old order's main architect - the United States - was actively undermining its own creation. After seven decades of peace, Russian tanks were once again crossing borders to seize land from weaker European neighbours. These are trying times for small prosperous nations who find themselves confronted with authoritarian and uncompromisingly nationalistic superpowers. As German Chancellor Angela Merkel phrased it in May 2018: 'It is no longer such that the United States simply protects us, but Europe must take its destiny in its own hands, that's the task of the future.' In the face of this uncertainty, hostility and aggression, the sheer size of the EU matters. With its population of over 400 million people, the EU economy rivals that of the USA and China; it is ten times larger than the Russian economy. These developments make it more important than ever to understand how and why Europe got to where it is today . The key to this comprehension is a thorough understanding of Europe's q,uite uniq,ue history. For the first half of the 1900s, Europe was wracked by the rise of fascism, communism, two world wars and the Great Depression. In the second half of the 1900s, European economic integration put an end to the turmoil by constructing closer economic cooperation among former enemies. This fostered peace, liberty and prosperity. Economic integration was the way Europe constructed the new reality, but the result was a type of political construction that the world had never seen before. Quite simply, it is impossible to understand the rather extraordinary things going on today without a firm grasp on Europe's post-Second World War history. This chapter presents the main events in chronological order, stressing, wherever possible, the economic and political economy logic behind the events.

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1.1 Early post-war period In 1945, a family standing almost anywhere in.Europe was in a nation that was recently ruled by a bmtal fascist dictator, occupied by a foreign army, or both. As a direct result of these governmental failures, tens of millions of Europeans were dead and Europe's economy lay in ruins. Worse yet, this was not new. If the parents were middle-aged, the Second World War would have been their second experience of colossal European death and destruction. Indeed, the Second World War was the fourth time in 130 years that France and Germany had fought horrifying wars. Forgetting about facts like these has allowed populist politicians to belittle how important the EU has been to building the prosperity and freedom that Emopeans take for granted.

1.1.1 A climate for radical change As the fog of battle lifted in 1945, it was clear to all that something was desperately wrong wi

th

the way Europe governed itself. This opened minds to radical changes - changes that would be absolutely unthinkable today. th3 It is hard for students born around the year 2000 to connect emotionally with the misery and hards~p ~ opened minds to such a drastic reconsideration. Yet making this connection is essential to really compr ehen what is going on in the EU today politically, economically and socially. The internet allows students to s_ee photos (see Figure 1.1), watch videos and listen to original speeches from early post-war years. The website of the Luxembourg-based Centre Virtuel de la Connaissance sur !'Europe (www.cvce.eu) provides access to a vaSt range of European documents. Just go to 'Historical events in the Eurooean inteqration process

Early post-war period

Figure 1.1 London Hospital in late 1940 and Dresden 1945

© Chronicle/Alamy Stock Photo

© dpa picture alliance/Alamy Stock Photo

(1945-2009)' and click on the 'Resources' tab. See www.jewishvirtuallibrary.org for audiovisual material on the Holocaust, and www.archives.gov for American material. For powerful photos and videos of Germany's experience, go to http://www.hdg.de/lemo/html/Nachkriegsjahre/. Table 1.1 shows some figures on the death and destruction caused by the Second World War. In western Europe, the war killed about 8 million people, with Germans accounting for three-q,uarters of this total. In central and eastern Europe, over 9 million perished, of whom 6.3 million were Poles. The Soviet Union alone lost over 20 million. The fact that much of the killing involved the deliberate slaughter and starvation of civilians made it even more horrifying. Ta ble 1.1

Death and destruction in the Second World War

Austria

525,000

1886

Belgium

82,750

1924

Denmark

4,250

1936

Finland

79,000

1938

France

505,750

1891

6,363,000

1908

Italy

355,500

1909

Netherlands

250,000

1912

Norway

10,250

1937

Sweden

0

(a)

Switzerland

0

(a)

325,000

(a)

Germany

UK (a) GDP grew during the Second World War.

Sou rce: GDP data from Crafts and Toniolo (1996), p. 4; death toll from https://en.wikipedia.org/wiki/World_War_II_casualties

CHAPTER 1 History

are difficult to find for cent 1 The war also caused enormous economic damage. Figures · T b ra and east t aggermg, E but the estimates for western urope are s as a le 1.1 shows. The war co t G ern E urop e, . s ermanu anct Ita1y f o ur decades or more of growth and put Austnan and French GDPs back to nineteenth- century level S,

Refugees, hunger and political instability situation in Europe was dire in the years 1945-4 7 e . The economic ' political and. humanitarian . . , specially in Germany. Food product10n m 1946 was low and the 1946-47 wmter was especially harsh. H was widespread. Food wa~ rationed in most European nations _up to the ~d-1950s. At times, ratio:;:~ to just 900 calories per da-y m some parts of Germany (2000 calones per da-y 1s the standard todalJ). Much of Europe's infrastructure, industr-y and housing la-y in ruins. Many Europeans in these -years were dependent on humanitarian aid, in much the same wa-y as people in war-tom African nations are todalJ. The UN Relief and Rehabilitation Administration (UNRRA) spent nearly $4 billion on emergency food and medical aid helped about 7 million displaced persons return home and provided camps for about a million refugees who' did not want to be repatriated. Politically, western Europe suffered governmental and constitutional crises. The French wartime leader General de Gaulle resigned as president in 1946 over a disagreement about France's new constitution. Italy and Belgium saw bitter internal conflicts over their monarchies. Italy abolished its monarchy in a referendum that involved accusations of communist manipulation. The return of the Belgian king sparked riots. If all this seems like the plot of a B-grade apocalypse movie, you should watch some of the online audiovisual material to see just how real it was. Hunger, riots and refugee camps were commonplace all across western Europe - and the people in these camps were not from Syria or Africa, they were Europeans.

1.1.2 The prime question and guiding ideologies The horror and revulsion arising from this devastation pushed one q,uestion to the forefront in the mid1940s: 'How can Europe avoid another war?' The solutions offered depended on beliefs about the causes of the war. Three schools of thought were in evidence:

Germany was to blame. Guided by this belief, the so-called Morgenthau Plan of 1944 proposed to avoid future European war by turning Germany into a backward country whose economy was based on agriculture. This was similar to the thinking that guided the solutions adopted after the First World War. The victors, especially France and Britain, blamed the First World War on Germanu, and decided they would punish the Germans by taking some German territory and demanding large payments called 'reparations'. After the First World War, the result was a cycle of recoveru, resentment and national rivalry that ultimately paved the road to the Second World War. 2 Capitalism was to blame. Marxism-Leninism blamed capitalism for most of the world's evils, including both world wars. This belief suggested that communism was the solution. 3 Nationalism was to blame. The third school blamed the excesses of destrucUve nationalism for the war. The solution suggested by this belief was tighter integration of all European nations. While calls for a united Europe were heard after the 1914-18 war and during the 1939-45 war, the school's mo st famous post-war statement was the 1946 'United States of Europe' speech by Winston Churchill (you can listen to it at www.cvce.eu). The European integration solution ultimately prevailed, but this was far from clear in the late 1940s. Most European nations were either struggling to re-establish their governments and economies or w~re under direct military occupation. Germany and Austria were divided into US, UK, French and Soviet zones (Figure 1.2). Soviet troops occupied all of central and eastern Europe. In western Europe, 1945 and 1946 passed with hardly any progress towards the establishment of a post-war architecture, and th e economic recovery was going nowhere. Western European governments' limited governance capacities were overloaded by the dismal humanitarian situation. Things moved more rapidly in the east as the Soviet Union implemented school-munber-two thinki~lg. Communism was imposed on the previously independent nations of Estonia, Latvia and ~ithuania dunng

Early post-war period

Figure 1.2 The four-way division of Germany

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the war. By 1948, communist parties had been pushed to power with Soviet help in every country occupied by the Soviet army at the end of the war. The spread of communism, however, went further. Communists took power in Albania and Yugoslavia, and were gaining strength in Greece. Communism had many supporters in western Europe as well. In the parliamentary elections of 1946, for example, communists won 19 per cent of the vote in Italy and 29 per cent in France.

1.1.3 Emergence of a divided Europe: the Cold War In the early post-war years, the USA, UK and USSR were the key players in Europe's architecture since all other nations were in ruins. America, Britain and the Soviet Union were the only nations that still had the strength to guide events internationally. Even as the war was coming to a close, America and Britain rejected the Soviet's anti-capitalism plans and the wartime alliance unravelled. The Allies-versusAxis confrontation was replaced by an East-West confrontation called the Cold War. This new conflict dominated economic, political and military thinking in Europe for 50 years. It also ruled out schoolnurnber-three thinking (especially the Morgenthau Plan) since restoring German power was essential to standing up to Soviet plans to spread communism to the west. In this way, the Cold War was a key driver of European economic integration. By 1947, the USA and Britain had concluded that an economically strong Germany would be essential to the defence of liberal democracy in western Europe. This led them to merge the UK and US occupation zones in Germany (see Figure 1.2) into one zone they called 'Bizonia'. France, which had originally favoured the Morgenthau Plan, added its zone in 1948, and the three created a new nation, called West Germany (the Federal Republic of Germany). In reaction to these western moves, the USSR escalated harassment of westerners travelling to Berlin. Ultimately, the Soviets imposed the famous 'Berlin Blockade' on 24 June 1948. Western powers countered with the eq,ually famous 'Berlin air bridge' (see www.cvce.eu for details and photos). Despite Soviet objections, West Germany (formally the Federal Republic of Germanu) was established in May 1949. The Soviet zone then became East Germany (German Democratic Republic). In summary, the USSR's aggressive promotion of its solution ( communism) triggered a western reaction that narrowed the three solutions down to two with an 'iron curtain' between them. East of the iron curtain, the post-war architecture was based on communism, one-party politics and Soviet leadership. To the west, it was built on multi-party democracy, the social market economy and European integration. This division ruled European realities for a half century.

CHAPTER 1 History

1.1.4 First steps: the OEEC and EPU From the perspective of European integration, the most important result of the western European effort to resist communism was the so-called Marshall Plan and the Organisation for European Economic Cooperation (OEEC). In reaction to the dire economic conditions that existed in Europe in the late 1940s and the attendant threat that commw1ists might come to power in Greece, Italy and France, US Secretar~ of State (i.e. Foreign Minister) George Marshall announced that the US would give financial assistance to all European nations 'west of the Urals'. The main condition for the money was that Europeans had to agree to a joint programme for economic reconstruction. Before the Marshall Plan, European integration was for dreamers. After the Marshall Plan, it became the main road to recovering prosperity. European nations gathered in Paris to study Marshall's proposal (the USSR and the central and eastern European countries attended at first but eventually withdrew and never received Marshall Plan funds). The conference was intended to determine the amount of aid req,uired and, at US insistence, to create a permanent organization (the Organisation for European Economic Cooperation, or OEEC) in which Europeans would cooperate in their mutual economic recovery. A joint programme and organization were duly developed by the Europeans. The US Congress, which was initially reluctant, funded the Marshall Plan in April 1948 after the Soviet-led communist takeover in Czechoslovakia. The OEEC started in 1948 with 13 western members of today's EU (Finland was under Soviet pressure to stay neutral and Spain was under Franco's dictatorship) plus Norway, Iceland, Switzerland and Turkey. Germany and Austria were still under Allied occupation, but representatives from the western zones participated. From 1948 to 1952, Marshall Plan aid amounted to $12 billion, with half of this going to the UK, France and West Germany. The OEEC divided American aid among its members (see Box 1.1), but a far more important role, as far as European history is concerned, was the OEEC's mandate to advance European economic integration. It did this by reducing intra-European trade barriers and improving the intra-European system of payments by establishing the European Payments Union, or EPU (see Box 1.1).

· Most European nat10ns wer e bankrupt after 1945' so trade was generally conducted on the basis al f of . ents often involving barter (that is, the swapping of one type of good, say co , or bilateral agreem f 0 0' d) The EPU 'multilateralized' these bilateral deals in the sense of pooling each th ano er type, say d d. f. its into a single deficit. Each month, EPU members added up their bilateral . n's bilateral tra e e ic . . • • t 10 na d r ·ts surpluses w1·th ever11:::i other EPU member to determme an overall surplus or def1c1t with respect e ici or 1 M t members had overall deficits since their economies were suffering from to th~ EPU as a who~. h osade exporting difficult), yet they all needed imports to rebuild. The great wartime damag_e (w r~a~ was that the need to import from or export to particular nations vanishedth1 advantage of s app h f on's overall trade balance. As a conseq,uence, it became practical to loosen all that mattered wast de na I trictions that had been set up in the early post-war years. In this way, the b of bilateral tra e res . . . • • · 1 h tEPU e we f th real start of post-war European economic mtegration smce 1t massive Y can be thought o as e liberalized trade flows inside Europe. . box is . b ase d Jar"ely Source: This l:I

011

Eichengreen and de Macedo (2001).

h 11 Plan proved to be a critical turning point in the history of European integration. Tentative The Mars· a11 based support for European mtegratlon . . . came to b e s t1.ong1y 1.e inforced by western and 1deolog1ca Y . . . European natl.ons pursuing the1r own national mterests. . . as a way of count erb a lancmg · US-UK influence on Fr nch leaders saw the Franco-German mtegration th: Continent while at the same time making sure that a reindustrialized Germany would become an economic partner rather than a military adversary.

Two strands of European integration: federalism and intergovernmentalism

The UK and the USA supported European integration as the best way to counter the spread of communism in Europe. German leaders embraced European integration as the surest route to re-establishing Germany as a 'normal' nation (Germany was recognized as an independent nation only in 1955). Italian leaders also welcomed European integration, which provided them with an ideological counterbalance to communism and helped shut the door on Italy's fascist past. The Benelux nations (Belgium, the Netherlands and Luxembourg) were happy about anything that reduced the chances of another Franco-German war. European integration got a new boost in 1949, when the USA said it would keep paying only if the OEEC made greater efforts to economically integrate Europe. The main demand was that the OEEC accelerate the liberalization of trade among its members. Up to this point, Marshall Plan money was mainly used to finance European countries' dollar deficits in the EPU (see Box 1.1). This spending had a very pro-trade effect, but the USA wanted deeper liberalization - hoping that it would accelerate Europe's economic recovery. Responding to this pressure, the OEEC nations removed q,uantitative trade restrictions among themselves. This OEEC trade liberalization was important in at least two ways. First, the liberalization fostered rapid growth in trade and incomes. Indeed, the 1950s as a whole were marked by spectacular growth in the exports of manufactured goods and in incomes. Several nations on the Continent grew at rates that are now seen only in rapidly industrializing Asian economies. Second, this rapid growth made economic integration look like a wondrous economic policy and this, in turn, shifted mindsets. Europe's leaders came to view European integration as an idea that made as much sense economically as it did politically. In particular, it helped gradually shift the thinking of Britain towards a pro-EU stance. This change in mindset was momentous. In the decades following the First World War, especially during the 1930s, economic growth was viewed as a competition between nations. In this competition, trade barriers played a central role as each nation sought to protect its domestic market for its own industrialists (the policy was called protectionism). In a sharp turnaround, the reduction in trade barriers that came with European integration fostered exports and industrial growth. Income rose at a spectacular rate and intra-European imports and exports expanded even faster. This experience firmly established a belief that European economic integration provided important economic benefits.

1.1.5 The drive for deeper integration The OEEC was an economic success, but would it prevent another war between France and Germany? And a new war was very much on people's minds. In the 1940s, people very clearly remembered how the end of the First World War in 1918 created conditions that led, just 20 years later, to the Second World War. Many also remembered that grievances that arose from the 1870 Franco-German war contributed to the First World War. The OEEC and EPU produced booming imports and exports and rising incomes but some OEEC members felt that European integration would have to be much deeper to make a new war unthinkable. The problem was that European nations disagreed sharply on how European integration should move beyond the OEEC and EPU.

1.2 Two strands of European integration: federalism and intergovernmentalism At the time of writing, in 2018, feelings about Europe were diverging. Many feel that EU integration has gone too far, that too much control has been handed over to EU decision-i~mking bo~ies in Brussels. Oth~rs feel that deeper integration is the only way to tackle the challenges facmg today s Europe - everyt~g from stagnant growth and high youth unemployment, to mass migration, the rise of China and the decline of American global leadership. This divergence is most definitely not new. The debate over whether we need 'more Europe' or 'less Europe' has been going on since the 1950s. . While it was clear by the late 1940s that European integration would be the foundation of wes~ern Europe's post-war architecture, a serious divide emerged about what this integratio~ should loo~ hke. The heart of the matter was the trade-off between European integration and nat10nal sovereignty.

CHAPTER 1 History

II I

'pooled' that is handed to joint decision-making bodies The debate was over h ow muc h power Should be , , , at the European level, and how much power should be keep at the national level. The fundamental debate, however, goes even further back and even deeper. In some_ EU memb:r states, like France, many decisions are taken at the national level - the curriculum for scho_olc~dren, for mst_an~e, is set in Paris for all French schools. By contrast, the responsibility for educatwn is at the provmc1al level (called Bundeslander) in Germany. The problem facing the leaders of Euro~ean integration was, in essence, which areas they wanted to centralize (like education in France) and which they wanted to keep decentralized (like education in Germany). Even today, this division defines the debate over European integration. The centralizers are called 'federalists'; the de-centralizers are called 'intergovernmentalists'. The British who voted to r:main in the EU tended to be in the federalist camp, while those who voted to leave tended to be m the intergovernmentalist camp. Federalists felt that national sovereignty and the nation-state constituted a fragile system prone to warfare. Since time immemorial, European states had been engaged in intermittent struggles for dominance - struggles that typically involved the invasion of other European nations. As industrialization made killing much more 'efficient', the cost of these struggles rose to the point where no one could win. To these thinkers, even democracy was insufficient to prevent horrifying wars. Hitler, after all, gained his first hold on power through democratic means. To prevent another cycle of recovery and national rivalry that might lead to a third world war, these thinkers believed that nations should be embedded in a federalist structure - a supranational organization embodied with some of the powers that had traditionally been exercised exclusively by nations. Other European nations, led by Britain, continued to view nation-states as the most effective and most stable form of government. To them, European integration should take the form of closer cooperation especially closer economic cooperation - conducted strictly on an intergovernmental basis, that is, all power would remain in the hands of national officials and any cooperation would have to be agreed unanimously by all participants. Not surprisingly, the federalist school was most popular in European nations where the nation-state failed the population most spectacularly, where failure here is measured in terms of wartime death and destruction (see Table 1.1). This group included the original six members of the EU: Belgium, the Netherlands, Luxembourg, France, Germany and Italy. People living in natio~s ':hose _wart~~ gover~m~nts avoid:d foreign occupation and/or catastrophic loss of life tended to mailltaill their tradit10nal faith ill the nat10n-state. This included the UK Denmark Norway and Icela~d, as well as the neutrals: Ireland, Sweden and Switzerland. Fascist dictators Spain and Portugal ruled until the was .long postponed in the Iberian Perun·sula , but w h en th ey . 1970s, so. the q,uest10n . . joined they were typically pro-illtegrat1on f edera~1s~s: Finland and Austria were also pro-integration but Cold War pressure from the USSR kept them fromJOinillg the EU until the Cold War ended in the late 1980s.

hl

1.2.1 Two early extremes: Council of Europe and the ECSC Intergovemmentalism the · 1y a matter of . . . initially dominated . . post-war architecture . · In part , thi·s was sunp tlmillg. The only maJor European nat10n with a truly effective dernocrat ·c gove t 1 1 11men b e f ore 1947 was . . . . . . . . Bntaill, and Bntaill was a f1rm believer ill illtergovernmentalism This is one · . . . · unpor t an t reason why the f1rst. three orgamzatlons - .the OEEC, the Council of Europe and the Coti1·t of Hum.an R"1ghts - followed . . . . the mtergovemmental trad1t10n. The OEEC was stnctly mtergovernm t 1 c· · . . . . d_ _. , en a 1.e. one nation, one vote, with unanmuty req,mre to agree any thmg), and the 1948 Congress of Europe' t bl' l d • t t . h c ·1 f E es a is 1e two mtergovernmental sf ruct_urets. dt e Tohunc1 o hurope (1949} and the Court of Human Rights (1950) - both of which continue to unc 10n o ay. ey are, owever, entirely unrelated to the EU The first big federalist step came in 1952 with im 1 t ~-1011 proposed that France and Germany should place tt ~men ~ of th e so-called Schuman Plan, which supranational authority called the European Coal an~e;tecoa allcl st ~el sectors un~er the control of a by the 'father of European integration' J M el Conunumty (ECSC). Tlus plan was inspired Schurnan. As these two are considered ' , ean , mmet but promoted by Fr ench F ore1gn . Minister Robert f ' . 1 about them. As a bonus their careers d 1eroes o ~ur~pean mtegration, it is worth learning a little bit ' an personal histones provid 1· . . . Europe was back then (see Box 1.2). e a rev ea mg glimpse mto how different

Two strands of European integration: federalism and intergovernmentalism

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Born in Luxembourg, Schuman studied and worked in Germany until the end of the First World War. He became French when Alsace-Lorraine reverted to France in 1918. He held several positions in the post-war French governments, including Finance Minister, Premier and Foreign Minister. Schuman provided the political push for the European Coal and Steel Community, which most consider to be the wellspring for the European Union. He was also the first President (1958-60) of the European Parliament. Jean Monnet, born in Cognac in 1888, was a brilliant organizer and as such helped to organize Allied military supply operations in the First and Second World Wars. Near the end of the Second World War he joined Charles de Gaulle's provisional Free French government, and was responsible for the 'Monnet Plan', which is credited with helping France's post-war industrialization. Monnet was a convicted Europeanist and led the European movement in the 1950s and 1960s. Monnet, who is sometimes called the 'father of European integration', was the intellect behind the idea of the ECSC and the first president of its 'High Authority' (precursor of the European Commission) from 1952 to 1955. He continued to push for the European Economic Community and the European Atomic Energy Community (Euratom). Sources: http://www.hdg.de/lemo/biografie/robert-schuman.html and http://www.hdg.de/lemo/htmJ/biografien/MonnetJean/index.html

© Popperfoto/Getty Images

Setting up the ECSC was a radical move. Coal and steel were then viewed as the 'commanding heights' of an industrial economy and crucial to a nation's military and industrial strength. Joining the ECSC was an enormous transfer of power from the national level to the supranational level. This transfer of power was not an accident, it was the point of the whole exercise: Schuman explicitly justified his plan as a means of rendering future Franco-German wars materially impossible. Nations could not go to war if they did not control the industry that made modern war possible. Other European nations were invited to join this European Coal and Steel Community (ECSC), and Belgium, Luxembourg, the Netherlands and Italy actually did so. This created a group of nations known simply as 'the Six' - a group that has been the driving force behind European integration ever since. The ECSC submerged the role of nation-states to an extent that seems unimaginable from today's perspective. Its institutions were the model for those in today's EU so they are worth understanding (see Box 1.3).

Box 1.3

The European Coal and Steel Community (ECSC)

Crucial decisions such as pricing, imports, exports and production of all the national coal and steel sectors were placed in the hands of the ECSC's High Authority, which can be thought of as the exec_u~ve branch of the ECSC. This body, the forerunner of today's European Commission, consisted of officials appointed by the six Member States. As is true for EU Commission today, this was a very federalist

►

CHAPTER 1 History

institution. ECSC officials were appointed by their governments but were supposed t~ be independen_t, and they pledged to defend the general interests of the Community rather than the mterests of th err own nation. b· t 1· · The High Authority's decisions, some of which were made by majority voting, were su ~e,ct O ~ted control by national governments via the 'Cow1cil of Ministers'. This body, a model f?r the EU s ~ouncil of Ministers, consisted of one representative of each nation. Oversight was also provided the Comma~ Assembly', whose members were appointed by national parliaments. Loosely speakmg, the Cow1c1l was like the US Senate (where states are represented) and the Assembly was like the US House of Representatives (where the people are represented). There was also a judicial branch consisting of t~e 'Court of Justice', tasked with ensuring compliance with the ECSC Treaty (known as the Treaty of Pans) and providing interpretations of the Treaty where necessary. Lastly, the ECSC had a consultative body with members of what we would today call civil society: firms, workers, consumers and dealers.

?Y

1.2.2 Expanding the federalist track European events moved q,uickly in the late 1940s and early 1950s. In the same year that Schuman proposed the ECSC to prevent another Franco-German war, NATO was set up to guard against a possible Soviet attack on western Europe. This was not a theoretical possibility. the USSR was ideologically committed to replacing capitalism with communism worldwide. Having made good on this promise in east and central Europe, many feared that west Europe was next. With East-West tensions rising steadily and the Cold War threatening to become a real war, it became clear that Germany would not only have to be allowed to regain its industrial might, it would have to rearm. This created a new problem that had to be solved. Since many Europeans, including many Germans, were still uncomfortable with the idea of an independent Germany that was both economically and militarily strong, integrating Germany into a supranational Europe seemed a natural way forward. The federalists' first instincts were to do with Europe's national armies what they had done with Europe's national coal and steel production, namely place them under a supranational institution.

Failed supranational integration: the EOG and EPC To deal with the f~ll rearmament of Germany, the S~ negotiated~ new treaty that would create a European Army and place 1t under the control of . a supranat10nal authonty. The new institution , whi ch was t o b e called the European Defence Commumty, had similar to the ECSC • The creat1·011 o f anewarmy . . a structure . . however, raised many issues that had been ignored m creatmg the ECSC. ' A European army would make it. difficult for the Six to conduct fully indepeilden t f ore1gn • po11c1es . . It would also have req,uired a substantial budget and thus taxation and spending atith ··t M . · . . . 011 y. ost importantly the soldiers would have to be frrmly under democratic control. The last item led to tl d. ft' f ' .. f d 1· t . t·t . h E le rn mg o plans for an even more amb1t10us e era 1s ms 1 ut10n - t e uropean Political Commm11·t (EPC) Th EP . . · Id · · Y · e C 1f 1t had come mto effect, really wou have been somethmg hke the United States of E . Ash' ' it, both the EDC and the EPC failed. mope. istory would have By the time the EDC treaty came up for ratification in 1954 Eur . . what it had been in 1945, or even 1950. Economically the Six we;· op~ wa~ a ver Y d1fferent place from never seen. As Figure 1.3 shows, the Six had mana~ed to get th:i:·~cenenc~ng growth like the world had 1940s via almost miraculous growth, and the high growtl . t . onm~11 es back on track by the late period is called the W_irts_chaftsw'Under ( economic miracle\~ a es contmued mto the 1950s. In German, this The spectacular nse m standards of Iiv1·11 g res t ore d many Europ , f 'th . . very real sense, the economic growth foste d b E eans a1 m their governments. In a nation-state (Milward, 1984). This rest dref . yl uropean economic integration rescued the European . ore ait 1 however r d d sovereignty to the European level - esp . ll f ' . ' e uce popular support for transferring ~ it turned out'. the French parliame~~1:u{edo~:o;eth_m_g_ as_ critical~~ military and foreign policy. have implemented it. Since the EPC was link d t th DC m1t1ative by fa1lmg to ratify the treaty that would EPC as well. e O e EDC, France's reiectirm nf c,""'-~--..L! - ••- - ---

Two strands of European integration: federalism and intergovernmentalism

Figure 1.3 Post-Second World War reconstruction Post-war Reconstruction Growth Rate

45% 40%

Netherlands,

35%

40%

30% 25% Austria, 15%

20% 15% 10% 5%

/

France, 19% 0

Denmark, 14%

~

Norway, 10%

Germany, 14% 0

Belgium, 6%

Italy, 11%

0%-i------.------,------,-------r-------r-------r-----~ 1945 1946 1947 1948 1949 1950 1951 1952 Source: Author's adaptation of data published in Nicolas Crafts, Gianni Toniolo, 'Postwar growth: an overview', in Nicholas Crafts, Gianni Toniolo (eds), Economic Growth in Europe since 1945 (1996) © Centre for Economic Policy Research 1996, published by Cambridge University Press.

Rejections of the EDC, however, left the challenge of German rearmament unresolved. The challenge became even more pressing when the Allied occupation of Germany formally ended in 1955, and West Germany became an independent member of NATO. By this point, it was clear that the ECSC would not be enough to make another Franco-German war unthinkable. Having failed in their efforts to integrate West Germany directly into defence and political communities, European leaders turned their minds to broader economic integration - the European Economic Community. The idea was to expand the coverage of economic supranationality from the coal and steel sectors to the whole economy. Given the revival of Europeans' faith in their national governments, the new institution would hand over less national sovereignty to the supranational organization. Nevertheless, the goal of this new body would be eventual political unification of Europe. What changed was the means of achieving the goal, not the goal itself.

Creation of the EEC Foreign Ministers of the Six met in Messina in June 1955 to start a process that soon led to the signing, on 25 March 1957, of two treaties in Rome: the first created the European Atomic Energy Community (Eura tom); the second created the European Economic Community (EEC). Because the EEC eventually became much more important than Euratom, the term 'Treaty of Rome' is used to refer to the EEC treaty. Britain partook in the preliminary meetings but dropped out in October 1955 since its leaders at tl1e time could not accept the supranationality that EEC membership would imply. The Treaty of Rome was q,uickly ratified by the six national parliaments and the EEC came into existence in January 1958. (The institutions of the ECSC, the EEC and Euratom were merged into the 'European Communities', or EC, in 1965.) The Treaty of Rome committed the Six to extraordinarily deep economic integration (see Chapter 2). In addition to forming a customs union (removing all tariffs and q,uotas on intra-EEC trade and adopting a common tariff on imports from non-member nations), it promised free mobility of workers, capital market integration and free trade in services as well as a range of common policies - some of which were to be implemented by a supranational body. The Treaty also set up a series of supranational institutions such as the European Parliamentary Assembly (forerunner of the European Parliament), the European Court of Justice and the European Commission. See Chapter 2 for details.

14-t}

l

CHAPTER 1 History

/

These steps towards deeper federalist integration among the Six triggered a reaction among other west European nations who would not or could not join the EEC. Britain led this reaction by forming the European Free Trade Association, or EFI'A.

1.2.3 Intergovernmental track: from OEEC to EFTA Formation of the EEC introduced discrimination - preferences is a nice word for the same thing - into European economic integration. Before the creation of the EEC, trade liberalization was extended to all OEEC nations on a non-discriminatory basis. The EEC's customs union meant that tariffs within the EEC would be lower than those charged to third nations. Fearing discrimination and marginalization, seven OEEC nations formed their own bloc in 1960 called EFI'A. With EFI'A in operation, all western European democracies had joined one bloc or the other. The exception was Ireland, which was already tightly integrated economically with its major trading partner (the UK), and had no interest in deeper integration since it had won full independence from Britain only in 1948.

1.2.4 Two non-overlapping circles: Common Market and EFTA The trade liberalization promised by the Treaty of Rome and the Stockholm Convention (EFI'A's founding document) rapidly came into effect in the 1960s. By the late 1960s, trade arrangements in western Europe could be described as two non-overlapping circles (Figure 1.4). The lowering of intra-EEC trade barriers had an immediate and dramatic impact on trade patterns. During the formation of the customs union (CU), the EEC's share in its own trade rose from about 30 per cent to almost 50 per cent. At the same time, the share of EEC imports coming from six other major European nations remained almost unchanged, falling from 8 to 7 per cent. (More on this in Chapter 5~) Figure 1.4 A Europe of two non-overlapping circles

IRL

Western European Trade Arrangements in the 1960s: the EFTA7 and the EEC6 form two non-overlapping circles. GR B = Belgium, NL = Netherlands, D = Germany, L = Luxembourg, F = France, I = Italy, E = Spain, GR = Greece, IS = Iceland, IRL = Ireland, UK = United Kingdom, P = Portugal, N = Norway, DK = Denmark, S = Sweden, CH = Switzerland, A = Austria, FIN = Finland Sou rce: Baldwin (1994)

\ Evolution to two concentric circles: the domino effect part I

I r

1.3 Evolution to two concentric circles: the domino effect part I At the beginning of the 1960s, EFTA-based and EEC-based firms had roughly eq,ual access to one another's marke:s ~s the preferential tariff cutting had only just begun. As the barriers began to fall within the EEC and within EFTA (but not between the groups), discrimination appeared. This discrimination meant lost profit opportunities for exporters in both groups. Importantly, the relative economic weight and economic performance of the two circles were far from eq,ual. The GDP - and thus the potential market size_ of the six EEC nations was more than twice that of the seven EFTA nations (EFTAns) and the EEC incomes were growing twice as fast. The EEC club was far more attractive to exporters than the EFI'A club. Accordingly, the progressive reduction of within-group barriers generated new political economy forces in favour of EEC enlargement, but how did discriminatory liberalization create these forces for inclusion? Discriminatory liberalization is studied in depth in Chapter 5, but the idea behind these new political economy forces can be illustrated with an anecdote. Two campers in Yellowstone National Park, who have just settled down in their tent, hear the roar of a hungry grizzly bear very close by. One camper sits up and starts putting on his rwming shoes. The other camper says: 'Are you crazy? You can't outrun a bear!' The first camper, who continues tying his laces, replies: 'Oh, I don't have to outrun the bear. I just have to outrun you.' When it comes to outrunning bears and succeeding in business, relative competitiveness is the key to success. A firm is harmed by anything that helps its rivals. In the case at hand, closer EEC integration diminished the relative competitiveness of non-EEC firms in EEC markets, thereby harming their sales and profits. Of course, the same happened to EEC firms in EFTA, but given the EEC's much greater economic size, pressures on EFTAmembers to adjust were much greater than those on EEC nations. This effect helps explain why preferential integration among some nations can change the political economy attitudes of excluded nations. This is what Baldwin (1994, 1995) calls the 'domino theory' of regional integration; the preferential lowering of some trade barriers creates new pressures for outsiders to join the trade bloc and, as the trade bloc gets bigger, the pressure to join grows. As history would have it, the British government was the first to react to the pressure.

1.3.1 First enlargement and EEC-EFTA FTAs In 1961, the UK applied for EEC membership -just six years after walking away from the Messina talks. There are many reasons for this change of heart. In 1955, Britain half expected the EEC to fail just as the EDC and EPC had before it. Moreover, British wartime successes hung heavy in the air. Clement Attlee, former UK Prime Minister, spoke for many Brits when he said Britain had just rescued four of the Six from the other two. Thinking changed once the EEC was up and working well. UK industries faced the reality of rising discrimination in Europe's largest and fastest-growing markets. The British government had to react; EFTA was not a substitute for free trade access t~ th_e EEC mark:t. . Britain's unilateral decision to apply for membership m the EEC tipped over more donunoes. If the UK was to jump from EFTA to the EEC, the remaining ~FTA members_would face discrimination in seven mark e ts , no t J·ust the Six. The point is that since the EEC 1s a customs uruon, the UK would have had.to adopt the same tariffs that EEC members had against non-EEC members. That, in turn, would mean havmg to reimpose tariffs on imports from the remaining other EFTA mem~ers. This possibility led som~ of the ?ther . s to change their attitude towards EEC membership; Ireland, Denmark and Nonvay q,mckly EFTA nat 10n f 1· . 1 l as followed Britain's unilateral move. The other EFTA nations did not apply or po 1t1ca reasons, sue 1 neutrality (Austria, Finland, Sweden and Switzerland), lack of democracy (Portugal), or because they were not heavily dependent on the EEC market (Iceland). . Whil G many was broadly in favour of UK membership, France was opposed to 1t. In a renowned J e19;; ress conference French President Charles de Gaulle said 'non' to this first enla~gement ~nuar~ Th / EFTAns reap~lied in 1967 and de issued another famous 'non', but, after he ret1:ed, the ;m:m:iFrA :pp~:ations were reactivated. After many delays, membership _fo: the four w~s gra~~ed but only three joined since Norway's population refused EEC membership ma referen um. e held a referendum on membership in 1975 · C t· nment but new elections brought a · · · · EEC d a centre-right onserva 1ve gover , Bntam Jomed the un er . 4 The left wing of Labour was, at the time, vehemently centre-left, Labour government to power ms ..t d t· p1·talist and they viewed the EEC as both · , anti-EU smce some o f 1·ts 1ea d ers were pro- ov1e an an 1-ca

;Kl=~~

197

15

)

r

I

16 /~-'f* )

CHAPTER 1 History

anti-Soviet and pro-capitalism. Many Labour leaders worried EEC membership would prevent them froni implementing socialist industrial policies. Other elements of the Labour Party were pro-EU. The divisions were almost as strong back then as they are now inside Britain's Conservative government. Some Labour ministers campaigned for membership and others campaigned against. Today's Labour leader, Jeremy Corbyn, for instance, voted against membership. As it turned out, EEC membership won two-thirds of the vote, and the UK stayed in the EEC. The impending departure of four EFTA nations to the EEC was anticipated well in advance and this triggered a secondary domino effect. The 1973 EEC enlargement meant a swelling of the EEC markets and a shrinking of the EFTA markets. Firms based in the remaining EFTA states would suffer a disadvantage ( compared to their EEC-based rivals) in more markets and enjoy an advantage ( over their EEC-based rivals) in fewer markets. Accordingly, EFTA industries pushed their governments to redress this situation. The result was a set of bilateral free trade agreements (FTAs) between each remaining EFTA nation and the EEC. These took effect at the same time as the EEC enlargement, so the three joining the EEC did not have to raise tariffs against the remaining EFTA members. Notice that this change of heart by the remaining EFTA nations does need some explaining. The _stance of, say, Sweden towards an FTA with the then-EEC was a matter of top-level political calculation. It may seem strange, therefore, that the calculations of Sweden's political elite led them to sign an FTA in 1972 with the EEC9 when they had not found it politically optimal to sign one in the preceding decades with the EEC6. The explanation, of course, is that tighter integration among a nation's trade partners (in this case between the UK, Denmark and Ireland and the EEC6) altered the economic landscape facing Swedish exporters. This reshaping of the economic landscape got translated into a new political landscape. To summarize, by the mid-1970s trade arrangements in western Europe had evolved into two concentric circles (Figure 1.5). The outer circle, which encompassed both EFTA and EEC nations, represents a 'virtual' free trade area for industrial products, formed by concatenation of the Treaty of Rome (for intra-EEC trade), EFTA's charter, the Stockholm Convention (for intra-EFrA trade) and individual bilateral FrAs between each EFrAmember and the EEC (for EEC-EFrA trade). The inner circle, the EEC, was more deeply integrated. Figure 1.5 A Europe of two concentric circles

Western Europe's Trade Arrangement in the mid-1970s: two concentric circles

~

1

Note: See Figure 1.4 for abbreviations and source.

GR

Euro-pessimism

1.4 Euro-pessimism Although the EEC's economic integration proceeded smoothly, European integration stagnated soon after the trade liberalization was completed. The Community was rocked by a series of political crises in the 1960s, soon to be followed by economic shocks in the early 1970s. The political and economic shocks together created a period known as 'Euro-pessimism' (1973-86).

1.4.1 Political shocks The spectacularly good economic performance of Europe's economies in the 1950s and 1960s - teamed with the manifest success of European economic integration - went a long way to restoring the confidence of Europeans in their governments' ability to govern. So much so that some nations began to regret the promis_es of deep integration they had made in the Treaty of Rome. Leading this charge for national sovereignty was French President Charles de Gaulle. The issue came to a head as the final stage in the Treaty of Rome's transition period approached (1 Ja~~ary 1966). At this stage, the voting procedures in the EEC's key decision-making body, the Council of Ministers, were scheduled to switch to majority voting (see Section 3.3.1). For the President of France, Charles de Gaulle, it was unacceptable. Majority voting would mean that France might be forced to accept a policy it had voted against if most of the other members wanted the policy. De Gaulle, in short, was not a federalist and he rejected the supranationality that majority voting implied. In the end, de Gaulle forced the other EEC members to accept his point of view in the so-called Luxembourg Compromise. Henceforth, unanimity was the typical rule in EEC decision-making procedures. The insistence on consensus radically reduced the EEC's ability to make decisions (see Chapter 3 on decision-making efficiency) and the problem only got worse as the EEC expanded to nine in 1973.

1.4.2 Failure of monetary integration The late 1960s saw the USA running a monetary policy that was irresponsibly inflationary. It was basically printing money to pay for the Vietnam War without raising taxes. Since all major currencies were linked to the dollar at the time (via the global fixed exchange rate system called Bretton Woods), US inflation was transmitted into inflation in Europe and elsewhere. This, in turn, led to the gradual breakdown of the global fixed exchange rate system between 1971 and 1973. See Chapter 14 for details. Exchange rate stability was widely viewed as a critical factor supporting the rapid post-war growth in trade and international investment (and the rising prosperity these brought). This was true in general, but it was especially important in the EEC. The fixed exchange rate system prevented EEC members from offsetting the market-opening effects of European integration with a competitive devaluation. Since exchange rate stability was viewed as critical to European economic integration, the EEC searched for ways of restoring intra-European exchange rate stability. To this end, it established the Werner Committee, which designed a step-by-step plan for European monetary union. EU leaders adopted the Werner Plan in 1971 with a goal of implementing a monetary union (like the one the Eurozone nations share today) by 1980. This was not to be. The economic environment for this new European monetary arrangement could not have been worse. Months after it was launched, the Yorn Kippur War in the Middle East triggered an oil boycott of America and some European nations (a boycott meant that OPEC members refused to sell oil to these nations). The boycott forced these nations to buy oil on the open market and the result was a very sharp rise in oil prices. This price hike had a ruinous economic impact on western Europe. Consumers switched their spending from domestically made goods to imported oil and this crashed the demand for goods. The result was falling incomes and rising unemployment. On top of this, the oil price rises provided a big inflation shock. Most European nations adopted expansionary monetary and fiscal policies to compensate for the economic downturn and these further fuelled inflation. The net result was falling incomes and rising inflation - a very bad combination that came to be known as 'stagflation'. And the bad news was not over. Just as the world was recovering from the 1973 oil shock, the Iranian Revolution produced a second massive oil price hike, in 1979. This further aggravated stagflation and produced a debilitating series of exchange rate crises. As a result, the Werner Plan was put on hold for ever. This monetary integration failure and the poor economic performance were key features of Euro-pessimism, but there was more.

CHAPTER 1 History

1.4.3 Failure of deeper trade integration

.

. _

.

. . c b t d ew trade barriers. These new barriers consisted of detailed As tanff barners fell, EE mem ers erec e n . .

technical regulations and standards, which had the effect of fragmentn~g t~~ Eur?pean markets. Wlulc these policies, called 'technical barriers to trade' (TBT), undoubtedly i~hibited mtra~Eu~-o_p_ean trade, their announced goal was to protect consumers. EEC leaders had recogmzed the t rad e-mhibiti_ng ~ffects of TB Ts in the Treaty of Rome (Article 100 req,uires 'approximation', Euro-speak for harmomzatwn, of national regulations for the 'proper functioning of the common market). However, as Euro_pean voters became richer, they demanded tighter regulation of markets and product~. The usual machmery of vested-interest politics meant that many of the new standards and regulat10ns tended to protect domestic firms. The EU first systematically took up the removal of technical barriers in 1969 with. its '~en~ral Programme'. This launched what came to be called the 'traditional' or 'old' approach to TBT liberahzatwn. The approach adopted relied on detailed technical regulations for single products or groups of prod~cts implemented by unanimously agreed directives. Since unanimity was req,uired, this approach failed. Harmonization proceeded much more slowly than the development of new national barriers. For example, ten years were req,uired to adopt a directive on gas containers made of unalloyed steel and nine and a half years was the average delay for the 15 directives adopted en masse in 1984. In the meantime, Member States were implementing thousands of technical standards and regulations a year. Stagflation, teamed with the failure of the initiatives to forge deeper monetary and trade integration, created a gloom over the 'European construction'. Many inside and outside Europe suspected that the ideals that had driven European integration since the late 1940s were dying or dead. Yet there were some bright spots in European integration.

1.4.4 Bright spots During the Euro-pessimism years, Spain, Portugal and Greece all adopted democratic governments, thus rendering them eligible for EEC membership. Greece joined in 1981, followed by the Iberians in 1986. Things also started looking up on the economic integration side. The European Monetary System (EMS) started operation in 1978 and was successful in stabilizing intra-EEC exchange rates. This was not as deep an integration as foreseen in the Werner Plan, but it demonstrated that the EEC was resilient to setbacks and capable of creative adaptation. Another bright spot came when EEC financing was put on a firm footing with two budget treaties (1970 and 1975; see Chapter 2 for details), and democratic control of the EEC was enhanced in 1979 when the EU Parliament was directly elected for the first time; previously, its Members of the European Parliament (MEPs) were drawn from the members' national parliaments. The economic malaise of the 1970s turned a corner in the 1980s when US and European central bankers decided to fight inflation. They did so by inducing a long, hard recession, which was painful for a couple of years, but it set the stage for an economic rebow1d. Starting in 1984, economic growth resumed. Political attitudes also changed-in particular, a strengthened belief in market economics began to spread throughout the industrialized world. US President Reagan and British Prime Minister Thatcher are often cited as vanguards, but even the socialist French President Mitterrand adopted a much more favourable attitude towards market-based solutions. While there are many causes for this philosophical shift, the fact that highly interventionist policies had failed to prevent ten years of poor economic performance is surely one of the most important.

1.5 Deeper circles and the domino effect part II: the Single Market Programme and the EEA !hls fa~ourable economic climate was matched with the arrival of a talented promoter of European mtegratwn, Jacq,ues Delors. As President of the European Commission from 1985 to 1994 Delors kickstarted European ~nt~gratio~ by pushing for the 'completion' of the 'internal market'. The ~oint was that of all th e economic mtegrat10n promised in the Treaty of Rome, only the tariff liberalization was fully ·

Deeper circles and the domino effect part II: the Single Market Programme and the EEA

implemented. All the other elements - such as the free movement of labour, capital and services - were still on the to-do list. Delors called this new initiative the 'Single Market Programme', to contrast it with the most common name used at the time for the EEC - the Common Market. Delors' plan, which was widely welcomed, was launched with great speed. The policy proposal ( or White Paper) was published in the middle of 1985 and, by July 1987, all Member States had ratified the resulting treaty which was called (somewhat confusingly) the Single European Act. This treaty was the biggest leap forward in economic and political integration since the Treaty of Rome. The Single Market, however, is not just a historical relic that students have to master for the exam and then forget. In 2018, the Single Market was one of the most contentious - and most misunderstood- issues in the Brexit negotiations. The economic fallout of Brexit depends critically on whether Britain stays in the Single Market, onl!J sta!Js in the Customs Union, or ends up with no special integration with the EU. Moreover, the struggles that went on within the British government between 2016 and 2018 are a repeat of the struggles that faced several other European nations in the late 1980s and early 1990s; these historical experiences have important implications for both the UK and the EU in today's Europe.

1.5.1 The Single Market Programme In 1985, EU firms enjoyed duty-free access to one another's markets because they were all inside the Customs Union. This meant that there were no tariffs or q,uotes imposed on any trade between EEC members. The lack of tariffs, however, did not mean that there was fully free trade. Intra-EC trade was shackled by a long list of trade-inhibiting barriers such as differing technical standards and industrial regulations, capital controls, preferential public _procurement, administrative and frontier formalities, VAT and excise tax rate differences and differing transport regulations, to mention just a few. Although the vast majority of these policies seem negligible individually, the confluence of their effects served to substantially restrict intra-Community trade. Likewise, the free movement of services - which was guaranteed in principle by the Treaty of Rome - was far from being a reality, again largely due to national prudential and safety regulations. Service providers typically were req,uired to possess local certification and the req,uirements for such certification often varied across nations. Moreover, the certification process was often controlled or influenced by the national service providers, which had an economic interest in excluding foreign competitors via this certification process. The key changes implemented by the Single Market Act were designed to reinforce the 'four freedoms' (free movement of goods, services, people and capital) promised by the Treat!J of Rome. The concrete steps were:

0

Further liberalization of trade in goods by streamlining or eliminating border formalities - from 1993, trucks could roll right through EU borders without having to stop for customs checks or to fill out VAT forms. Harmonization of VAT rates within wide bands so as to reduce the incentive for cross-border VAT fraud.

• Liberalization of government procurement so all EU firms could compete on an even footing when selling goods and services to any EU government. Harmonization and mutual recognition of technical standards in production, packaging and marketing to reduce the need for checking goods as they crossed intra-EU borders. Removal of all capital controls and increase in capital market integration via some harmonization of regulations. The Single European Act also implemented important institutional changes. To cl~ar the decisi~nmaking log-jam that had held up similar integration initiatives in the 1970s, the programm_e mcluded a maJor change in the way the EU made its decisions on things like new laws and new regulat10ns. The key was to move away from the unanimity principle (which had be~ome t~1e de facto norm after the Luxem_bourg Compromise) and towards the majority voting that was envisaged m the 1958 Treaty of Rome .. But thi~ ~as not for all decisions, but decisions concerning Single Market issues would be adopt_e~ on the ?as1s of maJonty votinrr im::tP~rl of on a hasis of unanimit"!,.J (see Chapter 3 for a discussion of EU dec1s10n-makmg procedures).

CHAPTER 1 History

J . f TBT liberalization and thus gave a big boost This change in voting procedures unleashed a massive wave o to further trade integration. . ade it much easier for EU firms to re~y on supply The resulting changes and common regulat10n mF" . th auto aerospace and machinery sectors chains that crossed borders within the Single Market. rr~s ~ e ppl~ chains is one of the reasons that took full advantage of this. The existence of these cr~ss- .or er ~u le Market many economists in the UK argued so strongly for staymg m the Smg ·

Focus on capital mobility . . . twas its focus on capital mobility; From an economic perspective, the most novel aspect of the Smgle Marke d d While some • • t· · ·r atives alrea y agree · other features can be viewed as deepening or extendmg mtegra wn llli 1. . •t 1 flows many EU members had already unilaterally liberalized their restrictions on rntematwna1 capi a . h di ' ti. . . . . fl h d been associated wit srup ve others were very reluctant to do so smce mternational capita1 ows a . . . . economic crises in the 1920s and 1930s. The Single Market Programme ruled out all remammg res:ncti~ns · movements among EU residents · · set the stage f or a n umber of important frnancial on capital by 1988. This . ' banking and exchange rate crises in the 1990s and 2000s. It also had the unintended conseq,uence of pushing the EU towards a single currency. The Single Market Programme unleashed a political economy snowball effect that eventually led to the euro. Simple macroeconomic logic (explained in Chapter 13) tells us that, without capital controls, nations must choose between controlling their exchange rate and controlling their monetary policy. Since exchange rate stability was considered paramount, EU members chose to sacrifice national control over their monetary policy in order to keep exchange rates stabilized (this was done in the context of the EMS). But once nations were no longer actively using monetary policy, national objections to centralizing monetary policy decisions in a European central bank were greatly weakened. Moreover, the exchange rate crises of the 1990s convinced many European leaders that creating a single currency would be a good way of preventing them.

1.5.2 The EEA and the fourth enlargement The Single Market was a powerful boost to the integration of EU members, but the non-member European (especially the EFTA nations) worried that their firms would face discrimination. In the new world of international supply c_hains, EFTA f~ms coul~ adjust by m~vin~ their production inside the Single Market. In othe: wo:ds,_the Smgle Ma~ket tnggered mvestment divers~on' l~ke the Customs Union had triggered trade divers10n ill the 1960s. As ill the 1960s and early 1970s, the diversion triggered a domino effect as EFTA firms prompted their governments to offset that discrimination by seeking closer ties to the EU. This is exactly the sort of political economy forces that drove the UK government · 2 018 t O retain access to the EU's Single Market even as the UK leaves the EU The experi·enc thmt th tr~ to . . . . · e a o er nations had ':1th such efforts ill the past pro~ide I~~ortant lessons for today's policymakers. As it turned out three solut10ns emerged. Some EFTA nat10ns JOilled the EU (Austria Finland ands d ) h ' .. . . . . . , we en , ot ers sacrif1ced nat10nal control over a wide range of pohcies to gam access to the Single M k t (N Liechtenstein). This is called the 'Norway option' in the Brexit debate. ar e orway, Iceland a nd The Norway solution was the outcome of a long negotiation that led to the • . the European Economic Area (EEA) agreement The EEA e t" creation rn January 1989 of 11 economies (apart from agriculture and the Com~on Exte s;~n I~ y extends the Single Market to EFTA the Single Market access was the benefit. The cost tl r~a an f). For the EFTA nations, like Norway, th pertaining to the Single Market without having fwas 1a ey had to adopt all EU laws and regulations Th any orma1representation or t · fl ~Y also had to pay contributions to the EU bud et Th . ~ower o m uence the policies. opt10n where post-Brexit Britain would h t , bg · at IS why th e EEA IS sometimes described as the Th S . ave o o ey and pay with no ' . e wiss government wanted to join the EEA but its . say . The fmal outcome that exists today . ' people reJected the agreement in a referendum. Th• 1 . . Is a messy set of comp · th is ets Swiss frrms participate in some but t 11 fOIDises at emerged from years of negotiation. has no voting rights over new Single Mark :orula ashpe~ts of the Single Market. As in the EEA Switzerland the EU budget Th" · e es t at It must follow d · ' · IS Is sometimes call the Swiss Option. , an It must make a contribution to

Communism's creeping failure and spectacular collapse

Given the political economy forces described above, it is easy to understand why EFrA nations wanted the EEA. Two aspects of the EEA, however, are extraordinary. First, the EEA is unbalanced in terms of the rights and obligations of EFTA nations in relation to future EEC legislation. The EEA commits EFrA nations to accepting future EU legislation concerning the Single Market, without any formal input into the formation of these new laws. This is why some in Britain have called the EEA option for Brexit an intolerable sacrifice of sovereignty. Second, the EEA created supranationality among the EFrA nations, a feature that they had resisted since the end of the war. As it turned out, almost none of the EFrA nations was happy with the EEA compromise on 'obey and pay but have no say'. The end of the Cold War lifted the Soviet restraints that had kept Austria and Finland out of the EU, and erased the importance of Cold War neutrality that had kept the Swiss and Swedish governments from joining. In fact, by the end of the EEA negotiations, Austria, Finland, Sweden, Norway and Switzerland had all applied for EU membership. They completed the EEA talks and signed the deal, but for them, the EEA was to be a transitional arrangement. As mentioned, Swiss voters rejected the EEA in December 1992, effectively freezing their EU application. Accession talks with Austria, Finland, Norway and Sweden proceeded and were concluded successfully. Norwegian voters rejected full EU membership in a referendum and so the country ended up with the EEA by default. These drives towards deeper European integration were launched while the Cold War was in full swing, but they came to fruition in a very different world.

1.6 Communism's creeping failure and spectacular collapse The division of Europe into communist and capitalist camps was cemented, q,uite literally, in 1961 by the construction of the Berlin Wall. Indeed, the wall became the symbol for Cold War forces that were, as mentioned, a key driver behind European integration in the early phases. A common saying at the time was that European construction was meant to keep the Americans in, the Russians out and the Germans down. That oversimplifies things enormously, but it captures the basic reality - early European integration was an economic project on the surface, but deep down it was a military, political and foreign policy project. For decades, millions of troops and billions of dollars of weapons were aligned East- West in anticipation of a new war. Imagine what a shock it was to European integration when all that went away without a single shot being fired. The whole East- West division, the whole Cold War conflict, just melted in the late 1980s and early 1990s - and it happened because of economics. It is a great story. In 1961, living standards on the two sides of the wall were not too dissimilar but by the 1980s western Europeans were living far better than those in eastern Europe and the USSR. At the time, it was clear that the West's economic system (free markets and an extensive social welfare system) when teamed up with its political system (multi-party democracy and freedom of the press) provided a far better way of life compared to the East's system of planned economies and one-party rule. While this 'creeping failure' of communism was apparent to the central and eastern European countries (CEECs), Soviet leaders repeatedly thwarted reform efforts via constant economic pressure, and military force when that failed. Soviet tanks, for instance, crushed independence movements in Hungary in 1956 and Czechoslovakia in 1968 (back then the Czech and Slovak republics were one nation). By the 1980s, however, the inadeq,uacy of the Soviet system was so clear that it forced changes inside the USSR itself. The USSR adopted a policy of pro-market reforms (perestroika) and openness (glasnost), which diminished interference in the affairs of the Soviet republics and the CEECs. As far as European integration was concerned, the switch in Soviet policy to non-intervention was critical. Pro-democracy forces in the CEECs flourished and eventually won the day. It started in June 1989 when the Polish labour movement 'Solidarity' forced the Polish cmmmmist government to accept free parliamentary elections. The communists lost and the first democratic government in the Soviet bl~c t_ook power. Moscow's hands-off approach to the Polish election triggered a chain of events that revolut10mzed European affairs. The Berlin Wall was torn down in November 1989, and by the end of 1991 this bloodless revolution was over. Democracy had spread to Poland, Hungary, Czechoslovakia and East Germany, and the three countries that the USSR had annexed during the Second World War - Estonia, Latvia and

CHAPTER 1 History

l

Lithuania - declared their independence. Finally, the Soviet Union dissolved itself with the former s . · · d oviet Republi cs b ecom111g 111 ependent nations or merging with Russia. This put an end to Russian interfer . in Europe until it aimexed, in 2014, a part of Ukraine called Crimea. ence The European Union reacted swiftly to this geopolitical earthq,uake by providing emergency aid a d loans to the fledgling democracies. n

1.6.1 Maastricht Treaty, the euro and German unification The collapse of the Soviet-bloc landscape started a chain of events that massively changed the EU. With the w~ll gone, unification of the western and eastern parts of Germany was the natural next step. But this ~aised a new challenge that was not unlike the one created by German industrialization and rearmament 111 th e 1950s. A unified Germany would be a behemoth. With 80 million citizens and 30 per cent of Europe's output, Germany would be more than a third larger than the other big EU nations (France, Britain or Italy). This raised many fears, ranging from a disturbed political balance in the EU to the unlikely, but still scary, spectre of German militarism. As in the 1950s, many Europeans, including many Germans, felt that German unification would best be teamed with a big increase in the forces tying EU members together. Riding high on his success with the Single Market Act in 1986, Jacq,ues Delors seized this historical moment and proposed a radical increase in European economic integration - the formation of a monetary union. Delors firmly believed that creation of a single currency would lead to further economic integration, and eventual political integration. The steps towards deeper integration that were taken among Eurozone members during and after the Eurozone Crisis of 2010 (see Chapter 19) are a testimony to his foresight on the further economic integration. Brexit, by contrast, is a warning that political integration is not the inevitable endpoint of deeper economic integration. The idea of a single currency was q,uickly championed by French President Franc;ois Mitterrand and German Chancellor Helmut Kohl. After extensive negotiations, the EU committed itself to a target of forming a monetary union by 1999 and adoption of the euro by 2002. This commitment was made in the Treaty of Maastricht (signed in 1992). The Maastricht Treaty is covered in depth in Chapter 14, but for the purposes of this chapter it is important to note that the Maastricht Treaty - formally known as the Treaty on European Union - embodied the most profound deepening of European integration since the Treaty of Rome - far greater than that of the Single European Act. In addition to committing members to a transfer of national sovereignty over monetary power to a supranational body (the European Central Bank), the Treaty also: created EU citizenship; this included the right to move to and live in any EU state (the Treaty of Rome only guaranteed the right to work in any Member State) and to vote in European and local elections in any Member State; strengthened EU cooperation in non-economic areas, including security and defence policy, law enforcernent, criminal justice, civil judicial matters, and asylum and immigration policies; strengthened the power of the European Parliament (whose members were directly elected by EU citizens) over EU legislation thus reducing the control of member nations' governments; introduced the 'Social Chapter' which expanded the EU's social dimension by introducing policies on workers' health and safety, workplace conditions, eq,ual pay and the consultation of employees. The immense size of the changes was recognized by a change in name. Before the Maastricht Treaty, people called it the European Comm1mity. After the Maastricht treaty, people calle_d it the Euro~ean ~nion. From today's perspective the most obvious change was the replacement of national currencies wit~ the euro, which is the topic of Part V of this book. This chapter deals only with the aspects that are essential to understanding subseq,uent developments.

Maastricht ratification difficulties

EU treaties such as Maastricht have power because they must be part of each Member State's dome5tic law, that is, EU treaties must be ratified by each and every member if they are to come into force. In m~ny EU nations. ratification involves a vote bu the national parliament: in others. a referendum. The Maastn cht

Preparing for eastern enlargement: a string of new treaties

Treaty experienced great difficulties with ratification. Some nations like Britain and Denmark d d d r . t . ' ' eman e exp ICI exceptwn~ from the commitment to join the monetary union. Britain got its exception in advance; Denmark got th errs after t~e Danes rejected the Treaty in a referendum. After the exception was granted, th: Danes voted agam and approved it. Ratification took almost two years, the Treaty came into effect only rn November 1993. . The c~llapse of comn1tmism not only triggered monetary integration, it also triggered a massive change m the EU s trade integration.

1._7 Reun iting East and West Europe Given th at almost every other nation in the region had free trade access to the enormous EU market, free t rad e agreements with the EU were a commercial necessity for the newly independent central and eastern European countries (CEECs). The strategic goal of CEEC leaders, however, went far beyond new free trade agreements. ~EEC leaders at the time felt unsure that the new situation in Europe was permanent. Russia under Pr_esiden~ Gorbachev seemed to pose no threat to the newly independent nations, but they worried that thin_gs rrught change under future Russian presidents. If this happened, and some sort of 'iron curtain' was agarn drawn across Europe, each CEEC wanted to be sure that the curtain would, this time, be drawn to the east of its border, not to the west. This is why they all wanted to join both the EU and NATO. Once again, the EU was being seen as a foreign policy project - not just an economic project.

1. 7.1 First steps: the Europe Agreements Each CEEC announced that its goal was to join the EU. The EU, by contrast, was reluctant in the early 1990s. Sidestepping the membership issue, the EU started signing bilateral free trade agreements, Association Agreements (also called Europe Agreements), with the CEECs in 1991 and the process was completed by 1994. The switch from plan to market was extremely disruptive for some socio-economic groups, but the ultimate prize of EU membership provided an important political anchorage that kept the pro-market reforms on track in the CEECs. The Europe Agreements stopped short of offering EU membership- reflecting the profound ambivalence that many West Europeans initially felt towards eastern enlargement in the 1980s. Most of the hesitation was due to the economic nature of the CEEC. The CEECs were poorer and more agrarian. Since the EU spent about 80 per cent of its budget on poor regions and farms, making the CEECs members would req,uire a bigger budget or cuts in spending in EU members in west Europe. Moreover, taken together, there were about 300 million people living in the CEECs, so an eastern enlargement would entail a vastly larger expansion than the earlier enlargements. The EU officially ended its hesitancy on CEEC membership at a June 1993 meeting in Copenhagen. That is where the EU's key political body - the European Council - decided that CEECs could become EU members subject to the membership criteria. These so-called Copenhagen Criteria for membership are the ones that are still applied today, so they are worth understanding. They are: (1) political stability of institutions that guarantee democracy, the rule of law, human rights and respect for and protection of minorities· (2) a functioning market economy capable of dealing with the competitive pressure and market forc~s within the Union; (3) acceptance of all EU economic and political rules (known as the 'acq,uis') and the ability to take on the obligations of membership, including adherence to the aims of political, economic and monetary union.

1.8 Preparing for eastern enlargement: a string of new treaties

.

Once the EUl5 leaders confirmed that the CEECs would eventually join, the next o~der of busrness ~as to get EU institutions ready for this massive enlargement. The EU's institutions - wluch had b~en designed · b d were strarnrn· · g to work with fifteen - had to change if they were to continue to work f or six mem ers an • · f ti1 Li b with a dozen new members. This started a chain of events that eventually ended m adopt10n o e s on Treaty in December 2009.

24 P

CHAPTER 1 History

/

The process was politically painful for the existing EU members since ~lmost every ch~nge helped some EU 16 nations but hurt others. For example, the EU's traditional decision-making process deliberately gave a share of voting power to small countries that was far out of line with their share of the El! population. This practice was started in the 1950s. Back then it made sense from a political-balance perspective. The EEC consisted of three big nations (France, Gennany and Italy) and three small ones (Belgium, Netherlands and Luxembourg). The basic sharing didn't change with enlargement but since most of the CEECs were small or tiny, the old power sharing rule would have given enormous power to small countries and taken it away from big countries. Any change in power shares, however, creates winners and losers - and the losers objected strenuously. While there was a shared understanding of the institutional challenges that eastern enlargement posed, there was little agreement on the solutions. This basic dilemma marked the four attempts at reform made by the EU over a 16-year period (Amsterdam, Nice, Constitutional and Lisbon Treaties). Moreover, the disagreements highlighted by the negotiation of these treaties picked up on the disagreements that had plagued European integration since the beginning _ big members vs small members, federalists vs intergovernmentalists, poor members vs rich members, and agricultural vs industrial members.

1.8.1 The four treaties The 1996 IGC produced the Amsterdam Treaty in 1997. Ambitions for the Amsterdam Treaty were high - the mandate was to agree all the necessary enlargement-related reforms, but it came up short. The Amsterdam Treaty is best thought of as a tidying up of the Maastricht Treaty. The substantive additions included a more substantial role for the EU in social policy formation (former UK Prime Minister Tony Blair cancelled the British opt-out). The powers of the European Parliament were modestly boosted, and the notion of flexible integration, so-called closer cooperation, was introduced (see Chapter 2 for details) so that sub-groups of members could proceed with deeper integration on their own. The key enlargement-related reforms were not settled but were still pressing, so EU leaders agreed a list called the 'Amsterdam leftovers'. They also agreed to launch a new IGC in 2000 to deal with the Amsterdam leftovers. After the year-long preparation of the IGC 2000, EU leaders met in Nice in December 2000 to wrap up a new treaty that was supposed to deal with the Amsterdam leftovers. At 4 o'clock in the morning, after the longest EU summit in history, EU leaders announced political agreement on a new treaty. The result the Treaty of Nice - was not a success. The critical Amsterdam leftover issues - the size and composition of the Commission, extension of majority voting in the Council of Ministers and reform of Council voting rules - were not fully solved (see Chapter 3 for details). For example, the chairmanship of then-French President Jacq,ues Chirac (France chaired the European Council at the time) was heavily criticized by leaders of the European Parliament and the President of the European Commission, Romano Pro di. Indeed, a few days after the Nice Summit the ' European Parliament adopted a resolution that accused the governments of having given 'priority to their short-term national interests rather than to EU interests'. Back then, however, the European Parliament did not have the power to block a new treaty. The Nice Treaty experienced some trouble with ratification but far less than the Maastricht Treaty. Only the Irish refused to ratify the Nice Treaty in a referendum. Since a new treatu cannot come into force until all EU members have ratified it, the Irish 'no' had to be addressed. The solution was to make a number of political commitments guaranteeing Irish neutralitu. Irish voters were then asked to vote again and the second time they said 'yes'. EU leaders at the Nice Summit knew that the Treaty did not fully adjust the EU to the new realities of the coming enlargement. In what had become a familiar pattern, part of the final political deal on the Treaty at Nice was an agreement to hold another IGC to complete the reform process. This 'Declaration on the Future of the Union' highlighted four themes: defining a more precise division of powers between the EU and its members (the old federalist vs intergovernmentalist trade-off); 2 clarifying the status of the Charter of Fundamental Rights proclaimed in Nice; 3 making the treaties easier to understand without changing their meaning;

4 defining the role of national parliaments in the European institutions.

-

Preparing for eastern enlargement: a string of new treaties

Eastern enlargement and the Constitutional Treaty ?ne yea~ after the Nice Summit, the European Council met in the Belgian city of Laeken to adopt the Declarat10n on the Future of the European Union'. This provided an outline for thinking about the new treaty to be written by the IGC in 2004. In light of the difficult Nice Summit, the Laeken Council also decided on a novel working method. It conv_ei~ed the 'Convention on the Future of Europe', which came to be known as the European Convention, cm~sistmg of_a large number of men and women representing current and prospective Member States, the nation~l parliaments, the European Parliament and the Commission. The Convention's output was to be the pomt of departure for the IGC 2004 that would draft the actual treaty (as req,uired by EU law). !he Laeken Dec_laration, which was in essence the political guidance for the next attempt to reform the EU, mcluded_ a crucial novelty - it mentioned the word 'constitution' in a way which suggested that the next treaty nught be a constitution for the EU. _The European Convention was run by former French President Valery Giscard d'Estaing with the assis~ance of a former Prime Minister of Italy and Belgium. By mid-2002, President Giscard d'Estaing had redefmed the Convention's purpose into a constitution-writing convention. The new goal was to present the EU heads of state and government with a fully written constitution. As it turned out, this new constitution proved to be an overreach by European federalists. The process of turning the Convention's draft into an EU treaty did not start well. Differences that had been papered over in the Convention emerged immediately when the document was considered hy EU member goven1ments. As it turned out, the differences could not be bridged. This failure to agree, in turn, had enormous conseq,uences. The whole reform process was designed to adopt reforms before enlargement happened, but the failure of the Convention to produce an acceptable treaty meant that the reform would have to take place after enlargement (the enlargement had been scheduled for 2004). All EU members - including the ten members that joined in 2004 - agreed that institutional reform was a must, so the Irish government, which took over the EU Presidency in 2004, made a new attempt to rewrite the European Convention's draft. Skilful diplomacy led to a grudging and difficult but ultimately unanimous acceptance of a new draft at the June 2004 summit of the EU25 leaders. With this high-level political compromise in hand, the IGC completed its work and the so-called Constitution Treaty was signed in Rome in October 2004. But this new Treaty did not pass the approval of EU citizens. French and Dutch voters rejected it in referendums, derailing the whole project. In 1c"eaction, EU leaders suspended the ratification process and declared a 'period of reflection'. This rejection was a very clear and very obvious sign _that the changes in Europe, changes that had come with the fall of the Berlin Wall, had forever changed the nature of the EU itself. Before, the EU was a fairly small club of rather prosperous west European nations. After, it was a large club of nations with much greater differences.

The Lisbon Treaty Two inadeq,uate reform attempts (Amsterdam and Nice Treaties), a decade of on-and-off negotiations, and four rejections by European voters mad~ it clear that EU inst~tu~ional reform ~as not eas11. It was _als~ clear that this reform was not popular with EU voters. Why didn t EU leaders Just abandon the proJect. The answer lies in the factors that had been obvious since the 1993. An EU of 25 had to reform its institutions if it was to continue functioning effectively and legitimately; the institutional reforms agreed in the Nice Treaty were not good enough. . . . . The process was relaw1 ched when Germany took on tl~e r~tatmg EU Presidenc11 m 2007. Gwded by forceful German leadership, EU leaders declared the Constitut10nal Treaty to be dead _an~ agr~ed ~n the basic outlines of its replacement. The result was the Lisbon Treat11, named after the city m which it was signed in December 2007. . . . The Lisbon Treaty included all the main institutional reforms that were m the Const1tut10nal Treaty but the were repackaged in a very different way. All the grandiloq,uent language and gestures to yf r ere dropped All references to symbols of statehood were jettisoned - the flag, the suptlrana 10ndath1sm1·i: The word ;constitution' was banished. This reflected a very real shift in attitudes an 1em an e 1 . t d Europe were over of Europeans. The old days, where many Europeans instinctive1y suppor e more , · _ __ ___

CHAPTER 1 History

This had been true in the western Member States since by the 2000s; most west Europeans trusted their governments to do the right thing. Transferring sovereignty to the EU was a cost, not a benefit as it had been in the early years. Moreover, the citizens and leaders of the new CEEC members grew up in a world where they had been taught that school-of-thought number two was the right one ( capitalism was to blame for the Second World War) - not school-of-thought number three, as was the case in west Europe. As a result, the belief that aggressive nationalism was harmful was not something that was firmly fixed in central and eastern European ways of viewing the world. If anything, bad memories were related to the lack of national control during the Soviet era, not aggressive nationalism before the Second and First World Wars. The idea behind the German repackaging strategy was to avoid referendums in as many nations as possible. By making it more of a technocratic amendment of the existing legal structure, most EU governments felt they would be justified in ratifying the Lisbon Treaty by a vote of the national parliament - the procedure adopted for most treaties by most members since the very beginning. By and large, it worked. The Irish constitution, however, req,uires a referendum on any law that changes the relationship between Irish law and EU law. Since the Lisbon Treaty certainly meets this criterion, a vote was held in July 2008. The no-voters won by a solid margin. To justify holding a new vote, the Irish government obtained promises from fellow EU leaders that directly addressed the concerns of certain segments of the Irish electorate. With these promises in hand, the Irish reversed their 'no' in October 2009. The Treaty came into effect in December 2009. The Lisbon Treaty instituted many important changes, and it is the Treaty that is in force today, so it is worth understanding (the key features are addressed at length in Chapters 2 and 3). An old saying in European affairs is that Europe is constructed one crisis at a time. This certainly rings true for the European history covered up to here. Today's Europe is the sum of the solutions to past crises, and the process is continuing. Just as the crises arising from the fall of the Berlin Wall were winding down, Europe experienced a new set of crises that were economic in their origin but political in their effect. The solutions were still a work in progress at the time of writing this book in 2018.

1.9 Global and Eurozone crises and institutional responses European economic integration during the 1990s and much of the 2000s was smooth sailing despite the 'Treaty troubles' discussed above. EU growth was good, unemployment was low, and inflation was low and steady. This period has been called the 'Great Moderation'. It seemed that superior monetary policy in all high-income nations was able to avoid important recessions while keeping inflation under control. In Europe, the monetary union was given a good deal of credit for this favourable outcome. An indicator of these happy economic times was a convergence of Eurozone long-run interest rates with the low levels achieved by Germany (see Figure 1.6). The economic logic here is simple. Long-run interest rates reflect the interest rate that investors demand for locking up their money for 10 years or so. Traditionally, nations with unstable monetary and economic policies - Greece, for example - would have to pay higher interest rates to convince investors. Think of it like the odds at a roulette table. If you bet on black the reward for winning is double your money because the chance of winning is almost 50 per cent. If you bet on a single number, the payoff for winning is much higher because the odds of winning are much lower. If gamblers were not compensated for the higher risk, no one would bet on a single number. Likewise, if Greek bonds did not pay a higher reward than German bonds, no one would buy Greek bonds since they are riskier than German bonds. The fact that the Eurozone erased the difference between Greek and German bonds in the late 2000s, as Figure 1.6 shows, demonstrates the enormous confidence that smart money placed in the solidity of the Eurozone. But this confidence turned out to be misplaced. In many nations, especially the USA, the UK and Ireland, the Great Moderation encouraged investors to borrow money to invest. The key here is that they were not just investing their savings, they were actively taking on new debt to invest in risking things like housing. This investment strategy, which is called 'leverage', makes borrowers vulnerable to shocks. It was like an average person taking out a second mortgage on their house and then investing the loan in risky stocks. If the stock market goes up, the lucky borrower/investor can pay off the second mortgage and pocket some winnings. If the stock market goes

Global and Eurozone crises and institutional responses

Figure 1.6 Eurozone long-run interest rates, 1993-2014

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by itself; Luxembourgers are more than twice as rich as the French. One explanation for thi~ is ~hat Luxembourg is economically speaking, a medium-sized city and incomes in cities tend to be q,mte high. The high-inc~me category - defined as incomes above the EU28 average (about €30,000 in 2017)-includes 11 of the 28 nations. In the medium-income category - defined somewhat arbitrarily as incomes between €30,000 and €25,000 - there are_ six natio~s. These are two 'old' members (Italy and Spain) and fo_llf 0 : : members (Malta, Czech Republic, Slovenia and Cyprus). Low-income nations, defined as those Wl th P capita incomes of less than €25,000, are Lithuania, Estonia, Portugal, Slovakia, Poland, Hungary, Greece, Latvia, Romania, Croatia and Bulgaria.

2.6.2 Size of EU economies The of European economies is also very uneven measuring economic size with total GDP: st size distribution th Ju six nations, e 'Big-5' (Gennany, the UK, France, Italy and Spain) and the Netherlands, account fol

The budget

about _75 per _c~~t of the GDP of the whole EU. The other nations are small, tiny or minuscule using the followmg defrmt10ns: ' 'Small' is an economy that accounts for between 1 and 3 per cent of the EU27's output. This includes Sweden, Poland, Belgium, Austria, Ireland, Denmark, Finland, Portugal, the Czech Republic, Romania and Greece. 'Tiny' is one that accounts for less than 1 per cent of the total. These nations are Hungary, Slovakia, Luxembourg, Bulgaria, Croatia, Slovenia and Lithuania. Minuscule is one that accounts for less than two-tenths of 1 per cent. The countries in this category are Latvia, Estonia, Malta and Cyprus.

2.7 The budget !he EU budget is the source of a great deal of both solidarity and tension among EU members, so it is rmportant to understand the basics. It is also an issue that will increasingly dominate EU public discourse as the _renewal of the seven-year budget plan (the so-called Multi-annual Financing Framework, MFF) comes up m 2020. Political fights concerning the MFF 2021-2027 will probably last right up to December 2020. Note that this is when the UK will stop making contributions to the EU budget (according to information available when this book went to press). To organize the presentation of the budget, this section looks at four q,uestions in order. What is the money spent on? Where does it come from? Who gets the most on net? How does the budget process work?

2.7.1 Expenditure Total EU spending for 2017 was about €160 billion. While this sounds like a lot to most people, it is really fairly small. The total economic income generated in all EU28 taken together is about €16 trillion, so the budget spending is about 1 per cent of total income, or about €310 per EU28 citizen. The first priority here is to study how this money is spent. We look first at spending by area and then spending by EU member.

Expenditure by area As with so many things in Europe, understanding EU spending in all its detail would take a lifetime, but

understanding the basics takes just a few minutes. Starting at the broadest level, the EU spends its money on farming, poor regions and other things. These categories, however, attract a great deal of criticism, especially _ as we shall see in Chapter 9 - that much of the agriculture money is given to large landowners. The official names of all main spending categories are not very clear for the very simple reason that they were changed to make them sound more positive. For example, the EU spends two-fifths of the budget on payments to farmers despite the sector's meagre contribution to EU growth, income and employment. To make this sound more in line with a forward-looking, dynamic EU, these expenditures were labelled 'Sustainable Growth: Natural Resources'. To clarify, we use plain English and focus only on the biggest areas (see Figure 2.6), which are farming (37 per cent) and poor regions (35 per cent). The rest is split among many different uses - the biggest being R&D and Training (14 per cent), Overseas Development Assistance (6 per cent) and Administration (6 per cent). Spending on agriculture and poor regions is so important that we have written separate chapters dealing with each, so we do not go into further detail here (see Chapter 9 on agriculture and Chapter 10 on poor regions).

Historical development of EU spending by area

.

.

. .

. .

The EU's spending priorities and level of spending have changed dramatically smce its mception ,m 1958. The EU budget grew rapidly, but started at a very low level Uust 8/lO0ths of 1 pe~ ~ent of ~he EEC6 s GDP). EU spending was negligible until the late 1960s, amounting to less than €10 per EU citizen. Tl~ changed as th_e cost of the Common Agricultural Policy (CAP) started to rise rapidly in the 1960s and spending on poor regmns · , gpen ding m· EU parlance - started to rise in the 1980s. From the early 1970s to the early 1990s, ca11e d 'C o h es1on L

CHAPTER 2 Fa

cts, law, institutions and the budget

. 2 6 The EU's 2014 budget F 1gure .

Farming 37%

Other EU programmes 2% Overseas development assistance 6% Administration 6% R&D, training & infrastructure 14%

Poor regions 35% Source: Based on data from ec.europa.eu/budget/ __ ____,,. __ _, __.. ... __ _ ... .. . .....,.,. ..

--------- &.£-:::>IU_j~

Treat are identical to those in the reJected Constitution. lJ

Source: Based on data from Eurostat, a nd Kirsch (20lG).

ion- How will Brexit affect the power distribution in the nswer to th e Cl;Uest · • b t h Figure 3.5 also shows t e a . clear and very simple. The UK's power share, which was a ou Council of Ministers? The answe: IS vdery or less evenly among all the large members, namely Germany, . di t bute more . . . . ·t· . 8 per cent in the EU28 will be s n . t the other members is negligible. It 1s slightly pos1 1ve 111 . d The impac on a 11 . France, Italy, Spam and Polan · . . the tiny and minuscule nat10ns. . htl Y negative m · the small nations, and slig

CHAPTER 3 Decision making

..

. EU decision making

so much national sovereignty been in . . Nowhere else in the wo rld has . death and destruction fro m · orgamzat10n. . d t the massive . . The EU is a truly umq,ue . bodt As Chapter 1 pomte ou .' fer but the continual willmgness of transferred to a_ supranat10;~:: EU'syfounders to contemplate this tra~s mo~e practical considerations. One two world wars I~ wt_hatol;~uropeans to accept it depends upon_mucrtant consideration is the democratic the current gene1 a 10n . . ults but another impo consideration is the EU's ability to deliver I es ' · · king process. legitimacy of the EU ,s d ec1s10n-ma

3.5 Leg1t1macy

3.5.1 Thinking about democratic legitimacy

. . . . ult stion so it helps to start with an •t· t ? This 1s a diff1c q,ue . . . Alm 1 What makes a decision-making system egi 1ma e · . k b t wh!J it seems illegitimate. ost extreme and obviously illegitimate voting scheme a nd to thin a landowning males the right to vote. every European would view as illegitimate a system that allo_wed ~ !Jd wning men were forward looking, Why? Because those without votes would find it u~ju st. And if t~e an. \ t one day lose their land. In short, they would also find it illegitimate since they or therr male offspring rm~ h , ule A system is legitimate . .. . 1 h ,. th therperson s s oes r . a good way to tlunk about legitnnacy 1s to app Yt e 111 e O . • which if you think if all individuals would be happy with any other individual's allocatwn of votmg powe~, . . ' 1e. .. . h us a very natural legitimacy pnncip about it req,uires eq,uality. Eq,ual power per c1t1zen 1st Th EU . • f ' e . 1s a uruon o But what constitutes a citizen? In the EU there are two answers.. nati. ons and people · · a c1t1zen ·· states so each state 1s and should thus have eq,ua1 vot·mg power. The EU is also a urnon of people' ' ·· to apply so people are citizens and so each person should have eq,ua1vot·mg power. This makes it impossible . . the eq,uality principle in a simple manner. Note that there is a more classical way to phrase this same po~t. Democracy, it has been said, is the tyranny of the majority. To avoid this tyrannical aspect, democracies must have mechanisms that protect the rights and wishes of minorities. Indeed, many nations provide mechanisms for giving disadvantaged groups larger than proportional shares of power, but the starting point for such departures is one vote per person. In the EU, the over-weighting of small nations' votes was one such mechanism. For example, eq,uality of power per person would grant Germany 2,000 per cent more power than Ireland; eq,uality per member would grant Luxembourgers 160 times more power per person than Germans. Given the dual-union nature of the EU, neither extreme is legitimate. Using the NBI described above, we have a very precise (albeit crude) measure of 'power per person' and 'power per nation'. The 'fair' power distribution for the union-of-states view is trivial; in the EU28, each member should get 1128th of the power. For the union-of-people view, power should be distributed such that each EU citizen has eq,ual power regardless of nationality. As it turns out the Lisbon Treaty's double majority voting rules achieve a very _nic_e b~lance between the union of states ~nd union of peoples perspective. As noted above, the power d1stnbut1on as measured blJ the NBI is in between members' population shares and their membership shares.

:;u

This does not let us concl~de that EU ~ecision ma~ing is legitimate, but at least it shows that it seems reasonable from the perspective of the EU s goal of bemg a union of people and nations.

3.6 Summary Just to continue to _o_perate, the EU mu~t make a steady stream of decisions to adjust to the ever-changing economic and poht1cal landscape. This chapter looked at the EU decision-making process from two perspectives. First, it considered the EU's current allotment of 'competences' between tlle EU and national government levels. In terms of actual practices and principles, the key points were: PolicQ making is categorized into areas in which the EU has 'exclusive competence', that is, where the decision is made only at the EU level; areas in which competence is shared· areas in which the EV can undertake supporting, coordinating or complementary actions; and area~ in which the EU has no competence, that is, where decisions are made only at the national or subnational level. • The allocation of policy areas to these categories is determined by the Treaties and, when necessary, by decision of the European Court. This allocation, however, is blurred since the Treaties do not always refer to specific fields. Sometimes they refer only to areas by functional description, for

Self-assessment questions

exa~pl_e th e interr:ial market, which themselves are only vaguely defined ( or at least vague from a legalisti_c pe~specti~e). To clarify the allocation, the EU operates on the principle of subsidiarity and proportionality, which says that unless there is a good reason for allocating a task to the EU level, all tasks shoul~ ~e allocated to national or subnational governments, and even then the EU should take 01~Y the mnurnum necessary action. The old three-pillar structure of the EU helped to clarify the allocat_wn; ~am~ly, first-pillar (Community pillar) issues were under EU competences while secondand ~hird-pillar_ issues were not. The Lisbon Treaty removed the pillars, but essentially merged the old firS t a nd third pillar into one supranational area while keeping the old second pillar (foreign and defence policy) as intergovernmental. The chapter also presented a framework for thinking about how tasks should be allocated between various levels of government (theory of fiscal federalism). This framework stresses four trade-offs that suggest whether or not a particular decision should be centralized: Diversity and information costs favour decentralized decision making 2 Scale economies favour centralization

3 Democracy-as-a-control-device favours decentralization 4 Jurisdictional competition favours decentralization. The second part of the chapter considered the EU decision-making process in more detail, focusing on efficiency (i.e. the EU's ability to act), national power shares and democratic legitimacy. These three concepts are inherently vague, but the chapter assumes a series of simplifications that enable us to present precise measures of all three. Of course, the necessary simplifications mean that the resulting measures provide only shallow indications of efficiency, power and legitimacy; however, they do at least provide a concrete departure point for further discussion. These measures were:

Efficiency. We measured efficiency using 'passage probability', that is, the likelihood that a randomly selected issue would win a 'yes' vote in the Council. We showed that enlargement has continually lowered the EU's passage probability, but that the 2004 enlargement lowered it by a large and unprecedented amount. We also saw that the voting reforms established in the Lisbon Treaty help restore efficiency. • l power distributions. This section presents a sophisticated measure of power called the N,a t wna b b"li h Normalized Banzhaf Index, which measures the pro a 1 ty t at a given nation will find itself in a position whereby it can break a winning coalition. . . This is by far the vaguest of the three concepts. The approach we adopt is to check L egitimacy. U' c ·11· · · cation of votes in the E s 0U11c1 mes up agamst two not10ns of legitin1acu. If the ll th h h w et. er. e da o urn·on-of-people a natural yar d s t·1ck 1s · eq,ua1 power per citizen. ·· If the EU is viewed , Eu 1s v1ewe as a . f t t the natural metric is eq,ual power per Member State. Under the principle of eq,ual as a umon-o -s a es, . . . . ·t· the mathematics of votmg tells us that this req,uires that the Council's votes per power per Eu c1 1zen, , . . "th th nuare root of the country s populat10n. The benchmark of eq,ual power per EU country nse WI e s'-1, . · enual number of votes per nat10n. Member State req,uires an '1,

Self-assessment q~estions the theory of fiscal federalism. Discuss how the tension · t de offs stresse d b!J 1 1.st t h e mam ra -. d diversity can explain the fact that the EU has adopted only very between negative spillovers an . . . . . t" of social pohc1es. hm1ted harmornza wn t d for the past couple of decades has been to decentralize ren I . 2 In many European n ations ' the . l level to the provincial or regional level. How could you exp am decision making from the natwn~f fiscal federalism? this trend in terms of the th eory

►

CHAPTER 3 Decision making

. titians that you might . T ty list five blockmg coa ·1 votes in the Lisbon rea ' 3 Using the actual Counci h voter has an eq,ual 'rk I ' that eac think of as i e Y . di ssed in the chapter assumes f the various voters I ower measure scu . d that the votes o 4 The forma P , , 'no' on a random issue, an rt" ular issue is unrelated

~;:~~:;e;:!::.y:i.r:,t ~:,St:: likelihood that vote\~;:J~~~e~~:~t~: tagrou~ of vote~ will 0

to whether voter B says 'yes'. However, 111 many are all lik~ly to have similar v1e:'7s _on ~ssues be correlated. For example, po~r EU membe:\ this correlation changes the di~~nbut;n if concerning spending in poor reg10ns. Work ~u ow an break a winning coaliti~n)._ o e power (defined as the likelihood that a particular vote~~) each has 20 votes, the maJonty rule concrete, assume that there are five voters (A, B, C, D an ' is 51 per cent and A and B always vote the same way. person) try to detennine . .. d 111 . th text ( eq,ual power per ' d 5 Using the definition of legitimacy propose e h two houses: the Senate an whether the US Congress is 'legitimate'. Note that the US Co~;;~:: Senators, while the number the House of Representatives. In the Senate, each of the 50 sta . of Representatives per state is proportional to the state's population.

i:

References and further reading

References Baldwin, R. and M. Widgren (2007) 'Pandora's (ballot) box', CEPR Policy Insight No.4, www.cepr.org/pubs/policyinsight.s. Bolkestein, F. (2004) 'UK in dock after booze-cruise blitz', http://www.thefreelibrary.com/UK+in+dock+over+booze-

cruise+ blitz.-a0 123434735. Borchardt, K.-D. (2010) The ABC of European Union Law. Download from http://europa.eu/documentation/ legislation/pdf/oa810714 7_en. pdf. · Felsenthal, D. and M. Machover (2001) Enlargement of the EU and Weighted Voting in the Council. LSE eBook on www.lse.ac. uk. House of Commons (2002) 'Crossborder shopping and smuggling'. House of Commons Library, Research Paper 02/40, London. Kirsch, w. (2016) 'Brexit and the distribution of power in the Council of Ministers', CEPS Commentary, 25 November.

Further reading: the aficionado's corner Baldwin, R. (2007) 'Stranger than fiction: The voting rules in the Reform Treaty are a victory for Poland', VoxEU.org,

24 June 2007. Bindseil, U. and C. Hantke (1997) 'The power distribution in decision making among EU Member States', European Journal of Political Economy, 13, 171-85. Kauppi, H. and M. Widgren (2004) 'What determines EU decision making? Needs, power or both?', Economic Policy,

19(39), 221-26.

More wide-ranging introductions to fiscal federalism applied to the European Union can be found in: Berglof, E., B. Eichengreen, G. Roland et al. (2003) Built to Last: A PoliUcal Architecture for Europe, CEPR Monitoring European Integration 12, CEPR, London. Dewatripont, M., F. Giavazzi, J. von Hagen et al. (1995) Flexible Integration: Towards a More Effective and

Democratic Europe, CEPR Monitoring European Integration G, CEPR, London. The latter includes a general discussion that applies the theory to the Constitutional Treaty.

For an opinionated view on what decisions should be allocated to the EU, see: Alesina, A. and R. Wacziarg (1999) Is Europe Going too Far?, Carnegie-Rochester Conference on Public Policy.

th0 Al ugh this contains several factual errors concerning EU law and policies, it provides a highly cogent application of the theory of fiscal federalism to decision making in the EU.

References and further reading

To learn more about formal measures of power and legitimacy, see: th nd Felsen al, D. a M. Machover (2001) Enlargement of the EU and Weighted Voting in the Council, www.lse.ac.uk. For historical power distributions, see: nd Laruelle, A. a M. Widgren (1998) 'Is the allocation of voting power among EU Member States fair?' Public Choice 94, 317-39. ' ' See also:

Baldwin, R. (1994) Towards an Integrated Europe, CEPR, London. Baldw~, R_., E. Berglof, F. Giavazzi and M. Widgren (2001) Nice Try: Should the Treaty of Nice be Ratified?, CEPR Momtonng European Integration 11, CEPR, London. Begg, D., C. Wyplosz, A.J. Venables et al. (1993) Making Sense of Subsidiarity: How Much Centralization for Europe? CEPR Monitoring European Integration 4, CEPR, London. Peet, J. and K. Ussher (1999) The EU Budget: AnAgendafor Reform?, CEPR Working Paper, February.

Useful websites Extensive explanation and use of formal voting measures can be found on the 'European Voting Games' website: http:// www.esi2.us.es/ ~mbilbao/eugames.htm. You can find software for calculating voting power indices at: http://homepages.warwick.ac.uk/~ecaae/index.html.

n Chapter 04 Chapter 05 Chapter 06 Chapter 07 Chapter 08

Essential microeconomic tools and tariff analysis The essential economics of preferential liberalization Market size and scale effects Growth effects and factor market integration Economic integration, labour markets

~ct~w~oo

97 119 143 159

1n

Chapter Contents 4 .1

4.2 4.3 4 .4 4 .5 4 .6 4 .7

Preliminaries I: supply and demand diagrams Preliminaries II: introduction to open-economy supply and demand analysis MFN tariff analysis GVC analysis Types of protection: an economic classification Sources of competitiveness differences

110 113

Summary

116

98 101 105 109

. I nd tariff analysis CHAPTER 4 Essential microeconom1c too s a

Introduction . t dy of European economic integration d l we begmours u l This chapter presents the tools that we shall nee w 1en l n· es of assumptions that great y reduce the . 1e b ecause we ma rn a se in the next chapter. The tools are sunp . . complexity of economic interactions. h b haviour of firms. In particular, all f1rms are . t 111s . c1mp ter concerns t e te f' s take as given t h e pnces . th ey observe The primary simplification m . . ' th t . we assume tha rrm h th assumed to be 'perfectly compet1t1ve , a is, . act on prices and t at ey co uld sell . that they have no lillP . 1s . t o view . in the market. Firms, in other wor ds, b e1ieve . k' bout this assumpt10n each th · A good way of m mg a Th' · b · k as much as they want at the mar et pnce. . ton market prices. 1s 1s o v1ous1y a . . . . h . Of output has no impac h firm as so small that 1t believes that its c mce D . h producer of Lego toys or t e Dutch . . d f ms - the ams very rough approximation since even medium-size rr is related to the price they charge. 11 th brewer of Heineken, for example - realize that the amoun~ ey ~a:s: scale economies. Scale economies The second key simplification concerns technology, m partic a re um·ts Almost every industm II f m produces mo · . 1:1 refer to the way that per unit cost (average cost) fa s a~ a _ir em (in Chapter 6) will be important, but a is subject to some sort of falling average cost, so considering ~h . lif' t·on m· turn allows us to master • b y 1gnormg · · them · This s1mp 1ca 1 , ' great deal of simplification can be gamed the essentials before adding in more complexity in subseq,uent chapters. 4

4.1 Preliminaries I: supply and demand diagrams

.

· · 1s · ma d e c1e arer with the help of a Slillple yet Assessing many economic aspects of European mtegrat10n . flexible diagram with which to determine the price and volume of imports, as well as the level ~f dom;s~c consumption and production. The diagram we use - the 'import supply and imp_ort_ demand ~agram ~ 18 based on straightforward supply and demand analysis. But to begin from the begmnmg, we q_ruckly review where demand and supply curves come from. Note that this section assumes that readers ha~e had s~me exposure to supply and demand analysis; our treatment is intended as a review rather than an mtroduction. Readers who find it too brief should consult an introductory economics textbook. Well-prepared readers may want to skip this section, moving straight on to Section 4.2.

4.1.1 Demand curves and marginal utility A demand curve shows how much consumers would buy of a particular good at any particular piice. Generally speaking, consumers strive to spend their money in a way that makes them better off. Their demand curve is thus based on some sort of economic calculation. To see this, the left-hand panel of Figure 4.1 plots the 'marginal utility' curve for a typical consumer. But what do 'utility' and 'marginal' mean in this context? Utility means nothing more and nothing less than 'happiness', and we measured the happiness in euros. Money sounds like a shallow measure of happiness, but we are talking about the happiness people get from consuming goods, like a cappuccino or a bottle of fresh-sq,ueezed orange juice. For such things, we are weighing the cost of buying the thing versus the money we have to give up to get it, so the money is a natural - if not perfect_ measure of the happiness the good gives us. The word 'marginal' is here used to mean nothing more and nothing less than 'one more'. Putting together, 'marginal utility' means the money-value of consuming one more cappuccino. For example, if we are considering the demand for cups of coffee, the marginal utility curve shows how much extra joy a consumer gets from having one more cup starting from any given number of cups already consumed. Typically the extra joy from an extra cup falls with the number of cups bought per day. For example, if the consumer buys very few cups of coffee today, say c' in the diagram, the gain from buying an extra one is likely to be pretty high, for example rnu' in the diagram. If, however, the consumer has already bought lots of cups already, then the gain from one more is likely to be much lower. This is shown by the pair, c" and rnu". This marginal utility curve allows us to work out how much the consumer would buy at any given price. Suppose the consumer could buy as many cups as she likes at the price p*. How many would she buy? If the consumer is wise, and we assume she is, she will buy cups of coffee up to the point where the last one bought is just barely worth the price.

Preliminaries I: supply and demand diagrams

Figure 4.1 Optimization and demand and supply curves Price

Price

Marginal cost

me'

mcm

Marginal utility

c' c*c"

Quantity

q'q* q"

Quantity

In the diagram, this level of purchase is given by c* since the extra benefit (marginal utility) from buying an extra cup exceeds the cost of doing so (the price) for all levels of purchase up toe*. At this point, the consumer finds that additional cups would not be worth the price. For example, the marginal utility from buying e* plus one cups of coffee would be below p *. This is the demand curve for one individual. When we want to know how many cups will be bought in a particular market, we add all consumers' individual marginal utility curves horizontally. This is obvious once you think about it. If the price is p* and there are 100 identical consumers, market demand will be 100 times e*. And a similar calculation holds for all prices. In particular, at pm, no one will buy coffee, so individual and group demand is zero. A key point to retain from this is that the price_that consumers face reflects the marginal utility of consuming a little more.

4.1.2 Supply curves and marginal co~ts_

.

.

Derivation of the supply curve follows a s1m1lar logic, but here the optlillization is done by firms. The righthand panel of Figure 4.1 shows the 'marginal cost' curve facing a typical firm ( assume they are all identical for the sake of simplicity). As before, marginal m~ans 'one more' and 'cost' means cost. Thus marginal cost is the extra cost involved in making one more umt of the good. While the marginal cost of production _in the real wo~ld often declil~es with. the scale of production, allowing for this involves consideration of scale econmmes_ and tl~ese, m turn, mtroduce a whole range of complicating factors that would merely clutt er th~ analysis. at tlus stage. T_o keep it simple, we assume that f,-rrn t· g at a point where the margmal cost is upward slopmg; that is, that the cost of u. mS are opera 1n . . . . . roduc· t •t ·ses as the total number of umts produced nses. The curve m the diagram shows, P ~~~ra~n . . for ex th t •t t me' to produce one more urnt when the product10n level ( e.g. the number of cups amp1e, a 1 cos s " f . t • h r· · · of coffee per day) is c( This is less than the cost, me , o · proc1ucmg an ex ra urut w11en t e rrm 1s producmg c(' Units per year. . . that the frrm . wants to make . . d termine the firm's supply behav10ur. Presurnmg smg this curve we can e . . . . profit), . the U the . f selling coffee (or as econormsts put 1t, they want to max1m1ze . 1 cos t JUS . t eq_ua1s the pnce. . w·t1 . firmmost . money poss1b1e rom th point where the margma 1 1 a 1·1tt1e refl ect10n, WI1I supply goods up to e

....., . tools and tariff analysis CHAPTER 4 Essential microeconom1c

G 0

ps of coffee should the firm proc.luc . er to the q,uestion: How many cu e ·11 see this is the correct answ ? . yodu will t tl1e price p* in order to make the most money. ly n* units. Why? If the frrm offered one less an se a . . ., _1 f . will want to supp '1, th · . · For example, if the pnce is p~' t 1e urn ft After all at that level of output: e pnce the firm than n* units it would be missing out on some ~rol 1 . t f producing it. Likewise, the firm would not Want ·r. ' ·1· d the rnargma cos o d . t . would receive for the good, p··, excee s 1 f tput the marginal cost of pro ucmg an ex ra unit is O • for such a leve u ouI curve ' · ct·1v1·d ua1 marginal · to supply any more than~-.·1· smce, by adding all the f"rrms ' m more than the price. Agam, we get the aggregate s PP y cost cmves horizontally. .. th rice facing producers reflects the marginal A key point here is that, under perfect competition, . e Ph the frr· m produces in eq,uilibrium. . . f d · e more umt t an production cost, that 1s, the cost o pro ucmg 011 d f" s act when faced with a particular . 1 t nl how how consumers an rrm As 1t turns out, t 1ese curves no o Y s . . u in for consumers, producing and price, they also show how much they will gain from their actions Cb Y g selling for firms).

4.1.3 Welfare analysis: consumer and producer surplus

.

Since the demand curve is based on consumers' evaluation of the happiness they get from consummg a good and the supply curve is based on firms' evaluation of the cost of producing it, the curves can be used to show how consumers and firms are affected by changes in the price. The jargon name for the concepts we will use are: 'conswner surplus' for consumers, and 'producer surplus' for firms. This section explains the concepts and how they are used to measure the value to consumers and firms from this buying and selling. Conswners buy up to the point where their marginal utility just eq,uals the price. For all other units bought, the marginal utility exceeds the price. This means that the consumer gets what is known as 'consumer surplus' from buying c* units at price p* (see Figure 4.2). In plain English, this says that consumers get more (in terms of utility) than they pay for. How much more? . For the first wlit bought, the marginal wlit was mu' but the price paid was only p*, so the surplus 1s the area shown by the rectangle 'a'. For the second ml.it, the marginal utility was somewhat lower

~

.

·~

- .

F_igure 4.2 Deriving consumer and produc~r surplus ~

Price /

Price 1

Supply curve 3

a

p':-p*

Demand curve

1 2 3 4 c*

Quantity

.

...

-· ..

q*

Quantity

CHAPTER 4 Essential microeconomic tools and tariff analysis

- · d welfare changes . Figure 4.3 Deriving the import demand curve an Home supply

Price

Price

NB : E == B + D

P* P" P"

P' Home import demand curve, MOH

Home demand

Z'

C"

Z"

M"

C' Quantity

M'

Imports

Note: Readers who find these diagrams complicated may benefit from the step-by-step explanations given in the interactive

PowerPoint presentation available on the companion website: http://www.:1heducation.~o.uk/textbooks/bald~. _ • ..

-----

--,,.,--•.o-

----

........

__ ... _

-

--

~-·--- .

~-•-

~,...-- ~

....-.-c

••

, _ , . , _..___,-.n • · w ,;.

•- ~ • - •

____ . .... ·-·

_ ,. . ...

How much would the nation import if the price were lower, say, P'? The first thing to note is that the import price will fix the domestic price. Imports are al~ays available_ ~t P', so ~o consumer would p~y m?re than P'. Of course, domestic producers must match the import competition, so P becomes the domestic pnce. The second thing to note is the impact of P' on consumption, production and imports. Consumption demand would be C' and domestic production would be Z'. As C' exceeds Z', consumers buy more than domestic firms are willing to produce at P'. The 'excess' demand is met by imports. That is to say, imports are the difference between C' and Z' (in symbols, M' == C' - Z'). For convenience, we can show the level of imports that corresponds to P' with a diagram that has imports on the horizontal axis and price on the vertical axis (this is the diagram on the right side of Figure 4.3). In particular, we plot the combination of import demand is M' at the price at P' as point 3 in the righthand panel of the diagram. Performing the same exercise for P" yields point 2, and doing the same for every possible import price yields the import demand curve, that is, the amount of imports that the nation wants at any given domestic price. The resulting curve is shown as MD 1.1 in the right-hand panel. (For convenience, we often call the nation under study 'Home' to distinguish it from its trade partner, which we call 'Foreign'.)

Welfare analysis: MD curves as the marginal benefit of imports When studying European economic integration, a critical q,uestion that arises time and again is the extent to which a policy raises or lowers nations' well-being. As before, we will use money to measure well-beingkeeping in mind the usual caveats about this being a rather shallow measure of happiness in the broad sense, but a good measure when it comes to pragmatic things like the price of goods. As it turns out, it is useful to know how to carry out welfare analysis with the right- and left-hand diagrams in Figure 4.3). Consider a rise in the import price from P' to P". As argued above, the higher import price means the domestic price rises by the same amount. The corresponding level of imports drops to M", since consumption drops to C" and production rises to Z". We can see the welfare analysis in the left-hand

f-lreliminaries II· int d t· · ro uc ion to open-economy supply and demand analysis

panel using the standard notions of . . consumer and producer surpluses (see Section 4.1). Specifically the pnce nse 1owers consumer sm-plt b A B ' A The right-hand panel shows is Y_ + + ~ + D. _The same price r~se increases producer surplus by 1low tlus appears m the import demand diagram. From the left-hand panel . rt . . the 1mpo pnce nse means a net 1 t tl . • · ' . oss o 1e country of B + C + D smce the area A cancels out (area A 1s a gam to Home producers and a los t O H •' . s ome consumers). In the nght-hand panel, these changes are shown as areas C an d E ; as 1t turns out, area E eq,uals area B + D.

A powerful perspective: trade volume effects and border price effects It proves insightful to realiz e tllat th e MDH curve shows the margmal · · of imports · . . benefit to Home. Before explanung why this is t h · · · · . rue, we s ow that it is a useful msight. As we saw above, Home loses areas C a nd E when th e pnce of imports rises from P' to P". Area C is easy to understand. After the price rise,

~ome pays more fo~ the units it imported at the old price. Area C is the size of this loss. (Say the price r~se was €1. 2 per,wut an_d 1!'1" was 100; the loss would be €1.2 times 100; geometrically, this is the area C smce a rectangles area 1s its height times its base.) Understanding area Eis where the insight comes in ha nd Y· Home reduces its imports at the new price and area E measures how much it loses from the drop in imports. The marginal value of the first lost unit is the height of the MDH curve at M". But since Home had to pay P' for this unit, the net loss is the gap between P' and the MDH curve. If we add up the gaps for all the extra wuts imported, we get the area E. The jargon terms for these areas are the 'border price effect' (area C) and the 'import volume effect' (area E). To understand why MDH is the marginal benefit of imports, we use three facts and one bit of logic: (1) the MDH curve is the difference between the domestic demand curve and the domestic supply curve; (2) the domestic supply curve is the domestic marginal cost curve, and the domestic demand curve is the domestic marginal utility curve (see Section 4.1 if these points are unfamiliar); and (3) the difference between domestic marginal utility of consumption and domestic marginal cost of production is the net gain to the nation of producing and consuming one more unit. The logical point is that an extra unit of imports leads to some combination of higher consumption and lower domestic production, and this leads to some combination of higher utility and lower costs; the height of the MD 8 curve tells us what that combination is. Or, to put it differently, the nation irnp~rts up to th: point where the marg~al_ gain fro~ do_ing _so eq,uals the marginal cost. Since the border price 1s the margmal cost, the border pnce 1s also an mdicat10n of the marginal benefit of imports. . . . . . . To see these points in more detail, see the mteractive PowerPomt pres_entat10ns available on this book's Online Learning Centre, http://www.mheducation.co. uk/textbooks/baldwin/.

4.2.2 The export supply curve .

.

.

10 ous line of reasoning to denve the import supply schedule. The first thing to keep ~~e 4 -_4 uses an ana f imports to Home is the supply of exports from foreigners. For simplicity's 0 th m mmd Is that e supp~ one foreign cow1try (simply called 'Foreign' hereafter) and its supply and 15 0 1 sake, suppose that th ~re h n ~t-hand panel of the figure. (Note that the areas in Figure 4.4 are mu·elated demand curves look hke t e 1e to the areas in Figure 4 .3.) t rt by asking how much Foreign would export for a particular .h h . rt demand curve, we s a As . wit t e Impo Id •t export if the price of its exports was P'? At price P', Foreign firms pnce. For example, how much won I Id buy C' The excess production ( eq_ual to .X' = Z' - CJ would "' d F ·gn consumers wou . . . . . would produce Z an orei_ case of import demand, the export price sets the pnce m Foreign; For~1gn be exported. (Note that, as 111 th e . ·tl 11 can always exJ)ort and competition among Foreign supphers . 11 f less smce 1e11 ' . f1rms have no reason to se or . F reign consumers a higher price.) The fact that Foreign would f om charging ◄ o . Would prevent any of t h em r . . P' is shown in the right-hand panel at pomt 2. like to export.X' when the export pnc~ IS H e's import price) rose, Foreign would be willing to supply a As the price for Foreign exports (1.eT.homh. her price would induce Foreign firms to produce more and • · higher level of exports for two re asons · e ig the price p" would bring forth an lillport supp 1Y eq,uaI t 0 .X" 1e, . 1 For examp · Foreign consumers to buy ess. . 3. tl ri'ght-hand panel. At pnceP', exports are zero. Plottil1g a 11 s pomt 111 1e · tl · 1 (this eq,uals Z" - C'J; this is shown a nel roduces the export supply curveXSp. We stress agam 1e s1mp e such combinations in the right-hand pa p 1 is the Home import supply, thus we also label XSF as MSH. • xport supp Y but critical point that the Foreign e

y

. tools a, . economic CHAPTER 4 Essential micro

,u

L'-'' ...

d welfare changes curve an 1 Figure 4.4 Deriving the export supp y Price Price

F == C+E

Foreign

supply

Foreign export supply curve, XSF, or MSH

Foreign demand !·

C"

C'

Quantity

X'

X"

Exports /

I

Welfare The left-hand panel also shows how price changes translate into Foreign welfare changes. If the export price rises from P' to P", consumers in Foreign lose by A+ B (these letters are not related to those in t~e previous figure), but the Foreign firms gain producer surplus eq,ual to A + B + C + D + E. The net gain IS therefore C + D + E. Using the export supply curve XSp, we can show the same net welfare change in the right-hand panel as the area D + F. Note that the insight from the MDH curve extends to the XSF curve, that is, the XSp curve gives the marginal benefit to Foreign of exporting. This review of import supply and demand was very rapid - probably too rapid for students who have never used such diagrams and probably too slow for students who have. For those who find themselves in the first category, intera~tive PowerPoint presentations that go over the diagram in greater detail are available at www.mheducation.co. uk/textbooks/baldwin.

4.2.3 The workhorse diagram: MD-MS The big payoff from having an import supply curve and an impo t d . . mi·ts us . the pnce . and q,uantity . of imports . curve is that it per e of to fmd that is produced bn th r kemand . h • 1 • of supply and demand in both Home and Forei ~ ne mar et,,• m .other words the. outconether t e mteraction T import demand and supply as shown in the left-hand p f F~ · he puce IS found by puttmg t 0 g ·pts for convenience. ane1O ~Igure 4.5; we drop the 'H' and 'F' subscn Assuming imported and domestically produced c ood . . _. oint where the demand and supply of imports m t g s are Identical, the domestic price is set at th~ P rt supply and demand diagram or MD M.S d' ee' n~mely, PrT (Fr stands for free trade). While the in1P0 ' iagram for short · 1 lUJlle of imports, it does not permit us to see the im act -- '. is 1andy for determining the price and vo . J1lS separately. This is where the right-hand pa 1b p of pnce changes on domestic consumers and fir ·s only when the plice is PFT, so we know lhn: Hecomes usefa!. In particular, we know that the market de•~ The eq,uilibrium level of imports may be ad production eq,uals Z and Home consumption eq,uals_ . ~ the right-hand one it is the differ b rea o either panel. In the left-hand panel it is shown directly, 11 ' ence etween domestic . ' consumption and production.

;;n~

MFN tariff analysis

Figure 4.5 The MD-MS and ope

n-economy supply and demand diagrams Domestic price, euros

Euros

Sdom

Domestic/ demand curve

Import supply curve

'Domestic supply

MS

/

Import demand curve

Imports

Imports

z

Imports

C

-

Quantity

I

-- - --------~----- - - _,/'

Having explained these basic microeconomic tools, ·we turn now to using them to study a simple but common real-world problem - the effects of a tax on imports from all nations. Such taxes are called tariffs.

4.3 MFN tariff analysis To build from simple to complex, we preface the analysis of preferential trade liberalization in Europe with a simpler example, but one that nevertheless is useful for understanding the world. That is, we introduce the basic method of analysis and gain e_xperienc~ in usiI~g the ~agra_ms by first studying the impact of removing the simplest type of trade barrier - a tariff that 1s apphed to rmports from all trade partners. We call this a non-discriminatory liberalization. Although this is not what happened when Europe integra~ed economically, we first look at the nondiscriminatory case since it is less complex. An extra benefit of taking this detour is that it helps us understand the effects of the EU lowering its common external tariff - as it does in the context of world trade talks (see Chapter 12). For historical rea~o~s, a non-discriminatory tariff is called a 'most favoured nation' tariff, which provides the handy abbreviation, MFN.

4.3.1 Price and quantity effects of a tariff

.

..

The first step is to determine how a tariff changes pnces and q,uantities. To be concrete, suppose that the

~au:~

tariff imposed eq,uals T euros per unit. . . . _ _ _ .· . The first step in finding the post-tanff pnce 1s ~o worl~ out how the chm~ges the MD-MS ~iagram; her Fi f - -t tes the analysis. (See Sect10n 4.2 if you are unianuhar with the MD-MS diagram.) e, gure 4 .6 ac111 a ·i·r. t d· 1 · ht h d pre-tan · · unpor · c1emanc1an import supp y curves as MD and Th e ng - an pane1o f Figure 4 ·6 shows the ' _ _ . . ._ . ,. . MS . Th 1 ft-hand panel shows the fo1e1gn expmt supply cmve as..t\'.S. Note that the vertical .' ~esp~ctt:e1y. ed e hows the domestic price, while the vertical axis in the left-hand panel shows axis m this nght-han pane1 s _ . . .· . . . . d"_ff e between the two 1s sunple, but cutical (see the note to Figrue 4.6). th e b order pnce - the 1 erenc

A tariff shifts up the MS curve

.

I .. . effect on the MD curve in the right-hand panel sm_ce the_ MD cur~e tells_ us how mpos1t10n of a tariff has n~ ·ven domestic price. By contrast, 1mposmg a tanff on rmports much Home would like to import at any gi

CHAPTER 4 Essential microeco

effects o Figure 4.6 Prl·ce and nuantity --,,

. Is and tariff analysis nom1c too

f an MFN tariff

Domestic price Border price

M5w ith T I

I MS XS= MS pFT P'- T

I MD

: , ----------~1::_+

pa - --------:---:---,

T/

:

I

I

/

xa

= Ma

/

X'

\

= M ' xn = MFT

Foreign exports

Home imports

· ti' on between the domestic and border prices. The domestic price is the price that domestic consumers Note: Observe the distine . e pay for the goo d . Th e b order price is the price foreign producers receive when they sell the good , to Home. They can ,differ becaus of the tariff . ( a tariff·is no thing more than a tax on imports). When you buy a coffee at a cafe for, say, 1 euro, the cafe owner, does not get the full euro because the owner has to pay a tax, called the VAT, on your purchase. As a result, the price that the cafe . • o nly 80 cents (the VAT is 20 per cent in this example) though you pay 100 cents. In exactly the same way, owner receives is . even . . . . · a price (the border price) that eq_uals the domestic pnce mmus the tariff. foreigners receive ------ - ..... - - - ---- ···• ·--- -- - · -- ------- - . ·- -- ---- ·---- - - - ·- - -

shifts up the MS curve by T. The reason is simple. _After ~he tariff is imposed, the domestic price must be h' her by T to get Foreign to offer the same q,uantity as 1t offered before the tariff. Consider an exampl_e. ~iw much would Foreign supply before the tariff if the Home domestic price before the tariff were P'? The answer, which is given by point 1 on the MS curve, is~- After the tariff, we get a different answer. To get Foreign to offer Af3- after the tariff, the domestic price must be pa+ Tso that Foreign sees a border price of P. . Having shown that the tariff shifts up the MS curve, consider next the tariff's impact on eq,uilibnum prices and q,uantities.

The new equilibrium prices and quanUUes Even without a diagram, readers will surely realize that a tariff raises the domestic price and lowers imports. After all, a tariff is a tax on imports and it is intuitively obvious that putting a tax on imports will raise prices somewhat and lower imports somewhat. Why do we need a diagram? The diagram helps us be more specific about this intuition; this specificity allows us to work out hoW much the nations gain or lose from the tariff. Returning to our analysis, note that, after the tariff, the oI_d import supply curve is no longer valid. The new import supply curve labelled MS with T, is what matteis and the eq,uilibrium price is set_at the point ';here the new import suppjy curve and the import demand cur;;: cross. As intuition would have 1t, the new pnce - marked P' in the diagram - is higher than the pre-tariff pn

,

MFN tariff analysis

pFT ( as

/'T

alrea~y noted: stands fo_r free trade). Because of the higher domestic price, Home imports are reduced to M from lv.rF · To summanze, there are five price and q,uantity effects of the tariff: The price facing Home firms and consumers ( domestic price) rises to P'. 2 The border price (i.e. the price Home pays for imports) falls to P' - T· this also means that the price received by Foreigners falls to P' - T. ' 3 The Home import volume falls to M'. The other two effects cannot be seen in Figure 4.6 but are obvious to readers who worked through Figure 4.3. The higher dome stic price stimulates production ~nd discourages consumption. Specifically: 4 Home production rises. 5 Home consumption falls. There are also production and consumption effects of the tariff inside the exporting nation. Since the border price falls, Foreign production drops and Foreign consumption rises. We could see this explicitly if we put a diagram like the left-hand panel of Figure 4.4 to the left of the diagram in Figure 4.6. You may want to do this as an exercise to test your familiarity with the diagrams.

4.3.2 Welfare effects of a tariff Having worked out the price and q,uantity effects, it is simple to calculate the welfare effects of the tariffs; that is to say, who wins, who loses and by how much. The analysis is really just a combination of what we did in Figures 4.3 and 4.4; this is done in Figure 4. 7. The left-hand panel shows Home's supply and demand, the middle panel shows the world market for imports and the right-hand panel shows the Foreign supply and demand. We start _w ith Home. Figure 4.7 Welfare effects _of an MF~ tariff Home price

Home price

Foreign price

Home supply

K=B+D MS

Foreign supply

Home demand

Foreign demand

I I

Quantity

Home imports

Quantity

)

Preliminaries II· int d t · · ro uc ion to open-economy supply and demand analysis

(not shown in the diagram) so th 1 · •• '. -~1 s~ us is lower; specifically, it is given by the area 'b'. Doing the same f or a 11 uru·ts shows th a t b uymg c· • urnts a t P* yie · Id s a total consumer surplus eq,ual to the sum of all the . t res ult mg rec ang1es. If we take tI · • . . tl le urnts to be very fmely defmed, the triangle defined by the points 1 2 an d 3 gives us 1e total consumer s 1 B 4 · · ' urp us. ox .1 discusses a real-world illustrat10n of consumer surplus.

Switzerland's wonderful rai·1 syst em can be expensive . so many tourists • buy the Half Fare Card; m · 20 18, t 120 it coS Swiss francs (CHF) for a one-month pass that lets the traveller buy train tickets at half price. The fact that people pay t 0 ge t mwrmted ~ 1~ • . is . an example of consumer surp1us . . . access to a lower pnce

111

acti~n. ~o see this, ask yourself what would be the maximum you would pay for being able to buy ha~-pn_ce tickets. For example, suppose you were planning a two-week trip that involved 20 individual tr~m tnps. Suppose the average, full price was 20 CHF, so you would spend 400 CHF without the card. With the card you spend only 200 CHF, so you would be willing to pay up to 200 francs for a Half Fare Card. In fact, you would probably be willing to pay a bit more than 200 CHF since at the lower per-trip price (i.e. 10 CHF versus 20), you would probably take a few trips more than you found optimal at the full price. In this example, you should buy the half-price card. Here you are paying a fixed amount to get access to a lower price. Even though you still have to buy every ticket, the fixed sum is worth it since you are getting utility in excess of the price you pay. When you think about it, this must be true since you are willing to pay a fixed fee of 120 CHF to be able to buy cheap tickets. This would not be the case if there were not consumer surplus.

An analogous line of reasoning shows us that the triangle formed by points 1, 2 and 3 in the right-hand panel gives us a measure of the gain firms get from being able to sell q,* units at a price of p*. Consider the first unit sold. The marginal cost of producing this unit was me' but this was sold for p* so the firm earns a surplus, what we call the 'producer surplus', eq,ual to the rectangle 'c' ~ the right-hand panel. Doing the same exercise for each unit sold shows that the total producer surplus is eq,ual to the triangle defined by

points 1, 2 and 3. . By drawing similar diagrams on your own, you should be a~le to convmce yourself that a price rise • mcreases pro ducer surplus and decreases consumer surplus. A pnce drop does the opposite.

4.2 Prelim inaries II: introduction to open-economy supply and demand analysis . . . d the 'workhorse' diagram - the open-economy supply and demand diagram - that This sect10n mtro uces . . • w . . . . . t d O f European economic mtegrat10n. ell-prepared readers may consider skippmg, 1s essential to ours u Y • 3 Th ct· · · . . t th tariff analysis in Sect10n 4. . e iagram, however, Is used tlu·oughout this 1 st movmg ra ght on e advanced readers may wish to briefly review the diagram's f mmdations; if chapter and the next, s~ eve~ with the terminology. nothing else, such a review will help

°

4.2.1 The import demand. curve .d

.

. ..

.

nd curve comes from. Figure ,1.3 facihtates the analysis. We first look at where the import ema d I·cts a imtion's supph1 and demand curves for a particular f the diagram ep c c , u . . . . The left-hand panel O . . tile vertical axis· nuantity IS on the honzontal axIS. If rmports f pnce IS on c ' ~\, good. As usual, the domes IC the nation would only be able to consume as much for some reas 011 , . . . of the good were banne d lein[J lowered" miarcts to protect their investm_en 'revent prices 110m to CTuarct their 'gold mine', that 18 ' p

i

2

1e EU's generosity was earlu 1990s, tl $13 000 less tlrnn at unus ual. In Uie e~· EU farmer was l~t of tl1e USA 1. f'lr111ers was n•·sidU ectuivalent ~ ) and about eq,ual tl < ent. oJJ01ts ' that the sllu 18 - - - - - - - - : - ~ , ' ecial treatrn Finland ancI Anstua ' It· ·trnportant to note that t h e EU s ksp OECD (2004)•tzeriand, re N rwau, 0 only in the middle of the OECD pac ·csweden, sw, df for details.

half the amount for EFTA members 06/annexl_en-P an.ct Japan. /fin/directaid/20 See ht tp://ec.europa.eu/agnc · ulture

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.

. price cuts Wl'th compensat10n 9 10 The new logic - .

. Figure . ·

.

.

•

·

Price EU supply

·

. t-reform: price falls to CAP price-cu t· t C' . b osting consump 10n o world price, o . Z' and lowering production to . a + b· producers lose Consumers gain ' · b +c+d a + b + c; taxpayers gain , net gain is b . t d-compensate reform: CAP pri~e-caun-:nquantity effects, and same price h same welfare effects except t e producers' loss is shifted to taxpayers

EU demand

C

C'

Z'

Z

Consumers gai·n a + b; producers lose nothing; taxpayers gain b + c + d but lose a + b + c; net gain is b + d

Quantity

9.3.2 Price cuts compensated by 'decoupled direct payments' , _ ,

j

.

I

. CAP

The political solution was to provide compensation that would, m essence, bnbe farmers mto allowmg . f t Proce ed This added the second element to the new CAP logic. In EU jargon, this compensation re orm o · , . , . , 1 d' rt is termed 'decoupled direct payments'. The direct payment part 1s self-explanatory; the decoup e pa indicates that payment of the money is not linked to food production levels. As it turns out such price-cuts-with-compensation are win-win. To see this, recall how the price support ' . was like a combination of a consumption tax and a production subsidy. In this light, the simple cut-the-pnce reform would have removed both the tax and the subsidy. The cut-prices-and-compensate reform removes the consumption tax and replaces the production-linked subsidy with a decoupled subsidy. In terms of Figure 9.10, the cut-prices-and-compensate reform lowers the price that both consumers and producers see in terms of the old price floor and the world price. This reduces EU output to Z', and raises EU consumption to C', thus eliminating the need for the EU to buy unwanted food and dump it on the world market. Full compensation of farmers would cost a+ b + c (eq,ual to their loss in producer surplus), but this would still make the whole reform a net winner for EU consumers and the EU as a whole. Consumer surplus would rise by a + b_ an~ the producer surplus reduction would be exactly offset by the compensation, leavmg tax revenue unphcattons. EU taxpayers would save (b + c + d) from eliminating the export subsidy, but have to pay (a + b + c) in compensation. EU welfare would thus rise by (a + b) + (0) ( a + b + c) + _(b + d + d), where the (0) shows the impact on EU producers. The sum of this is the same as the cu~-the-pnce reform, namely, a gain eq,ual to the area b + d. This result_1sshould readers who fully understand the logic in Chapter 4. Since to compensation - fromnot the surprise EU ·d . . the another set of EU ·r . h -WI _e perspective - JUS t one group of EU citizens transferring money cut-the-price and c~ti;~ns, it as no unpact on EU-level welfare. From an aggregate welfare point of vieW, - e-pnce reform-with-compensation are identical.

The sirn I p e economic I og1c of the new CAP

. g·3_3 Linking direct payments t0 environ

us cut-and-compensate reform mental and animal • welf 'fl rt of trans1·t·wna1 compensatio made se nse .m the sl are goals so . n was O 1ort run M for compensat10n began to fade Ti .. Wed to farmers AI . osl. Europeans w I eaders of this book were born t1le hrst steps tow·trcls .tl . ter manu years howou d agree that1some · v le 2000 ,. 1c new 1 • ' ever, the m r developments extenuated tl11·s. ""VO s, the payme11t t og1c happened in 1992 ora case ' . impress· . · s s artecl 1 1 · - bef 1 and farmers, the meq,uality docume11t e d 111 . ion. First, since the ct·1rect,opay ook more like unJ·ust1·r·1e d transfers ore most T bl inuch. . ,e Queen .o f E◄ ngland rece·1ved m . CAPa e 9.2 became very tra ments were made t o named farms. . ti to millions of farmers m Central an d Ea t payments (se e Box 9 5)nsparent. One could even see how s first place. They were being com s ern Europe who h d . . econd, the money start d . One reaction would have b pensated for losses th~n had a ne_ver experienced the pri~e cu~.. ~omthg . een to shift E t1 never me d "" m e deal with youth unemployment d U spending from f urre · . , or evelop . arms to other prevented tlus. The political s t' ment aid to Africa Th Ii . areas, say, R&D schemes to the environment, promoting aoI_u ion was to justify the pan.rn e":o tical power of the farmers, however , . mmal welf t1 en"" on social d ' 'decoupled direct payments are, encouraging rural d I groun s, such as protecting were recoupled to something th eve oprnent, and so on. In essence th~ o er than farm output. '

Bv

To . understand I d . how much big EU f armerswouldsp dt o resist . simple . price cuts, consider th e numb ers tmvo ve ' takmg the EU 2007-13 b u d get package en as a o pa~me~ts to farmers and the cost of kee in fa n e_xarnp!e. This package allocated €330 billion workmg m the farm sector If the m p g rm pnces high. There are only 12 6 million people . · oney were divided n1 · person - certamly something worth fighting for. eve Y, that would be about €26,000 per The money' however, is not distributed evenly as Table 9 2 largest farm owners. For example, in 2006, the EU25 aid €33. 1 sho_ws. Most of the money goes to the with about 70 per cent of the mone oin t . p . billion to 7.3 million farmland owners landholdings). Small fanners eamedyi:ucht:s J~:~~e~~n~;{ !'t:e (the ones with the larges~ would be driven out of farming altogether. ' t out the higher prices, many ~

a nutshell, the CAP meant loads of cash for the happy few (large farms but it survival for the 80 per cent of EU farmers with small operations. In addition to t~e cold-:.::::;a,tter of logic part of the farmers' disproportionate political aver of cash, E . . power sterns from the warm-hearte d feelin gthatthe age m· uropean has towards the sector; opll1lon polls show that most EU citizens approve of CAP spending genera.1 .

.

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Box 9:5 Queen Elizabeth1~ C~P·r.e'.ci ie'tSr ,_: : ,::· "-· ·-: , ~- -

-

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!he list of English CAP recipients (the Scottish and Welsh governments refuse to release the information) mcludes some of the richest people in the realm. The Duke of Westminster, whose net worth is about €7 billion, received about €1 million over two years, the Duke of Marlborough got €1.6 million over the same penod, and the Queen and Prince Charles received more than €1.5 million each, according to the data. The royal family is also a major landowner in Scotland (for which the data are still secret), so this is probably a ~eri?us underestimate. Multinational colJ)orations, however, received even more. At the head of the subsidy liS the multinational corporation Tate & Lyle. It received more than 10 times the payments received by t 18 fue Queen and Prince Charles, some €180 million (most of this was spent on dumping sugar on the world market). Nestle got €30 million. Overall, there were 24,525 names on the list, but half of the money went to :e top 2000 recipients. Or, to put it differently, half the money was divided among the 22,500 smallestfanns. ee the Guardian newspaper's website (http://unage.guardian.co.uk/sys-files/Guardian/documents/ 2005/03/23/CAP.pdf) for a full list. A similar list can be downloaded for Denmark from www.dicar.dk.

mon Agricultural Policy CHAPTER 9 The Com

9·4 CA Preform

. . h CAP costs was to. increase contributions· . d r 1 g with h1g er Up to the mid-1980s, the primary way _o f ea n The CAP was not very expensive from the ag~regate from Member States. This was understandable. . essentially European governments paying one viewpoint (less than half a per cent of EU GDP) and it wa~ d while the reverse was true for the French .d than they receive ' another's farmers. The Germans pa1 more . t duce their net payment. 0 and Italians. The British negotiated a 'rebate' 1111984 re •oined in 1986. As discussed in Chapter 3 . .. d h Spain and Portuga1 J . ' Tlus poht1cal balance change w en CAP did li'ttle to help Spamsh and Portuguese .. . ·1 111 · ·t· I wans The this altered the pohtlcs 111 the Counci en ica ::, · . h d that the CAP supported most that f oducmg t e goo s ' farmers since their climates prevented them rom pr t t to see their national contributions . . . f Th rs who were re1uc an is, dairy, sugar, wheat, nee and bee . e newcome ' . . roduction of rich northern European th to the budget rise ye~r after yea: in order to s ubsi~ize e p d and Greece) to shift EU spending farmers, teamed up with the two 111cumbent po_or nat10ns (Irelan furth details). One option would priorities towards 'structural spending' in poor nat10ns (see Chapter 3 for er h EU t t 'b t ding but t e ne con n u ors have been to expand the EU budget to pay for the extra structura1 spen , . · · EU 1ead ers decided instead to fmd ways of (especially Germany, Denmark and the UK) opposed this. capping CAP costs, so to speak. . From 1986 to the present, the CAP has been repeatedly refo.r med. Although the details a~e cornp_lex, the basic trend is simple. EU leaders were gradually guiding the CAP from the old simple logic of pnces explained in Section 9.1 to the new simple logic explained in Section 9.3. For most of this period, the overall level of support to farm incomes did not fall, as Figure 9.11 shows. The producer subsidy eq,uivalent (PSE), which is calculated by the OECD, shows the sum of all supports to EU farmers from the CAP and national sources. The chart shows both the level (billions of euros) and the PSE as a share of total farm output. Up until the mid-2000s, the total cost of the CAP was steady and it has fallen only moderately since. The PSE percentage, by contrast, has been on a clear downward trajectory since 1998. The difference indicates that EU agricultural output is falling more slowly than total PSE payments.

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g,4.1 Ad hoc supply control attempts posed a reform dilemma. Low . f . This situation . . enng arm pnces d

It . h prev10us section, but buying all the ex f ea wit the political roadblock discussed u cess ood was too . . try to work around the problem, dealing with the su lus . e_xpen~1ve. The EU's frrst reaction was to price-floor system. As the European Commission si~atwn without fundamentally changing the 199 experimentation' with supply controls. ( ) puts it, th e 1983 to 1991 period involved 'years of . 1 the

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The CAP during this period became fantasti 11 have been dropped, so most students of E c~ Y co~plex. Fortunately, most of these experiments important is the outcome of these new oli:::ean mte~ratwn have no need to study their details. What is olitical imperative of spendin more ~f · The CAP s share of the budget beg~n to fall to meet the new th e EU budget on poor members and reg10ns. p Tl dh g 1ese a oc supp1y control poli · h · . t· cies, owever, failed to address the supply problem. The wheat and butter mount ams con mued to grow al ·th • • . dt f t· ong WI subsidized exports, and, despite this, average farm incomes contmue o a 11 re1a 1ve to the EU-wide average.

9.4.2 The MacSharry reforms Th~ first really big reform was driven by pressure from the EU's trade partners, who were fed up with seemg the market for their exports ruined by export subsidies (the USA also subsidized its exports). The issue came into sharp relief when the global trade talks, known as the Uruguay Round, failed in December 1991 when the EU refused to commit to phasing out its export subsidies and open its agriculture markets. Since these global trade talks were viewed as vital to European exporters of goods, services and intellectual property, Europe's highest-powered exporters started to push for CAP reform. The political power of poor regions who wanted to use the money and European exporters who wanted the Uruguay Round to succeed were sufficient to get a major reform accepted by the Council of Ministers. The resulting reform package (the MacSharry reforms) put the CAP on the road to the economic logic of Figure 9.9. All subseq,uent reforms to date have followed its main outlines. There have been three major CAP reforms since the MacSharry package, which pushed the basic MacSharry logic even further. All involved further price cuts that were compensated by direct payments to landowners. The first resulted from the March 1999 meeting of the European Council in Berlin. The prime driver of this reform was the need to get the CAP ready for eastern enlargement and to prepare it for a falling budget share in the 2000-06 Financial Perspective. The second came in 2003. The third was embodied in the new 2014-20 Multiannual Financial Framework.

9.4.3 The 2003 CAP reform and 2008 Health Check . . h rent WTO trade talks (the so-called Doha Development Agenda). Th e dnvmg force was t e cur . Dev . . reluctant to start new WTO talks and were convmced only when the EU elopmg countne~ were. ·sed in November 2001 to liberalize agricultural markets as part of members and other nch natwns pronu • · · cancun, th . . •d-t rm meeting of mm1sters sch e du1e d f or sep t emb e1• ....?00~0 m e Doha Round. With the crucia1 mi ef of tlle CAP that would allow it to fulfil its liberalization pledge. Mexi th EU h d p with are orm . T co, e ~ to com~ u . Althou h there is plenty of blame to go round, manu observers believe he Cancun meetmg ended m failur~. hg CAP reform was at least one major reason for the fail me. The that the meagre liberalization contamed m ~ of sector-specific reforms in recent uears. 003 reform has been followed up b. Ya sen . iiaine the 'Health Check'. This agreement pushed I f with a pecu1tar , ' n 2008, the EU undertook a re orm Tl 1. ·fortll abolished arable set-aside (i.e. pauing farmers th . . AP further. 1e e .. t e market onentat10n of the C even, . s of the direct. payments was nut1gated under the name of 0 not grow food). Moreover, the unfmrnes . 1_ f•ii·mers are reduced and the moneu transferred 'm0 dulation'. This means that some crire ct' payments ,o '- its are no longer linked to the product10n . of a · . to th L tl the chrect paymet " . · d e Rural Development Fund. as Y, . t· i•esi·stant sectors-dairy-bu first relaxing an . d e ot the mos · · ' specific product. The reform also liberalize on then fully eliminated milk nuotas in 2015. . b dget which will cover the 2021-27 period, the ...,, EU' w seven-yeai u ' · As part of the preparation for the s ne . f tl1e CAP. The general thrust of the reforms IS O EUropean Commission is suggesting · f ur ther retorms t b tied to environmental goals, an d It · arms · more th h f O r more money o e . e same as the last reforms. It pus es t 1·n European agriculture. tow arcts allowing greater marke t f or ces to opera e

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CHAPTER 9 The Common Agricultural Policy

9.4.4 Reforms for 2021

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As part of the reflection on the next seven-year bu ge ' ca . the CAP. This contains a numb Commission has latmched a series of proposals for further reformmg f f B t ·t . . er of . t' f the last set o re orms. u 1 1s important interest~g e~ements - many of _w~ich constitute a cont~ua wn o cted without substantial modificatio to keep rn mmd that the Cornrn1ss10n proposals are unhkely to be ena th f n. f the EU budget, so e new re orms Will O t CAP spending is probably the most politically charged aspec d h h . •• 1 tw· sting between now an w en t e Multi surely rnvolve a great deal of discussion debate and poht1ca arm- 1 . · · · ' • · d If h. tory is a guide the seven-year budget annual Financial Framework for the 2021-27 penod 1s agree • IS ' planning won't be agreed until the very end of 2020. . . Ii •th th The basic premises of the new approach proposed by the Commission are entirely m ne WI e ge~eral th evolution of the EU as a whole. They push more responsibility to Member States, ey focus mo:e ~n socially appealing goals like youth employment, and pro-environment outcomes (European Commissi~n, 2017). The key realization is that the CAP has become too centralized, and too detailed for a body as diverse as the EU28, or EU27 if Britain leaves. Today's CAP delivery system relies on technical and highly detailed rules set at EU level by the Commission. These involve strict controls and audits, and financial penalties for violations. These regulations tend to be highly prescriptive - setting out what has to be done right down to the farm-level. But given the vast differences in climatic, economic conditions and historic attitudes, this sort of top-down, one-size-fitsall approach is not the most sensible way to govern Europe's agriculture. The Commission proposes to meet the main goals by shifting greater responsibility and rights to the members. The new approach would make the member nations more in charge of precise policies and more accountable for outcomes. This is best thought of as a massive shift towards subsidiarity. Members would come up with their own strategy plan that the Commission would have to approve as consistent with EU-wide goals and fair competition. In terms of direct payments - the most politically sensitive element - the Commission document proposes to shift more support to small and medium farms, including putting on an upper bound of €100,000 per farm. Moreover, at least 2 per cent of direct support payments should go to young farmers. Importantly, the Commission is pus~g the CAP to be greener. In partic_:ular, it stresses the goal of preserving carbonrich soils through protect~on o~ ~etl_ands and peatlands, of improving water q,uality, and encouraging crop rotation instead of crop diversiflcat10n.

9.5 Today's CAP Today's CAP has two pillars. The ,first concerns direct . , payments and th e cost of the rema1-111·ng price supports. The second 1s called Rural Development . The precise implem t t· f b th illars is , M' . t . fA . 1 . en a ion o o p ' delegated to Member States rms nes . . . . vonld . . o gr1cu ture - .the idea being that th e nat10nal numstnes' have better knowledge of local cond1t10ns and constramts. Substantial refo rms t o t111s . b . as1c sys tenl 'are being phased in between 2014 and 2020. We address the first pillar first.

9.5.1 CAP's first pillar: direct payments and market intervention A key• goal of the 2014-20 reforms is to achieve• 'convergence' that' is , ri.n~iple ... -.

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