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Chapter 5: The European Union
(latest revision June 2006)
1. Development of the European Union
The first half of the 20th century saw two World Wars in Europe, fueled by the
hostilities between France and Germany. At the end of World War II, there was a new
“dream” on the part of many Europeans --- a united Europe. It was hoped that a united
Europe would never again see the scourge of war. This dream of unity got its initial
impetus when the United States embarked on the Marshall Plan (named for Secretary of
State George Marshall). The Marshall Plan was a very large aid plan for Europe, given to
both the victorious countries such as France and to the defeated countries such as
Germany. This large aid plan required an organization to administer the distribution of
the aid money. So in 1948, the Organization for European Economic Cooperation
(OEEC) was created and headquartered in Paris.
A more significant step in the creation of a European Union came in 1951 with the
creation of the European Coal and Steel Community (ECSC). This was created
because of the fear that the recovery of the German economy might lead to the revival of
German militarism. The European Coal and Steel Community created a common
market in coal and steel. This means that coal (the main fuel of the time) and steel could
be sold without restriction in any of the member countries and that there was a central
authority (not controlled by the member countries) to make all decisions regarding coal
and steel. Originally, the members of the ECSC were France, Germany, Belgium, the
Netherlands, Luxembourg, and Italy.
The next major step in the creation of a European Union came in 1955 with the
Treaty of Rome. This treaty established the European Economic Community (the
EEC). To understand the EEC, we need to explain the various levels of economic
integration. The lowest level of economic integration is called a Free Trade Area. In a
Free Trade Area, goods and services can move freely between the countries with no
tariffs or quotas. We will see other examples of free trade areas in this course. The next
higher level of economic integration is called a customs union. A customs union is a
Free Trade Area in which the member countries agree to have a common external tariff
against the products of countries that are not members. So, for example, France and
Germany would have the same tariff on products made in the United States. The next
higher level of economic integration is called a common market. A common market is a
customs union in which workers can move without restriction between the member
countries and in which businesses can operate production facilities in any of the member
countries. The highest level of economic integration is called an economic union. An
economic union is a common market that also has a common currency. The United
States is therefore an economic union of the 50 states. In Europe, the six original
members of the ECSC completed the creation of a customs union by 1968 but did not
complete the creation of a common market until 1993.
Notice that the European Economic Community (EEC) did not include Britain.
Originally, Britain chose not to become a member. Instead, it led a rival organization, the
European Free Trade Area (EFTA) that included itself, Sweden, Norway, Denmark,
Austria, Switzerland, and Portugal. When Britain changed its mind and tried to join the
EEC in 1961, it was vetoed by France. Finally, Britain was admitted in 1969. At that
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time, Ireland and Denmark also became members. In 1981, Greece became a member.
And in 1986, Spain and Portugal were added as members. So by the early 1990s, there
were 12 member countries to the European Economic Community. This means that
there were no tariffs or quotas among these 12 countries and that the tariff for each of
these countries against products from non-members would be identical.
The next major step in the creation of the European Union was the Single European
Act of 1987. This created a project to move to a full common market. As noted above, a
common market requires the free movement of all goods and services, workers, and
capital goods between the member countries. The Single European Act took until 1993
to implement. It brought about the elimination of all customs barriers at the borders
of each member country. As of 1993, citizens of member countries would no longer
need passports to enter other member countries, much as citizens of California do not
need passports to enter Nevada. And goods could move between the countries without
being stopped at the border. The Single European Act also brought some standardization
of technical regulations between the member countries. Differences in these regulations
had made it difficult to sell products outside one’s own country. Finally, the Single
European Act brought about controls on the purchases of national and local governments.
In the past, the national and local governments had tended to give preference to local
companies in their purchases (only 2% of all government purchases had been made from
companies in a different country.) This could no longer occur.
The creation of a common market has expanded trade between the member countries
considerably. But it has not led to much internal migration. Most migration into the
original 12 countries has come from Eastern Europe, Turkey, Pakistan, and North Africa.
On the other hand, the creation of a common market did lead to a large amount of
foreign direct investment within these 12 countries. Foreign direct investment is the
owning and controlling of a company in another country. It has also led to a large
number of mergers. Companies have merged to become larger in order to take
advantage of the larger European market (see below)
In December, 1989, the European Union established the Social Charter, designed to
create consistent labor laws in all member countries. Labor unions were protected by law
and their right to engage in collective bargaining was guaranteed. (See Chapter 4 for a
discussion of European labor unions.) Workers were given the right to be represented on
the board of directors of companies and therefore to participate in decisions regarding the
operation of the company. (For this reason, Britain did not sign the Social Charter.) This
is called co-determination and was also discussed in Chapter 4. And finally, equal rights
were guaranteed for men and women, including comparable pay for comparable work.
In 1991, the members signed the Treaty on European Union, known as the
Maastricht Treaty (Maastricht is a small town in the Netherlands, near both Belgium and
Germany). At that time, the name was changed from the European Economic
Community to the European Union. The Maastricht Treaty created the conditions by
which the member countries could move to a full Economic Union. An economic union
is a common market in which there is also a common currency. We will discuss these
conditions below. In the matter of political integration, it was determined that all issues
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were to be handled by the lowest level of government that can effectively handle them.
This was a very general statement. It was not specific in resolving a main political
question: how much authority should go to the European Union and how much
should be retained by the member countries? Europe is still wrestling with this
question. (This question has also been a major one in the United States: how much
authority should go to the federal government and how much should be reserved for the
various states?)
In 1993, the European Union was expanded to 15 members as Austria, Sweden, and
Finland joined. Then, in 2002, it was decided to expand the European Union again. Ten
new members were admitted in 2004 --- Hungary, Poland, Estonia, the Czech Republic,
Slovenia, Latvia, Lithuania, Slovakia, Cyprus, and Malta --- bringing the total to 25.
Two more members are to be admitted in 2007 – Bulgaria and Rumania. There is still a
debate about admitting Turkey. As of now, both the population and the land area of the
European Union are considerably greater than those of the United States. The new
European Union has 455 million citizens compared to 300 million for the United
States. And the total Gross Domestic Product of the European Union is similar to
that of the United States at about $12 trillion.
2. The Institutions of the European Union
Before analyzing the economic effects of the integration of Europe, let us describe the
basic institutions of the European Union. The main bureaucracy of the European Union
is the European Commission. (For the United States, this would be the executive
branch of government.) The Commission meets every Wednesday in Brussels Belgium.
The Commission is the only body that can draft proposals for the Council and the
Parliament to vote upon. Other tasks of the Commission include seeing that the policies
of the Council and the Parliament are implemented, managing the common policies of the
European Union (in agriculture, fishing, energy, the environment, competition policy,
and so forth – see below), controlling the European Union’s budget (collecting and
spending the funds – see below), enforcing European Union law, and negotiating
agreements on behalf of the entire European Union. Despite being sent by the member
nations, the Commissioners are supposed to act independently of the governments of
their nations. The Commission is answerable to the Parliament who can dismiss the
whole Commission by a vote of censure. Commissioners attend Parliamentary sessions
and answer questions.
A new commission is appointed every five years. The member governments determine
whom to designate as the Commission President (approved by the Parliament). There are
currently 25 member governments – soon to be 27. The new President, together with the
governments of the member countries, chooses the other 24 members of the new
commission. There is one commissioner from each member country. (The proposed
Constitution tried to reduce this number to 15. But the Constitution was not ratified.)
This list of nominees is then adopted by the Council and sent to the Parliament. Once the
Parliament approves, the nominees are appointed by the Council. (The Parliament can
also force the Commissioners to resign as it did in 1998. 20 Commissioners were forced
to resign amid charges of corruption.) The President is presently Jose Manuel Barrosa of
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Portugal. His term (and the terms of the other current commissioners) runs until October
31, 2009. (The previous President, Romano Prodi, is now the Prime Minister of Italy.)
The 25,000 other people who work for the European Commission are permanent officials
(bureaucrats -- but called functionaries).
The overall agenda of the European Union are determined by the European Council.
This is composed of the President of the European Commission and the heads of
government of the member nations, with each member country presiding as for a six
month period. They meet up to four times a year. One might consider this analogous to a
Board of Directors! In the new Constitution that was proposed, the six month rotation
was to be eliminated. Instead, the 25 heads of state were to choose a “president of
Europe” who would serve a 2 1/2 year term. But this Constitution was not ratified.
Most day to day decisions are made by The Council of the European Union. This is
the de facto legislature. Each member government sends one minister to Brussels
Belgium. The Minister chosen will be different depending on the issue to be discussed.
This Minister has the authority to commit his or her home government. Much of the
legislation must be approved by both the Council and the Parliament. But the Council of
Ministers can issue some regulations and directives that are binding on all citizens
within the European Union. There are 321 votes possible in the council. Countries with
larger populations are accorded more votes. On some matters, 232 votes are required for
a vote to be passed (72.3%). As this is constituted now, winning 232 votes requires at
least 12 countries (and at least 62% of the population of the European Union). On other
matters, votes must be unanimous. The Council of Ministers has been set up so that the
small countries have a disproportionate influence. The Presidency of the Council rotates
every six months. (In the second half of 2006, the Presidency is held by Finland.)
The European Union has a directly elected parliament called the European
Parliament (in Strasbourg France, Brussels, and Luxembourg). With expansion, there
are 732 elected members of the European Parliament. They are directly elected in
elections held every five years. This has been a symbolic group in the past. But more
recently, this has become more of a legislative body as is the United States Congress. At
present, there are nearly 100 different political parties represented in the European
Parliament. The European People’s Party – Christian Democrats and the European
Democrats hold 267 seats (they would be considered the “center-right” but are probably
more liberal than the American Democratic Party) while the Socialist Group holds 201 of
the 732 seats. The Parliament is involved in legislation along with the Council (on an
equal basis). This is called “co-decision”. The Parliament approves the European
Union’s budget (and can make some modifications – see below) and provides supervision
of the Commission and the Council of Ministers.
It is typical that proposals will begin with the European Commission. These will then
be discussed with the European Parliament before being referred to the Council of
Ministers. The Council of Ministers can then adopt the proposals, amend them, or defeat
them according to the voting scheme mentioned above.
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The creation of a single currency also led to the creation of a European Central
Bank. This went into operation in 1999 based in Frankfurt Germany. Like the Federal
Reserve System in the United States, this has been designed to be relatively free of
political pressures. The 6-person Executive Board of the European Central Bank and its
President and Vice President (included among the six) are appointed for non-renewable
eight year terms (the 7 Governors of the American Federal Reserve System are appointed
for non-renewable 14 year terms while the Chair (included in the seven) is appointed for
a 4 year term and can be reappointed by the President of the United States.) The
Governing Council includes the six Executive Board members as well as the governors
of the national central banks of the twelve countries that are presently members of the
European Monetary System (see below). (In contrast, the American Federal Open Market
Committee includes all seven Governors and the Presidents of the 12 Federal Reserve
Banks. But only 5 of these Presidents can vote.) These people meet in Frankfurt
Germany every two weeks for the purpose of making policies concerning the money
supply and interest rates. While the American Federal Reserve Bank does have to report
to Congress (which can ultimately change the Federal Reserve legislation), the European
Central Bank is not under the control of either the Parliament or the Commission. This
gives it an even greater degree of independence than the American Federal Reserve.
As seen in the composition of the Governing Council, the national central banks, such
as the Bundesbank (Germany) and the Bank of France, still remain. They no longer
make monetary policy alone. But they are part of the decision-making at the Governing
Council. And they are responsible for supervising the commercial banks headquartered in
their own countries and for carrying out the policies of the European Central Bank. The
European Central Bank and the national central banks together are called the
Eurosystem.
The overriding goal of the European Central Bank is price stability (an inflation
rate of no more than 2% per year). The European Central Bank has accepted no
responsibility for maintaining low unemployment rates in Europe. Despite this single
goal, inflation rates within the European Union were higher than the 2% goal most of the
time between 1999 and 2004. The money supply seems to have grown faster than the
European Central Bank said that it would. This indicates that, despite the
pronouncements, the European Central Bank has acted to try to reduce the high
unemployment rates and to try to increase the slow rates of economic growth.
There is a European Court of Justice. This has sixteen judges appointed by a
member country for a six year term (and approved by the governments of the other
member countries). One of these judges, the Chief Justice, is elected by the other judges.
The Court decides cases in which someone complains that a law passed by the European
Union institutions or by a national government violates community law.
In 2004, the next step in European integration was attempted with the creation of a
European Constitution. The passage of the Constitution required the unanimous vote of
all member nations. In 2005, France and the Netherlands rejected the new constitution.
At this writing (2006), there is no European constitution.
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3. The Budget of the European Union
As an illustration of the working of the European Union institutions, let us examine
the budget. The initial budget proposal is drafted by the Commission and sent for review
to the Council. The Council accepts the budget, or amends it, and then sends it on to the
European Parliament. If the Parliament approves it, the process is over. If the Parliament
amends the budget, it goes back to the Council. The Council accepts or rejects the
amendments and then sends the budget back to the Parliament. If the Parliament rejects
the budget a second time, the Council must submit a new budget proposal. This has
happened very rarely. Eventually, they reach agreement and the new budget goes into
effect. The Commission is responsible for its implementation.
The budget of the European Union is small. It has amounted to about 1% of the
GDP of the member states (and about 2 ½ % of the government spending of the
member states). About 45% of the budget goes to the Common Agricultural Policy
(described below), down from 55% in the middle 1990s. An additional third of the
budget goes to what are called “Structural Measures” --- regional development
programs and some income transfer programs, up from about a quarter in the middle
1990s. The rest of the budget is spread among a number of areas, each of which involves
a small amount of money.
The money for this spending by the European Union comes from a few sources.
About 1/6 of the revenues come from the common external tariff on goods from
countries outside the European Union. Another 40% of the revenues come from a
surcharge on the value added tax. The value added tax (VAT) is common in European
countries and is like a sales tax. 1.4% is added on to each country’s value added tax and
that money is sent to the European Union. The rest of the money comes from what is
called the “Fourth Resource”. This is a contribution from each member country so that
every member country is contributing 1.27% of its GDP to the European Union. Today,
the money is collected in Euros. It is required that the European Union budget be
balanced. The European Union does not issue debt on its own and therefore cannot
borrow to finance a budget deficit.
4. The Economic Effects of European Integration --- Increased Trade
Most economists have long been supporters of free trade. Accordingly, most
economists supported the integration of Europe. Free trade has many beneficial effects.
First, free trade forces a country to specialize in those goods or services for which it
has a comparative advantage. In doing so, people and capital goods are forced to move
from production of goods and services for which productivity is relatively low to
production of goods and services for which productivity is relatively high. The resulting
increase in overall productivity causes the standard of living to increase. Second, by
allowing the goods and services of other countries to be sold in a country, the supply of
goods and services increases. For example, there are more automobiles in both Germany
and France when German automobiles can be sold in France and French automobiles can
be sold in Germany. The increase in the supply causes the prices of these goods and
services to be lower. Third, opening up to trade increases the amount of competition.
More competition means that products are better and that prices are lower. Fourth, the
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opening of trade means that companies can often sell their products to a larger market.
The larger market allows them to produce more. When they produce more goods and
services, companies often are able to produce at a lower cost (a phenomenon known as
economies of scale). Lower costs of production allow prices to be lower. This is the
reason that the creation of a large European market led to so many mergers. The net
result of trade is that more goods and services are available, prices are lower, and the
standard of living in the country is greater. Indeed, one recent study shows that if the
European Union eliminated all of its tariffs against outsiders, its prices would be 20%
lower and its GDP would be 6% greater.
While trade benefits all of the member countries, it does not benefit every citizen of
the member countries. Within each country, some people gain from greater trade and
some people lose. Since trade forces countries to specialize in those products for which
they have a comparative advantage, those who produce those specific products gain.
Those who produce products in which the country has a comparative disadvantage are
likely to lose. So within the European Union, people who produce capital intensive
products like German automobiles or produce technology intensive products like
computer software are likely to be “winners”. People who produce agricultural products
such as French farmers or produce textiles or apparel products would likely be “losers”.
Economic integration increases trade between the members of the European Union.
But it also may decrease trade between each member of the European Union and those
countries that are not members. The most important non-member country is, of course,
the United States. The increase in trade within the European Union is called trade
creation. The decrease in trade with non-members is called trade diversion. When the
European Economic Community (EEC) was established in the middle 1950s, the original
six member countries had about 2/3 of their imports coming from outside the EEC. By
1990, the original six member countries had about 2/3 of their imports coming from
within the enlarged EEC. All estimates that have been made have shown that the value
of trade creation from European integration far exceeds the value of trade diversion.
So, European integration has been one major reason for the rapid economic growth of the
European countries.
5. The Economic Effects of European Integration --- A Single Currency
The movement to a single currency was the most radical aspect of European
integration. It took a long time to bring about. In 1979, the European Monetary System
was created. This lasted until December 31, 1998. This system created fixed exchange
rates among the participating countries. (Actually, exchange rates were allowed to
fluctuate 2.25% above or below the fixed exchange rate.) The central bank of each
participating country agreed to intervene in the foreign exchange market to keep
the exchange rates fixed. This means that the central bank agreed to buy or sell foreign
money to keep the exchange rates stable. To illustrate this, let us suppose that inflation
occurred in France causing French consumers to want to buy more German products.
They would have needed more German marks. Their demand for these German marks
would normally have caused the price of these German marks to increase. To keep the
price stable, the central banks of both France and Germany agreed to intervene in the
foreign exchange market. Each central bank would enter the foreign exchange market
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and sell German marks to drive the exchange rate back down to the level agreed to.
Germany would get the German marks to sell by creating them. After all, marks were
money in Germany. France would get the German marks to sell from international
reserves that it had accumulated in the past (or by borrowing from Germany). If the
Bank of France sells German marks, the French people have German marks and the Bank
of France has French francs. Since francs were money in France, the French people
would have fewer francs. With fewer francs available to spend, the French people would
have to spend less. Less spending by the French people would cause the French inflation
to decrease.
For the first thirteen years of its existence, the European Monetary System
worked well. The band of plus or minus 2 ½% was wide enough to allow each country
to make small changes in its exchange rate when needed. But then, in 1992 and 1993,
the European Monetary System hit a major crisis. The origin of the crisis began with
the reunification of Germany in 1990 at a time when much of Europe was experiencing a
recession. When (the former communist) East Germany and West Germany were
reunified, West Germany was much richer and more productive than East Germany. In
order to bring the two regions into greater balance, Germany undertook a major
program of spending in the east. Fearing that this large increase in government
spending would cause inflation in Germany, the German central bank responded by
raising German interest rates. This increase in German interest rates attracted lending
from people in the United States, Japan, and the rest of Europe. To lend in Germany,
people had to buy German marks. Their buying of German marks would cause the
price of the German mark to increase. The increase in the price of the German mark
created problems because the countries of Europe had agreed to keep their exchange
rates fixed as part of the European Monetary System. In order to maintain a fixed
exchange rate with the German mark, the central banks of countries such as Britain,
France, Sweden, and Italy would have to either sell German marks in the foreign
exchange markets or increase their own interest rates to match those of Germany. Selling
marks would have decreased the money supply in Britain, France, and so forth (more
German marks and fewer British pounds means less money to spend by the British).
Given the recession that was going on in Europe at the time, a decrease in the money
supply or an increase in their interest rates would have decreased total spending in these
countries and plunged these countries into greater recession. At first, the leaders of these
countries pledged that they would do whatever was necessary to maintain the fixed
exchange rates. But foreign exchange speculators (especially one George Soros) did not
believe them. A speculator is one who tries to gain income by buying one currency and
selling another, hoping that the price of the one bought will rise and the price of the
one sold will fall. The speculator is gambling. A situation such as that of Europe in 1992
presented a great opportunity for these speculators. The great opportunity was to “bet”
that the French Franc, British pound, Italian lira, and Swedish crown would lose value in
relation to the German mark. That is, the speculators bet that these countries would not
accept the unemployment that goes with a deeper recession and therefore would not
maintain the fixed exchange rate. The speculators would “bet” by buying German marks
and selling French francs, British pounds, Italian lira, Swedish crowns, and so forth. If
the speculators were right and the fixed exchange rates were not maintained, they could
make a great amount of money. (They would sell their German marks back later for a
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higher price.) If the speculators were wrong and the fixed exchange rates were indeed
maintained, they could sell the German marks they bought at the same price and get their
money back. There was no possible way that the German mark would go down in value.
Either the speculators win or they break even. Not a bad deal for a gambler. Some of the
countries did try to maintain the fixed exchange rates. It has been estimated that the Bank
of England lost $7 billion of its reserves in just a few hours by this process. The Bank of
England could not go on losing reserves at this rate. So after awhile, it abandoned the
system of fixed exchange rates. Britain was no longer part of the European Monetary
Union and, as of this writing, still uses the pound instead of the Euro. Another example
was Sweden. At one time, it raised one of its interest rates to over 500%. But the
speculators kept on selling Swedish crowns. Eventually, Sweden too was forced to
abandon the system of fixed exchange rates. In a few months, the system of fixed
exchange rates was over and a new system of floating exchange rates had begun. (This
means that the countries would no longer agree to maintain the fixed exchange rates.)
George Soros has made billions of dollars.
Later in the 1990s, most of the countries of Europe decided to try fixed exchange rates
once again. Only this time, they decided to move to eliminate their national currencies
entirely and create a common currency, the Euro. This way, their system cannot be
undone by speculators buying one of their currencies and selling another (just as
speculators cannot sell a California dollar and buy a Texas dollar).
The program that was to lead to a single currency had actually begun in 1990. It
began with an attempt of the national central banks to more closely coordinate
monetary policy. Closer coordination would make it less likely that one country would
have inflation while the others did not. Therefore, closer coordination of monetary
policy would reduce the need for central bank intervention in the foreign exchange
markets. In 1992, both Britain and Italy decided that they were unwilling to coordinate
their own monetary policies with the other countries and each left the system. As we have
just seen, this attempt failed in 1992 when Germany wanted a contractionary monetary
policy with high interest rates while the other countries wanted an expansionary monetary
policy with lower interest rates. After the crisis of 1992, the European countries tried
once again to move toward a common currency. The next significant step in the
direction of a monetary union came in 1994 with the creation of the so-called
Maastricht criteria (once again, named for the small town in the Netherlands). The idea
was to ensure that the economies of the different member countries were on a similar
path. Each country that wanted to be part of the European Monetary System agreed to
ensure the following: (1) its inflation rate would not be more than 1.5% above the
average inflation rate of the three member countries with the lowest inflation rates, (2)
its long-term interest rates would be no more than 2 percentage points above the longterm interest rates of the three member countries with the lowest inflation rates, (3) its
government budget deficit would be no more than 3% of GDP, (4) its national debt
would be less than 60% of GDP, and (5) its exchange rate would be stable from 1997 to
1999. (Some have seen these requirements as assuring that each country was as
committed to low inflation as was Germany.) In 1999, 11 countries were admitted to the
monetary union. These were Germany, France, Italy, Austria, Belgium, Finland, Ireland,
Luxembourg, the Netherlands, Portugal, and Spain. In 2001, Greece joined, bringing the
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total number of member countries to 12 and covering more than 300 million people. It
was agreed that these countries had met the Maastricht criteria (except for the national
debt criterion which was waived). Britain, Sweden, and Denmark did not join. The
European Monetary System also created a new money --- called the Euro. At first,
this new money was just used as a unit of account. Records were kept in Euros as well as
in the currency of the country. But there were no actual Euros circulating. That changed
in 2002 when the Euro became a medium of exchange. Euro paper money and coins
replaced the national money. They could do so because of the long period of fixed
exchange rates. See the conversion rates below. The Euro now serves as money in 12 of
the member countries just as the dollar serves as money in the 50 American states. (The
Euro notes are identical in all countries. There are seven different notes in seven different
colors. But each country issues its own coins. There are eight Euro coins --- 1,2,5,10,20,
and 50 cents 1 Euro, and 2 Euros. One side of the coin is common to all countries. The
other side of the coin displays some distinctive national symbol.) Getting this done on
time was a major achievement. There were 14.5 billion bills to print and 51 billion new
coins to mint. They were all ready at the end of business on December 31, 2001. Thanks
to a major marketing campaign, people accepted the new money. By early January of
2002, Europe had accomplished the largest monetary conversion in world history without
a hitch. The old paper money was burned as fuel or turned into agricultural compost.
(Partly this conversion was facilitated by the fact that Europeans use cash cards – or debit
cards – for a much broader range of purchases than do Americans.) The ten countries that
have joined the European Union since 2000 are committed to adopting the Euro. As of
this writing (2006), none has done so. Denmark, Sweden, and the United Kingdom still
do not use the Euro.
Table. Conversion Rates of National Currencies into the Euro
Belgian Franc
40.3399
German Mark 1.95583
Spanish Peseta
166.386
French Franc
6.55957
Irish Punt
0.787564
Italian Lira 1936.27
Luxembourg Franc 40.3399
Dutch Guilder 2.20371
Austrian Schilling 13.7603
Portugal Escudo 200.482
Finnish Marka
5.94573
The main advantage of the creation of a single currency is that it eliminates the
need for currency conversion. Previously, any German traveling in France or doing
business in France would need to convert his or her German marks for French francs.
This conversion took time and labor. That time and those workers are now free for other
tasks. Estimates have shown that the cost of exchanging money is small – less than 1% of
the GDP of the European Union. A common currency also helps to integrate markets.
(Studies of North America, for example, have shown significant price differences
between Detroit Michigan and Windsor Ontario Canada, although these cities are only a
few miles apart. National boundaries seem to matter greatly. Reducing national
boundaries, aided by the common currency, should act to integrate the markets of
Europe.)
The single currency also eliminates exchange rate uncertainty. Someone doing
business in a member country no longer has to worry that a business deal that seemed
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profitable will turn unprofitable because of an unexpected change in the exchange rate.
The elimination of currency conversion and exchange rate uncertainty should make trade
easier and therefore bring the benefits of enhanced trade mentioned above.
The creation of a single currency also eliminates the need for each country to hold
international reserves. Remember that, in the example above, the French central bank
had to intervene in the foreign exchange market by selling German marks. The French
central bank no longer has to hold reserves of German marks (or the money of any other
member country) to be able to intervene. Holding these reserves entailed a cost.
The creation of a single currency also facilitates the creation of an integrated
market. We can measure how well markets are integrated by the differences in the prices
of the same products. In highly integrated markets, prices should be very similar. Prior
to the introduction of the Euro, prices could vary greatly. For example, a hamburger
from McDonalds could sell for $3.55 in Finland. The same hamburger sold for $2.00 in
Greece. Since the introduction of the Euro, prices have converged significantly. This
shows that the markets have become more integrated.
Finally, the creation of a single currency makes the Euro an important world
currency. Other countries will hold some of their reserves in Euros. The greater
importance of the Euro will also increase the importance of the European economies. It
may also stimulate business for European financial institutions.
The main disadvantage with the creation of a single currency is that it eliminates
the use of exchange rate policy as a means of dealing with economic problems. As an
example, a major hurricane hits Louisiana. The people of Louisiana have fewer goods to
sell to the rest of the United States and need to buy more goods from the rest of the
United States. If there were different monies, Louisiana would depreciate the Louisiana
dollar. This would encourage more buying of Louisiana goods (by making their goods
cheaper) and less buying by people in Louisiana of the goods of other states (by making
those goods more expensive). Since Louisiana is part of the United States, there is no
Louisiana dollar. Louisiana cannot adjust by depreciating its dollar. Instead, it has to
adjust by either accepting greater unemployment or by accepting lower wages. Accepting
lower wages requires that wages be able to fall easily. That is rarely the case. So the
result is more likely to be unemployment. The amount of unemployment that must be
endured depends on how mobile workers are. Louisiana workers can relatively easily
move to other states where jobs might be available. It might be harder for French workers
to move to Germany or vice versa as the cultures and the languages are quite different.
(In the early 1980s, only 0.2% of the people living in the European Union had moved
from one country to another.)
Other disadvantages of monetary union follow from the specifics of the Maastricht
criteria. As mentioned, the European Monetary Union required that each member country
keep its budget deficit below 3% of its GDP. Doing this eliminated the use of fiscal
policy as a stabilization tool. As unemployment rose in Europe, the normal response
would have been to increase government spending or reduce taxes (or both). But both
would have raised the budget deficits to unacceptable levels and reduce the prospect of a
country being accepted into the European Union. (In addition, the country experiencing
the budget deficit would have been subject to a fine of up to 0.5% of GDP.) And to keep
inflation and interest rates low, the monetary union took away from the countries the
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ability to use monetary policy to try to solve economic problems. As a result, the
economic growth rates of the countries trying to meet the Maastricht criteria were lower
throughout the 1990s than the growth rates of other countries, including the other
European countries. Unemployment rates in the eleven countries rose during 1991 to
1993 and then stayed high throughout the decade of the 1990s. Political systems are
still national. The reaction of French and Italian citizen to the inability of their
governments to use fiscal and monetary policies to reduce the high unemployment rates
or stimulate growth has major political implications inside France or Italy.
Test Your Understanding
In 2005 and 2006, the price of oil rose greatly. Oil is a major cost of production in all industrial
countries. So in all countries, costs of production increased, causing increases in prices of
products (inflation). As we saw in Chapter 4, countries with highly centralized collective
bargaining, such as Sweden, are more likely to take the inflationary impact of rising oil prices
into account than countries with decentralized collective bargaining, such as Italy. Therefore,
demands for wage increases should be more restrained in Sweden than in Italy, causing less
inflation in Sweden than in Italy. Analyze the adjustment that will be necessary in both Sweden
and in Italy assuming that they have different monies, the Swedish crown and the Italian lira.
Then, analyze the adjustment that will be necessary in both Sweden and in Italy assuming that
they have the same money, the Euro.
From a purely economic point of view, it does seem that the benefits of changing to
a common currency are small for most of the European countries. And the risk is
significant. Giving up both monetary policy and fiscal policy may make it very hard to
adjust to economic situations that may arise. Yet many European countries have chosen
to give up their national currency and substitute the Euro. This would seem to indicate
that there is a strong desire for the political integration of Europe and that monetary union
is seen as a step toward this political integration.
6. The Common Agricultural Policy (CAP)
Europe maintains agricultural support programs similar to those found in the United
States. There are two kinds of programs. One is a price floor. The European Union
(EU) sets a minimum price by which certain agricultural products can be sold. This price
is higher than the price that exists in the world market. This high price encourages
farmers to grow more than they otherwise would. The extra production has made Europe
self-sufficient in food production. (Before the Common Agricultural Policy, Europe used
to import about 20% of its food needs.) The high price also discourages buyers from
buying. This generates a surplus of these agricultural products. This surplus is bought by
the European Union and then stored at the expense of the European Union. (Remember
that expenses for these agricultural programs comprise about half of the European Union
budget.) Often the surplus is exported at low prices, with the loss taken by the European
Union, not the farmers. Selling this surplus acts to drive the world price down,
generating less income for farmers in poor countries who are trying to sell their
agricultural production in world markets. And because the price paid for food inside the
European Union is higher than the world price, there has to be a significant tariff on
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imported food. (Otherwise, food buyers would just buy the cheaper food from outside the
European Union.)
The other program involves output restriction. Farmers are paid not to grow
certain products. This, of course, raises the price of what is produced, but does not
generate a surplus that has to be stored. As a result of these two programs, the European
Union has some of the highest food prices in the world.
In recent years, the European Union has been acting to lower the minimum
prices at which the food products can be sold. Today, as we have noted, spending on
these agricultural programs comprises about half of the European Union budget. Before
the prices were lowered, this spending comprised about 70% of the European Union
budget.
Within the European Union, the Common Agricultural Policy generates winners and
losers. Winners are the farmers found in Greece, Ireland, Spain, France, and
Denmark. All the other countries are losers (farmers in these other countries produce
products that are not supported by the Common Agricultural Policy). Winners are
generally richer farmers while losers are poorer urban food consumers. So the
policy is regressive. Despite there being so many losers, the Common Agricultural
Policy has been maintained because it keeps the support of the farm interests for the
European Union and therefore helps keep the European Union together.
7. European Union – American Economics Relations
The United States and the European Union are each others’ largest trading
partners and foreign direct investment partners. (Foreign direct investment is the
owning and controlling of a company in another country.) In we count both goods and
services, almost 20% of all American imports come from the European Union and almost
22% of all American exports go to the European Union. With the enlargement of the
European Union, these numbers will increase. As of 2005, about 23% of the exports of
the European Union went to the United States and about 14% of the imports of the
European Union came from the United States. (Each area buys about one-fifth of the
others’ exports of high technology products.) By 2004, the foreign direct investment of
the European Union in the United States totaled approximately $950 billion while the
foreign direct investment of the United States in the European Union totaled
approximately $1,035 billion. An estimated 5 to 7 million Americans owe their jobs
directly or indirectly to European companies located in the United States and an equal
number of European owe their jobs directly to American companies located in the
European Union. Many of the brands that Americans are familiar with are European
owned. Examples include DKNY (France), Sunglass Hut (Italy), Brooks Brothers (Italy),
Mazola Oil (UK), Libby’s (Switzerland), Snapple (UK), Random House (Germany),
Chrysler/Jeep (Germany), Dove Soap, Slim Fast, and Vaseline (Netherlands), Pennzoil
(Netherlands), Birdseye (Netherlands), Dreyer’s Ice Cream and Power Bars
(Switzerland), Ben and Jerry’s (Netherlands), Shell (Netherlands), RCA (Germany),
American Heritage Dictionary (France), Miller Beer ((UK), Dr. Pepper and A&W Root
Beer (UK), Dunkin’ Donuts (UK), Verizon (UK), DHL (Belgium), and so on. The largest
food retailer in the Eastern United States is Royal Ahold (Netherlands). On the other
hand, many of the brands that Europeans are familiar with are American owned. As just
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one example, Ford owns Volvo, Jaguar, Aston Martin, and Land Rover. So these two
economic powers are obviously very important to each other.
When the Single Market was being created in the European Union in the 1990s, the
United States became very concerned. The phrase in vogue at the time was “Fortress
Europe”. While a good part of the trade for the European Union as a whole was with the
United States, the vast majority (almost 2/3 on average) of the trade for individual
members of the European Union was within the European Union. While most of the
member countries sell most of the products within the European Union, the largest
member countries – Germany, the United Kingdom, Italy, and France – do not. The
United States was concerned that with no tariffs between the 25 member countries of the
European Union and a high common external tariff against the United States, the United
States would be shut out of the European market. This fear has turned out to be
unfounded. As time has gone on, the common external tariff of the European Union has
fallen. The United States and the European Union together have been leaders in getting
tariff reductions at the international trade negotiations. And the data above show, the
United States has not been shut out of the European market at all.
In total, the relationship between the United States and the European Union has been
quite amicable. It has certainly been more amicable than the trade relationship between
the United States and Japan in the 1980s and the trade relationship between the United
States and China presently. These are discussed in later chapters. But recently, the
relationship between the United States and the European Union has become more
strained. There have been trade disputes over several issues. Let us just look at a few of
these issues.
1. The United States has had a program of tax breaks for subsidiaries of
American companies that conduct export sales. In 2000, the World Trade
Organization (WTO) found that these tax breaks were inconsistent with WTO rules.
Since these tax breaks were not changed to the satisfaction of the WTO, in March of
2004 the WTO authorized the European Union to impose sanctions. The European
Union imposed a tariff of 5% on American exports totaling $4 billion. This tariff
increased, reaching 14% by December of 2004. The tariff was removed in January of
2005 when it appeared that the tax breaks had been eliminated. But in February of 2006,
the WTO ruled that the United States was still conferring illegal subsidies on exports.
The European reimposed tariffs of 14% on $2.4 billion of American exports, beginning in
May of 2006. The United States has complained about the reimposition of the tariffs.
2. The United States has gone to the World Trade Organization (WTO) to argue
that European subsidies for Airbus are unfair. The WTO has created two panels to
hear the case. A decision is expected in 2007. (Airbus, which was a consortium of
national aircraft companies, is now a private company owned by just two companies,
80% by the European Aeronautics, Defense, and Space Corporation (EADS) and 20% by
British Aerospace Ltd. (BAE Systems). But it is still closely connected with European
governments.) In the past few years, Airbus passed Boeing as the world’s leading
producer in aircraft production. It did this by producing low cost aircraft for the low cost
airlines that arose in Europe (Ryan and EZJet and are similar to Southwest and Jet Blue
in the United States). The trade dispute began in 2000 when Airbus announced it would
15
build the world’s largest passenger aircraft, the Airbus A380. The United States (acting
mainly on behalf of Boeing) has complained about a $3.2 billion loan to Airbus from the
governments of France, Germany, Spain, and the United Kingdom. The United States has
also complained that European governments provided funds to the subcontractors on the
Airbus project and provided funds for infrastructure necessary for the project. The
United States contends that Airbus could never have found the funding for the A380
project because of its large risks had the European governments not acted to take over
much of the risk. In all, the United States contended that Airbus received about $13
billion in grants and another $26 billion in loans from European governments since its
founding. The European Union (on behalf of Airbus) argues that Airbus has repaid most
of the loans from the governments and that these loans were at commercial rates. Airbus
also claimed (correctly) that Boeing has also received huge government subsidies in the
form of military and space contracts, that American governments bought their planes
only from Boeing, and that Boeing’ newest project, the 787 (a 250 seat airplane), is
financed with a large tax break from the state of Washington. (Airbus is working on the
A350 to compete with Boeing’s 787. This has the United States very worried.)
3. One of the most bitter trade disputes has involved the European Union ban on
the import of American meat treated with growth-promoting hormones. There is
bitterness even though the amount of trade in dispute is small. The European Union
argues that meat treated with growth-promoting hormones is a risk to the health and
safety of European consumers. The United States argues that it is not. The World Trade
Organization (WTO) sided with the United States. The United States responded with
100% tariffs on certain agricultural products from the European Union. The European
Union responded by removing five of the growth hormones from its banned list. It
claims that the United States is now violating WTO rules by maintaining the 100%
tariffs. The United States holds its original position. The case is still being heard.
(There are also several other cases involving bio-engineered foods.)
4. Some of the disputes have involved competition policy (known as the anti-trust
law in the United States). The European Commission is responsible for competition
policy in the European Union. In most cases, there has been agreement between the
European Commission and the United States Department of Justice. But a major case
highlighted the differences. General Electric (GE) offered to pay $43 billion to buy
Honeywell International. GE and Honeywell do not generally produce the same
products (that is, they are not generally competitors). GE produces large aircraft engines.
Honeywell produced small and mid-size jet engines, air collision warning devices, and
navigation equipment. The U.S. Department of Justice concluded that the merger would
allow the single company to offer better products to companies such as Airbus or Boeing
than either company could do alone. Since the United States Department of Justice
believed that competition would be improved, it approved the merger. The one in charge
of anti-trust policy for the entire European Union is called the Director General for
Competition (DGC). His name was Mario Monti. He (and later the European
Commission) reviewed the merger and concluded that the merger would strengthen GEHoneywell’s dominant position in the industry and that the merger would make
competition more difficult for other producers of airplane equipment, such as Rolls
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Royce. The merger might even force other competitors out of business. So the European
Commission, on recommendation of the DGC, unanimously disapproved the merger (a
vote of 20 to 0). European anti-trust policy seems to be more concerned with the fact of
bigness than is American anti-trust policy. Ultimately, the merger of GE and Honeywell
did not occur even though both are American companies. The CEO of GE, Jack Welch,
lost his position as a result. Between 1990 and 2004, the European Commission dealt
with 2,508 mergers. Only 18 were disapproved. So this was a very special case.
5. A final case that we will discuss here involved Microsoft. The charge is that acts of
Microsoft tended to stifle competition. In 2004, the European Commission fined
Microsoft $612 million, ordered the company to disclose its code to competitors so
that their products could be used on the Windows operating system, and required
the company to offer a version of the Windows operating system without Windows
Media Player. These penalties were greater than those imposed in the United States.
Microsoft appealed. In December of 2004, a European judge upheld the imposition of
these sanctions. Microsoft appealed again, arguing its case in April of 2006. As of this
writing, the case has not been resolved. Several prominent people in the Bush
administration and several leading Republican Senators took the side of Microsoft.
Threats of a trade war were made. But so far, no trade war has materialized. (For a
detailed look at the Microsoft case in the United States, see my Microeconomics text,
Chapter 10.)
This section has shown some of the areas of disagreement between the United States
and the European Union. It should be noted that on most areas, the two sides have
managed to agree. They are also in the process of trying to create a regime that will
harmonize their policies better. On the whole, the United States and the European Union
are friends.
8. Summary and Challenges Facing the European Union
The European Union is one of the grand experiments of human history. In this
chapter, we have examined the history of the development of the European Union, the
arguments for the economic benefits from this union, and some of the institutions that
have been developed thus far. From a group of warring countries, Europe is attempting
to come together in ways that preserve a national identity but maintain the peace. By
increasing trade and allowing the free movements of people and of capital, European
integration has raised the standard of living to unprecedented levels, creating an economy
of the same magnitude as the United States. In a world in which the United States has
been the hegemon, the new Europe could emerge as a competitor in the 21st century.
With the shift to a common currency in 2002, this grand experiment took a very big step.
For those familiar with the history of Europe, the experience of integration since the end
of World War II has been an amazing time!
The European Union faces some serious challenges at the beginning of the 21st
century. One major challenge is unemployment and slow economic growth. As we
have seen, unemployment has been a serious problem in several European countries for
17
the past 15 years. It threatens social cohesion. The persistence of unemployment has also
threatened some of the major European institutions. As we saw in Chapter 4, some of
these institutions have been undergoing change as a result of the unemployment. The
European Union needs to find ways to return to the growth rates experienced in the
1960s. Doing this will not be easy.
Another major challenge comes from the new member countries. As was noted,
ten countries became members of the European Union in 2004. Two more countries will
become members in 2007. Turkey still wishes to become a member. Someday, perhaps
Russia will want to join. The new member countries are significantly poorer than the
original members. Many German companies have already located production facilities in
Eastern Europe to take advantage of the cheaper labor. This has made some German
companies more competitive internationally but could threaten some of the labor market
institutions of Germany.
A related challenge is immigration. The Common Market allows anyone to move
without restriction anywhere within the European Union (much as an American can move
freely to any state). So far, nearly all of the migration of people has been of people from
the poorer countries (such as Greece, Eastern Europe, and even Turkey) into the richer
countries (such as Germany, France, and Britain). This has created a “clashing of
cultures” in areas that had been relatively culturally homogeneous. Although it is still
small, the rise of Nazism in Germany is an ominous sign. Americans know full well the
problems that can come with attempting to integrate migrants into a dominant culture.
A final challenge that will be discussed here is political integration. Just how far
are Europeans willing to go to promote political integration? The defeat of the new
European constitution in France and in the Netherlands in 2005 shows that people still are
reluctant to give up sovereignty. Nonetheless, this could change. Young people in
Europe are being called “Generation E”. This means that they are more likely to see
themselves as European and less likely to see themselves as German or French than was
true in the past. Several programs have been developed (known as Socrates, Leonardo da
Vinci, and Youth) to allow students to study and volunteer in countries other than that of
their birth. As the new generation comes into influence, the idea of a European identity
(and therefore a European state) may gain more adherence. For now, that will have to
wait.
Europe has presented us with a model of capitalism that is different from the
American model. We have called the European model of capitalism the Social Market
Economy and the American model of capitalism the Liberal Market Economy. Japan
presents a somewhat different model of capitalism. Since the Japanese model has been
basically copied in countries like Korea and Taiwan, we will call this the Asian Model of
the Capitalist Market Economy. We turn to this model beginning in the next chapter.