Current Economic Issues in EU Integration

Current Economic Issues in EU Integration

Also by Mark Baimbridge FISCAL FEDERALISM AND EUROPEAN ECONOMIC INTEGRATION (co-editor) ECONOMIC AND MONETARY UNION IN EUROPE: Theory, Evidence and Practice (co-editor) THE IMPACT OF THE EURO: Debating Britain’s Future (co-editor)

Also by Jeffrey Harrop THE POLITICAL ECONOMY OF INTEGRATION IN THE EUROPEAN UNION STRUCTURAL FUNDING AND EMPLOYMENT IN THE EUROPEAN UNION THE POLITICAL ECONOMY OF INTEGRATION IN THE EUROPEAN COMMUNITY

Current Economic Issues in EU Integration Mark Baimbridge Bradford Centre for International Development University of Bradford, UK

Jeffrey Harrop Bradford Centre for International Development University of Bradford, UK and

George Philippidis Bradford Centre for International Development University of Bradford, UK and Unidad de Economia Agroalimentaria y de los Recursos Naturales Centro de Investigacion y Tecnologia Agroalimentaria de Aragon (CITA) Zaragoza, Spain

© Mark Baimbridge, Jeffrey Harrop and George Philippidis 2004 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is registered trademark in the European Union and other countries. ISBN 1–4039–1796–5 hardback ISBN 1–4039–1805–8 paperback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 13 12 11 10 09 08 07 06 05 04 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

Contents List of Tables

vi

List of Figures and Boxes

vii

Acknowledgements

viii

Preface

ix

1 Current Issues in EU Integration

Part I Agriculture, Competition and Industry

1

15

2 Common Agricultural Policy: Evolution and Economic Costs

17

3 Competition Policy in the Single European Market

35

4 Industrial Policy: The Changing Agenda

57

Part II Economic and Monetary Union

77

5 Central Bank Independence and Monetary Policy

79

6 EMU Convergence and Fiscal Policy

99

Part III Regional Convergence and Enlargement

119

7 The New Role and Resurgence of Regions in the EU

121

8 EU Enlargement: EMU and Agriculture

142

Part IV Alternative Futures for the UK 9 Alternatives to Further Integration

167 169

10 Is NAFTA Membership Really a ‘Barmy’ Idea?

183

Notes

200

References

209

Index

225

v

List of Tables 2.1 Transfers in a two-country community 2.2 Estimates throughout the 1980s of the deadweight costs of the CAP 2.3 Recent estimates of the deadweight costs of CAP reform 4.1 R&D spending and patent grants 5.1 Summary of political independence of EU central banks and ECB 5.2 Political independence of central banks 5.3 Economic independence of central banks 5.4 Comparison of central bank independence of EU member states and the ECB 5.5 Correlation between central bank independence and macroeconomic variables for EU member states 6.1 The number of MCC achieved by EU member states (1992–2002) 8.1 Summary of EU accessions 8.2 EMU convergence criteria and CEECs (2002) 8.3 Annual pre-accessional budget allocations for the CEECs 8.4 Financial framework for enlargement 2004–06 (€ million) 10.1 UK trade with North America and the EU(14), 1994–2001 (%) 10.2 Total inward and outward FDI for the UK (% of total investment) 10.3 The structure of UK trade and protection (% of market prices) 10.4 Changes in UK exports and imports under scenario (a) 10.5 Changes in UK exports and imports under scenario (b) USITC estimates 10.6 Cumulative changes in UK exports and imports in 2008 under scenario (a) compared with the baseline 10.7 Cumulative changes in UK exports and imports in 2008 under scenario (b) compared with the baseline 10.8 Changes in GDP by region (% real growth) 10.9 Changes in US–UK FDI relationships under NAFTA accession vi

26 29 31 66 82 85 86 86 94 104 144 150 157 162 186 187 191 192 192 194 194 195 196

List of Figures and Boxes 2.1 CAP expenditure 2.2 A simple partial equilibrium (PE) model of CAP transfers

20 25

Boxes 8.1 The relative role of agriculture in the EU(15) and the candidate countries 8.2 Agricultural trade statistics between the EU(15) and the CEECs in 2001 (€ million) 8.3 Development indicators for the CEECs

vii

153 155 159

Acknowledgements There are many people to thank for their input into making of this book possible. Most obviously, we must thank our Commissioning Editor at Palgrave/Macmillan, Amanda Watkins, for her immediate support for this project and patience over the duration of its writing. Second, we would like to thank our colleagues at the University of Bradford for their comradeship and general support for our research on European economic integration. Finally, we owe a deep sense of gratitude to our families and partners for their forbearance during the preparation of this book. It is to them that this book is dedicated: MB: Mary, Ken and Beibei; JH: Kandy and Graeme; GP: my late mother, Margaret.

viii

Preface The number of books available to analyse contemporary European economic integration have multiplied over recent years to the point where the ‘wood’ and ‘trees’ frequently become inseparable. However, despite this extensive choice of texts, a number of weaknesses remain. First, many of the leading texts have sought to maximise their marketability by attempting to cover the entire spectrum of EU related topics, but ultimately only do so at a superficial level. Whilst certain areas may lend themselves to a brief examination presented in a single chapter, many others are too complex to summarise in such a manner and require a more sophisticated approach if all the principal issues are to be analysed. In this book we have sought to address this dilemma through examining selected topics pertinent to the current and future development of the European Union (EU). It focuses upon a variety of microeconomic and macroeconomic issues, together with considering ‘blue sky’ scenarios of the future direction of Britain’s relationship with the EU. Our principal aim is to introduce readers to a variety of topics covering a broad range of issues relating to the process of European integration – agriculture, competition, industry, enlargement, regional and national convergence, central banking – and not merely focusing upon a single topic or seeking to be all-encompassing. The second problem for those seeking a greater understanding of European economic integration is that many books are ‘positioned’ and adopt a far from neutral stance when explaining the relevant arguments. It is, of course, natural that academics who have self-selected European integration as their speciality, are likely to possess strong opinions regarding this process. However, too frequently value judgements are permitted to influence the treatment given to the pertinent issues and arguments. We hope that this book succeeds in portraying a selection of the principal themes of the EU’s ongoing development with a balanced series of view across the spectrum. A third problem is that the fast-moving events of European integration can result in books becoming outdated soon after, or even before, their publication! Readers should always be aware of the time lag it takes for the latest ideas to be included in texts following their initial publication as working papers, conference contributions and journal articles. This process can often take several years, which when added to the time ix

x

Preface

taken to write, print and distribute a book, can make the end product appear dated by the time it reaches the shelves, real or virtual. The present text seeks to minimise these problems that all authors face by bringing together in a single volume a carefully chosen series of themes which seek to cover both the recent past but also to look forward where possible to future EU developments. Indeed, Part IV of the book, Alternative Futures for the UK, was specifically written as ‘blue sky’ research to provide a thought-provoking alternative to the content of mainstream EU-focused texts. Moreover, considerable effort has been taken to ensure that whilst the subject matter is academically rigourous, the ‘technical’ content is reduced to a minimum, without compromising the quality of its content, to ensure the highest possible degree of ‘readability’. The latter is all too frequently absent from some contemporary economics texts. Thus we hope to have widened the potential audience for this book beyond academic economists, to encompass all those in disciplines interested in European integration (European studies, economics, political science, languages) and undergraduate students undertaking courses in European economics, the political economy of Europe or international economics, together with providing a reference point for postgraduates and academics. Any remaining errors and omissions we gladly attribute to each other.

1 Current Issues in EU Integration

Overview The main impetus for the formation of a co-operative movement amongst countries in Western Europe, was the experience of the Second World War. Indeed, the need to avert further conflicts and consolidate peace is a goal that the process of European integration has certainly helped to achieve.1 The first initiative, drawn up by Jean Monnet, the head of the French Commission for Economic Planning, was to ensure that reconstruction in the heavy industries of (West) Germany should not endanger peace. The result was the European Coal and Steel Treaty (ECST) in 1951 which had three key objectives. First, to ensure integration through the removal of customs duties and quotas over a five-year transition period, modernisation and expansion of these industries through investment, the restriction of protectionist state aids and the provision of a common external commercial policy. Second, such detailed agreements were subservient to the political goal of achieving stability between France and Germany. Finally, the Treaty was instrumental in setting up supra-national institutions (e.g. the Council of Ministers, European Court of Justice) which would begin the process of closer co-operation between European partners. For her part, Germany was more than happy to accept the possibility of regaining control over its key industries as well as the prospect of rehabilitation, whilst the French, who largely engineered this initiative, along with Belgium, Italy, Luxembourg and the Netherlands also warmly received the proposals. More importantly, this agreement would also come to represent the first tentative steps towards European integration. Six years later the European Economic Community (EEC) Treaty was ratified, which laid the foundations for a market orientated Common 1

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Market through free movement in services and factors of production and the nurturing of free competition. In 1968, the six original members made further advances by blanket removal of intra-community trade tariffs, the formation of a common external tariff on trade with third countries and the adoption of a common commercial policy. The EEC Treaty continued to follow the supra-nationalist model employed in the ECST by creating a framework within which these institutions could more effectively enact EEC legislation and law pertaining to the principles of the single market. However, almost twenty years passed until further steps in European integration materialised in the form of the Single European Act (1986). This legislature would contribute significantly to the integration process through the introduction of qualified majority voting.2 In the 1990s, the remit of European integration broadened from that of a European Community to a European Union (EU). In the Treaty of European Union (TEU) (or the Maastricht Treaty) in 1992, three pillars of European decision making were formalised. The first pillar was essentially the European Community involving the adoption, modification and implementation of a legislative framework for the operation of the single market. The ethos behind the second and third pillars was to encourage intergovernmental co-operation in the areas of Foreign and Security Policy, and Justice and Home Affairs respectively.3 In this context, the role of the Commission and the European Parliament is limited, where decision making is made on the basis of member state representatives in the forum of the Council of Ministers. The EU was, however, still faced with the cumbersome procedure of having to ratify important international agreements with third countries both in the capacity of a single body and as a collection of member states. Accordingly, a key feature of the Treaty of Amsterdam in 1997 was to ordain the Council with powers to represent the EU thus providing a more focused point of reference on the world stage. This Treaty also shifted matters pertaining to external border controls, immigration and asylum from the third to the first pillar in an attempt to solidify the concept that full implementation of a single market required a working space that protected the rights and provided security for both EU and non-EU citizens alike. The other major achievement in the 1990s (within the TEU) was the formalisation of guiding principles and mechanisms for Economic and Monetary Union (EMU) within the first pillar, which would eventually lead to the adoption of a single currency. The other notable development over this fifty-year time frame has been the growth in EU stature on the world stage as membership in the

Current Issues in EU Integration 3

original club of six has expanded to fifteen, beginning with Denmark, Ireland and the United Kingdom joining in 1973. Enlargement to the ‘South’ previously had been deemed inconceivable due to the political affiliations of the ruling parties. Indeed, up until the early to mid-1970s, each of Greece, Portugal and Spain was governed by a non-elected body, which was considered as an unofficial (until Maastricht Treaty formalised this requirement) obstacle to entry. However, with the return of democracy, each sought and gained membership throughout the 1980s, starting with Greece (1981) followed by Portugal and Spain (1986). Finally, in 1996, the EU enlarged again with the accessions of Austria, Finland and Sweden. In 2004, the Union faces the inclusion of up to another ten members: Cyprus, The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia. As early as 2007, Bulgaria and Romania are set to join whilst Turkey is still under consideration as a candidate country. Further enlargements are to be expected, as Croatia has already applied for Candidate status whilst a number of Western Balkan states – Albania, Bosnia-Herzegovina, Macedonia, Serbia and Montenegro – are each aspiring for membership over the coming years.

Challenges in the twenty-first century The single internal market Since the inception of the first treaty over fifty years ago, the principle of a borderless zone for the trade of goods and services and free movement of factors of production has remained at the heart of European thinking. Whilst further legislation has helped to deepen the ties between member states through the introduction of three pillars of support, the prioritisation of the single market in the first pillar and the ratification and introduction of a single currency demonstrates the continued eagerness of EU policy to forge ahead with the creation of a truly integrated market system. Undoubtedly, remarkable progress has been made, whilst the goal of a single market is still a little way short of being realised. National government expenditure still generates a small proportion of cross-border trade, whilst external trade policy is not yet completely harmonised. Furthermore, discrepancies remain in the tax system across member states and the notion of free labour mobility, whilst true in theory, is minimal in practice. These apparent deficiencies are widely recognised as being attributed to the absence of a supranational EU government and associated budget mechanism. Moreover, the common usage of 11 spoken languages and rich diversity of traditions and customs are certainly admirable pan-European features, but

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seriously inhibit intra-EU labour migration. Despite these shortcomings, further steps are still being taken to continue the process of integration including liberalisation of national public and financial services sectors, the enforcement of competition policy and tougher rules on State aids. In the context of these ongoing developments in industrial and service sectors, it seems rather odd that agriculture should continue to be treated so differently. This contrast remains evident when examining the experience of the last decade, where on the one hand significant progress has been made in advancing the principles of competition and barrier free trade under the auspices of the single market, whilst Europeans continue to spend just under half of the EU’s budgetary resources subsidising a farming sector which today accounts for merely two per cent of EU(15) GDP. Justifiably, greater support for agriculture was taken from the political standpoint of ensuring food security and continued political stability in the early post-war years, whilst securing a fair standard of living for the rural community. However, the shift in Europe towards capital-intensive technology based industries moves hand in hand with World Trade Organisation (WTO) agreements designed to erode protectionist world agricultural markets and aid the development of poorer countries in an earlier stage of their development cycle. This change in doctrine from mercantilism to globalisation leaves European agriculture in a very different position to that fifty years ago, whilst changes in consumer expectations of agriculture in the twenty-first century have catalysed the beginnings of a reorientation in EU agricultural policy. In the context of these broad themes, Part I of this book focuses on specific issues relating to Agriculture, Competition and Industry which are discussed in turn in the following subsections. Chapter 2 – Common Agricultural Policy: evolution and economic costs The Common Agricultural Policy (CAP) is one of the oldest surviving legacies of European integration. Notwithstanding, the results of CAP support (e.g. ‘wine lakes’ and ‘butter mountains’) has left it with lasting scars. In response, a major overhaul began in earnest with the MacSharry Package (1992) which took the CAP in new directions, divorcing (to a certain extent) farm subsidies from output levels (‘de-coupling’) and reducing support prices afforded to the agricultural sector. Equally, in the wake of the Uruguay Round Agriculture Agreement, and with preparation for EU expansion to include ten additional eastern bloc members on the horizon, further reformation of the CAP under the auspices of the Agenda 2000 package and the Mid-Term Review continued the process of reform, albeit rather slowly, initiated under the MacSharry initiative.

Current Issues in EU Integration 5

Accordingly, the aim of this chapter is twofold. First, we seek to explain why the CAP continues to be heavily subsidised despite economic arguments to the contrary. In particular, the discussion attempts to identify the political forces that have shaped the evolution of the CAP over the last thirty years with greater emphasis on recent policy reforms. Second, with the aid of conventional theoretical analysis and up to date empirical research, the chapter assesses the consequences of the political process by reviewing the resource cost estimates of the CAP. Chapter 3 – Competition policy in the single European market Since the Treaty of Rome a strong policy has been followed against restrictive practices and abuse of a dominant position. The original Article 85 on restrictive practices and Article 86 on abuse of a dominant position became well known, but were renumbered in the Treaty of Amsterdam to Articles 81 and 82 respectively. The chapter examines the rationale for this strong competition policy. It shows how policy has developed new and stronger elements within the SEM to deal with mergers and also to make sure that state aids are not used more to replace other Non-Tariff Barriers (NTBs) which have been removed in the Single European Market (SEM). One current issue covered is the decision to end the block exemption for car manufacturers. This was created in 1984 and led to restrictive arrangements between manufacturers and dealers which raised car prices. Despite the SEM, price differences have continued to exist. The main explanation is one of anti-competitive behaviour by oligopolists practising price discrimination. The expiry of the block exemption reduces the power of the manufacturer, benefiting dealers and leading to more choice for consumers in purchasing different models and obtaining after-sales service. The final section of the chapter concludes with coverage of competition policy in the UK. Chapter 4 – Industrial policy: the changing agenda Chapter 4 starts by examining the nature of industrial change, including de-industrialisation and the growth of the service sector. It examines the performance of different industries, with the main focus being given to policies to strengthen European industry. The type of industrial policy used has varied significantly between the different member states. In recent years there has generally been a declining trend of national intervention, largely because of globalisation and privatisation. Some of the consequences of privatisation are covered. Given the recent trend at member state level and also a general preference for a liberal EU policy,

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how has EU policy manifested itself? How interventionist has EU policy been and in which sectors has this been most in evidence? The EU originally focused on basic industries, especially those connected with energy policy and subsequently focused too much on declining staple industries. It is argued in this chapter that it is necessary for the EU to re-orientate its policies towards sunrise industries incorporating new technology. Particular emphasis is given to technological indicators and the case for public support of science and technology by member states and by the EU. Many examples are provided of EU collaborative projects in different fields. Although the instruments and finance available to the EU are still less than at national level, EU support has been reflected particularly through its various framework programmes, such as ESPRIT. The chapter concludes on the EU and UK industrial policy and performance. The single currency One of the greatest milestones of political and economic integration has been the creation of the single European currency. Whilst indelibly linked to the ongoing process of greater integration of the single market, the scale and scope of the economic and political connotations warrant discussion in a separate section of this book. The ethos of this initiative was the need to increase ‘transparency’ between member states trade by eliminating transactions costs arising from the usage of national currencies. In eliminating such costs, price transparency between member states would enhance competitive forces, and also reduce risk associated with cross-border investments. Furthermore, in clearing a path for Monetary Union under the auspices of the TEU, qualification standards on economic convergence targets for inflation, budgetary discipline and interest rates had a beneficial effect on those countries which had up until that time been rather lax with their fiscal and monetary discipline. Clearly this undertaking has not been without risks either, particularly given the absence of any EU government or budget mechanism to preside over the system. Furthermore, the removal of national central banks from signatory members and the introduction of rules governing both budgetary and public debt limits under the auspices of the Stability and Growth Pact (SGP) agreed in 1997, has opened up potentially dangerous consequences to members states that fall out of synchronisation with the European business cycle. Indeed, without traditional means of macroeconomic management, many argue that the success of the currency for members in the long term relies at least partly on advances in

Current Issues in EU Integration 7

improving labour market flexibility both within and between member states. The importance of economic alignment within the common currency scheme has, to some extent, been highlighted by current events. Indeed, under the current framework of the SGP, member states with a deficit of over three per cent of GDP are accountable to pay an interest free deposit of 0.5 per cent of national GDP to the European Commission, returnable only if the offending member rectifies the problem within two years. It is therefore unfortunate for the architects of the SGP, that the two biggest economies within the euro zone, France and Germany, have breached this fiscal condition citing the need to stimulate sluggish economic growth. This is unlikely to bode well with smaller members in the euro zone who have adhered to the guidelines as it does not appear that any form of discipline under the auspices of the SGP agreement will be administered. In the absence of any EU supra-national government, the key driving forces behind the success of the single currency are the convergence guidelines and penalties outlined in the legislature, and the European Central Bank (ECB) in Frankfurt which is charged with the regulation of European monetary policy whilst functioning independently of both European institutions and national governments. Consequently, Part II of the book dealing with Economic and Monetary Union, focuses its attention on these mechanisms in successive chapters described in the following subsections. Chapter 5 – The ECB: central bank independence and monetary policy The ECB is a creation of the TEU, which designed it to be the most independent monetary authority in the world. The ECB’s architects sought to insulate it completely from political pressures, both at the national government and at the EMU-zone level. The position of the ECB under the TEU permits no clear accountability to national nor federal European institutions. It stipulates that the ECB Council’s deliberations remain confidential, whilst the only method of questioning the ECB’s policies is through periodic reports to the European Parliament. The ECB is the sole body credited with determining the appropriate monetary and exchange rate policy for the entire euro zone and as such its ability to fulfil its stated objectives will be crucial to the eventual success or failure of EMU. Consequently, the paucity of critical analysis of the ability of the ECB to stabilise the euro zone economy, complete with low inflation, full employment, a sustainable balance of payments and good level of economic growth, should be of great concern for all supporters of European integration.

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This chapter seeks to analyse the design of the ECB selected by the architects of the TEU and reviews the degree of independence attributed to the ECB in comparison to member states’ national central banks (NCBs). It then summarises the leading conceptual issues and empirical literature in order to examine the merits of establishing the ECB independent from democratic influence. The hypothesised relationship between independence and macroeconomic indicators is empirically evaluated, together with a review of challenges regarding the ECB’s ability to fulfil its objectives given its present policy framework. Chapter 6 – EMU convergence and fiscal policy Most academic social science literature either accepts that closer EU integration is desirable, or more usually, given the political will of EU leaders, is inevitable. Therefore economists, political scientists and sociologists frequently devote their research to the dynamics of the EMU, the political institutions fostering ‘ever closer union’ and the social implications of these momentous changes. However, whilst such detailed analyses generate important policy proposals, they tend by their weight to smother the crucial strategic issue: Is EMU beneficial or not, for the EU as a whole? The purpose of this chapter is to analyse this issue. More specifically, it seeks to evaluate the criteria which have been advanced by different authorities to assess whether or not membership of the single currency would prove beneficial. Over the last 20 years, economists have studied the potential impact of monetary union between countries under the rubric of optimum currency area theory. It concludes that a single currency boosts participants’ living standards when they possess similar economic structures and international trading patterns, but proves detrimental where these diverge. Consequently, to avoid making a potentially costly mistake there is an obvious need for a series of measurements to determine whether an individual economy is prepared for the demands of membership. These indicators must incontrovertibly demonstrate the existence of prior, sustainable ‘real’ convergence between participating economies, before the formation of a single currency between these countries is in their economic interests. Indeed, the convergence criteria contained within the TEU are more concerned with examining transitory cyclical movements in financial indicators, rather than concentrating upon structural convergence in the real economy in terms of the wealth of the different countries, their unemployment, productivity and growth rates, not the sectoral composition of economic activity. The chapter is divided into four sections. First, it reviews the degree of

Current Issues in EU Integration 9

economic convergence between the 15 EU member states, as reflected by the Maastricht criteria, for the period 1990–2002. It then summarises the established theory of optimum currency areas, which provides a benchmark for comparison with previously discussed measurements of economic integration. Finally, it reviews implications for national fiscal policy in light of the TEU and SGP obligations. Enlargement and convergence An examination of the EU budget reveals that approximately 45 per cent of the own resources are used to finance the CAP, whilst another 30 per cent are allocated towards structural policies including social, regional and rural development. Thus, approximately 75 per cent of the budget is allocated on either protecting one sector from global competition or to reduce economic disparities which exist between the EU’s richest and poorest members. In the case of the structural funds, such inequalities are often seen as a result of geographical factors and/or social and economic upheaval resulting in poorer education, higher unemployment levels and inadequate infrastructure. Accordingly, the guiding principles of regional policy in the EU are those of solidarity and cohesion. The former focuses on the need to help regions and individuals in relatively deprived areas, whilst within the latter, the priority is to derive an inherent economic and political benefit by narrowing inequality gaps (convergence) throughout the Union. The case of Ireland is a positive example of these initiatives, where on accession its per capita GDP was 64 per cent of the EU average, compared with the present where it is one of the highest in the EU. However, average national statistics such as these mask inequalities at the local level, which remains an important aspect of EU regional policy.4 The year 2004 also sees enlargement of the EU, which by 2007 could include up to 27 member states. This presents a fundamental challenge to EU policy makers, largely because it involves the costly supra-national policies of structural funding and the CAP. More specifically, a major problem for the EU is that the acceding countries have two pertinent characteristics in common. First, the Central and Eastern European Countries (CEECs) which form the bulk of the accession members, are still in a phase of transition since the fall of communism in the late 1980s and as such their level of development and comparative economic wealth (i.e. per capita income) is considerably lower than even the relatively poorest existing members of the Union (Greece and Portugal). Second, whilst there is slow convergence to the EU average,

10 Current Economic Issues in EU Integration

agriculture’s share of national output (and therefore employment) in each of the CEECs remains relatively high. Combining these factors, it is anticipated that on membership, population in the union will increase by 20 per cent whilst output growth will be only 5 per cent. As a result, these countries will undoubtedly become net recipients from the EU budget, at least in the medium term. However, this comes in a period where EU paymaster member states are seeking to rationalise contributions, particularly when in need of funds to alleviate national budgetary breaches pertaining to euro zone membership. Reminiscent of previous UK Prime Minister Margaret Thatcher, in the 1980s the Germans and the Dutch are attempting to claw money back from the EU budget, whilst the UK’s negotiated rebate looks more under threat. On the other hand, the Germans are also trying to hold onto structural policy revenues for their Länder, whilst the traditional beneficiaries Spain, Greece, Portugal and Ireland are looking to sustain their advantageous positions.5 A further immediate priority for the EU and the CEECs is the necessity for the latter to successfully adopt the EU’s common visa and border regimes, known as the Schengen system. Within most of the EU these borders have already disappeared, which is what will also be required of the new members over the coming years. Moreover, accession members will be expected to have successfully instigated tough new border controls on non-EU members, including previously communist trading partners, a prospect that worries some members.6 To some extent, pre-accession financial support mechanisms have been provided by the EU, although the ability of these members to align themselves successfully with the economies of the EU will be largely determined by their willingness to embrace continued institutional reform. Slightly further afield is the need for accession countries to consolidate their participation in the single market through eventual membership of the single currency. Indeed, unless an opt-out is negotiated (as in the case of Denmark, Sweden and the UK), new members are required to join the euro as soon as entry criteria are met although it is likely that a transition time period will be required before a number of these countries qualify. Advocates of the euro will clearly hail an extended euro zone as a major milestone towards an enlarged single market, although given the caveats of the current experience of euro membership for Germany and France, caution must be urged. Thus, in synthesising these issues in European integration, Part III focuses on the issues of Regional Convergence and Enlargement in Chapters 7 and 8 respectively.

Current Issues in EU Integration 11

Chapter 7 – The new role and resurgence of regions in the EU The growth of the EU reflects that of supra-national influence partly at the expense of the member state. However, there is a further challenge to the nation state through the growth of sub-national regional developments. While regional structures vary between member states, the EU has been keen to enhance regional inputs in a variety of ways. The chapter reviews the channels for regional inputs and outputs, in particular through the Structural Funds (SFs). What impact have these had in promoting regional convergence? The wisdom of the new rationalised focus on three Objectives and concentrating most of the support on Objective 1 is examined, together with the decision to whittle down the number of Community Initiatives and to reduce their funding. The re-shaping of EU regional policy is part of the enlargement process and has major implications for the poorer regions in existing member states. Given the low GDP and high unemployment in the CEECs, their development is dependent upon regional aid and outward migratory labour movements. As long as restrictions remain to a completely free labour market for the ten new members, regional aid will be very important. But is there likely to be sufficient solidarity within the EU(25) to underpin large transfers to the new member states in which the regional problem is mainly a national problem of underdevelopment? The chapter concludes on the implications for the UK which in the past was very much in favour of the SFs and a major beneficiary, but will see aid transferred and concentrated on even poorer regions elsewhere in the EU. Chapter 8 – EU enlargement: EMU and agriculture One of the future challenges facing the EU is the process of expansion to include the CEECs of Poland, Hungary, the Czech Republic, Slovakia, Slovenia, Latvia, Estonia and Lithuania, together with Cyprus and Malta who will join in 2004. Whilst there are a myriad of issues surrounding EU enlargement, this chapter focuses upon EMU membership and agriculture, which encapsulate the potential difficulties encountered by the CEECs in joining the EU. The potential hurdles associated with EMU include irrevocably fixing exchange rates, compliance with the SGP, ERM membership and monetary transmission to the euro. In relation to agriculture, this plays an important role since a relatively high proportion of the population in the CEECs lives in rural areas. Equally, in the context of debate surrounding excessive subsidisation of agriculture in the current EU(15), eastern farmers are keen to exploit the support mechanisms which will appear alongside the market opportunities from

12 Current Economic Issues in EU Integration

free access to the internal EU market. Thus, the chapter discusses the pre-Accession programmes for agriculture and examines the political and economic implications to both current and acceding members of extending the CAP mechanisms to an enlarged EU. Alternative futures in Europe Over the last five decades, a gradual increase in Community powers under the majority voting system has come at a price. Namely, member states who have been reticent to engage in further integration initiatives have had to face the potential dangers of being ‘left behind’ resulting in differentiated rates of integration. An example of this scenario is the adoption of the single currency, where Denmark, Sweden and the UK decided for political reasons to keep their national currencies.7 Subsequently, it is impossible to predict with certainty whether this will merely result in a medium-term period of two-speed integration or the beginnings of a permanent fragmentation of the Union. However, what is certain is that from the perspective of the UK, 2004 is set to be a turbulent year with impending enlargement of the EU to 25 members and its associated budgetary considerations, as well as the ongoing debate pertaining to reformation of the European Constitution. Indeed, one of the clauses in the latter, which the UK government has threatened to veto, is the proposal to eliminate unanimity requirements in sensitive areas such as taxation, social security and judicial co-operation. Additionally, with disagreements between French and UK officials on the issue of EU defence, proposals for an EU foreign minister and a powerful presidency for the European Council of Ministers, it appears that there is still some way to go to a successful ratification. Whilst on the one hand, it is understandable that the EU is looking for ways to prevent potential political deadlocks in an enlarged forum of member states, this may present scant consolation to those members who sometimes view further European integration initiatives as a threat to their national interests. What does all this mean for the UK? Often there have been calls from Eurosceptic politicians for the UK to take its future into its own hands by focusing on perceived opportunities outside of the EU (e.g. Commonwealth, North American Free Trade Area). The appeal of this argument is popularly reinforced by the dangers of Euro membership to the UK economy. In particular, proponents of keeping sterling point to the relatively poor economic track record of countries within the euro zone while popular opinion is heavily skewed against adoption of Euro notes and coins. Against this climate of anti-euro popular opinion, the

Current Issues in EU Integration 13

current pro-euro Labour government is unwilling to embrace the idea of a referendum in the near future given the short-term goal of winning a third consecutive General Election in 2005 (at the earliest). In the mean time, is the static ‘wait and see’ approach damaging UK business? Are there more viable alternatives than the status quo? In Part IV of this book, we examine the proposition of Alternative Futures for the UK from the perspective of theoretical macroeconomic policy alternatives and a discussion of the UK’s empirical trade and investment relations. Chapter 9 – Alternatives to further integration The EU was designed by the founding members to accommodate their perceived commonly shared objectives, whilst further measures of integration, including the abolition of exchange controls, the design of the single market, and the forfeiture of economic sovereignty through entering EMU, may be rational consequences for those EU nations which are locked closely through trade, but could be viewed as debateable for the UK which conducts a large proportion of its trade outside the EU and possesses closer cultural ties with the US and Commonwealth countries. However, the question that demands an answer is ‘What is the alternative?’. Given that the political and economic elite in most EU countries have consistently supported further integration, alternatives have rarely been discussed. In the countries which allowed referendums over the TEU and in the new 2004 EU entrants, almost without exception all major political parties, business and trade union leaders joined together in an alliance to persuade voters to back the integrationist project. However, public opinion and polls often appear to be questioning of EU political and economic integration, but the UK seems to be anxious of the consequences of lessening its membership. To confront such concerns a series of alternative strategies regarding the UK’s relationship with the EU: (i) a status quo strategy of excluding further integration, (ii) reducing membership to that of the European Economic Area, (iii) pursuing free trade in industrial and financial commodities and (iv) complete withdrawal with the options of rejoining EFTA, reinvigorate the Commonwealth trading bloc and/or association with the North American Free Trade Agreement (NAFTA). The second part of the chapter reviews the broad range of policies which could be enacted if Britain rejected participation in the single currency. For brevity and simplicity these are condensed into three general sets of ideas: (i) tight monetary policy/low interest rate strategy whereby national monetary authorities seek a higher long-term growth rate by providing a favourable climate for industrial expansion through low

14 Current Economic Issues in EU Integration

inflation and hence reduced long-term interest rates, (ii) a ‘Keynesian’ strategy with the more active use of fiscal as well as monetary policy in order to pursue both internal and external balance for the economy. Accordingly, unemployment could be reduced by a mixture of demandside reflation and supply-side labour market policies, particularly measures encouraging re-training and labour mobility and (iii) exchange rate policy strategy such that over a period the desired objectives of exchange rates are short-term stability and long-term flexibility. Chapter 10 – Is membership of NAFTA a barmy idea? Following receipt on 18 November 1999 of a Senate Finance Committee request, the US International Trade Commission (USITC) instituted an investigation on ‘The impact on the US Economy of including the United Kingdom in a Free Trade Arrangement with the United States, Canada, and Mexico.’ Such a campaign gained momentum in June of 1999, when four senators arrived in London to discuss the case for full UK membership in NAFTA with a number of senior conservative party officials. This chapter discusses the rationale for NAFTA membership for the UK both in the context of the political climate at home and abroad (e.g. Europe and North America) and collected data on the UK’s transatlantic trade and foreign direct investment relations. In the latter part of the chapter, we review two empirical studies which measure the impacts on the UK economy under two stylised NAFTA membership scenarios. In scenario (a), the estimates are based on the removal of UK trade barriers with NAFTA only. In scenario (b), in addition to the removal of trade barriers between the UK and NAFTA, it is assumed that the UK and EU erect import barriers on mutual trade at a rate equivalent to that imposed by the EU on third countries. Moreover, the UK continues to treat imports from the Rest of World (ROW) as if it were still a member of the EU.

Part I Agriculture, Competition and Industry

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2 Common Agricultural Policy: Evolution and Economic Costs

Introduction The inception of the common market was catalysed by a nucleus of western European countries1 wishing to create a political and economic union following the resolution of the Second World War. From this ideology, the Common Agricultural Policy (CAP) was born, targeted at curing balance of payments and food shortage problems from the war effort and offering the benefits of further political integration. However, in laying these foundations, there was a failure to recognise potential improvements in supply responsiveness and efficiency in agriculture. Moreover, in seeking to cement the European Economic Community (EEC) by striking a deal in agriculture, farm ministers took the decision to set agricultural prices for cereals some 50 percent in excess of what was then a stable world price. As Hubbard and Ritson (1997) observe, ‘because most other agricultural products are related to cereals, either as competitive arable crops or as users of cereal based feeding stuffs, most other agricultural product prices had similarly to be set at relatively high levels’ (p. 81). As a result, critics argued that the CAP penalised poorer consumers (due to high internal food prices),2 encouraged inefficient production leading to oversupply, created an excessive budgetary burden and ultimately damaged trading relations. For these reasons, the impact of agricultural support on EU and world markets has been the subject of intense debate, driving academics and policy makers alike to quantify the costs of the CAP. Thus, the aim of this chapter is twofold: In Part I, there is a discussion of CAP policy evolution with particular emphasis on the mid-term review agreement and the outlook for the CAP in the foreseeable future. In Part II, an economic framework is employed to explain the inefficiencies or ‘deadweight costs’ of the CAP. This 17

18 Current Economic Issues in EU Integration

theoretical analysis is complemented with an empirical review of work from the applied trade policy literature over the last two decades to estimate such deadweight costs.

The evolution of the CAP The road to multilateralism and MacSharry3 Up until the 1980s, the CAP operated solely on a system of artificially high support prices above world prices, sustained by quotas and tariff barriers on imports. Furthermore, export subsidies enabled the ‘dumping’ of excess food surpluses on global markets depressing world prices whilst guaranteeing farmers internal CAP support prices.4 Meanwhile, intervention purchases were used to remove surpluses from EU markets and sustain internal floor (intervention) prices. Thus, the CAP was transferring considerable funds from food consumers and taxpayers to farmers, producing surpluses, raising concern about the environment and creating tension with trading partners. The political will to respond to early calls for reform ( Josling, 1969) was largely absent due to the vested interests of the powerful farming lobby. However, the impact of spiralling budgetary costs in the 1980s and the failure of the Community’s ‘own resources’ to match budgetary growth resulted in concomitant one-off payments from national governments. This budgetary mismanagement was largely attributed to supply responsiveness from high price signals resulting in surpluses across many product categories. The first serious attempts to address burgeoning surpluses began with the introduction of production quotas in the dairy sector.5 To alleviate milk surpluses, sustain farming incomes and limit budgetary spending the only politically acceptable alternative to price reductions was the imposition of a quota mechanism.6 This was supported by a tax (co-responsibility levy) on those farmers who exceeded output limits. Whilst discouraging production and aiding budgetary concerns, these were administratively difficult to implement and therefore subject to fraud. In the cereals and livestock sectors, real price reductions were imposed although these were still not sufficient to curb supply responsiveness in these sectors. In 1988, EU budgetary reforms and the strengthening of financial discipline through the introduction of budgetary stabilisers7 helped maintain budgetary spending within certain designated guidelines. Unfortunately, the Community appeared to be resolved to keeping the essential mechanisms of CAP support intact.

CAP: Evolution and Economic Costs 19

Not surprisingly, by the end of the 1980s, further reform of the CAP was needed except now, EU policy makers were forced into reconciling (i) budgetary and (ii) farming income considerations, with (iii) the reformation of agricultural trade protectionism under the auspices of the General Agreement on Tariffs and Trade (GATT). Agriculture was now one of 13 negotiating groups within the trade talks, with many countries (Cairns Group8 ) expressing discontent at the EU’s insistence on subsidising agricultural surpluses, thus depressing world prices.9 Once again, the economic solution of deeper price cuts in support to meet criterion (i) and (iii), was ignored by EU politicians bent on placating the farming lobby. Faced with the prospect of a potential collapse in the trade talks, internal pressure from non-food trading groups eventually forced the EU to concede ground on agricultural support. The ‘MacSharry’ CAP reform proposals (named after Commissioner Ray MacSharry) tabled in 1991 and ratified in 1992, not only provided a major breakthrough in the GATT negotiations ultimately leading to the final agreement in 1994, but would also serve as a blueprint for future CAP reform. Essentially, the thrust of the MacSharry package was to soften producer surplus losses to farmers from further reductions in EU intervention prices,10 with the introduction of compensation payments, which partially divorced or ‘de-coupled’ support from production through payments related to farm inputs rather than outputs.11 In addition, the principle of cross-compliance in production limiting arrangements was introduced, based on rewarding farmers for less intensive usage of their inputs. For example, in the cereals sector, compensation was conditional on the ‘set-aside’ of registered arable land from production. Similarly, in livestock sectors, headage payments were subject to the requirement that farmers reduced stocking densities on each hectare of pasture.12 Whilst the overall level of support to farmers was not dramatically affected (Ackrill, 2000), the switch in the burden of support from consumers (lower prices) to taxpayers inevitably resulted in greater transparency with increases in ‘visible’ budgetary costs.13 From the perspective of the trade agreement, intervention price reductions were instrumental in reducing storage costs and export subsidies, which facilitated eventual accord on reduced export volume and subsidy expenditure constraints. Equally, the practise of ‘dirty tariffication’14 provided the EU with a degree of manoeuvrability in negotiating import tariff reductions. Finally, and perhaps most importantly, a key part of the 1993 Blair-House Accord between EU and US negotiators, was that CAP compensation payments to EU cereals and livestock sectors

20 Current Economic Issues in EU Integration % 90 80 70 60 50 40 30 20 10 0 1965

CAP expenditure as a proportion of the EU budget (1971–2006)

1970

1975

1980

1985

1990

1995

2000

2005

2010

(

millions)

Total CAP expenditure (1971–2006) 50 000 45 000 40 000 35 000 30 000 25 000 20 000 15 000 10 000 5 000 0 1965

Figure 2.1

1970

1975

1980

1985

1990

1995

2000

2005

2010

CAP expenditure.

Source: European Directorate (European Commission).

would not be viewed as trade distorting (amber box), but rather linked to production limiting arrangements (blue box) and therefore exempt from GATT reform. As a result, the stipulated 20 per cent reduction in amber box domestic support was not a binding constraint for the EU. Figure 2.1 shows the proportion of EU budget expenditure afforded to the CAP and nominal total CAP guarantee expenditure (the figures between 1999 and 2006 are agreed under the financial framework). A cursory glance at the figure reveals that the share of CAP expenditure was at a peak in the early 1970s, whilst steadily declining over the following two decades. Notwithstanding, nominal CAP expenditure has, over the same time period, been increasing.

Agenda 2000 and beyond As Ackrill (2000) notes, the unique characteristic of Agenda 2000 was that, ‘the reforms to the CAP agreed in 1999 (were) not the product of a current crisis’. Rather, the impetus for further change was motivated by the need to avert potential future difficulties presented by further enlargement of the EU and the next round of World Trade Organisation (WTO)15

CAP: Evolution and Economic Costs 21

multilateral trade negotiations. Essentially, the ethos of Agenda 2000 followed that of its predecessor in 1992, proposing further cuts in support prices for arable, beef and dairy sectors with simultaneous increases in direct payments. Moreover, compulsory set-aside would be eliminated, although a voluntary form of the scheme would remain intact. However, as the talks progressed, the issue of budgetary impact was once again the central tenet upon which the final form of the Agenda 2000 reforms would be agreed. With proposed significant cuts in support prices, the underlying issue was the (in)ability of the EU to (partially) compensate farmers without breaching the ceiling limits set under the financial framework perspective to 2006.16 This significantly weakened the proposals resulting in smaller support price reductions, and the reinstatement of compulsory set-aside to restrict surplus cereal production. The reform process also showed the EU at its weakest, with the countervailing political interests of member states having considerable influence over the timing and depth of market reform. In particular, it was the failure of member states to agree on reformation of the dairy sector which proved to be one of the greatest obstacles to overall consensus, with the ‘gang-of-four’ (Denmark, Italy, Sweden and the UK) calling for complete abolition of the quota mechanism by 2006. However, under the leadership of President Chirac who was largely sympathetic to the farming lobby, it was the French who prevailed, securing a delay in phased reduction of support prices until marketing year 2005/06.17 In many respects, Agenda 2000 fell short of its initial mandate as very little was done to reduce the budgetary cost of the CAP. For example, Swinbank (1999) notes that a number of ‘sweeteners’ (p. 393) were offered (e.g. increases in milk quota and reference yields, continued provision of area and headage payments), whilst price reductions did not sufficiently alleviate the pressures of EU export subsidy and volume constraints. Furthermore, the EU gambled heavily by signalling its intent to continue utilising ‘blue box’ support as a key foundation of the internal reform process.18 Whilst blue box measures are a permanent provision of the WTO, many WTO members are calling for them to be scrapped. Moreover, it should be noted that in the aftermath of its 2002 farm bill, the US no longer employs blue box support, which may not bode well for the EU. Insofar that CAP support continues to encourage intensive farming practice, there are associated environmental costs of agricultural support.19 A response to this within the Agenda 2000 package was the partial shift of resources from market support into rural development.

22 Current Economic Issues in EU Integration

Indeed, production became viewed as multifunctional in nature in that farmers would produce various non-commodity outputs geared towards consumer expectations of twenty-first century agriculture.20 For example, in the context of food safety and quality, consumer awareness has been heightened by a series of crises beginning with BSE in cattle, the representation of genetically modified products as ‘Frankenstein foods’ and most recently the ‘foot and mouth’ outbreak. Whilst environmentalists welcomed the introduction of ‘second pillar support’ focused on rural development initiatives, in the reform package it only accounted for 10–15 per cent of total CAP spending.21 Additionally, the reforms did little to address the ongoing problem of income inequality in the EU’s farming population, with OECD (2003) estimating that 25 per cent of the farms receive 70 per cent of support. Despite moving from price support to direct payments, the larger farms that were previously receiving generous handouts on higher output levels, would continue to receive similar proportions on input payments (on land, cattle head) given the scale of their operations. This explains why so many (smaller) farmers (typically family owned holdings) are still leaving the industry despite continued high levels of CAP expenditure. Furthermore, farm support continues to suffer from leakage with input suppliers (e.g. non-farm landowners, fertiliser and pesticide providers) estimated to be receiving up to 45 cents of every euro spent (OECD, 2003). In light of these shortcomings, it is perhaps not surprising that the Commissioner for Agriculture, Franz Fischler, pursued a strategy of pushing for radical reform under the ‘mid-term reviews’ (MTR), where the main thrust of his ‘European model of agriculture’ (as it has subsequently come to be known) was based on extending the role of ‘second pillar’ support. The MTR proposed that farmers should be granted a totally de-coupled lump sum payment for cross-compliance with the ‘new’ objectives of the CAP, whilst simultaneously breaking the ‘partial’ link between subsidisation and production initiated under the MacSharry package. In budgetary terms, with the exception of smaller farming units, traditional ‘first pillar’ payments would undergo annual cuts (‘degressivity’) and be gradually transferred to support both ‘second pillar’ rural development objectives and further market reform schemes (‘dynamic modulation’),22 an idea which was dropped under the Agenda 2000 agreement.23 At first sight, the MTR appeared to signal a bold shift in emphasis in relation to the structure of CAP support, but predictably, ratification of these proposals was fraught with difficulty and inevitably diluted by the vested interests of member states. A key obstacle appeared when it emerged that France and Germany, the largest

CAP: Evolution and Economic Costs 23

recipient and paymaster respectively, had struck a deal to resist complete decoupling of CAP support at the bilateral summit in Berlin on the 10 June, 2003. Consequently, after three arduous rounds of talks, EU farm ministers finally agreed on a ‘compromise’ deal in June 2003. The final agreement will become operational in 2005, although members are permitted to delay this until 2007 to allow for additional transition time. A proportion of payments granted to farmers under current schemes will be replaced by a single de-coupled farm-specific payment linked to environmental, food safety, animal and plant health and animal welfare standards. Thus, there will still be specific provisions to maintain production related payments in the arable and livestock sectors, although under the reform deal, the Commission estimates that 90 per cent of cereal subsidies and 70 per cent of beef subsidies will be decoupled from production levels over four years (EurActiv, 27/6/2003a). Dairy will not become part of the single payment scheme until 2008 (members may introduce the system earlier) to allow for full implementation of the dairy reforms. Agreed revisions have been implemented in the dairy,24 rice, cereals, durum wheat, dried fodder and nut sectors, although notably, sugar reform was absent. To provide additional funds for the ‘new’ rural development policy, farmers granted more than €5000 a year, will face modulated reductions of 3 per cent in 2005, 4 per cent in 2006 and further 5 per cent reductions for each of the years 2007–2013, where it is estimated that a modulation rate of 5 per cent will result in additional second pillar funds of €1.2 billion a year. In exchange, member states have been promised at least 80 per cent of their modulation funds. Finally, the switch in support between pillars will respect existing projected EU(25) budgetary ceilings, whilst offering no improvements to EU taxpayers. Indeed, with the CAP still consuming nearly half of the EU budget, it is very likely that there will be further serious reform in the coming years, particularly with accession of ten new members by 2007.25 Having achieved a compromise deal, the next hurdle facing the EU is the resumption of the Doha Round of trade talks. The major priority of the talks is to address the trade needs of the developing countries, in particular through greater access to EU and US agricultural markets and by drawing an end to subsidised dumping. Despite the fact that the MTR offers no cuts in border protection, the agreement still strengthens the EU’s position even encouraging EU officials to take the bullish line of calling upon the US to follow its example and cut subsidisation of its own farm policy (EurActiv, 27/6/2003). However, the success of the agricultural trade talks will have much to do with the treatment of the

24 Current Economic Issues in EU Integration

‘Peace Clause’ provision, which grants ‘blue box’ status for EU domestic support until the end of 2003. Beyond this point, it is likely that other contracting parties, particularly the US, will challenge these exemptions although their moral authority will be somewhat diminished by their recent farm bill.26 Failure to retain the ‘blue box’ exemption would put pressure on EU Trade Commissioner, Pascal Lamy, to convince WTO partners that the European model conforms fully with the detailed conventions of the ‘Green box’, where subsidies are effectively non-trade or non-production distorting. However, there may be associated problems with this strategy. For example, as Swinbank (1999) notes, ‘environment and other goods are often joint products with farm output, and it is difficult to encourage the production of one without the production of the other’ (p. 403). Equally, to qualify for Green box status, support must be ‘site-specific’, where payments are made to the relevant service provider irrespective of whether the recipient is in the farming industry. Another pertinent issue of controversy surrounds the treatment of export subsidisation. Whilst the WTO (supported primarily by the US, the Cairns group and major developing countries like India and China) is seeking to eliminate all export subsidies,27 the EU is committed to reducing export subsidies by only 50 per cent in the next trade agreement. The EU defends this proposal on the grounds that the revised blueprint tabled by the WTO as a negotiation guideline for agriculture does not adequately treat the issue of other trade-distorting instruments such as export credits and food aid. Indeed, the EU position has been that members employing such measures have so far not fulfilled promises made in the previous round to discipline these forms of export support. Furthermore, the EU argues that significant loopholes remain within the current statute, which they claim allows such ‘trade distorting’ practices to persist. Equally, EU import tariffs continue to remain prohibitive, where on grain it is in excess of 200 per cent compared with the average tariff on manufacturers of 3 per cent and even in the heavily protected textile and apparel sector tariffs are 25 per cent (Rollo, 2003). Whatever outcome, such an emotive issue will continue to be fiercely contested by poorer members whose export returns and import costs have been severely hit by EU protectionist policies. Such divisions were realised at the fifth ministerial meeting in Cancun, Mexico where developing countries were unhappy that wealthier nations appeared to be urging greater liberalisation whilst refusing to abolish their export subsidies. Ultimately, the developing countries’ rigid common bargaining position, despite pressure from the rich,

CAP: Evolution and Economic Costs 25

proved decisive and demonstrated that the developing nations now have real power in the WTO. Unfortunately, the deadlock threatens to prolong or possibly even scupper a successful conclusion to the entire trade talks, currently scheduled for January 2005. Much now depends on whether the realisation of the opportunity costs of failure will instil greater determination on all sides to strike a deal at the 2004 ministerial meeting in Hong Kong.

The economic costs of the CAP Economic costs of the CAP – a theoretical paradigm In the words of Buckwell et al. (1982), there is no such thing as an absolute cost. The cost of anything can only be measured in terms of what has to be given up to achieve it, that is, the cost relative to some alternative. (p. 39) This statement of opportunity cost is true of all of the empirical estimates that appear later in this chapter. In the illustrated analysis below, the economic impact of the CAP is compared with an alternative ‘free trade’ scenario (i.e. CAP abolition). A partial equilibrium (PE) single commodity representation (adapted from Buckwell et al., 1982) of a two-country community including community preferences and common financing is presented in Figure 2.2, where the EU agricultural support price (Ps) is set at an artificially high

Net importer

Net exporter D

S

Ps

Ps

Pw

Pw a

b c 1 c2 d e f

MI ME Figure 2.2

S

D

g

h i l

XI

j k m

XE

A simple partial equilibrium (PE) model of CAP transfers.

26 Current Economic Issues in EU Integration

level above the world price (Pw). Moreover, imports and exports have been disaggregated into intra- (MI; XI) and extra- (ME; XE) community trade, where trade within the EU is free from any ‘external’ trade barriers. The analysis also includes the role of common financing of CAP market support, which is characterised by export subsidies. Moreover, levies on extra-EU imports are paid into the community budget. The accompanying transfers of income are presented in Table 2.1. Thus, the first two rows of Table 2.1 show the total value of EU import and export trade. The summation of these value flows for both member states is the balance of agricultural trade. The next three rows in the table show the breakdown of the CAP budget, which are summed in row 7 under total community expenditure (Z) and split (row 8) into member state contributions by the share parameter
. Row 9 is the sum of rows 6 and 8, and shows the net contributory position of the two countries. The net importer pays
Z to the common budget as well as handing extracommunity import levy revenues over to the community. The net Table 2.1

Transfers in a two-country community Net importer

Trade flows: 1. Export receipts 2. Import payments 3. Balance of agricultural trade (1
2) Budgetary flows: 4. Export refunds 5. Import levies 6. Net CAP expenditure to each region (4
5) 7. Total community expenditure 8. Contributions 9. Balance of CAP payments (6
8) The welfare cost of CAP abolition: 10. Producers 11. Consumers 12. Taxpayers 13. Overall welfare 14. Deadweight welfare costs

c1
e
f
c2 (c1
e
f
c2)

Net exporter (h
i
j
k
l
m) (h
i
j
k
l
m)

(j
k) c2 c2

(j
k)

c2
j
k  Z (
Z) (c2

Z)

(1 
)Z j
k  (1 
)Z

a (a
b
c1
c2
d) (
Z
c2) (b
c1
2c2
d

Z) (b
d
h
k)

(g
h
i
j) g
h (1 
)Z  (j
k) (i
2j
k)
(1 
)Z

Source: Adapted from Buckwell et al. (1982).

CAP: Evolution and Economic Costs 27

exporter receives income in the form of export subsidies, and contributes (1 
)Z to the community budget. The final rows in the table examine the efficiency costs of CAP abolition (i.e. free trade). The transfer of funds to producers from consumers and taxpayers under this policy scenario is a measure of the economic or resource costs of this policy. Thus, under conditions of free trade, producers lose and consumers gain due to lower supply prices. The taxpayer costs represent the effect of removing the net contributory positions each state holds under the CAP. The extent to which transfers of funds do not sum to zero reflects the inefficiency of the policy in supporting producers (in this case), and is known as the deadweight welfare cost (row 14).28 Deadweight costs (i.e. the gains from CAP abolition) arise since subsidising agriculture draws resources away from other sectors where resources could be better employed. Indeed, as we see later in the chapter, the applied literature supports the basic theoretical analysis, that there is an inherent economic cost from CAP support. Partial equilibrium (PE) vs Computable General Equilibrium (CGE)29 Much of the literature on CAP costs throughout the 1970s and 1980s was based on the PE treatment. However, it has been recognised that this approach does suffer from certain limitations (Demekas et al., 1988): ●

●

●

●

PE models treat the market for agricultural commodities as mutually exclusive from the wider effects of resource reallocations on factors of production in the rest of the economy (i.e. non-agricultural sectors). In economic terms, there are no cross-price elasticity effects, as the prices of goods/services in other markets are assumed fixed.30 The analysis assumes that the country is a price-taker (i.e. the ‘small’ country assumption) in the world market, such that changes in domestic production will have no affect on world prices. Due to associated complete specialisation effects, this precludes gross bilateral trade flows. All demand is ‘final’ and does not capture the ‘intermediate’ nature of input demands which characterises much of the agricultural sector.

Demekas et al. (1988) highlight how the use of multicountry, multicommodity models (Tyers, 1985; Anderson and Tyers, 1988, 1993) can overcome some of these problems, although the resultant level of complexity can be significant. However, with the advent of more advanced computer software, as well as multiregion database syndicates, usage of CGE is now widely seen in the trade policy literature. This framework

28 Current Economic Issues in EU Integration

explores the ramifications of a policy change throughout the entire economy in that it captures all interactions between agriculture and nonagricultural sectors which typically magnify the costs of a given policy compared with a PE equivalent (de Janvry and Sadoulet, 1987; Hertel, 1992). Indeed, in some cases, PE and CGE can produce contradictory results for the same scenario.31 It is widely agreed that to identify the detail of economy-wide relationships, CGE models are a clear advance on partial equilibrium. However, this advantage does come at the cost of a degree of preconditioning of the model results by parameterising (e.g. ‘borrowing’ elasticity values from the literature) or calibrating behavioural parameters to the existing data set. Thus, it is more difficult to know whether the results are a reflection of reality or symptomatic of model structure. Nevertheless, such an extension is entirely necessary if the modeller wishes to better approximate the full impact of policy changes which go beyond the ‘first-round’ effects of partial equilibrium studies. Earlier empirical estimates of CAP costs There are several review papers offering good coverage on estimates of the opportunity costs of the CAP throughout the 1970s and 1980s.32 Table 2.2 presents estimates of the deadweight costs of the policy compared with an alternative of CAP abolition, as a percentage of real GDP foregone.33 All of the PE studies are multisector and have a broad level of CAP commodity coverage. A cursory glance at Table 2.2 reveals that there is a significant margin of error in terms of the magnitudes of the results which vary from 0.27 to 2.7 per cent of GDP. This is largely because data discrepancies occur in terms of the choice of reference years employed, commodity coverage varies and differences exist between model structures (i.e. PE vs GE). It is therefore difficult to draw comparisons or conclusions, although it is clear that the larger estimates are given by CGE models which capture the multiplier effects of inter-sectoral relationships within the broader economy, although as Atkin (1993) notes, even the smallest estimate (0.3 per cent of GDP) is not an insignificant cost. Recent empirical estimates of CAP costs Developments With evolutionary developments in both the structure of EU agricultural support (post-MacSharry) and advances in computational facility, there have been several important changes in the empirical literature. First, emphasis was no longer placed on abolition of CAP support, but rather on reform and compatibility with GATT requirements (Blake et al.,

CAP: Evolution and Economic Costs 29 Table 2.2 the CAP

Estimates throughout the 1980s of the deadweight costs of

Source

Countries

Model structure

% of GDP

Morris (1980) Harvey and Thomson (1981) Buckwell et al. (1982) Tyers (1985) Roberts (1985) Spencer (1985) Burniaux et al. (1985) Tyers et al. (1987) Stoeckel and Breckling (1989)

EC(9) EC(9)

PE PE

0.50 0.50

EC(9) EC(9) EC(10) EC(9) EC(9) EC(12) EC(4)*

PE PE PE GE GE PE GE

0.50 1.10 0.30 0.90 2.70 0.27 1.50

Note: * This application models the four biggest economies of the EU (Federal Republic of Germany, France, Italy and the UK) which account for 86 per cent of total EU(10) GDP.

1998; Weyerbrock, 1998; Van Meijl et al., 2002). Second, model structures have evolved radically to better characterise the intricacies of the CAP support mechanisms. Throughout the 1980s, policy modellers (in particular CGE studies) contented themselves by approximating CAP protection, insulation and distortionary effects through exogenous ad valorem tariff/subsidy equivalents. More recent studies (Blake et al., 1998; Weyerbrock, 1998; EC, 2000a) of the CAP have sought to provide a more detailed coverage of agricultural sectors, by introducing explicit characterisations of CAP support instruments (e.g. milk quotas, set aside, direct payments, CAP budget). Third, in an attempt to more realistically quantify the impact of CAP reform/removal, some comparative static studies (Blake et al., 1998; Philippidis et al., 2001) employ projections on key macro variables (e.g. growth, productivity, factor endowments, population change), whilst the EC (2000) has undertaken an evaluation of the Agenda 2000 package employing dynamic PE and CGE treatments, where year on year reforms are modelled as a gradual process of adjustment over a series of interdependent time periods. Finally, an additional feature is to incorporate modern trade theories pertaining to scale economies and imperfect competition (IC). Thus, these studies not only characterise the standard efficiency gains of resource reallocations from perfectly competitive agricultural sectors post CAP reform, but also welfare effects emanating from economies of

30 Current Economic Issues in EU Integration

scale (Blake et al., 1998)34 and utility effects associated with available food variety (Philippidis et al., 2001) as protected agricultural markets are opened up to global competition. Typically, these CGE model structures provide larger welfare estimates from agricultural liberalisation. Table 2.3 presents a range of recent estimates based on CAP abolition/reform in a comparable form (percentage of GDP). Discussion Using a partial equilibrium approach, the European Commission (1994) measured the economic inefficiency of CAP abolition at just over 13.7 billion ecus, or approximately 0.22 per cent of EU GDP. Using a CGE model, Hubbard (1995a) predicted larger EU welfare gains from CAP abolition of 0.8 per cent of GDP, which are comparable to earlier estimates of EU gains in the region of 0.5 per cent. Furthermore, conducting sensitivity analysis, Hubbard (1995b) revealed that quadrupling the trade elasticities between imperfectly substitutable imported and domestic goods gave EU resource gains of between 0.14 and 1.30 per cent of EU GDP. Folmer et al. (1995) looked at the effects on the EU(9) of a ‘reform’ scenario characterised by the elimination of all agricultural production, consumer and input subsidies, with compensatory lump sum transfers for the reduction in production and export subsidies, the removal of set-aside and the relaxation of sugar and milk quotas.35 The reported resource cost estimate of 0.3 per cent of EU GDP is lower than most estimates since CAP reform is only partial (i.e. not complete abolition). Interestingly, the authors estimate the MacSharry proposals to be broadly compatible with the Uruguay Round commitments, whilst predicting the need for further reductions in import tariffs. Blake et al. (1998) also studied a partial reform scenario of the 1992 CAP reforms and the Uruguay Round Agriculture Agreement (URAA) compared with status quo CAP support. The authors predicted a welfare gain to the EU of 0.42 per cent of EU GDP. This impact is dampened by the inclusion of farm-specific factors36 and endogenous export subsidy behaviour, where a 36 per cent reduction in export expenditure under the URAA requires less than a 36 per cent reduction in the subsidy rate (as is applied in many other studies). Interestingly, the introduction of imperfect competition into the food processing sectors increases welfare gains by between 0.44–0.53 per cent of EU GDP depending on the number of firms specified in the benchmark.37 Weyerbrock (1998) focused on the impacts of the 1992 CAP reforms and their compatibility with the URAA. The main findings are that CAP

Table 2.3

Recent estimates of the deadweight costs of CAP reform

Source

Model structure

Market structure

Countries

CAP policy instruments

Projections

% of GDP

Commission (1994) Hubbard (1995a) Hubbard (1995b) Folmer et al. (1995) Blake et al. (1998)2

PE CGE CGE CGE CGE CGE CGE CGE CGE Macro-econ. CGE

PC PC PC PC PC IC PC PC PC IC PC

EU(9) EU(12) EU(12) EU(9) EU(12)

N N N Y Y

N N N N N

EU(12)

Y

Y

EU(15) EU(15)

Y Y

Y Y

0.22 0.80 0.14–1.3 0.301 0.42 0.44–0.533 0.204 0.405 0.106 0.127 0.058

Weyerbrock (1998)

EC (2000) Philippidis and Hubbard (2003)

Notes 1 This estimate is based on the MacSharry CAP reform. 2 CAP reform including the full Uruguay Round reform package. 3 This study employs a Cournot oligopolistic model structure (see Harrison et al., 1995a for further detail). 4 1992 CAP reform only. 5 1992 CAP and GATT reform plus further reductions in intervention prices for sugar and dairy to meet GATT requirements. 6 1992 CAP and GATT reform plus quantity controls required to meet GATT targets. 7 Agenda 2000 reform. 8 Agenda 2000 reform including full implementation of the URAA.

31

32 Current Economic Issues in EU Integration

reform alone results in a 0.2 per cent increase in EU GDP in the long run compared with a status quo baseline. Contrary to Folmer et al. (1995), Weyerbrock (1998) predicted that CAP reforms do not meet many of the GATT commitments over the longer term. Although domestic support targets are met, import rules and export competition criteria in the sugar and dairy sectors are violated under the 1992 reforms. Moreover, the CAP budget is increased by 32 per cent as expenditure on headage premia, compensation payments and structural programmes exceed savings on export and oilseed subsidy payments. Based on this evidence, two further CAP reform scenarios are considered comparing the relative merits of price support and supply management. The first scenario evaluates the welfare implications of additional reductions in intervention prices and elimination of intervention buying of dairy and sugar to meet URAA requirements. The second scenario represents a further tightening in cereal set-aside and dairy/sugar production quotas to meet GATT restrictions. The results show respective long run gains of 0.4 and 0.1 per cent of real EU GDP. Weyerbrock concludes by confirming that price reductions are more efficient at curbing budgetary problems compared to quantity controls, since in the former scenario, dairy and sugar farmers are not compensated for intervention price reductions, whereas in the latter scenario, extra compensation must be paid on further cuts in land areas.38 An evaluation of the Agenda 2000 reforms is reported at the ‘aggregate’ EU level by the European Commission (2000) and Van Meijl et al. (2002), and at the member state level by Philippidis et al. (2003). To measure the economic cost at the aggregate level, the European Commission (2000) study employs a macro-econometric multi-country business cycle and growth model.39 Under the most optimistic case scenario that the reduction in consumer prices from the Agenda 2000 reform is passed on as wage reductions, model estimates predict that compared to status quo levels of CAP protection, GDP growth is likely to be 0.12 per cent higher in 2005, with a rise of up to 0.25 per cent GDP by 2030. Van Meijl et al. (2002), examine the impacts of the Agenda 2000 reforms on URAA export expenditure and volume limits. All CAP mechanisms are explicitly modelled (set-aside, compensation payments as input subsidies, milk quota) and the study also employs a novel price transmission mechanism to represent intervention price changes. The results suggest that export subsidy expenditure commitments are breached for a number of processed food products, although model outcomes are largely a function of the strength of world markets.

CAP: Evolution and Economic Costs 33

In Philippidis et al. (2003), a comparative static CGE model is employed to estimate the impact of Agenda 2000 reforms for each of the 15 members of the current EU. In calculating the policy shocks for the Agenda 2000 reforms, the study also incorporates country-specific data on agricultural support (e.g. sectoral expenditure limits, national envelopes and quota allocation rights) and export subsidy/volume commitments under the Uruguay round. As expected, a mild evolution of CAP policy reveals a small net gain of 0.05 per cent EU(15) GDP (€2.082 billion),40 although the gains to each member vary considerably.41 This result is broadly comparable to that of the European Commission (2000). Finally, the European Commission (2003) examine the impacts of the MTR compared with an Agenda 2000 reform scenario baseline. Given further slight reductions (increases) in intervention prices (compensation) cereals production is projected to fall 2 per cent with increased uptake of voluntary set aside. Similarly, it is suggested that the extensification of beef production through decoupling will reduce output by around 3 per cent, whilst increases in milk quota will increase production. Compared to Agenda 2000, reduced supply in cereals and beef is projected to push up respective producer prices, which in the case of the latter, will lead to greater competitiveness in white meat sectors (pork and poultry). The study predicts that by 2009, the loss in consumer surplus to the EU(15) from increases in producer prices will be offset by budgetary savings from dynamic modulation under the MTR package,42 whilst farm income is projected to increase slightly as producer price increases and falls as intermediate input costs offset premium payment reductions.

Conclusion The evolutionary path of the CAP has sparked considerable debate amongst politicians and stimulated a burgeoning of research papers quantitatively assessing the effects of CAP reform/abolition on producers, consumers, taxpayers as well as trade protection and distortion effects. Accordingly, the aim of the chapter was to provide commentary on the main problems that CAP policy makers have faced over the last 25 years whilst highlighting the relationship between political considerations and pragmatic economic rationale. In the latter part of the chapter, a parallel review of the relevant empirical trade-policy literature is also provided. The main result is that the literature unanimously supports the theoretical analysis in Part IV, that CAP reform/abolition bestows welfare gains to the EU.

34 Current Economic Issues in EU Integration

Studies in the 1980s place estimates between 0.27–2.7 per cent of EU GDP, although later estimates (Blake et al., 1998; Weyerbrock, 1998; European Commission, 2000; Philippidis et al., 2003) cluster towards a smaller range of gains. First, this is because the focus is on measuring CAP reform vis-à-vis abolition. Second, support is no longer characterised as direct (i.e. output subsidies), but has moved in tandem with developments in agricultural policy through representation of de-coupled cross-compliance (e.g. area payments, headage payments) either as lump sum transfers (Folmer et al., 1995; Weyerbrock, 1998) or input subsidies (Blake et al., 1998). Accordingly, reform, or removal of these mechanisms is likely to have less of an impact on resource reallocation estimates. Finally, the incorporation of factor specificity dampens the supply response of agriculture to changes in the level of support, resulting in smaller estimates of welfare gains from liberalisation scenarios.43 However, despite such a wealth of estimates, it must be recognised that there is still considerable debate on what the ‘true’ estimate is. Comparing between models is, at best, problematic where the scope of model structures (e.g. elasticities, factor mobilities), data sets, commodity coverage and aggregation all have far-reaching implications on welfare results.44 Appropriately, it makes better sense to interpret CAP costs within a range of model estimates. Moreover, the estimates have nothing to say about the distribution of welfare gains to economic agents, where considerable income disparities still exist amongst Europe’s farmers and consumers. In tandem with initial steps under the auspices of the MTR to alleviate the problem through de-coupling and dynamic modulation, this would also appear to be one of the key priorities for further research in the coming years.

3 Competition Policy in the Single European Market

Introduction This chapter examines different aspects of EU Competition Policy and begins by analysing the economic debate and case for pro-competition policy setting this within the context of the Single European Market (SEM). The development of EU policy is outlined in relation to restrictive practices and monopolies, with particular emphasis on the recent development of stronger powers relating to mergers and state aids. Also, there is a case study focus on the undesirable impact of the block exemption of motor vehicle distribution and servicing agreement and its recent expiry which should result in more effective choice for consumers. It will be shown that a pro-competition policy is most efficient in relation to eradicating restrictive practices and that in the case of monopoly, mergers and state aids the balance of policy is also tilted against these practices. Competition policy is of great importance to the European Union (EU) and is of interest to lawyers and particularly economists. Competition policy has been a preoccupation of microeconomists for a long time and a strong policy stance is favoured because it is conducive to an optimal allocation of resources and efficiency. In the past it would have been referred to more as anti-monopoly policy instead of the current term competition policy which is mainly used here.

The single European market The creation of a customs union with free trade between EU member states reduced prices and improved consumer choice. However by the mid-1980s it was recognised that an SEM did not really exist because 35

36 Current Economic Issues in Integration

of continuing Non-Tariff Barriers (NTBs). There were continuing administrative barriers to trade, plus different national standards and major obstacles to public procurement. In addition, the rapidly growing service sector faced major obstacles to cross-border trade. Economic analysis for the Commission based on business surveys, consultancy reports and mainly in-depth partial equilibrium analysis for different sectors estimated significant gains in economic welfare for consumers and producers (Cecchini, 1988; Emerson, 1988). Whilst producers would benefit from economies of scale and reduced X-inefficiency, competition would depress profit levels and the main benefits would be reaped by consumers. Further estimates of consumer benefits were made by examining the extent to which prices would converge either to an average level or to the level of the lowest price prevailing. Ex-post the EU has become a much more competitive market with significant price reductions in transport services such as airlines (partly assisted by privatisation and deregulation) and in financial services. However, some continuing national differences and restraints in implementing policy mean that the huge gains which were mainly to arise from competition can only emerge when complemented also by an effective competition policy. This is necessary to ensure that firms do not grow excessively by mergers in concentrated markets and that supplies are not restricted into segmented markets, and that national governments do not engage in domestic subsidies for their own producers.

Arguments for a strong competition policy Historically, economists have taken the view since the days of Adam Smith that monopolists represent a conspiracy against the public. They abuse their power by exploiting the consumer, with prices being higher and output lower than in a perfectly competitive market. In the latter, firms charge prices which are equal to marginal cost and in the long run can make only normal profits. By contrast, monopolists are able to charge prices above marginal (incremental) costs; also, they are able to enjoy supernormal profits which persist from the short run into the long run. In addition, monopolists, unlike firms in perfect competition, are able to engage in price discrimination, charging consumers different prices for the same product. By separating their markets, they can charge higher prices in those parts of the market where demand is more inelastic. Therefore, in terms of static analysis (ignoring changes which may occur over time), monopolists have been condemned for their allocative inefficiency.

Competition Policy in the SEM 37

The long established structure–conduct–performance paradigm has provided a clear link from a concentrated industrial structure to undesirable conduct and exploitative performance. This is the basic policy framework which is used, even though it has become increasingly criticised in recent years. For example, there may be a partly reversed sequence in the linkage in which conduct, such as advertising, may affect structure by raising entry barriers. Also theory and policy have been modified partially by criticism from the Chicago School which believes that competition can overcome many barriers to entry. There is also alternative focus on achieving contestable markets with emphasis on the need for free entry and exit (with no sunk costs). The result is then the same as in a competitive outcome, even with few firms in the industry. The reality unfortunately is that perfect contestability is unusual since there are sunk costs in most industries and with imperfectly contestable markets competition policy is still necessary. Nevertheless the new approach of contestability has been applied to several sectors and the provision of sunk facilities such as by a public authority has facilitated entry. The increased competition in the airline industry is a good example of this enabling a more lenient competition policy to be applied. While restrictive practices are more clearly undesirable since they offer no economies of scale, when one examines monopoly in terms of dynamic analysis (with long-run growth over time) the assessment is ambivalent. This is because there are two main benefits which can be derived by monopolists. The first is that they are able, through their size, to enjoy the benefits from economies of scale. This means the average and marginal cost curve of the monopolist is likely to be lower than that of the smaller supplier in a competitive market. Internal economies of scale apply to both larger plants and firms, with the range of economies varying between different industries – these are particularly high in industries such as aerospace, chemicals, the motor industry and so on. Second, it has been argued that large firms are able to spend more on research and development (R&D) and that their propensity to innovate is therefore greater. Hence competition is not just about price competition but also other important dimensions such as the ability to develop new products through innovation. These are the source of creative destruction by which only the fittest and healthiest firms survive through innovatory change and cost cutting. A critical assessment of these potential benefits indicates that economies of scale and R&D are of growing importance in many industries. However, they do not automatically swing the balance in favour of

38 Current Economic Issues in Integration

monopolists. This is because, though economies of scale may create lower costs per unit of production, the benefits are unlikely to be passed on to the consumer in the form of lower prices. Also, any increased productive efficiency may be offset by X-inefficiency or ‘slack’ of managers and workers arising from the lack of competitive pressure. They have greater discretion to maximise their own utility. Further considerations also weigh against monopoly, such as the degree to which there are diseconomies of scale present arising from more difficult managerial control and increasing costs; also the extent to which in some industries technology is favouring small- and medium-size enterprises (SMEs) in sectors such as textiles and engineering. The issue of R&D and innovation needs careful examination. Invention is different from innovation and historically many inventions have come from lone individuals or SMEs rather than larger firms. However, the latter may be the ones better able to finance commercial production and are increasingly important in many industries, such as the chemical and pharmaceutical industries. Monopolies have the resources to finance innovation, but often fail to do so because of the absence of competitive pressures. Hence there is a need to assess the extent to which high profits have arisen from monopoly power or from monopoly high spending on past R&D, and how far high profits are necessary in the future to maintain and reward R&D success. It can be seen, therefore, that economic theory has moved from an automatic and dogmatic condemnation of monopolies on static analytic grounds to a more pragmatic position in terms of dynamic efficiency considerations. Evidence of the welfare losses from monopolies shows that consumers lose consumer surplus and the welfare losses may be up to one-half of monopoly profits. It would appear, therefore, that economic theory does not offer a clear-cut position. While it starts off from a suspicious view of monopoly, it is prepared to assess and evaluate each case on its merits in the EU. In this respect it differs from the more clear-cut anti-trust policy in the US initially from the Sherman Act of 1890 creating a largely judicial system with criminal offences, and whose provisions were extended by subsequent Acts. The US, with its large unified market, has been able to take a stronger line, breaking up monopolies, but still having sufficient producers to reap economies of scale and maintain competition. Despite some softening of policy in the 1980s influenced by the Chicago School, US policy is still much tougher than in the EU or the UK. For example, there are no exemptions in the US on restrictive agreements (unlike the EU and the UK). Meanwhile monopoly policy reflected in predatory

Competition Policy in the SEM 39

pricing and bundling together of products was exemplified in 2000 when Microsoft was condemned for over-exploiting its interlinkages between Windows and its software which made it difficult for other software companies. It was recommended that the company should be broken up into two separate parts. In contrast, each national EU market has been too small to combine effective anti-monopoly measures with the reaping of sufficient economies of scale. This is why the SEM is so important in giving a market size comparable to the US, offering both economies of scale and competitive benefits (although the market is very different in character due to the diversity of history, culture and languages among EU members). It also underpins the growing importance and linkage between EU policies on the SEM, industrial policy and competition policy.

Restrictive practices As with monopoly legislation, so with restrictive practices; national and Community legislation apply with minor differences and in separate situations. In the UK, restrictive practices legislation is again more tightly defined in its legal form, whereas Community restrictive practices policy focuses more on the adverse effects of such restrictions. Article 81 (formerly Article 85) of the EU Treaty covers agreements or concerted practices between two or more enterprises which distort competition and are likely to affect trade between member states. This applies not just to current trade but also to future trade. Also, all firms operating in the Community are affected, whatever their nationality. Agreements may be written, oral or a consequence of a trade association (even including its recommendations), or a loose concerted practice where there is common action such as aligning price changes. Horizontal agreements which are prohibited include price fixing and market or production sharing (e.g. sharing sources of supply, quotas or sales). While cartels may at times offer superficial gains in reducing surplus capacity, they hamper the most efficient businesses and in practice ‘virtually no cartel with significant market power has been exempted’ (Swann, 1988, p. 120). Also prohibited are discriminatory practices; collective boycotts (forcing potential competitors out, or preventing market entry); and agreements which tie the sales of several products together. Other agreements which may pose some problems include joint purchasing agreements; joint selling agreements; sales promotion; exchange of information; trade association/market foreclosure; and non-competition clauses connected with the sale of an undertaking.

40 Current Economic Issues in Integration

Vertical agreements apply at different stages of economic activity, reflecting restraints, for example, between producers and distributors and the EU provisions explicitly cover both horizontal and vertical agreements. Vertical agreements which may adversely affect competition include simple distribution agreements; exclusive distribution agreements; selective purchasing agreements; and selective distribution. Exceptions are made for simple single distribution agreements where the distribution is by the manufacturer itself, a branch office, a local subsidiary or a true agency agreement. Where distribution is improved by exclusive distribution, a group exemption exists, but otherwise exclusive distribution agreements go too far when they have adverse effects on competition, particularly when no parallel imports are possible. Exclusive purchasing agreements occur when a seller is obliged to buy supplies exclusively from a stated manufacturer or other supplier. Group exemption was allowed from January 1984, but the maximum duration of the exclusive purchasing obligation was limited to five years (renewable) and the range of products had to be related to each other. For example, this applied to beer and other drinks, but for beer alone, or for petrol, the maximum duration of the exclusive tie was ten years (and for long tenancy agreements may be even longer). The tie does not extend to products other than petroleum-based motor vehicle fuels and lubricants or beer and other drinks (so does not extend to crisps, fruit machines and other such specified items). Selective distribution ensures that many products are sold by selected and appropriate technically qualified dealers. Hence in the motor industry a block exemption applied. However, concern about excessively high car prices in some national markets as a result of firms partitioning the market has led to firmer EU policy, which is covered in the next section as a separate case study. Franchising similarly has a block exemption since it offers positive benefits in improving distribution by accelerating the entry of new competitors. Industrial property rights cover patents, copyrights, trademarks, performing rights, registered designs and models. Group exemptions exist to recognise the beneficial effects of patents. However, industrial property rights have to be consistent with the free movement of goods across the national boundaries of the EU. Where restrictive practices exist, such as those described in this section, the parties have had to notify them to the Commission. The Commission may decide that some of these are safe and can be allowed to continue through negative clearance. Also, agreements of minor importance covering SMEs are normally permitted (under the

Competition Policy in the SEM 41

de minimis rule); for example, where they cover less than 5 per cent of market share and have a low financial turnover (Commission, 1989a, p. 16). Other exemptions exist in relation to particular co-operation agreements and R&D and where the participants have a combined market share of 25 per cent or less, exemption is granted for R&D and distribution for a minimum of seven years. Various agreements are allowed if the harmful effects of a restrictive agreement are offset by benefits such as improved production or distribution of goods, or promotion of technical and economic progress, and a fair share of the benefits go to consumers. Exemptions may be granted on an individual or a group basis; for example, in January 2000 the Commission approved an interesting exemption for washing machine producers to stop producing and importing the least energy-efficient machines on environmental grounds. This also offered consumer benefits by reducing electricity bills (Competition Policy Newsletter, 2000, pp. 13–14). Where companies are in doubt about the adverse effects of restrictive practices, particularly on trade, they are best advised to notify the Commission, otherwise they are liable to fines. Notification to the Commission is done on the official form and the information submitted should be accurate, since otherwise fines may be imposed. The Commission also obtains information from other sources, such as complaints from member states, companies and trade associations. The Commission is obliged to examine all formal complaints. It also has the power to carry out enquiries on its own initiative. It may make written requests for information, with daily fines for failure to respond and larger fines for incorrect or incomplete information. The Commission can also conduct its own investigations, sending in its own officials, sometimes unannounced, to prevent firms having forewarning and giving them the possibility to destroy incriminating evidence; for example, the raid on AstraZeneca in May 2000 to examine its activities in a particular patented drug. The Commission is responsible for enforcing competition policy, backed up by the European Court of Justice. The outcomes are either negative clearance, exemptions or decisions which order the termination of restrictive practices. The cases are presented in the Official Journal in order that interested parties can react; also, there is consultation with member state authorities who meet in the Advisory Committee on Restrictive Practices and Dominant Positions. When the Commission seeks to terminate an infringement, the parties involved are informed and given time to respond; they can also request an oral hearing organised by the DG for Competition and conducted by the

42 Current Economic Issues in Integration

Hearing Officer. The Commission has the power to impose fines of up to €1 million or 10 per cent of the world annual turnover of the undertaking in the previous business year (whichever of the two is greater). The fines are heaviest and most punitive where the restrictive practices have existed for a long time and are similar to those which have been clamped down upon in the past under Commission case law. Since Commission action may be lengthy in complex cases, interim measures are taken immediately to stamp out objectionable behaviour. The majority of cases are concluded by an informal settlement in which the undertakings sweep away the restrictive practices. The European Court of Justice has the power to review and vary all formal decisions of the Commission and to confirm, reduce, cancel or increase the Commission’s fines and penalty payments. Proposed reforms by the Commission have included abolition of the notification and authorisation system for restrictive practices, leaving it to undertakings themselves to decide whether their agreements comply with the ban on restrictive practices. This could create more uncertainty, but provide the national authorities and the Courts with a greater role to play in the application of competition rules, especially in the case of disputes. The entire application of EU competition law changed according to the adopted Regulation 01/2003. Current EU competition policy has been to take a strong line against cartels. Despite the pressure on the relatively small staff of 600 in the Commission’s competition division, the offensive against cartels included in a recent year fines of almost €2 billion and even included raids on business executive’s homes. In 2003 its authority was challenged by the European Court of Justice’s annulment of the large fine on the Trans-Atlantic Conference Agreement (TACA) between container shipping lines who were operating a price-fixing cartel. These conference agreements have long been used to stabilise rates and TACA notified its restriction in 1986 to the Commission. The Court decided that the companies had not had full opportunity to comment on the Commission’s interpretation and that the TACA had induced only 2 new competitors to join the agreement since 1994. While the annulment of the large fine may provide some temporary comfort to shipowners, the Commission is still determined in future to eliminate the conference system and to only allow agreements as long as the operators are not dominant on particular routes. EU competition policy in focusing on cartels has had most success in intermediate goods, with some beneficial effects of incentives for whistle blowing; but there has been less success with consumer products, despite attempts to focus more on these. For example, probes

Competition Policy in the SEM 43

into compact disc prices and mobile telephone cross-border charges have made slow progress.

A case study of the car industry The need for further tightening of EU competition policy was reinforced by continuing differences in car prices between member states. This has been shown by the European Commission which publishes a twice yearly report on car prices, and by the Competition Commission in the UK which finally condemned the practices of the car industry. The best measure is to compare list prices for standard models, making adjustments for national differences, for example, right-hand drive (RHD) models in the UK and a preference for sunroofs. Clearly the RHD adds a significant cost for non-UK producers. Generally, consumers in the UK have tended to pay more for extras which are often standard in other countries. List prices have tended to be higher in the UK than in other EU markets. Suppliers have used price discrimination, setting higher prices in separate markets such as the UK. They tend to set lower prices in other countries in which on the road costs (such as taxes) are higher. Thus on list prices the UK is expensive, but on the road prices are far higher in countries such as Denmark. Note that the transaction price, which is negotiated, depends on bargaining and part exchange and a discount against the list price. Both the SEM and Economic and Monetary Union (EMU) should have narrowed the difference in car prices far more quickly, and in the case of the UK the pound still fluctuates against continental currencies, but a high value of sterling should have reduced the cost of car imports. The best explanation for continued price difference is one of anti-competitive behaviour by oligopolists who have been able to engage in price discrimination to exploit consumers. Nearly three quarters of the EU car market has been supplied by six manufacturers. High entry barriers because of economies of scale and advertising to build brands, have led to a clear link to adverse conduct and performance. Producers have raised prices, especially in the UK, to make excessive profits at the expense of consumers. For example, the EU imposed its largest fine ever on a single company, Volkswagen, of €102 million in 1998 since the company’s dealers in Italy refused to sell Volkswagen and Audi cars to foreign buyers, especially from Germany and Austria. The level of fine reflects the severity of the infringement, past action and the degree to which the company has been unco-operative.

44 Current Economic Issues in Integration

A block exemption was created for motor distribution and service agreements which provided after 1984 a legal framework for restrictive arrangements between the manufacturers and the dealers. This existed because of the specialised after-sales service of complex and potentially dangerous vehicles. This expired in 1995 but was subsequently renewed for a further seven years. Increasing pressure has been brought to bear by the European Commission which has finally ended this restrictive agreement nationally from 1 October 2003, whereby from 2005 dealers can establish in any EU state. In future dealers will be able to select whether to have an exclusive or a selective sales network. In the former there is continuing sole distribution by a single dealer, but restrictions on resale, such as to supermarkets or the grey market, are inapplicable. It was assumed that the selective dealership would be most popular and the dealers will be able to sell outside their catchment area, such as over the internet. It will be possible to have multi-brand distribution by a single dealer with different brands exhibited in different parts of the showroom. This will significantly improve choice for consumers, though many small dealers will disappear replaced by large dealer groups. In addition, dealers will no longer be forced to offer guarantee and maintenance services but can subcontract these to specialist maintenance companies. When repair companies meet the appropriate standards, they can repair more than one make of car and will have to be provided with appropriate access to all the technical information needed to achieve this (Kangaroo Group Newsletter, 2002). The effect of the new changes will significantly benefit the dealers, reducing the power of control of the manufacturers whose profits on sales of parts and accessories will fall as parts can be purchased from other sources. Nevertheless, it would be unfortunate if massive dealer groups, with some owned by car manufacturers, eventually reduced the degree of price competitiveness. For example, though the consumer may think that a dealer is different because it still trades under a different name, the reality is that showrooms owned by the same dealer tend to quote the same prices since they see little to be gained by competing against each other. As the independent dealers diminish, the analogy appears of food retailing dominated by supermarkets, with the erosion of the small local dealer.

Monopoly power and its abuse Monopolies, in economic theory, are defined as single firms which dominate markets. However, the reality is that in practice most markets

Competition Policy in the SEM 45

are not dominated 100 per cent by a single firm. In other words, there are usually many markets which are oligopolistic, with a few large firms (or, in the case of a duopoly, two firms) dominating the market. Furthermore, oligopolies can choose either to collude or to compete, with the former being most likely to occur where there are fewer firms and product homogeneity. Where there is completely free entry and exit from an industry, this is defined as perfectly contestable. The basic approach and starting point from which to view the relative power of monopolies is that of market dominance. The more narrowly the market is defined, the greater is the degree of monopoly power; for example, on a regional or a national market compared with the whole Community market (which has grown enormously from the original 6–25 member states from 2004). Hence the monopoly problem is a lesser one within the Community market than within any national market. Market share depends upon just how few firms are chosen and a five firm concentration ratio for sales turnover in the EU shows that this has fallen in spite of mergers, from 24.5 per cent in 1987 to 23.9 per cent in 1993 and 22.8 per cent in 1997 (Commission, 2002, p. 128). The most concentrated industries include aerospace, motor vehicles, and computers/office equipment, and concentration has fallen mostly in highly concentrated industries; for example, motor vehicles from 55 per cent in 1987 to 49 per cent in 1997. However, this structural indicator can provide only a guide to policy makers since in these sectors economies of scale are high and the Community needs firms of sufficient size in these key sectors to compete with those in the US and Japan; also note that the Community market itself is dominated by foreign multinationals in some sectors, such as IBM in electronics. The share of the largest firms in total sales of manufacturing industry in the EU, compared with the US and Japan, is quite closely comparable with Japan, while both have less concentration of manufacturing share by the largest companies than the US. Market shares held by the largest firms, through the use of concentration ratios, are mainly used because of the availability of data and easy understanding. However, one has to recognise statistical limitations and that the dominant firms may change over time and be affected by imports; for example, there was some change in the membership in the top five firms (1987–97) in all EU industries, except glass, bread and biscuits, and alcohol (Commission, 2002, p. 133). Note also that the Herfindahl Index (H) is often considered to be more revealing since it reflects the distribution of the market shares of all firms. To obtain the index as a whole number, the squares of the market shares

46 Current Economic Issues in Integration

expressed as fractions are multiplied by 10 000. In the case of a monopoly with one firm holding 100 per cent of the market, H
10 000. Where the industry is composed of n firms of equal size, H
10 000/n. While industrial concentration provides an important guide to monopoly policy, it is also necessary to go beyond this to include conduct and performance in assessing the situation. UK national policy starts from a clear structural definition of a dominant firm, which accounts for 25 per cent or more of the market. National and Community policies are separate, with the latter being used where intra-Community trade is likely to be adversely affected. Some of the original articles of the Treaty of Rome are well known, such as Article 85 on restrictive practices and Article 86 on abuse of a dominant position. These articles have subsequently been renumbered in the Treaty of Amsterdam with the former now being Article 81 and the latter being Article 82. Other articles, such as Articles 86, 87 and 88 relate more to state aids. Under Article 82 (formerly Article 86) of the EEC Treaty the undertaking must be in the dominant position (usually meaning having more than 40 per cent of the market share), but the focus is far more upon the abuse of this position. Concern about dominant firm abuse goes back to the days of the European Coal and Steel Community (ECSC), when France was concerned about any renewed concentration in the German coal and steel industries. Article 82 of the Treaty has tackled different kinds of abuse by dominant firms. Adverse effects include charging unfair prices, not just high prices which exploit consumers, but also excessively low predatory prices to drive out competitors. Dominant firms which have been examined and acted against include manufacturers such as Commercial Solvents, which controlled materials and refused to supply them freely to other firms and Hoffmann-La Roche, which dominated the market for vitamins, charging different prices in various markets and also giving fidelity rebates which were aggregated across all products.

Merger policy Mergers are driven by increasing the value of two businesses, whereby one plus one increases beyond the mathematical value of two. Growth by acquisition is quicker than internal growth, offering immediate and less risky entry into a new product market. A full legal merger fuses the assets and liabilities of two or more companies into a single new or existing company. In the EU widespread legal obstacles have existed to this, with the most common type of merger involving a takeover of one

Competition Policy in the SEM 47

company by another, but with both companies continuing to exist as legal entities. Another loose link which falls well short of a legal merger includes a joint venture, where companies agree to co-operate together on a particular project. Mergers between firms may occur at different levels in the chain of production. While horizontal integration takes place between businesses at the same level of production, vertical integration may develop either backwards to sources of supply or forwards into the marketplace. The other type of merger to mention is the forming of a conglomerate, which brings together businesses to produce a disparate range of products, but in which a merger offers financial benefits. Stock markets can play a significant role in encouraging mergers when a company’s share price drops to such an extent that it becomes vulnerable to a takeover bid. This possibility serves as a spur to maintain company efficiency. It might be argued that mergers offer significant potential benefits to companies. These include better management, reduced transaction costs, rationalisation and the opportunities to exploit greater economies of scale. Furthermore, one of the main aims of the SEM is to allow Community companies to reorganise their operations to compete more effectively. However, the results of many mergers in the past have been disappointing. The mergers contributed little to increased profitability or sales and did not lead to lower prices for consumers. The latter point is of particular importance since it suggests that a significant adverse cost was the reinforcement of monopoly power (Commission, 1989b). Since mergers have increased in number, it is important to examine them closely, looking at sources of mergers and sizes of companies involved. While most mergers have been national ones, there has been an increasing and continuing trend in merger activity involving different EU countries, and also EU and non-EU countries combined. For example, historically the majority of mergers were national, but globalisation has led to more cross-border mergers. Mergers can involve companies of all sizes, but there has been a rapid growth of mergers between very large companies which provide a greater threat to competition than mergers between SMEs. Once other competition policies were in place, firms sought to find a loophole through mergers. Hence it became necessary to complete the fence around companies by scrutinising mergers. As mergers may result in a mix of both costs and benefits, it is necessary for policy makers to have some guidance about the sectors in which mergers may be beneficial or not. Horizontal mergers need to be scrutinized very closely and particularly in sectors which tend to be mature or declining and in

48 Current Economic Issues in Integration

which there is limited competition from imports. There is no problem in allowing mergers which raise efficiency without reducing competition, nor in banning mergers which offer no efficiency gains and reduce competition, but generally the EU lacks the efficiency defence criterion used by policy makers in the US and Canada. More careful and delicate assessment is necessary when mergers result in efficiency gains but do reduce competition. Mergers will be more tolerable when one has contestable markets in which there is complete freedom of entry and exit into the market. The Community’s policy on mergers was initially weak: it was only invoked where it was involved under Articles 85 and 86 of the Treaty of Rome on restrictive practices and abuse of an already dominant position. With a spate of mergers sparked off by the SEM programme, a European Merger Control Regulation was introduced in 1990. The Community investigates and controls mergers above a given sales turnover threshold. This measure is used since turnover figures are readily available and provide legal certainty about when the merger regulation will be applied. The Merger Task Force for DG IV has examined mergers with a Community dimension where the following two turnover thresholds have applied: 1. An aggregate worldwide turnover of all those involved in excess of €5 billion. 2. An aggregate Community turnover for at least two of the firms involved of over €250 million. Note that when each of the firms involved has two-thirds of its turnover within one member state the merger regulation does not apply. A stronger Commission role in controlling mergers would emerge if the turnover thresholds were to be lowered further in the future, as was suggested in a Commission Green Paper in 1996. Some would favour this to ensure that countries with few or no merger rules, such as Greece, Denmark and Italy, could be constrained from leniently supporting domestic mergers to create national champions. Mergers that meet the two turnover criteria above have to be notified to the Commission, which then investigates them. The Commission will also examine agreements which lead to an increase in industrial concentration, but with no economic benefits. Such potential mergers are put before the Merger Task Force which, within one month of notification, decides whether to act on the case and, if so, within another four months reaches its final decision. Despite the theoretical

Competition Policy in the SEM 49

independence of the Commission, some see it as being open to national political pressures; for example, the merger in 1988 between two Dutch coffee companies, Douwe Egbert and Van Nelle, created a near monopoly in the Benelux market. Some favoured a completely independent agency, modelled perhaps on the German Kartellamt. Some exceptions to the merger thresholds were permissible to reflect different national interests. For example, Germany was concerned that the EU might weaken its own strong merger policy and pressed for its own national merger authority to consider special cases. Similarly the French pressed for the Commission to consider gains from mergers as part of industrial policy. The UK pressed for provision to permit national intervention to protect the media and public security. Finally the Dutch clause allowed a member state to ask the Commission to investigate a particular merger even if it did not reach the turnover criteria (Utton, 2003, p. 193). The majority of the mergers dealt with have been allowed to proceed and of some 140 merger proposals up to the end of March 1993 only 11 resulted in serious doubts. In those where problems existed, conditions were imposed before allowing the mergers to occur. In one key industry, aerospace, there have been two interesting cases. In that of helicopters, the merger between Aérospatiale and Messerschmitt-Bölkow-Blohm was approved because sufficient competition existed to prevent a dominant position from arising. However, in the case of turbo-prop aircraft, the proposed merger between Aérospatiale, Alenia, and De Havilland was prohibited in a controversial decision since it would have resulted in the firm having a dominant position controlling well over half the world market. The Commission in Phase I gets a formal undertaking from the companies, hence reducing the number of more detailed Phase II investigations. In 1998 there were nine Phase II cases decided (Commission, 1999a, p. 212). Five involved clearances subject to formal undertakings, while three were approved without undertakings. The reasons for these being approved were interesting, concluding in the case of accountancy firms Price Waterhouse and Coopers & Lybrand, that there was no risk of a dominant position following the abandonment of a proposed merger between KPMG and Ernst & Young. The case of Enso/Stora in newsprint in Scandinavia was cleared because there was some countervailing buyer-power from big firms such as Tetra Pak. In the third case of ITS/Signode Titon the Commission approved it in spite of the high share of steel strappings because there was competition from plastic strappings. New technology featured in the single important prohibition of the proposed Bertelsmann-Kirch-Premiere and Deutsche

50 Current Economic Issues in Integration

Telecom/ Betaresearch mergers. The Commission was determined to avoid the creation or strengthening of dominant positions in digital television services. European Commission decisions have sometimes been challenged and the EU has been given the most marks for this aspect of its policy on democratic grounds (Zweifel, 2003). By comparison the Commission’s independence received the lowest rating because it has not delegated merger control to a separate independent agency. In recent years three mergers have been overturned by the European Court of Justice including Schneider and Legrand; Tetra Laval and Sidel; and Airtours and First Choice. Airtours (later My Travel) in 2001–02 appealed to the European Court to overturn a ruling to stop the company from taking over First Choice. Airtours argued successfully that its dominance in the holiday package market was exaggerated since there was competition between different destinations and profit margins were thin. The Commission decision was only the second of its kind based on collective dominance. The Court of First Instance ruled that the original judgment was wrong and this led My Travel to seek damages and compensation from the Commission for lost profits, lost synergy benefits and bid costs. The EU has sometimes been involved in mergers which have occurred outside the EU, such as the acquisition of MacDonnell Douglas by Boeing since this would further strengthen Boeing and adversely affect Airbus. An agreement was reached to permit the merger, subject to MacDonnell remaining a separate legal entity for ten years and giving regular information to the EU. The EU also challenged General Electrics takeover of Honeywell, the American electronics business, and GE also appealed against the Commission’s ruling.

State aids State aids cover any actions by any nation-state body which distort or threaten to distort competition by favouring certain national undertakings and adversely affecting trade with other nations. They are defined by the European Court of Justice as applying when firms would not be able to obtain the finance from private capital markets, or if they could do so, on less favourable terms. There is a wide range of state aids going beyond government grants, cheap loans, and interest subsidies, such as tax concessions, public guarantees of company borrowing, provision of goods and services on preferential terms, and, in certain circumstances, the acquisition of public shareholdings in businesses. These are all condemned unless they fall into the limited categories of state aids which

Competition Policy in the SEM 51

are compatible with the development of the common market. The Community makes clear that state aids have to be scrutinised closely where they are specific and offer unfair advantage to certain firms or goods compared with others. In a first best analysis or ideal world, since perfectly competitive markets provide the most efficient allocation of resources, subsidies would reduce economic welfare. However, when assumptions are relaxed to consider external factors, the public good, increasing returns to scale, imperfect information and so on, then it becomes possible to support some case for subsidies. Furthermore, in second best analysis, subsidies may improve welfare if they help to reduce a distortion in another market. Nevertheless, in reaching a balanced judgement on state aids, the general presumption is to rule against them. This is necessary so that the Community can establish and maintain a level playing field to promote trade and fair competition. Also, state aids are often driven not so much by any economic rationale as by the political process of vote seeking by politicians from particular interest groups. Subsidies cover all forms of specific transfers from the governmental sector which directly or indirectly benefit enterprises. The full scale of subsidies in Community countries is uncertain, but in 1994–96 national state aids were estimated at ecu 38 billion a year and ecu 1238 per job was granted to EU(15) manufacturing industry. The number of state aid cases dealt with remains high but peaked in 1993–94. About 20 per cent of cases in 1998 were due to a failure by member states to notify new state aid measures to the Commission. The heaviest state aids were provided by Belgium, Greece, Italy and Luxembourg, which were spending more than 3 per cent of their GDP on these, compared with just under 1 per cent of GDP on state aids in the UK and Denmark. Sectors which benefited most from state aids have included transport, especially the railways, agriculture and fisheries and the coal industry. In manufacturing, many state aids have been given in the steel, shipbuilding, car, electronics and aviation industries. The ECSC and EEC Treaties conferred power on the Commission to control state aids. Article 4 of the ECSC Treaty declared subsidies and state aids to be generally incompatible with the common market. Similarly, Articles 87 and 88 (formerly 92 and 93 of the EEC Treaty) forbid state aids which affect intra-EEC trade and competition. This can be interpreted to extend not just to firms which export, but also to those which are affected by imports in their home market. Member states have to notify the Commission before introducing new aid schemes or altering existing ones. If the Commission decides that a scheme is problematic,

52 Current Economic Issues in Integration

it invites comment from all those affected via the publication of a notice in the Official Journal of the European Communities. If any member state disagrees with the Commission’s conclusion, it has two months in which to demand a judicial review by the European Court of Justice. The Commission can order a member state to recover from the recipient any illegal aid which has been given. The basic principle is that state aids must not distort competition between firms in the Community, but that derogations are permissible in particular limited cases, for example, to promote regional development for Objective 1 regions to which investment aid of up to 75 per cent of net grant equivalent (NGE) of the investment cost may be given. The term NGE is used in order to standardise the different types of assistance given. Other areas are also eligible for state aids. For example, where GDP is 15 per cent below the national average or unemployment at least 10 per cent higher than the national average, then the ceiling is normally up to 30 per cent of NGE (Commission, 1991, pp. 58–9). Apart from regional aid schemes, the Commission has a block exemption for other acceptable types of state aid, such as SMEs, R&D, environmental protection, employment and training. Also, it may adopt a regulation in connection with the de minimis rule. It checks that measures conform, such as R&D, not being too close to the marketplace; or that training measures are general and not specific to particular firms and so on. The Commission concentrates on the more important cases and the new regulation in 1999 codified and speeded up its procedures (18 months) and enables immediate provisional recovery of unlawful aid from the original beneficiary; it provides for on-site monitoring visits; it enables examination of state aids over the past ten years; and also extends to unfair state aids in tax schemes (e.g. Irish preferential tax treatment of manufacturing has been declared an unauthorised state aid). State aid that falls foul of the following four tests is illegal: it confers an advantage to a firm or firms; it is granted by the states or through state resources; it is granted selectively to certain undertakings or to the production of certain goods and thus distorts competition; finally, it affects trade between member states (Commission, 1999a, pp. 81–110). The Commission assesses whether the benefits of state aids outweigh the disadvantages, particularly the potential trade distortion. Since the growth in state aids to help depressed industries in the 1980s, the Community has taken a stronger line against them during the current decade. This is because the SEM cannot bring about the projected gains if state aids grow and replace other barriers which have been removed. In addition, in view of the aims of Maastricht and EMU, the countries

Competition Policy in the SEM 53

with significant state aids, especially in southern Europe, had to reduce budgetary deficits which infringed the Maastricht fiscal criteria for EMU. The EU also wishes to ensure that richer countries are not giving their own state aids which merely offset the benefits which poorer countries are deriving from Community structural funding. The EU has started to look closely at general investment aid schemes (lacking a specific sectoral or regional objective) and approved years ago. These were discretionary national state aids which the EU wants to abolish. It also wishes to move from national support of industrial champions towards the creation of EU champions. Article 90 of the EEC Treaty states that public enterprises should also be subject to competition rules, but these tend not to be as transparent as those in the private sector. Large public enterprises have to show government transfers clearly in their financial accounts. Furthermore, with the current vogue for the privatisation of such industries, steps have been taken to ensure that they are sold to the private sector at more realistic prices which do not involve a subsidy to the private sector purchaser. Privatisation often occurs by selling not on the open market but by private sales, with great uncertainty in setting correct market values since these are dependent on future profits. Some governments have moved on to privatising more problematic industries such as coal and railways in the UK. Where governments still perceive some economic and political gains from an underpriced sale, it would be useful for the EU to have an independent consultant’s view of valuation. Otherwise it will be difficult for EU policy makers to control national governments, showing that hopes and reality are hard to match. The scope of EU competition policy has grown, especially when led from the top by a strong Competition Commissioner. Policy has become much tougher in liberalising public sector monopolies and in limiting state aids. Unfortunately the Commission has been constrained in exercising its power fully by its growing case load, some unclear Treaty articles, and particular interest groups including those of some member states. State aid should mainly be confined to cases such as restructuring, with more negative decisions in other cases, plus an attempt to shame those who persistently infringe competition policy.

Conclusion and UK competition policy Conditions conducive to competition, such as free trade in the nineteenth century, gave way to the recognition between the two World Wars that cartels were tolerable in a situation of depression and unemployment.

54 Current Economic Issues in Integration

Post-1945 the commitment to full employment and economic growth were complemented by stronger competition policies; for example, the establishment of the Monopolies and Restrictive Practices Commission in 1948. This was an advisory committee which reported directly to the President of the Board of Trade and examined monopolies and restrictive agreements. The 1956 Restrictive Practices Act broke new ground in laying down that all restrictive practices were to be registered with the Registrar of Restrictive Agreements. These were declared void unless they could pass through the permitted gateways which were laid down. The precedents set by the court’s adverse decisions led many firms to abandon similar restrictive practices. Also in 1956 Resale Price Maintenance was ended, apart from books and pharmaceutical products and now even these exceptions have been removed. UK policy pre-dated that of the EU, with important legislation in 1948 and 1956. The 1956 Restrictive Trade Practices Act was an apparent policy success story, though some favoured a more dogmatic policy banning all restrictive practices. However, greater criticism was levelled at the control of monopolies and mergers which was poorer. The UK left the enforcement of monopoly policy in the hands of an administrative tribunal, the Monopolies and Mergers Commission (MMC), instead of to the courts and the judiciary (as with restrictive practices) and as in the US. The Monopolies Commission has examined dominant firms, though relatively few have been found objectionable per se, but many of their undesirable practices have been criticised. It has condemned exceptionally high profits, such as Kodak, but has generally been more permissive where high profits have arisen from technical efficiency, such as Pilkingtons in the glass industry. A change in behaviour was usually recommended rather than structural change. Generally governments accepted recommendations of the Commission, such as cutting the prices of detergents and advertising expenditure, though some decisions were not accepted; for example, price controls for British Match and British Oxygen and rejection of proposed tariff cuts on cellulosic fibres affecting Courtaulds and colour film for Kodak. In 1980 the Competition Act introduced the concept of anti-competitive practices such as refusal to supply, tie-ins, full-line forcing and predatory pricing. Large firms above the turnover and market share thresholds and engaged in such practices have faced enquiries by the Office of Fair Trading (OFT) and MMC. After 1965 the Commission examined mergers where these would result in at least one-third of the market finishing up in the hands of a single supplier or where the value of the assets acquired exceeded £5 million. The Fair Trading Act in 1973 reduced the market share

Competition Policy in the SEM 55

criteria to 25 per cent of the market. Also newspaper mergers were normally investigated by the Commission because of worries about a monopoly of information developing. Many proposed mergers were examined by the Board of Trade (later the DTI) though only a small number were referred to the Commission. Many mergers were allowed to proceed after reassurances given by the firms. The Commission tended only to prohibit mergers which were clearly contrary to the public interest, rather than allowing only those where a positive benefit occurs. UK policy was quite pragmatic towards controlling some mergers, whilst occasionally encouraging others as part of industrial policy during the time of the Industrial Reorganisation Corporation (which was established in 1966). Some critics of the Monopolies Commission wanted a more dogmatic American-style policy in which companies with more than 50 per cent of market share should have to divest themselves and mergers would not be tolerated where these led to companies controlling half of the market. Whilst national policy continues, it has been increasingly influenced by the EU and realigned towards it. This is because it was recognised that there were major deficiencies in UK competition policy. For example, firms knew that if they were discovered to be engaging in collusion they would just be asked to cease such practices, but otherwise there was little deterrence in the absence of fines. The authorities had limited powers and could only ask for details of suspect agreements if there were grounds for thinking that these existed. Criticisms abounded especially from consumer groups which favoured a much stronger competition policy along the lines of that in the EU. This includes large fines and increased powers of investigation to enter premises and demand materials. Consequently in the UK the Competition Act of 1998 has closely followed the wording in EU Articles 81 and 82. Restrictive agreements in the UK are now to be judged on their effect rather than their form (Utton, 2003, p. 50) and exemptions are allowed. However for dominant positions (as under EU Article 82), no exemptions are permissible. Investigation is carried out by the Director General of Fair Trading (DGFT) which has been given stronger powers as in the EU to seize documents and to impose fines. Companies can be fined as in the EU up to 10 per cent of their UK turnover. After 2001 the UK also proposed even sterner policies to deal with offences, such as proposed prison sentences for highly restrictive cartels where there is now a maximum punishment of a five-year prison term. There is a memorandum of understanding between the OFT and the Serious Fraud Office (SFO) and when the OFT think that they have uncovered a cartel that merits investigation as a

56 Current Economic Issues in Integration

possible case of serious fraud, it will call in the SFO; for example, such as investigating alleged price-fixing of drugs supplied to the NHS. The renamed Competition Commission is less secretive than in the past; for example, in 2003 it arranged a public meeting to discuss extended warranties on products. These might lead to electrical retailers being prohibited from selling warranties at the same time as the goods themselves and also increasing the range of choice. Another public meeting at which parties could put their views was on the supermarket bids for Safeway. Initially only Philip Green, coming from a non-food sector was allowed to proceed, with even Morrison’s being referred along with others, despite its smaller market share (but finally being allowed to takeover Safeway). Merger policy which was introduced in 1965 was left unchanged by the 1998 Act, but in 2000 a government White Paper sought to remove the power of politicians in merger policy. There had long been worries that the role of Secretary of State was too vulnerable to the pleading of special interest groups and that this role needed to be diminished and made more transparent. The DGFT has sole authority to refer to the Competition Commission and giving this power to make decisions independent of politicians was almost as significant in its own field as financial independence for the Bank of England. The Enterprise Bill in 2002 only left a small amount of power for the minister in exceptional public interest issues such as defence and public security, placing control in the hands of the OFT. Also there is a competitive impact test which replaces the broad public interest approach, and only those mergers which lead to a substantial reduction of competition will be prohibited. On this basis, for example, in 2003 the OFT allowed a merger between software firms, iSoft and Torex; but its decision was overturned by the Competition Appeal Tribunal and if this interpretation and judgement were to be followed then more mergers will be referred. Mergers which create or increase a market share of 25 per cent continue to be investigated but the assets threshold of £70 million or more has been replaced by a turnover threshold of £45 million, since turnover is considered to be a more appropriate criterion, as in the service sector, and others. Also a larger range of remedies can now be used and on top of divestment or outright prohibition, the OFT can require companies to grant licences to competitors. Meanwhile larger mergers affecting intra-trade and competition fall into the province of EU policy.

4 Industrial Policy: The Changing Agenda

Introduction Whilst industrial policy may be considered to include all aspects of governmental policy which affect microeconomic activity, this chapter is using the term specifically in relation to its positive aspects. This is partly because the more negative elements of creating conditions in which the private sector can flourish through the Single European Market (SEM) and competition policy have been covered already in the previous chapter. Whilst the European Union (EU) has generally favoured a free market philosophy, policy increasingly has incorporated elements of more positive intervention to deal with problems of both declining industries and high technology sectors. The changing agenda involves not just reactive but also proactive policies to deal with the pattern of industrial change from older industries towards sunrise industries and services. It is insufficient to rely on the different policies of member states alone and it is recognised increasingly that the EU needs to develop new approaches to deal with greater international competition in both downmarket and upmarket economic sectors. An important aspect of this has been to encourage innovation and the chapter includes some indicators of comparative expenditure. The chapter also examines the different forms, which the collaboration has taken, in the EU in various sectors. At the Lisbon Summit in 2000 the European Council set a clear objective to make the EU the most competitive and dynamic knowledge-based economy in the world.

The nature of industrial change In the EU over time there have been remarkable changes in the distribution of employment and activity between different sectors of the 57

58 Current Economic Issues in EU Integration

economy. While EU policy has been preoccupied with agriculture, only about 1 in 20 workers in the EU is involved in this sector, whereas nearly 1 in 3 workers is still employed in industry. Although this varies between countries, for example, at the extreme, Greece has about 1 in 5 workers in agriculture and about 1 in 4 workers in industry, but more than half the labour force is in the service sector. In the EU just over 60 per cent of jobs are in the service sector and the EU will continue to follow the US where the figure is around 75 per cent. These trends have important policy implications as deindustrialisation with the hollowing out of industries creates a devastating impact on traditional industries and regions. Employment in EU manufacturing industry fell from 27 million in 1980 to 22.6 million in 1996 compared with 17 million in the US and under 10 million in Japan. What are the reasons for industrial decline and the consequences for industrial policy? Historically in a market system changes in demand have resulted as a consequence of price and income increases. Meanwhile technological change has fundamentally altered production methods, the capital/ labour ratio and the creation of entirely new industries. While the trends have been occurring over a long period in the decline of agricultural employment, the later decline in industrial employment in total, rather than in particular industries, has led to the fundamental question of the significance of industry per se and whether this is critical. Globalisation has contributed to industrial decline in the EU as jobs in labour-intensive sectors have been switched increasingly to low cost locations. The question for industrial policy is, if the primary and increasingly the secondary sector have reached maturity, should policy concentrate mainly on the tertiary sector if most people are employed in services and even more will be in the future? Whilst service employment will continue to grow, even in this sector globalisation may lead to a loss of some jobs to lower cost parts of the English speaking world, such as India. Industry in general still needs appropriate policies to deal with falling competitiveness as a result of economic failings. Also, industry provides more added value than services, more tradable products and cannot be divorced from many service activities. The large financial sector in the UK and more recently in Japan has been built on a successful and leading industrial performance historically. The facts are that deindustrialisation has manifested itself much less in terms of output than in jobs, largely because of significant increases in productivity. Also the scope for productivity increases is far higher in industry than in the service sector. The EU is still the leading industrial producer in the world ahead of the US and Japan. The dominant

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industrial country is Germany followed by France, Italy and the UK. The UK economy is much more service-based and its industrial strengths are narrower than those of Germany. The five largest EU industries based on value added are electronics and electrical engineering; food, drink and tobacco; transport equipment; basic metals and metal products; and chemicals. The electrical and electronic engineering sector is the biggest industry in terms of value added and covers a wide range of products from household appliances to computers and telecoms equipment. Although just over 20 per cent of output is exported, this sector has significant weaknesses since output is lower than in the US and Japan and the EU has had a trade deficit in this sector. The EU share in world trade in high technology products compared with its share in world trade in manufactured products has fallen and the trade deficit would have been even higher without Foreign Direct Investment (FDI) from the US and Japan. The trade deficit has been even higher than that in textiles, clothing, leather and footwear. These sectors have required different policies to deal with their problems. Fortunately many of the other key sectors have been stronger. Food, drink and tobacco are strong and production exceeds consumption, providing an overall trade surplus. The UK also excels in this sector. The transport equipment sector is dominated by motor vehicles and this has maintained employment recently and been in trade surplus in cars, commercial vehicles and especially in components. Germany is particularly strong in motor vehicles, while in other parts of the transport sector, such as railway equipment and aircraft, France is very important and is joined in importance in the latter by the UK. The basic metals and metal products industry is the largest industry in terms of employment and it includes iron and steel and non-ferrous metals and metalworking. The trade balance has fluctuated between deficit and surplus and the problems in the iron and steel industry have been of particular concern.

Industrial policy: a trend of declining intervention Industrial policies of countries have varied historically and at different periods, but it is still possible to categorise these roughly from passive to positive intervention, since there has been some consistency in overall approach. For example, the UK, the first to industrialise, developed mainly under private enterprise and a liberal free trade approach. Consequently the UK has had less active policies than other countries which developed later and mainly on the basis of greater state intervention and more trade protectionism. For example, Germany had a

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highly interventionist and strongly centralist state with considerable public enterprise, cartels and monopolies. Friedrich List emphasised the need for protection to stimulate home production. However, post-1945 the war time defeat of Germany led to a significant shift in policy towards a more market orientated approach. This was a result of allied influence from the UK and US and also following particular Schools of economic thought in terms of the approaches of the Freiburg and Austrian Schools. These emphasised the benefits from a more competitive economy which would generate high output and price stability. The pure market was modified by having a social market system with co-determination in industry and some limited state intervention in key areas. Once currency reform had created sound money, a free trade policy was pursued and by the start of 1954 over 90 per cent of imports in Germany were liberalised and Germany was a low tariff country when it was locked into the Common External Tariff of the European Economic Community (EEC). Industrial policy sought to prevent monopolies and to encourage small- and medium-sized businesses through tax concessions and placing government contracts with them. Emphasis was given to private industry, with the first wave of privatisation in the late 1950s and this was revived again from the early 1980s. However, success in Germany can be attributed to a combination of private enterprise supported by appropriate governmental intervention in allocating Marshall Aid funds, subsidising West Berlin and a pursuit of favourable policies towards education and training, and research and technology. There has been co-operation of the partners including trade unions, universities and research bodies. The efficiency of the banking system in taking a long-term view business has also been of importance when compared with the more distant and short-term approach of the banks in the UK. In contrast with Germany, other countries, such as France and Italy, have followed much more consistent positive policies of intervention. France has a long history of protectionism and state intervention and post-1945 it adopted a system of indicative planning for its economy including both industries and regions. While these were indicative and not the imperative planning techniques of Eastern Europe they constituted an interesting and at the time a much admired approach for the Labour government in the UK after 1964. The plans operated on both demand and supply and expectations of high demand led to high investment, creating a kind of virtuous circle of growth, unlike the UK. There was less worry about faulty investments because of a better informed business atmosphere. Though there was more collusion

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between firms, there was little danger of excessive monopoly because of a less concentrated industrial structure in France. Supply bottlenecks were identified and tackled nationally, sectorally and regionally. The first plan in 1946 was concerned with basic industries and the second plan in 1954 focused on manufacturing industries. Later plans placed more emphasis on key new industries and there has been an active policy of trying to pick winners and to create national champions. In 1961 De Gaulle argued a case to make planning la grande affaire de la France. Success of planning was achieved since they were indicative and not imperative (as in Eastern Europe) by a largish public sector plus nationalisation of the banks. Selective monetary and fiscal policies channelled finance to the most dynamic firms and industries. Firms wanting significant finance needed to have plan approval. Successful exporters and selected businesses were given favourable tax concessions and priority access to the capital market. The plans were carefully monitored by a series of indicators or early warning lights such as prices, unemployment and competitive performance internationally. Planning success was measured by plotting the predicted target changes in the plans against the realised changes. Despite some success, planning declined in importance with the spread of global market forces of freer trade and FDI. Italy and Spain have had even more extensive state ownership than France. Italy had large state holding companies arising partly from the collapse of the banking system in the depression of the 1930s. The state bailed out the banks and found that it owned the multiplicity of firms that the banks had lent to. The state holdings were used to support key sectors, to improve the trade balance and to play a major role in lessening regional inequalities. The role of the state as entrepreneur has been examined by various writers, such as Holland (1972) and the merits of this highly interventionist system were highly favoured in the past, though less so in more recent years. Italy which had its Instituto per la Riconstruzione Industriale (IRI) was able to control not just infrastructure, but the real commanding heights of the economy in both manufacturing and exports. There were significant partial holdings in firms and industries, leading to more competitive pricing between state and private firms than when 100 per cent single sector nationalisation exists. There was also greater commercial freedom for management and not as much government intervention as under UK nationalisation. Some sectors were state owned in Spain as in Italy and it had its Instituto Nacional de Industria (INI). Under Franco there was extensive national control and state direction through state-owned enterprises.

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Liberalisation was slow and only with its belated entry into the EU in the 1980s did Spain become a less regulated economy. Although it retains its own characteristic approach there is a new trend in industrial convergence among member states as a result of free trade in the EU, FDI and a change in ideology since the 1980s. The growth of a liberal market approach has been driven by the process of privatisation. This has been applied across Europe, both in the west and in the reformed east as it shook off the long period of state ownership and government control under Communism. The ideology of state ownership in Europe which had been much more extensive than in the US was eroded by its inefficiency and by recognition of the economic gains which could accrue at both a microeconomic and a macroeconomic level. The rapport in the UK in the 1980s between Mrs Thatcher and the model of a more successful economy in the US based on a higher degree of private enterprise and competition was to lead to a radical change in economic policy regarding nationalised industry. The injection of competition would lead to lower prices and better service. Organisations would have the freedom to recruit their own staff and pay competitive salaries to attract the talent needed. Companies could also diversify into different areas instead of being confined to separate industries, some of which were in terminal decline. There was an attempt to break down monopolisation of both the product market and also the labour market. Industries such as coalmining and the railways had been crippled by industrial unrest and trade union militancy. The National Union of Mineworkers (NUM) had brought down Edward Heath, Margaret Thatcher’s predecessor in the Conservative Party, and she was determined to reform trade union legislation to weaken trade union power and also to privatise industries in the public sector prone to labour disputes and unrest. At the macroeconomic level government was able to sell assets to bring in revenue and reduce the expenditure on many loss making industries. This helped to cut the Public Sector Borrowing Requirement. The policy proved popular since it contributed to wider share ownership which has always been highly concentrated and offered the prospect of huge windfall gains when the assets were under-priced. There was usually a discount for the small investor. Employees were generally offered only a small proportion of the shares. There was some discrimination against foreigners taking up too great a holding, though subsequently many of these industries have fallen under foreign ownership; for example, water companies, power generation and rail franchises in the UK. Sales were sometimes carried out in stages, as in telecommunications. In a few strategic sectors the government retained a golden shareholding.

Industrial Policy: The Changing Agenda 63

The UK model has been followed by other European countries and privatisation in France has ranged from banks to chemicals, motor vehicles and parts of aerospace, amongst others. However, privatisation in France has been slower and with less commitment than in the UK since it marked a reversal of its former successful strategy of active state intervention. It was faced with stronger opposition from vested interests such as trade unions whose power had not been diminished as much as in the UK (Hayward and Menon, 2003). France has also still tried to retain some strategic vision in selling off its holdings of state industry to the private sector and resisting hostile foreign takeover. For example, it sold Aerospatiale to Matra which in turn led to the creation of the European Aeronautic Defence and Space Company (EADS) in 2000. In Germany privatisation has included Volkswagen and Lufthansa, and a host of other state-owned firms have been privatised in the eastern part of the country since reunification. There has also been significant privatisation in both Italy and Spain, including much of IRI in Italy and part of the motor vehicle industry in Spain. This was partly to reduce the large public sector deficits and was necessary before they could meet the Maastricht convergence criteria for Economic and Monetary Union (EMU). However, given the size of the public sector in both countries they are still at the other end of the spectrum of industrial ownership compared with the more private enterprise economies of the UK and the Netherlands. The task of privatisation in Eastern Europe has been far greater than in the EU since nearly everything was state owned in the Central and Eastern European Countries (CEECs). Whereas the UK has an extensive capital market and people are used to equities, in Eastern Europe there was a need to persuade people to use very limited savings. Many of the assets fell into richer foreign hands. Nevertheless this paved the way for valuable FDI in those economies which were open and welcoming. Valuation of state companies is always difficult and there was a lack of proper accounting and often the assets were disposed of cheaply. Since buyers are only interested in companies which are potentially profitable, it became necessary to engage in massive restructuring. While the sale of state assets has improved efficiency and the budgetary balance there has been a significant increase in unemployment with all the consequent discontent from people who generally had a job for life previously. The effects of privatisation have been to increase competition as intended but this has been easier in some sectors than others; for example, there has been a huge increase in international competition in airlines, whereas other sectors have still required regulators to control prices and

64 Current Economic Issues in EU Integration

quality standards. The US with less nationalisation has had longer experience of regulating natural monopolies than Europe. In the US appropriate rates of return have been set whilst policy in Europe has swung towards regulation. In the UK price caps have been used more with price rises permitted to reflect an increase in the cost of inputs minus savings from autonomous progress and minus a further squeeze factor. Some industries have become sufficiently competitive, such as gas and electricity in the UK where many customers have switched supplier, to end price controls. Problem industries remain, including the later and more intractable industries which were nationalised in the UK, nuclear power and railways, with both experiencing financial collapse and requiring additional financial help from government. This reliance on governmental support has been far more a characteristic of Continental countries than the UK whose railways have suffered from insufficient investment over many years.

EU industrial policy The strong competition policy which was based upon Treaty requirements was not consolidated in the same way originally in the EEC for industrial policy. Apart from the specific case of the European Coal and Steel Community (ECSC) where special policies existed, it was only from 1967 and the creation of a DG for Industrial Affairs that there was full consideration of the direction of industrial policy. The initial approach of relying mainly on markets and limited intervention was reflected in the Colonna Report in 1970. It sought to establish a unified market and eliminate technical barriers to trade. In addition, it wanted to harmonise legal, fiscal and financial frameworks, encourage trans-national mergers and to promote technical collaboration. The approach was confirmed by the Spinelli Report in 1973 which proposed a few new measures, but these continued mainly in the framework of market-oriented policy. During the 1970s the recession led to a shift of national policy in the opposite direction towards support for declining industries such as shipbuilding, textiles and clothing, and the car and machine tool industries. The EC took over the co-ordination of many of these policies often reluctantly, but to make the assistance uniform and transparent. While national governments were still pursuing some separate trade controls with quotas and Voluntary Export Restraints, the EC gradually assumed even more complete power to control external trade and limit imports in sectors which were suffering from disruption. There was too much emphasis on long-term stability through subsidies and protection and

Industrial Policy: The Changing Agenda 65

insufficient industrial readjustment to reduce capacity. Measures are more appropriate in the short term to cushion the harshness of change, but to use intervention to create a smaller and more competitive industry which can stand on its own feet again eventually. Fortunately in the 1980s the EC recognised the folly of supporting industries which were in terminal decline too generously and that a far better policy was to switch towards support for technology. This was the basis of new industries, but in addition this could also often be applied to benefit declining industries as well.

Technology and comparative expenditure Whilst the EU is strong in agricultural products, largely because of the protective agricultural policy, in recent years it has increasingly fallen behind the US and Japan in terms of science-based and high technology industries. High technology industries include aerospace, office machinery and computers, electronics, pharmaceuticals, precision and measuring instruments and electrical machinery. The EU lags behind particularly in information and communication technologies (apart from telecommunications). Employment in high and medium-high technology manufacturing sectors as a per cent of total employment in the EU(15) was 7.64 per cent in 2000, being highest in Germany at 11.18 per cent in 2000 (Eurostat Yearbook, 2002). Even in sectors where the EU is strong, such as pharmaceuticals and the related biotechnology industry, it is second to the US and the main reason relates to the role of technology and policy. A distinction can be made between invention which is discovery and creation of something new and innovation which refers to commercial application and requires risk-taking business skills. New technology can be either in processes such as robotics or in new products such as mobile phones. Furthermore, one has to distinguish major product innovations, such as the computer, from minor product innovations, such as Dyson improvements to vacuum cleaners and washing machines. There are many measures of innovation, including research personnel (per 1000 in the labour force), and these showed a modest increase from 1.2 per cent of the EU(15) labour force in 1990 to 1.34 per cent in 2000. The technology balance of payments is another measure, relating to money payments for use of patents, licences, know-how, marks, models, designs, technical services and industrial research and development (R&D) carried out abroad. However, the most important measures of innovation are probably best seen on the input side by the amount spent on R&D and on the output side by patents.

66 Current Economic Issues in EU Integration Table 4.1

R&D spending and patent grants R&D as a % of GDP

France Germany Italy Sweden UK USA Japan

US Patent Grants

1985

2000

1985

2000

2.3 2.7 1.1 2.8 2.3 2.8 2.6

2.2 2.5 1.0* 3.8* 1.9* 2.8 2.9*

2 400 6 718 919 857 2 494 39 556 12 746

3 674 9 095 1 582 1 225 3 464 80 294 30 841

Note: * (Figures for 1999: OECD, 2001). Source: Hall (2002).

Data is shown from the mid-1980s and with the exception of Sweden, both the US and Japan spend a higher percentage of their GDP on R&D than Germany, France or the UK. Whilst the US has maintained its R&D spending as a percentage of GDP and Japan has increased it, there have been reductions in France, Germany (as a result of reunification) and a marked reduction in the UK (see Table 4.1). A further distinction between countries also exists in relation to non-defence R&D which is significantly higher in countries such as Sweden and Japan, compared with others such as the US, the UK and France. Data available on enlargement countries show as expected that R&D expenditure is lower than the lowest countries in the EU such as Portugal and Spain, apart from one country, the Czech Republic. Patenting enables firms to appropriate benefits from their inventions and innovations and is necessary to prevent free-riding. The more important patents are those which are cited in subsequent patent descriptions. Patenting has increased even more than R&D spending, with the US and Japan accounting for most patents and showing the fastest growth rate since 1985. The UK has shown one of the slowest growth rates of patents. Other data is available on patents filed at the European Patent Office. These show a rise from 32 310 in 1990 to 44 725 in 1999 for the EU(15). US patent applications in Europe rose from 19 077 in 1990 to 31 157 in 1999, and Japanese applications rose from 13 146 in 1990 to 14 236 in 1999. In the EU Germany is dominant and in 1999 accounted for 19 552 patent applications, followed in importance by France and the UK. Patent applications per million of the labour force rose from 206.4 in 1990 to 260.8 in 1999 in the EU(15) (Eurostat

Industrial Policy: The Changing Agenda 67

Yearbook, 2002). The countries well above average included Germany, Sweden and Finland whereas the UK was below average. While high technology patents per million of the labour force in the EU(15) rose from 19.2 in 1990 to 50.8 in 1999, they lagged behind those in the US which rose from 21.2 in 1990 to 71.8 and in Japan rose from 49.5 in 1990 to 60.4 in 1999 (Eurostat Yearbook, 2002). There is concern to foster invention and innovation and also the diffusion of best practice by appropriate policies. These involve concern with size of firm, industrial structure, national systems of innovation and the role of collaborative EU programmes. Many inventions have emanated from smaller firms and also much innovation, though more financial resources are needed for the latter. In some industries larger firms are important such as chemicals, pharmaceuticals and electronics with high R&D costs. The pharmaceutical industry is one in which the big European countries such as Germany and the UK have traditionally been strong, yet in recent years the US has spent more on R&D and increased its patent share. The large US market has had quicker regulatory approval than in the EU, especially before the EU Single Market improvements. Most of the major and best selling drugs are made by US companies which are highly profitable, though the EU and Switzerland have many of the leading pharmaceutical companies in the world. The biotechnology industry is linked to such industries as pharmaceuticals, chemicals and food and though Germany, the UK and Switzerland are strong they lag behind US firms. The US has widened the gap on patents and patent citations (Johnson ed., 2003, p. 196). The US had the advantage of being first with more public funding and plenty of venture capital. Unless the EU takes a less restrictive approach to genetically modified (GM) foods it will be difficult to close the gap on the US. The structure of markets is one in which a monopolist has the financial resources but generally lacks the competitive pressure to innovate. Firms with a smaller market share and operating in a competitive market tend to be most innovative (Shepherd, 1999). This is because a monopolist would compete with itself, whereas in a competitive market firms can take market share from others by reducing prices. The speed of innovation also tends to be slower by a monopolist and faster by the smaller firm. Smaller firms have a high share of innovation in sectors such as scientific instruments and software and were also important initially in biotechnology. Small- and medium-size enterprises (SMEs) tend to be at the forefront of innovation and when successful in many industries the larger firms later assume the greater role since they have the resources to commercialise products.

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The case for public support of science and technology Underinvestment in R&D occurs in a free market because of the costs and uncertainty in investing in new technology. Although some research is curiosity driven, much of it is a function of profitability. Firms are under particular pressure during recession when profits are low, but innovation can reduce costs and/or hopefully lead to new products. Hence the downswing of the Kondratieff long wave cycle has often been turned by the application of new technology involving an upturn in new investment. Firms are faced either by extinction or innovation. The effect of new technology is to lead to a recovery in economic growth and in the long run to increase demand as prices fall and sales of new products increase. Countries which fail to innovate and remain at the forefront of new technology lose international competitiveness. Governments in all European countries have pursued science and technology policies, adding resources and providing direction towards innovation, because of public benefits such as increased competitiveness. Since most expenditure has taken place at the national level, distinctive differences are apparent between member states (see Jacobson and AndreossoO’Callaghan, 1996, pp. 183–95). For example, France has been similar to the UK with its heavy focus on military expenditure. However, the approach to policy has differed with the state historically playing a much more central role in France. While France has strong historical traditions in industries such as engineering and to a lesser extent chemicals, post-1945 it prioritised new sectors such as nuclear energy and aerospace. It has been particularly successful in aerospace, though a secretive military emphasis on sectors like this has unfortunately restricted diffusion to other sectors and has not involved SMEs as much as would have been desirable. French performance in other more competitive market sectors, such as IT, has been less impressive since it lacked the large private sector research tradition of German or American firms. In the pharmaceutical industry, despite companies such as Rhône-Poulenc, French firms have not been at the forefront of best selling drugs or pioneering in biotechnology. In contrast Germany has a long tradition of innovation, based upon a well-educated labour force and companies with a strong record of innovation in many sectors such as engineering and chemicals. Post1945 naturally it concentrated mainly on non-military and more private sector industries. There has been a partnership with banks which have provided long-term credit and employees have been integrated into participation and decision making, being less likely to oppose technology which erodes jobs.

Industrial Policy: The Changing Agenda 69

The UK in contrast has relied more on financial markets for finance and this has posed problems particularly for new high tech SMEs since lenders prefer more traditional sectors. Although venture capital is available, even higher rates of return are expected before undertaking the financing of high tech projects. The UK’s historical lead in innovation has not been maintained, partly because policy has lacked consistency. It has been much less interventionist than in France, although in the 1960s and 1970s the Labour government sought to imitate some aspects of French planning but they were never as successful. A Ministry of Technology was established in the late 1960s. In the 1970s the National Enterprise Board (NEB) acted as a capitalist for investment in advanced technology; for example, it established Inmos, a state semi-conductor company, and Celltech in biotechnology. With the return of the Conservative governments the NEB was merged with the NRDC in 1981 to form the British Technology Group to provide venture capital through equity mainly to smaller firms. The Alvey programme for information technology was launched in 1987 but has come to an end. The separate Office of Science and Technology created by the Major government with its Minister in the Cabinet finished in 1995 when it was subsumed in the Department of Trade and Industry. The search for value for money in science and technology expenditure has led to more central government control of policy, though there has also been some privatisation of public research establishments. The UK’s main success has been in the aerospace industry, though over-concentration on this has tended to drain other sectors particularly of engineers. The UK has failed to generate the status which engineering holds in Germany and with the decline in manufacturing industry and engineering, the UK has lost its indigenous strength in key sectors such as the motor vehicle industry. The success of Arnold Weinstock in creating GEC has been squandered with the demise and restructuring of Marconi. Although the high-tech engineering was merged with French Alsthom (which became Alstom when it floated in 1998), the UK business is becoming a service business and ceasing to be an exporter. In 2003 the French government offered support to Alstom, whereas the UK government reiterated its belief in non-intervention refusing support. The UK’s most successful high tech sector has been the pharmaceutical industry, though even here multinationals are of growing significance in the UK economy. Other countries tend to be weaker, especially the smaller ones and the more peripheral European countries. Italy has been characterised more by the regional innovation in particular industries based largely

70 Current Economic Issues in EU Integration

on the links between firms in the supply chain. This has been important in industries such as machine tools and textiles.

EU collaboration Whilst national systems are most important in terms of expenditure and culture, the EU has increasingly taken on a policy role. This first emerged in Euratom, though there were problems between different interests and a number of failures, such as reactor design. The EU has followed this sectoral focus in industries where costs are too high for each member state alone and duplication of expenditure on increasingly expensive projects would be wasteful. There are some sectors in which the EU has been seen to be at a growing competitive disadvantage vis-à-vis its international competitors, such as the US. These sectors have included, amongst others, aerospace and information technology. Common policies were developed especially from the 1970s and these accelerated in the 1980s as part of a more supply-side economic approach in which expenditure on R&D was critical to promote economic growth. The Single European Act in 1986 marked an important acknowledgement of the Community’s role in technology policy. The EU has developed Framework programmes such as the European Strategic Programme for Research and Development in Information Technology (ESPRIT). The EU felt able to reconcile and dampen its competition policy by encouraging co-operation between firms of a particular kind. First, the focus was on what is called generic technologies which can be used in a variety of industries. Second, whilst maintaining competition within the marketplace, some co-operation is seen to be desirable at the earlier pre-competitive level. One might note that occasionally this distinction is not always completely clear cut, with a microprocessor not being too far from the market. The first ESPRIT began in 1984 and ran to 1988. It concentrated on microelectronics, advanced information processing and software technology and application to computer and integrated manufacturing and office systems. The next ESPRIT in 1989, though lower than originally proposed, more than doubled the expenditure of the first ESPRIT. The main focus of expenditure was microelectronics, IT processing systems and applications technology. The third ESPRIT 1990–94 further prioritised key areas. ESPRIT was the first programme based on competitive bids. It encouraged co-operation between large firms and provided the forerunner of later complementary programmes; for example Research and Development

Industrial Policy: The Changing Agenda 71

in Advanced Communication Technologies for Europe (RACE). Whilst most concern is with new industries, the Basic Research in Industrial Technology for Europe (BRITE) was launched in 1985 particularly to encourage advanced technology for traditional industries. The EU system of collaboration has brought firms together with the incentive of providing half of the cost. Subsequent programmes have tried to rectify the natural deficiencies of insufficient involvement of SMEs and also insufficient participation of firms from weaker regions. These regions are weak partly because they lack a sufficient number of new innovation-based industries and this relates to the problems of regional development covered in a later chapter. Priorities in the EU Framework programmes have been modified; for example, the fifth programme 1998–2002 placed emphasis on problem solving in areas of social concern complementing generic research activity. The sixth framework programme, up to 2006, concentrates on support in areas such as genomics and health, IT, nanotechnologies, intelligent materials and new production methods, aeronautics and space, and food safety. The purpose of EU technology policy is not just to co-ordinate national policies but to go further by adding to the resources available in critical sectors. Whilst EU expenditure is intended to be additional, as in other policy areas such as the Structural Funds, it is not easy to establish full additionality, though clearly there has been some addition and not total replacement of national expenditure. The creation of networks and underpinning these financially has been a useful step forward in making trans-national teams and partnerships a more normal activity. Many of these links from early co-operation in projects such as ESPRIT have been carried a step further forward closer to the market place in other bodies such as EUREKA (European Research Coordination Agency). Here the focus is on projects with a commercial and market application. Detailed studies have been made of different sectors with interesting results, for example, in telecommunications (Meeusen, 1999). Overall EU policy has encouraged more co-operation of national efforts but also provided a clear focus of priorities. It has been necessary to be selective partly because of the limited share of the budget provided for this compared with the waste seen in other sectors of expenditure such as agriculture. However the culture of trans-national company partnerships which increased in the EU in the 1980s has been followed as a result of globalisation by a growth of global alliances between EU companies and those in the US and Japan. About two-thirds of these are in IT and biotechnology and more of these are between Europe and the

72 Current Economic Issues in EU Integration

US than are in intra-European (Hall, 2002; and also see Meeusen, 1999 for the trend in telecommunications). Co-operation has taken place in other sectors as a result of the initiatives of firms themselves supported by government financial help and also by EU creation of a special legal framework of European Economic Interest Groups. However, the latter in the late 1980s had already been preceded by many years of co-operation between firms in industries such as aerospace. These are several different types of co-operation which can range from bilateral development of new planes, such as the UK and French production of Concorde which preceded UK membership of the EU. This joint production was a precursor of what was possible in high technology when the UK entered the EU. However, in many instances the French have chosen to produce some military planes independently or with other partners. In some projects co-operation has been of a multilateral nature with several partners and some of these projects have transformed the position of the European industry. Nevertheless, it is an uphill battle against the superiority of the US in this field. The US industry is dominated by four large aerospace and defence companies: Boeing, Lockheed Martin, Northrop Grumman and Raytheon. The high US military expenditure and the substantial market for civil aviation have made the US the frontrunner in this sector. They have benefited from economies of scale and from the further unit cost reductions resulting from the learning effects. The latter arises from the learning and experience from cumulative production and in the case of aerospace can create a 20 per cent fall in unit cost as production is doubled. These effects are important when the highly skilled workforce quickly improves its experience and rapidly increases production (See Emerson et al., 1988, pp. 137–40). The European industry has searched for competitive solutions and like the US has tried to restructure, but on a cross-national basis in recent years EADS was created in 2000 from the merger of Aerospatiale Matra in France, Daimler Chrysler Aerospace in Germany and CASA in Spain. Another group, MBDA, consists of Matra (France), BAe Dynamics (UK) and Alenia Marconi Systems (Italy). In helicopters there is Agusta (Italy) and GKN Westland (UK). In France there is Thales which was formed from Thomson-CSF and acquired some UK companies such as Racal, Thomson Marconi Sonar and Shorts Missile Systems. In the UK BAE Systems was formed after the merger of British Aerospace and Marconi Electronics plus other acquisitions, but it has been seeking another strong partner either in Europe or in the US. Since BAE failed in its strategy to be part of a super-defence company in Europe, a merger

Industrial Policy: The Changing Agenda 73

with an American company would give it access to the big US market. For example, it has close ties with Lockheed Martin on the Joint Strike Fighter. In links with other US companies it would have to sacrifice its valuable existing European business, of which the Airbus is crucial and any merger into Boeing would strike at the heart of the most successful European collaboration. This is now emphasised in more detail. Airbus resulted from an agreement in the late 1960s with France and Germany being the major equal partners. BAE has a 20 per cent holding and there is a tiny Spanish holding. Each company specialises in different parts of the aircraft and BAE, for example, produce the wings. The partners are not allowed to develop rival aircraft. There is a wide product range with a family of aircraft of different ranges and seating capacity. The major rival, Boeing, has gradually been caught up, and whereas in 1999 Boeing delivered 620 planes against 294 by Airbus, in 2003 Airbus had planned deliveries of about 300 planes and Boeing 285. While the market is one of long-term growth it has been cyclical and there is intense competition between Boeing and Airbus. Since aircraft are priced in dollars a fall in the value of the dollar and an increase in the value of the Euro against it puts continuing pressure on Airbus to cut costs and become more efficient. Both companies have fought battles over the years about unfair government subsidies and led to some modifications in financing. Airbus has new planes in the pipeline, such as the A380, a new super jumbo to carry 550 passengers exceeding the Boeing 747 which carries 400. Airbus has spent £2 billion on the design and manufacture of the wings which are made in the UK. The plane is expected to come into commercial service in 2006. Meanwhile, Boeing is struggling in its own product development. Also, for the first time, Airbus is moving into a military transport plane, the 400 M, though this is not due into service until 2009 or later. There are orders for 180 aircraft from 7 nations and the hope is that it could add another 200 export orders subsequently. The order has been signed between Occar the European arms procurement agency created in 1996 and Airbus Military. This seeks to end work share based on juste retour, to place contracts on a competitive basis and to widen membership further. European collaboration has reduced cost compared with national production which has ceased to be economic for national markets. However, costs are not at their minimum because of the extra costs of co-ordination, sometimes sharing out work on equity rather than efficiency grounds, and occasionally overambitious and expensive projects to meet general needs. It has been estimated that collaborative costs can

74 Current Economic Issues in EU Integration

be 140 per cent for bilateral projects, such as helicopters, 170 per cent for trilateral projects such as the Tornado and almost twice as high for projects with four countries involved such as the Eurofighter ( Johnson ed., 2003). The Eurofighter contract, signed in 1988 for nearly 800 planes, was between Germany, the UK, Italy and Spain. The plane is designed as a highly agile fighter but its 14-year development and high cost per plane cast doubts over it in relation to the US advanced fighter aircraft competitor. The large US market always offers a fully competitive plane. Why therefore do European countries not purchase even more US planes which can be produced at lower cost and generally superior technology, plus the offset agreements in production? The reason is that the US would have a monopoly position in a crucial technological sector and Europe would be forced into a position of dependency.

Conclusion: the EU and UK industrial policy and performance The relative economic and industrial decline in the UK can be attributed to both macro and microeconomic problems. Fortunately the greater macroeconomic fluctuations than in comparable economies have lessened since independence of the Bank of England in 1997 and government borrowing only for investment. At the microeconomic level there have been big improvements in efficiency in privatised industries but continuing failures to improve transport infrastructure. There are continuing weaknesses in labour skills, though the legacy of the Conservative governments in reforming industrial relations has weakened trade union powers and strikes. Large UK companies with their reliance on Stock Market performance have generally had a short-term perspective, focusing on profitability and generous dividend payments to shareholders to try to ward off hostile takeovers. Large UK companies with over 500 employees are disproportionately important but their performance has been mixed. Although the few are outstanding, many under-perform and lag behind their competitors in countries such as Germany, France, the Netherlands and Finland (Commission on Public Policy, 1997, pp. 21–3). This applies in many industries from office machinery and chemicals to services. In addition many large UK companies were complacent and ignorant about their weaknesses. Large companies now account for a smaller share of employment than in the past, with downsizing and outsourcing of products to flexible

Industrial Policy: The Changing Agenda 75

SMEs. However SMEs in the UK still account for a smaller share of employment than in many Continental economies. In the UK they have faced a more hostile financial climate of higher interest rates and greater dependence on overdraft finance than in Germany or Italy. In Germany the banks have been more accommodating, while in Italy and to a lesser extent France local firms co-operate in mutual guarantee schemes to cover borrowing risks. In Germany firms are obliged to join associations or Chambers of Commerce, while Italy is renowned for its successful clusters or industrial districts. It has been argued that the UK should adopt similar co-operation in networks to improve its performance (Commission on Public Policy, 1997). UK technology policy has been referred to earlier and unfortunately the UK has seen its lead lost as other countries have increased their R&D expenditure and improved their performance in innovation. The UK has concentrated its efforts disproportionately on the military and though this has made the defence sector and in particular the aircraft industry highly competitive, this has been at the expense of other sectors. Even in the aerospace industry the UK has found itself too small to produce new planes independently and been pulled into collaboration. While much of this has been European collaboration, the EADS has an 80 per cent holding in Airbus and BAE has been looking for a partner which could well turn out to be American, threatening its participation in Airbus and other European projects. UK policy has generally been to insist that co-operation must be chosen wisely and be effective with proper evaluation and administration. It has also leaned towards co-operative activities such as EUREKA which is directed towards privately funded activities and applied technology. In referring to UK industry or business one is including all those businesses operating within the country, though a distinctive feature that has resulted from UK strategy is that there is a high level of foreign ownership. While the ideal would be industrial resurgence driven by indigenous industry, the only way of maintaining a presence in key sectors has been through attracting inward investment. Without that the balance of payments would have been disastrous in sectors such as motor vehicles. The UK has shown particular dependence on inward investment from the US over a long period of time and in more recent years on Japanese investment. The UK has been an attractive location for inward investment and in spite of worries expressed by some companies about the added costs from not being part of the euro zone, the UK has the advantage of being a flexible and generally low cost economy in which to operate. This will continue as long as sterling continues to depreciate

76 Current Economic Issues in EU Integration

against the Euro. However the longer term worry is that in the search for low cost locations the UK will eventually lose its dominant position in competition with other lower cost locations in the periphery of the EU and increasingly from the CEEC as they improve their infrastructure. This aspect is covered in the later chapter in relation to EU regional policy and its implications spatially.

Part II Economic and Monetary Union

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5 Central Bank Independence and Monetary Policy

Introduction The European Central Bank (ECB) is a creation of the Treaty on European Union (TEU), which designed it to be the most independent monetary authority in the world. The ECB’s architects sought to insulate it completely from political pressures, both at the national government and at the Economic and Monetary Union (EMU)-zone level. The position of the ECB under the TEU permits no clear accountability to national nor federal European institutions. It stipulates that the ECB Council’s deliberations remain confidential, whilst the only method of questioning the ECB’s policies is through periodic reports to the European Parliament. The introduction of EMU is one of the most momentous economic events of our generation. Policy makers and economic commentators have concentrated upon criteria denoting initial convergence to trigger membership of the single currency, stringent rules restricting national fiscal policies and the anticipated benefits which may derive from EMU. However, far less attention has been played to how EMU will operate in practice. In particular, the institutional design of EMU stipulates a central role for an ECB, established independent of government, which is charged with sustaining the stability of the currency zone in the face of asymmetric external shocks. The ECB is the sole body credited with determining the appropriate monetary and exchange rate policy for the entire euro zone and as such its ability to fulfil its stated objectives will be crucial to the eventual success or failure of EMU. Consequently, the paucity of critical analysis of the ability of the ECB to stabilise the euro zone economy, complete with low inflation, full employment, a sustainable balance of payments and good level of economic growth, should be of great concern for all supporters of European integration. 79

80 Current Economic Issues in EU Integration

This chapter seeks to compensate for the dearth of current analysis by examining the capability of the ECB to fulfil its designated role. The analysis is divided into six sections. The following section evaluates the design of the ECB selected by the architects of the TEU and reviews the degree of independence attributed to the ECB in comparison to member states national central banks (NCBs). The next section summarises the leading conceptual issues and empirical literature in order to examine the merits of establishing the ECB independent from democratic influence. Section IV reviews the hypothesised relationship between independence and macroeconomic indicators, whilst Section V concludes this re-evaluation through a review of challenges regarding the ECB’s ability to fulfil its objectives given its present policy framework. This is followed by some concluding remarks.

The design of the ECB The structure and role of the ECB is detailed in the Articles of the TEU. It is headed by a Governing Council comprising the governors of the NCBs, together with members of the Executive Board of the ECB. The latter consists of professional bankers or monetary experts nominated by the member states for a single eight year term of office (Article 109a). All members of the Executive Board and ECB in general, are expected to act independently of ‘Community institutions or bodies, from any Government of a Member State or from any other body’ (European Communities, 1991). However, the legal framework, institutional arrangements and emerging operating practices of the ECB are increasingly coming under closer scrutinisation and criticism (Buiter, 1999; Howarth and Loedel, 2003). Elsewhere, however, the TEU provides for the Council and Commission to possess non-voting representation at meetings of the ECB’s Executive Council, whilst the ECB must present an annual report to the EU’s institutions and appear before the relevant committees of the European Parliament when requested (Article 109b). The crucial operational features of the ECB are that its sole policy objective is the pursuit of price stability. It will also be responsible for defining and implementing the EU’s monetary policy, together with supporting the attainment of general economic objectives. This design format is founded upon both theoretical (Barro and Gordon, 1983; Alesina, 1989; Alesina and Grilli, 1991; Kydland and Prescott, 1997) and empirical (Alesina, 1988, 1989; Bade and Parkin, 1988; Cukierman, 1992; Alesina and Summers, 1993) studies whereby the transfer of monetary policy from governments to an independent central bank is likely to result in lower inflation.

Central Bank Independence and Monetary Policy 81

Additionally, the powers and tasks of the ECB are highly significant, with the Bank exclusively responsibility for authorising the issuance of bank notes (Article 105a). It is also able to make legally binding and directly applicable regulations on the minimum level of reserves to be held by NCBs, the efficiency of clearing and payment systems and on the supervision of credit institutions. Moreover, where an undertaking fails to comply with a ECB regulation or decision, the Bank will be able to impose a fine (Article 108a). Finally, the ECB is to be consulted by other EU institutions and national authorities and may issue opinions to them on matters within its competences (Article 105). Table 5.1 illustrates the individual features of each of the NCBs (NCBs) together with the ECB, with respect to political independence. It is suggested that the capacity of the monetary authorities to choose the final objectives of policy is primarily determined by three aspects of a monetary regime. First, the procedure for appointing the members of the central bank governing bodies, second, the relationship between these bodies and the government and finally, the formal responsibilities of the central bank. In principle, independence to determine ultimate goals may be defined without reference to their contents, but in practice the main virtue claimed for an independent central bank is that they can provide credibility. Hence, independence is frequently identified with autonomy from political interference to pursue the objective of low inflation, so that any institutional feature that enhances its capacity to pursue this goal is hypothesised to increase central bank independence. Table 5.1 indicates that the architects of the TEU were faced with a wide range of alternative variations of central bank political and economic autonomy from government out of which they created the institutional structure of the ECB. Contemporary examples of operationally independent central banks include the German Bundesbank, the Federal Reserve of the United States of America, the Bank of England and the Reserve Bank of New Zealand. Each has a different degree of autonomy concerning different operational issues. The German Bundesbank is probably the most important of these alternatives as it is perceived to have a track record of delivering consistently low inflation (Marsh, 1992). Faced with a number of alternative models (e.g. US Federal Reserve, Reserve Bank of New Zealand), the designers of the TEU preferred to follow the Bundesbank blueprint when establishing the design of the ECB given that Germany achieved low inflation over the period since 1961 and that those countries which pegged their currencies to the deutschmark ‘imported’ a similar inflation performance. Hence, the ECB is anticipated to be as successful in safeguarding low inflation and price stability across the euro zone.

82

Table 5.1

Summary of political independence of EU central banks and ECB Features of political independence – central bank governor

Features of political independence – central bank board

Governor appointed by:

Term (years)

Reapppoin- Board tability appointed by1

Belgium

Sovereign (i.e government)

5

Yes

Sovereign (i.e. government)

Denmark

Sovereign (i.e. government)

Indefinite

No

France

President

Indefinite

No

Parliament (8); Trade Minister (2); Bank Board (15) Minister of Finance (9) Bank (1)

Germany

President proposal of the government

Eight

No

President proposal of the government

No. of Term members (years)

Features of political independence – central bank, government and accountability

Reappointment

Government representatives

Relation with government

Relation with parliament

Monetary Provisions stability in case of objective disagreement with government

Government Approval Commissioner (advisory/ suspensive rights) Minister of ConsulTrade tation (supervisory right)

Through government

No

Yes – government directives

Annual report

Yes

No

Director Minister of Finance (advisory/ suspensive right) None

Approval

Through government

No

No

Consultation

Not accountable

Yes

Yes – temporary postposition

3–6

6

Yes

25

5

Yes

10

6

Yes

8

8

No

Greece

Government –proposal of the Bank President

4

Yes

Shareholders general meeting

9

3

Yes

Ireland

President – proposal of the government

7

Yes

Government

3–8

5

No

Bank Board – proposal of the government Netherlands Sovereign (i.e.government)

Indefinite

No

Shareholders regional meetings

13

3

Yes

None

7

Yes

Sovereign (i.e. government)

3–5

7

Yes

None

Consultation

Portugal

Government

5

Yes

Government

7–9

5

No

None

Spain

Sovereign – proposal of government

4

Yes

2

No

UK

Sovereign – proposal of government

5

Yes

Government 10–14 (6); Minister of Finance (2); Governor (1–4); Bank (1) Sovereign 16 (i.e. government)

4

No

Italy

Government Commissioner (suspensive right) Permanent

Consultation

N/A.

No

Yes – arbitration commission

Yes

No

No

Yes – government directives

Through government

Yes

Approval

Through government

No

None

Approval

Through government

Yes

Yes – government directives Yes – government directives No

None

Approval

Through government

No

No

ConsulAnnual tation report Secretary Minister of Finance Approval On call

83

Continued

84

Table 5.1

Features of political Features of political independence – central bank governor

European Central Bank 11.2)

Features of political independence – independence – central bank board

Governor appointed by:

Term (years)

Reapppoin- Board tability appointed by1

European Council (Article

8 (Article 11.2)

No (Article 11.2)

No. of Term members (years)

European Council (6) (Article 11.2) National governments (15) (Article 11.2

21

5–8 (Articles 11.2 and 14)

central bank, government and accountability Relation with government

Relation with parliament

Monetary Provisions stability in case of objective disagreement with government

Reappointment

Government representatives

No (Article 11.2)

Council of The The ECB Primary Explicit shall objective conflicts European ECB, nor Communities the address shall between and/or NCBs an annual be to ECB and European nor the report on maintain governCommission other the price ments are representative members activities stability may attend of the of the (Article possible meetings Council ESCB 2) (Articles 2 and 7) but cannot may seek and on vote (Article or take monetary 15.1) instruction policy of from both the Community previous Institutions, and the governcurrent ments of year to member the states or European any other Parliament, body Council (Article 7) and Commission (Article 15)

Source: Adapted from Alesina and Grilli (1991) and EC Commission (1992).

Central Bank Independence and Monetary Policy 85 Table 5.2

Political independence of central banks Appointments (Governor  Board)

1 Belgium Denmark France Germany Greece Ireland Italy * Netherlands Portugal Spain UK Column total ECB

1

2

3

Relationship with government

4

5

Constitution

6

7

*

*

*

*

*

*

*

*

8

* * * *

* *

*

* * * *

* * *

6 *

2

* * * * *

* *

*

*

5

6

4

5

3

*

*

*

*

*

Index of political independence

9 1 3 2 6 2 3 4 6 1 3 1

6

Sources: Adapted from Grilli et al. (1991) and EC Commission (1991).

Where: [1] governor not appointed by government; [2] governor appointed for
5 years; [3] all the board not appointed by government; [4] board appointed for
5 years; [5] no mandatory participation of government representative on the board; [6] no government approval of monetary policy formulation is required; [7] statutory requirements that central bank pursues monetary stability amongst its goals; [8] legal provisions that strengthen the central bank’s position in conflicts with the government are present. The apolitical status of the ECB can be examined in greater detail in relation to the concepts of economic and political independence. The latter refers to its decisions not being conditional on the approval of government, whilst the former pertains to its ability to operate monetary policy without government undertaking contrary actions. Tables 5.2 and 5.3 indicate the relative nature of political independence concerning the original signatories of the TEU when compared to the ECB with an asterisk indicating possession of a specific feature. Table 5.4 illustrates the comparative position in terms of the political, economic and combined indices of NCBs, following the adoption of the ECB criteria. The comparative figures are calculated by subtracting the value of the ECB

86 Current Economic Issues in EU Integration Table 5.3

Economic independence of central banks

Monetary financing of budget deficit

1

2

Belgium Denmark France Germany * Greece Ireland Italy Netherlands Portugal Spain UK *

* *

3

4

5

6

*

* * * *

* * * * * *

*

* *

*

* *

* * * * * * * * *

*

*

*

* *

Monetary instruments

7

8

9

* * *

5 4 4 7 2 4 1 4 2 3 5

*

* *

Column total

2

5

5

10

5

9

2

ECB

*

*

*

*

*

*

*

Index of economic independence

3 7

Sources: Adapted from Grilli et al. (1991) and EC Commission (1991).

Table 5.4 the ECB

Comparison of central bank independence of EU member states and

Present Comparison Present Comparison Comparison index of to political index of to economic to combined political independence economic independence independence independence of ECB independence of ECB of ECB

Belgium Denmark France Germany Greece Ireland Italy Netherlands Portugal Spain UK

1 3 2 6 2 3 4 6 1 3 1

5 3 4 0 4 3 2 0 5 3 5

5 4 4 7 2 4 1 4 2 3 5

2 3 3 0 5 3 6 3 5 4 2

7 6 7 0 9 6 8 3 10 7 7

Mean

3

3

4

3

6

Source: Derived from Tables 5.2 and 5.3.

Central Bank Independence and Monetary Policy 87

indices from those of the EU member states’ central banks. This procedure clearly identifies the German Bundesbank as providing the blueprint for the ECB with no required revisions to its independence characteristics. The central bank of the Netherlands is the only other to fall below the overall mean comparison figure of six, whilst Denmark and Ireland coincide with the average. In contrast, those NCBs requiring the largest institutional reforms to meet the TEU requirements were, in ascending magnitude: Belgium, France, Spain, Britain, Italy, Greece and Portugal. It is interesting to note that this division of EU member states mirrors the established concept of ‘core’ and periphery groups regarding the formation of the single currency area. Where: [1] direct credit facility – not automatic; [2] direct credit facility – market interest rate; [3] direct credit facility – temporary; [4] direct credit facility – limited amount; [5] central bank does not participate in the primary market for public debt; [6] discount rate set by central bank; [7] banking supervision not entrusted to the central bank at all; [8] banking supervision not entrusted to the central bank alone.

Evaluation of independence The belief that central banks should be independent from political influence has deep historical roots and featured in the discussions leading to the establishment of many twentieth-century central banks (Toniolo, 1988). The historical desire to impose limits upon the government’s ability to fund itself through seignorage is combined with the orthodox contemporary argument that politicians manipulate monetary policy to win elections, resulting in an excessive concentration upon short-term macroeconomic fine tuning (Swinburne and Castello-Branco, 1991). Consequently it is argued that long-term economic efficiency requires the removal of monetary policy from the sphere of democratically accountable politics, and its delegation to an independent central bank with an effectively designed constitution and internal reward system that impose price stability as the overriding policy objective. Few institutional reforms recommended by economists have gained such rapid, widespread acceptance as the demand to grant central banks independence from political control. Countries of the North and the South, the post-communist nations of Central and Eastern Europe as well as established capitalist states have all been affected by the debate on the appropriate role and status of the central bank (Posen, 1993). Thus the notion of central bank independence has taken on the character of a panacea, a quick institutional fix, producing desirable

88 Current Economic Issues in EU Integration

macroeconomic results in a wide variety of national contexts. It is the analysis of this apparently highly desirable position to which the chapter now turns. The conceptual case for central bank independence is primarily based on the view that arrangements raising the credibility of monetary policy will increase its effectiveness in pursuit of price stability. Although this view has long been held, only in recent years has the concept of policy credibility been defined and analysed rigorously (Cukierman, 1986; Blackburn and Christensen, 1989). The establishment of an independent central bank with strong antiinflationary preferences is seen as a way for the state to bind its hands against the electoral temptation of inducing unanticipated increases in the price level. As commitment increases credibility, orthodox theory predicts that divergences between the central bank’s policies and people’s expectations will become smaller. Therefore lower costs and fewer delays are incurred when adjusting to monetary policy shifts. It is from this theoretical perspective of monetarism and rational expectations that the ECB was launched. However, this approach has been challenged. First, if central bank independence increases credibility, it should be associated with greater rigidity in the setting of nominal prices and money wages, reflecting the fact that the bank’s promise to keep inflation low is believed. However, studies of OECD countries by Posen (1993, 1998) indicated that neither effect occurs. Indeed independence, not merely fails to reduce the cost of disinflation, but rather seems to increase it. Lowering inflation takes as long, and calls for a larger short-term sacrifice of output and jobs, on average, in countries with relatively independent central banks as compared to those democratically accountable monetary institutions. Second, most of the contemporary support for central bank independence stems from a partial and frequently historically naive view of West German experience whereby any one item that helped to promote rapid post-war German growth, such as the independent Bundesbank, was part of a structural totality defining its role. Accordingly it is unlikely to be effective if transferred by itself to other countries or onto the broader EU stage (Dowd, 1989, 1994). It may be more appropriate to reverse the fashionable view; the structural conditions that produced the strength of the German economy, allowing it to grow while maintaining a low inflation rate also enabled it to afford the luxury of an independent central bank concentrating on monetary stability. For example, the wage negotiations system in Germany has generally produced a less inflationary outcome than in many other countries over the post-war period, thus not requiring intervention from the Bundesbank. Therefore

Central Bank Independence and Monetary Policy 89

it must be open to question whether the creation of a more independent central bank is significant in containing inflation, or whether the existence of an independent bank merely reflects a political economy in which price stability is a widely shared objective, where governments, as well as the central bank, regard low inflation as an overriding objective (Mitchell, 1993). Consequently, the possibility of ‘reverse causality’ is accepted by economists as a significant constraint when interpreting the experience of countries with independent central banks. Moreover, the theoretical case for independence is based on two analytical assumptions that have become generally accepted by economists. First, the vertical long-term Phillips curve, which implies that price stability can be achieved at no long-term cost of unemployment; and second, the political business cycle. However, both rest on insecure foundations. The vertical Phillips curve analysis rests upon the concept of a natural rate of unemployment, the frequently changing determinants of which economists remain largely ignorant (Davidson, 1998; Karanassou and Snower, 1998; Madsen, 1998; Nickell, 1998; Phelps and Zoega, 1998). Moreover, repeated studies indicate that relatively little evidence exists for the occurrence of any systematic political business cycle (Kalecki, 1943; Breton, 1974; Nordhaus, 1975; MacRae, 1977; Wagner, 1977; Frey, 1978; Alesina, 1989). Fourth, difficulties are compounded by the empirical evidence concerning central bank independence and lower-than-average inflation, which again drew heavily upon the German Bundesbank, although counter-examples exist. For instance, the US with an independent central bank has not enjoyed such a phenomenon. Moreover, German experience since reunification demonstrated that an independent central bank is unable to guarantee low inflation. However, the persuasive nature of monetarist ideas led to the widespread conviction that low inflation is an important condition for high and sustained growth. Thus its achievement should be the priority for government economic policy. The importance attached to low inflation as the prerequisite for high employment and rapid growth is central to the case for an independent central bank. However, the belief that low or zero inflation produces sustained growth is once again, not supported by the available evidence. Indeed, many studies indicate that no significant relationship exists between low inflation and higher rates of growth, until double-digit rates of price increase occur, which do retard economic development (Thirlwall and Barton, 1971; Brown, 1985; Stanners, 1993). Thus, the consensus of research fails to provide the evidence to support the advantages of prioritising low inflation above all other objectives.

90 Current Economic Issues in EU Integration

Moreover, economic policy objectives should be sufficiently comprehensive as to include the pursuit of multiple policy targets. However, if responsibility for price stability rests solely with an independent central bank, while others remain with government, economic management potentially becomes more difficult due to the separation of monetary and fiscal policy (Blake and Weale, 1998). Hence, an advantage of a nonindependent central bank is that budgetary and monetary measures can complement each other, forging a co-ordinated strategy of economic management. A failure of policy co-ordination was demonstrated in the US by the shortcomings of the Reagan–Volcker era and within the EU by Germany’s problems in the aftermath of reunification. Such policy inconsistency highlights the ambiguous nature of ‘independence’ itself. Analysis of the role of a central bank confirms that, in a world of external shocks, the case for delegating monetary policy is weak and that a co-ordinated approach is more likely to achieve the electorate’s objectives (Rogoff, 1985a,b). Furthermore, if eliminating inflation is allimportant and elected politicians cannot be trusted to give it priority, the logical conclusion is that all economic instruments should be taken out of their hands. The assertion often made is that monetary policy is different, because it is a technical operation with a single objective and well understood, reliable techniques. Such a belief is questionable, since monetary policy impacts upon employment and living standards, as vitally as does fiscal policy. Moreover, periods of high inflation have not occurred wholly, or even mainly, due to lax monetary expansion, whilst there is greater international evidence of fiscal, rather than monetary, policy being manipulated for electoral ends (Alesina, 1989). When assessing the impact of central bank independence upon price stability, economists have mostly utilised imputed ‘degrees of independence’ to evaluate the heterogeneous character of central banks. A large body of literature focusing upon single or multi-country timeseries studies has accumulated, with an additional series of studies attempting to rank independence for a cross-section of countries. The majority of this research draws attention to the inherent difficulty of defining, let alone measuring, the concept of independence (Mangano, 1998). The initial method of imputing degrees of independence, based solely on legislature arrangements, found no relationship between inflation performance and independence (Bodart, 1990). The index was refined by subsequent studies, which constructed a measure of central bank independence that reflected both ‘political independence’ and ‘economic independence’ (Alesina and Grilli, 1991; Grilli et al., 1991). The former relates to the ability of the monetary authorities to choose

Central Bank Independence and Monetary Policy 91

the goals of policy, whilst economic independence is defined by their capacity to choose the instruments with which to pursue policy objectives. The main conclusion from such analyses is that the average rate of inflation, and occasionally its variability, is significantly lower in countries that possess independent central banks. However, the value of such evidence is problematic, as the authors usually acknowledge, because measurement of ‘degrees of independence’ possesses serious weaknesses, which cast doubt upon the purported association between central bank independence and the attainment of price stability. The main failings this approach are, first, that a limited spread of rankings inevitably restricts sensitivity across a wide number of inherently different countries, which raises difficulties concerning the index’s analytical usefulness. Second, that many of the studies cover overlapping time periods, opening up the possibility that they have found a result unique to that particular set of data. Therefore it becomes crucial to test a hypothesis on data sets other than those which suggested the hypothesis (Friedman and Schwartz, 1991). Furthermore, the time periods covered by some studies increase concern over the reliability of their findings. For instance, the participation of countries within the European Monetary System (EMS) could be viewed as a potentially important determinant of inflation rates. Consequently, if all countries in a pegged exchange rate system are compelled to possess the same rate of inflation over the long run, whatever the various influences are on that rate, the status of NCBs cannot be the main influence. Fourth, disregard for noneconomic factors that shape fiscal and monetary policy choices is a consistent feature of these studies, illustrated by their assumption that electorates always prefer low inflation to the possible trade-off of higher economic growth and employment (Muscatelli, 1998). However, even after analysing the role of political factors, other potential sources of differences in inflation rates are often neglected. For instance, even if EU countries were subject to the same exogenous shocks in the post-war period, structural differences – labour relations systems, wage indexation mechanisms, vulnerability to raw material price changes, varying preferences for inflation versus unemployment – between them may explain their different reactions. Indeed, the position of the government in the political spectrum and various proxies of social consensus offer some explanation of inflation rates in different countries (Hansson, 1987). Likewise, the size of the public sector appears to be another significant factor (Alesina, 1988). Moreover, lower inflation in Germany and Switzerland could result from the presence of ‘guest’ workers during periods of economic growth, who absorb part of the unemployment costs

92 Current Economic Issues in EU Integration

of disinflationary policies by having to return to their country of origin when the work is no longer available (Burdekin and Willett, 1990). In an attempt to compare monetary regimes, many studies focus exclusively on institutional characteristics disregarding behavioural indicators, such as the average rate of growth of the money supply or the level and variability of interest rates. However, new research rarely possesses at first the reliable database it requires. Therefore greater attention should be devoted to improving databases and to recording any national specificity that may exist or has occurred. Moreover, many studies suffer from the omission of indicators not identified as potential explanatory factors, so that influences other than central bank independence may be important, but as yet unidentified, determinants. Finally, a problematical aspect of this research is the statistical analysis of the link between central bank independence and inflation, with most studies relying upon the plotting of graphs. Indeed, Alesina and Summers (1993, p. 154) admit that ‘our empirical procedure is extremely simple. We plot various measures of economic performance covering the entire 1955–1988 period against measures of central bank independence’. Furthermore, the manner in which the determined characteristics of central banks are aggregated to produce the overall index of central bank independence is a major area for concern. Consequently, the index is usually constructed through one of a number of alternative methods, none of which is universally valid. Indeed, despite the occasional econometric testing, the results provide little support for the notion that independent central banks consistently deliver low inflation, whilst the more common approach of the unscientific plotting of a line between inflation and only one other variable (when there are many determinants) constitutes scant evidence upon which to rest the case for central bank independence. Hence, in view of these potential difficulties associated with the frequently prevailing use of imputed degrees of independence, the chapter now re-examines this issue.

Empirical analysis of central bank independence This section examines the issue of central bank independence within those EU members states (excluding Luxembourg which at the time did not possess its own central bank), which were original signatories to the TEU. Although this reduces the number of countries in comparison to several of the previous studies, it offers a logical basis for the subsequent analysis. For example, little analytical precision is gained, when examining the likely impact of the ECB, by including those countries which will

Central Bank Independence and Monetary Policy 93

never enter EMU (e.g. Australia, Canada, Japan, New Zealand and the US). Moreover, few previous studies offer a rationale for the countries they include, for instance, whilst focusing upon industrialised economies, they all fail to incorporate every member of such a representative grouping as the Organization for Economic and cooperation Development (OECD). A further aspect that differentiates this analysis is that it disaggregates central bank independence into its constituent features of political and economic independence. The approach involves dividing these principal features into 16 individual components, thereby enabling a detailed examination of the separate elements that comprise a central bank’s independence alongside an evaluation of the aggregate level analysis pursued in previous research. Finally, in addition to the now traditional comparison of central bank independence and inflation, GDP growth is introduced to evaluate the proposition that independence carries no detrimental consequences for output (Eijffinger et al., 1996). Table 5.5 shows the correlation results between the series of measures of central bank independence and both the rate of inflation and growth over the period 1961–94. Analysing a positive hypothetical relationship between central bank independence and inflation, the only statistically significant factors include the ‘board being appointed for a period exceeding 5 years’ and the ‘absence of prior government approval of monetary policy formulation’. Likewise, the fact the bank provides a ‘direct credit facility at market interest rate’ and ‘not participating in the primary market for public debt’, are the sole significant economic characteristics. Hence only four of a possible sixteen features of central bank independence appear to contribute to lowering inflation. Such findings contrast with the blanket contention that an independent central bank is an effective antiinflationary mechanism. Although these findings partially support the conclusions of previous studies (Alesina, 1989; Grilli et al., 1991; Alesina and Summers, 1993), there are several important caveats. First, the analysis of the individual features of political and economic independence indicates that only a limited number are statistically significant, raising difficulties concerning the necessity for all such characteristics to be present simultaneously within the ECB. Second, the overall index of political independence is insignificant indicating that such criteria proved historically inconsequential to EU member states’ inflation rates. Third, although the indices of economic and combined independence are inversely related to inflation, only 66 per cent of the variation of inflation is ‘explained’. This appears to offer marginal evidence at best from which to launch such a fundamental institutional reform, or to expect it persist over the

94 Current Economic Issues in EU Integration Table 5.5 Correlation between central bank independence and macroeconomic variables for EU member states Indicator of central bank independence

Indicators of political independence Governor not appointed by government Governor appointed for
5 years All the board not appointed by government Board appointed for
5 years No mandatory participation of government representative on the board No government approval of monetary policy formulation is required Statutory requirements that central bank pursues monetary stability amongst its goals Legal provisions that strengthen the central bank’s position in conflicts with the government are present

Rate of inflation

GDP growth

0.20 0.51 0.52 0.63** 0.07

0.05 0.20 0.31 0.13 0.10

0.55*

0.23

0.39

0.01

0.20

0.02

0.48

0.12

0.34 0.52* 0.32 0.13 0.84***

0.60** 0.57* 0.15 0.34 0.53*

0.32 0.16

0.31 0.10

0.42

0.35

Cumulative index of economic independence

0.81***

0.62**

Cumulative index of political and economic independence

0.81***

0.45

Cumulative index of political independence Indicators of economic independence Direct credit facility – not automatic Direct credit facility – market interest rate Direct credit facility – temporary Direct credit facility – limited amount Central bank does not participate in primary market for public debt Discount rate set by central bank Banking supervision not entrusted to the central bank at all Banking supervision not entrusted to the central bank alone

Notes: ***  p 0.01; **  p  0.5; *  p  0.1. Source: Baimbridge et al. (2002).

medium- to long-term, particularly if negative externalities are associated with greater independence. The second part of this empirical analysis examines the relationship between central bank independence and output to evaluate the orthodox hypothesis that the former constitutes ‘a free lunch’ (Grilli et al., 1991, p. 375), because it carries no detrimental consequences for GDP growth. The final column of Table 5.5 shows the correlation results for the individual features and the three overall indices of independence in

Central Bank Independence and Monetary Policy 95

relation to growth. With respect to political independence, neither the individual factors nor the index are statistically significant, whilst three of the economic independence criteria are significant: ‘direct credit facility not automatic’, ‘direct credit facility at market interest rate’ and ‘central bank does not participate in the primary market for public debt’. Of particular interest, however, is the negative association between these features and GDP growth, which contradicts the previously established proposition that central bank independence has no ‘costs in terms of macroeconomic performance’ (Grilli et al., 1991, p. 375). The implication therefore is that independent central banks exert a negative impact on the rise in their citizens’ standards of living and constitutes an ominous background to the actual operation of the ECB.

Monetary policy and philosophy The final aspect of this chapter briefly reviews the conduct of monetary policy by the ECB. Initially, the TEU left the role of the ECB uncertain, suggesting that it would mainly implement the policies determined by the NCBs by delegating the common monetary policy to the ESCB (von Hagen and Brückner, 2002). In view of such institutional vagueness a key concern has been how ECB Council members could reach an agreement on a common monetary policy, to what extent that policy would be affected by national circumstances and preferences and how it could be communicated effectively to a very heterogeneous European public (Cecchetti et al., 1999). Initially the European Monetary Institute (EMI) preparatory work narrowed the choice of a monetary policy strategy down to monetary targeting vs inflation targeting (EMI, 1997). However, in October 1998, the Governing Council of the ECB announced that a key aspect of monetary policy strategy being a quantitative definition of price stability. Furthermore, in order to assess risks to price stability, the ECB would make use of two pillars. First, it attributes a prominent role to monetary indicators as signalled by the announcement of a quantitative reference value for the growth of a broad monetary aggregate and second, it undertakes a comprehensive analysis of a wide range of other economic and financial variables as indicators of price developments (ECB, 1998, 1999, 2000, 2001; Issing et al., 2001). In relation to the quantitative definition of price stability it does not give a precise definition. In order to specify this objective more precisely, the Governing Council announced, in October 1998, the quantitative definition of price stability as ‘a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%’ which

96 Current Economic Issues in EU Integration

was ‘to be maintained over the medium term’ (ECB, 1998). Such an announcement is argued to enhance the transparency of the overall monetary policy framework and provides a clear and measurable benchmark against which to hold the ECB accountable. Furthermore, it gives guidance to expectations of future price developments, thereby helping to stabilise the economy. Consequently, the ECB (2003) argued that this definition of price stability has been conducive to a firm anchoring of inflation expectations in the euro area at levels compatible with the definition, thereby helping to contain the inflationary effects of the substantial price shocks which have occurred. While the announcement of a quantitative numerical value for the price stability objective of the ECB was welcomed, there has been criticism regarding specific features of the definition. First, regarding the choice of the price measure it has been argued that the ECB should put more emphasis on measures of ‘core’ or ‘underlying’ inflation, or even specify its objective in terms of a measure of core inflation (Alesina et al., 2001; Gros et al., 2001). Such measures could help to avoid the risk of monetary policy makers focusing excessively on temporary price fluctuations. Second, that the ECB’s quantitative definition may be too ambitious given a positive measurement bias in the HICP that could hamper the adjustment process at low levels of inflation, substantial divergences in inflation rates across countries that imply ‘too low’ a level of inflation and possibly frequent deflationary situations and the presence of a zero boundary on nominal interest rates that could hamper the effectiveness of monetary policy in the face of large negative demand shocks and expose the euro area to the risks associated with deflation and deflationary spirals (De Grauwe, 2002; Fitoussi and Creel, 2002). Third, that the ECB’s definition is imprecise and asymmetric as it specifies the upper boundary, but leaves the lower boundary undefined. This may result in it being less effective in anchoring inflation expectations and possibly hinder the clarity of explanations of policy moves. Consequently, it has been suggested that the ECB should make its objective more precise, for instance, by officially announcing a lower boundary in the definition or by specifying the objective in terms of a point inflation rate (IMF, 2002; Svensson, 2002, 2003). Finally, the choice of the specific quantitative objective requires a balance between the costs of inflation and rationales for small positive inflation rates. The costs primarily relate to the misallocation of resources, the inflation tax on real balances, the effects of inflation on income distribution and inflation uncertainty and associated risk premia, menu costs and those costs stemming from the interaction of inflation with the tax system. In

Central Bank Independence and Monetary Policy 97

contrast, the case for small positive inflation relates to measurement bias in the price index, downward nominal rigidities, sustained inflation differentials and the risk of protracted deflation or a deflationary spiral (Yates, 1998; Wynne and Rodriguez-Palenzuela, 2002; Coenen, 2003; Klaeffling and Lopez-Perez, 2003). Unfortunately, such a review of the costs and benefits of moderate inflation does not allow the optimal rate of inflation to be precisely defined, it indicates the need for an inflation objective embodying a sufficient safety margin against deflation. In response to this criticism the ECB (2003) suggested that inflation objectives above 1 per cent provide sufficient safety margins to ensure against these risks.2 In relation to the first pillar, its key characteristic is the announcement of a reference value for the annual growth of M3. Hence, the ECB seeks to communicate the medium-term focus of monetary policy to the public, as it relieves the central bank from responding to short-run fluctuations in financial and other variables (ECB, 2003). Furthermore, by signalling continuity of the Bundesbank’s strategy, the ESCB hoped to quickly establish credibility (von Hagen and Brückner, 2002). However, the role of money and monetary analysis has generated controversy regarding the robustness of the chosen leading indicator’s properties with respect to price developments on the grounds that the correlation between money growth and inflation appears to have declined over time in parallel with restored conditions of price stability (Begg et al., 2002). In this context, the necessity for announcing a reference value for money growth has also been queried, together with the usefulness per se of a separate ‘money’ pillar (Svensson, 2003). In contrast, the second pillar consists of an assessment regarding future price developments (ECB, 1998). Initially, it represented the analysis of short-run price developments based on measures of real activity, wage cost, asset prices, fiscal policy indicators, together with indicators of business and consumer confidence (ECB, 1999). However, no framework was specified how these variables would be used to assess price developments, nor their relative weights in such assessments. It is therefore an opaque part to the ESCB’s strategy, being void of systematic analysis and fully discretionary (von Hagen and Bruckner, 2002). Furthermore, Gaspar et al. (2001) suggest that the analysis is now organised in the form of a macroeconomic projection, although the ECB does not provide confidence intervals for its projections (Gali, 2001). According to the ECB (2003), the two pillars are used in parallel in monetary policy decision making. However, there is no indication of what their relative weights are resulting in an incomprehensible strategy,

98 Current Economic Issues in EU Integration

as Issing et al. (2001) partially acknowledge. Although there is nothing that would make the use and revelation of the relative weights of the two pillars impossible the reason why the ECB has so far denied the public transparency of its strategy is more likely related to the internal decision making processes (von Hagen and Bruckner, 2002). Finally, from its ostensively monetarist pre-history the ECB argues that the majority of euro zone’s high unemployment originates from structural deficiencies on the supply side of its member states’ economies. Consequently, it denies responsibility for increasing aggregate demand to lower unemployment, since no scope exists to reduce unemployment without accelerating inflation. However, if the sole objective of policy is to maintain a constant rate of inflation, wide variations in output and employment may be required. In so far as a potential conflict exists between steady inflation and full employment, the latter should enjoy priority, because of the consequences of market failure in terms of high rates of employment are more serious than those associated with moderate levels of inflation.

Conclusion The theoretical and empirical evidence surveyed in this chapter suggests that, the creation of an independent central bank is a more finely balanced exercise than is frequently portrayed in particular given national economies which continue to experience varying economic cycles and possess divergent economic structures. Moreover, the interest rate decisions taken by central banks are amongst the most sensitive actions deployed in a modern economy, influencing growth, living standards, the level of unemployment and the cost of credit and mortgages. However, the ECB publishes neither forecasts nor the minutes of its deliberations and its members cannot be removed from office by the European Parliament, the Council of Ministers or even by the European Court. The ECB’s problems arise from its lack of democratic accountability, transparency and democratic legitimacy, arbitrary objectives, questionable economic philosophy and the potential for intermittent conflict with the national governments over whose destinies it possesses considerable influence. An alternative model of a democratically accountable and controlled ECB, operating in co-ordination with a combination of nationally determined fiscal policies, or a newly established federal authority, would prove a more effective and desirable model for EMU.

6 EMU Convergence and Fiscal Policy

Introduction Most academic social science literature either accepts that closer European Union (EU) integration is desirable, or more usually, given the political will of EU leaders that it is inevitable. Therefore economists, political scientists and sociologists frequently devote their research to the dynamics of Economic and Monetary Union (EMU), the political institutions fostering ‘ever closer union’ and the social implications of these momentous changes. However, whilst such detailed analyses generate important policy proposals, they tend by their weight to smother the crucial strategic issue: is EMU beneficial or not, for the EU as a whole? The purpose of this chapter is to analyse this issue. More specifically, it seeks to evaluate the criteria which have been advanced by different authorities to assess whether or not membership of the single currency would prove beneficial. Over the last 20 years, economists have studied the potential impact of monetary union between countries under the rubric of optimum currency area theory. It concludes that a single currency boosts participants’ living standards when they possess similar economic structures and international trading patterns, but proves detrimental where these diverge. The danger of locking a country’s currency within an international regime ill-suited to meeting domestic and external economic goals is illustrated by British mass unemployment under the Gold Standard of the 1920s and, to a lesser extent, the 1990–92 recession worsened by Sterling’s overvaluation within the European Exchange Rate Mechanism (ERM). Consequently, to avoid making a potentially costly mistake, especially since single currency membership is intended to be permanent and irrevocable with no exit clause negotiated in the Treaty on European 99

100 Current Economic Issues in EU Integration

Union (TEU), there is an obvious need for a series of measurements to determine whether an individual economy is prepared for the demands of membership (EC Commission, 1992). These indicators must incontrovertibly demonstrate the existence of prior, sustainable ‘real’ convergence between participating economies, before the formation of a single currency between these countries is in their economic interests. However, despite the critical importance of such indicators in establishing whether or not membership of EMU is ‘good’ or ‘bad’ for a particular country, their construction has been paid relatively scant attention. Indeed, the convergence criteria contained within the TEU are more concerned with examining transitory cyclical movements in financial indicators, rather than concentrating upon structural convergence in the real economy (EC Commission, 1992). Thus the only questions asked are those concerning the levels of price inflation, interest rates, exchange rate stability, public debt and annual budget deficits. The TEU focused upon ‘nominal’ convergence, measured by reference values (e.g. 60 per cent debt; 3 per cent deficit) which largely reflect historical levels of debt and deficit in the ‘core’ EU countries. Their relevance to future conditions is unclear. By contrast, the TEU contained no similar tests to compare the wealth of the different countries, their unemployment, productivity and growth rates, nor the sectoral composition of economic activity. Perhaps this is not entirely surprising as the EMU project was designed by central bankers whose particular concern was to devise rules restraining potentially profligate national governments from destabilising the monetary system. However, whilst these matters are important, it is problematic that EMU is designed to proceed from such a narrow, theoretically questionable foundation. Such concerns are magnified by the fact that EMU possesses no historical precedents. No monetary union has existed independently of political union and no independent country has ever unilaterally abandoned its own currency (Goodhart, 1995). EMU is therefore a ‘leap in the dark’ which has potentially destructive implications if its participants are not sufficiently converged prior to its establishment (Eichengreen, 1992, 1993). The chapter is divided into four sections. First, it reviews the degree of economic convergence between the 15 EU member states, as reflected by the Maastricht criteria, for the period 1990–2002. It then summarises the established theory of optimum currency areas, which provides a benchmark for comparison with previously discussed measurements of economic integration. Finally, it reviews implications for national fiscal policy in light of the TEU obligations. This is followed by some concluding remarks.

EMU Convergence and Fiscal Policy 101

Attainment of the Maastricht convergence criteria The identification of those individual EU member states which have demonstrated their suitability for single currency membership is officially determined by their attainment of the five Maastricht convergence criteria (MCC) established in the TEU. These are: 1. each country’s rate of inflation must be no more than 1.5 per cent above the average of the lowest three inflation rates in the EMS; 2. its long-term interest rates must be within 2 per cent of the same three countries chosen for the previous condition; 3. it must have been a member of the narrow band of fluctuation of the ERM for at least two years without a realignment; 4. its budget deficit must not be regarded as ‘excessive’ by the European Council, ‘excessive’ being defined as deficits greater than 3 per cent of GDP for reasons other than those of a ‘temporary’ or ‘exceptional’ nature; 5. its national debt must not be ‘excessive’, defined as above 60 per cent of GDP and not declining at a ‘satisfactory’ pace. Thus, the MCC are denominated exclusively in terms of ‘nominal’ rather than ‘real’ convergence targets. Nominal values as represented here concentrate upon specific financial ratios rather than measurements of productivity and output growth, changes in the level of employment and other indicators from the real economy. The initial two criteria have a clear rationale with respect to the establishment of a single currency area based upon the achievement of prior cyclical convergence. The similarity of inflation rates denotes a low probability of a sudden loss of competitiveness inside a single currency which might lead to unemployment blackspots and a growing inequality at the heart of the monetary union. Moreover, comparable interest rates indicate a relatively straightforward transition to a common monetary policy, that does not require dramatic changes in the national strategies formally pursued by the nation states. However, whilst these two MCC are theoretically sound, the latter three have generated both analytical and empirical controversy. The third Maastricht convergence indicator, the ‘normal’ fluctuation bands, was interpreted until 1992 as the relatively narrow margins of
/2.25 per cent around the central parity which then operated for most ERM currencies. However, following the 1992–93 exchange rate crises, the bands were widened to
/15 per cent for an indefinite period

102 Current Economic Issues in EU Integration

in order to reduce the speculative pressure upon the ERM, whilst Italy and the UK were forced to withdraw from the system entirely. As a result, the third MCC was relaxed in order to adapt to this new reality, so that member states only had to achieve the looser measure of currency stability required by the ERM (Aglietta and Uctum, 1996). However, the redefinition significantly reduced this indicator’s utility, because the looser arrangement allowed for a currency to fluctuate by a potential of 30 per cent and still be considered stable. During any period other than an economic crisis or massive competitive misalignment, it would be unlikely that a currency would threaten to breach such a lax target, so that the criteria becomes increasingly difficult to defend. Indeed, at their June 1996 meeting EU Finance Ministers agreed to ignore the ERM membership precondition entirely. The decision was particularly fortuitous, since a significant number of countries still failed to meet such modest standards. The UK and Sweden have not rejoined the ERM, whilst Spain and Ireland realigned their central parity rates; thus they failed to meet the original principle of successively reducing exchange rate fluctuations, whilst preventing realignments prior to the establishment of a single currency in order to minimise adjustment costs. The inclusion of the final two targets as means to establish the compatibility of potential participants within a monetary union raises further problems. The justifications for their use are, first, that they would result in a stable debt ratio in a steady-state economy with 2 per cent inflation and 3 per cent real growth (Trades Union Congress, 1993); and second, advocacy of the ‘golden-rule’ that current government expenditure and revenue should be equated, together with an estimate that EU public investment approximately averaged 3 per cent over the period 1974–91, indicates adoption of the MCC (Buiter et al., 1993). However, the first justification fails to provide a convincing case for the specific values chosen for maximum government borrowing as a proportion of GDP, since the fiscal reference values are compatible with any combination of inflation and growth which summate to 5 per cent per annum. Moreover, there is no evidence that attainment of these criteria would result in a steady-state economy (Arestis and Sawyer, 1996). Consequently the justification for the last two MCC is far from secure and the case for their reliability must rest upon the second justification. However, it appears to be based upon the simplifying and unlikely assumption of zero inflation, otherwise inflation accounting must be included into the calculation. The 60 per cent national debt criterion is of doubtful use in any case, because it is primarily a consequence of the prior accretion of debt, reflecting past fiscal activities rather than current

EMU Convergence and Fiscal Policy 103

policy (Goodhart, 1992). Whilst it is important to avoid a country joining a monetary union so over-burdened by the results of poor previous macroeconomic management that it is susceptible to current repayment crises, the adoption of a 60 per cent maximum figure appears somewhat arbitrary and unnecessarily harsh. Despite the problematic nature of the MCC, the architects of EMU believed that their attainment would indicate the compatibility of potential participants, together with providing a guide to their subsequent maintenance in both favourable and unfavourable economic conditions (Baimbridge, 1997). The prerequisite of prior convergence is significant over each stage of the economic cycle, if EMU is to prove robust against symmetric and asymmetric shocks (Eichengreen, 1992; Bayoumi and Eichengreen, 1993). However, examining the extent to which EU member states have actually met the MCC over the period 1992–2002 following the signing of the TEU encapsulates both a recession and recovery makes difficult reading for supporters of European monetary integration. Only in 1998, the crucial year prior to the irrevocable fixing of national exchange rates did compliance with the MCC begin to approach that necessary for a sustainable monetary union. Even then, however, only six EU member states achieved strict adherence to all five MCC. Table 6.1 shows that attainment of all five criteria was fulfilled on only 29 from a possible 165 occasions over the 1992–2002 period. A record of achievement of approximately 18 per cent is a particularly poor reflection of the prior convergence of the EU economies, as measured by the MCC, particularly manifested in the period preceding EMU, when member states retained considerable control over their economies. Indeed, only Luxembourg, a country atypical of other EU members’ economies in terms of its size, industrial base, and the fact that it does not possess its own central bank (allowing Belgium to operate its monetary policy) appears able to consistently meet the five criteria. Of the remaining fourteen EU members states, only seven have ever secured total compliance with the convergence indicators with key euro zone countries such as Austria, Belgium, Italy and Greece failing to achieve all five criteria. Moreover, the number attaining all five MCC peaked in the period 1998–2001, but has since fallen thereby illustrating the difficulties in maintaining political willpower after the commencement of EMU and adherence in light of an economic slowdown. Whilst the Stability and Growth Pact (SGP) was designed to reinforce the former, the latter is a consequence of the MCC’s inherent design faults and questionable a priori convergence between EMU candidates.

104

Table 6.1

The number of MCC achieved by EU member states (1992–2002)

Country

1992

1993

1994

1995 1996 1997 1998

Luxembourg Denmark* France Germany Ireland Belgium Netherlands Austria Britain* Finland Sweden* Spain Portugal Italy Greece

5 4 4 4 4 3 3 3 2 1 2 1 0 0 0

4 3 4 3 3 3 3 2 2 1 1 1 0 0 0

5 3 4 5 3 3 3 3 3 2 1 1 0 0 0

5 4 4 4 4 3 3 3 3 2 1 1 0 0 0

5 4 4 3 4 3 4 3 2 3 2 1 1 0 0

5 4 5 4 4 4 4 4 4 4 3 4 4 3 0

Number of member states meeting all MCC

1

0

2

1

1

2

Note: * member states exercising their opt-out from the single currency. Source: Adapted from Baimbridge et al. (1999).

1999

2000

2001

2002

Ave

SD

5 5 5 4 5 4 4 4 4 5 3 4 5 4 2

5 5 5 4 4 4 4 4 4 5 3 3 4 4 4

4 5 5 4 4 4 5 4 4 4 4 3 5 4 3

5 5 5 4 4 4 4 4 4 5 4 5 3 4 3

5 5 4 3 4 4 4 4 4 5 4 4 4 4 3

5 4 4 4 4 4 4 3 3 3 3 3 2 2 1

0.4 0.8 0.5 0.6 0.5 0.5 0.6 0.7 0.9 1.6 1.2 1.6 2.2 2.0 1.6

6

4

4

5

3

2

1.9

EMU Convergence and Fiscal Policy 105

An additional measure of the ability of each EU member state to participate in monetary union is provided by Table 6.1, through examining the average number of criteria met in a given year and by a given country. This examination indicates that although, only Luxembourg, Denmark, France, Germany, Belgium, the Netherlands and Ireland come close to satisfying the convergence indicators on a permanent basis; although even their record raises significant doubts about their longterm ability to achieve the MCC. Thus the available evidence provides little support for the ability of member states to both achieve, and maintain, the stipulated convergence criteria for more than momentary periods. To the extent that the MCC satisfactorily indicate ‘fitness’ of entry for EMU, the failure of EU member states to consistently meet these criteria raises the prospect of the single currency becoming unsustainable in the medium to long term. The inclusion of standard deviation (SD) figures for each EU country illustrates the degree of variability in their attainment of the five MCC over the 1992–2002 period. As previously identified, Luxembourg was the best performing member state in this regard closely followed by France, Ireland, Belgium, Germany and the Netherlands. However, the more disturbing finding is the significant level of variability of countries such as Finland, Spain, Greece, Portugal and Italy where the SD figure exceeds either 1 or 2 convergence criteria. Although this is offset by their movement towards fuller compliance in more recent years, such historical instability regarding the adherence of the MCC highlights the potentially fragile nature of the euro project as presently conceived. The conclusions reached from the examination of Table 6.1 diverge significantly with the examination of the progress towards convergence and sustainability of the monetary union completed by the EU Commission (1998). Indeed, the Commission concluded that 11 EU member states have ‘achieved a high degree of sustainable convergence’, with the UK, Sweden and Denmark utilising their opt-outs from membership and only Greece deemed incompatible with EMU. However, its conclusion conflicts with the economic data; for example, Belgium, Germany, Greece, Spain, Italy, the Netherlands, Austria and Sweden all possessed a government debt ratio exceeding 60 per cent in 1999. Even assuming that the economic climate is favourable to reducing previous debt burdens, it is most improbable that Italy and Belgium will be able to meet this criteria since both have government debt ratios in excess of twice the MCC limit. Indeed, their government debt share of GDP is significantly higher than that of Greece, although Italy and Belgium were passed as ‘fit’ for monetary union membership whereas Greece was initially rejected.

106 Current Economic Issues in EU Integration

The variance between the historical evidence that a large number of EU member states will not consistently meet the MCC by the establishment of EMU, and that their participation in the monetary union has already been endorsed by the Commission, may indicate that the decision as to which countries qualify has been taken on political rather than economic grounds. The problem with undermining a rigorous interpretation of the MCC is that, to the extent that they reflect necessary prerequisites for a sustainable EMU, failure to comply could create a potentially weakened single currency which will suffer from a higher degree of inherent tension than would otherwise have been the case. The experience of those countries which narrowly comply with the MCC for only a minority of the period since the TEU was adopted, suggests that they are not permanently converged, but only achieve the necessary conditions in the most favourable economic circumstances. The implication is that, once a recession occurs, the majority of EMU participants will demonstrate a significant divergence from the established criteria, thereby increasing the potential for destabilisation at the heart of the single currency.

EMU and optimum currency area theory The debate surrounding the prospects for a single EU currency has begun to focus upon the prior necessity for structural economic convergence, which is wider than simply meeting the Maastricht conditions or the Treasury tests. These criteria may be largely necessary for a successful and sustainable EMU, but they are not sufficient to fulfil this objective. Therefore a need exists to develop a more comprehensive set of criteria to complement the MCC. To do so, it is necessary to examine that section of economic theory which discusses the optimality of monetary unions and exchange rate arrangements, namely the theory of optimum currency areas (De Grauwe, 1994; Corden, 2003). This extensive literature points to a number of distinct, yet interrelated characteristics which are likely to determine the probable consequences of monetary union. Nine elements are discussed here which are integral to the establishment of an additional set of convergence criteria. (i) Degree of factor mobility. Countries between which there is a high degree of factor mobility are viewed as better candidates for monetary integration, since it provides a substitute for exchange rate flexibility in promoting external adjustment (Mundell, 1961; Ingram, 1962). However, in practice it is unlikely that the EU, with its different cultures, languages

EMU Convergence and Fiscal Policy 107

and traditions across member states, displays sufficient inter-regional labour mobility to act as a mechanism for payments adjustment. Available evidence suggests that labour mobility within European nation states is one-third the level found in a mature EMU such as the US, despite the existence of greater regional inequality and unemployment in Europe. This implies that European labour mobility is less responsive to employment and income incentives (OECD, 1986; Eichengreen, 1997). Moreover, these figures relate to labour mobility within individual countries, whereas mobility between countries is likely to be much lower due to language barriers, cultural differences and residual non-recognition of qualifications (Ermisch, 1991; Masson and Taylor, 1993). Furthermore, capital mobility is unlikely to generate sufficient short-term stabilisation due to the time lags involved in the movement of physical capital whilst, due to the transactions costs involved, factor movements are an inefficient means of reacting to transitory regional shocks (von Hagen, 1993; Romer, 1994). (ii) Degree of commodities’ market integration. This criterion is concerned with structural convergence and specifically with the requirement that countries should possess similar production structures. Economies exhibiting such symmetry are deemed to be more welfare-efficient candidates for currency area participation than those whose production structures are markedly different (Mundell, 1961). The reason for this belief is that external shocks will tend to impact upon given industries in certain ways, and therefore a group of economies with similar industrial structures should experience similar effects, making it easier for a common monetary and exchange rate policy to mitigate any negative results of the shock. However, in comparison to most EU members, Britain possesses a different industrial structure. For example, it possess a relatively small agricultural sector, this difference being most noticeable in comparison with Ireland, Denmark and the Mediterranean countries. It would be magnified if Poland, Hungary and the Czech Republic gained full EU membership. In contrast, the UK has a much larger energy industry than other EU countries except the Netherlands, and possesses specific service sector concentration in the financial and media sectors. Thus the UK balance of payments structure depends more heavily on investment earnings than any other EU member economy, to the extent that British direct and portfolio overseas investment earnings totalled £38.5 billion compared to £28.2 billion occurring from exports of finished manufactures. Britain enjoys a greater reliance upon high technology exports, particularly in the fields of aerospace and pharmaceuticals, where its main

108 Current Economic Issues in EU Integration

competitors are US or Japanese firms, a few of which may be located in continental Europe. Indeed, prices in many of these sectors, such as the oil and high technology markets, are typically denoted in US dollars. EMU might lead to greater exchange rate variability in these areas of UK competitive advantage, since the Euro would be less affected by trade in these markets than sterling is at present. Finally, the UK economy is significantly different from most continental European economies in terms of its reliance upon variable-rate interest borrowing to finance private housing owner-occupation and industrial investment. This makes the UK economy more reactive to changes in short-term interest rates than other EU economies, so that the ECB would be likely to vary a common interest rate more than is necessary to stabilise the UK economy, because other EU member states are less responsive to such movements (Weber, 1991; Taylor, 1995; Bank for International Settlements, 1996; Burkitt et al., 1996; Eltis, 1996). It has recently been estimated that the impact of an interest rate change on UK domestic demand after two years is four times the EU average (Pennant-Rea, 1997). (iii) Openness and size of the economy. It is an observed fact that economies where international trade accounts for a high proportion of national income tend to prefer fixed exchange rates, because exchange rate changes in such economies are unlikely to be accompanied by significant effects on real competitiveness. In this sense, the greater the potential for damage to the economy from a fluctuating currency, the more business leaders and employees desire exchange rate stability. If a fluctuating exchange rate affects only an insignificant proportion of the economy, the pressure for such arrangements is lower. Moreover, in open economies frequent exchange rate adjustments diminish the liquidity property of money, since the overall price index varies more than in relatively closed economies (McKinnon, 1963). However, whilst relatively open economies might prefer exchange rate stability, they also require the ability to correct any fundamental misalignment of their currency. Such over or undervaluation could occur gradually, over time, as the competitiveness and productivity of the economy changes relative to others with whom the country has a fixed exchange rate, or more rapidly as a result of an internal (e.g. wage–price explosion) or external (e.g. oil price rise) shock. Irrespective of the cause, failure to adjust exchange rates to their long-term equilibrium value, itself changing over time, prove damaging to the economy in question, unless alternative adjustment mechanisms are sufficient to achieve the same outcome. Most small- or medium-sized industrialised nations fulfil this condition.

EMU Convergence and Fiscal Policy 109

(iv) Degree of commodity diversification. Highly diversified economies are better candidates for currency areas than less diversified economies, since their diversification provides some insulation against a variety of shocks thereby forestalling the need for frequent changes in the exchange rate (Kenen, 1969). Countries reliant upon a small number of prominent industries react significantly differently to other monetary union participants in the face of changes within those particular markets. This would increase the difficulty of operating a common monetary policy which could stabilise all participants. In general terms, virtually all industrialised member states fulfil this particular criteria, at least prior to the establishment of a single currency. However, the combination of a single market and EMU is likely to generate a degree of specialisation that potentially undermines such insulation. Multinational corporations, in particular, are anticipated to respond to the opening of markets and greater transparency of prices by expanding throughout Europe. Indeed, the creation of large European corporations, intensifying specialisation in fewer, larger concerns better equipped to compete globally, was one principal impetus behind the push towards greater European integration (EC Commission, 1990). (v) Fiscal integration and inter-region transfers. The higher the level of fiscal harmonisation, the greater is the ability to smooth divergent shocks through transfers from low to high unemployment regions. This feature is important for the emerging EMU because, in the absence of national exchange rate variation, wage–price flexibility and/or labour mobility are unlikely to prove sufficiently powerful to adjust economies in the face of asymmetric external shocks. Consequently, budgetary policy can be an important tool to cushion individual countries from shocks. Such fiscal flexibility may involve the discretionary strategies associated with ‘fine tuning’, but can also arise from the operation of automatic stabilisers (Kenen, 1969). It can also occur at the national as well as the federal level. Therefore, despite the constraints placed upon national fiscal policy by the operation of the MCC and the Stability and Growth Pact, it is probable that federal policy will expand over time. The current size of the EU budget, at only 1.24 per cent of total EU GDP, appears to preclude the development of any significant inter-regional fiscal transfer system for the foreseeable future (MacDougall, 1992, 2003). Moreover, its cost may defer meaningful consideration of this potential mechanism to stabilise EMU (Burkitt et al., 1997; Whyman, 1997). However, in the absence of alternative stabilising mechanisms, fiscal integration may be the only practical means of sustaining EMU in

110 Current Economic Issues in EU Integration

the medium and long term, given the likely persistence of asymmetric external shocks. (vi) Degree of policy integration. The fact that monetary union requires the establishment of a common monetary and exchange rate policy, applied across the entire union, means that external shocks which impact upon individual economies in a significantly different manner than for the majority, require different policy instruments in order to restore stability (Ingram, 1969; Haberler, 1970; Tower and Willett, 1970). Fiscal policy variations between member countries can potentially offset a nationally based disequilibria, but the constraints imposed by the MCC effectively limit what can be achieved on a national basis. In any case, the argument for greater macroeconomic policy co-ordination is independent of whether monetary union exists, namely that a more efficient outcome results if all countries affected by a given shock respond in an optimum manner. For example, if the UK suffers a negative shock which reduces its competitiveness and increases unemployment, whilst Germany experiences the opposite effect, an increase in competitiveness and an over-tight labour market, mutual benefit flows from a co-ordinated policy response by both countries. In this case, Germany would raise taxation or reduce government spending in order to prevent inflationary pressure, whilst the UK would reflate its economy. If fiscal federalism existed, part of the resources needed for such a reflation could be transferred from Germany to the UK, thereby enhancing the stabilisation of the union between them. However, although the need for an ‘economic’ as well as monetary union is recognised by the TEU, its only practical applications thus far have been the continuation of EMS membership until monetary union and the SGP. (vii) Similarity of inflation rates. This criterion focuses upon the significance of divergent trends in national inflation rates as a source of balance of payments problems. Diverse price changes impacting upon national competitiveness arise from a variety of potential causes including: differences in national propensities for trade union wage militancy, acute shortages of highly trained employees or differences in investment rates and therefore industrial capacity growth (Haberler, 1970; Fleming, 1971; Magnifico, 1973). The architects of EMU were aware of the danger and included this target as one of the five MCC. Moreover, ERM membership resulted in most EU member states adapting their economic strategies in order to achieve similar inflation rates, particularly during the 1980s when the mechanism was reinterpreted as a means of achieving monetary union through the absence of further realignments.

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This strategy was partially successful, average EU inflation rates declining from 10.7 per cent during the 1970s to 6.5 per cent in the following decade and further during the 1990s, with the variance between most EU member states declining dramatically during this period. Although these trends was largely in line with international ones outside the ERM, EU member states enjoyed success in reducing both their absolute inflation rates and differentials between them. However, the adjustment of economic policies undertaken by ERM members, in order to reduce inflation differentials, carried the cost of high, persistent unemployment for many countries. Not only was this a high price to pay in terms of economic and social costs to the states and individuals concerned, but it means that non-ERM countries, such as the UK, are less likely to meet this criteria unless they reduce growth rates and operate tighter fiscal and monetary policies. (viii) Price and wage flexibility. When prices and wages are flexible between regions adjustment to destabilising shocks is less likely to be associated with unemployment in one region and inflation in another. The need for exchange rate changes is diminished, because wage–price flexibility takes the place of exchange rate variations in maintaining a competitive balance between countries (Friedman, 1953). For example, if the UK suffered an inflationary shock which meant that the prices of its exports suddenly increased by 10 per cent in the absence of an accommodating fall in the exchange rate, only a 10 per cent reduction in UK prices would restore the former competitive equilibrium. This, in turn, would require a fall in wages. However, available evidence indicates that substantial wage–price rigidity persists across Europe, so that market flexibility is unlikely to restore former competitiveness either easily or quickly. As a result, wage–price flexibility cannot prevent the generation of areas blighted by high and persistent unemployment, a fact confirmed by the large literature concerning nominal and real wage rigidity in Europe (Bruno and Sachs, 1985; Carlin and Soskice, 1990; Dréze and Bean, 1990; Eichengreen, 1990, 1993, 1997; Layard et al., 1991; Bini-Smaghi and Vori, 1992; Blanchard and Katz, 1992; Kenen, 1995; Goodhart, 1995). If wage–price rigidity prevents an immediate and full restoration of former competitiveness, output will fall and unemployment will rise, until wage reductions, or at least slower wage growth, enhance competitiveness. However, the country in question may suffer from the dual problems of persistent high unemployment and a decline in incomes for its citizens relative to the monetary union as a whole.

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(ix) The need for real exchange rate variability. The real exchange rate (i.e. adjustment of the nominal exchange rate by the rate of price increases) measures the shifts in a nation’s competitiveness. For example, if the nominal exchange rate of sterling against the US dollar declines by 5 per cent, but UK inflation is 5 per cent higher than the American equivalent rate, the real exchange rate remains unchanged as no movement has occurred in relative competitiveness between the two countries. Thus, when a country participates in a monetary union and its nominal exchange rate is fixed at a given value to those of other members, the real exchange rate denotes whether that country (now a region of the monetary union) remains competitive over time. A negative shift in competitiveness will typically cause a deterioration in the balance of payments. However, in the absence of any changes permitted in the nominal exchange rate, a lack of competitiveness could result in areas of high, persistent unemployment. The only available method of reducing the real exchange rate, and thereby restoring competitiveness, is to reduce relative prices. This could be achieved over time if investment in capital and education produced a new competitive edge. However, a more immediate method would be to reduce relative wages, leading to lower income growth than in the remainder of the monetary union. The smallness of countries’ real exchange rate movements is a crucial characteristic for determining currency area optimality, because real exchange rate changes are clearly measurable and automatically give the appropriate weights to the economic forces of which they are the result (Vaubel, 1976, 1978). Given that real exchange rate variability depends upon the absence of real wage rigidity, the comments made for (viii) equally apply in this instance. The nine optimum currency area criteria, outlined in this chapter, indicate the relative probability of the efficient operation of a single currency. They appear more extensive than either the MCC or the UK Treasury ‘tests’, both of which constitute an incomplete guide on which to base the decision as to whether the UK should participate in EMU. However, the available evidence gleaned from applying optimum area criteria to the question of potential participation in the EU single currency identifies significant differences between the UK economy and the majority of nations who are joining the single currency, which are likely to persist. For example, whilst inflation rates appear to be sufficiently similar at present, there must be some probability that, unless the UK submitted to ERM discipline over the medium term and accepted the significant increase in unemployment that this would imply, differential patterns of inflation will remain over the economic cycle. Neither

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wage–price flexibility, nor labour mobility is sufficiently extensive to restore competitive equilibrium, when the relative movement of prices negatively affects UK competitiveness and hence real exchange rates. The marked differences in industrial structure leads the UK to respond to external shocks in a markedly different manner from other EU economies, thereby undermining the ability of a common monetary and exchange rate policy to meet the needs of all participating member states. Moreover, the constraints placed upon national economies by the MCC and SGP, in the absence of future policy co-ordination or some form of fiscal federalism, will prevent fiscal policies from moderating either an initial shock or the subsequent destabilisation caused by inappropriate monetary policies operated by the ECB for the monetary union as a whole.

Fiscal policy within EMU The conduct of economic policy within EMU is considerably different from that previously experienced by EU member states. Monetary policy (interest rates) is now set by the independent ECB, whilst national governments possess fiscal and supply-side policies. Hence, from an individual country’s viewpoint, interest rates are now ‘fixed’ and will only move if the ECB decides that economic conditions are changing for the euro zone as a whole and not if an individual country, or group of countries, suffer an economic shock (McKinnon, 2003; von Hagen, 2003; Wyplosz, 2003). Thus, EMU participating countries now have two choices. First, provided that it does not infringe the MCC/SGP it can use fiscal policy to counteract whatever shock has occurred (Gali and Perotti, 2003). Second, the country can wait for its labour market to alter wages and then prices and thus its overall degree of international competitiveness. EMU is based on a unique arrangement of public finance relations whereby fiscal policy remains decentralised to EU member states, but is subject to rules to combine discipline and flexibility (Buiter, 2003; Buti et al., 2003). This is provided by the SGP, which complements and tightens the fiscal provisions laid down in the TEU.1 Buti and van den Noord (2003, p. 4) argue that the SGP is ‘unquestionably the most stringent supranational commitment technology ever adopted by sovereign governments on a voluntary basis in the attempt to establish and maintain sound public finances’. If fully applied it will have important implications for the behaviour of budgetary authorities in both the short-term (cyclical stabilisation, policy co-ordination) and long-term (sustainability of

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public finances). It seeks to achieve a balance between constraining national fiscal policy to protect the ECB whilst it established credibility and permitting limited flexibility for counter-cyclical fiscal policy. This was deemed necessary since although ECB policy might be expected to create stable macroeconomic conditions for the euro zone as a whole it could not be expected to resolve regional cyclical imbalances.2 The SGP consists of several central elements (Buti et al., 1998; EU Commission, 2000). First, a commitment to medium-term budgets that are ‘close to balance or in surplus’ which is interpreted by Canzoneri and Diba (2000) as an implied promise to balance structural (or cyclically adjusted) budgets. Second, submission of annual programmes specifying medium-term budgetary objectives thereby creating a track record when assessing compliance with the SGP, or MCC in the case of member states who are not in the euro zone (EU Commission, 2000). Third, countries that run excessive deficits will be subject to financial penalties and public approbation. Deficits are defined as ‘excessive’ if they exceed 3 per cent of GDP, unless they occur under ‘exceptional’ circumstances which is defined as an annual decline in real output of more than 2 per cent of GDP, whilst a decline of 0.75 per cent of GDP might be deemed ‘exceptional’ if there is additional supporting evidence. The sanctions associated with such deficits are that the member state has to make an interest free deposit of 0.2 per cent of GDP, plus 0.1 per cent of the amount by which its deficit to GDP ratio exceeded 3 per cent. The maximum deposit would be capped at 0.5 per cent of GDP, which is forfeited after two years if the ‘excessive deficit’ persists. Canzoneri and Diba (2000) estimate that the foregone interest in the first year of sanctions would be in the range of €250–500 million for one of the larger member states. However, the initial years of EMU have demonstrated little progress towards lower public deficits and debts by participating nations in terms of budgetary consolidation let alone in structural terms. Furthermore, following the omission of the automatic effects of growth on the budget, countries have relaxed their retrenchment efforts in the 1998–2002 period. In particular, the three largest countries of the euro area (Germany, France and Italy) as well as Portugal did not behave according to the SGP. Indeed, although the SGP appears rigid, it fails to address a typical failure of fiscal policy behaviour in Europe, namely the tendency to run expansionary pro-cyclical policies in good times (European Commission, 2000). Whilst an excess over the 3 per cent of GDP deficit ceiling is sanctioned, there is no apparent reward for appropriate budgetary behaviour during cyclical upswings, leading Buti and van den Noord (2003) to argue that the political temptation to ‘spend

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the money when it comes in’ may prove irresistible. Hence, the suggestion that the SGP is ‘all sticks and no carrots’ (Bean, 1998) and may result in a pro-cyclical bias in the conduct of budgetary policy since the only carrot is the opportunity for automatic stabilisers to operate during economic downturns. However, Buti and Martinot (2000) argue that if governments retain their historical budgetary culture they will tend to offset the working of the automatic stabilisers for sufficiently large, positive output gaps. These questionable incentive structures may be further tested during electoral periods. In contrast to the advent of the euro when the incentive to maintain the announced fiscal consolidation path were evident, the situation may be different once in EMU when adherence to the SGP’s rules may be politically inefficient (Buti and Giudice, 2002). Resolving such political bias is likely to be problematic. Potential solutions, range from the introduction of ‘rainy-day’ funds permitting countries to set aside revenue in good times (Buti et al., 2003) to the harmonisation of electoral cycles in EMU, which would reduce politically induced distortions and be welfare-enhancing (Sapir and Sekkat, 1999). However, the most likely outcome is the increasing of budgetary surveillance focusing on structural balances and using peer pressure and ‘early warnings’ to curb fiscal misbehaviour (Viren, 2001; Korkman, 2001; EU Commission, 2002). In addition to ensuring member states adhere to the rules of the SGP, a further series of difficulties have arisen regarding the MCC reference values for both the deficit and the debt to GDP ratios, whilst none were defined for structural deficits. Subsequently, the SGP added a commitment to structural balance, but the ‘excessive deficits’ procedure is its only explicit enforcement mechanism. Thus, actual deficits are the focus of the SGP that appear to take primacy over both structural deficits and debt levels (Canzoneri and Diba, 2000). Consequently, it has been suggested that the SGP will become an impediment unless its focus is shifted from constraints on actual deficits and towards constraints on structural deficits, or better yet, constraints on debt levels (Canzoneri and Diba, 2000; Artis and Buti, 2001; Dalsgaard and de Serres, 2001; Missale, 2001; Rostagno et al., 2001). Furthermore, various studies regarding the flexibility built into the ‘excessive deficits’ procedure suggest that once governments have further reduced structural deficits the ‘excessive deficits’ procedure should not constrain normal countercyclical efforts (EU Commission, 2000). However, at the present time, given the unlikely prospects for achieving structural balance, the current emphasis on the excessive deficits procedure seems misplaced (Balassone

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and Franco, 2001; Casella, 2001). Moreover, it is unclear how strictly the EU will interpret the provisions in the SGP with it possessing a history of exerting discretion in such decisions. Even in light of the issues discussed above, potentially the single largest problem for the euro zone is that at the present time there is no substantive federal fiscal system in place whereby a central government sets taxes and expenditure rules that apply in constituent states or countries. Hence, fiscal policy is confined to backward-looking automatic stabilisers confined by MCC/SGP rules, such that the only channel for a forward-looking policy is through interest rates that are now controlled by the independent ECB.

Conclusion The decision whether to join EMU must depend upon an analysis of its probable benefits and costs. Economic theory suggests that a monetary union will prove generally beneficial, and be sustainable over time, if the participants are sufficiently converged before they enter. Thus, it is necessary to establish an unambiguous, comprehensive and theoretically sound set of convergence criteria, which can indicate whether such convergence has occurred prior to participation. However, it is questionable whether the Maastricht criteria satisfactorily perform this role. The MCC presents a series of financial tests, of which some are theoretically spurious, whilst the remainder are inadequate to indicate the range of consequences of participation. Consequently, the view advocated in this chapter is that future potential euro members should adopt the more comprehensive guide offered by optimum currency area theory and examine the extent to which they fulfil the elements outlined. A brief examination of available evidence suggests that the Central and East European Countries are not obvious candidates for monetary union without undertaking major structural changes, which are likely to take decades to complete (see Chapter 8 for a discussion of this issue). The decision on whether countries should participate within EMU carries further consequences. The advantages of low inflation and high employment could be obtained by pursuing coherent domestic economic policies (see Chapter 9), whilst European co-operation may be undermined more effectively by increasing national divergences within an EMU governed through inflexible rules than by countries opting-out. Such a situation could lead to the opposite outcome to that envisaged by the proponents of EMU. However, if participation within EMU is considered to be in the national interest, economic theory demonstrates

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that membership should wait until prior convergence has been achieved; optimum currency area theory provides the tests to establish the validity of convergence. Unless these tests can be attained, monetary union could prove damaging to existing and future EMU countries as a combination of external shocks to the system and a destabilising common monetary policy exacerbate existing differences between economies.

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Part III Regional Convergence and Enlargement

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7 The New Role and Resurgence of Regions in the EU

Introduction It will be argued in this chapter that a key current issue is the role not just of the EU in relation to the nation state, but also of the region in relation to both. It will be shown that the EU has become an independent actor of economic and political stature which has also provided an enhanced role for regions. The chapter begins by examining the reasons for the divide between the core and peripheral regions. It then looks at the case for an EU regional policy which is justified from competing perspectives of the integration process. The effects are discussed within the two analytical approaches of regional divergence and convergence. The main indicators referred to are those of GDP and unemployment. Emphasis is given to the operation of the Structural Funds (SFs) and the continued attempts to re-prioritise the different Objectives to achieve a policy of convergence. The economic effects of the SFs are emphasised and also the involvement of regions through different links and networks. The factors underlying this resurgence of the regions are explained particularly in terms of the growth of the SFs and the new institutional framework, such as the Committee of the Regions. The enlargement of the Union is covered, especially in terms of its growing membership involving poorer countries with more severe regional problems. The implications of these changes are examined for those involved, including regional policy in the UK.

The core and peripheral regions Regional integration covers the coming together of countries in different parts of the world, based originally on the European example. 121

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Regional policy, however, is something which is applied to a much lower, sub-national level. The process of economic integration involves the removal of barriers which affects trade and the pattern of location. There are centripetal forces which are based upon market size in which companies benefit from increasing returns to scale (Krugman, 1998). Businesses which are concentrated at the core of the EU market maximise sales and reduce transport costs, though the latter may be of diminishing significance nowadays (Chisholm, 1995). Businesses also reap external economies of scale and benefit from all the linkages backwards and forwards with suppliers and customers. In addition, knowledge is clustered, for example, around university sites even though information is dispersed more easily nowadays by telecommunications. Agglomeration is increasingly visible and regional specialisation has risen as a consequence of economic integration. This is true of both the North American Free Trade Agreement (NAFTA) and also the European Union (EU). In the former, for example, there has been growing industrial concentration particularly on the Canadian/US border and the Mexican/US border (Keating and Loughlin, 1997; Hanson, 1998). Industry in the EU has also become more geographically integrated as a result of more economies of scale (Amiti, 1998). An interesting consequence of this may be a greater likelihood of asymmetric shocks adversely affecting highly concentrated areas, especially under the Economic and Monetary Union (EMU). The latter curtails national monetary policy with the loss of national exchange rate policy plus some weakening of fiscal policy. In consequence there have been proposals for the provision of regional insurance against asymmetric shocks (von Hagen and Hammond, 1998). This would be short term and financially balanced. However, there is also a long-term case for redistribution to help lowincome regions, and all this reinforces the case for stronger EU regional policy. In the EU, unlike NAFTA (and unlike the European Free Trade Association – EFTA), there is concern not just with efficiency from free trade, but with equity to increase the solidarity necessary for further integration. The core of the EU can be conceived as lying in north-west Europe in the golden triangle running from London to Paris and encompassing most of Belgium and much of the Netherlands. In addition, the so-called Blue Banana runs in the shape of a banana through the golden triangle down through German cities such as Bonn and Frankfurt, through parts of Switzerland and Austria and into northern Italy, including cities such as Milan (Williams, 1996). The core is characterised by high incomes and employment based upon the presence of high technology activities.

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These include new industries such as electronics; other high technology sectors include aerospace, medical equipment, pharmaceuticals, biotechnology and telecommunications equipment. These sectors have high research and development (R&D) and a skilled, well-paid labour force. The dynamic core areas also have a large service sector, such as producer services, covering transport and communications, and banking and financial services. These are more stable and also likely to generate bigger multiplier effects than consumer services (which include distribution, hotels and catering, and community, social and personal services). Good infrastructure reinforces the prosperity of these central core areas. Capital cities dominate core areas and are in increasingly global competition between one another for specific roles, such as London and Frankfurt financially and Brussels as the political capital of the EU and Berlin as the capital of the re-unified Germany. In contrast, the poorer periphery shows a greater dependence on agriculture and fisheries, and in supplying these primary products tends to suffer from less efficient farming structure and production methods and also less price support for Mediterranean-type produce than for some north European products (such as cereals and butter). The periphery seeks to develop on the basis of its comparative advantage, such as abundant cheap labour and through greater dependence upon attracting tourists. However, given the low capacity of the periphery to create jobs, resulting in low activity rates, especially for women, the higher rate of unemployment results in the emigration of workers. This is a mixed blessing, though it reduces overpopulation and improves agricultural efficiency through increased capital intensity. Migrants send home remittances, a valuable source of investment, and migrants may eventually return home with skills and financial capital. The periphery may also be able to take advantage of centrifugal forces caused by the high rents in central locations. Capital is highly mobile and peripheral areas have become an increasingly attractive source for investment by multinational companies (MNCs). Though most of their investment is still in central areas, the spatial international division of labour has led MNCs to concentrate more of their assembly type low skill operations in less developed regions. The strategy of linking in the sourcing of parts from local producers in the region has had beneficial glocalisation effects. The main problems with the strategy of inward investment are first, the costly subsidies to capital in which countries compete for mobile MNC investment and the richer countries can afford larger subsidies. Second, capital-intensive development often does not provide many jobs for workers. Third, MNCs tend to exploit

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regions and when a global economic downturn occurs, then distant branch plants are closed down. Finally, a strategy based on attracting MNCs often brings in screwdriver-type activities which are low skilled operations. Reliance upon inward investment is inferior to one based upon local indigenous enterprise, relying more on small- and mediumsized enterprises (SMEs), and encompassing the service sector which in most developed countries is now the main source of employment. The problems in peripheral national border regions have been alleviated through the process of economic integration turning some of these into more central locations. Also, some of the EU’s peripheral countries have made significant strides in improving their relative economic position. Just one example is the Republic of Ireland, now described as one of Europe’s tiger economies with rapid economic growth based especially on the attraction of MNCs in high technology sectors. The Republic of Ireland has a plentiful supply of well-educated labour; good quality of life; great improvements recently to its telecommunications infrastructure; and generous financial help including only 10 per cent corporation tax and lavish government grants (including 100 per cent grant on training labour). However, note that Irish focus on overall sectoral growth has meant that its internal regional inequalities have shown little sign of narrowing, with the west remaining particularly depressed.

The evolution of an EU regional policy There are competing theories of European Integration, but one important theory is that of functionalism which shows that integration in one sector of the economy will inevitably spillover and generate integration of other economic and political activities. The process of integration was seen as linear and driven mainly by economic forces, but later neofunctionalism recognised that integration was less likely on a smooth linear path, but that incremental spillover was more likely to take place. One can find justification in this framework for the development of regional policy through the links between the customs union, the Single Market, the CAP and the establishment of a Community regional policy. However, one should not neglect the fact that an alternative explanation can be based upon inter-governmentalism since governments only support integration where it is convenient to do so. At other times they largely obstruct such progress, demanding compensating side-payments. The creation of the European Regional Development Fund (ERDF) in the early 1970s and national quotas were all concerned with trying to balance national interests and in particular to develop policies to suit

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the UK to limit its growing budgetary imbalance. Likewise the later development of the Cohesion Fund can again be seen in this light of providing compensation to southern Europe and Ireland as a result of national demands in relation to EMU. A different approach is provided by federalism which aims more overtly at the withering away and replacement of the nation state by new supranational organisations. Note however that federalism can be interpreted in different ways, and not just by centralisation, but by a devolved system of subsidiarity with national and local participation. Whilst in a federal system the separation of powers is clearly laid out, in multi-level governance, the outcome depends on the participants. The Committee of the Regions, whilst mainly a consultative body, is just one example of the potential for enhanced bottom-up regional participation. The EU has moved from a hierarchical top-down relationship to a more consultative relationship and is on the road to a more participatory relationship with the regions. Many regions and local authorities recognise that with national government overload and failure to deliver, the regional link to the EU offers a different regional development path.

Regional convergence and divergence Neoclassical economic analysis rests upon simplifying assumptions, such as identical production technologies, constant returns to scale and production factors being imperfect substitutes. It argues that there will be a trend towards long-run convergence, as capital flows into weaker regions to take advantage of lower wage costs and lower rents, whilst labour emigrates from those regions reducing the excess supply of labour and raising wages. In contrast, cumulative causation (Myrdal, 1957) focuses upon continued divergence because the core retains its dynamic benefits polarising development at the expense of the exploited periphery. These benefits in the core include technical progress continuing to be more advanced and increasing returns to scale based on economies of scale and beneficial spillover effects from the concentration of firms. More recent endogenous growth theories emphasise various processes such as the importance of human capital, innovation and spillover effects in raising the long-run growth rate, but recognises still the possibility of a cumulative causation process. The neoclassical convergence approach assumes that growth will be faster in poorer regions. Convergence is either absolute or conditional (depending on identical structural characteristics). Per capita income levels are seen to converge in the long run independently of their initial

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conditions. Empirical evidence shows that there has been some convergence and for a summary of results for three different groups of regions (Martin, 1999, pp. 46–58). Convergence can be attributed partly to the liberal market mechanism of EU integration via free trade and free factor movements; but it is also a result of governmental intervention via fiscal transfers and because of the creation and growth of SFs (Harrop, 1996). The process of convergence has been slow and much more pronounced at times of economic expansion and high demand for labour when businesses are searching for new location sites. Constraints on convergence have been provided by economic recession during which all regions have struggled, especially the weaker ones. Furthermore, over the years some EU policies have actually aggravated regional inequalities such as the Single Market, the Common Agricultural Policy (CAP), the Common Industrial Policy (were focused towards high-technology sectors located mainly in core regions) and transport policy (were focused again on core regions) (Molle and Cappellin, 1998). Whilst the EU as recognised the benefits from Trans-European Networks, these are simply a precondition for regional development and no guarantee that it will occur automatically. Empirically one can find some limited evidence to support convergence both between weaker and richer members of the EU and between their weaker regions. The main indicator used is that of GDP per capita, and there has been a converging trend between countries, with recently a significant catching up, especially in countries such as Ireland and Spain. Note however, that GDP overstates income and exceeds GNP where multinational companies are a significant feature of the domestic economy. The use of a different indicator, that of unemployment, shows that this has been particularly high at times in both Spain and Ireland, particularly when both countries sought to dampen inflation in preparation for their membership of the Euro. Unemployment continues to be at a high level in many parts of the EU and even those areas in which it is lower, such as the UK, are now concerned that the eligibility of some of their depressed regions for EU funding will be reduced, despite a low relative level of GDP per capita. Also, there is the problem for the UK that with enlargement of the EU to include countries with an even lower level of GDP per capita, the UK’s relative position improves, but its absolute regional problems remain unchanged. Despite some convergence in GDP per capita between countries in the EU there has sometimes been little improvement in the regional performance within particular countries. For example, in Portugal there has been very clear widening of regional GDP between the lowest and

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the highest Portuguese regions, partly because most new investment has been concentrated in the Setubal region. In other countries, such as Italy, there has been only slight improvement in the south (the Mezzogiorno) for GDP per head which in 2000 was 56.4 per cent of the Centre-North (Di Matteo and Piacentini, 2003, p. 106). The improvement is also more pronounced for consumption levels (as a consequence of state transfers) than for private sector output. The Cassa per il Mezzogiorno became less successful post-1973 and finally post-1992 the Cassa was liquidated. The regional picture is much more of a mosaic now in which the level of inequality is as marked within the south as it is between north and south. In addition, the traditional dualism of a two-Italys classification has become blurred by the expansion of the third Italy; for example, in regions such as Tuscany and Emilia-Romagna there is increasingly flexible specialisation and co-operation by many SMEs (Rhodes, 1995).

Structural fund Objectives Enlargement of the EU to include countries with more severe regional disparities led to growing pressure to establish a strong regional policy. It was insufficient just to control national regional policies but to ensure that aid was directed mainly to the poorer countries which lacked the resources to help their own backward regions. EU regional policies have also grown partly as a consequence of spillovers from other policies, most recently the Single Market and EMU where the weaker areas lacked competitiveness and were relinquishing the last vestiges of national control of trade, currency levels and interest rates. There has also been inter-governmental bargaining both in variable sum and zero sum games, for example, the development of regional policy was partly a transfer to offset the EU budgetary problems of some countries, especially those of the UK after its entry into the EU in 1973. For example, the SFs include the ERDF which was set up in 1975 after the first enlargement of the Community. Assistance from it is limited to the most disadvantaged regions and it concentrates mainly on productive investment, infrastructure and the development of small businesses. There is also the continuing role of the European Social Fund (ESF) which has existed since the beginning of the EU and concentrated on labour mobility, vocational training and recruitment aid. Whilst most of agricultural expenditure has gone on guaranteeing prices, the Guidance Section of the European Agricultural Guidance and Guarantee Fund (EAGGF) supports agricultural structures and rural

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development. Since 1993 the Financial Instrument for Fisheries Guidance (FIFG) has helped the adjustment of the fisheries section in which over-fishing in common waters has necessitated restructuring of the industry to benefit coastal communities. The other cohesion instruments which reinforce the SFs are the Cohesion Fund (covered in more detail in a later section) and the European Investment Bank (EIB), whose role is of long standing since the inception of the Community (Harrop, 1978). The EIB borrows money on international markets to finance its lending and its part-lending provides the confident support to attract in other sources of finance. Historically, about two-thirds of EIB lending has been prioritised for regional development, though the role of the EIB goes well beyond this, such as financing communications infrastructure, conserving the environment and quality of life, boosting the competitive base industrially, helping SMEs and supporting EU energy policy. The EU has defined its priorities trying to concentrate help where it is most needed, though political pressures still result in aid being spread too thinly across too many areas. The switch from projects to programmes was sensible in co-ordinating development, as was fostering partnership between all the actors involved in regional development. The EU took over the driving seat of regional policy setting out clear development objectives based upon particular criteria. Objective 1 is concerned with the economic adjustment of regions whose development is lagging behind. These are regions where per capita GDP is less than 75 per cent of the Community average or there are special reasons for their inclusion under this Objective. Areas in industrial decline are covered in Objective 2 and these are mainly areas where the rates of unemployment and industrial employment are higher than the Community average and where industrial jobs are in structural decline. Post-2000 changes have been made to the number of objectives, but from 1989–99 Objectives 3 and 4 had a regional bias, but were more social in origin, applying horizontally throughout the Community. Objective 3 has varied in composition, but mainly covered the longterm unemployed, young people in search of jobs and those threatened with exclusion from the labour market. Objective 4 covered workers whose employment situation was threatened by changes in industry and production systems. Throughout the Community, farmers, fishermen and those involved in the processing and marketing of products from those sectors which were facing changes in the structures of production were covered under Objective 5a. Meanwhile, Objective 5b related to vulnerable areas with a low level of socio-economic development which met two of the following three criteria: a high proportion

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of employment in agriculture, a low level of incomes and a low population density or a high degree of out-migration. Finally, after the enlargement of the EU to include Sweden, Finland and Austria, a minor concession was made with the creation of an extra Objective 6, to cover areas with an extremely low population density; that is, those with fewer than eight people per square kilometre. The latest reforms of the SFs for the 2000–06 period in preparation for further enlargement have made significant changes by whittling down the previous Objectives by re-adjustment to three Objectives. Objective 1 still covers the development and structural adjustment of regions which are lagging, with less than 75 per cent of EU GDP, but now includes the previous Objective 6 areas. While most of the expenditure is still on Objective 1 regions (nearly 70 per cent), the EU’s Objective 1 territory has been reduced to 22 per cent of the EU population (compared with 27 per cent from 1994–99). The consequences are that most northern European member states have lost an Objective 1 region, and those Objective 1 regions which pass the 75 per cent EU GDP threshold are cushioned by transitional support up to 2005. Objective 2 includes the previous Objective 2 areas plus Objective 5b, fisheries areas, and also urban problem areas. It is still concerned with above average unemployment in all of these areas. It accounts for about 11.5 per cent of SF expenditure, but now covers only 18 per cent of the EU population (compared with 25 per cent previously). Transitional support again cushions those areas affected and no member state loses more than a third of the previously covered area. The new Objective 3 is still concerned with modernisation of education and training systems and adapting the employment system and accounts for 12.3. per cent of SF spending. The remaining balance of expenditure is made up of a halving of SF spending on Community Initiatives CIs from 10 to 5 per cent and a reduction in the number of CIs from 13 to 4. This pruning back of expenditure is reflected in various other ways, for example, the EU has financed 70 per cent of total costs of public investment in Objective 1 areas and 50 per cent in Objective 2 areas, but under the new SF, financial assistance for business investment projects is reduced from 50 per cent in Objective 1 to 35 per cent, and in Objective 2 from 30 to 15 per cent. Profit orientated investment assistance has been cut (to 40 per cent in Objective 1 and 25 per cent in Objective 2 areas). Other changes involve abandoning commitments which do not lead to payments within two years. Also, schemes not started within 18 months have to be repaid; advance payments are reduced significantly (from 50 to 7 per cent)

130 Current Economic Issues in EU Integration

and afterwards are paid only to reimburse actual expenditure. The tightening up of expenditure in existing member states has been necessary to make room for provisions of pre-accession aid to the CEECs which account for 10.2 per cent of the new SF.

The Cohesion Fund The Cohesion Fund came into effect in May 1994 to help the four poorest nations of Spain, Portugal, Greece and Ireland which lacked the financial resources to invest, but at the same time were committed to reducing public expenditure in preparation for convergence in EMU as part of the Maastricht Treaty. The Cohesion Fund is important for a variety of reasons. It represented a belated attempt to redistribute income to countries which have a GNP per capita less than 90 per cent of the EU average. GNP per capita in 1995 (in PPS) was lowest in Greece (65.8), followed by Portugal (72.3), Spain (75.7) and Ireland (78.9). Ireland is rapidly closing the per capita GNP gap towards the EU average. The aim is to have an even division of expenditure between transport and environmental projects. Cost–benefit analysis is undertaken and can be more precise with the former than the latter. The focus is mainly on projects or groups of projects, though some of these projects have been too piecemeal (compared with the programmes in the SFs). Support can only come from both funds at different stages of projects. The Cohesion Fund has a higher level of financial support than is provided by the SFs, and the Cohesion Fund finances up to 85 per cent of the cost of projects which do not lead to profits. Cohesion funding is conditional, based on the principle of countries converging towards the lower budgetary deficits laid down under the Maastricht proposals for EMU. Whilst this reduces governments’ additional expenditure, it is assumed that lower interest rates will bring about increased private sector investment. Although the Cohesion Fund has no explicit remit to create jobs, employment creation has been significant. This has emanated from the initial effects of construction (and demand-side effects), plus long-term supply-side benefits from these projects. It is worth noting, however, that in the case of the Cohesion Fund this has led to the main emphasis being placed primarily on national development, with regional development being secondary, particularly in Ireland and Portugal. The accession of the CEECs will see the spread of Cohesion funding to carry out much needed improvements to the infrastructure and environment in new member states in the future.

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Regional participation in the EU institutional framework Regional offices have been set up in Brussels to lobby the Commission for finance and to influence policy initiatives at an early stage. The offices are either for each region, or groups of regions in one country, or groups between Euro-regions. While German Länder are represented, initially the Dutch provinces were slower to establish a presence, being more involved in policy application than in policy initiation. In 2000 there were over 160 regional offices in Brussels and the UK had the largest number with 26, followed by Germany with 21 and Spain with 19 offices. At the opposite end, Portugal had just one, Ireland two and Greece three offices in Brussels. The Commission has been particularly concerned to elevate the role of regions and their input and development are facilitated where they co-operate with each other. For example, there is not a single border in the EU in which there is not some co-operation across it. It is easier in some policy fields than others; for example, the environment and infrastructure (though not necessarily if there is a regional airport on each side of the border). INTERREG was established to promote cross-border co-operation and concentrated initially mainly on land borders and later more on maritime border areas, for example, across the English Channel with Nord-Pas de Calais and across the Irish Sea between eastern Ireland and west Wales. There is also co-operation between regions which have similar problems, for example, the declining industries, such as coal mining. There are also examples of co-operation between capital cities and between regions in distinct geographical groupings in the EU. Another variation is manifested by links between strong, central and innovative regions; for example, the four motor regions (Baden-Würtemburg, Rhône-Alpes, Lombardy and Catalonia). Finally, there are links between different types of regions to benefit from a comparative learning programme, such as the transfer of technology. In some countries, such as Germany and Belgium, there has been regional representation in the Council of Ministers and Belgium has a system of different regional rotation every six months (akin to the EU system of holding the Presidency). The representation of regions in the Council of Ministers is now allowed for in the UK, for example, for Scotland post-devolution. Regional influence in the European Parliament has generally not been strong since few regional parties are represented there, apart from countries such as Belgium (which is

132 Current Economic Issues in EU Integration

wholly regional parties), Italy, Spain, the UK and others. A few MEPs also have dual mandates in regional bodies. The Committee of the Regions (COR) reflects a federalist vision of the EU, diminishing the national level of activity and elevating the regional level as in Germany with the Länder and in Belgium. The new institutional structure in the EU gives the regions recognition and enables the Commission to obtain other views than those of national governments, providing a more bottom-up approach. The COR, which had its first meeting in Brussels in March 1994 had 222 full members (and 222 alternates) in the EU (15). This consisted of 24 members each from France, Germany, Italy and the UK; 21 from Spain, 12 each from Austria, Belgium, Germany, Netherlands, Portugal and Sweden; 9 from Denmark, Finland and Ireland; finally, 6 from Luxembourg. The COR has a Bureau elected every two years with a president, vice-president and 34 members who organise the plenary assembly and opinions. There are eight Commissions (and four Sub-commissions). These are first, for regional development and finance, and a Sub-commission on local regional finance. Commission 2 relates to spatial planning and agriculture, whilst Sub-commission 2 covers tourism and rural areas. Commission 3 covers transport and communications networks, and Sub-commission 3 is telecommunications. Commission 4 is urban policies, Commission 5 land use planning, the environment and agriculture, Commission 6 education and training, Commission 7 citizens’ Europe, research, culture, youth and consumers, with a Sub-commission 7 for youth and sport. Finally, Commission 8 covers economic and social cohesion, social policy and public health. The COR issues opinions on the basis of three types of referrals. The first are mandatory referrals which are required by the Treaty on European Union. Second, there are optional referrals by the Commission or Council. Third, there are self-referrals which are opinions by the Committee on its own initiative on matters involving specific regional interest or on any area that the COR wishes to address. The COR held a Summit on the European Regions and Cities in 1997 in Amsterdam to provide an input into the Inter-Governmental Committee (IGC). The COR saw its own Summit being complementary to the Summit of Heads of State and Government. The two representative associations of local and regional authorities in Europe – the Assembly of European Regions (AER) and the Council of European Municipalities and Regions (CEMR) – contributed to the organisation of the Summit. The COR presented the Stoiber-Gomes Report as a working document for the Amsterdam Summit. It called for consultation over more areas,

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and that its members should be all elected, and that it wanted to be fully autonomous from the Economic and Social Committee (ESC). It was supportive of adding a new title of employment to the Amsterdam Treaty and supported territorial employment pacts bringing together public and private sectors locally at grass roots level with €200 000 per pact made available to reduce unemployment. The COR also emphasised the need for the subsidiarity principle to be paramount, seeking a demarcation of its own rights under subsidiarity. Notwithstanding the COR’s limitations mainly as a consultative body, it does represent a useful democratic addition of sub-national interests to the institutional framework.

The impact of EU funds Neither the EU budget, nor even the increased spending on the SFs per se, is of a sufficient size to transform the regional imbalance within all EU member states (Harrop, 1996). Whilst the gains from the Single European Market were estimated at around €216 billion for the EU12 at 1988 prices, or 5.3 per cent of GDP (Cecchini, 1988), the total EU budget was set to rise to only 1.27 per cent of EU GNP by 1999. The size of the EU budget is minuscule in comparison to the percentage of national income which is channelled through national budgets through taxation and state expenditure. Furthermore, continuing conflicts between the member states and the EU mean that the scale of the federal budget seems unlikely to grow very much. While SF outlays have risen significantly to account for a third of the budget, total structural spending during the 1990s fell far short of the projected Single Market benefits. Furthermore, the latter tend to aggravate regional imbalance since the more dynamic sectors located in the core expand and the weaker sectors contract within a more competitive market (Vickerman, 1992). It also needs to be remembered that national regional expenditure has been pruned back severely in most north European countries; for example, in the UK it fell by just over half between 1978/79 and 1988/89. Also, in the search for greater cost effectiveness many countries switched from automatic to more discretionary financial incentives. Hence member states turned more towards the EU as a potential source of regional funding and development. The significance of the SFs lies more in terms of an innovatory approach and concentration of effort. The EU has examined what improvements are needed in weaker regions to enable them to catch up. There is a neoclassical economic focus on tackling supply-side deficiencies. These go much wider than normal national regional measures which

134 Current Economic Issues in EU Integration

are mainly of infrastructure and productive business investment. SF operations include human resource development; environmental improvement; research; innovation and technology transfer; and community development which includes health care (Keating and Loughlin, 1997, p. 83). There is a growing concentration of expenditure on the poorest regions which is having a significant beneficial impact on some of these. There were few regions in the EU (15) with a GDP as low as half the EU average, though plenty of contiguous regions, especially in southern Europe, were below 75 per cent. The greatest impact has been on the smaller economies which have received significant injections of expenditure as a proportion of their GDP. The ERDF has raised regional income slightly in Spain which received about 30 per cent of ERDF grants, but its impact was greater in Greece, Ireland and Portugal which each obtained about 15 per cent of ERDF grants but constituted a larger share of their investment in GDP (Fuente and Vives, 1995). The effectiveness of the SFs can be seen by the extent to which expenditure has raised economic growth in some of these peripheral countries, with particular success in the Celtic Tiger Irish economy, with its high growth rate and significant reduction in unemployment. Employment has grown significantly in Spain, though it still manifests high unemployment because of labour market rigidities. The performance of Greece and the south of Italy (Mezzogiorno) has been less satisfactory. In the author’s view the lack of success in job creation in Objective 1 regions has constituted a major failing and Greece in particular has performed poorly here, partly because of such large numbers employed in agriculture indicating significant underemployment. Greece has also had a low level of FDI compared with the other cohesion countries. There has been greater improvement in job creation through transforming some Objective 2 industrial regions towards faster growing sectors. But the major blight on the EU as a whole has been the persistently higher rate of unemployment in recent years than in the US which has had a much more dynamic capacity to create new employment opportunities. The SF expenditure is supposed to be additional expenditure, promoting spending for specific purposes which the recipient would not have undertaken in the absence of a grant. Unfortunately, in some instances they have substituted for national government expenditure going into general government funds. Although this fulfils the redistributive function at least for the poorest member states, the resource allocation effect is lost. SF expenditure should also be matched by

Role and Resurgence of Regions in the EU 135

member state contributions which therefore means a bigger multiplier effect, though one has to recognise that some poorer member states such as Greece have struggled to come up with matching funding. EU structural funding has taken an increased share of total regional expenditure as the latter has been severely pruned in many northern European countries. This has been a consequence partly of a neoliberal philosophy reducing the extent of public expenditure. It has also been reinforced by the EU Directorate General for competition policy in cutting the amount of expenditure on state aids. Richer member states could afford to support various sectors and areas, distorting competition and offsetting the concentration of EU regional aid on the poorest areas, especially in southern Europe. Studies have shown that incentives for investment in the productive sector by richer member states to help their own needy regions have been particularly detrimental to EU convergence (Martin, 1998). With regard to state aids, it has been argued elsewhere in the chapter on Competition Policy that policy on state aids needs to be tightened and steps are being taken in this direction. Although exemptions exist in particular cases, such as SMEs and so on, unjustified state aids have to be repaid; also, action can be taken by national courts to restrain aids until these have been dealt with by the European Court of Justice; finally, action may be taken by those adversely affected. The EU has altered the perception by regions of their own role. They have been able to enhance their own position to fill a gap left by the constraints being placed on the nation-state by the higher supranational EU. Given the EU emphasis on partnership with the region (and within it) there has been a strong pressure to create new regional political structures. While some federal member states such as Germany and Austria have had strong regional control via the Länder, others which were formerly more centralised have been pushed towards decentralisation. Spain has exemplified this with political powers for the Basques, Catalonia and Galicia, plus greater autonomy in other regions. Meanwhile, elsewhere in Ireland, Greece and Portugal and other regions, administrative regionalisation has been introduced to administer EU structural funding. The EU has had the effect of shifting countries from regionalisation (that is, top-down regional policies) towards regionalism, characterised by decentralisation in response to bottom-up pressure (Keating and Loughlin, 1997). Whilst the Cohesion countries are classified nationally as Objective 1 regions, the more normal definition of a region lies at the sub-national level and the EU Nomenclature of Territorial Units for Statistics (NUTS)

136 Current Economic Issues in EU Integration

were created mainly on the basis of existing national administrative practices. NUTS operate at three levels. NUTS-1 units are the largest level covering areas such as the Länder in Germany and the standard regions of the UK. In the cases of Denmark, Ireland and Luxembourg, because of their fairly small size the whole of the country is considered to be one NUTS-1 region (Williams, 1996). NUTS-2 units are provinces, smaller regions, and for the UK, group of counties. NUTS-3 units are the lowest level, such as French départements, and in the UK, counties/local authority areas. However, perhaps the biggest change is that regions are being redefined in European geographical terms (Williams, 1996). The future is likely to see not only that of continued inter-regional links (between regions in close proximity, between those with similar or even with different problems), but also the emergence of new Euro-wide regions. There is increased networking, not only within regions between the public and private sector and other key groups, but also networks are being formed between Europe’s regions. They can learn from each others’ experiences, and also by making alliances they can lobby more effectively for their distinctive regional difficulties from offices in Brussels. Cross-border co-operation between regions is a step on the road to much more co-ordinated regional planning. This has been encouraged by some of the CIs such as INTERREG. The old relationship between the dominant state and the subservient sub-national level of activity has been transformed. The region, the meso level between the national and the local, has come of age. It is exemplified by new political powers. Governments have responded to new pressures by loosening central control, transferring functions downwards, even in formerly highly centralised systems such as France since the 1980s and the UK since 1997. These changes are coupled with broader pressures not just from the EU, but also the global system and regions themselves seeking to compete more effectively and to have greater control over their own affairs. Hence there is not only a Europe of regions, but also a Europe with regions which have joined other actors in an emerging multilevel governance (Goldsmith, 2003, p. 116). The EU offers the opportunities for regions to break free from the stranglehold of the existing nation-state. It liberates them to create new links. For example, it is not inconceivable in the future to see Scotland with its own parliament eventually breaking free from England to benefit from stronger separate representation within the EU (like the Republic of Ireland). The lure of joining the Euro and enjoying lower interest rates might boost investment and economic growth in such peripheral areas.

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EU regions and enlargement At its inception the EU was mainly concerned with aggregate economic growth since regional differences were relatively narrow, apart from in the south of Italy. It was the first enlargement of the EU in 1973 from six to nine members which provided greater impetus to the creation of a stronger regional policy, manifested, for example, by the establishment of the ERDF. Southern enlargement of the EU in the 1980s led to much greater regional differentials, and countries in southern Europe have benefited from Integrated Mediterranean Programmes and significant regional transfers which they are loathe to sacrifice to meet the new demands from subsequent enlargement. It is true that the enlargement from 12 to 15 members to include Austria, Sweden and Finland has led to only minor additional problems, such as those of sparsely populated areas. However, the next enlargement to involve initially the favoured countries Poland, Hungary, the Czech Republic, Slovenia and Estonia requires massive transfers. Whilst they may be able to benefit from favourable factor endowment, such as low labour costs, as in southern Europe, this may lead to an even narrower pattern of specialisation. Furthermore, under a market system, a marked division of labour will exist, with the richer central areas still concentrated and exporting the more highly skilled, capital intensive and knowledge-based industries and services. The Commission in its Agenda 2000 Report in 1997 agreed that those countries which met the political and economic conditions and took on board the aquis communautaire would be eligible for membership. One applicant, Slovakia, struggled to fulfil the political criteria. The rejection initially of Slovakia, plus delays for Bulgaria, Romania, Latvia and Lithuania were merely a difference of degree until they could meet the EU’s entry conditions. In 2004 the EU (25) enlarged to include the CEECs consisting of Estonia, Latvia, Lithuania, Czech Republic, Slovakia, Slovenia, Hungary and Poland, plus Malta and Cyprus. The target date for the inclusion of Bulgaria and Romania is 2007 to give them more time to fully meet the entry conditions, such as a properly functioning market. There are other countries which may join later such as Turkey, Ukraine and other parts of ex-Yugoslavia. Many of the new members are small, such as the Baltic states, and the inclusion of countries sometimes smaller than the regions in the large member states (such as Germany and the UK), makes the regions in the large member states reluctant to see their role diminished. However, the level of poverty in the CEECs means that the EU has been

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obliged to refocus its aid towards them. There is low GDP per capita with wider regional differences on this basis in the EU(25). Regional differences are less acute when measured on the basis of unemployment, partly because of the increase in unemployment in some of the existing member states. However there is high unemployment in most of the CEECs, especially among the young and the elderly; for example, unemployment in 2001 was nearly 20 per cent in Slovakia and Bulgaria, nearly 17 per cent in Lithuania and nearly 13 per cent in both Latvia and Estonia. Even with a higher growth rate in the new members it will take many years to close the large economic gap nationally, let alone the regional disparities. Many of the new entrants are located distantly from the core of the EU and it is mainly the capital cities and the western border regions which are best placed to benefit. There has also been significant funding to promote cross-border links and the growth of trade across the East German and Polish border, for example, leading to close co-operation in many fields such as transport and the environment. In contrast eastern border areas remain peripheral and many agricultural and industrial areas will continue to face massive restructuring and temporary increases in unemployment. The EU has drawn up a new financial framework, targeting set expenditure to help potential new member states along with pre-accession aid. This was set at €45 billion including €7 billion pre-accession aid for the five applicant countries of Eastern Europe plus Cyprus. The EU Commission proposed a simplification of its Objectives into only three. All the countries are eligible ultimately under Objective 1, with GDP per capita in 1995 only around a third of the EU average (ranging from Latvia at the lowest of 18 per cent to Slovenia at 59 per cent). The Commission under Objective 2 covers areas with structural difficulties (industrial decline, rural zones, depopulation and deprived urban regions). Objective 3 focuses on adaptation and modernisation of education, training and employment policies. Furthermore, the number of Community Initiatives is significantly reduced and a smaller percentage of the SFs is allocated to new CIs (only 5 per cent). The Cohesion Fund is maintained to help with improvement of infrastructure and the environment since this is much needed in Eastern Europe. For example, the transport infrastructure needs massive investment in both roads and railways, preferably with a continued bias towards railways on environmental grounds. There needs to be more linking up of track and connections to other EU centres, especially from the Baltic states, whereas past links were more to Russia. The EU financial transfers to the new

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members will be helpful, though a funding ceiling has been established of not more than 4 per cent of the national GDP to be brought into the new member states. EU budget constraints exist, partly from member states which are net contributors and also from existing regions in the EU(15) which receive aid. Since the 10 new members will absorb about one-third of EU Structural funding, the existing members want to cap this. They are fighting beyond 2006 to have two separate regional thresholds, with one for themselves and one for the new members. There is also concern not just about the level of expenditure needed for new members, but also with ensuring that structures are in place to ensure that money is spent effectively. In the past even in existing member states there has been criticism of the pace at which SF expenditure has occurred and of its impact, particularly in poorer countries which could not afford matching funding. Many of the new members have had a national rather than a regional focus, both because of small size and also previous national communist ideology. In parts of Eastern Europe there is also a lack of regional or local administrative institutions which are able to manage the EU funded projects. The EU has recognised the need to designate NUTS levels for new members, preferably with more similarity in population size than in the past and also to strengthen institutions at the local and regional level. However, it is accepted that the main priority is to accelerate the low general level of national economic development, and also small size of most of the potential new members does not make the creation of new administrative structures an immediate priority. However, Poland, the largest new applicant, proposed a switch from its 49 provinces and return to the 17 provinces that existed before 1975. This will improve its relations with the EU which prefers to work with a few large regions and Poland has some large regions. Whilst most in Poland favour regional self-government, there is some opposition towards autonomous regions (Winiarski, 1995). For example, Poland post-1945 was concerned with cementing nationhood, rather than splitting up the country. Membership of the EU will mean that areas west of the Vistula are best able to cope with EU competition, with regional problems likely to increase in the east. Another country which has decided to develop regional self-government to conform with EU preferences has been the Czech Republic which has opted for 14 regional governments to facilitate its access to and operation of the EU structural funds. One can see therefore the EU having a significant regional impact on the formerly highly centralised communist regimes of the CEECs.

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Conclusion and implications for UK regional policy The UK has made significant progress under the Labour government since 1997 in decentralising political and economic activity to the regions, in a form much approved by the EU. Radical changes have included devolution and the creation of a Scottish Parliament with significant powers, plus a Welsh Assembly and referenda for the creation of regional government in the northern regions of England. The spread of regionalism became inevitable once changes were made in Scotland, Wales and Northern Ireland. Regions such as the north of England felt hampered, considering Regional Development Agencies to be insufficient per se, without also the added powers of regional government. These changes should be helpful in enabling regions to devise their own regional strategies and to present a higher profile and external image. The latter is important particularly in attracting inward investment. Regional Selective Assistance (RSA) in the UK is given to companies which can show that without government cash backing, the investment would go elsewhere. Also on top of RSA other grants are added such as land, infrastructure and labour training grants and others. The RSA has been tied to job creation, but ex-post many companies have closed and cut back jobs. Spectacular examples include the Korean LG Group in Wales and the Taiwanese Chungwa Picture Tubes in Scotland, the German companies Siemens on Tyneside and BMW in the West Midlands. Although all investment, especially high technology is risky, companies play off governments and regions against each other. The ex-ante case needs to be scrutinised very closely on job creation, whilst ex-post recoupment of expenditure needs to be pursued vigorously where companies shut down quickly. Whilst FDI has been a useful strategy to develop regions, competition for mobile investment from other regions and especially from low cost areas in the CEECs will be intense in the future. This means that alternative strategies will also have to be pursued such as local endogenous development encouraging indigenous SMEs by proactive policies on technology transfer. Whilst the UK has always firmly supported EU regional policy, its evolution and focus towards poorer Objective 1 areas and the enormous demands which will be made by the CEECs, may result in the UK being more lukewarm on this aspect of integration. For example, the Chancellor of the Exchequer Gordon Brown has become dubious about the size of gross financial transfers involved and the original conception of regional aid to the UK helping to offset its budgetary imbalance with the EU has weakened. Furthermore with pressure

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also building up against the UK’s budgetary rebate negotiated by Mrs Thatcher at Fontainbleau, the future is likely to see conflicting pressures between member states and regions. The failure of the Brussels Summit in December 2003 to approve a constitution for the EU (largely because of Polish opposition to a change in the voting rules) coincided with a stern demand by the main Budget contributors for financial restraint. They consider that the EU Budget should not rise to its limit of 1.27 per cent of EU GNP, but should be kept closer in spending to 1 per cent. In conclusion, the issue for the UK is one of whether there is sufficient feeling of social solidarity across European regions to justify fiscal transfers from poor UK regions to even poorer regions not only in Southern Europe but also in the CEECs. The absolute situation in existing UK regions remains unchanged, with only a relative statistical improvement in their position in the EU(25). The magnitude of regional problems has increased greatly through northern, southern and most recently eastern enlargement, placing severe pressure on the limited EU budget. This has major implications for countries such as the UK which has moved from being a major beneficiary of the structural funds to a position in which it will have to face up to funds being increasingly channelled towards even poorer regions elsewhere in the EU.

8 EU Enlargement: EMU and Agriculture

Introduction A significant transformation has taken place in Europe since the late 1980s when the EU was still emerging from its internal difficulties of eurosclerosis and the ‘iron curtain’ was firmly in place across the Continent. However, with the EU pursuing the single internal market programme and monetary union, together with the collapse of Communism both an economic and political transformation swept across Central and Eastern European countries (CEECs) which ultimately led to the clamour for EU membership. At the commencement of this process, Redmond (1994) forwarded three reasons regarding the transformation of the EU into the leading economic and political force within Europe. First, the EU’s position as the major player in Europe was firmly established following the resolution of the internal budgetary and agricultural disputes with non-EU countries having to re-evaluate their relationship to ensure market access such that the costs of non-membership were raised to unacceptable levels. Hence, the long-term option to resolve this dilemma became the seeking of EU membership as it appeared the only viable ‘club’ in Europe with the European Free Trade Association (EFTA) reduced to a rump of Iceland, Liechtenstein, Norway and Switzerland. Second, the momentous changes in the CEECs have transformed the economic and political landscape of the Continent with a range of new possibilities and scenarios opening up. In particular, the previously unimaginable prospect of EU membership became the goal of many countries that did not even exist as sovereign nations 15 years ago. Finally, the increasing globalisation of world commerce has illustrated the importance of the EU as a regional trade bloc alongside those of NAFTA, APEC, ASEAN, Cairns Group and MERCOSUR to name but a few. 142

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Its fifth enlargement increased the Union’s membership to 25 countries on 1 May 2004, following the conclusion of accession negotiations in December 2002. The ten applicant countries (ACs) are: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. Whilst this enlargement process is unprecedented in terms of the number of countries, it is less so in terms of more important features such as population and economic status (Gros, 2002). Further enlargements are planned to incorporate Bulgaria and Romania in 2007 at the earliest, whilst in its second annual Stabilisation and Association Process report, released in March 2003, the Commission indicated that the enlargement process would extend to Albania, Bosnia and Herzegovina, Croatia, Macedonia and Serbia-Montenegro after the planned accession of Bulgaria and Romania. Finally, following an unfavourable Commission opinion in December 1989, Turkey was subsequently recognised as a candidate country at the Helsinki European Council in December 1999, but negotiations will not be launched before it meets key political accession criteria, such as protection of minorities and respect for human rights. It is, however, informative to place this recent enlargement of the EU in the context of previous phases of accession. Table 8.1 summarises the history of EU enlargement dating back to the first addition in 1973 to the original Six. In particular, it illustrates the variation in time countries have held candidate status, which steadily declined through successive (and successful) enlargements to a period of only 3 years for Finland. In contrast, the latest EU expansion has witnessed time lags of 8–14 years reflecting both the economic and political legacy of the current ACs combined with the deepening process of integration undertaken by the EU since the early 1990s.

Estimated economic impact of enlargement A traditional approach to determine a country’s prospects when considering EU membership has been through cost-benefit analysis, although this rarely results in fully measurable outcomes given the sizable number of subjective features (policy autonomy over the exchange rate, national sovereignty and identity etc.). However, in contrast to many of the EU(15) member states, for the 2004 enlargement countries this is potentially less finely balanced given that euro membership, for example, entails the loss of relatively weak currencies with ensuing benefits of enhanced monetary stability, certainty and investment, together with both reduced risk premiums and interest rates (Read, 2002).

144 Current Economic Issues in EU Integration Table 8.1

Summary of EU accessions

Country

Application

Membership

Candidate status period

Ireland United Kingdom Denmark Greece Portugal Spain East Germany

July 1961 August 1961 August 1961 June 1975 March 1977 July 1977

12 12 12 6 9 9

years years years years years years

Austria Sweden Finland Cyprus Malta Hungary Poland Slovakia Romania Latvia Estonia Lithuania Bulgaria Czech Republic Slovenia

July 1989 July 1991 March 1992 July 1990 July 1990 March 1994 April 1994 June 1995 June 1995 October 1995 December 1995 December 1995 December 1995 January 1996 June 1996

January 1973 January 1973 January 1973 January 1981 January 1986 January 1986 October 1990 (German reunification) January 1995 January 1995 January 1995 May 2004 May 2004 May 2004 May 2004 May 2004 May 2004 May 2004 May 2004 May 2004 May 2004 May 2004 May 2004

6 4 3 14 14 10 10 9 9 9 9 9 9 8 8

years years years years years years years years years years years years years years years

Consequently, economic studies have generally concluded that the benefits of enlargement outweigh the costs because the ACs start from a lower economic base. Indeed, the Directorate General for Economic and Financial Affairs (European Commission, 2001) estimated that enlargement could increase GDP growth of the acceding countries by 1.3–2.1 percentage points per annum and for existing members by 0.7 percentage points on a cumulative basis. An earlier study by Baldwin et al. (1997) estimated that accession of CEECs would, even in a conservative scenario, bring an economic gain for the EU(15) of €10 billion and for the new members of €23 billion. However, of this measurable benefit of 5.4–7.3 per cent of GDP the majority of this (4.4–6.0 per cent) is a consequence of the single internal market rather than adopting the euro (Baldwin et al., 1997 and Gros, 2002). Whilst, an analysis of business cycles argued that there are potentially significant economic and business gains of accession (European Round Table of Industrialists, 2001; Grabbe, 2001).

EU Enlargement: EMU and Agriculture 145

However, studies examining the impact of enlargement upon the labour market and migratory flows have estimated that 335 000 people would move to the EU(15) from CEECs if there were free movement of workers (Boeri and Brücker, 2000). Subsequently, the EU agreed on a flexible transition period of up to seven years for limiting the inflow of workers from the ACs. Moreover, in relation to the EU budgetary consequences of enlargement, the framework includes transfers for the period up to 2006 with expenditure depending on a series of decisions to be taken in the fields of cohesion policy, agricultural policy and so on, for the following period. This chapter focuses upon two aspects of the current process of EU enlargement, Economic and Monetary Union (EMU) membership and agriculture, which encapsulate the range of potential difficulties encountered by the ACs in joining the EU. Hence, the initial part of this chapter reviews the enlargement process and its implications for the euro given that it will take place in Stage 3 of EMU and therefore possesses a substantial economic dimension for both the EU and the ACs themselves (Read, 2002). First, the major challenges raised by accession in terms of the main economic conditions of the Copenhagen and Maastricht convergence criteria (MCC) are discussed, followed by the route towards membership and macroeconomic policy reforms, which are necessary to meet the Copenhagen criteria and to endorse the aim of EMU. Given that agriculture plays an important role since a relatively high proportion of the population in the CEECs lives in rural areas, the chapter then seeks to examine recent empirical estimates on the economic costs of accession to the EU(15) and the CEECs. In particular, this chapter discusses the problems of enlargement on future reform of the Common Agricultural Policy (CAP) facing EU policy makers.

The Copenhagen and Maastricht criteria Candidate countries are expected to accept the EU accession criteria agreed at the June 1993 European Council meeting in Copenhagen which defined the economic and political conditions in order to accede to the EU (European Council, 1993). The Copenhagen criteria were that the candidate country has achieved: ●

The existence of a functioning market economy as well as the capacity to cope with competitive pressure and market forces within the Union (Economic criteria);

146 Current Economic Issues in EU Integration ●

●

Stability of institutions guaranteeing democracy, the rule of law, human rights and respect for and protection of minorities (Political criteria); The ability to take on the obligations of membership including adherence to the aims of political, economic and monetary union (Acquis criteria).

And has created: ●

The conditions for its integration through the adjustment of its administrative structures, so that European Community legislation transposed into national legislations implemented effectively through appropriate administrative and judicial structures.

Although they do not have to fulfil the MCC (price stability, low longterm interest rates, sound public finances and exchange rate stability) at the time of accession, in practice the ACs will not be in a position to opt out of EMU which is considered to be a membership obligation (Lavrac, 1999). Hence, in contrast to the MCC, the Copenhagen criteria define both economic and political standards. Consequently, the two sets of criteria constitute distinct benchmarks focusing upon nominal MCC and real/institutional/legal Copenhagen convergence (Backe, 1999). However, the Copenhagen criteria are very general and need to be made more explicit and operational. The first entails a comprehensive liberalisation of the price, trade and foreign exchange regimes, a system of legal and commercial rules and the presence of institutions which make possible decentralised intermediation through private economic agents. The second requires the development of some sectors which are essential for a modem and competitive market economy, in particular, public administration and the financial system. The former is needed not only to implement the requirements that EU members have to meet, but also to ensure high and sustained economic growth whilst the latter is a significant element in assessing a country’s readiness for membership. Third, new member states will be expected to take on the acquis communautaire in full, which as the EU is more integrated and in a dynamic phase of integration, is a higher requirement compared with previous accessions. Hence, given the magnitude of the task facing ACs seeking to join the EU, a major effort has been put in place for the progressive integration of the ACs into the EU’s political and economic framework. This process started with the Europe Agreements and entered a new phase with the so-called pre-accession strategy adopted by the European Council at

EU Enlargement: EMU and Agriculture 147

Essen in December 1994 which sought to create mutual confidence through a framework of regular contacts. In the economic domain, initiatives in the framework of the pre-accession strategy have entailed participation of ACs Ministers of Finance to the Economic and Financial Affairs Council, the organisation of regular meetings for the discussion of major economic policy issues, the creation of various working groups, as well as collaboration at the technical level in areas like statistics or macroeconomic forecasting. Following the economic and political criteria of the pre-accession phase, the next issue relates to the acquis communautaire in the area of EMU. For instance, Ilzkovitz (1996) suggested that the major challenge for the ACs would not be to enter the EMU, but to adopt the acquis communautaire in the area of the EMU as non-participating countries. In this respect, the new member states will participate fully regarding the procedures of co-ordination of economic policies, be required to follow the rules disciplining fiscal policy and shall have completed the liberalisation of their capital movements.

Towards EMU membership? Under Article 109k of the Treaty on European Union (TEU) a condition of EU membership is that countries acceding after the commencement of Stage 3 of EMU accept monetary union in principle and are committed to its membership. The applied convergence criteria is expected to be the original TEU reference values for interest rates, price stability and debt in relation to concurrent macroeconomic performance of the EMU(12). Derogation under Article 122 of the Copenhagen Treaty permits the ACs to accede without immediately joining EMU, but they will be included in Exchange Rate Mechanism (ERM) II which represents an intermediate stage in the process towards their eventual membership of the euro (EC, 2002). However, as for all EU countries economic policies become a matter of common concern and hence are subject to policy co-ordination and multilateral surveillance procedures. Hence, ACs are obliged to pursue a high degree of sustainable convergence required for the adoption of the euro, which will depend on the economic characteristics of each country and its success in applying the policies geared to sustainable convergence. The main instruments for co-ordination are the Broad Economic Policy Guidelines, the Stability and Growth Pact and a number of processes which deal with specific policy areas. Participation in EMU for the new ACs will be judged on the basis of the MCC whereby full participation means that the convergence

148 Current Economic Issues in EU Integration

criteria have to be fulfilled, not only when entering into Stage 3, but also on a permanent basis after a transition period. Therefore, the ability of the ACs to (i) adopt sound fiscal policies, (ii) to pursue disciplined and responsible monetary policies and (iii) to avoid large movements in nominal exchange rates and misalignments, have and will continue to be major factors in judging accessions. In relation to fiscal policy, the ACs have made progress reducing fiscal deficits to levels below those prevailing in many industrialised countries and most also possess low debt/GDP ratios. However, ACs are likely to face substantial revenue losses from customs duties following the reduction of tariffs combined with pressure on the expenditure side will derive from the continuous process of structural reforms (enterprise restructuring and consolidation of the financial system), non-performing bank loans, the accession process itself (approximation of legislation, strengthening of regulation, adoption of stricter environmental standards, etc.) and social security (health care and pensions etc.). Furthermore, following accession the ACs will have to set aside substantial budgetary resources to meet the co-financing requirements for EU transfers from structural funds and devote transient budgetary compensation to mitigate any socially negative consequences of accession to specific groups (Backe, 1999). In terms of monetary policy the main question to be addressed is whether reforms have gone far enough towards the establishment of an environment permitting the use of market-based instruments. Moreover, the ACs capital markets continue to lack liquidity and deepness and continue to suffer from a number of regulatory deficiencies (Rosati, 1995). Indeed, the considerable adjustments which the ACs will need to face when joining EMU will have to be borne by greater labour flexibility given that alternatives such as labour mobility or fiscal transfers are only likely to play a minimal role (De Grauwe and Lavrac, 1999). In relation to this, the study of Andreff (1999) found that since 1989 in the CEE(10) nominal convergence may take place in spite of real divergence. Whilst this is reassuring in terms of the MCC, it highlights the potentially debilitating deflationary consequences upon real economics variables such as incomes and employment. Finally, to this end it would seem expedient to improve their competitive positions with a view to smoothing the future incorporation into both the internal market and the EMU. This would relate to further developing and strengthening the financial sector, restructuring the enterprise sector, fostering competition and generally reforming all aspects of public administration (Backe, 1999). Moreover, such is the potential time discrepancy between nominal and real convergence for the ACs with the EU(15) that the extent to

EU Enlargement: EMU and Agriculture 149

which their premature entry into EMU could destabilise the operation of the euro zone becomes a key issue (Read, 2002). Table 8.2 illustrates the position of the 2004 and 2007 accession CEECs with regard to the MCC as of 2002. Clearly two areas for concern relate to price stability and interest rates where half of the 2004 ACs fail the convergence criteria, although Hungary is the only CEECs to do so for both targets. Moreover, both 2007 ACs exceed these criteria, albeit marginally in the case of Bulgaria, but significantly by Romania. The previous worrying performance by Hungary is repeated for the budgetary deficit together with the Czech Republic and Poland. However, with the potential immediate prospect of joining ERM II upon accession, exchange rate stability appears only a concern for Poland, which continues to be the lone floating regime amongst the CEECs. In relation to EMU entry following the 2004 enlargement, Gros (2003) has suggested 2006 as a theoretically feasible date with this optimistic forecast based on the notion of a minimum delay between the commencement of EU membership and the required 2-year period of purgatory within ERM II. In contrast to the often cited inability of the ACs to meet the MCC, Gros (2003) advances a comparative analysis between them and the ‘Club Med’ countries1 of the EU(15) which suggests that the three major ACs (Poland, the Czech Republic and Hungary) are closer to achieving the MCC than the Club Med countries were at a comparable stage prior to the start of EMU. However, it should be remembered that speculative attacks upon the EMS in the early 1990s occurred at the time when most commentators similarly believed the convergence process nearing completion with the primary triggers being concerns over fiscal adjustment and overvalued currencies. Indeed, the former appears to a growing difficulty for the 2004 ACs and there are indications that some currencies are overvalued and share some of the features (large current account deficits financed by FDI inflows and appreciating real exchange rates) of those EU member states most severely affected by speculative attacks (Gros, 2003). Consequently, Gros (2003) concludes by arguing that it would be dangerous for the ACs to tie their currencies to the euro within ERM II prior to having a clearer view of whether prevailing exchange rate parities are sustainable in the long-run.

Problems and prospects Although the initial prospects for EMU participation seem promising in terms of their fiscal positions, the ACs lag behind the EU(15) in terms

150

Table 8.2

EMU convergence criteria and CEECs (2002) Inflation

Reference value EMU(12) 2004 enlargement Czech Republic Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia 2007 enlargement Bulgaria Romania

Interest rates1

Fiscal deficit (% of GDP)2

Public debt (% of GDP)2

Exchange rate (against EUR parity)3

Currency regime

3.0

5.5


3.0

60.0

15%

1.8

3.8


6.8

29.9


2.7

Managed float (EUR)

3.6

2.8

1.2

5.2


1.6

5.3 1.8 0.3 1.9 3.3 7.5

8.0 7.4 6.4 6.6 5.0 5.1


9.3
2.5
1.2
5.1
1.5
1.0

49.2 14.6 27.0 46.1 44.3 30.5


8.8
12.4
3.5
18.6
5.6
4.9

Currency Board (EUR) Target zone (EUR) Peg (SDR) Currency Board (EUR) Floating Managed Float (EUR) Managed Float (EUR)

5.8 22.5

5.8 20.2

0.2
2.2

60.7 25.7


0.4
29.7

Currency Board (EUR) Managed Float (USD)

Notes 1 Long-term interest rate on 10-year government bonds, short maturities are taken for Bulgaria, Estonia, Latvia, Lithuania, Romania, Slovenia. 2 Definitions could differ from those of the EU and of the accession countries. 3 Parity defined as the last 3-year average exchange rate against EUR. Source: Deutsche Bank (2004). Where figures in bold and italics indicate none compliance with convergence criteria by ACs.

EU Enlargement: EMU and Agriculture 151

of price stability and convergence of interest rates (see Table 8.2). Such assessment nevertheless against the MCC requires careful consideration. First, ACs have frequently referred to the MCC to demonstrate their readiness for accession on the basis that if they out-perform some EU countries in such an advanced matter as EMU it is logical to infer that they are more than ready for EU membership itself. However, the Copenhagen criteria for admission are substantially different from this notion, whilst the MCC assume that Stages 1 and 2 of EMU have been successfully undertaken. Indeed, most ACs have yet to fully instigate all the single internal market requirements as precursors to Stage 3 of EMU, whilst it remains difficult to obtain reliable and compatible data on the MCC (Lavrac, 1999). Second, embarking on a fast-track move towards full financial convergence and, in particular, towards complete monetary convergence as defined by the MCC could prove counterproductive. Such a policy stance could distract from the challenge of removing underlying structural weaknesses and/or lead to structural reform delays which would have negative effects on financial indicators in the short-term, but are important for long-term macroeconomic sustainability (Backe, 1999). Moreover, such a strategy could possibly lead to uneven policy mixes with the overburdening of monetary and exchange rate policy. Hence, the MCC should be viewed during the accession period as medium and longer-term reference points and not as immediate operational targets (Backe and Linder, 1996). Third, some concepts such as long-term interest rates or fiscal deficits do not possess the same meaning as in established market economies with data on long-term interest rates not fully comparable with those of the EU member states, as long-term capital markets are still insufficiently developed in the accession countries (Backe, 1999). The budget position is also difficult to assess given that it is calculated contrary to the basis of the TEU with the position of regional and local government budgets as well as of social security funds difficult to assess. Moreover, state enterprises continue to perform functions that in market economies are financed through the government budget, which need to be properly accounted for in the budget. Fourth, until the ACs formally join the EU they cannot enter its mechanisms of monetary integration, in particular ERM II, which is only open to member states (Backe, 1999). Prior to this, they have been able to prepare themselves for inclusion in ERM II through either shadowing, pegging or irrevocably fixing their exchange rate to the euro thereby committing themselves to a de facto monetary union albeit

152 Current Economic Issues in EU Integration

with an asymmetric cost burden. The arguments in favour of an early inclusion of ACs in ERM II range from the technical ability to fulfil the MCC, to giving ERM II meaning and importance and accustom them to the concepts of monetary and exchange rate discipline and co-operation (De Grauwe and Lavrac, 1999). Moreover, a relatively wide standard fluctuation band and interventions at the margins, which will in principle be automatic and unlimited, combined with the timely adjustment of central rates should avoid significant misalignments (Lavrac, 1999). Additionally, the principal requirements of the ACs successfully and sustainably entering an optimal currency area are degree of economic integration and labour market flexibility. The former is likely to evolve over time following EU accession, but fundamental differences in economic structures, patterns of productions and consumption suggest a continued susceptibility to asymmetric shocks in the short- to mediumterm because of both the significant real economic divergence between them and also within the ACs themselves (Read, 2002). In terms of labour markets, most likely immediate route towards greater flexibility is via wages rather than further shock-therapy retrenchment, together with inflows of capital from the EU(15). Although certain features such as labour market flexibility in the ACs may be at least similar to that within the EU(15), according to Dangerfield (2002) overall the ACs whether as a whole or divided into sub-groups are unlikely to satisfy the optimal currency criteria given the limited extent of trade and integration between themselves in spite of the Central European Free Trade Agreement (CEFTA) and Baltic Free Trade Agreement (BFTA). The emphasis therefore is that accession will encourage further trade and integration which in turn will result in increasing convergence between themselves and the established EU member states (Gabrisch and Werner, 1999). Additionally, as discussed in Chapter 7, the speed and smoothness of economic integration will also be influenced by the future size and efficacy of regional policy under the auspices of EU Structural Funds (Gabrisch and Werner, 1999).

European enlargement and agriculture In 2004, the EU is set to encompass additional membership, mainly from the CEECs.2 From the perspective of agriculture, these accessions require careful (economic and political) consideration in extending the complex framework of instruments under the CAP to a structurally diverse range of candidates (see Box 8.1). To achieve this goal, EU legislative guidelines were drawn up and from 1998, have been

EU Enlargement: EMU and Agriculture 153 Box 8.1 The relative role of agriculture in the EU(15) and the candidate countries

Agriculture’s share (%) of the total workforce Bulgaria Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia 0

5

10

15 1990

20

25 1997

30

35

40

45

2000

Agriculture’s share (%) of GDP

s* ep * ub lic ** Es * to ni a* ** H un ga ry ** La tv ia Li ** th * ua ni a* ** M al ta ** Po la n d R om *** an ia Sl ** * ov ak ia ** Sl * ov en ia ** EU (1 5) ** *

ru yp

C

ze c

h

R

C

Bu

lg

ar

ia

*

16 14 12 10 8 6 4 2 0

With transition to ‘free’ market competition, a diminished share of agriculture in economic output is a key feature of economic development as labour resources are diverted into areas with higher marginal productivity and labour saving technology is introduced into agriculture. Between 1990 and 2000 (see above), the success of this transition has varied across the CEECs, with some (Czech Republic, Estonia, Hungary, Slovakia, Poland)

154 Current Economic Issues in EU Integration experiencing declining agricultural employment, whereas elsewhere (Romania, Bulgaria, Lithuania and surprisingly, Slovenia) it has increased. Such variances in agricultural mobility may be attributed to a number of factors including poor infrastructure, underdeveloped housing in ‘growth’ areas, low human investment (i.e. education), relatively low capital investment in agriculture and a lack of will by rural residents to move to urban areas (Ingham, 2002). (*  2000; **  2001; ***  2002). Data sources: OECD (1999); EC (2002c); Eurostat (2004).

implemented with financial support from the EU to prepare and equip candidates for accession (known as the acquis communitaire), although the process of harmonisation and regulation is far from complete. The following section briefly elaborates on this theme, reviewing the main legislative, trade and development initiatives (and their budgetary costs), which have been designed to help prepare the candidates for imminent membership. The other major worry for agriculture in an enlarged union is the politically sensitive issue of extending budgetary support. With the CAP currently accounting for approximately 45 per cent of the EU(15) budget and with the first wave of accession expecting to enlarge the farming population (recipients) by at least 40 per cent (EC 2002a),3 fundamental challenges lie ahead in terms of respecting pre-agreed CAP budgetary limits and WTO related constraints. The final section commentates on the political and economic difficulties in extending the CAP to accession members, the potential budgetary and welfare implications and prospects for conformity with WTO trade restrictions.

EU pre-accession agricultural programmes Under the auspices of the Europe Agreements, reciprocal tariff concessions were bilaterally negotiated with the CEECs (from 1999) and Cyprus and Malta (from 2002), with further concessions on agricultural trade tariffs and export refunds.4 However, the nature of ‘bilateral’ tariff concessions between accession members and the EU has had the effect of diverting intra-CEECs trade to the EU (Baldwin, 1994). For example, a number of agricultural areas of potential export growth for the CEECs have been designated as ‘sensitive’ for existing EU members, thus being excluded from the agreements. Moreover, on the grounds that EU producers may be severely threatened by competing CEECs exports, many bilateral routes where EU tariff concessions have been granted are controlled by highly complex quota regulations (Hertel

EU Enlargement: EMU and Agriculture 155

et al., 1997). Furthermore, real exchange rate increases in the CEECs,5 slow economic adjustment, shifts in consumer preferences towards westernised style food produce (Buckwell and Tangermann, 1997), considerably higher rates of agricultural support in the EU, low competitiveness in downstream industries, poor product quality, sanitary standards and market orientation, and the loss of traditional export markets such as the Former Soviet Union,6 have all conspired to turn what was a CEECs trade surplus with the EU in the early 1990s into a sizeable deficit (see Box 8.2).

Box 8.2 Agricultural trade statistics between the EU(15) and the CEECs in 2001(€ million)

Bulgaria Czech Rep. Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia Total –3 000 –2 000 –1 000

0

1 000

Balance

2 000

3 000

Imports

4 000

5 000

6 000

7 000

Exports

Although exports from the CEECs to the EU doubled between 1988 and 1998, over the same period EU exports to the CEECs increased almost tenfold (Kearney, 2002). Indeed, 2001 trade statistics reveal that with only two exceptions (Bulgaria and Hungary), the CEECs are in agricultural trade deficit with the EU, whilst the net agricultural trade balance between the CEECs and the EU was €1.857bn. Data sources: EC (2002b).

156 Current Economic Issues in EU Integration

The other task facing policy makers was the implementation (and maintenance) of legislation and internal market requirements under the acquis communautaire. Indeed, if such (bureaucratic) harmonisation was not implemented strictly and swiftly, the resulting non-tariff barrier costs would largely nullify the gains from market integration (Bauer, 1998). Accordingly, a 4-year period of formal bilateral negotiations with the EU began in 1998. Each candidate had to abide by the legislature of these chapters and (in the case of agriculture) demonstrate that transitional reform was proceeding at a pace to allow for the administration and management of various Common Market Organisations, rural development programmes and the implementation of veterinary and phytosanitary standards upon accession. At the time of writing, it appears that there is still considerable work to be done. More specifically, the Commission fears that several accession countries (especially Poland with over two million farmers) face delay or even loss of subsidies if they fail inter alia to correctly administer farm-paying mechanisms before the May 2004 deadline.7 The transition costs of implementation are shared through EU funding initiatives and discussed below.

CEECs Under the Berlin agreement of 1999 as part of the Agenda 2000 budgetary guideline (2000–2006), the Commission agreed to sanction €21.8 billion towards pre-accession convergence funds for the CEECs after which candidates will be supported through mainstream programmes (e.g. the CAP). Pre-accession funding is split into three areas, PHARE, ISPA and SAPARD. With an annual budget of €1.085 billion between 2000 and 2006, the PHARE8 programme is designed to aid institutional (30 per cent of the budget) and investment (70 per cent of the budget) projects. The Instrument for Structural Policies for Pre-Accession (ISPA) has a (minimum) approved annual budget of €0.878 billion and is targeted at funding up to 85 per cent of the cost of individual infrastructure projects in the field of transport and environment. In the context of ‘agriculture’, aside from the obvious benefits of transport infrastructure to industry, ISPA also covers finance towards improving drinking water standards, treatment of waste and air pollution initiatives. Finally, the Special Accession Programme for Agriculture and Rural Development (SAPARD) possesses annual funds of €520 million (Table 8.3), which are designed to aid implementation of structural adjustment in agriculture and rural areas of the economy by improving market efficiency, quality and

EU Enlargement: EMU and Agriculture 157 Table 8.3

Annual pre-accessional budget allocations for the CEECs

Applicant

SAPARD

PHARE

ISPA Minimum

Maximum

Bulgaria Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia

52.1 22.1 12.1 38.1 21.8 29.8 168.7 150.6 18.3 6.4

100 79 24 96 30 42 398 242 49 25

83.2 57.2 20.8 72.8 36.4 41.6 312.0 208.0 36.4 10.4

124.8 83.2 36.4 104.0 57.2 62.4 384.8 270.4 57.2 20.8

Total

520.0

1085

878.8

1201.2

Source: EC (2002d).

health standards, maintaining and creating jobs and the development of further environmental protection. The allocation of each of these funds is based on agricultural area, farming population and GDP per capita. In terms of administration, each of the CEECs candidates are themselves responsible for putting bids to the Commission, which if approved, are administered nationally. Each project has a co-financing principle with the EU contribution capped at 75 per cent. Cyprus and Malta The economies of Cyprus and Malta are quite apart from the remaining candidates in that they have a longer history of market orientation and smaller agricultural sector in both relative and absolute terms. Thus, it is not envisaged that either will have major impacts on Community agricultural markets. Whilst these acceding member states do not benefit from the PHARE, ISPA or SAPARD funds, both have received financial assistance from the EU under four financial protocols between 1978 and 1999 as part of the Euro-Mediterranean Partnership.9 From 2000, both Cyprus and Malta received pre-accession funds over five years to 2004, with Cyprus (Malta) projected to receive a total of €57 (€38) million. These funds will be used for grants projects designed to facilitate transposition, application and enforcement of the acquis communautaire (technical assistance and institution building). In addition, financial support to Cyprus is also targeted at initiatives designed to improve relations between the two Cypriot communities on the island.

158 Current Economic Issues in EU Integration

CAP and enlargement When the EU first held out the prospect of membership to the CEECs at the June 1993 European Council meeting in Copenhagen, the vision was to restore peace and stability (both political and economic) throughout Europe through the restoration of democracy, the rule of law and the protection of human rights and minorities. Consequently, the adoption of the acquis (discussed above) was a means to this end, which has subsequently presented, inter alia, agricultural policy makers with tough choices. Indeed, it was envisaged that with low land and labour costs, together with the availability of CAP price supports and subsidies, there would be considerable scope for productivity improvement in what are still largely agricultural accession economies, fuelling speculation that cheap food products would flood Western markets after enlargement. However, for various reasons this sentiment appears to have abated somewhat in recent years and is subject of discussion in the following sub-section. Key issues One of the main concerns was the price hike, (whether total or gradual) in the CEECs on adoption of CAP price mechanisms leading to significant supply response.10 After ten years of transformation by the CEECs, price gaps remain for dairy, beef and sugar products (Kierney, 2002), although quality differences account for much of this disparity, whilst the price gap for cereals and oilseeds following implementation of the Agenda 2000 reforms is considerably less.11 Furthermore, prices rose in many CEECs due to increased protectionism after the shock of liberalisation in the early 1990s, whilst the euro has depreciated since its launch in 1999. However, whilst CEECs produced surplus gains may be muted, it is unlikely that the impact of higher food prices on household expenditure will have quite the same impact as previously feared12 (see Box 8.3). Second, the application of CAP supply management (e.g. set-aside and headage payments, quotas) to a heterogeneous group of acceding members could entail significant implementation costs. For example in Slovenia, Poland, Romania and Bulgaria, much of the agricultural land is accounted for by small scale enterprises, whilst in the Czech Republic and Slovakia, collectives are still highly prevalent (Ingham and Ingham, 2002). Furthermore, the impacts of imposing constraints on output (sugar, milk) or inputs (cereals set-aside, livestock) on pre-mature production activities could have detrimental efficiency effects on what are still transforming farming structures lacking in investment capital.

EU Enlargement: EMU and Agriculture 159 Box 8.3

Development indicators for the CEECs

Household food expenditure shares (%)

Bu lg ar ia * C C yp ze r ch us * R ep * ub Es lic* to ni a* H un ** ga ry ** La Li tvia th * ua ni a* * M al ta * Po ** la nd R om ** an ia Sl ** ov ak ia ** Sl * ov en ia EU ** (1 5) **

40 35 30 25 20 15 10 5 0

GDP per capita index: 2004 forecasts (EU(15) = 100)

ia ov en

Sl

Sl

ia ov ak ia

d

an

ta al

an

om R

Po l

M

ni

a

ia

ua

ry

tv

th Li

La

a

ga

ni to

un H

ep R

C

ze c

h

Es

s ru

ia

yp C

ar lg Bu

ub lic

90 80 70 60 50 40 30 20 10 0

Traditional indicators of development are household food budget shares and GDP per capita data, where in the former case, households with lower incomes typically apportion more of their financial resources into necessities (i.e. food and drink). The data in the figure not only illustrate the differences in development between the candidate countries and the EU, but also indicate the level of heterogeneity that exists between aspiring members, particularly within the CEECs. Note that where per capita incomes are relatively low (particularly Bulgaria and Romania) compared with the EU(15), household food budget shares are high (*  2000; **  2001; ***  2002). Data sources: Eurostat (2004).

160 Current Economic Issues in EU Integration

Third, the system of direct payments, introduced under the MacSharry reforms may pose a number of equity problems for the EU. Given variations in land ownership across accession members, there is no guarantee that needy farmers will receive most of the support. Equally, the capitalisation of agricultural payments into higher land rents may considerably hamper agricultural restructuring with high current levels of over-employment and land fragmentation. In support of this point, European Economy (1996, p. 6) notes that, ‘structural measures seem more appropriate (vis-à-vis direct subsidies) to create the conditions for improving the economy in a sustainable fashion and shorten the time it will take for the economy to catch up with the EU’. Furthermore, Josling (1998) suggests that completely withholding support from agriculture would particularly benefit the transition economies, since the absence of market distortions would facilitate a swifter competitive process thus improving long-term export competitiveness. Thus, it appears that the future of CEECs agricultural development, will be resultant upon changes in productivity rather than implementation of CAP payments. However, with much of agricultural production on small land holdings, low levels of capital investment and skilled labour, policy constrained (supply management) access to inputs and continued appreciation in the real exchange rate it may take some time before the productivity gap narrows. Ultimately, the future success of these candidates rests on their ability to attract investment activities and improve infrastructure and administration facilities. Political developments and final agreement Part of the implicit mandate of the Agenda 2000 reforms was to ready the CAP for enlargement mainly through significant intervention price reductions in exchange for compensation payments. However, the budgetary implications were largely unpalatable to the net contributing regions, resulting in a significantly weakened reform process. With enlargement due in 2004, the EU failed again to impose support price reductions under the auspices of the 2003 Mid-Term Review (MTR) largely due to French intransigence (with support from CAP beneficiaries Ireland, Spain, Greece and Portugal), whilst the cost to the EU taxpayer remains the same. Against this policy background, there has been considerable contention over extending CAP support to accession members. The EU maintained that granting full support to a single group (i.e. agriculture) would put the social balance within the candidates at risk, whilst claiming that direct payments were only introduced to compensate farmers

EU Enlargement: EMU and Agriculture 161

for losses in income due to EU support price drops, which excludes farmers in accession countries. This latter argument is a little hard to justify given that Austrian, Finnish and Swedish farmers received full compensation on accession in 1995, despite not undergoing MacSharry price reductions in 1992. Instead, the EU proposed that accession members should only receive EU structural funds for developing their poorest regions.13 Such an initiative is, however, unjustifiable since different rules for different member states under the acquis is against the spirit of the Treaty of Rome, and so, withholding payments to very poor farmers in the CEECs, whilst continuing to advocate support to wealthy landowners and farmers in the EU(15) is politically untenable. Ultimately the only plausible outcome was some halfway position of the two involving the phasing-in of agricultural subsidies and further rural development support. Thus, following the decision of the Copenhagen Summit in December 2002 and ratification in April 2003 in Athens, it was ‘agreed’ that an enhanced rural development package of €5.1 billion for the years 2004–06 would be made available to co-finance (up to 80 per cent EU funded) a range of rural development measures (e.g. less favoured area and environmental support, technical assistance, early retirement, afforestation etc.).14 Additional rural development initiatives will be funded from the structural funds. Discrete rises in direct payments will be phased over ten years starting in 2004 at 25 per cent of current support levels rising to equal support by 2013. Between 2004 and 2006, new members have the option of topping up these levels of support to pre-agreed ceiling limits employing not more than 40 per cent of their rural development funds. From 2007 onwards, top ups to pre-agreed ceiling limits are still permitted although these must be financed entirely from member states’ own national budgets. New members will also have full and immediate access to CAP market measures, such as export refunds, cereal, skimmed milk powder and butter intervention, whilst reference quantities (e.g. quotas, base land areas) have been agreed for all relevant products based on recent historical performance and country specific circumstances (e.g. drought). Budgetary and welfare costs of enlargement and WTO compatibility The Commission has maintained that financial framework totals for enlargement period 2000–06 agreed at the Berlin European Council in 1999 will be respected (see Table 8.4), through phased increases of support, lower appropriations on rural development and delayed membership.15 Indeed, despite fluctuations in world market conditions, the

162 Current Economic Issues in EU Integration Table 8.4

Financial framework for enlargement 2004–06 (€ million)

Commitment appropriations Agriculture Structural actions Internal policies Administration Total commitment appropriations Total commitment appropriations in Agenda 2000

2004

2005

2006

2 048 7 067 1 176 503 10 794

3 596 8 150 1 096 558 13 400

3 933 10 350 1 071 612 15 966

11 610

14 200

16 780

Source: EurActiv (2003b).

Commission expects that savings accruing on delayed membership are considered to be enough to keep total spending at 6 per cent below the enlargement commitment appropriations to 2006 (EC, 2002e, 2002f). However, there is still concern about medium-to long-term budgetary projections, with estimates from the literature predicting annual costs of extending CAP mechanisms to an enlarged union in 2007 of between €8 and 10 billion.16 Compared with the forecasts for 2006 under the financial perspective, these estimates represent an increase of up to 16 per cent and 6 per cent of agricultural and total EU budget appropriations respectively, and are clearly above the Commission’s target of 2006 levels plus 1 per cent per year. The budgetary situation could be further exacerbated by reform to dairy and sugar regimes with concomitant additional compensation estimates of between €2 billion in 2007 to €4.3 billion in 2013 (Swinnen, 2002). On this basis, agricultural and total ‘enlarged’ budget expenditure could rise by 26 per cent and 10.5 per cent respectively. Finally, the inclusion of the largely agricultural candidates of Bulgaria and Romania, currently scheduled for 2007,17 will add even further budgetary pressure.18 Further studies have sought to estimate the broader welfare impacts on the CEECs and the EU from accession, where bestowing considerable support to agricultural factors of production inevitably results in economy-wide resource reallocation effects.19 Earlier studies (Anderson and Tyers, 1993 and 1995) predicted significant expansion of CEECs agriculture from associated price hikes on accession, although with generally poor levels of agricultural performance throughout the latter half of the 1990s and considerable narrowing of CEECs and EU prices, such optimism has been tempered somewhat with studies stressing dampening factors such as restructuring efforts, macro-economic factors (Swinnen

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and Bojnec, 1997; Bojnec et al., 1998) and investment risk (Baldwin et al., 1997). Later studies also illustrate the sensitivity of economy-wide opportunity cost estimates of EU-CEECs market integration to model assumptions.20 For example, real income estimates of accession in Baldwin et al. (1997) based on a sensitivity analysis of variations in investment risk premium on capital investment and single market accession costs21 yield estimated welfare gains of between ECU2.5 and ECU30.4 billion to the CEECs and ECU9.8 to ECU11.8 billion for the EU(15). Such gains are justified on the basis of allocative efficiency gains22 from single market access and resulting capital accumulation effects in the CEECs.23 On the other hand, Bach et al. (2000) include explicit characterisation of CAP policy mechanisms with an endogenous EU budget. Accordingly, the EU welfare gain predicted above is recorded as a ECU12 billion loss, with roughly equivalent real income gains in the CEECs.24 The study reveals that welfare outcomes are dominated by significant budgetary transfers from EU taxpayers to Eastern European farmers.25 Finally, in terms of the current Doha round of trade talks, agriculture is once again likely to feature highly and remain instrumental to a successful conclusion. At the time of writing, nothing has been agreed between the key players, although the gravitas of the debate will once again be based on the criteria of (i) import tariffs; (ii) domestic support and (iii) export subsidisation. In terms of market access, there is the danger that candidate’s tariff levels will have to rise to align with the EU’s common external tariff (CET). Under WTO trading provisions, which a number of the acceding members have committed to, such tariff increases are not permitted under the formation of trading agreements as it will lead to tariff increases on third countries. However, given the lack of clarity in the WTO legislature on the formation of regional arrangements, this may ultimately involve necessary compensations from the EU to third countries for a number of agricultural products. In terms of domestic support limits, there is a danger that candidate countries’ proportionally low ‘amber box’ ceiling limits may not sufficiently cover increased price support within the CAP on accession.26 However, it is envisaged that the EU has sufficient margin within its own agreed ceiling to absorb any potential surplus arising from the CEECs (Swinnen, 2001). The main problem facing the EU is continued adherence to the export restitution and quantity commitments, although this will depend largely on whether the increase in export surpluses from additional members will be greater than the additional subsidy rights that these members bring with them and for which commodities CEECs (EU) limit

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breaches mesh with EU (CEECs) slack areas. Furthermore, in some acceding countries, such as Hungary, value commitments in ‘local currency’ are already closely binding due to periods of high inflation. Whilst the recent MTR has partially succeeded in decoupling support from production, this could be (partially) undone by demand falls in many CEECs as food prices rise on accession. Notwithstanding, the EU will be looking for recognition from trading partners in the current round, having stated categorically that the stabilisation and development of world (agricultural) markets, should be given its due weight in the negotiations (Kierney, 2002, p. 18).

Conclusion The initial part of this chapter has sought to illustrate that good reasons exist to suggest that EMU should not be an immediate target for the majority of the ACs. First, given the lateness of determining the appropriate timetable for accession it is conceivably more important that they should firmly cement their progress towards a functioning market economy, competitiveness and participation in the single market combined with sustainable macroeconomic stability. Second, it might indeed be difficult for most of them to implement the acquis in the area of EMU. Third, premature adoption of the convergence criteria could also be too constraining for them given the need for transition economies for public investment (Kok, 2003). Potential obstacles to implement the acquis communautaire in the area of EMU include their specificity as transition economies, whereby the ACs are likely to grow faster than Western Europe catching-up in terms of productivity and standard of living. This process implies a real appreciation of their exchange rates which can result from either an appreciating nominal exchange rate or a higher inflation rate than in the EU. Further, the loss of the exchange rate instrument might also be too costly for some such that during the transition period, they might require some exchange rate flexibility to elevate capital inflows or inflationary pressures. Additionally, adopting too tight fiscal criteria should not be an immediate target for transition economies before restructuring is completed, whilst a high potential return on public investment should allow, to some extent, running budget and external deficits if money is being invested in transition. Finally, EU membership is likely to induce a further rise of capital inflows resulting in ACs potentially having increasing difficulties in preventing their economies from overheating and therefore to achieve the objective of price and exchange rate stability (Daviddi and Ilzkovitz, 1997).

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In view of these obstacles and challenges there has been much debate regarding the timeframe for ACs to meet the MCC and hence be in a position to join the EMU. Under the assumption of appropriate economic and structural adjustment, sustainable compliance with the fiscal criteria could be attainable within a period of five years. In contrast, monetary convergence appears to be a more significantly more remote perspective, with a time horizon of 7–10 years (Backe, 1999). In this chapter, we (also) discuss the challenges facing an enlarged union from the perspective of agriculture. The foundation (acquis communataire) of preparing accession countries for membership began in 1998, whilst the implementation of various trade and development initiatives supported by (mainly) centralised EU funding have sought to speed up this process although substantial work still remains. The second pertinent issue relates to the nature of implementation and timing of CAP support to the accession members. Aside from the economic counter-arguments of subsidising developing agricultural systems, a key political worry was the likely budgetary impact of ‘fully’ supporting member states which in some cases had considerable farming populations. Clearly, it was not realistic to expect any of the member states to become net contributors to the CAP budget (at least in their first few years of membership), whilst the precariousness of the budgetary issue was further affected by the EU’s previous unwillingness under the Agenda 2000 and MTR reforms to ready the CAP for further enlargement (e.g. through considerable price reductions). Ultimately, the solution of phased support was the only logical reconciliation between existing and acceding members, however, as this chapter shows, the EU is far from being ‘out of the woods’ as far as further CAP reform is concerned. Indeed, with estimates forecasting potential breaches in the EU’s financial framework and the threat of significant trade reform under the auspices of the Doha Round, it is highly probable that the CAP will have to reform again sooner rather than later.

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Part IV Alternative Futures for the UK

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9 Alternatives to Further Integration

Introduction The EU was designed by the founding members to accommodate their perceived commonly shared objectives, whilst further measures of integration, including the abolition of exchange controls, the design of the single market, and the forfeiture of economic sovereignty through entering EMU, may be rational consequences for those EU nations which are locked closely through trade, but could be viewed debateable for the UK which conducts a large proportion of its trade outside the EU and possesses closer cultural ties with the USA and Commonwealth countries. However, the question that demands an answer is ‘What is the alternative?’ Given that the political and economic elite in most EU countries have consistently supported further integration, alternatives have rarely been discussed. In the countries which allowed referendums over the Treaty on European Union (TEU) and in the new 2004 EU entrants, almost without exception all major political parties, business and trade union leaders joined together in an alliance to persuade voters to back the integrationist project. However, public opinion and polls often appear to be questioning of EU political and economic integration, but the UK seems to be anxious of the consequences of lessening its membership. To confront such concerns a series of alternative strategies regarding the UK’s relationship with the EU and the rest of the world are formulated here derived from Burkitt et al. (1996) and Baimbridge et al. (2000). This chapter seeks to explore four alternative strategies for UK’s relationship with the EU: (i) a status quo strategy of excluding further integration, (ii) reducing membership to that of the European Economic Area, (iii) pursuing free trade in industrial and financial commodities 169

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and (iv) complete withdrawal with the options of rejoining EFTA, reinvigorate the Commonwealth trading bloc and/or association with the North American Free Trade Agreement (NAFTA). The second part of the chapter reviews the broad range of policies which could be enacted if Britain rejected participation in the single currency. For brevity and simplicity these are condensed into three general sets of ideas: (i) tight monetary policy/low interest rate strategy whereby national monetary authorities seek a higher long-term growth rate by providing a favourable climate for industrial expansion through low inflation and hence reduced long-term interest rates, (ii) a ‘Keynesian’ strategy with the more active use of fiscal as well as monetary policy in order to pursue both internal and external balance for the economy. Accordingly, unemployment could be reduced by a mixture of demand-side reflation and supply-side labour market policies, particularly measures encouraging re-training and labour mobility, and (iii) exchange rate policy strategy such that over a period the desired objectives of exchange rates are short-term stability and long-term flexibility.

The status quo This is the most obvious short-term position, whereby the UK retains EU membership but relies upon its opt-outs from EMU and refuses to participate in further economic and political integration. The maintenance of a national veto over economic proposals (i.e. taxation) remains one consistent feature of UK government policy towards the development of the EU, irrespective of the composition of government. Moreover, there are a number of precedents where individual member states have continued to pursue their individual national interests even if this threatened to hamper the effectiveness of the EU institutions. Furthermore, there appear to be no grounds for the EU to expel the UK for a bilateral trade agreement with a third party, even if this were an alternative trade association. For example, Denmark had an agreement with fellow Nordic states that permitted the free movement of people, goods and services despite Norway, Sweden and Finland not at the time being members of the EU single market. Moreover, as of October 1998 formal negotiations commenced to establish a Canadian-EFTA free trade agreement. The practicalities of the UK being a member of two trade organisations are relatively easy to reconcile, requiring that all imported goods and services bear the mark of the country of origin, to prevent differential tariff rates creating a market for arbitrage in order to avoid paying higher rates of import taxation. Once labelled according to the country of

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origin, if re-exported from the EU to USA (or vice versa), the correct tariff charge can be applied when it enters the final market. The advantages of the UK remaining a full member of the EU are that it retains access to the single market and is able to jointly determine the harmonisation definitions and other trade-related rules which define the marketplace. Disadvantages include the net budget contributions, continuing trade deficits and the fact that, technically, the UK has an opt-out only from Stage 3 of EMU, but not from earlier stages including the requirement to meet the convergence criteria established in the TEU.1 Thus, the UK would be economically tied to the euro area and be required to implement policies perhaps unsuitable to the particular requirements of a recession or wider national economic interest.

EFTA and the EEA This second strategy would involve the UK formally withdrawing from the EU and re-joining the European Free Trade Association (EFTA) it helped found in 1960 along with Austria, Denmark, Norway, Portugal, Sweden and Switzerland. In the process, the UK would be eligible for membership of the European Economic Area (EEA). Article 41 of the convention establishing EFTA states that any state may accede provided it receives the approval of the EFTA Council, or alternatively the Council may negotiate bilateral agreements with individual states subject to its unanimous approval by all member states. Article 42 establishes the right to withdraw from the convention after 12 months advance notice. Similarly, Article 128 of the EEA Agreement states that any European state becoming a member of EFTA can apply to the EEA Council to be party to the agreement, with the terms and conditions subject to negotiation. Indeed, all future EU members are required to apply to become party to the agreement. The EEA is an agreement made between EFTA (less Switzerland) to extend the internal market of the EU and that of the EFTA participants to create a trading area of 18 countries with some 370 million people. This is the world’s largest and most comprehensive multinational trading area which came into force on 1 January 1994. Under the agreement, there is free movement of goods, services and capital across the entire area, whilst Article 28 also provides for the free movement of persons and a single labour market across all 18 countries. Participants are encouraged to co-operate in the fields of environmental protection, social policy, education and research and development programmes. Exceptions to this coverage include agriculture and fisheries. Moreover,

172 Current Economic Issues in EU Integration

the EEA, has no common external tariff and therefore requires the identification of country of origin for all goods and services. As a member of the EEA, the UK would possess full access to the EU’s single internal market and retain some influence over the rules which affect trade with EU nations. The EEA ensures free trade without the discrimination against external nations created by a customs union. The terms of the EEA stipulate that the UK business sector would operate under the same general conditions as its EU competitors, whilst ensuring that EEA member states develop relevant legislation jointly without the EU arbitrarily imposing standards. Indeed, the EEA provides member states with the right to oppose and veto EU law if they feel that it operates against their national interest. It also offers the possibility to participate in EU research projects and co-operation on the environment and the social dimension of EU legislation should any EEA participant find these beneficial. Although a net transfer of income to the EU budget is part of the requirement for EEA membership it would be significantly lower than the budgetary burden imposed by full EU membership upon the UK. Membership of the EEA also releases the UK from pressure to participate in ERM II, stipulated by the TEU, and in eventual EMU. Given the UK’s previous unfortunate experience of ERM I membership, and the still larger potential problems posed by EMU, this could constitute a significant advantage. Thus, the EEA provides many of the advantages of EU membership without some of the costs. Norway can be regarded as a precedent for this scenario since their electorate has consistently rejected EU membership in national referenda and yet it has been able to participate in the EU single market by means of the EEA. Subsequently, the EU have not sought to ‘punish’ Norway for failing to join the EU and on the contrary appear eager to take advantage of their addition to the single market to export goods and services, whilst having Norway pay a contribution towards the EU bureaucracy which manages the market. One disadvantage of the EEA over full EU membership is a current power imbalance between EU states and EFTA/EEA members, particularly once Finland, Austria and Sweden became full EU members in 1995, which could undermine many of the benefits that such an agreement currently provides. However, if the UK reduced its membership to that of EEA status, this problem would be reduced since the UK and Norway would jointly provide a far more credible counter-balance to the EU in future negotiations. In relation to EFTA, an advantage is that it is a similar type of trade agreement to NAFTA in that it does not impose undue costs and

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restrictions upon member governments, barring those minimum rules necessary to maintain the effectiveness of the free trade area. The only significant differences are that the EEA is not as explicit on the issues of intellectual property and foreign investment, whilst it progressively adopts updated rules on trade harmonisation once these are agreed between the EU and EFTA members. Thus, UK membership of the EEA and NAFTA could establish closer co-operation between two trade blocks around two very similar free trade agreements.

Free trade in industrial and financial commodities Since the UK is generally ill-served by participating in the Common Agricultural Policy (CAP) and the Common Fisheries Policy (CFP), a restriction of free trade with EU nations to industrial and financial goods and services would in all likelihood prove more beneficial than the present status-quo. The remaining EFTA countries negotiated such a free trade agreement with the EU in 1972 after the UK, Denmark and Ireland had joined the EU, thus escaping from the financial burdens and policy constraints imposed by EU membership. As with membership of the EEA, this approach would allow the UK to reorientate its economic policy to serve its own needs. The money saved by non-contribution to the EU budget could, for example, be used to increase incentives for productive investment within the UK and for state expenditure on infrastructure and research-based projects which increase long-term competitiveness. This option provides greater freedom than EEA membership, which implies the agreement of common rules and equal conditions for competition, so that greater pressure would be placed upon EEA participants to accept EU regulations to ensure continued co-operation. Consequently, restricting EU relations to a free trade agreement would remove the possibility of such behind-the-scenes pressure. This third option closely resembles Switzerland’s current position, after a majority of its citizens and cantons voted against EEA membership in December 1992. This decision was motivated partly by a desire to preserve its 700 year independence from the rest of Europe and partly by a disillusionment with an EU model which would undermine the country’s tradition of direct democracy for a federation operated by an elite largely unaffected by its member states’ citizens (Economist, 1992). Such a decision did not haemorrhage Switzerland’s economic vitality; instead it strengthened its economy. For instance, a sharp influx of foreign funds occurred after the ‘No’ vote, raising the stock market by 30 per cent and strengthening the value of the Swiss Franc. This allowed

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Switzerland to maintain the lowest interest rates in Europe, which facilitated investment growth of 2 per cent in 1994 and 3.5 per cent in 1995. Inflation is currently 0.2 per cent (compared to 2.0 per cent in the euro zone), unemployment is 4.3 per cent (compared to 8.8 per cent in the euro zone), whilst in 2004 GDP growth is forecast at 1.6 per cent (compared to 1.9 per cent in the euro zone). Thus Switzerland, despite a continued eagerness amongst its political elite for future EU membership, is largely benefiting from its arm’s-length relations. These relations are based upon over 100 bilateral treaties, including a 1972 Free Trade Agreement which covers industrial goods (Church, 1993). Amongst Organisation of Economic Co-operation Development (OECD) countries, agriculture apart, there is no economy more open to the outside world than Switzerland. Exposure to such competitive pressures encouraged the development of some of the world’s most internationally orientated companies. Switzerland is the fourteenth trading nation in the world and the second trade partner with the EU (after the USA) and the third supplier after the USA and Japan. Consequently nonmembership of the EU has failed to hamper its economic development or its trading potential. Despite economic success outside the EU, the Swiss authorities express two familiar fears. First, since the majority of trade is done with EU nations, membership is essential to protect it. However, approximately some 60 per cent of exports and 70 per cent of imports relate to the EU, so that the Swiss economy is less orientated towards the EU than most commentators claim. Additionally, like the UK, an increasing proportion of its international trade is being conducted with rapidly growing areas rather than with the slowgrowing EU. Thus Switzerland’s dependence upon the EU market is likely to diminish in the future. Second, absence from the EEA will result in EU discrimination against Swiss-made goods through technical barriers. However, EU nations benefit far more than Switzerland from their bilateral trade so that they are unlikely to engage in discriminatory practices that could endanger their own more sizeable exports. Moreover, the WTO framework prevents arbitrary treatment of a nation’s exports in any market, thus preventing active discrimination against Swiss, or any other countries’, exports by the EU. Of course, unofficial barriers to trade do exist, but EU membership is no guarantee that these will be dismantled.

Withdrawal The previous three options each retain varying constraints by the EU upon the UK’s economic behaviour. The status quo option implies

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similar costs to EMU unless the UK breaks the MCC, whilst the EEA involves a budgetary cost and a general acceptance of the EU’s regulations for the long-term survival of the agreement. The third option is perhaps the most palatable but if this is achieved with the UK remaining bound by the Treaty of Rome, economic policy remains fundamentally constrained and speculators could therefore ‘punish’ Sterling for noncompliance with EMU rules. Therefore, in view of the varying but probable net costs implied by any form of EU membership, a fourth option for the UK is complete withdrawal, so that it can reclaim the ability to determine its economic fate. The legalistic aspect of withdrawal would take the form of the UK Parliament repealing the European Communities Act of 1972 under which EU directives take precedence over UK law, as well as the 1986 and 1993 European Communities (Amendments) Acts which added the single internal market and the TEU. Following the example of Greenland which left the EU after 12 years of membership in 1985, the UK could negotiate a ‘Treaty of Separation’ to establish formal future trade cooperation on a mutually beneficial basis under the auspices of WTO rules. However, the potential of obtaining such economic independence is dismissed by supporters of EU integration as illusory, arguing that sterling would be prey to speculation outside EMU, requiring higher interest rates to be maintained than would be necessary inside with severe consequences for productive investment. Moreover, it is argued that the only way in which the UK can exercise any power in world affairs is as part of the EU, because it is too small to do so on its own. Furthermore, withdrawal may endanger FDI and cause negative reactions from remaining EU members. Such arguments require careful examination given the profound economic and political ramifications for the UK following withdrawal from the EU. However, after the ERM debacle, it is disingenuous of the supporters of European integration to suggest that sterling would be damaged by floating. During the two years of ERM membership the UK lost over a million jobs, with between £4 and 15 billion expended in defending sterling’s value (Burkitt et al., 1997). International speculation does not occur against currencies set at the equilibrium level nor against rational exchange rate systems. Destabilising speculation is best prevented by international action; perhaps with a tax on currency transactions which are reversed within a short period of time. Although the history of free-floating currencies is not as successful as its advocates often claim, managed floating is certainly preferable to the damage that can be inflicted by an inflexible and ill-designed fixed system.

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Furthermore, the argument that the UK can only exercise any influence on world events from within the EU is again questionable. The UK lost its former world position because of economic problems whereby decades of slow economic growth reduced the UK from being the leading world economy before the turn of the twentieth century to a medium sized economy by its close, with political power declining accordingly. In contrast, Japan and Germany increased their international influence not because of foreign policy or military might, but because their economic strength compelled attention. Hence, if the UK is to regain influence, it must be based upon economic success. Furthermore, the UK could secure international influence far in excess of its size through less conventional means. For example, the Scandinavian countries achieved significant prestige for their environmental and human rights campaigns. The UK, when it implemented many of the ideas within the 1942 Beveridge Report, was likewise a model which countless other countries used when constructing their own welfare systems. International influence does not, therefore, have to be of the traditional type. Even the latter can be more effectively attained through UK participation in the G7 summits than by being one voice amongst 25 within the EU. The belief that withdrawal would reduce the flow of FDI has been widely held, but a UK economy growing faster outside the EU with a permanently competitive exchange rate is more attractive to foreign markets than an EU member state. Nor is the idea that withdrawal would provoke retaliation from current EU ‘partners’ any more probable. Apart from EU political pressure attempting to persuade the UK to change its mind, the other EU countries will not engage in a trade war because their surpluses with the UK means that it would be self-defeating. Indeed, if the UK could reorientate its economic policy outside the EU to promote greater economic growth, the UK would be able to buy more EU goods than if it stayed a member and remained a low growth economy within a low growth bloc (Burkitt et al., 1996). Withdrawal from the EU, however, is only a first step. Once achieved, the UK can develop whatever trading relations with other nations it desires. For instance, as previously discussed one possibility is to rejoin EFTA, so taking advantage of a free trade area without the pretensions of economic and political union. EFTA could be expanded to include those nations seeking to join the EU (e.g. Turkey, Romania, Bulgaria and the states of the former Yugoslavia), but which the EU is currently hesitant to admit even in light of associated obstacles. An EFTA free trade area in manufactures, without agricultural protection, would assist all nations.

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A second alternative could be to reinvigorate the Commonwealth trading bloc (West, 1995). Australia, New Zealand and Canada were severely damaged by the UK’s decision to join the EU (Burkitt and Baimbridge, 1990) and subsequently reorientated much of their trade towards the emerging economies of East Asia. However, ties of language, culture and mutual advantage would ease a resumption of trade between them, other Commonwealth nations and the UK. The Commonwealth is an asset which the UK often underestimates, particularly since it now includes some of the fastest growing economies in the world. A third alternative is to form an association with the NAFTA, which comprises the USA, Canada and Mexico (see Chapter 10 for an in-depth analysis of the economic implication of such a development). Since approximately one quarter of UK trade is already done with the USA, this bloc, together with the Commonwealth link to Canada, would be beneficial for the UK. Furthermore, talks between the USA, China, Japan and fifteen other Pacific nations concluded with their determination to form a Pacific Free Trade Area by the year 2010, which would encompass most of the fastest growing economies in the world. It is in the UK’s economic self-interest to negotiate a trade agreement with such countries rather than to remain within the EU, since the export potential is significantly higher. If the UK were to join NAFTA, it would be required to leave the EU since the latter compels its member states to adopt a common external tariff and to subscribe to an EU-wide uniform external trade policy. There are, however, a number of reasons why both the USA and the UK could actively promote such a development. First, the UK and USA economies are closely intertwined; further trade liberalisation would result in immediate benefits for both. The USA and UK share a common culture and language, which make a contemporary trade relationship between them more likely to prove successful. A free trade area centred around an Anglo-American nexus is a more efficient fit than any conceivable alternative economic arrangement; it would also be building upon success, because over the past 15 years the USA and Canada have created 2 million more jobs than EU countries. Third, the telecommunications revolution has led to the ‘death of distance’ whereby sharing borders no longer necessarily translates into increased trade and financial transactions, compared to a geographically distant country. Furthermore, such a grouping would help to protect both the USA and the UK from whatever outcome emerges from the EU experiment in supranationalism. A more broad-based NAFTA can counter the impact of both an imploding or a successful integrating, but inward-looking EU.

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Finally, NAFTA countries are already negotiating with EFTA and those of South America. If Britain participated in such a grouping, an expanding NAFTA could ultimately be transformed into a global free trade association, which could potentially incorporate such countries as Australia, New Zealand, South Africa, the Caribbean countries, Norway and Switzerland. It would be based solely upon a commitment to free trade, seeking no control of trade relations with non-members nor would it possess the motivation to pursue ‘ever closer union’ in the EU’s terminology. In contrast, NAFTA respects each member’s democratically accountable sovereignty. Consequently, whilst withdrawal from the EU provides the UK with an opportunity to operate an independent trading policy relying upon bilateral agreements with major trading nations, a combination of free trading areas between EFTA, the Commonwealth, NAFTA and in future the Pacific nations would create potentially superior trading opportunities for the UK than remaining within the EU could do.

Alternative economic policies A decision by the UK to permanently reject further EU integration, and in particular participation of EMU, would enable the devising of different economic programmes to pursue the multiple objectives of full employment, high economic growth and a sustainable balance of payments as well as low inflation. To illustrate the broad range of different policies which could be enacted, two alternative economic strategies are outlined in this section. Additionally, the development of an exchange rate policy, which supports the successful implementation of both outlined options for macroeconomic policy is also discussed. The first potential strategy seeks to emulate the framework established by Alan Greenspan and the US Federal Reserve Bank, whereby national monetary authorities seek a higher long-term growth rate by providing a favourable climate for industrial expansion through low inflation and hence reduced long-term interest rates. Fiscal policy is used to support the more dominant monetary policy by restraining inflationary pressures, thereby reinforcing the low interest rate objective. Given that the globalisation of financial markets prevents governments from ‘persuading’ financial institutions to finance public sector borrowing at less than the market rate, the higher the level of public sector borrowing on the international money markets, the higher the price for that borrowing in terms of long-term interest rates. This approach assumes crowding-out in the financial markets due to limited resources for lending to prospective

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borrowers, because, were banks to create money simply to meet the additional demand for funds so that the supply of loanable funds was relatively elastic, interest rates would be unaffected. However, the strategy seeks to reduce government expenditure in order to reduce borrowing and, hence, interest rates. In ‘hard’ versions of this strategy, the government endeavours to maintain a high value for the currency in order to restrict further inflation. This is comparatively easy to accomplish if the country enjoys a trade surplus, because of the upward pressure on its exchange rate, assuming the absence of speculative motives to counter this fundamental relationship. However, since the UK typically suffers from a current account deficit, a rise in short-term interest rates is needed to attract sufficient short-term capital investment to counterbalance trade-related downward pressures on the currency, thus maintaining a high value for sterling. However, these developments impact upon long-term interest rates and thus conflict with the fundamental goal of the strategy. Nevertheless, there is no reason why sterling should not prove to be a stronger currency than the euro, particularly due to the participation of high-inflation southern European member states, the 2004 enlargement countries, together with an ECB forced to balance economic policy between conflicting needs and time to establish anti-inflation credibility (Baimbridge et al., 1999; Weber, 1991).2 A second distinctive economic strategy involves the more active use of fiscal as well as monetary policy in order to pursue both internal and external balance for the economy. Accordingly, growth and employment could be enhanced by a mixture of demand-side reflation and supply-side labour market policies. Thus, the net stimulative effect is targeted upon specific sectors of the economy which most require assistance, rather than raising aggregate demand per se and creating inflationary bottlenecks. Economic growth could be facilitated by the maintenance of a competitive exchange rate through managed floating, together with tax incentives for firms which increase productive investment. Inflation could be restrained by a mixture of fiscal and monetary policy. However, if this proved difficult to achieve, rather than abandon the other internal objectives, governments could enact additional measures to restrain inflationary pressures, which might include the temporary re-introduction of credit controls, an incomes policy (tax-based or otherwise) or co-ordinated national bargaining. Although currently unpopular amongst economists who prefer the allocative efficiency of free markets, the reality of sticky wages and prices due to oligopolistic markets and trade unions, gives rise to the possibility of market failure

180 Current Economic Issues in EU Integration

resulting in persistently high unemployment and slower-than-trend output growth. Finally, external balance can be achieved through the provision of a competitive exchange rate, although structural problems in export sectors are likely to require supplementary supply-side measures to improve product quality, reliability and to encourage a shift of resources to provide goods and services in growing rather than stagnant markets. This strategy is different from the first approach due to its positive role for government action in wider areas of economic activity. Accordingly, an approach of this nature would probably be accompanied by an industrial policy designed to enhance the long run competitiveness of UK industry. The stylised facts of trade flows indicates that Britain enjoys a comparative advantage in financial and media services, and those areas of manufacturing which rely upon a high degree of scientific innovation, such as telecommunications, pharmaceuticals, aerospace, energy exploration and generation, biochemicals and computer-related activity.3 In contrast, Britain is less competitive in lower value added manufactures, most notably in engineering and metalworking sectors. Consequently, the UK government could seek to strengthen its competitive position by enhancing the productive potential of already strong sectors through targeted reductions in corporation tax, R&D tax credits, and greater spending upon education. The promotion of firms based in the UK has the further advantage that it will substantially improve the balance of payments position in the long run, whilst ensuring that the majority of the improvements in living standards and profitability remain in the UK economy. However, it is important to note that the above two strategies are dependent upon an appropriate exchange rate system encompassing short-term stability and long-term flexibility whereby the dangers to avoid are long-term fixity and short-term volatility. Hence, the only way of achieving these goals is by following a system that permits long run change whilst avoiding short run fluctuations. Various policies are available to secure this end, but membership of the euro prevents them being implemented by establishing a permanent fixity. The correct level for the exchange rate at any one time is that which enables an economy to combine full employment simultaneously with an approximate balance of payments equilibrium. However, it has been emphasised that this ‘correct’ exchange rate varies in value over time (Jay, 1990) whereby a variety of influences affecting economic performance (trade balances, productivity, price movements, discoveries of natural resources, etc.) combine to ensure that the ‘correct’ value of the

Alternatives to Further Integration

181

exchange rate alters with the years. Therefore, a country needs to retain its ability to adjust the external value of its currency. Consequently, a potential alternative strategy for Britain is to retain the national policy instruments required to increase its competitiveness in a socially acceptable manner. Thus, it is essential that the UK retains control over its interest rate, uses Bank of England intervention to smooth speculative fluctuations, encourages worldwide co-operation (e.g. through the G8) between central banks and aims for the maximum long-term exchange rate flexibility combined with the maximum practical short-term stability. Under such a regime, the exchange rate fulfils its role as facilitator of greater growth, higher living standards and full employment, without becoming an end in itself. Supporters of further EU integration argue that the degree of economic autonomy outlined here is illusory, because globalisation and the integration of financial markets will not allow differences in economic policy to persist. However, the experience of the UK economy between 1990 and 1992 demonstrated that being tied into a fixed exchange rate system at an uncompetitive high rate leads to a fall in output and a rise in unemployment.4 However, departure from the ERM I and the subsequent 20 per cent depreciation in sterling resulted in the resumption of economic growth, which facilitated a fall in unemployment to levels last experienced two-and-a-half decades earlier. Thus, arguments that economic policy autonomy is impossible because of financial market integration are questionable. Devaluation gave UK firms a much needed increase in competitiveness, which was not instantly lost due to inflation, as new-classical theorists claim, but instead provided government with a freedom of manoeuvre that could have resulted in the adoption of either strategy outlined in this chapter or a multiplicity of alternatives.

Conclusion In reality, Britain enjoys long-run choice concerning its future strategy; it can embrace an essentially European identity or, if it decides to optout of further EU integration at whatever level, it can pursue a global strategy. Moreover, the advantages of free trade within the EU and the imposition of a common external tariff on outside imports have become progressively smaller since 1973, as restrictions on trade have been steadily diminished world-wide. Under the auspices of the WTO the average tariff on industrial goods between developed countries has been reduced to just 3.8 per cent.

182 Current Economic Issues in EU Integration

Hence, Britain need not fear that a long-term disengagement with movements towards further EU integration will lead to a powerless isolation. Britain is a member of the G8 industrial nations; its economy ranks as the fifth largest in the world and the third largest in the EU. It is a member of the World Bank and the International Monetary Fund. It possesses a seat on the United Nations Security Council and remains the head of the Commonwealth (West, 1995; Burkitt et al., 1996). Moreover, Britain enjoys a substantial portfolio of overseas assets and investments, and attracts the highest level of inward investment in the EU. It is the world’s second largest financial centre and global investor, together with more companies in the world’s top 500 than any other EU country. Furthermore, among Britain’s greatest assets, underpinning its global economic effectiveness, is the English language. More than 1400 million people live in officially English-speaking countries with 20 per cent of the world’s population speaking English. Hence, the UK is well placed to be one of the most dynamic and innovative global economies (Taylor, 1995). The widely held view that Britain has ‘no alternative’ but to participate in European integration is clearly open to question whereby a range of possible alternatives exists. Britain could remain an EU member and secure, under WTO rules, free trading arrangements with the EMU-zone through a series of mutually beneficial, bilateral agreements. It could explore the possibility of a closer relationship with the NAFTA now that formal negotiations have been launched to establish a free trade pact between Canada and the European Free Trade Association, the UK could follow the same procedure. Above all, it should intensify its trading and investment links with the Commonwealth and the nations of the Pacific Rim. In these ways Britain would be able to pursue its true contemporary role of global trader and investor, while at the same time retaining its scope for a largely autonomous economic and social policy, such as the those possible strategies detailed above.

10 Is NAFTA Membership Really a ‘Barmy’ Idea?

Introduction Since the Second World War, the UK has benefited greatly from transAtlantic economic relations, although this has come at a price. For example, prior to the 2003 Iraqi conflict, the UK found itself embroiled in eleventh hour arbitrage to foster diplomatic reconciliations between the USA and the remaining members of the United Nations (UN) Security Council (including France and Germany).1 The failure of these negotiations and ensuing ‘unilateral’ action spearheaded by US and UK forces further entrenched political division across the Atlantic, whilst damaging Prime Minister Blair’s efforts to present himself as proEuropean. Against this political background, continued EU membership will present further challenges to the UK with the ongoing debate pertaining to euro-membership, which has become a mainstay of division amongst politicians and the general public, and the reconstitution of the EU in light of enlargement in 2004 dominating the agenda.2 These developments also come amidst eurosceptic fears in the UK, with senior right-wing parliamentarians (e.g. Iain Duncan Smith, John Redwood, William Hague) and political commentators (Black, 2000; Bandow, 2001) intimating that EU integration damages the UK’s ‘special relationship’ with the USA. Indeed, in his manifesto the then Conservative leader, Iain Duncan Smith, suggested that a trade pact with the North American Free Trade Agreement (NAFTA) offered a more secure long-term footing for the UK economy. Accordingly, the aim of this chapter is to examine the proposition that sustained integration within the EU is a ‘second best’ solution for the UK economy. Furthermore, we investigate if Britain’s economic 183

184 Current Economic Issues in EU Integration

prospects are better served as a member of the NAFTA trading bloc. The following section provides political and economic context to the debate, whilst in the next section we examine the obstacles and counterarguments surrounding NAFTA membership. The chapter then reviews the empirical estimates of the impacts of NAFTA membership on the UK economy, followed by some concluding remarks.

The political and economic background Political background In the general election of 2001, Tony Blair’s ‘new Labour’ recorded a further landslide victory in securing a second successive term of office. Only five months prior in an address to both houses of the Canadian parliament in Ottawa, Mr Blair said he rejected point blank the claim among some Tories that the UK had to make a choice between Europe and America (Guardian, 23 February 2001). Moreover, he went on to burnish his credentials as an ‘Atlanticist’ by categorically stating that ‘We (the UK) will have the best of both worlds. We will give up neither relationship. We will make them both work’ (Guardian, 23 February 2001). However, treading the ‘Atlanticist’ path has not been easy for the Blair administration. On the one hand, the US’s insistence in employing a ‘unilateralist stance’, on issues of trade (e.g. increased subsidisation of US agriculture), and the environment (boycotting the Kyoto protocol), as well as seeking exemptions from the reach of the International Court of Justice, has not endeared the Bush administration to many within the international community. On the other hand, the EU often presents itself as an experiment in the ‘social market’, if not sometimes as an antagonistic outright challenger to the United States. For instance, French Foreign Minister Pierre Moscovici observed: ‘We don’t agree with the Americanisation of the world … we are saying that together we can build a new superpower … and its name will be Europe’ (Daily Mail, 24 May 2001). The European Commissioner for Regional Policy, Michael Barnier, echoed this same theme: ‘The choice is between an independent Europe and a Europe under American influence’ (Yahoo! France, 27 February 2002). Even stronger anti-Americanism has also sometimes been at the heart of European ‘federalist’ thinking. The late President Mitterand once remarked ‘we are at war with America. … a permanent war, a vital war, an economic war’ (Bandow, 2001). Diplomatic and economic relations between the two regions have often been fraught with difficulty. From the perspective of trade, the

Is NAFTA Membership Really a ‘Barmy’ Idea? 185

inability of both EU and US negotiators to come to an agreement on agricultural subsidies at the last round of negotiations under the auspices of the World Trade Organisation (WTO) resulted in the final agreement being delayed some three years past the original deadline. More recently, further trade conflicts have arisen on Caribbean bananas, hormone-enhanced American cattle, genetically modified foods and steel. In terms of international security, tension arose over the EU’s insistence of having a rapid reaction force, which the French wanted to make independent of NATO, as well as Europe’s rejection of President Bush’s national missile defence project. Whilst splits such as these could easily be dismissed as part of the give and take of trans-Atlantic diplomacy, the legacy of the Iraq war appears to have left more lasting scars. As a permanent member of the UN Security Council, France continued to spar with the US over Iraq, whilst the UK’s attempts to reconcile differences between the US’s insistence on immediate action under interpretation of UN resolution 1441 and European (in particular Franco–German) misgivings about an all out ground assault, failed. In the mean time, Germany’s Chancellor Gerhard Schroeder successfully rode national public opinion by turning anti-Americanism into a campaign issue, which has compromised German–US relations, whilst the Blair–Schroeder relationship in advocating the ‘middle-way’3 also appears to have soured (Daily Telegraph, 5 September 2002). In the wake of the Iraqi conflict, many in Europe even perceive the US as having apparent pretensions of hegemony, which has further dented Blair’s Atlanticist stance. It is against this political background that the UK must take further decisions about its future role in Europe. At the top of the political agenda are the key issues of euro membership and the reconstitution of Europe following enlargement. Prominent UK Cabinet minister, Peter Hain, views the latter as little more than a tidying up exercise to the existing body of EU treaties, whereas others on the right worry that proposals for an EU foreign minister and a powerful presidency for the European Council of Ministers is a major new step towards realising the federalist vision of a ‘United States of Europe’. A similar polarisation of opinion exists on the issue of euro membership, although if acceding EU member states do not immediately adopt existing EU commitments leading to a two-tier Europe, this could conceivably open the door for the UK to prolong its own decision on the euro. Notwithstanding, over the longer term, the UK will inevitably be forced into taking difficult decisions about its own identity.

186 Current Economic Issues in EU Integration

Economic background Trade Trade data are presented in Table 10.1, where total UK exports and imports are disaggregated into North American and EU components between the years 1994 and 2001. Not surprisingly, reference to Table 10.1 shows that the EU dominates UK trade, with Germany and France accounting for approximately 40 per cent. Over the same time period, North American export and import shares have increased steadily over the period shown, whilst UK trade with North America is mainly with the US, where in 2001, the US accounted for 87 per cent of UK exports to North America and 85 per cent of UK imports from North America. Indeed, by the end of the period shown, the US became the UK’s largest single trading partner surpassing France and Germany.4 Foreign Direct Investment (FDI) The last 40 years have witnessed a rise in multinational enterprise and a global spread of foreign direct investment. Today world business is dominated by the largest 500 multinational enterprises in the world, virtually all of them from the ‘triad’ of the United States, EU and Japan. Table 10.1

UK trade with North America and the EU(14), 1994–2001 (%)

UK exports (%) North America: USA Canada Mexico EU(14): Germany France UK Imports (%) North America: USA Canada Mexico EU(14): Germany France

1994

1995

1996

1997

1998

1999

2000

2001

14.6 12.6 1.4 0.5 56.7 12.7 10.0

13.3 11.7 1.2 0.5 57.9 13.0 9.8

13.5 11.9 1.2 0.4 56.6 12.4 10.1

13.9 12.2 1.3 0.5 55.3 11.8 9.4

15.0 13.2 1.3 0.5 57.7 12.2 9.8

16.8 14.6 1.5 0.6 58.3 12.1 10.0

18.1 15.7 1.9 0.5 56.9 11.9 9.6

17.9 15.6 1.7 0.5 57.3 12.2 10.0

13.4 11.9 1.3 0.2 55.3 14.6 10.0

13.7 12.1 1.4 0.2 55.3 15.3 9.6

14.0 12.4 1.4 0.2 54.1 14.5 9.4

14.9 13.3 1.4 0.3 53.2 13.5 9.3

15.1 13.5 1.4 0.3 53.6 13.2 9.2

14.6 12.7 1.6 0.3 53.0 13.4 9.1

15.5 13.2 1.8 0.5 49.9 12.5 8.0

15.8 13.4 1.7 0.7 50.3 12.5 8.3

Source: HM Customs and Excise (2003).

Is NAFTA Membership Really a ‘Barmy’ Idea? 187

These 500 multinational enterprises account for over 90 per cent of the world stock of FDI and account for over half of the world’s trade (Rugman and Kudine, 2001). In the context of UK FDI (inward and outward), there is greater parity between the UK’s interests in the EU and North America (Table 10.2) compared with the trade situation presented in Table 10.1. Indeed, towards the end of the period shown, North American investment appears to dominate UK inward and outward FDI positions, where the importance of the USA alone exceeds that of the whole of the EU.5

UK at the crossroads? An examination of the UK trade and investment data clearly supports ‘Atlanticist’ rationale, that the UK benefits most from strong relations on both sides of the divide. Furthermore, taking a pro-European ‘Blairite’ perspective, it is highly plausible that (eventual) euro-membership would not only boost trade between the UK and the rest of the EU considerably,6 but that continued high levels of investment (from the US) into the UK hinge on the expectation that at some point the UK will enter the euro.7 However, in a speech to the House of Commons on 9 June 2003, Chancellor Brown maintained that the time is not yet right for euro zone entry. Indeed, whilst the pound was competitively priced against the euro, the Chancellor felt that the lack of economic convergence, especially in the housing and labour markets ruled out immediate membership.8 Accordingly, overcoming structurally economic differences could delay the referendum and therefore possible euro membership until after the next election in 2005 or even 2006.9 Ostensibly, if membership of the single currency is rejected in a referendum, this could seriously compromise the UK’s future role in the EU and disrupt the UK’s long-term ‘equilibrium’ trade and investment Table 10.2

Total inward and outward FDI for the UK (% of total investment) Inward FDI

Europe EU North America USA Asia

Outward FDI

1995

1997

1999

2001 1995

45.9 38.9 42.0 42.5 7.1

50.7 55.7 31.3 35.4 3.1

44.3 29.8 45.9 43.0 2.6

51.0 28.2 41.6 41.4 3.2

Source: Office for National Statistics (2003).

33.3 34.3 44.1 42.9 6.0

1997

1999

2001

53.1 46.2 32.1 27.9 6.0

35.5 31.2 57.0 56.2 3.7

34.8 26.6 49.8 42.7 0.0

188 Current Economic Issues in EU Integration

position. Furthermore, based on current opinion, the British public may not ascribe to the concept of political union possibly favouring EU withdrawal rather than membership of a super-state.10 In recent times, the eurosceptic right purported the view that to preempt the political and economic ‘baggage’ of euro membership, the UK could take a pro-active stance and join NAFTA. In 1999, the Senate Finance Committee requested the United States International Trade Commission (USITC) to investigate the impact of including the UK within NAFTA in response to a lobbying campaign by Conservative frontbench eurosceptics. In June 2000, senior members of the Shadow Cabinet, including the then leader of the Conservative Party, Iain Duncan-Smith, received an unofficial delegation of four US senators. At the time, Iain Duncan-Smith remarked that the unofficial visit demonstrated that membership of NAFTA was, ‘becoming quite a serious issue’ (Trade Policy Monitor, 2000). Whilst the Foreign Office has curtly dismissed this plan as ‘barmy’ (Guardian, 22 August 2001), the notion is at least consistent with the UK’s previous stance on Europe. More specifically, the UK originally signed up for a ‘free trade agreement’ in 1973, not a customs union (which the EU eventually became) and certainly not monetary union (explicitly ruled out by the ‘Yes’ campaign in the 1975 referendum) or political union. Moreover, senior Conservative Party officials are keen to point out that with poor flexibility in EU labour markets, job creation in NAFTA has been far more prolific (Guardian, 30 June 2000), and amid recent fears that economic growth in the eurozone has been sluggish, the UK could benefit significantly from integration into NAFTA.11 An additional impetus for this course of action is the belief that there is a common politico-economic culture between the UK and the USA. In particular, the model of ‘free-market’ economic management exhibited in both economies is seen as incongruous with European ‘statist’ principles, which favour a significant role for government intervention and a greater tendency towards protectionism (Hulsmann, 2000; Global Britain, 2000). A high profile example of such ‘statist’ dogma is evidenced by the level of agricultural subsidisation, which constitutes nearly half of the total EU budget (Leach, 2000). Indeed, primary agriculture accounts for only 0.8 per cent of UK GDP but costs £6 billion annually in gross contributions, of which only half is recouped from the EU (DEFRA, 2002). Whilst this has prompted UK politicians to call for deeper cuts in farm support, the Franco-German agreement in June 2003 seeks to preserve ‘real’ expenditure ceiling limits until 2013. Furthermore, French President, Jacques Chirac, renewed calls for the

Is NAFTA Membership Really a ‘Barmy’ Idea? 189

British budget rebate negotiated under the Thatcher government to be reviewed. If ceiling limits are maintained and the rebate is receded, this could imply a severe worsening of the UK’s financial position, particularly with enlargement of the Union proceeding on schedule. In the literature, a number of estimates have emerged on the viability of EU membership to the UK. Black (2000) argues that unilateral withdrawal from the Common Agricultural Policy (CAP) alone would result in significant budgetary savings, where the loss in revenues to farmers would be more than compensated by significant welfare gains to consumers from cheaper food prices arising from trade diversion and creation effects.12 This assertion is supported by Hindley and Howe (1996) and Leach (2000), who predict a UK net cost of approximately 1 per cent of GDP from EU membership largely due to the CAP, whilst Mindford (1996) suggests that the figure could be as high as 1.5 per cent. Other commentators (Barrel et al., 1998; Pain and Young, 2001) remain sceptical, arguing that the UK’s ‘special relations’ with transatlantic partners are heavily dependent on our continued membership and influence within the EU. Pain and Young (2001) estimate that UK membership of the EU yields a net benefit of 2.25 per cent of GDP principally from FDI effects. Importantly, these empirical cost estimates assume unilateral UK withdrawal from a customs union when in reality, a renegotiation of the UK’s position would either; (i) preserve many aspects of the UK’s relationship with the EU; (ii) involve a secure deal with another trading body (i.e. NAFTA); or (iii), a combination of (i) and (ii). Outcome (i) could be achieved via membership of the European Free Trade Association (EFTA), which would qualify the UK for membership of the European Economic Area (EEA).13 A perceived advantage of EEA membership is that the UK reaps the benefits of tariff free access to the single market, whilst remaining free from the commitments of monetary union, existing (and proposed) common policies (e.g. CAP, common defence policy) and closer political integration. However, membership of the EEA requires significant contributions to support development initiatives throughout the EU, in exchange for free EU market access. Clearly, disaffiliation from the EU would not entitle the UK to any reciprocal funding, and with considerable potential enlargement of the single market to the East, these signatory costs may increase markedly. Moreover, Rollo (1995) states that EEA membership would result in regulation without representation, as the UK would have little or no input into EU decision-making, whilst being forced to accept the outcomes of this process. Pain and Young (2001) concur, noting that, ‘against a background of growing political complaints about the legislation which is

190 Current Economic Issues in EU Integration

already passed as a result of majority-voting in the EU, it seems more plausible to assume that the UK would not(solely) withdraw into the EEA’ (p. 19). For these underlying reasons, this option does not appear to have been quantified in the empirical literature. In (ii), the UK could withdraw from the EU altogether and join NAFTA, or alternatively under (iii), it could combine membership of both the EU and NAFTA. Short of a renegotiation of the Treaty of Rome, simultaneous membership of the EU and NAFTA is not feasible, where articles 133 and 310 of the Treaty forbid any member to negotiate bilateral trade deals whilst still a full member, although Black (2000) and Bandow (2001) suggest that the UK could join the EEA, which in turn would allow negotiation for joint membership of NAFTA.14 Thus, in the next section, we quantify the impacts on the UK economy from (a) membership of the EEA and NAFTA and (b) full withdrawal from the European single market and membership of NAFTA.

The impacts of NAFTA membership on the UK Since 1973, the EU has negotiated all of the UK’s external trade relations with third countries. Consequently, acting independently, the UK is unlikely to receive as favourable terms whilst being forced into the uncertainty of renegotiating all its external trade arrangements. The USITC report (2000), commissioned by the Senate Finance Committee, and Philippidis (2003) examine two stylised NAFTA accession scenarios. More specifically, in scenario (a), the estimates are based on the removal of UK trade barriers with NAFTA only. In scenario (b), in addition to the removal of trade barriers between the UK and NAFTA, the report assumes that the UK and EU erect import barriers on mutual trade at a rate equivalent to that imposed by the EU on third countries. Moreover, the UK continues to treat imports from the rest of the world (ROW) as if it were still a member of the EU.15 To characterise both the trade shocks and the complex interactions that would occur both intra- and inter-regionally between agents and markets, the USITC (2000) study employs estimates from a comparative static (CS) computable general equilibrium (CGE) multi region framework.16 The model data is benchmarked to 1995, where in addition it is assumed that both NAFTA and EU-Mexico FTA agreements are fully implemented (in 1995).17 As a member of the single market, the UK enjoys tariff free access to the EU, while as Table 10.3 reveals, UK trade protectionism on NAFTA trade is highest for agro-food products under the auspices of the CAP.

Is NAFTA Membership Really a ‘Barmy’ Idea? 191 Table 10.3

The structure of UK trade and protection (% of market prices)

Import Tariff Rates: Agriculture Food Processing Other* Manufacturing Services Export Subsidy Rates: Agriculture Food Processing Other* Manufacturing Services

USA

Canada

Mexico

ROW

11.9 19.7 0.1 3.2 0.0

19.9 29.1 0.0 2.8 0.0

8.4 25.4 0.0 3.8 0.0

9.5 30.0 0.0 4.4 0.0

0.3 2.0 0.0 0.0 0.0

0.4 3.4 0.0 0.0 0.0

0.1 10.7 0.0 0.0 0.0

5.2 4.8 0.0 0.0 0.0

Note: * (Primary or Jossil Juel Industries). Source: GTAP database version 5: Dimaranan and McDougall (2002).

For remaining aggregate sectors, trade protection is relatively low (zero in services trade), although in manufacturing there are clearly sectorspecific tariff peaks. As a result, the trade impact on real growth in the UK reported in both of these studies is rather minimal (see Table 10.8). However, with neither study accounting for the potentially significant impact of non-tariff barrier removal/implementation, it is likely that the quantitative estimates presented are understated. The results in Tables 10.4 to 10.6 are the measured impacts on the UK under both scenarios compared with the benchmark 1995 UK trade and output position. In scenario (a), USITC (2000) estimate (Table 10.4) that UK total exports would increase by $1.8 billion (0.63 per cent). This is mainly attributed to substantial increases in UK exports to the US of $2.8 billion (7.29 per cent), with countervailing trade diversionary falls in UK exports to the EU of $1 billion (0.76 per cent). With the exception of trade in services, UK exports to NAFTA increase in all sectors, whilst there are drops in UK exports (except agriculture) to the nonNAFTA regions. Total UK imports in Table 10.4 rise by $3 billion (1.02 per cent), resulting in an overall trade deficit under scenario (a). Once again there are considerable import swings towards the USA ($5 billion) and away from the EU (
$1.7 billion). The estimated impacts of scenario (b) are presented in Table 10.5. Notably, the strength of the UK’s trade diversion effects from the EU towards the US is much more pronounced due to the erection of trade barriers between the EU and UK. Indeed, exports to the EU now fall by almost $19 billion (13.33 per cent), of which 83 per cent of this drop is

192 Current Economic Issues in EU Integration Table 10.4

Changes in UK exports and imports under scenario (a) Rest of NAFTA

US

0.5 35.3 727.9 210.2

8.2 174.6 2720.7 2115.1

Total Imports: Agriculture Food Manufacturing Services

753.5

Total

Exports: Agriculture Food Manufacturing Services

EU

ROW

Total

3.4 226.1 2834.5 2209.3

4.7 218.3 2421.7 2277.9

16.9 165.5 2192.5 2612.6

2788.4

21066.5

2713.2

1762.3

27.5 300.0 303.1 1.5

598.6 277.3 4238.7 23.0

2145.8 2185.3 21519.6 135.8

2213.0 2113.1 2802.1 111.8

267.3 278.9 2220.1 273.2

632.1

5137.6

21714.9

21016.4

3039.5

Source: USITC (2000) ($US millions, 1995 values).

Table 10.5 estimates

Changes in UK exports and imports under scenario (b) USITC

Rest of NAFTA Exports: Agriculture Food Manufacturing Services Total Imports: Agriculture Food Manufacturing Services Total

US

EU

ROW

Total

2.5 41.5 920.8 63.4

13.0 201.1 3916.6 663.8


1111.5
2881.7
15634.6 808.8

79.9 131.0 2284.8 1264.4


1016.1
2508.1
8512.3 2800.4

1028.2

4794.5


18819

3760.1


9236.1

47.1 409.9 428.0
39.1

724.4 439.3 6285.7
405.3


2083.6
4119.8
19132.0
305.1

383.3 1047.7 2908.3
452.1


928.8
2222.9
9509.9
1201.4

845.9

7044.1


25640.5

3887.2


13863.0

Source: USITC (2000) ($US millions, 1995 values).

attributed to manufacturing. This deterioration in UK–EU trade also accounts for a fall in total UK exports of $9.3 billion (3.31 per cent). Elsewhere, UK exports to the US (Canada) increase by a magnitude of $4.8 ($1.0) billion or 12.54 per cent (23.78 per cent). Similarly, UK exports to the rest of the world also rise by $3.8 billion (3.96 per cent).

Is NAFTA Membership Really a ‘Barmy’ Idea? 193

Imports follow a similar pattern with significant trade diversion effects from the EU (
$26 billion) to the USA ($7 billion), the Rest of the World ($3.9 billion) and the rest of NAFTA ($0.8 billion). Once again, these trends are largely dictated by changes in UK manufacturing exports. A similar study by Philippidis (2003) employs essentially the same scenarios as in USITC (2000), although it incorporates additional modelling features. First, the accession of the UK into NAFTA is characterised as a gradual process of adjustment over a series of interdependent time periods.18 Accordingly, the estimates employ a dynamic CGE representation (Ianchovichina and McDougall, 2000), where results show the cumulative impact of both scenarios in 2008 relative to a ‘baseline’ scenario.19 Importantly, the dynamic treatment also captures capital accumulation and associated income effects,20 as well as international capital mobility21 not inherent within the standard comparative static approach. Tables 10.6 and 10.7 show the cumulative differences in trade values from the baseline in 2008 for each scenario. Whilst broad trade trends are comparable with USITC (2000), there are methodological and data differences which account for specific differences in magnitude. First, the baseline or point of comparison for the two scenarios differs from USITC (2000) (see note 16). Second, in Philippidis (2003), the UK accession period begins in 2003 rather than 1995, which implies a lower tariff and subsidy structure between the UK and NAFTA prior to accession.22 Third, the characterisation of food processing, manufacturing and services sectors as imperfectly competitive allows for ‘procompetitive’ effects when markets are liberalised.23 Finally, the impacts of resource growth and capital accumulation within the dynamic model framework provide magnification of the initial policy shocks, which are not captured in the ‘traditional’ comparative static characterisation. The erection of import barriers between the UK–EU in scenario (b) (Table 10.7) greatly increases UK trade diversion relative to scenario (a) due to significant manufacturing sectoral trade effects. Interestingly, the magnitude of the total UK trade shift is greater than in USITC (2000), despite the fact that the UK’s trade protective structure in Philippidis (2003) is less prohibitive on NAFTA accession (2003 instead of 1995). Examining the overall trade impact on real growth for each of the regions (Table 10.8) reveals that the impact of a renegotiation of the UK’s position in either scenario is negligible. With free access to both NAFTA and EU (under scenario (a)) markets, estimates of real growth gains to the UK tightly range between 0.10 per cent to 0.12 per cent, where in Philippidis (2003), increases in UK services output (from positive pro-competitive and dynamic capital accumulation effects) result in

194

Table 10.6 Cumulative changes in UK exports and imports in 2008 under scenario (a) compared with the baseline Rest of NAFTA Exports: Agriculture Food Manufacturing Services

US

EU

ROW

Total

0.9 214.4 611.5
1.2

57.4 167.6 3077.7 65.3


4.7 940.8
2701.0
380.5

20.8 1533.5
1854.6
311.5

74.4 2856.3
866.4
627.9

Total Imports: Agriculture Food Manufacturing Services

825.6

3368.0


2145.4


611.8

1436.4

146.4 3287.4 255.9 64.2

360.4 1961.1 6907.1 221.4


233.4
2034.3 606.1 346.8


75.6
1213.2
3.5 447.7

197.8 2001.0 7765.6 1080.1

Total

3753.9

9450.0


1314.8


844.6

11044.5

Source: Philippidis (2003) ($US millions, 1997 values).

Table 10.7 Cumulative changes in UK exports and imports in 2008 under scenario (b) compared with the baseline

Exports: Agriculture Food Manufacturing Services

Rest of NAFTA

US

EU

ROW

Total

1.2 231.7 673.8 59.5

69.3 195.9 3453.3 197.1


787.2
3864.2
25188.1 92.5

65.7 2075.4
748.5 364.4


651.0
1361.2
21809.5 713.5

Total Imports: Agriculture Food Manufacturing Services

966.2

3915.6


29747.0

1757.0


23108.2

208.1 3698.9 338.0
44.8

544.5 2112.0 8242.2
291.4


1297.8
8324.7
23940.1
59.9

308.5
938.9 2108.0
318.3


236.7
3452.7
13251.9
714.4

Total

4200.2

10607.3


33622.5

1159.3


17655.7

Source: Philippidis (2003) ($US millions, 1997 values).

Is NAFTA Membership Really a ‘Barmy’ Idea? 195 Table 10.8

Changes in GDP by region (% real growth) Canada

Mexico

USA

UK

EU

ROW


0.01
0.01

0.00 0.00

0.00 0.00

0.10
0.02

0.00
0.01

0.00 0.00

0.06 0.08

0.00
0.01

0.01 0.02

0.12
0.06


0.04
0.11

0.00 0.00

ISITC (2000) Scenario (a) Scenario (b) Philippidis (2003) Scenario (a) Scenario (b)

greater UK real growth gains.24 Conversely, both studies predict that a unilateral trade agreement with NAFTA involving a loss of free trade with the EU, will result in an aggregate UK real growth loss of between
0.02 per cent to
0.06 per cent.25 A shortcoming of both studies is the limited treatment of foreign investment impacts from UK accession to NAFTA (see Table 10.3). Whilst the dynamic CGE model provides more detailed coverage of the linkage between trade and investment through capital accumulation effects, both treatments favour a simpler characterisation of foreign investment behaviour over the potential model complexity and computational expense arising from a full characterisation of the financial sector. However, an additional part of the USITC (2000) study employs a partial equilibrium (PE) approach to assess the impact of UK–US tariff liberalisation on UK manufacturing FDI in the US, and US manufacturing FDI in the UK, with further simulations examining the additional impacts of UK–EU tariff barriers.26 As previously, no attempt is made to assess the impact of non-tariff barrier removal on FDI. Estimates (Table 10.9) reveal that the effect of UK accession to NAFTA would have modest impacts on US–UK FDI flows, where the ‘primary channel through which tariff decreases or increases affect FDI is by lowering or raising the cost of imported intermediate inputs’ (p. xv, USITC, 2000). Under conditions of scenario (a), UK-owned manufacturing affiliates in the United States increase by $408 million (0.41 per cent), where the largest sub-total increase in value terms is for chemical products ($269 million). Similarly, US-owned manufacturing capital in the UK increases $413 million (0.27 per cent) where the largest value increases also come from the chemical products industry ($98 million). In scenario (b), it is estimated that US FDI in the UK will decline by $851 million (0.56 per cent) as the UK removes itself from the European market.27

Changes in US–UK FDI relationships under NAFTA accession

Sector

196

Table 10.9

Scenario (a): Tariff elimination between the US and UK UK FDI in the US Millions ($)

(%)

US FDI in the UK Millions ($)

(%)

Scenario (b): Scenario (a)  erection of tariffs between UK and EU US FDI in the UK Millions ($)

(%)

Food beverages and tobacco Textiles and apparel Wood and furniture Paper, printing and publishing Chemical products Nonmetallic minerals Primary and fabricated metals Machinery and equipment including computers Electronic and electrical equipment Transportation equipment Other manufacturing

59 6  4 269 6 8 6

0.30 0.31 0.02 0.05 0.57 0.08 0.12 0.05

12 19 1 4 98 6 8 92

0.08 1.19 0.13 0.06 0.22 0.48 0.18 0.30


8
34
3
15
467
9
45
157


0.05
2.18
0.24
0.25
1.03
0.77
0.95
0.51

23

0.56

64

0.59


66


0.61

9 18

0.11 0.37

47 62

0.19 0.75


41
6


0.17
0.08

Total

408

0.41

413

0.27


851


0.56

Sensitivity analysis with trade elasticities Lower bound Upper bound

138 701

0.14 0.71

128 760

0.08 0.50


159
1 795


0.11
1.19

Note:  indicates less than $500 000. Source: USITC (2000).

Is NAFTA Membership Really a ‘Barmy’ Idea? 197

Conclusion In this chapter we investigate the political and economic context within which further integration with North America could be beneficial to the interests of continued prosperity for the UK economy. An examination of the trade data reveals that whilst UK trade relations with the EU are more important than those with North America, the US is the UK’s largest single trading partner. The case for strong relations across the Atlantic is further enhanced by strong FDI links between the UK and the USA. Over the sample period, the USA is the largest investor in (recipient of investment from) the UK, exceeding even the EU(14). However, the UK cannot expect the status quo to persist if it continues to stagnate with respect to further European integration. Indeed, the UK’s political and economic future in Europe appears to be indelibly linked to the finely balanced issue of euro membership. Whilst the UK has temporarily vetoed the single currency, this has raised concerns amongst pro-Europeans (Britain in Europe, 2003) that as a gateway between the EU and North America, remaining outside the euro-bloc could jeopardise future foreign investment, carry a high opportunity cost in terms of lost trade with the eurozone and damage the UK’s influence in shaping European constitutional reform. The juxtaposition, postulated by the eurosceptic right, has been to suggest that a ‘one size fits all’ euro scheme is incompatible with the structural differences that exist between the UK and the euro zone (e.g. labour markets, housing markets). Furthermore, acceptance of Euro notes and coins would be tantamount to taking the road to deeper integration and political union raising fears that the ‘British identity’ could be subsumed within a federalist superstate.28 In the context of this debate, we examine the alternative of UK accession into NAFTA. We compare two quantitative NAFTA accession studies where empirical estimates are based on (a) UK accession into NAFTA, whilst maintaining economic links with the European single market through the EEA and (b) UK accession into NAFTA with concurrent UK withdrawal from the EU. As trade between the UK and NAFTA is relatively unprotected (except for food and agriculture) the estimated effects on real growth are negligible. Both studies predict slight increases in UK real growth between 0.10 per cent and 0.13 per cent of GDP under scenario (a), whilst UK access to both markets fosters total trade increases. In contrast, both studies estimate that under scenario (b), the UK would lose between
0.02 per cent and
0.07 per cent of real growth in GDP, with potentially significant trade reducing effects from the manufacturing sector.

198 Current Economic Issues in EU Integration

Taking the results of these studies at face value, the UK would be better pursuing a strategy of withdrawing from the EU and joining the EEA to allow negotiations for NAFTA membership. However, as stated in USITC (2000), ‘there is no precedent for a member withdrawing from the EU, so the impact on the UK’s trade relationships with non-EU and non-NAFTA countries is unclear’ (p. iii). The USITC report also points out that the results do not, ‘take into account any retaliatory trade measures that the UK may face’ (p. xiv). Additionally, there are several methodological and data issues to consider. First, it is likely that the estimated gains/losses reported here are understated given that the impact of non-tariff barriers on trade have been ignored.29 Second, these CGE model frameworks do not explicitly incorporate bilateral financial mechanisms, which makes it difficult to put an accurate figure on the ‘real’ trade and investment effects under both scenarios, although USITC (2000) have conducted a separate PE study focusing on FDI effects, which suggests that changes in foreign investment (at least in manufacturing) would also be relatively small. However, even this study has shortcomings in that it only examines US–UK investment relations whilst omitting UK–EU investment, solely concentrates on manufacturing investment30 and ignores non-tariff barriers. Third, by continuing to enjoy the benefits of free market access to Europe in scenario (a), the UK would be expected to pay substantial contributions to fund development initiatives in the EU, in which case initial net economic gains could still have eventual cost implications. Fourth, these experiments compare the impact of NAFTA accession with the current ‘status quo’. However, for the purposes of this discussion, a more pertinent empirical investigation would have been to directly compare the impacts of NAFTA accession with the alternative of Euro membership. In other words, a gain relative to the status quo under scenario (a) may or may not yield greater returns to the UK economy than a euro membership scenario. Economic considerations aside, it is interesting to note that rhetoric on possible NAFTA membership has been somewhat insular, where it is implicitly assumed that North American opinion (particularly in the USA) is also skewed in favour of closer trading ties with the United Kingdom. Admittedly, this initiative has had high profile support in the form of Phil Gramm, ex-Senator, ex-chairman of the US Senate’s banking committee and friend of George Bush, as well as the former Speaker of the House of Representatives Newt Gingrich. However, successive administrations have always favoured, ‘Britain to be part of the European Union – an ally to offset the influence of Germany and France. At every

Is NAFTA Membership Really a ‘Barmy’ Idea? 199

opportunity, the USA has pushed Britain towards closer integration with Europe’ (Guardian, 22 August 2001). This theme is perhaps more pertinent in the current political climate than ever before, although it does not preclude the possibility of eventual free trade between the UK and NAFTA. Indeed, the USA may be more amenable to a North Atlantic Free Trade Agreement with the UK if it involves the rest of the EU. Accordingly, the precedent of the EU–Mexico free trade agreement and the accession of pro-US eastern European members31 in 2004 may bode well for closer transatlantic relations although it may well be a bitter pill for anti-euro campaigners.

Notes Chapter 1 Current Issues in EU Integration 1. Also, the role of NATO and the American influence should not be underestimated. 2. Except, inter alia, in the area of tax harmonisation which still relies on unanimity. 3. Despite the formulation of a common foreign and security policy, the experience has, at best, been mixed with failure to forge a coherent policy towards the Balkans, whilst there were well publicised splits over Iraq. 4. Although the per capita GDP of Ireland is some 120 per cent of the EU15 average compared with the regional fund cutoff of 75 per cent, it became split into two regions. The first including Dublin with well over 100 per cent of EU25 average per capita GDP, whilst the second area was around the 75 per cent mark. 5. Ireland is beginning a phasing-out of the Cohesion Fund from 2004 onwards. Moreover, these countries have a substantial blocking minority of 157 (186 if Italy supports as well) votes out of 321 in the European Parliament which could threaten the net payers of the budget, although the impact of the new members in 2004 will inevitably impact on this. 6. Of the current accession wave, Poland would like to keep ties with the Ukraine; whilst Hungary is keen to maintain relations with ethnic Hungarians in Serbia and the Ukraine. 7. Indeed, all three countries met all the entry criteria for Euro membership.

Chapter 2 Common Agricultural Policy: Evolution and Economic Costs 1. The original six members of the EU are: Belgium, France, Germany, Italy, Luxembourg and the Netherlands. 2. Furthermore, compared with richer consumers, poorer consumers have higher food budget shares. Thus price floor rises in food are tantamount to imposing a higher food tax on the relatively poor vis-à-vis the relatively rich. 3. A full description of the history of the CAP is well documented (Ritson, 1988; Ritson and Harvey, 1997; Ackrill, 2000). Accordingly, in this section, we merely aim to provide a brief overview. 4. The export subsidy per unit is the difference between the CAP support price and the world price. With greater surpluses and dumping, came the vicious circle of higher export subsidy expenditure, as world prices were further depressed. 5. At the time (1984), expenditure on milk production was around 30 per cent of the total agricultural budget.

200

Notes 201 6. Quotas are only viable where production must pass through controllable food processing units such as in milk (and sugar), although this does not occur in cereals (Hubbard and Ritson, 1997). 7. Stabilisers worked in tandem with market support, where if production broke through pre-designated ceiling limits, support was automatically reduced for that product. 8. A group of 18 agricultural exporting countries, led by Australia, Argentina and Brazil. 9. Tyers and Anderson (1987) estimated that the price depressing effect of the CAP on world markets ranged from between 6 per cent for wheat to 33 per cent for dairy products. 10. Whilst intervention prices were reduced on cereals and livestock, milk and sugar policies were left unchanged. 11. Thus, payments per head of cattle (‘headage’) and per hectare of land (‘area’) were granted to livestock and cereals sectors respectively. Interestingly, Ackrill (2000) maintains that farmers were actually overcompensated following the MacSharry reforms since extremely high world prices throughout the mid-1990s meant that actual price cuts faced by EU farmers were less than expected. 12. Livestock farmers with very low stocking density rates were eligible for an additional extensification premium. 13. From 1994 onwards, compensation payments became the largest proportion of the CAP budget replacing export refunds and intervention/storage payments, which concurrently reduced. 14. Several GATT members, including the EU, declared excessive tariff equivalent rates, in an attempt to minimise the impact of agreed import tariff reductions. 15. Superseding the GATT, the WTO was established at the Marrakesh agreement in 1994 and was further empowered with a more formal dispute settlement system. 16 At the EU Heads of State meeting in Petersberg in February 1999, it was agreed that the CAP was to not exceed €40.5 billion per year for the sevenyear time horizon of the agreement (i.e. total cost of €283.5 billion). Allowing for 2 per cent annual inflation this came to a target level of €307.1 billion. 17. The delay in milk reform also eases the burden on the budget, coming only one year before the conclusion of the financial perspectives framework. 18. Reported in Swinbank (1999), it has been argued that the EU reinstated compulsory set-aside in the final Agenda 2000 agreement such that arable payments would remain within the boundaries of production limiting arrangements. 19. Trapp Steffensen (2003) estimates that intensive farming practices are causing environmental damage costing approximately €9 billion a year. 20. Some of the key areas are landscape and open space amenities, rural economic viability, animal welfare, food safety and quality, prevention of natural hazards, cultural heritage, and preservation of biodiversity. 21. Since Agenda 2000, the CAP has 2 support pillars. Pillar 1 includes price support payments (i.e. export subsidies and intervention costs), and subsidies

202 Notes

22.

23.

24.

25.

26. 27. 28. 29.

30.

31.

32. 33. 34.

paid direct to farmers (e.g. headage payments, area payments etc.). Pillar 2 promotes rural development initiatives (mainly production neutral). Under the market reform component of the MTR, it was proposed to cut by a further 5 per cent the cereals intervention price and bring forward a year the changes to the dairy sector agreed in 1999. Furthermore, it was envisaged that reform would also occur in sugar, olive oil, cotton, tobacco, fruit and vegetables and wine sectors. Given the current financial framework runs until 2006, this shift between budget headings will not be implemented until 2007 at the earliest. Furthermore, it was proposed to apply degressivity to larger farm units to address current income imbalances amongst farmers. In the dairy sector, it has been agreed to reduce the intervention price for butter by an additional 10 per cent price cut compared to Agenda 2000 and to maintain a reformed dairy quota system until 2014/15. The current MTR agreement (prior to WTO discussions) will not fully impact on acceding member states until 2013 (at the earliest). A full discussion of the impacts of enlargement on CAP reform is provided in Chapter 8. The 2002 US farm bill has dramatically increased subsidisation to US farmers and is certainly against the spirit of the Doha Declaration of November 2001. Around 90 per cent of export subsidy expenditure is currently from the EU (USDA, 2002). The deadweight estimate assumes that MI
XI. The author accepts that ‘economy-wide’ models other than CGE (e.g. input–output models, macro-econometric models) can be used to analyse CAP costs, although most of the work in the academic literature is either PE or CGE. It is, however, possible to justify the use of PE to analyse EU (15) agricultural liberalisation since developed countries have small agricultural GDP shares and consequently, the impact of reform is arguably minimal in non-agricultural sectors. Anderson and Tyers (1988) predicted in their study of trade liberalisation under the Uruguay Round, that a fall in the economic welfare of the developing countries would follow liberalisation by industrialised nations due to the rise in international food prices, with consumer losses outweighing producer gains. The same scenario was conducted under CGE conditions (Burniaux and Waelbroeck, 1985; Loo and Tower, 1989) both of which showed welfare gains, due to the effects of the non-agricultural sectors. Noting the reconciliation of the structural differences between the model approaches, Anderson and Tyers (1993) reverse their initial estimates from a sizeable loss (1985 US $14 billion) into a significant gain (US $11 billion). See Buckwell et al. (1982), Winters (1987), Demekas et al. (1988) and Atkin (1993). This statistic illustrates the relative inefficiency of the CAP in the total economy. ‘Scale’ effects emanate from movements down the average total cost curve with increases in firm output. Pro-competitive effects (Hertel, 1994) include this effect but also examine the simultaneous reduction of the mark-up price distortion.

Notes 203 35. Authors did not have data to include Greece, Spain and Portugal. 36. This is where the modeller assumes that land is relatively immobile between sectors. For example, land in agriculture is not easily transferred from pasture to arable usage. Moreover, set-aside puts a constraint on the base allowable level of land used in arable sectors. 37. The smaller the number of firms the greater is the benchmark mark-up of price over marginal cost. Hence the greater are the potential gains from CAP liberalisation as tariff protection is removed and the industry rationalises. 38. The budget situation actually improves 11 per cent from the base under further price reductions compared with an increase in budgetary pressure of 11.5 per cent under further quantitative restrictions. 39. Quest II (Roeger and Veld, 1997) is a dynamic optimisation model of demand and supply. The model also has the added benefit of endogenously incorporating financial behaviour (i.e. money and government debt) and savings/ investment decisions. However, given the degree of behavioural detail, the model sectors are highly aggregated. 40. A sensitivity analysis of the trade elasticities reveals that the EU gains vary between 0.03 per cent (half the standard trade elasticities) to 0.09 per cent (double the standard trade elasticities) of EU GDP. 41. The largest gainers from the Agenda 2000 reforms are Luxembourg (0.53 per cent GDP) and Finland (0.49 per cent GDP), whilst Spain loses by 0.15 per cent of GDP. 42. Note that these budgetary savings are first pillar only and do not account for the fact that these funds will be redirected to second pillar environmental and rural development schemes. 43. These considerations outweigh the additional welfare gains accruing from later studies employing imperfect competition. 44. Arce and Reinhart (1994) demonstrate how aggregation affects welfare results.

Chaper 5 Central Bank Independence and Monetary Policy 1. Figures in parentheses indicate the number of board members appointed by each institution. 2. This is also in line with the practice followed by all of the central banks of the major developed countries that have specified numerical values for their objectives; all have a midpoint above 1 per cent. For example: the Bank of England: 21/2 per cent (RPIX index, approximately 13/4 on average in HICP terms); Sveriges Riksbank: 2  1 per cent (CPI); Norges Bank: 21/2  1 per cent (CPI); Bank of Canada: 1–3 per cent (CPI); Bank of Australia: 1–3 per cent (CPI); Reserve Bank of New Zealand: 1–3 per cent (CPI). The Federal Reserve System and the Bank of Japan have not specified a quantitative definition of their price stability objectives. The Swiss National Bank has adopted a definition of price stability which is equivalent to that of the ECB.

204 Notes

Chapter 6 EMU Convergence and Fiscal Policy 1.

2.

The SGP consists of a Resolution adopted by the European Council in June of 1997, and two Council Regulations adopted in July of 1997. It clarifies the ‘excessive deficits’ procedure and penalties that were agreed in the TEU. Stark (2001) discusses the rationale for the original German proposal regarding the SGP. For a description its basic features see Buti et al. (1998) and Cabral (2001), whilst EU Commission (2000) and Fischer and Giudice (2001) discuss the implementation and operation of the SGP. See Brunila et al. (2001) for an overview of the institutional, legal, theoretical and empirical aspects of the SGP.

Chapter 8 EU Enlargement: EMU and Agriculture 1. The ‘Club Med’ EU member states are Portugal, Spain, Italy and Greece. 2. Along with Cyprus and Malta, the CEECs set to join in 2004 are the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic and Slovenia. Bulgaria and Romania are provisionally scheduled for membership in 2007. 3. Poland alone accounts for 39.6 per cent of the EU (15’s) total farming population (EC, 2002a). 4. Approximately 88 per cent of EU agricultural imports and 75 per cent of EU agricultural exports to the CEECs are tariff free or have reduced duty rates (EC, 2002). 5. The real exchange rate is the ratio of the price of non-tradables (i.e. production inputs) to tradables. 6. The EU has become the most important trade partner for all of the countries of the CEECs (EC, 2002c). 7. Notably, Estonia and Slovenia have been singled out as making excellent progress. 8. The acronym was based on its initial aim, to help Hungarian and Polish accessions. Whilst the remit of these funds has broadened, the acronym has remained unchanged. 9. Those Mediterranean countries not currently part of the EU are: Algeria, Cyprus, Egypt, Israel, Jordan, Lebanon, Malta, Morocco, the Palestinian Authority, Syria, Tunisia, and Turkey. From 2004, Cyprus and Malta will be EU members. 10. A discussion of price alignment strategies is given in Grant (1997). 11. Considerable price variation still exists within CEECs. 12. Given that proportionally high levels of household income are spent on food. 13. Even on this point, there was concern from the relatively less wealthy members of the current EU (15), Spain, Portugal and Greece, about the potential loss to their cohesion funding. 14. The term ‘agreed’ is used loosely, since it has been suggested (Rollo, 2003) that the final agricultural package for the CEECs is a long way short of what was originally promised within the Agenda 2000 framework. In the EU’s defense, the original financial framework was designed for an additional six members in 2002, rather than an additional ten joining in mid-2004.

Notes 205 15. Originally, it was envisaged that enlargement would take place in 2002, with large agricultural recipients, Bulgaria and Romania, facing entry in 2007, after the current framework expires. 16. Froheberg and Webber (2001) predict annual costs of €7.74 billion, Silvis et al. (2001) suggest a figure of €9.85 billion and Weise et al. (2001) estimate annual costs of €10.13 billion. 17. Romania accounts for 69.2 per cent of the total EU (15) farming population (EC, 2002a). 18. These estimates are likely to be slightly overblown given that compensation is to be phased in rather than total and immediate, although it is still uncertain whether the EU will be able to accommodate candidates given agricultural market volatility and small margins for error in the budget guideline. 19. Such responses typically favour the Computable General Equilibrium approach. There are numerous estimates of welfare in the literature, which employ this modelling technique. 20. Assumptions pertaining to trade elasticities, detailed representation of agricultural policies (set-aside, quotas, compensation, CAP budget – as in Bach et al., 2000), and the nature of agricultural compensation, whether it be partial (Swaminathan et al., 1998; Liapis and Tsigas, 1998) or total (Bach et al., 2000). 21. For example, consistent health, safety, industrial and environmental standards, adoption of common competition policies and most significantly, the removal of frontier controls (non-tariff barriers). 22. Allocation effects are based on how integration induces efficiency changes through the reallocation of resources and expenditures. Thus, the size of the allocation effect is determined by the extent of market imperfection (i.e. tariff/subsidy) and therefore the size of the resource inefficiency. 23. Accumulation effects are increases in the stock of resources (i.e. capital) which are induced through market opportunities from free trade. 24. In Baldwin et al. (1997) real welfare costs are in 1992 values, whereas Bach et al. (2000) employ 1995 values. 25. Bach et al. (2000) do not incorporate (capital) accumulation effects which can greatly affect model outcomes. 26. Amber box subsidies (i.e. price support) were considered to be production and trade distorting in the Uruguay Round agreement and therefore subject to agreed reductions.

Chapter 9 Alternatives to Further Integration 1. See Chapter 6 for a description and critical evaluation of these convergence criteria. 2. Kydland and Prescott (1977) argue that rules or pre-commitment are more relevant when the monetary and fiscal authorities enjoy a reputation for discipline and consistency over time, whereas discretionary policy is more appropriate when such credibility is lacking. 3. It is worth noting that the international price structures of many of these key products are denominated in US dollars. Moreover, the Euro is likely to have a more volatile medium-term relationship with the US dollar than Sterling has experienced since the UK’s withdrawal from the ERM in September 1992.

206 Notes 4. One estimate, made by Burkitt et al (1996), concluded that the UK’s two-year membership of the ERM cost an estimated £68.2 billion in 1992 prices (equivalent to 11.5 per cent of UK GDP), in terms of lost output and oneand-a-quarter million more unemployed.

Chapter 10 Is NAFTA Membership Really a ‘Barmy’ Idea? 1. Germany’s membership of the Security Council is scheduled to end in December 2004. France is a permanent member of the Council. 2. Given discord between existing members, it appears that a resolution on the EU constitution will occur later rather than sooner. 3. Proponents of ‘the middle way’ recognise that free-market capitalism has virtues, whilst emphasising the role of the state in developing social justice and equality. 4. USITC (2000) also show (page 2.4) that throughout the 1990s, the UK’s percentage share of total North American trade has been approximately double that of the corresponding EU (14) statistic. 5. Where US investment shares exceed North America indicates disinvestment in the Canadian-Mexican composite region. 6. Cross-border flows of goods and services among the 12 countries of the euro zone have increased by between 3 per cent and 25 per cent since the single currency was launched in 1999. Accordingly, the Treasury predicts that, given sustained convergence with the rest of Europe, ‘A reasonable range for the potential increase in UK trade with the euro area resulting from UK membership of EMU is between 5 per cent and 50 per cent’ (Guardian, 10 June 2003). 7. The impact of euro entry on FDI is the basis of one of the ‘five tests’ of Euro membership, the other tests being convergence with the euro zone, impact on jobs, flexibility to adapt and impact on financial services. It is only the latter test which has so far been met, although in his address to the Commons on 9 June, the Chancellor stressed that progress on passing two of the tests – flexibility and convergence – would lead to the remaining two tests being satisfied. 8. According to the Treasury’s housing market study, ‘The UK’s level of mortgage debt and its greater reliance on variable-rate mortgages imply that the sensitivity of housing-related interest payments to changes in interest rates is higher in the UK than in any other EU country, and far higher than in the other large EU economies’ (Guardian, 10 June 2003). 9. A recent poll (January 2004) conducted by the Guardian newspaper suggests that if a referendum were held, the majority of people in Britain (66 per cent) would vote against joining the euro. Interestingly, the government has not said what it would do if the referendum verdict was negative. In terms of timing, it is far less likely that the UK government will hold a euro referendum before the next general election given the return of a ‘no’ vote in the Swedish referendum in September 2003. 10. A recent MORI poll conducted in April 2003 asked respondents to choose between Europe, the Commonwealth, America and ‘other’ as ‘most important’ to the UK. Only 42 per cent favoured Europe with exactly half the respondents choosing either the Commonwealth or America.

Notes 207 11. As a free trade area, NAFTA shares some of the traits of a customs union such as free movement of goods and services, mutual respect for intellectual property rights and free movement of capital. However, it stops well short of enforcing a common external tariff and the principle of free labour movement. Moreover, NAFTA does not ascribe to the notion of economic or political union amongst member states. 12. Pain and Young (2000) suggest that UK food prices could be reduced by as much as 20 per cent on leaving the EU. 13. EFTA pressure for closer ties with the EU resulted in the EEA agreement in 1992, which extends free movement of goods, services, labour and financial services to signatory members. EFTA currently includes Iceland, Liechtenstein, Norway and Switzerland, although the latter has not joined the EEA. 14. Given recent unified actions in trade and regulation between the EEA and EU members, such a move is somewhat contrary to the spirit of EEA membership (USITC, 2000). 15. It is unclear under what specific format the UK would enter into a trade agreement with NAFTA. Thus, the two scenarios implemented here are to be interpreted as upper and lower bound trade estimates. 16. The USITC study employs the standard Global Trade Analysis Project (GTAP) model and associated database (Hertel, 1997). 17. In the NAFTA agreement, all trade protection within the NAFTA trade-bloc is removed by 2003. The EU–Mexico free trade area, ratified in 2000, allows Mexico unfettered access to EU markets from the beginning of 2003, with reciprocal trade from the EU to Mexico facing a maximum import tariff of 5 per cent over the same time period. The agreement stipulates that almost all EU exports to Mexico will be allowed free access by 2007. 18. In USITC (2000), it is assumed that all policy shocks occur instantaneously in 1995. In Philippidis (2003), it is assumed that there is a gradual adjustment in the UK’s accession to NAFTA over a five-year period from 2003 to 2007. Furthermore, the changing state of the global economy is based on annual projections on factor endowments, productivity and growth, population and Uruguay Round liberalisation shocks (Walmsley et al., 2000). 19. In the baseline, the study gradually implements the NAFTA and EU–Mexico agreements as well as reform of the CAP under the Agenda 2000 proposals. Scenarios (a) and (b) include all of these shocks in addition to the scenario specific shocks. 20. Comparative static models only assess the welfare effects emanating from ‘current’ resources. In particular, a long-run behavioural assumption is employed where investment is allocated over regions such that the next period’s expected rates of return are all equalised. However, since there is only one time period, the model does not capture the impacts of investment on ‘capital accumulation’ in the next period, or tell us whether expected rates of return are indeed realised. 21. Given the importance of foreign investment, it would seem appropriate to have an improved characterisation of international financial behaviour within the model. However, this dynamic framework does not include detailed bilateral FDI data, but rather characterises foreign investment through gross flows of funds between each region and a ‘global trust’ entity.

208 Notes 22. The EU–Mexico Agreement and the Uruguay Round Agreement reduce tariffs and subsidies further (particularly in agriculture and food) compared with the protection data reported in Table 10.3. 23. Thus, the competitive impacts of liberalisation on markets is magnified by changes in the scale of output per firm as it moves down the average cost curve and reductions in the mark-up of price over marginal cost. In the literature (Vousden, 1990; Hertel, 1994) the combination of these factors is known as the ‘pro-competitive’ effect. 24. According to the underlying data in the model, services is the largest aggregate sector in the UK (60 per cent share of total UK output). In USITC (2002), service sector output in the UK actually falls slightly in scenario (a). 25. Conducting a sensitivity analysis of removing CAP support, Philippidis (2003) finds that UK real growth could increase by as much as 1.14 per cent in Scenario (a) relative to the baseline. 26 US–UK FDI dominates total FDI relations between the UK and NAFTA. Note that the partial equilibrium studies only assess the impacts of accession on manufacturing FDI, whilst no attempt is made to assess the impacts on financial services or other sectors. 27. A variation of the trade elasticities in the simulation run led to estimates as high as $1.8 billion (1.19 per cent). 28. An ICM poll reveals that if voters were forced to choose between leaving the EU or joining the euro then support for leaving the EU would total 48 per cent, with 44 per cent backing the euro (Daily Mail, 6 June 2003). 29. This point is particularly pertinent given that the services sector is the preserve of non-tariff barriers (Deardorff and Stern, 1998; Park, 2002). Moreover, services such as finance, insurance, and real estate account for a significant proportion of UK (US) -owned direct investment assets in the United States (United Kingdom). 30. See note 24. 31. Especially Poland which is already a NATO member. The Baltic countries are also set to join NATO this year (2004) along with Bulgaria, Romania, Slovakia, Slovenia.

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Index

acquis communautaire 146, 147, 154, 156, 157, 158, 161, 164 Advisory Committee on Restrictive Practices and Dominant Positions 41–2 Aerospace industry 72–4 Aérospatiale 49, 63, 72 Agenda 2000 20–5, 32, 33, 137, 160 agricultural agreements Central and Eastern European Countries 154–5 agricultural funding Central and Eastern European Countries 156–7 Cyprus 157 Malta 157 agricultural policy 4, 163 See also Common Agricultural Policy agricultural surpluses 18 agriculture 153–4 Airbus 73–4 Airtours 50 Alenia 49 Alenia Marconi Systems 72 Alstom 69 Alvey programme 69 Assembly of European Regions (AER) 132 AstraZeneca 41 Augusta 72 BAe Dynamics 72 BAE Systems 72–3 Bank of England 81 Baltic Free Trade Agreement (BFTA) 152 Barnier, Michael on United States 184 Basic Research in Industrial Technology for Europe (BRITE) 71

Bertelsmann-Kirch-Premiere 49 Blair, Tony 183, 184, 185 Blair-House Accord 19–20 block exemption 5, 40 car industry 44 Blue Banana 122 blue box measures 21, 24 BMW 140 Boeing 50, 72, 73 British Technology Group 69 Brown, Gordon 140 Brussels Summit, 2003 141 Bundesbank 81, 89 business mergers 46–50 United Kingdom 55, 56 CASA 72 Central and Eastern European Countries (CEECs) 9–10, 11, 63, 130, 137–8, 142, 162–3 development indicators 159 Central European Free Trade Agreement (CEFTA) 152 Chirac, Jacques 21, 188–9 Chungwa Picture Tubes 140 Cohesion Fund 125, 128, 130, 138 Colonna Report, 1970 64 Committee of Regions (COR) 132–3 commodity diversification 109 Common Agricultural Policy (CAP) 4–5, 9, 154 1992 reforms 30–2 applicant countries 160–2 costs 25–8 empirical studies 28–33 evolution 17, 18–20, 33–4 expenditure 20 price mechanisms 158 transfers 25–7 equilibrium model 25

226 Index common external tariff (CET) 2, 60, 163, 172, 177, 181 Common Market 1–2, 17 common monitory and exchange rate policy 10 Commonwealth trading bloc 177 competition policy 35, 42 car industry 43–4 United Kingdom 53–6 computable general equilibrium (CGE) model 27–8, 30, 33 co-operation 1, 71–2, 131 Coopers & Lybrand 49 Copenhagen criteria 145–6 co-responsibility levy 18 Council of European Municipalities and Regions (CEMR) 132 Daimler Chrysler Aerospace 72 De Gaulle, Charles 61 De Havilland 49 de minimis rule 41, 52 deadweight costs 27, 28, 29, 31 Deutsche Telecom/Betaresearch 49–50 Doha Round of trade talks 23, 163 Douwe Egbert 49 Economic and Monetary Union (EMU) 2, 7, 8–9, 13, 79, 99, 100, 103, 122 competition policy car industry 43 fiscal policy 113–17 membership 11, 148–52 economic integration 122 economy United Kingdom 107–8 Enso/Stora 49 Enterprise Bill, 2002 56 Ernst & Young 49 Euro 10, 12 Europe and United States 184–5 European Aeronautic Defence and Space Company (EADS) 63 European Agricultural Guidance and Guarantee Fund (EAGGF) 127–8

European Central Bank (ECB) 7–8, 79, 98, 113 independence 87–92 empirical studies 92–5 structure and role 80–1, 85–7 European Coal and Steel Community (ECSC) 46, 64 European Coal and Steel Community Treaty, 1951 1, 2 state aids 51 European Communities Act 175 European constitution reformation 12 European Court of Justice mergers 50 restrictive practices 41, 42 European Economic Area (EEA) 171 and United Kingdom 172–3 European Economic Community (EEC) See European Union European Economic Community Treaty 1–2 article 82 46 article 90 53 state aids 51 European Free Trade Association (EFTA) 122 and United Kingdom 170, 171–3, 176 European integration 124 European Investment Bank (EIB) 128 European Merger Control Regulation 48 European model of agriculture 22 European Regional Development Fund (ERDF) 124–5, 127, 134, 137 European Research Coordination Agency (EUREKA) 71 European Social Fund (ESF) 127 European Strategic Programme for Research and Development in Information Technology (ESPRIT) 70–1

Index European Union (EU) 142, 169 and Switzerland 173–4 and United Kingdom 12, 13, 170–1, 174–9, 181–2, 183, 189–90, 197, 198–9 trade 186–7, 190–5 budget 133, 139 core regions 122–3, 125 enlargement budgetary costs 161–4 economic impact 143–5 financial framework 162 welfare costs 162 history 2–3 membership 3, 11, 137–8, 142, 144, 147, 164–5 peripheral regions of 123–4, 136 European Union Treaty (TEU), 1992 2, 7, 8, 13, 79, 100, 147, 169 state aids 52–3 exchange rate 108, 110, 180–1 Exchange Rate Mechanism (ERM) 102, 111, 147, 149, 151–2 exclusive purchasing agreements 40 export subsidies 24–5 Fair Trading Act, 1973 54–5 Federal Reserve Bank of the United States of America 81, 178 Federalism 125 Financial Instrument for Fisheries Guidance (FIFG) 128 First Choice 50 fiscal integration 109–10 fiscal policy 8–10 United Kingdom 179–80 Fischler, Franz 22 Foreign Direct Investment (FDI) United Kingdom 186–7, 196 Framework programmes 70, 71 franchising 40 Frankenstein foods 22 General Agreement on Tariffs and Trade (GATT) 19–20, 28, 32 General Electrics (GE) 50 GKN Westland 72 globalisation 58 Gramm, Phil 198

227

Green box 24 Greenspan, Alan 178 group exemptions 40 Hain, Peter 185 Harmonised Index of Consumer Prices (HICP) 95–6 Heath, Edward 62 Herfindahl Index (H) 45–6 High technology industries 65 Hoffmann-La Roche 46 Honeywell 50 industrial policy 5–6, 57–8, 60 European Union 64–5 France 60–1 Germany 59–60 Italy 61 Spain 61–2 United Kingdom 59, 74–6 industries 59 Europe 72 United States 72 inflation rate 110–11 innovation 65–7, 68 France 68 Germany 68 United Kingdom 69 Instituto Nacional de Industria (INI) 61 Instituto per la Riconstruzione Industriale (IRI) 61 Instrument for Structural Policies for Pre-Accession (ISPA) 156 INTERREG 131, 136 iSoft 56 ITS/Signode Titon 49 Kodak 54 Kondratieff long wave cycle 68 KPMG 49 labour mobility 107, 145 Lamy, Pascal 24 large firms 45 research and development 37, 38 Legrand 50 LG Group 140 List, Friedrich 60

228 Index Lockheed Martin 72, 73 Lufthansa 63 Maastricht convergence criteria (MCC) 101–6, 109, 110, 112, 113 applicant countries 146, 147–52 Central and Eastern European Countries 149 Luxembourg 103 Maastricht Treaty See European Union Treaty MacDonnell Douglas 50 MacSharry Package 4, 19, 22, 160 Marconi 69 Matra 63, 72 MBDA 72 mergers See business mergers Messerschmitt-Bölkow-Blohm 49 Microsoft Corporation 39 mid-term reviews (MTR) 22–3, 33, 164 Mitterand, Francois on United States 184 monetary policy 110 applicant countries 148 European Central Bank 95–8 Monnet, Jean 1 monopolies 36, 37–9, 44–5, 67 Monopolies and Mergers Commission (MMC) 54 Monopolies and Restrictive Practices Commission 54 Moscovici, Pierre on United States 184 multinational companies (MNCs) 123–4, 186–7 My Travel See Airtours National Central Banks (NCBs) 80, 81, 82–5, 86 National Enterprise Board (NEB) 69 National Union of Mineworkers (NUM) 62 Nomenclature of Territorial Units for Statistics (NUTS) 135–6, 139 Non-Tariff Barriers (NTBs) 5, 36

North American Free Trade Agreement (NAFTA) 13, 14, 122 and United Kingdom 14, 170, 177–8, 188, 197–9 trade 186–7, 190–5 Northrop Grumman 72 optimum currency area theory 106 Organization for Economic and Cooperation Development (OECD) 88, 93, 174 Pacific Free Trade Area 177 partial equilibrium (PE) model 27, 30, 36 patents 66–7 PHARE 156, 157 Pilkingtons 54 planning France 61 price flexibility 111 Price Waterhouse 49 privatisation 53, 62, 63–4 Racal 72 Raytheon 72 real exchange rate 112–13 regional convergence 125–7 regional participation 131–13 regional policy 11, 121, 122, 124–5, 127, 135–6, 137 Czech Republic 139 economic development 128–9 Poland 139 United Kingdom 140–1 Regional Selective Assistance (RSA) 140 research and development (R&D) spending 66 United States 67 Research and Development in Advanced Communication Technologies for Europe (RACE) 70–1 Reserve Bank of New Zealand 81 restrictive practices policy 39–43 Restrictive Trade Practices Act, 1956 54 Rhône-Poulenc 68 rural development 161

Index Schengen system 10 Schneider 50 Schroeder, Gerhard 185 science and technology policy 68, 71 selective distribution 40 Sherman Act, 1890 38 Sidel 50 Siemens 140 single currency 6, 12, 99–100, 101 Single European Act, 1986 2, 70 Single European Market (SEM) 5, 35, 47 competition policy car industry 43 state aids 52 single market 2, 3–4 small and medium size enterprises (SMEs) 38, 124, 128, 140 restrictive practises 40–1 Smith, Iain Duncan 183, 188 Special Accession Programme for Agricultural and Rural Development (SAPARD) 156–7 Spinelli Report, 1973 64 Stability and Growth Pact (SGP), 1997 6–7, 109, 113–16 state aids 50–3, 135 state intervention 60 Stoiber-Gomes Report 132–3 Structural Funds (SFs) 11, 71, 127–30, 133–5 Summit on the European Regions and Cities, 1997 132

229

Tetra Laval 50 Tetra Pak 49 Thales 72 Thatcher, Margaret 10, 62, 141 Thomson-CSF 72 Thomson Marconi Sonar and Shorts Missile Systems 72 Torex 56 trade cartels 39, 42–3 Trans-Atlantic Conference Agreement (TACA) 42–3 Treaty of Amsterdam, 1997 2, 5, 46, 133 Treaty of Rome 5, 46, 161 merger policy 48 United States International Trade Commission (USITC) 14, 188, 198 United States of Europe 185 Uruguay Round Agriculture Agreement (URAA) 4, 30, 32 Van Nelle 49 vertical Phillips curve 89 Volkswagen 43, 63 wage flexibility 111 warranty 56 Weinstock, Arnold 69 World Trade Organisation (WTO) 4, 20, 21, 24, 154, 163