1 The Economics of European Integration* Chapter 1 ‘Economic Integration in Europe’ Chapter 2 ‘The Traditional Theories of Customs Unions and Single Market’ Chapter 3 ‘New Trade Theories and the Integration of Commodity Markets’ Chapter 4 ‘Common Market Theory’ Chapter 6 ‘Micro Economic Policies’ Sections marked with blue are cursory reading. *Updated and adapted manuscript from J. D. Hansen and J.U-M. Nielsen, An Economic Analysisof the EU, McGrawHill, 1997.
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Economic relationships in Europe are changing. Trade, capital flows, migration and technology
increasingly link the economies of the countries of Europe. Basically, this trend is due to the
general globalization process on world scale which has taken place since mid of 20th century for
all market economies but in Europe the process has become much deeper due to the regional
integration in the European Union (EU). The EU includes most of the European countries as
members, namely: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Italy,
Ireland, Luxembourg, the Netherlands, Portugal, Spain, Sweden, the United Kingdom, Estonia,
Latvia, Lithuania, Poland, the Czech Republic, the Slovak Republic Hungary, Slovenia, Maltaand Cyprus. These 27 countries have developed a formal system of close co-operation aimed at
creating a cohesive economy encompassing the whole of the EU, and within which there is free
mobility not merely of goods but also factors of production. In other words it is hoped that in
many respects the 27 diverse economies can function as a single economic unit. This process of
dissolving the boundaries of the segmented economies illustrates the concept economic
integration.
The purpose of this book is to discuss economic integration in the EU within the framework of
economic theory. Though economic relationships are examined at a fairly abstract level, the
book has its roots in the economy of the EU as it exists today and as it may develop in the future.
The first chapter provides a brief survey of the history of the EU, the political decision making
process in the EU, its administrative apparatus or legal system. All the remaining chapters focus
The overall goal for the European Union goes thus far beyond economic cooperation. Basically
the aim the Union is first and foremost to promote peace and ensure the basic values on
democracy, human rights etc. The benefits of economic cooperation should be seen as a lever for
these ultimate goals.
The EU has supra-national elements in that there are institutions which have the power to make
commitments which are binding on member states. The most central of these institutions are the
European Commission, the European Council of Ministers, the European Court of Justice, the
European Parliament and the European Central Bank (ECB). The Commission has the "right of initiative", that is it can make proposals for the implementation of EU policy and make plans for
the further development of the EU. Decisions about the proposals and plans are taken in the
Council of Ministers, which consists of ministers from all the member states. To some extent the
Council of Ministers can make decisions by majority voting. The Court of Justice is also a
supra-national body in that it can pass judgment not only for individuals and firms but also
member states. The Parliament has a right to be heard, and certain matters, such as the
appointment of Commissioners and the annual EU budget, require its approval. The European
Central Bank conducts the monetary policy for the group of EU-countries which participates in
the EMU.
1-3 DIMENSIONS OF EUROPEAN INTEGRATION
1-3-1 The widening and the deepening of the EU cooperation
The development of the European Union has been a dynamic process where the political and
In a single market for commodities (often shortened to single market and also known as an
internal commodity market) all restrictions on trade within the market have been abolished. Thisis true of both visible and invisible barriers. The latter include such obstacles to trade as product
standards that differ from country to country and the tendency of public authorities prefer to buy
from domestic suppliers. A single market, like a customs union, has a common external tariff.
A common market presupposes a single market for commodities, and in addition has free
mobility of factors of production and of financial assets. Thus, any citizen of a common market
country can obtain employment, establish a business and make passive investments in bank
accounts or securities in any common market country without approval from any authority,
unless such approval is also required of citizens of the country concerned.
A monetary union reflects an even higher degree of integration, for it presupposes a common
market and in addition either irrevocably fixed exchange rates or a common currency for all
member countries so that economic transactions within the union are not affected by exchange
rate uncertainty. However, the weaker form of monetary union, fixed exchange rates, implies
The term quasi monetary union is sometimes applied where exchange rates in principle are
fixed, but may be adjusted.
An economic union is a monetary union in which the economic policy of member countries is
extensively coordinated. Since monetary union implies a unified monetary policy, the further
integration brought about by an economic union mainly concerns fiscal policy. In principle, an
economic union has uniform or very similar tax rates and procedures, a high degree of
uniformity in transfer payments (such as social benefits), co-ordination of government
expenditures as stabilization policies are now a matter of common concern, and also co-
ordination of sector policies such as taxation and subsidy of agriculture and manufacturing. Thecompleteness of economic unions may of course vary, as we see if we compare the integration
of the countries of U.K. with the looser integration of the provinces of Canada or the states of
the U.S.A.
Conceptually, we distinguish between negative and positive integration. Negative integration
consists of the removal of rules discriminating against partner countries in the union. Positive
integration consists of common efforts to reach a specific objective. The creation of a free trade
area, a customs union, a single market or a common market are all cases of negative integration,
for their essence is the removal of restrictions on the mobility of goods or factors of production
and financial assets. A monetary and economic union on the other hand includes elements of
positive integration since it implies common or coordinated monetary, fiscal and sector policies.
This book has a structure based on the typology of economic integration shown in Table 1-1. It
must be mentioned, however, that in the literature on economic integration the meaning of
certain terms may vary. Thus the term monetary union is sometimes used of a group of
countries, which merely have a common currency but do not have a common market or even a
customs union1. Sometimes the term economic union is also used in a broader sense, in which
case it may refer to a group of countries where economic policy is partly a result of joint
decisions or mutual understanding among the members. Economic union described in this way
represents a lesser degree of economic integration than a monetary union.
1-3-3 Stages in the Process of Deepening of the Economic Integration in the EU
1 The monetary unions that existed between Ireland and the UK or between France and its former African
According to the definitions of Table 1-1, the EU, in its present form, is a fully developed
customs union which already has the most important elements of a single market for
commodities and a common market. Moreover monetary co-operation has moved forward by
establishing of a monetary union. Since some sectoral policies are very much the outcome of
joint decisions, and since macro-economic policy will be increasingly coordinated with the
creation of a monetary union, the EU also contains elements of an economic union.
The EU has more or less continually moved towards closer economic integration. Roughly
speaking, the EU moved downwards in Table 1-1, as the customs union was completed in 1968
and the outline of the common market was completed in 1993. The process of integration hashowever at times been interrupted or even reversed. Between 1973, when the first oil crisis
occurred, and the mid 1980s there was almost no progress. The first plan for an economic and
monetary union, the Werner Plan of 1970, was never implemented; but the Delors Plan of 1989
outlined more in details the idea of establishment of an Economic and Monetary Union (EMU)
in the EU. The Delors plan was incorporated in the Maastrict Treaty and in 1999 the EMU was
launched based on the common currency; the euro. However, only a subset of Member States
participated in the euro partly because they have obtained the right to stay outside the EMU and
partly because countries should fulfill the so-called convergence criteria for membership. The
initial group of EMU countries was Austria, Belgium, Finland, France, Germany, Italy, Ireland,
Luxembourg, the Netherlands, Portugal, and Spain. Later this group was expanded by Greece in
2001, Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009 and Estonia in 2011.
1-3-4 The Economic Policy Areas of the EU
Table 1-1 provide for an overall classification of various degrees of integration. As far as the
cooperation goes beyond a customs union policy the condition for a well functioning
cooperation may make it necessary to establish common policies on specific areas i.e. to develop
at least some elements of an economic union. It is apparent from the reviewing the functional
Article 3 in the Treaty on European Union gives an overview of the various policy areas, some
of which have hitherto been relatively insignificant, while the following areas of major
importance: (1) the Common Agricultural Policy (CAP), (2) policies concerning the
establishment of the Common Market, (3) the Competition Rules (which also regulate subsi-
dies), (4) the Common Commercial Policy, (5) the Regional Policy and (6) macroeconomic
policies especially related to the Economic and Monetary Union (EMU).
The CAP has traditionally been regarded as the most important EU policy area, at least from an
economic point of view, and it still absorbs over half the EU budget. However, from the mid
1980s, the establishment of a well functioning common market became a central matter, and theEU concerned itself with reducing not merely tariff and quotas on trade but also other
hindrances to the movement of commodities as well as legal barriers to the free movement of
labour and capital. The establishment (in 1992) of the Single Market, which in principle requires
the removal of such hindrances to trade as discrimination in public purchasing and differences in
product standards, is clear evidence of changed policy priorities. The third policy area
supplements the second, for the Competition Rules are a prerequisite for an open and integrated
market in that they limit the misuse of monopoly power and national subsidies in inter-country
commerce.
The Common Commercial Policy means that there is a common external tariff and a common
trade policy towards third party countries. This ensures that a member country can neither obtain
an unfair competitive advantage by importing raw materials or intermediate products more
cheaply than other members, nor profit from cheaper imports which are re-exported to other
members.
The four previous policy areas may to a large extent be justified by considerations of allocative
efficiency, although the rationale of the CAP is also to secure fair living standards for farmers.
The Regional Policy exists primarily to redistribute income from richer to poorer members and
thereby promote economic and social cohesion. Apart from the five major areas, the EU
economic policy has now developed to include transport, energy, social conditions, the labour
market, the environment, the strengthening of industrial competitiveness, research and
technology, public health, education, the developing countries and consumer issues.
Some of these policy areas such as transport are justified by efficiency considerations, and
others, such as social policy and labour market policy, by both a desire to attain social goals and
a belief that large differences in the area concerned will make it difficult to complete the
establishment of the common market.
Until the establishment of the EMU the EU have had little influence on macro-economic policy.
The Member States were only bound by the loose commitment to ‘regard their economic
policies as a matter of common concern’ (TFEU, Article 121, paragraph 12). However this
situation changed dramatically by the establishment of the EMU at least for those EU countries
which participated in the monetary union. The centerpiece of this cooperation is the commoncurrency the euro and for the euro area the monetary policy and exchange rate policy is
centralized and administered by the new established institution the European Central Bank.
Moreover fiscal policy of the Member States should respect the principle of sound public
finances defined by the Stability and Growth Pact approved by the Europe Council which is the
highest level for decision making consisting of the prime ministers or head of states of the
Member States.
EU policies build on a balance between efficiency considerations and distributional
considerations. In purely economic analyses a trade-off exists between efficiency and equality.
However, in regime optimization between efficiency and distribution more fundamental political
dynamics should be taken into account. If the distribution objective is to be sacrificed to
efficiency in integration there is the risk that the integration process is derailed, and that
economies are segmented again. In the light of this cohesion is a condition for achieving
efficiency through integration.
Table 1-2 summarizes the development of the legal framework of the EU and the associated
landmarks of European integration.
2In the following we refer to the number of Articles after the renumbering of Treaties in TEU and
The EU forms a considerable part of the world economy. Table 1-3 shows a set of key economic
figures which enable both individual EU countries and the EU as a whole to be compared with
the United States and Japan.
It appears from the table that the population of the EU is more than one and half times larger
than that of the United States and nearly 4 times larger than that of Japan. The EU's gross
domestic product (GDP) is slightly larger than that of the United States for 2010 and about 3
times larger than that of Japan. It is important to emphasize, however, that the figures for GDPare not adjusted for differences of price levels i.e. in purchasing power parity. What matters for
differences in living standards is per capita income adjusted for differences of price levels. The
relevance of this appears from Table 1-3 where GDP per capita is reports at current exchange
rates in column 3 but in purchasing power parities (PPS) in column 4. Comparing the figures in
two columns illustrates that GDP per capita at current exchange rates exaggerate considerably
differences in living standards within the EU, underestimate living standards in the USA and
overestimate them in Japan.3
Germany is clearly the dominant EU economy with about 20 per
cent of total EU production, and the four largest EU countries (France, Germany, Italy and the
United Kingdom) have about 63 percent of total EU production.
3
Purchasing power parity theory can be used to calculate synthetic exchange rates so that one ECU, in principle,represents the same purchasing power everywhere. Such alternative are published regularly in the source quoted
However, the disadvantage of Europe a la carte is the risk of serious legal, political and
administrative complications for the institutions and decision making processes of the EU when
different policy areas involve different group of participating countries. The EU Commission is
therefore very reluctant towards such a fragmentation of the Union.
1-5-2 Local Autonomy versus State Autonomy
As emphasized by Alesina and Spolaore (1995), integration can give increased local autonomy
within a nation state, for ties between local areas and the national state are loosened as power
and responsibilities are transferred from the national to the federal level. Local areas have
cultural, economic and political differences which cause them to have their own ideas about theinstitutional framework of their region and such matters as how taxes are raised and on how
money from the public budget should be spent. If a national state is surrounded by trade barriers,
it is of vital importance for the local area to have close ties to the national state, for consumers
and producers need access to a larger market and firms must ensure that their interests are
protected when trade with other nations is regulated. Local areas are also tied to the national
state by the public sector's redistribution of wealth between regions, and they are thus to some
extent protected against a sudden fall in living standards.
Integration in the EU reduces the dependence of local areas on the national state. Every local
area has direct access to the Single Market; transfers direct from the EU via, for example, the
Structural Funds can by-pass the national state; it is the EU which increasingly regulates
agriculture, manufacturing and services; and Monetary Union would subject local areas to EU
rather than national monetary policy. Seen in this light, continued integration of the EU suggests
a Europe of regions rather than a Europe of countries. Such a development would be in harmony
the TFEU, Article 167 which says that "The Union shall contribute to the flowering of the
cultures of the Member States, while respecting their national and regional diversity and at the
same time bringing the common cultural heritage to the fore".
1-6 PLAN OF THE BOOK
The book is divided into three parts: Part I, which is made up of Chapter 1, gives a background
to European economic integration; Part II, which includes Chapters 2-6, analyses the various
forms of economic integration within the framework of welfare and growth theory, while Part III
analyses macroeconomic issues, especially the monetary integration in Europe.
In Chapters 2 and 3 the welfare effects of removing internal trade restrictions, both visible and
invisible, are analysed, first in the light of perfect competition and subsequently under imperfect
competition.
Chapter 4 deals with some further issues that arise when economic integration is deepened
through the establishment of a common market. Chapter 5 analyses the dynamic effects of
economic integration, i.e. the question of whether the setting up of a common market influences
the growth rate in the EU member states over time. However, as it is not certain that economic
growth will distribute evenly in the various countries, the Chapter will also throw light on theregional economic consequences of integration. Efficiency and distribunal consequences of the
agricultural, competition, subsidy and external trade policies are being discussed in Chapter 6
together with a more fundamental discussion of whether the EU is the right level for pursuing
these microeconomic policies.
Chapters 7-10 deals with macroeconomic issues related to the establishing of the EMU. Chapter
7 discusses, based on the theory of the optimum currency area, the basic rationale for
establishing a currency union. Chapter 8 develops a macroeconomic model for a monetary union
based on external free float of common currency and free mobility of capital. Chapter 9 presents
the frame work for the monetary policy in the EMU. The mighty institution is here the European
Central Bank (ECB) and the competences, institutional set up and experiences on monetary
policy in the EMU are described in Chapter 9. Chapter 10 analyzes the framework for fiscal
policy in the EMU especially the Stability and Growth Pact. The Maastricht Treaty creates an
Economic and Monetary Union (EMU) by 1999 at the latest. Central to these chapters is thus an
analysis of the macroeconomic conditions for the countries who participate in a monetary union.
Participation in a monetary union may influence the countries' GDP, the price level, the balance
of payments, interest and currency rates. The possibilities to influence these variables by
economic policy are analyzed, partly at the abstract level by means of macroeconomic models,
and partly in relation to the factual conditions within the EU.
This appendix provides a brief presentation of the EU budget i.e. the expenditures and revenue
of EU-institutions. The EU Budget is established in accordance to the following principles and
guidelines:
• Principle of budget balance. This principle is outlined in TFEU Article 310, paragraph
1 which says that ”All items of revenue and expenditures of the Union shall be included
in estimates to be drawn up for each financial year and shall be shown in the budget.
…The revenue and expenditure shown in the budget shall be in balance”
• The basis for establishing the EU-budget is the Financial Framework which is a multi
annual budget of the yearly expenditures for a 7 years period. At present the items of expenditures of the EU annual budget follows from the Financial Framework 2007-
2013. For a detailed description and analysis of the EU-public finance, see EU-
Commission (2008).
The level and main structure of the expenditures is reported in Table A.1 for 2010.
Nearly half of the total expenditures is used to the common agricultural policy (CAP)
while the budget to regional policy (support of least developed countries and regions)
makes up about a third of total expenditures. Administrative costs make up about 8
percent of the total budget. This structure of expenditures is quite stable in the present
financial framework although the share of expenditures related to agriculture decline
slightly while expenditures to support economic growth is on rise, see Table A.3. Total
expenditures make up just about one percent of total EU Gross National Income
throughout all years of the present Financial Framework.
• The budget for revenue should be consistent with overall budget balance and
commitments given by the Financial Framework. Revenue consists of so-called ‘own
resources’ and for a very little fraction of ‘other revenue’, see Table A.3. The own
revenue consists of ‘traditional own resources’ which mostly is tariff revenue from
imports to the EU and member States contribution which is partly related to the tax base
for value added in the Member States and partly the Member States Gross National
The tariff revenue depends by and large on external conditions out of control of planner
of the budget. This is also the case for VAT-based contribution, which is calculated for
the individual countries in accordance to a given procedure. Hence, the GNI-based
resource is the ‘residual resource’ which is calculated so it closes the gap between total
expenditures and the total revenue from the other sources of revenue. The GNI
contribution in 2010 covers about 75 percent of the total budget while the VAT
contribution and the ‘traditional own resources’ only make up 11- 12 percent each of the
total budget. Similar to the expenditure structure the structure of sources of revenue is
quite stable from year to year.
•
Overall budget constraint. In the Financial Framework impose an overall ceiling ontotal own contribution to GNI. In the present Financial Framework the ceiling of ‘own
resources’ to GNI is 1.24 percent. This leaves a small margin between the ceiling of
total ‘own resources’ and total planned expenditures in accordance to the Financial
Framework, see Table A1.
Table A.1 Expenditure of the EU, 2010
Billion Percent of
Euro total expenditureSustainable growth
• Competitiveness for
growth and employment(1)
14.2 10
• Cohesion for growth and
employment(2)
49.4 35
Preservation and management
of natural resources (3) 60.0 43
Citizenship, freedom, security
and justice (4) 1.7 1EU as a global player 7.9 6
Administration(5)
7.9 6
Total planned expenditures 141.0 100
Notes: 1) Such as expenditure to research and development, education and training and trans – European
networks, 2) Support of the least developed countries and regions, 3) Most of these expenditures are related to
the common agricultural policy (CAP), 4) Expenditures to justice and home affairs, border protection,
immigration and asylum policy, 5) Expenditures to external actions including pre-accession support, (6)