International Trade

LEARNING OBJECTIVES

1 Describe the different levels of regional economic integration.

2 Understand the economic and political arguments for regional economic integration.

3 Understand the economic and political arguments against regional economic integration.

4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

5 Understand the implications for business that are inherent in regional economic integration agreements.

opening case I Want My Greek TV!

It’s now almost two decades since the member-states of the European Union started to implement a treaty calling for the establishment of a single market for goods and services across the union, and yet progress toward this goal is still not complete. A case in point: the TV broadcasts of Premier League soccer. The English Premier League, which is one of the most lucrative broadcasting sports franchises in Europe, if not the world, has for years segmented Europe into different national markets, charging different prices for broadcasting rights depending on local demand. Not surprisingly, the rights are most expensive in the United Kingdom, where the league has contracted with British Sky Broadcasting Group and ESPN to screen games.

Karen Murphy, the owner of the Red, White and Blue pub in Portsmouth, England, didn’t want to pay the £7,000 annual subscription fee that Sky demanded for access to the Premier League feed. Instead, she purchased a TV signal decoder card and used it to unscramble the feed from a Greek TV broadcaster, Nova, which had purchased the rights to broadcasting Premier League soccer in Greece. This cost her just £800 a year. In 2005, it also brought down a lawsuit from the Premier League. The initial judgment in a British court upheld the right of the Premier League to segment the market and charge a higher price to UK subscribers. Murphy was fined £8,000. She appealed the ruling, claiming the practice violated the EU’s Single Market Act, which the United Kingdom had signed in 1992.

The case eventually landed in the European Court of Justice, the EU’s highest court. The Premier League argued before the court that the EU needs individual national TV markets to satisfy the “cultural preferences” of viewers. The court did not agree. In a bombshell for the Premier League, on February 3, 2011, the court stated, “Territorial exclusivity agreements relating to the transmission of football matches are contrary to European Union Law. European Law does not make it possible to prohibit the live transmission of Premier League matches in pubs by means of foreign decoder cards.” In short, Murphy can continue to purchase her feed from Nova. This decision was a legal opinion prepared by the court’s advocate general, so technically it is still possible that the full court might overturn it, but in four out of five cases this does not happen.

This was not the first time the EU court had issued a ruling that affected Premier League soccer. In 1995, the court upheld the right of a Belgian soccer player to play in another EU country, stating athletes had the same freedom of movement as other EU workers. Ironically, this ruling, which also affirmed the principle of a single market, benefited Premier League clubs, enabling them to sign foreign players, rapidly transforming the league into the best in the world. The new ruling, however, creates significant challenges for the league. Revenue from broadcasting is a major source of income for Premier League clubs. The current deal giving British broadcasting rights to Sky and ESPN is worth some £1.782 billion to the league between 2010 and 2013. If the EU court affirms the ruling, many consumers may follow Murphy and buy TV decoders so that they can watch lower-cost feeds. If enough do this, the income loss from arbitrage by consumers may force the Premier League to move toward pan-European broadcasting and pricing. This will reduce income to the clubs, which could have a profound impact on the players they can recruit and the wages they can afford. In short, the ruling, while benefiting consumers such as Murphy and her customers at the Red, White and Blue pub, is a dark cloud hanging over the future of British soccer.•

Source: O. Gibson, “Round One to the Pub Lady,” The Guardian, February 4, 2011, p. 5; J. W. Miller, “European TV Market for Sports Faces Turmoil from Legal Ruling,”The Wall Street Journal, February 4, 2011; and J. Wilson, “What the Legal Wrangle Means for Armchair Fans,” The Daily Telegraph, February 4, 2011, p. 8.

Introduction

This chapter takes a close look at the arguments for regional economic integration through the establishment of trading blocs such as the European Union and the North American Free Trade Agreement. By regional economic integration we mean agreements among countries in a geographic region to reduce, and ultimately remove, tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other. The opening case illustrates some of the issues surrounding the creation of a trading bloc. By creating a single market, the EU aimed to lower the price for goods and services across the bloc. Such a policy is good for consumers, because it lowers prices, but it presents challenges to some producers who have to adapt to a more competitive environment. In the case of broadcasting rights for Premier League soccer, adopting a single market approach, as required by EU law, means the league cannot stop consumers in one country from subscribing to TV feeds from another country where the price is lower. While this is good for consumers, it reduces the value of Premier League broadcasting rights, driving down the income to Premier League clubs and hence the players they can afford to recruit and the salaries they can afford to pay. Thus, as with free trade in general, regional economic integration creates gain for consumers, but it can be challenging for some producers.

Regional Economic Integration

Agreements among countries in a geographic region to reduce and ultimately remove tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other.

The past two decades have witnessed an unprecedented proliferation of regional trade blocs that promote regional economic integration. World Trade Organization members are required to notify the WTO of any regional trade agreements in which they participate. By 2010, nearly all of the WTO’s members had notified the organization of participation in one or more regional trade agreements. The total number of regional trade agreements currently in force is more than 500.1

Consistent with the predictions of international trade theory and particularly the theory of comparative advantage (see Chapter 6), agreements designed to promote freer trade within regions are believed to produce gains from trade for all member countries. As we saw in Chapter 7, the General Agreement on Tariffs and Trade and its successor, the World Trade Organization, also seek to reduce trade barriers. With 153 member-states, the WTO has a worldwide perspective. By entering into regional agreements, groups of countries aim to reduce trade barriers more rapidly than can be achieved under the auspices of the WTO.

Nowhere has the movement toward regional economic integration been more successful than in Europe. On January 1, 1993, the European Union (EU) formally removed many barriers to doing business across borders within the EU in an attempt to create a single market with 340 million consumers. However, the EU did not stop there. The member-states of the EU have launched a single currency, the euro; they are moving toward a closer political union. On May 1, 2004, the EU expanded from 15 to 25 countries, and in 2007 two more countries joined—Bulgaria and Romania—making the total 27. Today, the EU has a population of almost 500 million and a gross domestic product of €12 trillion ($15.7 trillion), making it larger than the United States in economic terms.

Similar moves toward regional integration are being pursued elsewhere in the world. Canada, Mexico, and the United States have implemented the North American Free Trade Agreement (NAFTA). Ultimately, this aims to remove all barriers to the free flow of goods and services among the three countries. While the implementation of NAFTA has resulted in job losses in some sectors of the American economy, in aggregate and consistent with the predictions of international trade theory, most economists argue that the benefits of greater regional trade outweigh any costs. South America, too, has moved toward regional integration. In 1991, Argentina, Brazil, Paraguay, and Uruguay implemented an agreement known as Mercosur to start reducing barriers to trade between each other, and although progress within Mercosur has been halting, the institution is still in place. There are also active attempts at regional economic integration in Central America, the Andean region of South America, Southeast Asia, and parts of Africa.

While the move toward regional economic integration is generally seen as a good thing, some worry that it will lead to a world in which regional trade blocs compete against each other. In this future scenario, free trade will exist within each bloc, but each bloc will protect its market from outside competition with high tariffs. The specter of the EU and NAFTA turning into economic fortresses that shut out foreign producers through high tariff barriers is worrisome to those who believe in unrestricted free trade. If such a situation were to materialize, the resulting decline in trade between blocs could more than offset the gains from free trade within blocs.

With these issues in mind, this chapter will explore the economic and political debate surrounding regional economic integration, paying particular attention to the economic and political benefits and costs of integration; review progress toward regional economic integration around the world; and map the important implications of regional economic integration for the practice of international business. Before tackling these objectives, we first need to examine the levels of integration that are theoretically possible.

Levels of Economic Integration

LEARNING OBJECTIVE 1

Describe the different levels of regional economic integration.

Several levels of economic integration are possible in theory (see Figure 9.1). From least integrated to most integrated, they are a free trade area, a customs union, a common market, an economic union, and, finally, a full political union.

FIGURE 9.1 Levels of Economic Integration

In a free trade area , all barriers to the trade of goods and services among member-countries are removed. In the theoretically ideal free trade area, no discriminatory tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade between members. Each country, however, is allowed to determine its own trade policies with regard to nonmembers. Thus, for example, the tariffs placed on the products of nonmember countries may vary from member to member. Free trade agreements are the most popular form of regional economic integration, accounting for almost 90 percent of regional agreements.2

Free Trade Area

A group of countries committed to removing all barriers to the free flow of goods and services between each other, but pursuing independent external trade policies.

The most enduring free trade area in the world is the European Free Trade Association (EFTA) . Established in January 1960, EFTA currently joins four countries—Norway, Iceland, Liechtenstein, and Switzerland—down from seven in 1995 (three EFTA members, Austria, Finland, and Sweden, joined the EU on January 1, 1996). EFTA was founded by those western European countries that initially decided not to be part of the European Community (the forerunner of the EU). Its original members included Austria, Great Britain, Denmark, Finland, and Sweden, all of which are now members of the EU. The emphasis of EFTA has been on free trade in industrial goods. Agriculture was left out of the arrangement, each member being allowed to determine its own level of support. Members are also free to determine the level of protection applied to goods coming from outside EFTA. Other free trade areas include the North American Free Trade Agreement, which we shall discuss in depth later in the chapter.

European Free Trade Association (EFTA)

A free trade association including Norway, Iceland, Liechtenstein, and Switzerland.

ANOTHER PERSPECTIVE Economic Integration in the Classical World

Traditionally, the success of the Roman Empire has been explained by economic historians as an example of centralized, forced reallocation of goods. Recent scholarship, though, suggests that there was not a single empire-wide, centralized market for all goods, but that local markets were connected and that most exchanges were voluntary, based on reciprocity and exchange. Ancient Rome had an economic system that was an enormous, integrated conglomeration of interdependent markets. Transportation and communication took time, and the discipline of the market was loose. But there were many voluntary economic connections between even far-flung parts of the early Roman Empire.

Sources: Karl Polanyi, The Livelihood of Man (New York: Academic Press, 1977); and Peter Temin, “Market Economy in the Early Roman Empire,” University of Oxford, Discussion Papers in Economic and Social History.

The customs union is one step farther along the road to full economic and political integration. A customs union eliminates trade barriers between member countries and adopts a common external trade policy. Establishment of a common external trade policy necessitates significant administrative machinery to oversee trade relations with nonmembers. Most countries that enter into a customs union desire even greater economic integration down the road. The EU began as a customs union, but it has now moved beyond this stage. Other customs unions include the current version of the Andean Community (formerly known as the Andean Pact) among Bolivia, Colombia, Ecuador, and Peru. The Andean Community established free trade between member-countries and imposes a common tariff, of 5 to 20 percent, on products imported from outside.3

Customs Union

A group of countries committed to (1) removing all barriers to the free flow of goods and services between each other and (2) the pursuit of a common external trade policy.

The next level of economic integration, a common market , has no barriers to trade among member-countries, includes a common external trade policy, and allows factors of production to move freely among members. Labor and capital are free to move because there are no restrictions on immigration, emigration, or cross-border flows of capital among member-countries. Establishing a common market demands a significant degree of harmony and cooperation on fiscal, monetary, and employment policies. Achieving this degree of cooperation has proven very difficult. For years, the European Union functioned as a common market, although it has now moved beyond this stage. Mercosur—the South American grouping of Argentina, Brazil, Paraguay, and Uruguay—hopes to eventually establish itself as a common market. Venezuela was accepted as a full member of Mercosur subject to ratification by the governments of the four existing members. As of early 2012, Paraguay has yet to ratify Venezuela’s membership.

Common Market

A group of countries committed to (1) removing all barriers to the free flow of goods, services, and factors of production between each other and (2) the pursuit of a common external trade policy.

An economic union entails even closer economic integration and cooperation than a common market. Like the common market, an economic union involves the free flow of products and factors of production among member-countries and the adoption of a common external trade policy, but it also requires a common currency, harmonization of members’ tax rates, and a common monetary and fiscal policy. Such a high degree of integration demands a coordinating bureaucracy and the sacrifice of significant amounts of national sovereignty to that bureaucracy. The EU is an economic union, although an imperfect one because not all members of the EU have adopted the euro, the currency of the EU; differences in tax rates and regulations across countries still remain; and some markets, such as the market for energy, are still not fully deregulated.

Economic Union

A group of countries committed to (1) the removal of all barriers to the free flow of goods, services, and factors of production between each other; (2) the adoption of a common currency; (3) the harmonization of tax rates; and (4) the pursuit of a common external trade policy.

The move toward economic union raises the issue of how to make a coordinating bureaucracy accountable to the citizens of member-nations. The answer is through political union in which a central political apparatus coordinates the economic, social, and foreign policy of the member states. The EU is on the road toward at least partial political union. The European Parliament, which is playing an ever more important role in the EU, has been directly elected by citizens of the EU countries since the late 1970s. In addition, the Council of Ministers (the controlling, decision-making body of the EU) is composed of government ministers from each EU member. The United States provides an example of even closer political union; in the United States, independent states are effectively combined into a single nation. Ultimately, the EU may move toward a similar federal structure.

Political Union

A central political apparatus that coordinates economic, social, and foreign policy.

• QUICK STUDY

What are the differences among a free trade area, a customs union, a common market, and an economic union?

At what level of regional economic integration does a degree of political unification become desirable?

The Case for Regional Integration

LEARNING OBJECTIVE 2

Understand the economic and political arguments for regional economic integration.

The case for regional integration is both economic and political, and it is typically not accepted by many groups within a country, which explains why most attempts to achieve regional economic integration have been contentious and halting. In this section, we examine the economic and political cases for integration and two impediments to integration. In the next section, we look at the case against integration.

THE ECONOMIC CASE FOR INTEGRATION

The economic case for regional integration is straightforward. We saw in Chapter 6 how economic theories of international trade predict that unrestricted free trade will allow countries to specialize in the production of goods and services that they can produce most efficiently. The result is greater world production than would be possible with trade restrictions. That chapter also revealed how opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. Chapter 6 detailed how foreign direct investment (FDI) can transfer technological, marketing, and managerial know-how to host nations. Given the central role of knowledge in stimulating economic growth, opening a country to FDI also is likely to stimulate economic growth. In sum, economic theories suggest that free trade and investment is a positive-sum game, in which all participating countries stand to gain.

Given this, the theoretical ideal is an absence of barriers to the free flow of goods, services, and factors of production among nations. However, as we saw in Chapters 7 and 8, a case can be made for government intervention in international trade and FDI. Because many governments have accepted part or all of the case for intervention, unrestricted free trade and FDI have proved to be only an ideal. Although international institutions such as the WTO have been moving the world toward a free trade regime, success has been less than total. In a world of many nations and many political ideologies, it is very difficult to get all countries to agree to a common set of rules.

Against this background, regional economic integration can be seen as an attempt to achieve additional gains from the free flow of trade and investment between countries beyond those attainable under international agreements such as the WTO. It is easier to establish a free trade and investment regime among a limited number of adjacent countries than among the world community. Coordination and policy harmonization problems are largely a function of the number of countries that seek agreement. The greater the number of countries involved, the more perspectives that must be reconciled, and the harder it will be to reach agreement. Thus, attempts at regional economic integration are motivated by a desire to exploit the gains from free trade and investment.

THE POLITICAL CASE FOR INTEGRATION

The political case for regional economic integration also has loomed large in several attempts to establish free trade areas, customs unions, and the like. Linking neighboring economies and making them increasingly dependent on each other creates incentives for political cooperation between the neighboring states and reduces the potential for violent conflict. In addition, by grouping their economies, the countries can enhance their political weight in the world.

These considerations underlay the 1957 establishment of the European Community (EC), the forerunner of the EU. Europe had suffered two devastating wars in the first half of the twentieth century, both arising out of the unbridled ambitions of nation-states. Those who have sought a united Europe have always had a desire to make another war in Europe unthinkable. Many Europeans also believed that after World War II, the European nation-states were no longer large enough to hold their own in world markets and politics. The need for a united Europe to deal with the United States and the politically alien Soviet Union loomed large in the minds of many of the EC’s founders.4 A long-standing joke in Europe is that the European Commission should erect a statue to Joseph Stalin, for without the aggressive policies of the former dictator of the old Soviet Union, the countries of western Europe may have lacked the incentive to cooperate and form the EC.

IMPEDIMENTS TO INTEGRATION

Despite the strong economic and political arguments in support, integration has never been easy to achieve or sustain for two main reasons. First, although economic integration aids the majority, it has its costs. While a nation as a whole may benefit significantly from a regional free trade agreement, certain groups may lose. Moving to a free trade regime involves painful adjustments. For example, due to the 1994 establishment of NAFTA, some Canadian and U.S. workers in such industries as textiles, which employ low-cost, low-skilled labor, lost their jobs as Canadian and U.S. firms moved production to Mexico. The promise of significant net benefits to the Canadian and U.S. economies as a whole is little comfort to those who lose as a result of NAFTA. Such groups have been at the forefront of opposition to NAFTA and will continue to oppose any widening of the agreement.

A second impediment to integration arises from concerns over national sovereignty. For example, Mexico’s concerns about maintaining control of its oil interests resulted in an agreement with Canada and the United States to exempt the Mexican oil industry from any liberalization of foreign investment regulations achieved under NAFTA. Concerns about national sovereignty arise because close economic integration demands that countries give up some degree of control over such key issues as monetary policy, fiscal policy (e.g., tax policy), and trade policy. This has been a major stumbling block in the EU. To achieve full economic union, the EU introduced a common currency, the euro, controlled by a central EU bank. Although most member-states have signed on, Great Britain remains an important holdout. A politically important segment of public opinion in that country opposes a common currency on the grounds that it would require relinquishing control of the country’s monetary policy to the EU, which many British perceive as a bureaucracy run by foreigners. In 1992, the British won the right to opt out of any single currency agreement, and as of 2012, the British government has yet to reverse its decision—and it does not seem likely to do so, given the sovereign debt crisis in Europe and the strains it has placed on the euro (more on this later).

• QUICK STUDY

What are the main economic arguments for regional economic integration?

What are the main political arguments for regional economic integration?

What are the main impediments to regional economic integration?

The Case Against Regional Integration

LEARNING OBJECTIVE 3

Understand the economic and political arguments against regional economic integration.

Although the tide has been running in favor of regional free trade agreements in recent years, some economists have expressed concern that the benefits of regional integration have been oversold, while the costs have often been ignored. 5 They point out that the benefits of regional integration are determined by the extent of trade creation, as opposed to trade diversion. Trade creation occurs when high-cost domestic producers are replaced by low-cost producers within the free trade area. It may also occur when higher-cost external producers are replaced by lower-cost external producers within the free trade area. Trade diversion occurs when lower-cost external suppliers are replaced by higher-cost suppliers within the free trade area. A regional free trade agreement will benefit the world only if the amount of trade it creates exceeds the amount it diverts.

Trade Creation

Trade created due to regional economic integration; occurs when high-cost domestic producers are replaced by low-cost foreign producers in a free trade area.

Trade Diversion

Trade diverted due to regional economic integration; occurs when low-cost foreign suppliers outside a free trade area are replaced by higher-cost foreign suppliers in a free trade area.

Suppose the United States and Mexico imposed tariffs on imports from all countries, and then they set up a free trade area, scrapping all trade barriers between themselves but maintaining tariffs on imports from the rest of the world. If the United States began to import textiles from Mexico, would this change be for the better? If the United States previously produced all its own textiles at a higher cost than Mexico, then the free trade agreement has shifted production to the cheaper source. According to the theory of comparative advantage, trade has been created within the regional grouping, and there would be no decrease in trade with the rest of the world. Clearly, the change would be for the better. If, however, the United States previously imported textiles from Costa Rica, which produced them more cheaply than either Mexico or the United States, then trade has been diverted from a low-cost source—a change for the worse.

ANOTHER PERSPECTIVE China Complains to WTO Against the U.S. Solar Protectionism

The United States Department of Commerce (DOC) recently imposed import tariffs from 31 percent to 250 percent on Chinese solar panel manufacturers, accusing Beijing of dumping the solar cells in the U.S. It all started in October when seven solar firms, including SolarWorld A.G. (ETR:SWV), filed a complaint with the U.S. International Trade Commission and Commerce accusing the Chinese solar cell manufacturers of improper trade practices. The U.S. immediately started investigating into the matter, which eventually led to trade barriers. This compelled China to start its own investigation into the U.S. in November. According to China’s mission to WTO headquarters in Geneva, the U.S. investigation process was inconsistent with “WTO rules and rulings in many aspects.” If the U.S. import subsidies were meant to support the local solar industry, which has witnessed four bankruptcies in the past year, then it has missed its target by miles. The U.S. actions could have initiated a trade war between the two biggest economies of the world. The U.S. and other western economies are going through a period of financial recovery. Their focus is on cutting down expenses and creating more jobs. Under such circumstances, according to WTO chief Pascal Lamy, the wrong thing to do is to erect more trade barriers, which can provide short-term relief at the cost of long-term damage.

Source: Excerpted from “China Complains to WTO Against the U.S. Solar Protectionism,” by Sarfaraz Khan, May 26, 2012, http://solarpvinvestor.com/spvi-news/222-china-complains-to-wto-against-the-us-solar-protectionism. Reprinted with permission.

In theory, WTO rules should ensure that a free trade agreement does not result in trade diversion. These rules allow free trade areas to be formed only if the members set tariffs that are not higher or more restrictive to outsiders than the ones previously in effect. However, as we saw in Chapter 7, GATT and the WTO do not cover some nontariff barriers. As a result, regional trade blocs could emerge whose markets are protected from outside competition by high nontariff barriers. In such cases, the trade diversion effects might outweigh the trade creation effects. The only way to guard against this possibility, according to those concerned about this potential, is to increase the scope of the WTO so it covers nontariff barriers to trade. There is no sign that this is going to occur anytime soon, however, so the risk remains that regional economic integration will result in trade diversion.

• QUICK STUDY

What are the main economic arguments against regional economic integration?

When does the establishment of a regional bloc result in trade creation? When does it result in trade diversion?

Regional Economic Integration in Europe

LEARNING OBJECTIVE 4

Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

Europe has two trade blocs—the European Union and the European Free Trade Association. Of the two, the EU is by far the more significant, not just in terms of membership (the EU currently has 27 members; the EFTA has 4), but also in terms of economic and political influence in the world economy. Many now see the EU as an emerging economic and political superpower of the same order as the United States. Accordingly, we will concentrate our attention on the EU. 6

EVOLUTION OF THE EUROPEAN UNION

The European Union (EU) is the product of two political factors: (1) the devastation of western Europe during two world wars, and the desire for a lasting peace, and (2) the European nations’ desire to hold their own on the world’s political and economic stage. In addition, many Europeans were aware of the potential economic benefits of closer economic integration of the countries.

European Union (EU)

An economic group of 27 European nations; established as a customs union, it is moving toward economic union; formerly the European Community.

The forerunner of the EU, the European Coal and Steel Community, was formed in 1951 by Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands. Its objective was to remove barriers to intragroup shipments of coal, iron, steel, and scrap metal. With the signing of the Treaty of Rome in 1957, the European Community was established. The name changed again in 1993 when the European Community became the European Union following the ratification of the Maastricht Treaty (discussed later).

Treaty of Rome

The 1957 treaty that established the European Community.

The Treaty of Rome provided for the creation of a common market. Article 3 of the treaty laid down the key objectives of the new community, calling for the elimination of internal trade barriers and the creation of a common external tariff and requiring member-states to abolish obstacles to the free movement of factors of production among the members. To facilitate the free movement of goods, services, and factors of production, the treaty provided for any necessary harmonization of the member-states’ laws. Furthermore, the treaty committed the EC to establish common policies in agriculture and transportation.

The community grew in 1973, when Great Britain, Ireland, and Denmark joined. These three were followed in 1981 by Greece; in 1986 by Spain and Portugal; and in 1995 by Austria, Finland, and Sweden—bringing the total membership to 15 (East Germany became part of the EC after the reunification of Germany in 1990). Another 10 countries joined the EU on May 1, 2004—8 of them from eastern Europe plus the small Mediterranean nations of Malta and Cyprus. Bulgaria and Romania joined in 2007, bringing the total number of member states to 27 (see Map 9.1). With a population of almost 500 million and a GDP of €12.5 trillion, the EU is larger than the United States. Through these enlargements, the EU has become a global superpower.7

MAP 9.1 Member-States of the European Union in 2011

Source: Copyright © European Communities, 1995–2009. Reproduced with permission.

POLITICAL STRUCTURE OF THE EUROPEAN UNION

The economic policies of the EU are formulated and implemented by a complex and still-evolving political structure. The four main institutions in this structure are the European Commission, the Council of the European Union, the European Parliament, and the Court of Justice.8

The European Commission is responsible for proposing EU legislation, implementing it, and monitoring compliance with EU laws by member-states. Headquartered in Brussels, Belgium, the commission has around 23,000 employees. It is run by a group of commissioners appointed by each member country for five-year renewable terms. There are 27 commissioners, one from each member state. A president of the commission is chosen by member-states, and the president then chooses other members in consultation with the states. The entire commission has to be approved by the European Parliament before it can begin work. The commission has a monopoly in proposing European Union legislation. The commission makes a proposal, which goes to the Council of the European Union and then to the European Parliament. The council cannot legislate without a commission proposal in front of it. The commission is also responsible for implementing aspects of EU law, although in practice much of this must be delegated to member-states. Another responsibility of the commission is to monitor member-states to make sure they are complying with EU laws. In this policing role, the commission will normally ask a state to comply with any EU laws that are being broken. If this persuasion is not sufficient, the commission can refer a case to the Court of Justice.

European Commission

Body responsible for proposing EU legislation, implementing it, and monitoring compliance.

The European Commission’s role in competition policy has become increasingly important to business in recent years. Since 1990 when the office was formally assigned a role in competition policy, the EU’s competition commissioner has been steadily gaining influence as the chief regulator of competition policy in the member-nations of the EU. As with antitrust authorities in the United States, which include the Federal Trade Commission and the Department of Justice, the role of the competition commissioner is to ensure that no one enterprise uses its market power to drive out competitors and monopolize markets. In 2009, for example, the Commission fined Intel a record €1.06 billion for abusing its market power in the computer chip market. (See the next Management Focus for details.) The previous record for a similar abuse was €497 billion imposed on Microsoft in 2004 for blocking competition in markets for server computers and media software. The commissioner also reviews proposed mergers and acquisitions to make sure they do not create a dominant enterprise with substantial market power.9 For example, in 2000 a proposed merger between Time Warner of the United States and EMI of the United Kingdom, both music recording companies, was withdrawn after the commission expressed concerns that the merger would reduce the number of major record companies from five to four and create a dominant player in the $40 billion global music industry. Similarly, the commission blocked a proposed merger between two U.S. telecommunication companies, WorldCom and Sprint, because their combined holdings of Internet infrastructure in Europe would give the merged companies so much market power that the commission argued the combined company would dominate that market.

MANAGEMENT FOCUS The European Commission and Intel

In May 2009, the European Commission announced that it had imposed a record €1.6 billion ($1.45 billion) fine on Intel for anti-competitive behavior. This fine was the result of an investigation into Intel’s competitive conduct during the period from October 2002 to December 2007. During this time period, Intel’s market share of microprocessor sales to personal computer manufacturers consistently exceeded 70 percent. According to the Commission, Intel illegally used its market power to ensure that its major rival, AMD, was at a competitive disadvantage, thereby harming “millions of European consumers.”

The Commission charged that Intel granted major rebates to PC manufacturers—including Acer, Dell, Hewlett-Packard, Lenovo, and NEC—on the condition that they purchased all or almost all of their supplies from Intel. Intel also made payments to some manufacturers in exchange for them postponing, canceling, or putting restrictions on the introduction or distribution of AMD-based products. Intel also apparently made payments to Media Saturn Holdings, the owner of MediaMarkt chain of superstores, for only selling Intel-based computers in Germany, Belgium, and other countries.

Under the order, Intel had to change its practices immediately, pending any appeal. The company was also required to write a bank guarantee for the fine, although that guarantee is held in a bank until the appeal process is exhausted.

For its part, Intel immediately appealed the ruling. The company insisted that it had never coerced computer makers and retailers with inducements and maintained that Intel had never paid to stop AMD products from reaching the market in Europe. Although Intel acknowledges that it did offer rebates, it claimed that they were never conditional on specific actions by manufacturers and retailers aimed to limit AMD. As of early 2012, the appeal was still working its way through the judicial process.

Sources: M. Hachman, “EU Hits Intel with $1.45 Billion Fine for Antitrust Violations,” PCMAG.com, May 13, 2009; and J. Kanter, “Europe Fines Intel $1.45 billion in Antitrust Case,” New York Times, May 14, 2009.

The European Council represents the interests of member-states. It is clearly the ultimate controlling authority within the EU because draft legislation from the commission can become EU law only if the council agrees. The council is composed of one representative from the government of each member-state. The membership, however, varies depending on the topic being discussed. When agricultural issues are being discussed, the agriculture ministers from each state attend council meetings; when transportation is being discussed, transportation ministers attend, and so on. Before 1993, all council issues had to be decided by unanimous agreement among member-states. This often led to marathon council sessions and a failure to make progress or reach agreement on commission proposals. In an attempt to clear the resulting logjams, the Single European Act formalized the use of majority voting rules on issues “which have as their object the establishment and functioning of a single market.” Most other issues, however, such as tax regulations and immigration policy, still require unanimity among council members if they are to become law. The votes that a country gets in the council are related to the size of the country. For example, Britain, a large country, has 29 votes, whereas Denmark, a much smaller state, has 7 votes.

European Council

The ultimate controlling authority within the EU.

The European Parliament , which as of 2012 has 754 members, is directly elected by the populations of the member-states. The parliament, which meets in Strasbourg, France, is primarily a consultative rather than legislative body. It debates legislation proposed by the commission and forwarded to it by the council. It can propose amendments to that legislation, which the commission and ultimately the council are not obliged to take up but often will. The power of the parliament recently has been increasing, although not by as much as parliamentarians would like. The European Parliament now has the right to vote on the appointment of commissioners as well as veto some laws (such as the EU budget and single-market legislation).

European Parliament

Elected EU body that consults on issues proposed by European Commission.

One major debate waged in Europe during the past few years is whether the council or the parliament should ultimately be the most powerful body in the EU. Some in Europe expressed concern over the democratic accountability of the EU bureaucracy. One side argued that the answer to this apparent democratic deficit lay in increasing the power of the parliament, while others think that true democratic legitimacy lies with elected governments, acting through the Council of the European Union.10 After significant debate, in December 2007 the member-states signed a new treaty, the Treaty of Lisbon , under which the power of the European Parliament is increased. When it took effect in December 2009, for the first time in history the European Parliament was the co-equal legislator for almost all European laws.11 The Treaty of Lisbon also creates a new position, a president of the European Council, who serves a 30-month term and represents the nation-states that make up the EU.

Treaty of Lisbon

Treaty signed in 2007 that made the European Parliament the co-equal legislator for almost all European laws and also created the position of the president of the European Council.

The Court of Justice , which is comprised of one judge from each country, is the supreme appeals court for EU law. Like commissioners, the judges are required to act as independent officials, rather than as representatives of national interests. The commission or a member-country can bring other members to the court for failing to meet treaty obligations. Similarly, member-countries, companies, or institutions can bring the commission or council to the court for failure to act according to an EU treaty.

Court of Justice

Supreme appeals court for EU law.

THE SINGLE EUROPEAN ACT

The Single European Act was born of a frustration among members that the community was not living up to its promise. By the early 1980s, it was clear that the EC had fallen short of its objectives to remove barriers to the free flow of trade and investment among member-countries and to harmonize the wide range of technical and legal standards for doing business. Against this background, many of the EC’s prominent businesspeople mounted an energetic campaign in the early 1980s to end the EC’s economic divisions. The EC responded by creating the Delors Commission. Under the chairmanship of Jacques Delors, the commission proposed that all impediments to the formation of a single market be eliminated by December 31, 1992. The result was the Single European Act, which was independently ratified by the parliaments of each member-country and became EC law in 1987.

The Objectives of the Act

The purpose of the Single European Act was to have one market in place by December 31, 1992. The act proposed the following changes:12

• Remove all frontier controls among EC countries, thereby abolishing delays and reducing the resources required for complying with trade bureaucracy.

• Apply the principle of “mutual recognition” to product standards. A standard developed in one EC country should be accepted in another, provided it meets basic requirements in such matters as health and safety.

• Institute open public procurement to nonnational suppliers, reducing costs directly by allowing lower-cost suppliers into national economies and indirectly by forcing national suppliers to compete.

• Lift barriers to competition in the retail banking and insurance businesses, which should drive down the costs of financial services, including borrowing, throughout the EC.

• Remove all restrictions on foreign exchange transactions between member-countries by the end of 1992.

• Abolish restrictions on cabotage—the right of foreign truckers to pick up and deliver goods within another member-state’s borders—by the end of 1992. Estimates suggested this would reduce the cost of haulage within the EC by 10 to 15 percent.

All those changes were expected to lower the costs of doing business in the EC, but the single-market program was also expected to have more complicated supply-side effects. For example, the expanded market was predicted to give EC firms greater opportunities to exploit economies of scale. In addition, it was thought that the increase in competitive intensity brought about by removing internal barriers to trade and investment would force EC firms to become more efficient. To signify the importance of the Single European Act, the European Community also decided to change its name to the European Union once the act took effect.

COUNTRY FOCUS Creating a Single Market in Financial Services

The European Union in 1999 embarked upon an ambitious action plan to create a single market in financial services by January 1, 2005. Launched a few months after the euro, the EU’s single currency, the goal was to dismantle barriers to cross-border activity in financial services, creating a continentwide market for banking service, insurance services, and investment products. In this vision of a single Europe, a citizen of France might use a German firm for basic banking services, borrow a home mortgage from an Italian institution, buy auto insurance from a Dutch enterprise, and keep her savings in mutual funds managed by a British company. Similarly, an Italian firm might raise capital from investors across Europe, using a German firm as its lead underwriter to issue stock for sale through stock exchanges in London and Frankfurt.

One main benefit of a single market, according to its advocates, would be greater competition for financial services, which would give consumers more choices, lower prices, and require financial service firms in the EU to become more efficient, thereby increasing their global competitiveness. Another major benefit would be the creation of a single European capital market. The increased liquidity of a larger capital market would make it easier for firms to borrow funds, lowering their cost of capital (the price of money) and stimulating business investment in Europe, which would create more jobs. A European Commission study suggested that the creation of a single market in financial services would increase the EU’s gross domestic product by 1.1 percent a year, creating an additional 130 billion euros (€) in wealth over a decade. Total business investment would increase by 6 percent annually in the long run, private consumption by 0.8 percent, and total employment by 0.5 percent a year.

Creating a single market has been anything but easy. The financial markets of different EU member-states have historically been segmented from each other, and each has its own regulatory framework. In the past, EU financial services firms rarely did business across national borders because of a host of different national regulations with regard to taxation, oversight, accounting information, cross-border takeovers, and the like—all of which had to be harmonized. To complicate matters, longstanding cultural and linguistic barriers complicated the move toward a single market. While in theory an Italian might benefit by being able to purchase homeowners’ insurance from a British company, in practice he might be predisposed to purchase it from a local enterprise, even if the price were higher.

By 2012, the EU had made significant progress. More than 40 measures designed to create a single market in financial services had become EU law and others were in the pipeline. The new rules embraced issues as diverse as the conduct of business by investment firms, stock exchanges, and banks; disclosure standards for listing companies on public exchanges; and the harmonization of accounting standards across nations. However, there had also been some significant setbacks. Most notably, legislation designed to make it easier for firms to make hostile cross-border acquisitions was defeated, primarily due to opposition from German members of the European Parliament, making it more difficult for financial service firms to build pan-European operations. In addition, national governments have still reserved the right to block even friendly cross-border mergers between financial service firms.

The critical issue now is enforcement of the rules that have been put in place. Some believe that it will be at least another decade before the benefits of the new regulations become apparent. In the meantime, the changes may impose significant costs on financial institutions as they attempt to deal with the new raft of regulations.

Sources: C. Randzio-Plath, “Europe Prepares for a Single Financial Market,” Intereconomic, May–June 2004, pp. 142–46; T. Buck, D. Hargreaves, and P. Norman, “Europe’s Single Financial Market,” Financial Times, January 18, 2005, p. 17; “The Gate-keeper,” The Economist, February 19, 2005, p. 79; P. Hofheinz, “A Capital Idea: The European Union Has a Grand Plan to Make Its Financial Markets More Efficient,” The Wall Street Journal, October 14, 2002, p. R4; and “Banking on McCreevy: Europe’s Single Market,” The Economist, November 26, 2005, p. 91.

Impact

The Single European Act has had a significant impact on the EU economy.13 The act provided the impetus for the restructuring of substantial sections of European industry. Many firms have shifted from national to pan-European production and distribution systems in an attempt to realize scale economies and better compete in a single market. The results have included faster economic growth than would otherwise have been the case.

However, 20 years after the formation of a single market, the reality still falls short of the ideal. In the opening case, for example, we saw how until 2011 sports organizations such as soccer’s Premier League had still been able to segment the EU into different national markets for auctioning off broadcast rights. Another example is given in the accompanying Country Focus, which describes the slow progress toward establishing a fully functioning single market for financial services in the EU. Thus, although the EU is undoubtedly moving toward a single marketplace, established legal, cultural, and language differences among nations mean that implementation has been uneven.

THE ESTABLISHMENT OF THE EURO

In February 1992, EC members signed a treaty (the Maastricht Treaty ) that committed them to adopting a common currency by January 1, 1999.14 The euro is now used by 17 of the 27 member-states of the European Union; these 17 states are members of what is often referred to as the euro zone. It encompasses 330 million EU citizens and includes the powerful economies of Germany and France. Many of the countries that joined the EU on May 1, 2004, and the two that joined in 2007, originally planned to adopt the euro when they fulfilled certain economic criteria—a high degree of price stability, a sound fiscal situation, stable exchange rates, and converged long-term interest rates (the current members had to meet the same criteria). However, the events surrounding the EU sovereign debt crisis of 2010–2012 persuaded many of these countries to put their plans on hold, at least for the time being (further details provided later).

Maastricht Treaty

Treaty agreed to in 1991, but not ratified until January 1, 1994, that committed the 12 member-states of the European Community to adopt a common currency.

Establishment of the euro was an amazing political feat with few historical precedents. It required participating national governments to give up their own currencies and national control over monetary policy. Governments do not routinely sacrifice national sovereignty for the greater good, indicating the importance that the Europeans attach to the euro. By adopting the euro, the EU has created the second most widely traded currency in the world after that of the U.S. dollar. Some believe that the euro could come to rival the dollar as the most important currency in the world.

Three long-term EU members—Great Britain, Denmark, and Sweden—are still sitting on the sidelines. The countries agreeing to the euro locked their exchange rates against each other January 1, 1999. Euro notes and coins were not actually issued until January 1, 2002. In the interim, national currencies circulated in each participating state. However, in each country the national currency stood for a defined amount of euros. After January 1, 2002, euro notes and coins were issued and the national currencies were taken out of circulation. By mid-2002, all prices and routine economic transactions within the euro zone were in euros.

Benefits of the Euro

Europeans decided to establish a single currency in the EU for a number of reasons. First, they believe that businesses and individuals realize significant savings from having to handle one currency, rather than many. These savings come from lower foreign exchange and hedging costs. For example, people going from Germany to France no longer have to pay a commission to a bank to change German deutsche marks into French francs. Instead, they are able to use euros. According to the European Commission, such savings amount to 0.5 percent of the European Union’s GDP, or about $80 billion a year.

Second, and perhaps more importantly, the adoption of a common currency makes it easier to compare prices across Europe. This has been increasing competition because it has become easier for consumers to shop around. For example, if a German finds that cars sell for less in France than Germany, he may be tempted to purchase from a French car dealer rather than his local car dealer. Alternatively, traders may engage in arbitrage to exploit such price differentials, buying cars in France and reselling them in Germany. The only way that German car dealers will be able to hold on to business in the face of such competitive pressures will be to reduce the prices they charge for cars. As a consequence of such pressures, the introduction of a common currency has led to lower prices, which translates into substantial gains for European consumers.

Third, faced with lower prices, European producers have been forced to look for ways to reduce their production costs to maintain their profit margins. The introduction of a common currency, by increasing competition, has produced long-run gains in the economic efficiency of European companies.

Fourth, the introduction of a common currency has given a boost to the development of a highly liquid pan-European capital market. Over time, the development of such a capital market should lower the cost of capital and lead to an increase in both the level of investment and the efficiency with which investment funds are allocated. This could be especially helpful to smaller companies that have historically had difficulty borrowing money from domestic banks. For example, the capital market of Portugal is very small and illiquid, which makes it extremely difficult for bright Portuguese entrepreneurs with a good idea to borrow money at a reasonable price. However, in theory, such companies can now tap a much more liquid pan-European capital market.

Finally, the development of a pan-European, euro-denominated capital market will increase the range of investment options open to both individuals and institutions. For example, it will now be much easier for individuals and institutions based in, let’s say, Holland to invest in Italian or French companies. This will enable European investors to better diversify their risk, which again lowers the cost of capital, and should also increase the efficiency with which capital resources are allocated.15

ANOTHER PERSPECTIVE Can the Euro Survive 2012?

With the current eurozone crisis the question is, will the euro survive? The answer lies in examining several interesting facts of the European Union. First, the lack of a European treasury is the missing piece of the puzzle. Without it, the ECB is limited in the assistance it can provide to eurozone member states. In theory, the ECB could bail out those member states burdened with excessive debt by printing more money. However, that would require the approval of all 27 member states (not just the 17 eurozone that use the euro as their national currency) that make up the EU. Germany is opposed to any such measure that may light the fires of inflation. Some of the EU members also think it is unfair to bail out those states that have lived beyond their means for many years now. It is difficult to compare the difficulties within the EU to those of other nations that have faced similar problems and survived. That’s because the EU is not a cohesive nation. The 27 member nations of the EU are separated geographically. In addition, they literally and figuratively don’t even speak the same language. United States has a vested interest in EU[;] the collapse of the EU, or the euro, would have an impact on the U.S. economy. The eurozone by itself is the United States’ third-largest export destination, accounting for 15 percent of total U.S. exports.

Source: http://seekingalpha.com/article/565381-can-the-euro-survive-2012.

Costs of the Euro

The drawback, for some, of a single currency is that national authorities have lost control over monetary policy. Thus, it is crucial to ensure that the EU’s monetary policy is well managed. The Maastricht Treaty called for establishment of the independent European Central Bank (ECB), similar in some respects to the U.S. Federal Reserve, with a clear mandate to manage monetary policy so as to ensure price stability. The ECB, based in Frankfurt, is meant to be independent from political pressure—although critics question this. Among other things, the ECB sets interest rates and determines monetary policy across the euro zone.

The implied loss of national sovereignty to the ECB underlies the decision by Great Britain, Denmark, and Sweden to stay out of the euro zone. Many in these countries are suspicious of the ECB’s ability to remain free from political pressure and to keep inflation under tight control.

In theory, the design of the ECB should ensure that it remains free of political pressure. The ECB is modeled on the German Bundesbank, which historically has been the most independent and successful central bank in Europe. The Maastricht Treaty prohibits the ECB from taking orders from politicians. The executive board of the bank, which consists of a president, vice president, and four other members, carries out policy by issuing instructions to national central banks. The policy itself is determined by the governing council, which consists of the executive board plus the central bank governors from the 17 euro zone countries. The governing council votes on interest rate changes. Members of the executive board are appointed for eight-year nonrenewable terms, insulating them from political pressures to get reappointed. Nevertheless, the jury is still out on the issue of the ECB’s independence, and it will take some time for the bank to establish its credentials.

According to critics, another drawback of the euro is that the EU is not what economists would call an optimal currency area. In an optimal currency area , similarities in the underlying structure of economic activity make it feasible to adopt a single currency and use a single exchange rate as an instrument of macroeconomic policy. Many of the European economies in the euro zone, however, are very dissimilar. For example, Finland and Portugal have different wage rates, tax regimes, and business cycles, and they may react very differently to external economic shocks. A change in the euro exchange rate that helps Finland may hurt Portugal. Obviously, such differences complicate macroeconomic policy. For example, when euro economies are not growing in unison, a common monetary policy may mean that interest rates are too high for depressed regions and too low for booming regions.

Optimal Currency Area

One where similarities among the economic structures of countries make it feasible to adopt a single currency.

One way of dealing with such divergent effects within the euro zone is for the EU to engage in fiscal transfers, taking money from prosperous regions and pumping it into depressed regions. Such a move, however, opens a political can of worms. Would the citizens of Germany forgo their “fair share” of EU funds to create jobs for underemployed Greece workers? Not surprisingly, there is strong political opposition to such practices.

The Euro Experience: 1999 to the Sovereign Debt Crisis

Since its establishment January 1, 1999, the euro has had a volatile trading history against the world’s major currency, the U.S. dollar. After starting life in 1999 at €1 = $1.17, the euro steadily fell until it reached a low of €1 = $0.83 in October 2000, leading critics to claim the euro was a failure. A major reason for the fall in the euro’s value was that international investors were investing money in booming U.S. stocks and bonds and taking money out of Europe to finance this investment. In other words, they were selling euros to buy dollars so that they could invest in dollar-denominated assets. This increased the demand for dollars and decreased the demand for the euro, driving the value of the euro down.

The fortunes of the euro began improving in late 2001 when the dollar weakened; the currency stood at a robust all-time high of €1 = $1.54 in early March 2008. One reason for the rise in the value of the euro was that the flow of capital into the United States stalled as the U.S. financial markets fell during 2007 and 2008.16 Many investors were now taking money out of the United States, selling dollar-denominated assets such as U.S. stocks and bonds, and purchasing euro-denominated assets. Falling demand for U.S. dollars and rising demand for euros translated into a fall in the value of the dollar against the euro. Furthermore, in a vote of confidence in both the euro and the ability of the ECB to manage monetary policy within the euro zone, many foreign central banks added more euros to their supply of foreign currencies. In the first three years of its life, the euro never reached the 13 percent of global reserves made up by the deutsche mark and other former euro zone currencies. The euro didn’t jump that hurdle until early 2002, but by 2011 it stood at 26.3 percent.17

Since 2008 however, the euro has weakened, reflecting persistent concerns over slow economic growth and large budget deficits among several EU member-states, particularly Greece, Portugal, Ireland, Italy, and Spain. During the 2000s, all of these governments had sharply increased their government debt to finance public spending. Government debt as a percentage of GDP hit record levels in many of these nations. By 2010, private investors became increasingly concerned that many of these nations would not be able to service their sovereign debt, particularly given the economic slowdown following the 2008–2009 global financial crisis. They sold off government bonds of troubled nations, driving down bond prices and driving up the cost of government borrowing (bond prices and interest rates are inversely related). This led to fears that several national governments, particularly Greece, might default on their sovereign debt, plunging the euro zone into an economic crisis. To try and stave off such a sovereign debt crisis, in May 2010 the euro zone nations and the International Monetary Fund (IMF) agreed to a €110 billion bailout package to help rescue Greece. In November 2010, the EU and IMF agreed to a bailout package for Ireland of €85 billion; in May 2011, euro zone countries and the IMF instituted a €78 billion bailout plan for Portugal. In return for these loans, all three countries had to agree to sharp reductions in government spending, which meant slower economic growth and high unemployment until government debt was reduced to more sustainable levels. While Italy and Spain did not request bailout packages, both countries were forced by falling bond prices to institute austerity programs that required big reductions in government spending. The euro zone nations also set up a permanent bailout fund—the European Stability Mechanism—worth about €500 billion, which was designed to restore confidence in the euro. As detailed in the next Country Focus, by early 2012 Greece had been granted two more bailout packages in an attempt to forestall a full-blown default on payment of its sovereign debt.

As might be expected, the economic turmoil led to a decline in the value of the euro. By early 2012, the dollar euro exchange rate stood at €1 = $1.32, some way below its 2008 level but still significantly better than the exchange rate in early 2000. The euro also declined by 20 to 30 percent against most of the world’s other major currencies between late 2008 and 2012.

More troubling perhaps for the long run success of the euro, many of the newer EU nations that had committed to adopting the euro put their plans on hold. Countries like Poland and the Czech Republic had no desire to join the euro zone and then have their taxpayers help bail out the profligate governments of countries like Greece. To compound matters, the sovereign debt crisis had exposed a deep flaw in the euro zone—it was difficult for fiscally more conservative nations like Germany to limit profligate spending by the governments of other nations that might subsequently create strains and impose costs on the entire euro zone. The Germans in particular found themselves in the unhappy position of having to underwrite loans to bail out the governments of Greece, Portugal, and Ireland. This started to erode support for the euro in the stronger EU states. To try and correct this flaw, 25 of the EU’s 27 nations signed a fiscal pact in January 2012 that made it more difficult for member-states to break tight new rules on government deficits (the UK and Czech Republic abstained). Whether such actions will be sufficient to get the euro back on track remains to be seen.

COUNTRY FOCUS The Greek Sovereign Debt Crisis

When the euro was established, some critics worried that free-spending countries in the euro zone (such as Italy and Greece) might borrow excessively, running up large public-sector deficits that they could not finance. This would then rock the value of the euro, requiring their more sober brethren, such as Germany or France, to step in and bail out the profligate nation. In 2010, this worry became a reality as a financial crisis in Greece hit the value of the euro.

The financial crisis had its roots in a decade of free spending by the Greek government, which ran up a high level of debt to finance extensive spending in the public sector. Much of the spending increase could be characterized as an attempt by the government to buy off powerful interest groups in Greek society, from teachers and farmers to public-sector employees, rewarding them with high pay and extensive benefits. To make matters worse, the government misled the international community about the level of its indebtedness. In October 2009, a new government took power and quickly announced that the 2009 public-sector deficit, which had been projected to be around 5 percent, would actually be 12.7 percent. The previous government had apparently been cooking the books.

This shattered any faith that international investors might have had in the Greek economy. Interest rates on Greek government debt quickly surged to 7.1 percent, about 4 percentage points higher than the rate on German bonds. Two of the three international rating agencies also cut their ratings on Greek bonds and warned that further downgrades were likely. The main concern now was that the Greek government might not be able to refinance some €20 billion of debt that would mature in April or May of 2010. A further concern was that the Greek government might lack the political willpower to make the large cuts in public spending necessary to bring down the deficit and restore investor confidence.

Nor was Greece alone in having large public-sector deficits. Three other euro zone countries—Spain, Portugal, and Ireland—also all had large debt loads, and interest rates on their bonds also surged as investors sold out. This raised the specter of financial contagion, with large-scale defaults among the weaker members of the euro zone. If this did occur, the EU and IMF would most certainly have to step in and rescue the troubled nations. With this possibility, once considered very remote, investors started to move money out of euros, and the value of the euro started to fall on the foreign exchange market.

Recognizing that the unthinkable might happen—and that without external help, Greece might default on its government debt, pushing the EU and the euro into a major crisis—in May 2010 the euro zone countries, led by Germany, along with the IMF agreed to lend Greece up to €110 billion. These loans were judged sufficient to cover Greece’s financing needs for three years. In exchange, the Greek government agreed to implement a series of strict austerity measures. These included tax increases, major cuts in public-sector pay, reductions in benefits enjoyed by public-sector employees (e.g., the retirement age was increased to 65 from 61 and limits were placed on pensions), and reductions in the number of public-sector enterprises from 6,000 to 2,000. However, the Greek economy contracted so fast in 2010 and 2011 that tax revenues plunged. By the end of 2011, the Greek economy was almost 29 percent smaller than it had been in 2005, while unemployment approached 20 percent. The contracting tax base limited the ability of the government to pay down debt. By early 2012, yields on 10-year Greek government debt reached 34 percent, indicating that many investors now expected Greece to default on its sovereign debt. This forced the Greek government to seek further aid from the euro zone countries and the IMF. As a condition for a fresh €130 billion bailout plan, the Greek government had to get holders of Greek government bonds to agree to the biggest sovereign debt restructuring in history, In effect, bondholders agreed to write off 53.5 percent of the debt they held. While the Greek government had not technically defaulted on its sovereign debt, to many it seemed as if the EU and IMF had orchestrated an orderly partial default. Whether that might be enough to stave off a complete default in Greece remains to be seen.

Sources: “A Very European Crisis,” The Economist, February 6, 2010, pp. 75–77; L. Thomas, “Is Debt Trashing the Euro?” The New York Times, February 7, 2010, pp. 1, 7; “Bite the Bullet,” The Economist, January 15, 2011, pp. 77–79; and “The Wait Is Over,” The Economist, March 17, 2012, pp. 83–84.

ENLARGEMENT OF THE EUROPEAN UNION

A major issue facing the EU over the past few years has been that of enlargement. Enlargement of the EU into eastern Europe has been a possibility since the collapse of communism at the end of the 1980s, and by the end of the 1990s, 13 countries had applied to become EU members. To qualify for EU membership, the applicants had to privatize state assets, deregulate markets, restructure industries, and tame inflation. They also had to enshrine complex EU laws into their own systems, establish stable democratic governments, and respect human rights.18 In December 2002, the EU formally agreed to accept the applications of 10 countries, and they joined May 1, 2004. The new members include the Baltic countries, the Czech Republic, and the larger nations of Hungary and Poland. The only new members not in eastern Europe are the Mediterranean island nations of Malta and Cyprus. Their inclusion in the EU expanded the union to 25 states, stretching from the Atlantic to the borders of Russia; added 23 percent to the landmass of the EU; brought 75 million new citizens into the EU, building an EU with a population of 450 million people; and created a single continental economy with a GDP of close to €11 trillion. In 2007, Bulgaria and Romania joined, bringing total membership to 27 nations.

The new members were not able to adopt the euro until at least 2007 (and 2010 in the case of the latest entrants), and free movement of labor among the new and existing members was prohibited until then (none of them had adopted the euro as of early 2012). Consistent with theories of free trade, the enlargement should create added benefits for all members. However, given the small size of the eastern European economies (together they amount to only 5 percent of the GDP of current EU members), the initial impact will probably be small. The biggest notable change might be in the EU bureaucracy and decision-making processes, where budget negotiations among 27 nations are bound to prove more problematic than negotiations among 15 nations.

Left standing at the door is Turkey. Turkey, which has long lobbied to join the union, presents the EU with some difficult issues. The country has had a customs union with the EU since 1995, and about half of its international trade is already with the EU. However, full membership has been denied because of concerns over human rights issues (particularly Turkish policies toward its Kurdish minority). In addition, some on the Turk side suspect the EU is not eager to let a primarily Muslim nation of 74 million people, which has one foot in Asia, join the EU. The EU formally indicated in December 2002 that it would allow the Turkish application to proceed with no further delay in December 2004 if the country improved its human rights record to the satisfaction of the EU. In December 2004, the EU agreed to allow Turkey to start accession talks in October 2005, but those talks are not moving along rapidly, and at this point, it is unclear when the nation will join.

• QUICK STUDY

What political and economic forces led to the establishment of the European Community (the forerunner of the European Union)?

Why is the EU such an important player on the world stage?

What were the basic goals of the Single European Act?

Why did the EU introduce the euro? What were the benefits?

What are the potential drawbacks of the euro?

What were the causes of the EU’s sovereign debt crisis?

LEARNING OBJECTIVE 4

Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

ANOTHER PERSPECTIVE As NAFTA Nurtures Mexican Economy, Illegal Immigration Dwindles

The wave of immigration from Mexico that began four decades ago, most of it unauthorized, has ended, possibly for good. As a report from the Pew Hispanic Center confirms, net migration from Mexico to the U.S. sank to about zero in the past five years. Did the North American Free Trade Agreement play a role? Yes and no. Actually, the number of Mexicans living illegally in the U.S. shot up from 2.5 million in 1995, the year after NAFTA took effect, to 11 million in 2005. The main reason was the booming U.S. economy, which generated huge demand for labor just as the share of Mexico’s population aged 15 to 39, prime migration years, was peaking at about 75 percent. Migration plummeted after 2005 because of reduced U.S. demand for labor and the slowing of Mexican population growth, but also because NAFTA started to pay off in the form of dynamic new export industries in Mexico such as automobile manufacturing. The gap in wages, although wide, between U.S. and Mexico, has narrowed to the point where staying home is economically rational for a growing number of Mexican workers. NAFTA encouraged both the U.S. and Mexico to make optimal use of their scarce resources. Over time, NAFTA helped make Mexico more efficient and, hence, wealthier. It formed part of a broader restructuring that has transformed Mexico from the underdeveloped, authoritarian country it was 30 years ago to the increasingly middle-class democracy it is now.

Source: www.lehighvalleylive.com/opinion/index.ssf/2012/04/editorial_as_nafta_nurtures_me.html.

Regional Economic Integration in the Americas

No other attempt at regional economic integration comes close to the EU in its boldness or its potential implications for the world economy, but regional economic integration is on the rise in the Americas. The most significant attempt is the North American Free Trade Agreement. In addition to NAFTA, several other trade blocs are in the offing in the Americas (see Map 9.2), the most significant of which appear to be the Andean Community and Mercosur. Also, negotiations are under way to establish a hemispherewide Free Trade Area of the Americas (FTAA), although currently they seem to be stalled.

MAP 9.2 Economic Integration in the Americas

THE NORTH AMERICAN FREE TRADE AGREEMENT

The governments of the United States and Canada in 1988 agreed to enter into a free trade agreement, which took effect January 1, 1989. The goal of the agreement was to eliminate all tariffs on bilateral trade between Canada and the United States by 1998. This was followed in 1991 by talks among the United States, Canada, and Mexico aimed at establishing a North American Free Trade Agreement for the three countries. The talks concluded in August 1992 with an agreement in principle, and the following year the agreement was ratified by the governments of all three countries. The agreement became law January 1, 1994.19

North American Free Trade Agreement (NAFTA)

Free trade area among Canada, Mexico, and the United States.

NAFTA’S Contents

The contents of NAFTA include the following:

Abolition by 2004 of tariffs on 99 percent of the goods traded among Mexico, Canada, and the United States.

Removal of most barriers on the cross-border flow of services, allowing financial institutions, for example, unrestricted access to the Mexican market by 2000.

Protection of intellectual property rights.

Removal of most restrictions on foreign direct investment among the three member-countries, although special treatment (protection) will be given to Mexican energy and railway industries, American airline and radio communications industries, and Canadian culture.

Application of national environmental standards, provided such standards have a scientific basis. Lowering of standards to lure investment is described as being inappropriate.

Establishment of two commissions with the power to impose fines and remove trade privileges when environmental standards or legislation involving health and safety, minimum wages, or child labor are ignored.

The Case for NAFTA

Proponents of NAFTA have argued that the free trade area should be viewed as an opportunity to create an enlarged and more efficient productive base for the entire region. Advocates acknowledge that one effect of NAFTA would be that some U.S. and Canadian firms would move production to Mexico to take advantage of lower labor costs. (In 2004, the average hourly labor cost in Mexico was still one-tenth of that in the United States and Canada.) Movement of production to Mexico, they argued, was most likely to occur in low-skilled, labor-intensive manufacturing industries where Mexico might have a comparative advantage. Advocates of NAFTA argued that many would benefit from such a trend. Mexico would benefit from much-needed inward investment and employment. The United States and Canada would benefit because the increased incomes of the Mexicans would allow them to import more U.S. and Canadian goods, thereby increasing demand and making up for the jobs lost in industries that moved production to Mexico. U.S. and Canadian consumers would benefit from the lower prices of products made in Mexico. In addition, the international competitiveness of U.S. and Canadian firms that moved production to Mexico to take advantage of lower labor costs would be enhanced, enabling them to better compete with Asian and European rivals.

The Case Against NAFTA

Those who opposed NAFTA claimed that ratification would be followed by a mass exodus of jobs from the United States and Canada into Mexico as employers sought to profit from Mexico’s lower wages and less strict environmental and labor laws. According to one extreme opponent, Ross Perot, up to 5.9 million U.S. jobs would be lost to Mexico after NAFTA in what he famously characterized as a “giant sucking sound.” Most economists, however, dismissed these numbers as being absurd and alarmist. They argued that Mexico would have to run a bilateral trade surplus with the United States of close to $300 billion for job loss on such a scale to occur—and $300 billion was the size of Mexico’s GDP. In other words, such a scenario seemed implausible.

More sober estimates of the impact of NAFTA ranged from a net creation of 170,000 jobs in the United States (due to increased Mexican demand for U.S. goods and services) and an increase of $15 billion per year to the joint U.S. and Mexican GDP, to a net loss of 490,000 U.S. jobs. To put these numbers in perspective, employment in the U.S. economy was predicted to grow by 18 million from 1993 to 2003. As most economists repeatedly stressed, NAFTA would have a small impact on both Canada and the United States. It could hardly be any other way, because the Mexican economy was only 5 percent of the size of the U.S. economy. Signing NAFTA required the largest leap of economic faith from Mexico rather than Canada or the United States. Falling trade barriers would expose Mexican firms to highly efficient U.S. and Canadian competitors that, when compared to the average Mexican firm, had far greater capital resources, access to highly educated and skilled workforces, and much greater technological sophistication. The short-run outcome was likely to be painful economic restructuring and unemployment in Mexico. But advocates of NAFTA claimed there would be long-run dynamic gains in the efficiency of Mexican firms as they adjusted to the rigors of a more competitive marketplace. To the extent that this occurred, they argued, Mexico’s economic growth rate would accelerate, and Mexico might become a major market for Canadian and U.S. firms.20

Environmentalists also voiced concerns about NAFTA. They pointed to the sludge in the Rio Grande and the smog in the air over Mexico City and warned that Mexico could degrade clean air and toxic waste standards across the continent. They pointed out that the lower Rio Grande was the most polluted river in the United States, and that with NAFTA, chemical waste and sewage would increase along its course from El Paso, Texas, to the Gulf of Mexico.

There was also opposition in Mexico to NAFTA from those who feared a loss of national sovereignty. Mexican critics argued that their country would be dominated by U.S. firms that would not really contribute to Mexico’s economic growth, but instead would use Mexico as a low-cost assembly site, while keeping their high-paying, high-skilled jobs north of the border.

NAFTA: The Results

Studies of NAFTA’s impact suggest its initial effects were at best muted, and both advocates and detractors may have been guilty of exaggeration.21 On average, studies indicate that NAFTA’s overall impact has been small but positive.22 From 1993 to 2005, trade among NAFTA’s partners grew by 250 percent.23 Canada and Mexico are now among the top three trading partners of the United States (the other is China), suggesting the economies of the three NAFTA nations have become more closely integrated. In 1990, U.S. trade with Canada and Mexico accounted for about a quarter of total U.S. trade. By 2005, the figure was close to one-third. Canada’s trade with its NAFTA partners increased from about 70 percent to more than 80 percent of all Canadian foreign trade between 1993 and 2005, while Mexico’s trade with NAFTA increased from 66 percent to 80 percent over the same period. All three countries also experienced strong productivity growth over this period. In Mexico, labor productivity has increased by 50 percent since 1993, and the passage of NAFTA may have contributed to this. However, estimates suggest that employment effects of NAFTA have been small. The most pessimistic estimates suggest the United States lost 110,000 jobs per year due to NAFTA between 1994 and 2000—and many economists dispute this figure—which is tiny compared to the more than 2 million jobs a year created in the United States during the same period.

Perhaps the most significant impact of NAFTA has not been economic, but political. Many observers credit NAFTA with helping to create the background for increased political stability in Mexico. For most of the post-NAFTA period, Mexico has been viewed as a stable democratic nation with a steadily growing economy, something that is beneficial to the United States, which shares a 2,000-mile border with the country.24 However, recent events have cast a cloud over Mexico’s future. In late 2006, newly elected Mexican President Felipe Calderon initiated a crackdown on Mexico’s increasingly powerful drug cartels (whose main business has been the illegal trafficking of drugs across the border into the United States). Calderon sent 6,500 troops into the Mexican state of Michoacan to end escalating drug violence there. The cartels responded by escalating their own violence, and the country is now gripped in what amounts to an all-out war. Fueled by the lucrative business of selling drugs to the United States and armed with guns purchased in the United States, the cartels have been fighting each other and the Mexican authorities in an increasingly brutal conflict that claimed 9,000 lives in 2009 and another 15,000 in 2010, and which many fear threatens to spill into the United States.25

Enlargement

One issue confronting NAFTA is that of enlargement. A number of other Latin American countries have indicated their desire to eventually join NAFTA. The governments of both Canada and the United States are adopting a wait-and-see attitude with regard to most countries. Getting NAFTA approved was a bruising political experience, and neither government is eager to repeat the process soon. Nevertheless, the Canadian, Mexican, and U.S. governments began talks in 1995 regarding Chile’s possible entry into NAFTA. As of 2011, however, these talks had yielded little progress, partly because of political opposition in the U.S. Congress to expanding NAFTA. In December 2002, however, the United States and Chile did sign a bilateral free trade pact.

THE ANDEAN COMMUNITY

Bolivia, Chile, Ecuador, Colombia, and Peru signed an agreement in 1969 to create the Andean Pact. The Andean Pact was largely based on the EU model, but was far less successful at achieving its stated goals. The integration steps begun in 1969 included an internal tariff reduction program, a common external tariff, a transportation policy, a common industrial policy, and special concessions for the smallest members, Bolivia and Ecuador.

Andean Pact

A 1969 agreement among Bolivia, Chile, Ecuador, Colombia, and Peru to establish a customs union.

By the mid-1980s, the Andean Pact had all but collapsed and had failed to achieve any of its stated objectives. There was no tariff-free trade among member-countries, no common external tariff, and no harmonization of economic policies. Political and economic problems seem to have hindered cooperation among member-countries. The countries of the Andean Pact have had to deal with low economic growth, hyperinflation, high unemployment, political unrest, and crushing debt burdens. In addition, the dominant political ideology in many of the Andean countries during this period tended toward the radical/socialist end of the political spectrum. Because such an ideology is hostile to the free market economic principles on which the Andean Pact was based, progress toward closer integration could not be expected.

The tide began to turn in the late 1980s when, after years of economic decline, the governments of Latin America began to adopt free market economic policies. In 1990, the heads of the five current members of the Andean Community—Bolivia, Ecuador, Peru, Colombia, and Venezuela—met in the Galápagos Islands. The resulting Galápagos Declaration effectively relaunched the Andean Pact, which was renamed the Andean Community in 1997. The declaration’s objectives included the establishment of a free trade area by 1992, a customs union by 1994, and a common market by 1995. This last milestone has not been reached. A customs union was implemented in 1995—although Peru opted out and Bolivia received preferential treatment until 2003. The Andean Community now operates as a customs union. In December 2005, it signed an agreement with Mercosur to restart stalled negotiations on the creation of a free trade area between the two trading blocs. Those negotiations are proceeding at a slow pace. In late 2006, Venezuela withdrew from the Andean Community as part of that country’s attempts to join Mercosur.

MERCOSUR

Mercosur originated in 1988 as a free trade pact between Brazil and Argentina. The modest reductions in tariffs and quotas accompanying this pact reportedly helped bring about an 80 percent increase in trade between the two countries in the late 1980s.26 This success encouraged the expansion of the pact in March 1990 to include Paraguay and Uruguay. In 2006, the pact was further expanded when Venezuela joined Mercosur, although it may take years for Venezuela to become fully integrated into the pact. As of 2012, Paraguay had yet to ratify the agreement allowing Venezuela to become a full member of Mercosur.

Mercosur

Pact among Argentina, Brazil, Paraguay, and Uruguay to establish a free trade area.

The initial aim of Mercosur was to establish a full free trade area by the end of 1994 and a common market sometime thereafter. In December 1995, Mercosur’s members agreed to a five-year program under which they hoped to perfect their free trade area and move toward a full customs union—something that has yet to be achieved.27 For its first eight years or so, Mercosur seemed to be making a positive contribution to the economic growth rates of its member-states. Trade among the four core members quadrupled between 1990 and 1998. The combined GDP of the four member-states grew at an annual average rate of 3.5 percent between 1990 and 1996, a performance that is significantly better than the four attained during the 1980s.28

However, Mercosur had its critics, including Alexander Yeats, a senior economist at the World Bank, who wrote a stinging critique.29 According to Yeats, the trade diversion effects of Mercosur outweigh its trade creation effects. Yeats pointed out that the fastest growing items in intra-Mercosur trade were cars, buses, agricultural equipment, and other capital-intensive goods that are produced relatively inefficiently in the four member-countries. In other words, Mercosur countries, insulated from outside competition by tariffs that run as high as 70 percent of value on motor vehicles, are investing in factories that build products that are too expensive to sell to anyone but themselves. The result, according to Yeats, is that Mercosur countries might not be able to compete globally once the group’s external trade barriers come down. In the meantime, capital is being drawn away from more efficient enterprises. In the near term, countries with more efficient manufacturing enterprises lose because Mercosur’s external trade barriers keep them out of the market.

Mercosur hit a significant roadblock in 1998, when its member-states slipped into recession and intrabloc trade slumped. Trade fell further in 1999 following a financial crisis in Brazil that led to the devaluation of the Brazilian real, which immediately made the goods of other Mercosur members 40 percent more expensive in Brazil, their largest export market. At this point, progress toward establishing a full customs union all but stopped. Things deteriorated further in 2001 when Argentina, beset by economic stresses, suggested the customs union be temporarily suspended. Argentina wanted to suspend Mercosur’s tariff so that it could abolish duties on imports of capital equipment, while raising those on consumer goods to 35 percent (Mercosur had established a 14 percent import tariff on both sets of goods). Brazil agreed to this request, effectively halting Mercosur’s quest to become a fully functioning customs union.30 Hope for a revival arose in 2003 when new Brazilian President Lula da Silva announced his support for a revitalized and expanded Mercosur modeled after the EU with a larger membership, a common currency, and a democratically elected Mercosur parliament.31 As of 2011, however, little progress had been made in moving Mercosur down that road, and critics believed the customs union was, if anything, becoming more imperfect over time.32

CENTRAL AMERICAN COMMON MARKET, CAFTA, AND CARICOM

Two other trade pacts in the Americas have not made much progress. In the early 1960s, Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua attempted to set up a Central American Common Market . It collapsed in 1969 when war broke out between Honduras and El Salvador after a riot at a soccer match between teams from the two countries. Since then, the member-countries have made some progress toward reviving their agreement (the five founding members were joined by the Dominican Republic). The proposed common market was given a boost in 2003 when the United States signaled its intention to enter into bilateral free trade negotiations with the group. These culminated in a 2004 agreement to establish a free trade agreement between the six countries and the United States. Known as the Central America Free Trade Agreement , or CAFTA , the aim is to lower trade barriers between the United States and the six countries for most goods and services.

Central American Common Market

A trade pact among Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua, which began in the early 1960s but collapsed in 1969 due to war.

Central America Free Trade Agreement (CAFTA)

The agreement of the member-states of the Central American Common Market joined by the Dominican Republic to trade freely with the United States.

A customs union was to have been created in 1991 between the English-speaking Caribbean countries under the auspices of the Caribbean Community. Referred to as CARICOM , it was established in 1973. However, it repeatedly failed to progress toward economic integration. A formal commitment to economic and monetary union was adopted by CARICOM’s member-states in 1984, but since then, little progress has been made. In October 1991, the CARICOM governments failed, for the third consecutive time, to meet a deadline for establishing a common external tariff. Despite this, CARICOM expanded to 15 members by 2005. In early 2006, six CARICOM members established the Caribbean Single Market and Economy (CSME) . Modeled on the EU’s single market, CSME’s goal is to lower trade barriers and harmonize macroeconomic and monetary policy between member states.33

CARICOM

An association of English-speaking Caribbean states that are attempting to establish a customs union.

Caribbean Single Market and Economy (CSME)

Unites six CARICOM members in agreeing to lower trade barriers and harmonize macroeconomic and monetary policies.

FREE TRADE AREA OF THE AMERICAS

At a hemispherewide Summit of the Americas in December 1994, a Free Trade Area of the Americas (FTAA) was proposed. It took more than three years for the talks to start, but in April 1998, 34 heads of state traveled to Santiago, Chile, for the second Summit of the Americas, where they formally inaugurated talks to establish an FTAA by January 1, 2005—something that didn’t occur. The continuing talks have addressed a wide range of economic, political, and environmental issues related to cross-border trade and investment. Although both the United States and Brazil were early advocates of the FTAA, support from both countries seems to be mixed at this point. Because the United States and Brazil have the largest economies in North and South America, respectively, strong U.S. and Brazilian support is a precondition for establishment of the free trade area.

The major stumbling blocks so far have been twofold. First, the United States wants its southern neighbors to agree to tougher enforcement of intellectual property rights and lower manufacturing tariffs, which they do not seem to be eager to embrace. Second, Brazil and Argentina want the United States to reduce its subsidies to U.S. agricultural producers and scrap tariffs on agricultural imports, which the U.S. government does not seem inclined to do. For progress to be made, most observers agree that the United States and Brazil have to first reach an agreement on these crucial issues.34 If the FTAA is eventually established, it will have major implications for cross-border trade and investment flows within the hemisphere. The FTAA would open a free trade umbrella over 850 million people, who accounted for some $18 trillion in GDP in 2008.

Currently, however, FTAA is very much a work in progress, and the progress has been slow. The most recent attempt to get talks going again, in November 2005 at a summit of 34 heads of state from North and South America, failed when opponents, led by Venezuela’s populist President Hugo Chavez, blocked efforts by the Bush administration to set an agenda for further talks on FTAA. In voicing his opposition, Chavez condemned the U.S. free trade model as a “perversion” that would unduly benefit the United States to the detriment of poor people in Latin America whom Chavez claims have not benefited from free trade details.35 Such views make it unlikely that there will be much progress on establishing a FTAA in the near term.

Regional Economic Integration Elsewhere

LEARNING OBJECTIVE 4

Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

Numerous attempts at regional economic integration have been tried throughout Asia and Africa. However, few exist in anything other than name. Perhaps the most significant is the Association of Southeast Asian Nations (ASEAN). In addition, the Asia-Pacific Economic Cooperation (APEC) forum has recently emerged as the seed of a potential free trade region.

ASSOCIATION OF SOUTHEAST ASIAN NATIONS

Formed in 1967, the Association of Southeast Asian Nations (ASEAN) includes Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam. Laos, Myanmar, Vietnam, and Cambodia have all joined recently, creating a regional grouping of 500 million people with a combined GDP of some $740 billion (see Map 9.3). The basic objective of ASEAN is to foster freer trade among member countries and to achieve cooperation in their industrial policies. Progress so far has been limited, however.

Association of Southeast Asian Nations (ASEAN)

An attempt to establish a free trade area among Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam.

MAP 9.3 ASEAN Countries

Source: Reprinted with permission, www.asean.org.

Until recently, only 5 percent of intra-ASEAN trade consisted of goods whose tariffs had been reduced through an ASEAN preferential trade arrangement. This may be changing. In 2003, an ASEAN Free Trade Area (AFTA) among the six original members of ASEAN came into full effect. The AFTA has cut tariffs on manufacturing and agricultural products to less than 5 percent. However, there are some significant exceptions to this tariff reduction. Malaysia, for example, refused to bring down tariffs on imported cars until 2005 and then agreed to lower the tariff only to 20 percent, not the 5 percent called for under the AFTA. Malaysia wanted to protect Proton, an inefficient local carmaker, from foreign competition. Similarly, the Philippines has refused to lower tariff rates on petrochemicals, and rice, the largest agricultural product in the region, will remain subject to higher tariff rates until at least 2020.36

Notwithstanding such issues, ASEAN and AFTA are at least progressing toward establishing a free trade zone. Vietnam joined the AFTA in 2006, Laos and Myanmar in 2008, and Cambodia in 2010. The goal was to reduce import tariffs among the six original members to zero by 2010 and to do so by 2015 for the newer members (although important exceptions to that goal, such as tariffs on rice, will persist).

ASEAN also recently signed a free trade agreement with China that removes tariffs on 90 percent of traded goods. This went into effect January 1, 2010. Trade between China and ASEAN members more than tripled during the first decade of the twenty-first century, and this agreement should spur further growth.37

ASIA-PACIFIC ECONOMIC COOPERATION

The Asia-Pacific Economic Cooperation (APEC) was founded in 1990 at the suggestion of Australia. APEC currently has 21 member-states, including such economic powerhouses as the United States, Japan, and China (see Map 9.4). Collectively, the member-states account for about 55 percent of the world’s GNP, 49 percent of world trade, and much of the growth in the world economy. The stated aim of APEC is to increase multilateral cooperation in view of the economic rise of the Pacific nations and the growing interdependence within the region. U.S. support for APEC was also based on the belief that it might prove a viable strategy for heading off any moves to create Asian groupings from which it would be excluded.

MAP 9.4 APEC Members

Source: From www.apec.org. Reprinted with permission.

Interest in APEC was heightened considerably in November 1993 when the heads of APEC member states met for the first time at a two-day conference in Seattle. Debate before the meeting speculated on the likely future role of APEC. One view was that APEC should commit itself to the ultimate formation of a free trade area. Such a move would transform the Pacific Rim from a geographical expression into the world’s largest free trade area. Another view was that APEC would produce no more than hot air and lots of photo opportunities for the leaders involved. As it turned out, the APEC meeting produced little more than some vague commitments from member-states to work together for greater economic integration and a general lowering of trade barriers. However, member-states did not rule out the possibility of closer economic cooperation in the future.38

The heads of state have met again on a number of occasions. At a 1997 meeting, member-states formally endorsed proposals designed to remove trade barriers in 15 sectors, ranging from fish to toys. However, the vague plan committed APEC to doing no more than holding further talks, which is all that has been accomplished to date. Commenting on the vagueness of APEC pronouncements, the influential Brookings Institution, a U.S.-based economic policy institution, noted APEC “is in grave danger of shrinking into irrelevance as a serious forum.” Despite the slow progress, APEC is worth watching. If it eventually does transform itself into a free trade area, it will probably be the world’s largest.39

REGIONAL TRADE BLOCS IN AFRICA

African countries have been experimenting with regional trade blocs for half a century. There are now nine trade blocs on the African continent. Many countries are members of more than one group. Although the number of trade groups is impressive, progress toward the establishment of meaningful trade blocs has been slow.

Many of these groups have been dormant for years. Significant political turmoil in several African nations has persistently impeded any meaningful progress. Also, deep suspicion of free trade exists in several African countries. The argument most frequently heard is that because these countries have less developed and less diversified economies, they need to be “protected” by tariff barriers from unfair foreign competition. Given the prevalence of this argument, it has been hard to establish free trade areas or customs unions.

The most recent attempt to reenergize the free trade movement in Africa occurred in early 2001, when Kenya, Uganda, and Tanzania, member-states of the East African Community (EAC), committed themselves to relaunching their bloc, 24 years after it collapsed. The three countries, with 80 million inhabitants, intend to establish a customs union, regional court, legislative assembly, and, eventually, a political federation.

Their program includes cooperation on immigration, road and telecommunication networks, investment, and capital markets. However, while local business leaders welcomed the relaunch as a positive step, they were critical of the EAC’s failure in practice to make progress on free trade. At the EAC treaty’s signing in November 1999, members gave themselves four years to negotiate a customs union, with a draft slated for the end of 2001. But that fell far short of earlier plans for an immediate free trade zone, shelved after Tanzania and Uganda, fearful of Kenyan competition, expressed concerns that the zone could create imbalances similar to those that contributed to the breakup of the first community.40 Nevertheless, in 2005 the EAC did start to implement a customs union. In 2007, Burundi and Rwanda joined the EAC. The EAC established a Common Market in 2010 and is now striving toward an eventual goal of monetary union.

• QUICK STUDY

What were the main arguments for establishing NAFTA?

What were the arguments against NAFTA?

What has the track record of NAFTA been?

Outline the goals of Mercosur. Why has it not fulfilled its promise to date?

Which are the main trading blocs in Asia and Africa?

Focus on Managerial Implications

LEARNING OBJECTIVE 5

Understand the implications for business that are inherent in regional economic integration agreements.

Currently, the most significant developments in regional economic integration are occurring in the EU and NAFTA. Although some of the Latin American trade blocs, ASEAN, and the proposed FTAA may have economic significance in the future, developments in the EU and NAFTA currently have more profound implications for business practice. Accordingly, in this section, we will concentrate on the business implications of those two groups. Similar conclusions, however, could be drawn with regard to the creation of a single market anywhere in the world.

Opportunities

The creation of a single market through regional economic integration offers significant opportunities because markets that were formerly protected from foreign competition are increasingly open. For example, in Europe before 1992, the large French and Italian markets were among the most protected. These markets are now much more open to foreign competition in the form of both exports and direct investment. Nonetheless, to fully exploit such opportunities, it may pay non-EU firms to set up EU subsidiaries. Many major U.S. firms have long had subsidiaries in Europe, and those that do not would be advised to consider establishing them, lest they run the risk of being shut out of the EU by nontariff barriers.

Additional opportunities arise from the inherent lower costs of doing business in a single market—as opposed to 27 national markets in the case of the EU or 3 national markets in the case of NAFTA. Free movement of goods across borders, harmonized product standards, and simplified tax regimes make it possible for firms based in the EU and the NAFTA countries to realize potentially significant cost economies by centralizing production in those EU and NAFTA locations where the mix of factor costs and skills is optimal. Rather than producing a product in each of the 27 EU countries or the 3 NAFTA countries, a firm may be able to serve the whole EU or North American market from a single location. This location must be chosen carefully, of course, with an eye on local factor costs and skills.

For example, in response to the changes created by EU after 1992, the St. Paul–based 3M Company consolidated its European manufacturing and distribution facilities to take advantage of economies of scale. Thus, a plant in Great Britain now produces 3M’s printing products and a German factory its reflective traffic control materials for all of the EU. In each case, 3M chose a location for centralized production after carefully considering the likely production costs in alternative locations within the EU. The ultimate goal of 3M is to dispense with all national distinctions, directing R&D, manufacturing, distribution, and marketing for each product group from an EU headquarters.41

Even after the removal of barriers to trade and investment, enduring differences in culture and competitive practices often limit the ability of companies to realize cost economies by centralizing production in key locations and producing a standardized product for a single multiple-country market. Consider the case of Atag Holdings NV, a Dutch maker of kitchen appliances.42 Atag thought it was well placed to benefit from the single market, but found it tough going. Atag’s plant is just one mile from the German border and near the center of the EU’s population. The company thought it could cater to both the “potato” and “spaghetti” belts—marketers’ terms for consumers in northern and southern Europe—by producing two main product lines and selling these standardized “euro-products” to “euro-consumers.” The main benefit of doing so is the economy of scale derived from mass production of a standardized range of products. Atag quickly discovered that the “euro-consumer” was a myth. Consumer preferences vary much more across nations than Atag had thought. Consider ceramic cooktops: Atag planned to market just 2 varieties throughout the EU but found it needed 11. Belgians, who cook in huge pots, require extra-large burners. Germans like oval pots and burners to fit. The French need small burners and very low temperatures for simmering sauces and broths. Germans like oven knobs on the top; the French want them on the front. Most Germans and French prefer black and white ranges; the British demand a range of colors including peach, pigeon blue, and mint green.

Threats

Just as the emergence of single markets creates opportunities for business, it also presents a number of threats. For one thing, the business environment within each grouping has become more competitive. The lowering of barriers to trade and investment among countries has led to increased price competition throughout the EU and NAFTA. Over time, price differentials across nations will decline in a single market. This is a direct threat to any firm doing business in EU or NAFTA countries. To survive in the tougher single-market environment, firms must take advantage of the opportunities offered by the creation of a single market to rationalize their production and reduce their costs. Otherwise, they will be at a severe disadvantage.

A further threat to firms outside these trading blocs arises from the likely long-term improvement in the competitive position of many firms within the areas. This is particularly relevant in the EU, where many firms have historically been limited by a high-cost structure in their ability to compete globally with North American and Asian firms. The creation of a single market and the resulting increased competition in the EU produced serious attempts by many EU firms to reduce their cost structure by rationalizing production. This transformed many EU companies into more efficient global competitors. The message for non-EU businesses is that they need to respond to the emergence of more capable European competitors by reducing their own cost structures.

Another threat to firms outside of trading areas is the threat of being shut out of the single market by the creation of a “trade fortress.” The charge that regional economic integration might lead to a fortress mentality is most often leveled at the EU. Although the free trade philosophy underpinning the EU theoretically argues against the creation of any fortress in Europe, occasional signs indicate the EU may raise barriers to imports and investment in certain “politically sensitive” areas, such as autos. Non-EU firms might be well advised, therefore, to set up their own EU operations. This could also occur in the NAFTA countries, but it seems less likely.

Finally, the emerging role of the European Commission in competition policy suggests the EU is increasingly willing and able to intervene and impose conditions on companies proposing mergers and acquisitions. This is a threat insofar as it limits the ability of firms to pursue the corporate strategy of their choice. The commission may require significant concessions from businesses as a precondition for allowing proposed mergers and acquisitions to proceed. While this constrains the strategic options for firms, it should be remembered that in taking such action, the commission is trying to maintain the level of competition in Europe’s single market, which should benefit consumers.

• QUICK STUDY

1. What opportunities for businesses are created by regional economic integration?

2. What are the threats to businesses that might arise from regional economic integration?

Key Terms

regional economic integration, p. 250

free trade area, p. 251

European Free Trade Association (EFTA), p. 252

customs union, p. 252

common market, p. 253

economic union, p. 253

political union, p. 253

trade creation, p. 255

trade diversion, p. 255

European Union (EU), p. 256

Treaty of Rome, p. 256

European Commission, p. 256

European Council, p. 258

European Parliament, p. 258

Treaty of Lisbon, p. 259

Court of Justice, p. 259

Maastricht Treaty, p. 260

optimal currency area, p. 262

North American Free Trade Agreement (NAFTA), p. 266

Andean Pact, p. 268

Mercosur, p. 269

Central American Common Market, p. 270

Central America Free Trade Agreement (CAFTA), p. 270

CARICOM, p. 270

Caribbean Single Market and Economy (CSME), p. 270

Association of Southeast Asian Nations (ASEAN), p. 271

Chapter Summary

This chapter pursued three main objectives: to examine the economic and political debate surrounding regional economic integration; to review the progress toward regional economic integration in Europe, the Americas, and elsewhere; and to distinguish the important implications of regional economic integration for the practice of international business. The chapter made the following points:

1. A number of levels of economic integration are possible in theory. In order of increasing integration, they include a free trade area, a customs union, a common market, an economic union, and full political union.

2. In a free trade area, barriers to trade among member-countries are removed, but each country determines its own external trade policy. In a customs union, internal barriers to trade are removed and a common external trade policy is adopted. A common market is similar to a customs union, except that a common market also allows factors of production to move freely among countries. An economic union involves even closer integration, including the establishment of a common currency and the harmonization of tax rates. A political union is the logical culmination of attempts to achieve ever-closer economic integration.

3. Regional economic integration is an attempt to achieve economic gains from the free flow of trade and investment between neighboring countries.

4. Integration is not easily achieved or sustained. Although integration brings benefits to the majority, it is never without costs for the minority. Concerns over national sovereignty often slow or stop integration attempts.

5. Regional integration will not increase economic welfare if the trade creation effects in the free trade area are outweighed by the trade diversion effects.

6. The Single European Act sought to create a true single market by abolishing administrative barriers to the free flow of trade and investment among EU countries.

7. Seventeen EU members now use a common currency, the euro. The economic gains from a common currency come from reduced exchange costs, reduced risk associated with currency fluctuations, and increased price competition within the EU.

8. Increasingly, the European Commission is taking an activist stance with regard to competition policy, intervening to restrict mergers and acquisitions that it believes will reduce competition in the EU.

9. Although no other attempt at regional economic integration comes close to the EU in terms of potential economic and political significance, various other attempts are being made in the world. The most notable include NAFTA in North America, the Andean Community and Mercosur in Latin America, ASEAN in Southeast Asia, and perhaps APEC.

10. The creation of single markets in the EU and North America means that many markets that were formerly protected from foreign competition are now more open. This creates major investment and export opportunities for firms within and outside these regions.

11. The free movement of goods across borders, the harmonization of product standards, and the simplification of tax regimes make it possible for firms based in a free trade area to realize potentially enormous cost economies by centralizing production in those locations within the area where the mix of factor costs and skills is optimal.

12. The lowering of barriers to trade and investment among countries within a trade group will probably be followed by increased price competition.

Critical Thinking and Discussion Questions

1. NAFTA has produced significant net benefits for the Canadian, Mexican, and U.S. economies. Discuss.

2. What are the economic and political arguments for regional economic integration? Given these arguments, why don’t we see more substantial examples of integration in the world economy?