Case Study of EU
WHAT IS REGIONAL INTEGRATION?
After two centuries of nation-building, the world has entered an era of region-building in search of political stability, cultural cohesion, and socio-economic development. Nations involved in the regional structures and integration schemes that are emerging in most regions of the world are deepening their ambitions, with Europe’s integration experience often used as an experimental template or theoretical model.
Regional integration can be defined along three dimensions:
(i) Geographic scope illustrating the number of countries involved in an arrangement (variable geometry)
(ii) The substantive coverage or width that is the sector or activity coverage (trade, labor mobility, macro-policies, sector policies, etc.), and
(iii) The depth of integration to measure the degree of sovereignty a country is ready to surrender, that is from simple coordination or cooperation to deep integration.
Integration also occurs at various levels of society (local, national, regional and international) and takes economic, social and political forms and its success or failure is determined by the interaction of enabling and inhibiting variables.
Integration as an Outcome
Defining integration as an outcome means that one describes integration as something static, whereby a situation of integration is achieved only when certain predefined criteria are fulfilled. Integration is thus seen as a property of a system, which characterizes the structure or a particular conjuncture. Scholars define the criteria of what they believe constitutes integration, and then examine whether case studies match their standards. For instance, if we consider the formation of the EU as a process of institutionalization, we could examine how "integrated" the EU is at a certain point in time, thus study the degree and type of integration as a characteristic of the EU.
Integration as a Process
Integration as a dynamic process refers to the development of a state of isolation to a condition of integration. Research in this case is concerned with the variables, which are likely to induce or inhibit integration. If we resume our example of the EU as a process of institutionalization, we might then study the process through which the EU has been integrated.
Integration as a Combination of Outcome and Process
A combination of both integration as an outcome and integration as a process defines integration as any level of association ascertained by specified measures or as any level of association between actors, on one dimension or another. This way of defining integration allows the researcher to speak of various types of integration (economic, social, political et cetera), and of various levels of integration. This enables researcher to do comparative research.
It is obvious that the static and dynamic approaches are complementary, for at any given point in time, the units will be situated at any point along the spectrum of integration.
GAINS/ BENEFITS OF REGIONAL INTEGRATION:
From the literature and experience, some traditional and non-traditional gains from regional integration arrangements could be identified, including:
Traditional Gains from Regional Integration Arrangements
Trade gains: If goods are sufficiently strong substitutes, regional trade agreements will cause the demand for third party goods to decrease, which will drive down prices. In addition, more acute competition in the trade zone may induce outside firms to cut prices to maintain exports to the region. This will create a positive terms of trade effect for member countries. However, the move to free trade between partners who maintain significant tariffs vis-à-vis the rest of the world may well result in trade diversion and welfare loss. The risk of trade diversion could be mitigated if countries implement very low external tariffs (“open regionalism” arrangements).
Increased returns and increased competition: Within a tiny market, there may be a trade-off between economies of scale and competition. Market enlargement removes this trade-off and makes possible the existence of (i) larger firms with greater productive efficiency for any industry with economies of scale and (ii) increased competition that induces firms to cut prices, expand sales and reduce internal inefficiencies. Competition may lead to the rationalization of production and the removal of inefficient duplication of plants. However, pro-competitive effects will be larger if low external tariff allows for a significant degree of import competition from firms outside the zone. Otherwise, the more developed countries within the regional integration scheme would most probably dominate the market because they may have a head-start. On the other hand, current technology may be obsolete in these countries compared to current and future needs of the regional market. Firms may then decide to re-deploy new technology and relocate in other areas depending on factor costs. In this case, countries with the most cost effective infrastructure and human resources would be the beneficiaries.
Investment: Regional trade agreements may attract FDI both from within and outside the regional integration arrangement (RIA) as a result of (i) market enlargement (particularly for “lumpy” investment that might only be viable above a certain size), and (ii) production rationalization (reduced distortion and lower marginal cost in production). Enlarging a sub-regional market will also bring direct foreign investment, which will be beneficial, provided that the incentive for foreign investors is not to engage in “tariff-jumping”. This advocates once again for the necessity to reduce protection and more specifically external tariffs.
Non-traditional Gains from Regional Integration Arrangements
The theoretical as well as applied literatures indicate that there are several “non traditional gains” from regional integration arrangements.
Lock in to domestic reforms: Entering into regional trade agreements (RTAs) may enable a government to pursue policies that are welfare improving but time inconsistent in the absence of the RTA (e.g. adjustment of tariffs in the face of terms of trade shocks, confiscation of foreign investment, etc.). There are two necessary conditions for an RTA to serve as a commitment mechanism. One is that the benefit of continued membership is greater than the immediate gains of exit and the value of returning to alternative policies. The other is that the punishment threat is credible. Regional integration arrangements work best as a commitment mechanism for trade policy. But RTAs can also serve to lock the country into micro and macroeconomic reforms or democracy if (i) those policies or rules are stipulated within the agreement (deeper integration arrangements) and (ii) the underlying incentives have changed following the implementation of the RTA. RIAs may be an instrument for joint commitment to a reform agenda, but their effectiveness may be limited by the low cost of exit and difficulties in implementing rules and administering punishment. With respect to other macroeconomic reforms, one may argue that the degree of openness of RIAs may help discipline in macro policies (especially if the zone shares or target a common exchange rate).
Signaling: Though entering RTAs is costly (investment in political capital and transaction costs), a country may want to do so in order to signal its policy orientation / approach, or some underlying conditions of the economy (competitiveness of the industry, sustainability of the exchange rate) in order to attract investment. This may be especially important for countries having a credibility and consistency problem.
Insurance: RTAs can also be seen as providing insurance to its members against future hazards (macroeconomic instability, terms of trade shocks, trade war, resurgence of protectionism in developed countries, etc.). Given that countries are in the “same boat”, the insurance argument may not be an important rationale for regional arrangements between developing countries. But with asymmetric terms-of-trade shocks (such as with oil in Nigeria and the rest of ECOWAS), “insurance” may become an important rationale for integration.
Coordination and bargaining power: Within RTAs, coordination may be easier than through multilateral agreements since negotiation rules accustom countries to a give-and-take approach, which makes tradeoffs between different policy areas possible. Since RTAs may enable countries to coordinate their positions, they will stand in multilateral negotiations (e.g. World Trade Organisation – WTO) with at least more visibility and possibly stronger bargaining power. The collective bargaining power argument is especially relevant for the poor and fractioned countries within a sub-region. It may help countries to develop common positions and to bargain as a group rather than on a country by country basis, which would contribute to increased visibility, credibility and even better negotiation outcomes.
Security: Entering RTAs may increase intra-regional trade and investment and also link countries in a web of positive interactions and interdependency. This is likely to build trust, raise the opportunity cost of war, and hence reduce the risk of conflicts between countries4. Regarding security, RTAs could also create tensions among member countries should it result in more divergence than convergence by accelerating the trend of concentration of industry in one or a few countries. On the other hand, by developing a culture of cooperation and mechanisms to address issues of common interest, RIAs may actually improve intra-regional security. Cooperation may even extend to “common defense” or mutual military assistance, hence increasing global security.
COSTS OF REGIONAL INTEGRATION
Regional co-operation and integration do not always lead to peace nor to development. Contrary to the dominant discourses, efforts at regional integration may generate conflicts and tensions within and between states, especially when opposing ideological and political systems are involved or when the economic benefits of integration are perceived to be uneven.
Regional integration also has costs. Among others, these include:
Interference in internal affairs, which may compromise sovereignty.
The pressure and obligation to confirm to the values, principles and protocols of the regional grouping may also negatively affect domestic policy.
Similarly, payment of membership fees may be a burden to the tax payer of impoverished member states.
Finally, in the event of violent conflict in a member country, member states may pay with the lives of their citizens, for example as happened for Angola, Namibia and Zimbabwe during the DRC conflict.
In general, however, the benefits of integration must exceed the costs for membership to a regional grouping to be attractive.
BARRIERS TO REGIONAL INTEGRATION
Very often, progress towards free trade is hampered by a lack of political will.
Many countries are reluctant to abolish customs duties which make an important contribution to their national budgets.
High levels of protectionism not only raise costs for both producers and consumers, they systematically discourage investment in export-oriented activities and inhibit economic transformation.
National monopolies constitute restraints on competition, free trade and investment; and the thrust of national reform programs is, among other things, to eliminate them. But as the market expands beyond national boundaries as part of the integration process, the subregion must guard against the appearance of sub-regional monopolies.
Differences in approach and pace inevitably occur from diverse priorities and understandings of the costs, benefits and risks of regional cooperation.
While cooperation and integration are desirable policy objectives, the mechanisms for cooperation and integration call for linkages of disparate institutions or organisations, which require commonalities or interconnectivity in standards, codes and regulatory rules.
High on the list of barriers to cooperation is the lack of clarity as to how much individual countries can benefit from opening up their markets and what the costs are. A process is, therefore, needed to build consensus towards reaching commonality of purpose and to fostering confidence that regional financial integration is in the interest of all stakeholders. Against this background, a wide range of fresh efforts are being initiated by ASEAN +3 governments and central banks and by the ADB to build consensus on, and initiate processes in support of, regional capital market integration.
Sometimes, the main impediment to closer economic integration among the countries can be attributed more to political rather than economic factors. The main reasons why regionalism in East Asia was slow to take off despite the strong economic grounds are political in nature. Since the end of World War II, the United States has sought to protect and advance its major interests in East Asia. These interests include preventing any single power from dominating the region, maintaining a reasonable degree of order and regional stability, and safeguarding its economic partnerships in the region. To achieve this, the United States has arrogated the role of regional hegemony. There has been no indication that the United States is willing to allow any East Asian country, not even an ally such as Japan, to share equal responsibility in preserving stability in the region. This explains why the United States has been highly sensitive to any move, economic or otherwise, that would bring the East Asian countries together to the exclusion of the United States. Closer economic integration in East Asia could adversely affect the influence of the United States and its interests in the region.
Monetary and Financial Integration:
Monetary integration is crucial in regional economic integration. Strong monetary integration is required if regional integration objectives go beyond free trade agreements or custom unions to a truly unified common market (Eichengreen, 1998). International trade increases significantly when countries adopt an advanced form of monetary cooperation such as a common currency (Rose 1999; Glick and Rose 2001;Bun and Klaassen 2002).So does economic performance and output per capita participating countries (Frankel and Rose 2000).
Different levels of monetary integration impose different constraints on the macro-economic policies of participants. The most common case is a pegged exchange rate. Pegging mechanisms differ in strength and reversibility. With standard pegs (systems with exchange rate bands) the decision of monetary authorities to realign parity is not subject to formal constraints, but with harder pegs (a currency board),legal and institutional constraints make realignment more difficult and costly. The debate over optimal exchange rate arrangements suggests that countries should go for either flexible exchange rates or for the hardest forms of peg (Obstfeld and Rogoff 1995).
Formation of a monetary union requires:
•Identifying the objectives, policy rule, accountability, and degree of independence from national governments of the common central bank.
• Allocating responsibility for bank supervision and lending of last resort.
•Establishing mechanisms and procedures for making national fiscal policies consistent with the union’s monetary objective.
Macroeconomic convergence criteria
The transition towards a monetary union can be gradual or fast. The gradual strategy involves a long transition of macroeconomic convergence among prospective members and the development of institutions. A typical example is the European Monetary Union. A “big bang” strategy entails a much faster transition, without convergence. An example is the monetary unification in Germany in 1990.
Macroeconomic convergence criteria, generally defined as upper or lower bounds for macroeconomic variables, are intended to guide the economic policy of future members in the transition period.
Macroeconomic convergence criteria ensure that, prior to the formal start of the union, all prospective members commit to low inflation and prudent fiscal policies. The intention is to avoid the distortionary effects that may arise from the participation of countries whose macroeconomic policy stance and fundamentals are not consistent with the common central bank’s monetary objectives. The main variables of concern are the inflation rate, the budget deficit, and the stock of public debt. To meet a low inflation target, countries must commit to tough anti-inflationary policies and bear the associated output loss. Their willingness to pay these real costs will be evidence of their commitment to monetary stability. Budget and debt requirements will force countries to adjust their fiscal policies to maintain an overall balance between spending and revenues. These adjustments, too, can be large and costly (expenditure cuts, increased taxation). A government that carries them out will thus signal its commitment to sound fiscal management.
Political economy constraints
The success of monetary integration also depends on the interplay of various political economy factors. The experience of the European Monetary Union, among others, suggests that the balance between the costs and benefits of integration as well as its long-term sustainability are heavily affected by the ability to design institutions that take political economy constraints into account.
Policy conflicts. The basic issue concerns the possibility of policy conflicts. Such conflicts can arise even when shocks are perfectly correlated across countries, to the extent that policy preferences are heterogeneous. A typical case concerns the different preferences that countries have in terms of the unemployment-inflation tradeoff when asymmetric shock hits the region. When policies are evaluated on the basis of different
The success of monetary integration also depends on the interplay of various political economy factors social welfare functions, monetary integration might have welfare reducing effects for countries whose preferred policy from the common policy response.
The heterogeneity of policy preferences can thus pose a threat to the sustainability of monetary integration in the long run. Careful institutional design is needed to prevent this. If decision making power in the common monetary authorities is not equally shared among member countries, then disadvantaged countries will be more likely to drop out. Thus allocating decision making power in the common central bank on the basis of country size might impede monetary integration.
One way to address the problem of policy conflicts is to ensure that countries share substantially similar objectives and evaluate policies on homogeneous grounds. This is possible if monetary integration is matched by political integration. The formation of supranational political institutions is, however, a long and difficult process that poses clear problems of institutional design. Monetary integration is often regarded as a way to achieve political union. The imposition of macroeconomic convergence criteria during the transition to monetary integration can help push countries to adopt common objectives.
Another important political economy dimension relates to seignior age revenues. When the monetary policy is delegated to a common central bank, seignior age revenues constitute a common pool of resources to be shared by countries. Conflicts are likely to arise over the splitting rule. The problem can be exacerbated by the probable shrinking of the common pool of revenues if the common central bank takes a tight monetary policy stance. The political economy implications are clear.
Countries unhappy with the splitting rule might decide to drop out, while those that remain might experience an under provision of public goods. Alternatively, the common central bank, if not adequately protected from the pressures of national fiscal authorities, might be induced to take a loose monetary policy stance, thus eliminating most of the benefits expected from monetary integration.
The allocation of seignior age revenues is an instance of the more general issue of fiscal redistribution in a monetary union. Centralization of monetary policy requires the establishment of compensation mechanisms to transfer resources across countries.
One way to address policy conflicts is to ensure that countries share substantially similar objectives and evaluate policies on homogeneous grounds typical case is the one where shock asymmetries imply recessions in some countries and expansions in others. The political feasibility of such mechanisms cannot be taken for granted, however. Rules are required to promote the credible commitment of national governments to the system of cross-country redistribution. Lack of enforcement would put the continuation of the integration process at risk.
Economic and financial integration in Europe: A Case Study
In the next section three aspects of economic integration in Europe, namely trade, labour mobility and business cycle synchronization will be discussed.
i) First, economic integration has been reflected in a marked increase in intra-euro area trade in goods and services. The share of exports and imports of goods in terms of GDP within the euro area increased by 6 percentage points between 1998 and 2006, to stand at around 32% of GDP. The share of intra-euro area exports and imports of services increased by about 2 percentage points in this period, to almost 7% of GDP.
ii) A second aspect of the process of economic integration is the degree of synchronization or co-movement between different cyclical positions across the euro area countries. This degree of synchronization has increased since the beginning of the 1990s. In other words, a large number of euro area economies now share similar business cycles.
In addition, the decline in inflation differentials across the euro area countries has been impressive in recent years. The level of dispersion is currently at a lower level than that among 14 US Metropolitan Statistical Areas. Dispersion in real GDP growth rates across the euro area countries has been fluctuating around a level similar to the one observed in output growth across regions within the United States.
iii) Labour mobility within the EU constitutes a third aspect of economic integration. Labour mobility offers additional choices to workers. It can dampen the effects from country-specific shocks and decrease the risks of wage pressures as labour markets tighten. Available evidence suggests that, overall; cross-border labour mobility is still limited within the European Union with regulatory barriers still existing, even within the euro area itself with respect to labour from Slovenia, for example. Germany belongs to the countries which currently prevent labour mobility from some EU countries. This comes at a time when many companies are reporting problems in finding properly skilled labour. For instance, the German industry currently reports very significant shortages of labour, according to a survey by the European Commission.
Financial integration in Europe
The introduction of the euro has contributed to intra-European financial integration which, in turn, has facilitated the free movement of capital in the euro area. Financial integration strengthens competition and raises the potential for stronger non-inflationary economic growth. It also improves the smooth and effective transmission of the single monetary policy throughout the euro area.
Financial integration also helps financial systems to channel funds from those economic agents that have a surplus of savings to those with a shortage; in particular, it enables agents to effectively trade, hedge, diversify and pool risks. As a result, there is a better sharing and diversification of risk.
According to academic research, in the United States, over the period 1963-90, capital markets smoothed out 39% of the shocks to gross state product (the equivalent to GDP), the credit channel smoothed out 23% and the federal government, through the fiscal channel, 13%. Around 25% of the shocks were not smoothed out. Hence financial markets and financial institutions contributed 62% to the absorption of idiosyncratic state shocks. We therefore see from the US example that the financial channel can be much more important than the fiscal channel. This is an additional reason for speeding up financial integration in Europe. In a more recent study, it was found that the situation in the euro area countries has begun to converge towards that of the United States as inter-euro area country capital flows increase. It was found that in what would become the euro area countries (excluding Luxembourg), capital markets would have smoothed out about 10% of the country-specific shocks to GDP between 1993 and 2000.
A set of indicators, published by the ECB, points to an increasing degree of integration of euro area financial and banking markets since 1999. Moreover, the size of capital markets — in terms of the ratio of the total value of stock, bond and loan markets to GDP — has increased substantially since 1999, and has the potential to grow even further, as seen from a comparison with the United States. In the period 1995-99, it was 177% of GDP in the euro area and 279% in the United States; in 2005-06 it had increased to 256% in the euro area, and 353% of GDP in the United States. In Germany this ratio rose from 202% to 229% of GDP.
Integration in retail banking, by contrast, has been slow so far. There are still significant differences in bank deposit and lending interest rates across euro area countries. In the euro area, the cross-country dispersion is higher than the intra-regional dispersion of the same rates in the United States.
This notwithstanding, overall there is evidence of growing economic and financial integration among the countries of the European Union. The adoption of the euro has contributed to this development by reducing information costs, enhancing price transparency and eliminating exchange rate risk between countries in the euro area. Nonetheless, in some fields, a lot remains to be done, for example, that of increasing intra-euro area labour mobility and financial integration in retail banking.
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