Frantiek Turnovec, Wadim Strielkowski et al.

Advanced Economics of European Integration: Selected issues

Frantiek Turnovec, Wadim Strielkowski et al.

Advanced Economics of European Integration: Selected issues

Charles University in Prague, Faculty of social sciences

Charles University in Prague Faculty of social sciences

Reviewed by: Professor Anna Zieliska-Gbocka (University of Gdansk) Dr. Dennis Hckl (Technical University of Dresden) Acknowledgements: This book is based on the Jean Monnet permanent course JEM081 Advanced Economics of European Integration - Microeconomic Aspects" developed with the support the European Commissions Jean Monnet Programme. The authors would like to thank the EU Commission and the Czech Ministry of Education, Youth and Sports for their generous support.

URL: http://ies.fsv.cuni.cz/en/syllab/JEM081/ Cover image by Wadim Strielkowski

Copyright 2012 by Frantiek Turnovec, Wadim Strielkowski, Petr Novk, Tomasz Brodzicki, Jan Andr, Udo Broll, Eithne Murphy, Zuzana Cahlkov, Barbara Du, Jan Melichar, Vojtch Mca, and Milan asn

All rights reserved, no part of this book may be reproduced or transmitted in any form or by any means, electronic, mechanical, photocopying or otherwise, without the prior written permission of the authors. Publisher: Charles University in Prague, Faculty of social sciences

ISBN 978-80-87404-33-1

Prague 2012
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Table of contents:

1. Introduction..........................................................................................................................................4 2. Political economy of decision making in the EU: coalition formation in the European Parliament ...7 3. Free movement of labour: lessons for NAFTA from the EU 2004 Enlargement ..............................26 4. Quo vadis europa: EU governance at cross-roads .............................................................................38 5. European Union and single currency: on optimality or non-optimality of the Euro zone .................59 6. Regional Policy and Economic Development: the case study of Dresden Cluster............................71 7. Understanding and Evaluating the Architecture of the Euro Area ....................................................81 8. Impacts of climate change on environment and economic sectors in Europe ...................................98 9. Environmental policies of the EU: a case study of market-based instruments and internalization of environmental externalities from airborne pollution in the Czech Republic...................................110 Authors index .....................................................................................................................................126

1. Introduction
Nowadays, when the European Union is looking for its way out of the economic and political crisis, and the decades of integration and economic cooperation seem to be lost in vain, it becomes clear that the new inspiration for Europe is required. The question is: what has gone wrong with the EU, why the largest economy of in todays global world cannot compete with its rivals and perform accordingly? Where to look for the solutions? It might be that the answers to these questions are very easy to find and one should not look very far. Currently, the European Union is facing many problems: recent world's economic and financial crisis put several Member States into the deep crisis, the future of the common currency is unknown, economic growth stagnates, the Member States can not agree on a Common Defense and Security Policy (CFSP) and the influence of Euro sceptics is perhaps the strongest since the days of the infamous collapse of the League of Nations in the 1930s. According to the results of the latest polls, even the people in Germany the Europe's largest economy and the engine of European development are rapidly loosing confidence in the European institutions and, above all, in further economic and political integration and accepting new members. What has gone awry? What happened to the European Union? What mysterious illness is spreading old continent? And what do we, Europeans, have to do to return the momentum of European integration and enhance the our believes in the future of united Europe? The European Union is currently the most powerful economy in the world, comprising 27th economies inhabited by 504 million people and producing GDP of $17.5 trillion per year. EU possess all necessary potentials, whether someone likes it or not. Unlike over-globalized world economies (such as the U.S. or Southeast Asian countries), EU demonstrates a very special model of economic and social development. Being the cradle of Western civilization and often the bearer of its major novel ideas, EU embraces the model of the "multicultural melting pot": there is hardly any other place in the world where the multiculturalism blossoms as much as in the EU. European culture is largely based on contradicting antagonisms: where else in the world years of wars and conflicts resulted in efforts to create a common economic and cultural area, where the rivers of blood spilled laid the beginning of friendship and mutual tolerance? Where else in the world former foes were able to shake each other's hands and proceed as far as introducing a common currency and unifying their markets? All these things make the European Union a very unique project. It clearly possesses something that no one else can imitate or implement, the idea, the spirit that form its path to the worldwide success. However, one should not forget that there are also threats and pitfalls for European Union in today's global world. The recent economic and financial crisis and the on-going competition with the economies of the U.S. and the countries of Southeast Asia (such as China, Taiwan and South Korea) might be the good examples. If one looks at the economic indicators such as gross domestic product per capita, or performance of the economy, the U.S. might beat most of the European countries (perhaps with the exception of Switzerland or Luxembourg). However, it is important to take into account other aspects. In his book "The European Dream", the American political scientist Jeremy Rifkin compares Europe and the United States. He concludes that while the average American "lives to work", an average European works to live. Europe beats the U.S. In the length of annual leave (an average of 6 weeks in Europe compared to an average of 2 weeks in the U.S.), health care (about 322 doctors per 100 000 inhabitants in Europe compared to only 279 in the U.S.), and the overall level of education of the population. The total commuting time in Europe is 18 minutes, while it is usually measured in hours in the U.S. Overall, it appears that not everything can be measured
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by GDP growth and other economic indicators. As the late former Czech President Vaclav Havel put it, economists must learn to distinguish between economic gain from a gain for the society as a whole, while the latter one very often represents the most important item in the total balance of payments. What can give the European Union its momentum, what can strengthen the integration and support the unique project that started over 50 years ago? We argue that it is all in the hands of Europeans. Because the Europe's path has always been laid by the visionaries such as Giuseppe Mazzini, Victor Hugo, Eduard Herriot, Jean Monnet or Altiero Spinelli, just to name a few. The biggest experiment in the history of Europe began fifty years ago thanks to them and many others and it has been going well since. Recent EU enlargements that included the countries of Central and Eastern Europe, Malta and Cyprus brought a transfusion of the new blood into the Europe's veins and demonstrated to the whole world that the European experiment is viable and capable. Why to look for inspiration elsewhere when all recent problems of the EU can be solved by the Europeans themselves? This book was created based on the teaching in the course entitled Advanced Economics of the European Integration Microeconomic Aspects (AEEI) that is taught at the Institute of economic studies, Faculty of social sciences, Charles University in Prague. AEEI is a Jean Monnet permanent course developed with the support the European Commissions Jean Monnet Programme. The course focuses on economic theory, methods and outcomes of integration between a group of countries (economies of national states). The course includes the following aspects: historical experience and future prospects of the European Union, welfare effects of trade and economic cooperation, partial and general trade equilibrium, economics of customs union, Common Market, monetary union, regulation and microeconomic policies in the European Union, and institutional economics of the European Union. The course's methodological background is based on general equilibrium theory, welfare economics, and public choice. Thanks to the financial support from the European Commission and the Czech Ministry of Education, Youth and Sport, the course's instructors were able to invite to Prague a number of visiting professors from various EU institutions and European academic institutions over the winter semester of the 2011/2012 academic year. Selected issues of European economic integration were covered during these guest lectures and the idea emerged to write a book covering less-discussed topics of European economic integration. This book opens with a chapter by Frantisek Turnovec who analyzes whether there is a difference between a priori voting power of national groups in the case of national coordination of voting and in the case of partisan coordination of voting in the European Parliament. The chapter by Wadim Strielkowski explains the differences and the similarities between the EU and NAFTA with regard to the free movement of labour and the EU Eastern Enlargement in 2004. The chapter by Petr Novak from the European Parliament analyses the evolution of the EU governance in the times of the world's economic and financial crisis as well as the thorough transformation induced by the Lisbon Treaty. The author concludes that the observed transformation of the EU decision-making is a precursory sign of a future multi-speed Europe. The chapter by Tomasz Brodzicki from the University of Gdansk discusses the optimality of the existing and the enlarged Eurozone. The author argues that in spite of the progress made so far, the Eurozone is still far away from fulfilling the criteria for becoming the Optimal Currency Area (OCA). Further EU enlargements, accompanied by the increase in the overall internal diversity of the European Union, are likely to increase this gap. The chapter by Jan Andra and Udo Broll from the Technical University of Dresden describes regional policy and economic development in the EU on the example of Dresden. The chapter
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introduces a simple model of concentration advantage to formalise the development of semiconductor industry in the specific region of East Germany. The chapter by Eithne Murphy from the National University of Ireland Galway discusses the economic architecture of Euro as a single currency with a special focus on macroeconomic aspects of adopting the Euro and using it a single European currency. The chapter by Zuzana Cahlikova and Barbora Duzi from the Global Change Research Centre summarize possible impacts on physical environment and economics induced by climate change across the European Union. Finally, the chapter by Jan Melichar, Vojtech Macha and Milan Scasny elaborates on the environmental policies of the EU. It presents a case study of market-based instruments and internalization of environmental externalities from airborne pollution using the case of the Czech Republic Overall, the Economics of European Integration presents a number of interesting questions and issues to tackle. In this book we tried to collect some of them and to present them to the general public in an innovative and interactive way.

Frantiek Turnovec and Wadim Strielkowski Prague, October 2012

2. Political economy of decision making in the EU: coalition formation in the European Parliament
Frantiek Turnovec Charles University in Prague, Faculty of social sciences, Institute of economic studies Abstract: Increasing number of studies is focusing attention to constitutional analysis of European Union institutions and distribution of intra-institutional and inter-institutional influence in the European Union decision making. Most of the studies are related to distribution of voting power in the EU Council of Ministers as reflecting the influence of member states (or, more precisely, member states governments). Significantly less attention is paid to the analysis of European Parliament (EP). In this paper we address the following question: Taking as decisional units national chapters of European political parties, is there a difference between a priori voting power of national groups in the case of national coordination of voting and in the case of partisan coordination of voting? By coordination of voting we mean two step process: in the first step there is an internal voting in the groups of units (national or partisan), in the second step there is a voting of aggregated groups (European political parties or national representations) in the EP. In the both cases the voting has an ideological dimension (elementary unit is a party), difference is only in dimension of aggregation. Power indices methodology is used to evaluate voting power of national party groups in the cases of partisan and national coordination of voting behaviour.

1. Introduction During last two decades we can observe a boom of power indices literature related to constitutional analysis of European Union institutions and distribution of intra-institutional and inter-institutional influence in the European Union decision making. While most of the studies focused on models of institutional system of the European Union (EU) emphases analysis of voting power in the EU Council of Ministers as reflecting the influence of member states (or, more precisely, member states governments)1, significantly less attention is paid to the power analysis of European Parliament (EP). Historically first paper on model analysis of the EU institutions (Holler and Kellermann, 1997) was focused on national distribution of voting power in the European Parliament (even before the first direct election of the EP in 1979), but there were not many followers of this direction of model oriented EP analysis. In Johnston (1982) the fairness of regional representation in parliamentary bodies was investigated with empirical illustrations based on national representation in the European Parliament. Hosli (1997) analyzed new situation in EP after 1994 reallocation of seats of national representations and introduced into power considerations voting strength of European political parties. Nurmi (1997a) formulated model of political representation in the European Parliament (how voters of different political parties
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Distribution of power in the EU Council of Ministers and European and the recent development associated with the 1995 and 2004 enlargement of the EU has been analyzed in Brams and Affuso (1985), Widgrn (1994, 1995), Steunenberg,, Smidtchen and Koboldt (1999)Tsebelis (1994), Nurmi (2000), Nurmi, Meskanen and Pajala (2001), Bindseil and Hantke (1997), Laruelle (1998), Felsenthal and Machover (2004), Holubiec and Mercik (1996), Knig and Brauninger (2001), Turnovec (1996, 2001, 2002), Plechanovovov (2004), Baldwin and Widgrn (2004), Somczyski and yczkowski (2006) and others.

are represented from the point of view of influence of national chapters of European political parties that follows from ideological voting). Hix (2002) investigated two political dimensions (national and ideological) in EP voting and Noury (2002) provided empirical data about voting in the EP to establish the proportion of nationally and ideologically motivated voting. Mercik, Turnovec, and Mazurkiewicz (2004) demonstrate the fact that for some countries it would be more beneficial to coordinate voting of its members of EP on national level rather than on ideological level. Hix, Noury and Roland (2006) provide the most extensive insight into the development of political process in the EP, of history of developing European political parties, conflicts and coalition formations. In this paper we extend Nurmi (1997a) and Mercik, Turnovec and Mazurkiewicz (2004) analysis and formulate the following problem: taking as decisional units national groups of European political parties, is there a difference between a priori voting power of national groups in the case of national coordination of voting and in the case of partisan coordination of voting? By coordination of voting we mean two step process: in the first step there is an internal voting in the groups of units (national or partisan), in the second step there is a voting of aggregated groups (European political parties or national representations). In both cases the voting has an ideological dimension (elementary unit is a national party group), difference is only in dimension of aggregation. To evaluate voting power (or influence) of actors in EP decision making we use the power indices methodology. Two most widely used power indices were proposed by Penrose and Banzhaf (1946, 1965) and Shapley and Shubik (1954). There exist also some other well defined power indices, such as Holler-Packel index (1983), Johnston index (1978), and Deegan-Packel index (1979). The most comprehensive survey and analysis of power indices methodology see in Felsenthal and Machover (1998, 2004). We selected Shapley-Shubik power measure for its appealing properties (local and global monotonic property, equality of absolute and relative power, see Turnovec 1996, 2004), but any other power measure mentioned above can be used as well. In the second section of this paper we shortly recapitulate committee model and a priori voting power methodology in setting suitable for hierarchical and more-dimensional extension of the model. Section three presents two level committee model of power decomposition: in a grand committee consisting of subcommittees it is assumed that into the first step each subcommittee looks for joint position in internal subcommittee voting and than (depending on result of internal voting) the subcommittees vote unanimously in the grand committee decision making. A short description of the structure of recent EP is outlined in section four. Section five applies the two-level committee model with two dimensions of decision making hierarchy (ideological and national) in EP and defines measures of influence of national party groups, European political parties and national representations in each of two dimensions. Using Berg and Holler (1986) concept of randomized decision making rules and some empirically established proportion of ideological and nationally driven voting acts we can define (as a synthetic measure) expected power of national party groups, European political parties and national representations reflecting both dimension of voting. Empirical results of power analysis for ideological and national dimension of EP decision making are provided in section six. In section seven conclusions and further research possibilities in this field are discussed.

2. Power Indices Methodology Let N = {1, 2, ..., n} be the set of agents (indiviudals, parties) and wi (i = 1, ..., n) be the (real, non-negative) weight of the i-th agent and t be the total sum of weights of all agents. Let g be a real number such that 0 < g < t (minimal sum of weights necessary to approve a proposal). The (n+1)-tuple [g ,] = [g , w1 , w 2 ,..., w n ] such that :

w i = t , w i 0, 0 g t
i= 1

we call a committee (or a weighted voting body) of the size n = card N with quota g, total weight t and allocation of weights. = (w1 , w 2 , ..., w n ) . Assume that each agent i uses in

voting all his resources given by his weight wi undivided, i.e. he casts all his votes either as yes votes, or as no votes. Any non-empty subset of agents S N we shall call a voting configuration. Given an allocation w and a quota g, we shall say that S N is a winning w i g w i < g voting configuration, if iS and a losing voting configuration, if iS . Let n T = ( g ,) R n +1 : w i = t , w i 0, 0 g t i =1 be the space of all committees of the size n, total weight t and quota g.
+ A power index is a vector valued function : T R n that maps the space T of all committees of the size n into non-negative quadrant of Rn. A power index represents for each of the committee agents a reasonable expectation that she will be decisive in the sense that her vote (YES or NO) will determine the final outcome of voting. To define a particular power index one has to clarify what this reasonable expectation means, to identify some qualitative property (decisiveness) whose presence or absence in voting process can be established and quantified (Nurmi, 1997b). Generally there are two such properties, related to committee agents positions in voting, that are being used as a starting point for quantification of an a priori voting power: swing position and pivotal position of a committee agent. We shall use pivotal positions based power measure introduced by Shapley and Shubik (1954), so called SS-power. Let the numbers 1, 2, ..., n be fixed names of committee agents. Let (i1, i2, ..., in) be a permutation of those numbers, agents of the committee, and let agent k is in position r in this permutation, i.e. k = ir. We shall say that an agent k of the committee is in a pivotal situation (has a pivot) with respect to a permutation (i1, i2, ..., in), if

j =1

wi j g

and

j =1

wi j - wi r < g

Let us assume that a strict ordering of agents in a given permutation expresses an intensity of their support (preference) for a particular issue in the sense that, if an agent is precedes in this permutation an agent it, then agent is support for the particular proposal to be decided is stronger than support by the agent it. One can assume that the group supporting the proposal will be formed in the order of positions of agents in the given permutation. If it is so, then the agent k will be in situation when the group composed from preceding agents in the given permutation still does not have enough of votes to pass the proposal, and a group of agents place behind him in the permutation has not enough of votes to block the proposal. The group that will manage his support will win. Agent in a pivotal situation has a decisive influence on the final outcome. In an abstract setting, assuming many voting acts and all possible preference orderings equally likely, under the full veil of ignorance about other aspects of
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individual agents preferences, it makes sense to evaluate an a priori voting power of each committee member as a probability of being in pivotal situation. This probability is measured by the SS-power index: p p iSS (g , ) = i n! where pi is the number of pivotal positions of the committee agent i and n! is the number of permutations of all committee agents (number of different strict orderings). 3. Two level committee model of power decomposition Let p = (p1, p2, , pn) be the vector of Shapley-Shubik power indices of agents in the committee [g ,] = [g , w1 , w 2 ,..., w n ] . Then pi is a probability that agent i N will be in a pivotal situation. Each agent i can be denoted as a group Gi with cardinality wi (number of individual members of the committee belonging to i). Let us assume that group Gi consists of several subgroups. Let Gij Gi be a subgroup j of the group Gi and wij = card (Gij), number of members of Gi belonging to Gij. Assuming that each group (agent) i is partitioned into m(i) subgroups Gij, we can consider the following two step procedure of voting: first each agent Gi looks for joint position in a subcommittee [gi; wi1, wi2, , wim(i)], where gi is the quota for voting in subcommittee i (e.g. the simple majority). There is a vote inside the group first (micro-game) and then the group is voting together in the committee on the basis of results of internal voting (macro-game). If si = (si1, si2, , sim(i)) is the internal power distribution in subcommittee [gi; wi1, wi2, , wim(i)] where sij be an internal power of subgroup Gij in micro-game, and pi = (pi1, pi2, , pim(i)) be the power distribution of members of group Gi in committee [g ,] = [g , w1 , w 2 ,..., w n ] then the voting power pij of the subgroup Gij in macro-game is pij = pisij expressing the probability of the subgroup Gij being pivotal in the committee decision making. Using SS-power concepts it is easy to show that
m (i ) j =1

p ij = p i

so we obtained decomposition of the power of agent i among the subgroups Gij. There exist different more-level committees. For example the upper houses of national parliaments have twofold affiliation of its individual members: they represent citizens of the region they were elected in and on the other side they are affiliated to some political party. The same is true for European Parliament: each individual member is affiliated to some European party faction, and at the same time he represents interests of citizens of its own country. Formally we can consider two models of such a committee: one model with agents aggregated into the party factions, the second with regional (country) aggregation. Then it makes sense to consider the distribution of power in each dimension: partisan coordination and national coordination. 4. European Parliament The European Parliament, designed to represent the citizens of European Union member states, is the only directly elected institution of the European Union. European Parliament (EP) has a dual structure: members of EP represent their own countries (and in certain extent they are aware of national interests) and at the same time they belong to national political parties (and in this sense they represents ideological preferences of the groups of citizens).
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Internally, members of European Parliament are clustered in European political parties, forming clubs (factions) in the EP. In the sixth legislative term (2004-2009) there are 732 members of the EP elected by citizens of 25 member states.2 They are divided into seven political groups (European political parties): PPE-DE - Group of the European People's Party (Christian Democrats) and European Democrats, PSE - Socialist Group in the European Parliament, ALDE - Group of the Alliance of Liberals and Democrats for Europe, Verts/ALE - Group of the Greens/European Free Alliance, GUE/NGL Con-federal Group of the European United Left - Nordic Green Left, IND/DEM - Independence/Democracy Group, UEN - Union for Europe of the Nations Group, NI - Not-attached Members. European Parliament acts on the basis of simple majority rule, and in some cases absolute majority is required. Composition of the European Parliament after 2004 election is provided in Table 1. Table 1: Members and political factions of European Parliament of the sixth term, situation as at 30 November 2004
Country Austria Belgium Cyprus Czech R. Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxemburg Malta Netherlands Poland Portugal Slovakia Slovenia Spain Sweden United Kingdom Total
2

PPE DE 6 6 3 14 1 1 4 17 49 11 13 5 24 3 2 3 2 7 19 9 8 4 24 5 28 268

PSE 7 7 2 5 3 3 31 23 8 9 1 16 2 1 3 7 8 12 3 1 24 5 19 200

ALDE 6 1 4 2 5 11 7 2 1 12 1 7 1 5 4

Verts ALE 2 2

GUE NGL

IND DEM

UEN 3 3

NI

1 1 6 13

2 6 1 1 3 7 4 1 7

1 1

1 1

3 1 1 4 4 9 4 2

2 1 1 4

2 3

2 10

6 3

2 2 3 12 88

3 1 5 42

1 2 1 41

3 10 36

27

3 30

Total 18 24 6 24 14 6 14 78 99 24 24 13 78 9 13 6 5 27 54 24 14 7 54 19 78 732

We reflect the situation after 2004 election, before the accession of Romania and Bulgaria in 2007.

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Individual members of the EP represent citizens of member states and number of seats is distributed roughly proportionally to the size of population among the member states. The election to the EP has an ideological dimension: using proportional electoral systems citizens are casting votes for national political parties. EP is institutionally structured on ideological principle, the individual members work in factions of the European political parties. While empirical evidence indicates, that almost in all cases members of the national party groups are voting together, Noury (2004) demonstrated, using empirical data about voting acts in EP of the fifth term, that ideological dimension in EP voting prevails (in almost 80% of cases EP members voted according European party affiliation), but there were still more than 20% of voting driven by national dimension (voting by national affiliation). Consequently, to measure influence in the EP basic decision making unit is a national party groups and it makes sense to measure not only voting power of European political parties and/or voting power of national representations, but also the voting power of national party groups, both in ideologically driven voting and nationally driven voting. 5. Modelling distribution of power in the European Parliament To evaluate distribution of power of national party groups in European Parliament as basic decision making units we use the Shapley-Shubik concept of voting power and model of twolevel committee from section 3. To reflect the double dimensionality in voting we use two dimensions of committee structure: the European party factions decomposed into national groups, and the national representations decomposed into the party groups. Basic unit remains the same in both cases: national party group. Then we obtain two schemes of decision making coordination: first based on European party factions and national party groups, second based on national representations and national party groups. First (ideological) dimension leads to committee model A with European parties as agents voting together, [g, p1, p2, , pn], the second (national) dimension leads to committee model B with national representations as agents voting together, [g, n1, n2, , nm], where g is the quota (the same for both models), pi is the weight (number of seats) of European party i, nk is the weight (number of seats) of member state k (n is the number of European parties, m is the number of member states). Committee A generates n subcommittees Aj such that [gj, p1j, p2j, , pmj], where pij denotes number of members of party group j from country i, gj being a specific quota for subcommittee Aj. Each of these subcommittees consists of at most m national subgroups of the European political party j, where in each subcommittee the members of each party from the same member state k are voting together. We shall refer to the corresponding two-level model: A A1 , A2 ,..., An as the ideologically structured committee system {A/Aj}. Committee B generates m subcommittees Bk such that [dk, pk1, pk2, , pkn], where pki denotes number of members of party group i from country k, dk being a specific quota for subcommittee Bk. Each of these subcommittees consists of at most n party subgroups of the national representation k, where in each subcommittee the members of from the same party j are voting together. We shall refer to the corresponding two-level model B B , B ,..., B m 1 2 as the nationally structured committee system {B/Bk}.
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Let us denote by: aj voting power of the European party j in the committee A (voting by ideological dimension), probability that party j will be pivotal in ideologically coordinated voting, bk voting power of the nation k in the committee B (voting by national dimension), probability that nation k will be pivotal in nationally coordinated voting, akj voting power of the national segment k of party j in subcommittee Aj, probability that national segment k of party j will be pivotal in internal party voting, bkj voting power of the national segment k of party j in subcommittee Bk, probability that party segment j of representation of country k will be pivotal in internal national voting, pkj voting power of the national segment k of party j in the committee {A/Aj}, probability that national segment k of party j will be pivotal in the grand committee voting based on ideological coordination, jkj voting power of the national segment k of party j in the committee {B/Bk}, probability that party segment j of national representation k will be pivotal in the grand committee voting based on national coordination. Using standard algorithms we can find SS-power indices aj in committee A and akj in committees Aj (probabilities of being pivotal in corresponding committees) and then calculate p kj = a kja j as conditional probability of two independent random events pivotal position of j in grand committee A and pivotal position of k in subcommittee Aj. From probabilistic interpretation and properties of SS-power indices
j =1

a j = 1, a j 0 and
m m

k =1

a kj = 1, a kj 0

for all j = 1, 2, , n and k = 1, 2, , m it follows that

k =1

p kj = a j a kj = a j
k =1

The sum of voting powers of national groups of European political party j in ideological voting is equal to the voting power of the European political party. The total power is decomposed among the national units of the party. In a more intuitive way: the national group k of political party j is in a pivotal position in ideologically structured committee system {A/Aj} if and only if it is in pivotal position in subcommittee Aj and the party j is in a pivotal position in committee A. Less trivial is the following result: The country k is in a pivotal position in ideological coordination of voting if some party group from k is in pivotal position. Pivotal positions of national party groups of the same country in ideologically voting are mutually exclusive random events, hence the probability that some party group from state k is in a pivotal position is:
j =1

p kj = a j a kj = q k
j =1

(sum of power indices of all party groups from member state k). Then qk can be interpreted as measure of country k influence in ideologically coordinated voting. From properties of SSpower it follows that:
k =1

q k = a ja kj = a j a kj = a j = 1
k =1 j =1 j =1 k =1 j =1

There is no other direct way how to evaluate qk. In the same way we can find bk in committee B and bkj in committees Bk and then calculate:
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j kj = b kj b k as conditional probability of two independent random events - pivotal position of k in grand committee B and pivotal position of j in subcommittee Bk). Measure of party j influence in nationally coordinated voting is :
k =1

j kj = b k b kj = J j
k =1

(sum of power indices of party group j from all member states). Berg and Holler (1986) introduced concept of randomized decision making rules: let D be a set of decision making rules and Q a probability measure over D, then appropriate power measure in family of committees [dD; w1, w2, , wn] is expected value: p i = p i (d )dQ
d D

where pi(d) stands for power index in the committee [dD; w1, w2, , wn]. For discrete D = {d1, d2, , dk} with probabilities p1, p2, , pk the expected value is:

p i = ptp t
t =1

In our case we have two matrices of power indices of national party groups, P and F, corresponding to two decision making rules (partisan and national coordination). Assuming mix of national and party coordination with probability l of party coordination of voting and 1-l probability of national coordination of voting, we obtain expected voting power of national party groups in our model as: S(l) = lP+(1-l)F where S(l) = (sij(l)), sij(l) stands for expected a priori voting power of party group j from region i. 6. Illustrative example Let us consider hypothetical parliament consisting of representatives of three regions A, B, and C decomposed into three super-regional parties L, M, R (altogether 6 national party groups). Distribution of seats is provided in Table 2.

Table 2: Distribution of seats in a hypothetical parliament of 3 regions Regions/parties L M R total seats A 7 10 3 20 B 15 15 0 30 C 3 22 25 50 total 25 47 28 100

Influence of super-regional parties Committee [51; 25, 47, 28] Voting power (1/3, 1/3, 1/3) Influence of regional representations Committee [51; 20, 30, 50] Voting power (1/6, 1/6, 2/3) Influence of regional party groups in ideologically coordinated voting?
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Party group L Part L committee [13; 7, 15, 3] Voting power of regional party groups in party L committee (0, 1, 0) Total power of L in the parliament ideological voting 1/3 is decomposed among the regional party groups (0, 1/3, 0) Party group M Party M committee [24; 10, 15, 22] Voting power of regional party groups in party M committee (1/3, 1/3, 1/3) Total power of M in the parliament ideological voting 1/3 is decomposed among the regional party groups (1/9, 1/9, 1/9) Party group R Party R committee [15; 3, 0, 25] Voting power of regional party groups in party R committee (0, 0, 1) Voting power of R in the parliament ideological voting 1/3 is decomposed among the regional party groups (0, 0, 1/3) Evaluation of voting power of regional party groups in ideological voting is provided in Table 3 that follows. Table 3: Evaluation of voting power of regional party groups in ideological voting Regions/parties L M R total voting power A 0 1/9 0 1/9 B 3/9 1/9 0 4/9 C 0 1/9 3/9 4/9 total 3/9 3/9 3/9 1

Table 3 provides decomposition of power among national party groups in ideologically coordinated voting (last row) and at the same time decomposition of power (national influence) among national representations in ideologically coordinated voting (last column). Influence of regional party groups in regionally coordinated voting? Region A Region A committee [11; 7, 10, 3] Voting power of regional party groups in region A committee (1/6, 4/6, 1/6) Total power of region A in the parliament regionally coordinated voting 1/6 is decomposed among the regional party groups (1/36, 4/36, 1/36) Region B Region B committee [16; 15, 15, 0] Voting power of regional party groups in region A committee (1/2, 1/2, 0) Total power of region B in the parliament regionally coordinated voting 1/6 is decomposed among the regional party groups (3/36, 3/36, 0) Region C Region C committee [26; 3, 22, 25] Voting power of regional party groups in region C committee (1/6, 2/60, 3/6) Voting power of region C in the parliament regionally coordinated voting 4/6 is decomposed among the regional party groups (4/36, 8/36, 12/36) Evaluation of voting power of regional party groups in regionally coordinated voting is provided in Table 4

15

Table 4: Evaluation of voting power of regional party groups in regionally coordinated voting Regions/parties L M R total voting power A 1/36 4/36 1/36 6/36 B 3/36 3/36 0 6/36 C 4/36 8/36 12/36 24/36 total 8/36 15/36 13/36 1 Table 4 provides decomposition of power among national party groups in regionally coordinated voting (last column) and at the same time decomposition of power (ideological influence) among super/regional parties in nationally coordinated voting (last row). Let us assume that 3/4 of voting acts are ideologically coordinated and 1/4 of voting acts are regionally coordinated. Then, from the following matrix equation:

we obtain the expected voting power of regional party groups, super-regional parties and regional representations (see Table 5). Table 5: Voting power of regional party groups, super-regional parties and regional representations Regions/parties L M R total expected voting power A 1/144 16/144 1/144 18/144 B 39/144 15/144 0 54/144 C 4/144 20/144 48/144 72/144 total 44/144 51/144 49/144 1 7. Empirical results In Table 6 we provide internal distribution of Shapley-Shubik power of national party groups in national representations (in our notations bkj). Table 7 presents distribution of SS power among national party groups, national representations and European parties in simple majority voting based on national coordination (in our notations jkj, bk and xj). Table 8 shows internal distribution of Shapley-Shubik power of national party groups in European parties (in our notations akj). Distribution of SS power among national party groups and national representations in simple majority voting based on ideological coordination is presented in Table 9 (in our notations pkj, aj and qk). Table 10 compares power of national representations in voting based on partisan and national coordination and Table 11 compares power of European political parties on partisan and national coordination. All results are multiplied by 100 (in percentage terms), data are rounded. Using Hix, Noury and Roland (2007) empirical evaluation of proportion of ideologically and national driven voting

16

coordination with l = 0,8 and 1-l = 0,2, we obtain expected power of national party groups, European political parties and national representations (Table 12). Table 6: Internal distribution of Shapley-Shubik power of national party groups in national representations
Internal SS-power of national party groups in national representations (in %) PPE-DE PSE ALDE Verts/ALE GUE/NGL IND/DEM UEN NI Total Austria 25 41,67 0 8,33 0 0 0 25 100 Belgium 28,33 36,68 28,33 3,33 0 0 0 3,33 100 Cyprus 66,67 0 16,66 0 16,66 0 0 0 100 Czech R. 100 0 0 0 0 0 0 0 100 Denmark 7,14 35,72 21,44 7,14 7,14 7,14 7,14 7,14 100 Estonia 16,67 66,67 16,67 0 0 0 0 0 100 Finland 28,33 28,33 36,67 3,33 3,33 0 0 0 100 France 13,81 50,48 13,81 7,14 3,81 3,81 0 7,14 100 Germany 60 10 10 10 10 0 0 0 100 Greece 41,67 25 0 0 25 8,33 0 0 100 Hungary 100 0 0 0 0 0 0 0 100 Ireland 40 10 10 0 10 10 20 0 100 Italy 38,46 21,07 14,4 1,07 7,02 4,4 9,18 4,4 100 Latvia 16,67 0 16,67 16,67 0 0 50 0 100 Lithuania 0 0 100 0 0 0 0 0 100 Luxemburg 75 8,33 8,33 8,33 0 0 0 0 100 Malta 0 100 0 0 0 0 0 0 100 Netherlands 30 30 20 6,67 6,67 6,67 0 0 100 Poland 43,37 13,33 8,33 0 0 18,33 8,33 8,33 100 Portugal 16,67 66,67 0 0 16,67 0 0 0 100 Slovakia 100 0 0 0 0 0 0 0 100 Slovenia 100 0 0 0 0 0 0 0 100 Spain 31,67 31,67 6,67 23,34 6,67 0 0 0 100 Sweden 30 30 13,33 0 13,33 13,33 0 0 100 United Kingdom 44,28 19,29 19,29 2,62 0,95 10,95 0 2,62 100 Country

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Table 7: Distribution of SS power of national party groups in simple majority voting based on national coordination
SS power of national party groups in voting based on national coordination SS power of national representations based on national coordination 2,34 3,14 0,77 3,14 1,81 0,77 1,81 11,02 14,53 3,14 3,01 1,68 11,02 1,16 1,68 0,77 0,64 3,54 7,35 3,14 1,81 0,90 7,35 2,47

Country Austria Belgium Cyprus Czech R. Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxemburg Malta Netherlands Poland Portugal Slovakia Slovenia Spain Sweden United Kingdom SS power of parties based on national coordination

PPEDE 0,59 0,89 0,51 3,14 0,13 0,13 0,51 1,52 8,72 1,31 3,01 0,67 4,24 0,19 0,00 0,58 0,00 1,06 3,18 0,52 1,81 0,90 2,33 0,74 4,88

PSE 0,98 1,15 0,00 0,00 0,65 0,51 0,51 5,56 1,45 0,79 0,00 0,17 2,32 0,00 0,00 0,06 0,64 1,06 0,98 2,09 0,00 0,00 2,33 0,74 2,13

ALDE 0,00 0,89 0,13 0,00 0,39 0,13 0,66 1,52 1,45 0,00 0,00 0,17 1,59 0,19 1,68 0,06 0,00 0,71 0,61 0,00 0,00 0,00 0,49 0,33 2,13

Verts/ALE 0,19 0,10 0,00 0,00 0,13 0,00 0,06 0,79 1,45 0,00 0,00 0,00 0,12 0,19 0,00 0,06 0,00 0,24 0,00 0,00 0,00 0,00 1,71 0,00 0,29

GUE/NGL 0,00 0,00 0,13 0,00 0,13 0,00 0,06 0,42 1,45 0,79 0,00 0,17 0,77 0,00 0,00 0,00 0,00 0,24 0,00 0,52 0,00 0,00 0,49 0,33 0,10

IND/DEM 0,00 0,00 0,00 0,00 0,13 0,00 0,00 0,42 0,00 0,26 0,00 0,17 0,48 0,00 0,00 0,00 0,00 0,24 1,35 0,00 0,00 0,00 0,00 0,33 1,21

UEN 0,00 0,00 0,00 0,00 0,13 0,00 0,00 0,00 0,00 0,00 0,00 0,34 1,01 0,58 0,00 0,00 0,00 0,00 0,61 0,00 0,00 0,00 0,00 0,00 0,00

NI 0,59 0,10 0,00 0,00 0,13 0,00 0,00 0,79 0,00 0,00 0,00 0,00 0,48 0,00 0,00 0,00 0,00 0,00 0,61 0,00 0,00 0,00 0,00 0,00

0,29 11,02

41,57

24,1 2

13,13

5,34

5,60

4,58

2,67

2,99 100

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Table 8: Internal distribution of Shapley-Shubik power of national party groups in European political parties
Country Austria Belgium Cyprus Czech R. Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxemburg Malta Netherlands Poland Portugal Slovakia Slovenia Spain Sweden United Kingdom Total Internal SS power of national party groups in European political parties PPE-DE PSE ALDE Verts/ALE GUE/NGL IND/DEM UEN 2,09 3,17 0 4,15 0 0 0 2,09 3,17 6,74 4,15 0 0 0 1,04 0 1,07 0 4,53 0 0 5,02 0,89 0 0 15,14 2,54 0 0,34 2,24 4,39 2,01 2,25 2,54 6,67 0,34 1,33 2,16 0 0 0 0 1,39 1,33 5,55 2,01 2,25 0 0 6,16 15,97 13,18 12,8 6,98 8,17 0 20,81 11,27 7,96 39,57 18,27 0 0 3,9 8,58 0 0 9,54 2,54 0 4,65 4,11 1,07 0 0 0 0 1,74 0,44 1,07 0 2,25 2,54 13,33 8,94 7,55 14,6 4,15 18,27 12,06 36,67 1,04 0 1,07 2,01 0 0 13,33 0,69 0,89 7,96 0 0 0 6,67 1,04 0,44 1,07 2,01 0 0 0 0,69 1,33 0 0 0 0 0 2,45 3,17 5,55 8,26 4,53 4,68 0 6,94 3,63 4,39 0 0 28,37 23,33 3,17 5,55 0 0 6,98 0 0 2,81 1,33 0 0 0 0 0 1,39 0,44 2,16 0 0 0 0 8,94 11,82 2,16 6,18 2,25 0 0 1,74 2,24 3,25 2,01 4,53 8,17 0 10,6 9,1 14,6 10,68 2,25 28,37 0 100 100 100 100 100 100 100 NI 9,76 9,76 0 1,43 0 0 0 25,24 0 0 0 0 11,9 0 0 0 0 0 22,38 0 9,76 0 0 0 9,76 100

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Table 9: Distribution of SS power of national party groups in simple majority voting based on party coordination
SS power of national party groups in voting based on partisan coordination SS power of national representatios based on partisan coordination NI 0,43 0,43 0,00 0,06 0,00 0,00 0,00 1,11 0,00 0,00 0,00 0,00 0,52 0,00 0,00 0,00 0,00 0,00 0,98 0,00 0,43 0,00 0,00 0,00 0,43 2,14 3,10 0,84 3,28 1,87 0,70 1,87 10,17 15,37 3,89 2,82 1,79 11,22 1,29 1,87 0,79 0,53 3,43 7,59 2,74 1,82 0,95 6,71 2,41 10,81

Country PPE-DE Austria Belgium Cyprus Czech R. Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxemburg Malta Netherlands Poland Portugal Slovakia Slovenia Spain Sweden United Kingdom SS power of parties Based on partisan Coordination 0,85 0,85 0,42 2,04 0,14 0,14 0,56 2,50 8,45 1,58 1,89 0,71 3,63 0,42 0,28 0,42 0,28 0,99 2,82 1,29 1,14 0,56 3,63 0,71 4,30 PSE 0,60 0,60 0,00 0,17 0,42 0,25 0,25 3,02 2,13 1,62 0,78 0,08 1,43 0,00 0,17 0,08 0,25 0,60 0,69 1,05 0,25 0,08 2,24 0,42 1,72 ALDE 0,00 0,96 0,15 0,00 0,62 0,31 0,79 1,87 1,13 0,00 0,15 0,15 2,07 0,15 1,13 0,15 0,00 0,79 0,62 0,00 0,00 0,31 0,31 0,46 2,07 Verts/ALE 0,27 0,27 0,00 0,00 0,13 0,00 0,13 0,84 2,59 0,00 0,00 0,00 0,27 0,13 0,00 0,13 0,00 0,54 0,00 0,00 0,00 0,00 0,40 0,13 0,70 GUE/NGL 0,00 0,00 0,26 0,88 0,13 0,00 0,13 0,41 1,07 0,56 0,00 0,13 1,07 0,00 0,00 0,00 0,00 0,26 0,00 0,41 0,00 0,00 0,13 0,26 0,13 IND/DEM 0,00 0,00 0,00 0,13 0,13 0,00 0,00 0,42 0,00 0,13 0,00 0,13 0,62 0,00 0,00 0,00 0,00 0,24 1,45 0,00 0,00 0,00 0,00 0,42 1,45 UEN 0,00 0,00 0,00 0,00 0,29 0,00 0,00 0,00 0,00 0,00 0,00 0,59 1,61 0,59 0,29 0,00 0,00 0,00 1,03 0,00 0,00 0,00 0,00 0,00 0,00

40,60

18,93

14,17

6,55

5,83

5,12

4,40

4,40

100

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Table 10: Power of national representations in voting based on partisan and national coordination
SS power of national representations based on party coordination Austria 2,14 Belgium 3,10 Cyprus 0,84 Czech R. 3,28 Denmark 1,87 Estonia 0,70 Finland 1,87 France 10,17 Germany 15,37 Greece 3,89 Hungary 2,82 Ireland 1,79 Italy 11,22 Latvia 1,29 Lithuania 1,87 Luxemburg 0,79 Malta 0,53 Netherlands 3,43 Poland 7,59 Portugal 2,74 Slovakia 1,82 Slovenia 0,95 Spain 6,71 Sweden 2,41 United Kingdom 10,81 100,00 Country SS power of national representations based on national coordination 2,34 3,14 0,77 3,14 1,81 0,77 1,81 11,02 14,53 3,14 3,01 1,68 11,02 1,16 1,68 0,77 0,64 3,54 7,35 3,14 1,81 0,9 7,35 2,47 11,02 100,00

Table 11: Power of European political parties in voting based on partisan and national coordination
SS power of European parties SS power of European parties Party PPE-DE PSE ALDE Verts/ALE GUE/NGL IND/DEM UEN NI based on party coordination 40,6 18,93 14,17 6,55 5,83 5,12 4,4 4,4 100 based on national coordination 41,57 24,12 13,13 5,34 5,6 4,58 2,67 2,99 100

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Table 12: Expected power of national party groups, European political parties and national representations based on mix of national and party coordination with l = 0,8
Expected SS power of national party groups in voting based on mix of national Expected SS power of and party coordination nat. representations based on mix of national and party coordination Country Austria Belgium Cyprus Czech R. Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxemburg Malta Netherlands Poland Portugal Slovakia Slovenia Spain Sweden United Kingdom Expected SS power of European parties based on mix of national and party coordination PPE-DE 0,80 0,86 0,44 2,26 0,14 0,14 0,55 2,31 8,50 1,53 2,11 0,70 3,75 0,38 0,22 0,45 0,22 1,01 2,89 1,13 1,27 0,63 3,37 0,71 4,42 PSE 0,68 0,71 0,00 0,13 0,47 0,30 0,30 3,53 2,00 1,46 0,62 0,10 1,61 0,00 0,13 0,08 0,33 0,69 0,75 1,26 0,20 0,07 2,26 0,49 1,80 ALDE 0,00 0,94 0,15 0,00 0,58 0,27 0,76 1,80 1,19 0,00 0,12 0,15 1,97 0,16 1,24 0,13 0,00 0,77 0,62 0,00 0,00 0,24 0,34 0,43 2,08 Verts/ALE 0,26 0,24 0,00 0,00 0,13 0,00 0,12 0,83 2,36 0,00 0,00 0,00 0,24 0,14 0,00 0,12 0,00 0,48 0,00 0,00 0,00 0,00 0,67 0,11 0,62 GUE/NGL 0,00 0,00 0,24 0,71 0,13 0,00 0,12 0,41 1,14 0,60 0,00 0,14 1,01 0,00 0,00 0,00 0,00 0,26 0,00 0,43 0,00 0,00 0,20 0,28 0,13 IND/DEM 0,00 0,00 0,00 0,10 0,13 0,00 0,00 0,42 0,00 0,16 0,00 0,14 0,59 0,00 0,00 0,00 0,00 0,24 1,43 0,00 0,00 0,00 0,00 0,40 1,40 UEN 0,00 0,00 0,00 0,00 0,26 0,00 0,00 0,00 0,00 0,00 0,00 0,54 1,49 0,59 0,23 0,00 0,00 0,00 0,94 0,00 0,00 0,00 0,00 0,00 0,00 NI 0,46 0,36 0,00 0,05 0,03 0,00 0,00 1,05 0,00 0,00 0,00 0,00 0,52 0,00 0,00 0,00 0,00 0,00 0,91 0,00 0,34 0,00 0,00 0,00 0,40 2,19 3,11 0,82 3,25 1,86 0,71 1,85 10,34 15,20 3,74 2,86 1,77 11,18 1,27 1,83 0,79 0,55 3,45 7,54 2,82 1,82 0,94 6,84 2,42 10,85

40,80

19,97

13,96

6,31

5,79

5,01

4,05

4,12

100,00

8. Concluding remarks In this chapter we attempted to show that it is possible to evaluate not only the influence of European political parties as entities in ideologically driven voting and of national representations as entities in nationally driven voting, as it is usually done in analytical papers (Holler and Kellermann (1977), Hosli (1997), Nurmi (1997a)) but also the influence of national chapters of European political parties both in ideological and national voting and national influence in ideological voting, as well as the European political parties influence in national voting. Moreover, using mix of partisan coordination and national coordination (based on empirical ex post data about voting and assuming the same behavior in future), we can evaluate expected power of national party groups, European political parties and national representations reflecting both ideological and national dimension.
22

We demonstrated that different dimensions of voting (ideological, national) lead to different levels of influence of the same national party group, European political party and national representation. For example, by our model the national chapter of the two Czech Social Democrats has zero influence in national coordination of voting, but measurable non-zero influence in partisan coordination within parliamentary faction of PSE. The national influence of the Czech Republic in ideologically coordinated voting is greater than in nationally coordinated voting. While the influence of PSE in ideologically coordinated voting is 18.93%, in nationally coordinated voting it increases to 24.12%. Disaggregated structural effects, abandoned by most of standard analyses, are at least as important as aggregated effects. The findings of our model analysis open the problem of strategic considerations, such as coalition formation, that can go across the existing structure, e.g. coalition of a country representation with some European political party, or preferring national coordination of different party groups of the same country to ideological coordination (this problem was opened with respect to Poland in Mercik, Turnovec, and Mazurkiewicz, 2004). There is a broad area for extensions of presented model. Used methodology of power indices has its critics. What exactly power indices are measuring is controversial, see e.g. arguments of Garrett and Tsebelis (1999) about ignoring preferences, and response of Holler and Widgrn (1999), but they are of general interest to political science because they may measure players ability to get what they want. Admittedly significant share of decisions under the EU decision making procedures are taken without recourse to a formal vote. But it may well be the case that the outcome of negotiation is conditioned by the possibility that a vote could be taken, and than a priori evaluation of voting power matters. Moreover, analyses of institutional design of decision making could benefit from power indices methodology (Holler and Owen 2001, Lane and Berg 1999). Continuing research and deeper understanding of power indices methodology reflect an actual demand for amendment of traditional legal and political analysis of institutional problems by quantitative approaches and arguments. Acknowledgments This research was supported by the Czech Government Research Target Program, project No. MSM0021620841 and by the joint program of Ministry of Education of the Czech Republic and Ministry of Education of the Republic of Poland, project No. 2006/12 The economics of democratic governance in an extending European Union. References
Baldwin, R. and M. Widgren (2004), Winners and Losers Under Various Dual Majority Rules for the EUs Council of Ministers. In: M. Wiberg (ed.), Reasoned Choices, The Finnish Political Science Association, Turku, 42-89. Banzhaf, J.F., (1965), Weighted Voting doesn't Work: a Mathematical Analysis. Rutgers Law Review, 19, 317-343. Berg, S. and M. Holler (1986), Randomized Decision Rules in Voting Games: a Model for Strict Proportional Power. Quality and Quantity, 20, 419-429. Bindseil, U. and C. Hantke (1997), The Power Distribution in Decision Making among EU Member States. European Journal of Political Economy, 13, 171-185. Brams,S.J. and P.Affuso (1985), New Paradoxes of Voting Power on the EC Council of Ministers. Electoral Studies, 4, 135-139. Deegan,J. and E.W.Packel (1979), A New Index of Power for Simple n-person Games. International Journal of Game Theory, 7, 113-123.

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Felsenthal,D.S., M.Machover (2004), A Priori Voting Power: What is it All About. Political Studies Review, 2, No. 1, 1-23.. Felsenthal,D.S., M.Machover, 1998. The Measurement of Voting Power, Theory and Practice, Problems and Paradoxes. Edward Elgar, Cheltenham, Northampton. Garrett,G. and G.Tsebellis (1999), Why Resist the Temptation to Apply Power Indices to the EU. Journal of Theoretical Politics, 11, 321-331. Hix, S. (2002), Parliamentary Behavior with Two Principals: Preferences, Parties, and Voting in the European Parliament. American Journal of Political Science, 46, 3, 688-698. Hix, S., Noury, A. G. and G. Roland (2006), Democratic Politics in the European Parliament. Cambridge Universitz Press, Cambridge. Holler, M., J.Kellermann (1977), Power in the European Parliament: What Will Change?. Quantity and Quality, 11, 189-192. Holler,M. and M.Widgren (1999), Why Power Indices for Assessing EU Decision-Making?. Journal of Theoretical Politics, 11, 291-308. Holler,M. and G.Owen (2001), Why Power Indices and Coalition Formation? In: M. Holler and G. Owen, eds., Power Indices and Coalition Formation. Kluwer, Boston, Dordrecht, London, 1-13. Holler,M.J. and E.W.Packel (1983), Power, Luck and the Right Index. Journal of Economics, 43, 21-29. Holubiec,J.W. and J.W. Mercik (1996), Inside Voting Procedures. Accedo Verlagsgesellschaft, Munich. Hosli,M.O. (1997), Voting Strength in the European Parliament: The Influence of National and of Partisan Actors. European Journal of Political Research, 31, 351-366. Johnston, R.J. (1978), On the Measurement of Power: Some Reactions to Laver. Environment and Planning, 10A, 907-914. Johnston, R. J. (1982), Political Geography and Political Power. In: M. Holler, ed., Power, Voting, and Voting Power. Physica Verlag, Wrzburg, Wien, 289-306. Knig,T. and T. Bruninger (2001), Decisiveness and Inclusiveness: Two Aspects of the Intergovernmental Choice of European Voting Rules. In: M. Holler and G. Owen, eds., Power Indices and Coalition Formation. Kluwer, Boston, Dordrecht, London, 273-290. Lane J.-E. and S. Berg (1999), Relevance of Voting Power. Journal of Theoretical Politics, 11, 309-320. Laruelle, A. (1998), Game Theoretical Analysis of Decision Making Processes with Applications to the European Union. CIACO, Universit Catholique de Louvain, Louvain-laNeuve. Mercik, J. W., Turnovec F. and M. Mazurkiewicz (2004), Does Voting over National Dimension Provide more National Influence in the European Parliament than Voting over Ideological Dimension? In: Owsinski, J. W. ed., Integration, Trade, Innovation and Finance: From Continental to Local Perspectives, Warszawa, Polish Operational and Systems Research Society, 173-186 Noury, A.G. (2002). Ideology, Nationality and Euro-Parlamentarians. European Union Politics, 3(1), 33-58. Nurmi, H. (1997a), The Representation of Voter Groups in the European Parliament, A Penrose-Banzhaf Index Analysis. Electoral studies, 16, 317-327. Nurmi, H. (1997b), On Power Indices and Minimal Winning Coalitions. Control and Cybernetics, 26, 609-611. Nurmi, H. (2000), Game-Theoretical Approaches to the EU Institutions. An Overview and Evaluation. Homo Oeconomicus, XVI (4), 363-389. Nurmi, H., T. Meskanen and A. Pajala, (2001), Calculus of Consent in the EU Council of Ministers. In: M. Holler and G. Owen, eds., Power Indices and Coalition Formation. Kluwer, Boston, Dordrecht, London, 291-313. Penrose, L. S. (1946), The Elementary Statistics of Majority Voting. Journal of the Royal Statistical Society, 109, 53-57. 24

Plechanovov, B. (2004), Institucionln vvoj Evropsk Unie od Maastrichtsk smlouvy k vchodnmu rozen. Karolinum, Charles University in Prague. Shapley, L S. and M.Shubik (1954), A Method for Evaluation the Distribution of Power in a Committee System. American Political Science Review, 48, 787-792. Somczyski W. and K. yczkowski (2006), Penrose Voting System and Optimal Quota. Acta Physica Polonica B, 37, No. 11, 3133-3143.

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3. Free movement of labour: lessons for NAFTA from the EU 2004 Enlargement
Wadim Strielkowski Institute of economic studies, Faculty of social sciences, Institute of economic studies Abstract: This work presents a framework for comparison of Mexican immigration in the United States with immigration from EU-8 Member States (post-transition economies of the Central and Eastern Europe that joined the EU in 2004) to the EU-15 countries. First, the provisions of the North American Free Trade Agreement (NAFTA) and Preaccession agreements of the EU and other accession countries are analyzed and common features are vivisected. Second, the flows of Mexican immigration to the United States (legal and illegal) as well as immigration from EU-8 states are described. Similarities and differences are analyzed and discussed. Third, some conclusions are made and lessons from EU Eastern Enlargement are derived. It appears that similar to the EU Enlargement in May 2004, gradual opening of the U.S. labor market for those Mexicans who are willing to live and work in the United States will not dramatically increase immigration. Similarly to the 2004 EU Eastern Enlargement, when the accession of 10 New Member States made it possible for their citizens to live and work legally in selected EU countries, the migration wave appeared to be smaller than expected. In addition to that, many Mexicans have already made their way to the United States pushed by hard conditions at home and pulled by the social ties to compatriots communities. Despite many differences between Mexican migration to the U.S and Eastern European migrations to the EU-15, many similarities are found that make the appeal for opening the borders even more justifiable than it seems.

1. Introduction Throughout the last century immigration has become an inextricable issue of social and economic agenda in the majority of the worlds developed countries. This is of no surprise, as far as today about 100 million people in the world live in a country other than their own. Although immigration is often associated with such traditional immigration-receiving countries as Australia, Canada and the U.S. it has also started to play an important role in Europe. In many EU countries, such as France or United Kingdom 11% and 9% of population respectively are foreign born (Borjas, 1994). Membership in European Union entails an obligation to open national borders to any European migrants wishing to come (unless other restrictions apply). However, most of the studies dealing with immigration chose the example of immigration to the United States. This is being done for two main reasons: (i) ever since immigration figures have been available it is clear that the U.S. has been the most common destination; (ii) most of the economic literature that has been written about the economic impact of immigration relates to the U.S. And of all immigration source countries that provided steady flows of immigrants to the U.S., Mexico has always been among the top five (Freeman, 1993). The immigration Act was adopted in 1965 and opened the doors for immigrants from nonEuropean countries. However, even well before that Mexico had been the only developing immigrant source country alongside with such developed countries as Canada, Germany, Italy and the United Kingdom. Nowadays, Mexico contributes by the 40% of all immigration to the U.S. (Friedberg and Hunt, 1995).
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Mexico has always been a special neighbor for the U.S. which cannot be easily ignored: the proximity of both countries (2 000 mile-long common border) and therefore susceptibility to domestic events of each other make Mexico to be of a special importance for the U.S. To strengthen this fact the North American Free Trade Agreement (NAFTA) was launched in 1994 making Mexico the U.S. second largest trading partner (Rodrigues-Scott, 2002). However, NAFTA is a free-trade agreement that does not include provisions on the free movement of persons. Thus, the issue of Mexico immigration has just been tackled but not solved. The successive U.S. governments realize the necessity of undertaking firm action towards demarcation of rules for Mexican immigration, although none of them wants to take political responsibility for that action. Meanwhile mostly illegal immigration from Mexico is growing, bringing low-educated and unqualified Mexicans to the U.S. On the other side of the world a quite similar story is taking place, although in somewhat different dimensions. The story is called EU integration. The European Union which is a supranational union of 25 Member States was established in 1992 by the Maastricht Treaty (The Treaty on European Union). The EU became a successor of European Communities and other forms of predecessor relationships dating back to 1957. Since the beginning of the European integration Member States have agreed on leaving the doors for the new Members open. Throughout the decades European countries have been joining the block and they are recently followed by the former Communist states from behind the Iron Curtain. Those former Communist countries which are now full-time EU Members is the case that can be used in order to analyze the challenges for U.S. Mexico relations with regard to opening the U.S. borders for Mexican immigrants. What is strikingly similar between the two cases is the fear of the wealthier party to open the borders to legal migration, although illegal and hidden migrations have already existed. Pre-accession agreements EU-15 members had with the former Communist countries applying for the EU Membership (referred as EU-8) were also about free trade with no mention of free movement of labor. On the 1st of May 2004, however, 8 former Communist countries (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia) finally joined the EU which was followed by opening of the labor markets of selected EU-15 Member States (Ireland, Sweden and the United Kingdom). Two years after Greece, Finland, Portugal and Spain opened their labor markets for the newcomers. Although numerous studies and reports had been warning general public against opening the borders for the labor force from new states predicting millions of people to flood the labor markets, none of that ever happened. At the moment, immigration from the EU-8 Member States is as low as 200-300 thousand people per year with most of them being young and well-educated people working seasonally (usually during the school holidays) and returning to their home countries after some period of time. 2. Main differences and similarities between NAFTA agreement and the EU preaccession agreements Regional economic integration may generally take four basic forms depending on the degree of integration between countries: (i) free trade agreement; (ii) customs union; (iii) common markets; and (iv) single markets. NAFTA, a free-trade agreement elaborated between Canada, Mexico and the U.S. was designed to open borders and promote free trade between its members. The Agreement was signed in 1992, ratified by the U.S. Congress in November 1993 and implemented in January 1994 forming the world largest free trade area. According to its founding Treaty NAFTA has six main objectives: (i) eliminate barriers to trade in, and facilitate the cross-border movement of, goods and services between its Members; (ii) promote conditions of fair competition in the free trade area; (iii) increase substantially investment opportunities; (iv) provide adequate and
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effective protection and enforcement of intellectual property rights; (v) create effective procedures for the implementation and application of the Agreement, for its joint administration and for the resolution of disputes; and (vi) establish a framework for further trilateral, regional and multilateral cooperation to expand and enhance the benefits of this Agreement (Article 102, The North American Free Trade Agreement). Immediately after it came into existence, NAFTA reduced some tariffs, while others were scheduled to fall to zero over a fifteen-year period. While some areas such as increase in mutual trade, closer relations among government of all three Members and, for Mexico, stronger economy are attributed to the successes of NAFTA, other areas raise doubts about its value and use for all (McMahon, 2002). Leaving aside the debate about whether NAFTA itself caused the increase of Mexican immigrants in the U.S. (discussed, for example, in Hinojosa and Robinson (1991) or Martin (1993)) this section would focus on comparing NAFTA with another similar Treaty the Treaty establishing the European Community. The EC Treaty (officially called The Treaty establishing the European Economic Community) was signed in Rome in 1957. After the Treaty of Maastricht and other amendments the Treaty became the Treaty establishing the European Community. According to the Article 3 the activities of the Community were set up in order to follow the timetable that included: (i) the elimination as between Member States, of customs duties and quantitative restrictions on the import and export of goods, and of all other measures having equivalent effect; (ii) a common commercial policy; (iii) an internal market characterized by the abolition, as between Member States, of obstacles to the free movement of goods, persons, services and capital; (iv) measures concerning the entry and movement of persons in the internal market; (v) a common policy in the sphere of agriculture and fisheries; (vi) a common policy in the sphere of transport; (vii) a system ensuring that competition in the common market is not distorted; (viii) the approximation of the laws of the Member States to the extent required for the functioning of the common market; (ix) a policy in the social sphere comprising a European Social Fund; (x) the strengthening of economic and social cohesion; (xi) a policy in the sphere of the environment; (xii) the strengthening of the competitiveness of Community industry; (xiii) the promotion of research and technological development; (xiv) encouragement for the establishment and development of trans- European networks; (xv) a contribution to the attainment of a high level of health protection; (xvi) a contribution to education and training of quality and to the flowering of the cultures of the Member States; (xvii) a policy in the sphere of development cooperation; (xviii) the association of the overseas countries and territories in order to increase trade and promote jointly economic and social development; (xix) a contribution to the strengthening of consumer protection; (xx) measures in the spheres of energy, civil protection and tourism (EC Treaty, 1957). A rule of the free movement of labor allows a worker from one Member state to look for employment and actually work in another Member state on the same basis as a national, no restrictions and discrimination involved. For the six founding members of the European Economic Community (Belgium, France, Germany, Italy, Luxembourg and the Netherlands) this has finally came to power in 1968, though there were some so-called safeguard clauses applicable until 1991 in case of single countries. Transitional agreements were also applied both at the times of EU accession of Greece, Spain and Portugal five years later. When the introduction of freedom of movement was discussed at the beginning of the 1960s, there was a fear that Germany and France would be overflowed with Italian workers. At this time, of course, Italy was a classic emigration country. However, the feared wave of immigrants did not materialize. Although the number of Italian workers elsewhere in the EC did grow, increases in migration following the introduction of freedom of movements remained below the EC average. Nor did the accession of the United Kingdom, Ireland and
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Denmark in 1973 create a wave of migration. The same kind held true when free movement of workers was granted in full to Greece (1987) and to Spain and Portugal (1992) after a transition period of several years. When Austria, Sweden and Finland joined in 1995 they were immediately granted full freedom of movement. However, when 8 formerly Communist countries were joining the EU in May 2004 the freedom of movement of labor was postponed. The accession of economically weaker candidates became a source of mass fears in EU-15 Member States. According to the opinion pall made by Eurobarometer in 1997 the mass flows of cheap labor force from the new Member States was feared by 51% of the respondents and high costs of western enlargement consequently by 44% (Eurobarometer, 1997). Fears of mass migration of workers from EU-8 countries after EU enlargement become a topic of political and economic debates, studies and simulation models created both for the European Commission and in the acceding countries. These fears, supported by the politicians never materialized, although they gave some countries such as Germany and Austria (that generally profit from the Enlargement in terms of trade and investments) grounds to use the restriction on workers from the East for the maximum period of time allowed by the EU rules. What do both stories have in common? Undoubtly, there are differences: the scope of economic and social integration in EU is deeper (Single Market) and there is a strong political motivation behind the EU integration process. The idea of the creation of European Union came as a result of devastating wars and European rivalry and much of the political pressure have been put in order to reach the present level of economic integration. On the other hand, NAFTA is merely a trade agreement which does not even mean to harmonize trade barriers with regard to non-member countries. The approach to labor migration is also different: while the EU is aiming at finalizing its Single Market by opening the borders for labor force from all Member States, NAFTA perceives labor mobility as a less relevant issue. Only temporary entry permits for certain business categories are issued under NAFTA with Canadians having more advantages and freedom of movement in the U.S. than Mexicans. Nevertheless, there is one similar pattern in common: wealthier countries enjoy opening their markets to free trade but they do not like to grant free movement of labor for their poorer counterparts. Both in case of NAFTA and EU, the wealthier parties (the U.S. or EU-15) effectively ban the immigrants from poorer countries (Mexico and EU-8) to enter their labor markets. As in the case of NAFTA Canadian citizens have more rights, especially in terms of living and working in the U.S., in the case of EU citizens of some Member States can live and work in all EU-25, while citizens of EU-8 have a limited selection of countries to choose from when they are thinking of moving somewhere else to live and work. In both cases, it seems that nothing proves that once borders are open, mass inflows of immigrants from poorer countries would appear. Rather than that, it seems that there is politics underlining the whole story: politicians have to keep their voters calm and besides stories of hungry hoards of immigrants always attract masses and can be useful to build up someones political career. Therefore, in both NAFTA and EU-25 cases there have never been any serious economic grounds to ban the free movement of persons/labor. Those who wanted to work and live in the wealthier neighboring country are already there and those who would never leave their home are not likely to change their minds abruptly once the milestones and border guards with their dogs leave the frontiers. 3. Inter-EU and U.S.-Mexican migrations: comparing like with like? General economic theory suggests that labor tends to move from low-wage areas to highwage areas. In accordance with this it is not surprising to see that people are eager to move
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from such a low-wage country as Mexico (GDP per capita of $10,000) to such high-wage country as the U.S. (GDP per capita of $42,000) (Wolfram, 2006). Leaving aside the issues how the newcomers affect the wages of the domestic population and what their impact on local economy might be (which are analyzed by many authors, for instance, see Borjas (1990), La Londe and Topel (1991), Nixon (1993) or Pope and Winters (1993)), the question that arises in this elaboration is the following: providing that the borders are opened for newcomers from the source countries, will the target country be over-flooded by immigrants? We argue that such thing would never happen in the case of the U.S. and Mexico as it has not happened in the case of the EU-8 Member States and EU-15. Any attempt to state and explicit judgment such as the one above requires, however, serious grounds on which it can be built. The line of argumentation used here is the following: there are similar trends in immigration from poorer countries to the wealthier ones: from Mexico to the U.S. as well as from the EU-8 Member States to the EU-15. Recent EU Enlargement and opening of the labor markets for the EU newcomers by the richest EU-15 members with one of the highest GDP per capita and wages in the EU (Ireland and United Kingdom) has not triggered off mass labor migration. In fact, those people from the EU new Member States who wanted to live and work in Ireland and United Kingdom moved there well before the Enlargement (either legally or illegally). It has been estimated by the European Foundation for the Improvement of Living and Working Conditions that before 2004 about 3% of the total EU population (1 million people) from former Communist countries that joined the EU in 2004 worked in EU-15 countries (European Foundation for the Improvement of Living and Working Conditions, 2005). Since EU Enlargement, an additional 200,000-300,000 of immigrants from these countries have entered EU-15 Member States each year. Most of these people have gone to Austria and Germany, although Ireland and the United Kingdom have received more workers than anticipated. According to European Policy Center most of these migrant workers in Sweden and the United Kingdom are highly-skilled but concentrated in low-skilled jobs in sectors such as hospitality, catering, agriculture and construction. In the United Kingdoms poorly-regulated labor market immigrants from EU-8 Member States often experience substandard conditions and low wages (European Policy center, 2006). Chart 1: Main causes for people to move to another EU country

Source: own estimations None of these figures ever matched the prognoses that were elaborated by various authors in the 1990s. The majority of the most relevant studies has been summarized in the paper by Strielkowski and ODonoghue (2006): although the actual migration to the EU-15 states was somewhat higher than estimated for example by Salt et al. (1999), ujanova and ujan (1997)
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or Huber-Pichelmann (1998), Hofer (1998), it has never reached the heights as estimated in Brucker/Franzmeyer (1997), Lundborg et al. (1997) or Fassman and Hinterman (1997) (Strielkowski and ODonoghue, 2006). According to the Eurobarometer survey held in 2006, the majority of immigrants from EU-8 Member states were young people and students (so-called a 15-34 age group). Apart from that, EU immigrants are known to be well-educated people on average. The main drivers of mobility were the opportunity to meet new people and discover new places (40%), economic reasons such as more money and better quality of employment (38%), better housing conditions (17%) and better local environment (17%) (Eurobarometer, 2005). Chart 1 above summarizes the main drivers for people to move into another EU country. European Foundation for the Improvement of Living and Working Conditions made the distinction of the new Member States using the data from Eurobarometer surveys (2001, 2005) by mobility levels. According to it in four low mobility EU-8 Member States (Czech Republic, Hungary, Slovakia and Slovenia) only 1-2% of citizens have any intention of moving. On the other hand in such high mobility Member States as Estonia, Latvia, Lithuania and Poland between 7 and 9% of population have some interest in moving (European Foundation for the Improvement of Living and Working Conditions, 2005). For the EU-15 or EU old Member States high mobility countries include Denmark, Ireland, Finland and Sweden the interest in moving is about 4-6% on average. Apart from that even the low mobility EU-15 countries have a slightly higher intention of moving that surpasses such EU-8 Member States as the Czech Republic, Hungary or Slovenia. Such mobility levels (alternatively called proximity to migration in the literature) are very low, if compared to the U.S. where around 32% of population live outside the state in which they were born (U.S Census Bureau, 2000). Notwithstanding, the U.S. and EU cannot be compared directly: lower institutional and language barriers in the U.S. do not enable to compare like with like. As European Foundation report points out, it would be more realistic to compare U.S. migration with migration within EU regions. This comparison changes the picture: about 21% of the EU population has lived in a region (or country) other than their own (European Foundation for the Improvement of Living and Working Conditions, 2005). The case of the U.S is somewhat different. For decades the U.S. did not put any restrictions on immigration flows from Latin America yet massive flows of immigrants did not come. Mexican workers were widely used in agriculture and in railroads construction since early 19th century. Rapid development of the U.S. economy, construction of major railroads and agriculture boom required many working hands. Being a neighboring country with relatively poor population Mexico was an ideas source of labor resources. U.S immigration act of 1917 created a legal framework for employing Mexican laborers (called braceros or day laborers) allowing firms to employ Mexicans and issuing special working visas for them. There were even attempts to attract more workers by using advertisements in newspapers, radio and through the word of mouth offering them (Driscoll 1999; Gamboa 1990). Slowly but gradually, Mexican laborers were diversifying into the meat packing industries, automotive plants, and steel plants. Because they were moving deeper into the U.S. territory and could not easily commute back and forth from the interior, they began to establish neighborhoods in areas near their place of employment. This was the beginning of a social process in which Mexican immigrants began to establish roots in the U.S. (Rodriguez-Scott, 2002). New immigration legislation of 1921 and 1924 introduced the fees for working visas which triggered off the process of illegal immigration from Mexico to the U.S. Together with legal labor immigrants thousands of illegal workers were crossing the U.S. border each year. However, the flow of Mexican immigrants has never been overwhelming. In the 1950s the number of Mexican immigrants barely exceeded the number of Canadian immigrants. The
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reason why large numbers did not migrate despite the huge U.S.- Latin American wage differences may be found in the huge non-pecuniary costs of being a pioneer immigrant (Freeman, 1993). Costs are presumably high because pioneers have no friends or cultural community with which to interact in the receiving country. Although immigrant networks of Mexicans existed since the end of the 19th century, working opportunities and demand for working force were so disperse that there were still parts of the country without established communities of Mexican immigrants. One special feature of Mexican immigration to the U.S. is remittances. Mexican immigrants have been traditionally sending part of the earned money back home to help their families and communities as well as indirectly boost the economic growth in the country. Banco de Mexico calculated that Mexican migrants working in the U.S. sent to Mexico 6.5 billion U.S. dollars in 2000 and an estimated 10 billion U.S. dollars in 2001. In October 2001, the remittances had already been calculated at 8 billion U.S. dollars (SourceMex 2001). Many researchers calculated remittances in particular towns throughout Mexico as having reached 86.464 U.S. dollars or 13% of total community income but some towns had as much as 28.4% of total income (Verduzco and Unger 1998). What is special for Mexican immigration to the U.S are its push factors, such as: unemployment, financial crisis, low level of industrialization as well as crisis in the farming sector. It has been stated by many authors that the wealth distribution in Mexico is not equal (see for example Skidmore and Smith (1997); Rodriguez-Scott (2002); American Immigration Law Foundation (2002)). For years the rich became even richer in Mexico and the poor poorer, with no middle class being created. A large number of people in Mexico are dependent on agriculture and its crises increases migrations. Generally, most of the immigrants come from rural areas: according to Varduzco and Unger (1998) migratory activity levels in Mexico are at 62%. Of these, the primary states of emigration origin are Jalisco, Michoacan, Zacatecas, Durango, and Oaxaca. Mexican south-western states of Chiapas, Tabasco, Campeche, Yucatan and Quintana Roo have 66.5% of no participation in migrant flows, central states Oaxaca, Veracruz, Guerrero, Puebla, Tlaxcala, Hidalgo, Queretaro, Mexico, Morelos have 33.8% that do not participate and in the border states there is only a 10.2% that do not participate in the migratory flows (Verduzco and Unger 1998). Chart 2: Main causes of Mexican immigration to the U.S.

Source: own estimations

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Another trend in recent Mexican immigration to the U.S. is that low-skilled labor force gives way to educated and skilled professionals. With the launch of NAFTA in 1994 migratory patterns have started to change. This process will continue to develop as Mexico gradually gains equality with Canada in NAFTA. It is estimated that NAFTA permitted an increase of professional migrants from Mexico by 2003. Chart 2 above summarizes the main causes of Mexican immigration to the U.S. Eight main causes are indicated as being the incentives for immigrants. Now that two cases have been described, a question can be posed: is comparing immigration from EU-8 to EU-15 and from Mexico to the U.S. means comparing like with like? It can be shown that it is, indeed. There are several aspects to prove this thesis. These aspects include proximity to target country, wage gaps, globalization and public facilities. All these aspects are discussed below in a greater detail. Proximity to target country: One of the factors that facilitate immigration is undoubtly proximity of the target country. Some might argue that this proximity is different in case of Mexico and in case of EU-8 and EU-15 immigrations. Indeed, sometimes it takes 50 kilometers to cross U.S.-Mexican border, while people from EU-8 have to cover about 1000 kilometers to come to the United Kingdom or Ireland. However, it can be shown that the costs of such trips are roughly equal. According to the Greyhound transportation company website, the cost of crossing the Mexico-U.S. border by bus equals at around 40 U.S. dollars. In addition to that, illegal border crossing provides alternative opportunity how to get to the U.S. According to Migration News (2000) a U.S. company Tyson Foods Inc. was indicted of recruiting illegal workers from Mexico to work in their poultry plant. Workers would be recruited just inside the U.S. border by smugglers who were paid 100-200 U.S. dollars by each worker (Migration News, 2000). In 2003 there were estimated 5.9 million unauthorized Mexican immigrants to the U.S. among a total unauthorized population of 10.3 million (Passel, 2005). People crossing the border with the U.S. illegally do not risk anything in case they are caught by the U.S. border guards: illegal border crossing involved voluntary deportation which is basically a free bus ride across the border back to Mexico, leaving the immigrants in position to attempt illegal entry in the near future (Hanson, 2005). In case of the EU-8 and EU-15 immigrations, no border restrictions apply any longer and the costs of trips are as low as in case of U.S and Mexico, sometimes even cheaper. This is happening due to the boom of low-fare airlines (such as Ryanair, SkyEurope, Wizzair, EasyJet and CentralWings just to name the few). Wage gap: traditionally, the wage gap has been the main motivation for migrants to live and work in another country. It has been shown that the wage gap between the U.S. and Mexico is 8:1. This is, however, very similar to the situation in EU-8 and EU-15: according to Eurostat (2006) the wage gap between the poorest EU country, Latvia, and the richest, Luxembourg, is 5:1 (Latvia with wages at 40% of EU average and Luxembourg at 210% of EU average) (Eurostat, 2006). Apart from that regional differences should not be forgotten: some regions in Mexico can overpass regions in the U.S. and some regions in the EU-8 can be poorer than well-developed regions in Mexico.

Globalization: globalized world of today creates numerous ways for migration though facilitating movement of people not only within the regions, but also between the countries and even throughout the globe. Better access to information provides grounds for comparison of wages and initiates the search for better employment opportunities in other countries. Both Mexicans and people from EU-8 countries
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widely use these public information networks in their attempt to grasp the opportunities provided by the possibility to live and work abroad. Public facilities: Immigration often happens because migrants seek for economic stability for themselves and their families. Moreover, when established in the target country immigrants start to benefit from improved living standards. These standards include improved public facilities, such as healthcare, education and transport. Thus, according to Mines and Massey (1985) migration process changes the goals of immigrants: initially they move to obtain money that will provide immediate relief to their economic situation at home. Consequently they begin to enjoy improved living standards and public facilities which becomes their main benefit from immigration (Mines and Massey, 1985). Table 1 summarizes main differences and similarities between immigration in the EU and the U.S. Table 1: Main differences and similarities: migration in the EU and NAFTA
EU: differences 1. Social networks (meeting new 2. people) 3. Public and local environment Housing facilities EU & Mexico: similarities 1.Proximity to target country (low emigration costs) 2. Wage gap (wage inequalities between source and target country) 3. Globalization 4. Public facilities Mexico: differences 1.Immigrant networks 2. Financial crisis 3. Social inequality and unequal distribution of wealth 4. Low regional level of industrialization 5. Crisis in the farming sector

Source: own estimations Thus, apart from differences, the cases of Mexican immigration to the U.S. and EU-8 immigration to the EU-15 have a number of similarities. The next part of this paper will focus on lessons NAFTA can draw from the experience of the EU Enlargement and discuss implications of opening the U.S. borders for Mexican migrant workers. 4. Lessons for NAFTA A number of lessons can be drawn from the EU Eastern Enlargement for NAFTA. Similarly to the pre-Enlargement public debates that were taking place in the EU, creation of NAFTA caused many doubts and fears. For instance, there have been debates about the possibility of loosing jobs for many U.S. low-qualified workers as low-paid jobs would move to Mexico (Martin, 1993). Apart from that labor migration from Mexico (legal and illegal) was the point of most controversies. Former Mexican President Carlos Salinas de Gortari explained the relationship between NAFTA and migration in this way: Today, Mexicans have to migrate to where jobs are being created, the northern part of our country. With NAFTA, employment opportunities will move toward where people live, reducing drastically migration, within the country and outside the country (San Diego Tribune, November 14, 1993). However, many politicians and economists tend to think differently. Generally, labor migration from less developed countries is seen as the generator of social and economic problems in the target countries due to wage and unemployment effects. Indeed, wage convergence for unskilled workers for U.S. and Mexico still remains very low and the trend is not likely to change in the nearest future (Markusen and Zahniser, 1999). On the other
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hand trade liberalization and economic integration are expected to foster economic development of less developed countries which would lead to the decrease in migration. However, the EU experience (accession of Spain and Greece) shows that higher trade intensity does not cause the reversal of migration flows the turnaround of migration occurred before the trade barriers were dismantled, mainly due to the economic development and catch-up of Southern Europe (Fies and Fugazza, 2002). Substantial wage gaps between the U.S. and Mexico which are the most relevant and most widely-used concern for not opening the borders for Mexican immigrants can nonetheless be compared to the situation of EU-8 accession into the EU-15. Differences in economic development were looked at as the possible cause of major change in specialization patterns and massive jobs dislocation. Still, the negative impact of EU Eastern Enlargement on wages and employment has been assessed as being very low (see for example Konnings, 1999; Bellak, 2000; Dohrn, 2001; Boeri, Brucker and al., 2001). Recent investigations for NAFTA show similar findings a negative integration effect on wage and employment did not materialize (Fies and Fugazza, 2002). Quite adversely, the U.S. workers appear to have gained through NAFTA. The explanation can be that the trade openness between the U.S. and Mexico was already strong in the times of signing NAFTA agreement (Hanson, 1998). 5. Conclusions In spite of some fundamental differences, there are striking similarities in the cases of EU Eastern Enlargement and the U.S.-Mexico relations under the provisions of NAFTA agreement. Both benefit from free trade and both feel the need to tackle the issue of labor migration. Labor migration (either legal or illegal) is becoming the point of political and economic controversies and public debates in both cases. While in the case of the EU which is already at the last step of economic integration with the Single Market, labor migration is the last remaining aspect to be resolved in order to reach its final goal, U.S.-Mexico position in NAFTA are too far from freeing up labor movements. Withal, neither EU, nor NAFTA have any economic reasons to ban labor migrations from less developed countries (EU-8 and Mexico): there are unlikely to be any adverse effects on wages and employment and all the immigrants that wanted to come are already there. Moreover, recent experience with the EU Eastern Enlargement and labor migrations from EU-8 to Ireland, Sweden and the United Kingdom that were taking place in the last two years shows that migration flows are manageable and cannot be a threat to the domestic economies of more developed countries. Yet, there are still concerns about labor migration issue and one can see that there are more of those in the case of NAFTA, rather than in the case of the EU. It becomes clear that NAFTA has to push up its limits. Labor migration is still one of the issues that should be considered in the context of deepening the cooperation within NAFTA. Although some provisions have been suggested on Bush-Fox summit in September 2001, the terrorist attacks that followed and the consequent War on Terror the U.S. waged around the world tightened the border protection regime and slowed down the immigration of labor from Mexico. These trends create a delay for possible implementations of the road map for freeing up Mexican immigration to the U.S. It therefore becomes clear that in the case of NAFTA free movement of labor should remain an objective for the longer term once economic convergence has gone further. In pursuing this goal NAFTA can draw lots of inspiration from the EU Enlargement story and integration as it proceeds forward towards the creation of complete Single Market for all EU-25 with free movements of goods, persons, services and capital.

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References

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Mines, R.,and Massey. D. (1985): Patterns of Migration to the US From Two Mexican Communities. Latin American Research Review 20(2); NAFTA, http://www.dfait-maeci.gc.ca/nafta-alena/menu-en.asp; Nixon, F. (1993): Friends or Strangers? Examining the Empirical Evidence of Immigration, International Journal of Social Economics, vol. 20, No. 10; Passel, J. (2005): Estimates of the Size and Characteristics of the Undocumented Population. Pew Hispanic Center; Pope, D., and Winters, G. (1993): Do Migrants Rob Jobs? Lessons of Australian History, 1861-1991, Journal of Economic History, vol. 53, issue 4 (December); Rodriguez-Scott, E. (2002): Patterns of Mexican migration to the United States, paper presented at the 82nd annual meeting of the Southwestern Social Science Association, New Orleans, Louisiana, March 27-30, 2002; San Diego Tribune, November 14, 1993; Skidmore, T., and Smith, P. (1997): Modern Latin America. New York: Oxford University Press; Strielkowski, W., and ODonoghue, C. (2006): Ready to go? EU Enlargement and Migration Potential: Lessons for the Czech Republic in the Context of Irish Migration Experience, Published in Prague Economic Papers, no.1; SourceMex. (2001): "Remittances From Mexican Expatriates Increase This Year, but are expected to decline with downturn in U.S. Economy (www.elibrary.com); Verduzco, G., and Unger, K. (1998): Impacts of Migration in Mexico. Migration Between Mexico and the United States: Binational Study. www.utexas.edu/lbj.usair/binpapers/v1-4bverduzco.pdf; U.S Census Bureau, www.census.gov.

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4. Quo vadis europa: EU governance at cross-roads

Petr Novak European Parliament, policy advisor to MEP Abstract: The article analyses the evolution of the EU governance under the pressure of the economic and financial crisis as well as transformations brought by the entry into force of the Lisbon Treaty. In the first section, it examines the situation from the point of view of its historical, economic and political rationale of the EU integration and concludes that EU is still in the process of transforming itself into a political union. In the second part the attention is paid to the role of the various EU institutions in the decision-making architecture and the reconfiguration of the landscape of the EU governance in the light of the entry into force of the Lisbon treaty. Third part focuses on the effects of both financial and economic crisis on the EU institutions and the sets of remedies that they brought into play. The author concludes that the observed transformation of the EU decision-making is a precursory sign of a future multi-speed Europe.

1. Introduction Two symbolic events transformed substantially the nature of the European Union governance in the recent years: on the one hand, the collapse of Lehman Brothers in September 2008, the widely recognized triggering moment of the global economic crisis and on the other hand, the entry into force of the Lisbon Treaty in December 2010, to date most complete and complex institutional transformations of the European project. The financial crisis, although attributable mainly to the banking sector and of excess of securitized American subprime mortgages, started quickly to spread into corporate world and further to the real economy. One year passed between end of August 2007 when Europe first witnessed a freeze of interbank assets and the mid-September 2008 collapse of the emblematic investment banking institution. Remedies to combat the contagion were essentially national and delivered very little of coordinated action at the EU level. The first meeting at the level of heads of state and government that took place on 12th October 2008 in Paris presented series of loosely coordinated national measures. Only when the crisis started to morph into to a seemingly endless spiral of sovereign debt crisis, the need for both collective and coordinated action became apparent. The absence of a robust crisis management mechanism at the EU level forced the EU to rethink fundamentally the nature and structure of the EU governance. On the backdrop of the crisis, for many the entry into force of lengthy negotiated Lisbon treaty as the successor of ill-fated Constitution passed barely noticed. Although the Treaty didnt appear provide all the tools to shape the response to the problems that have arisen from economic crisis specifically, it constituted first essential transformation of the governance mechanisms in the EU since the 2003 when the Nice Treaty entered into force reinforcing its competencies and redistributing them in a substantially new way. The subject of this article, broadly subsumed under the term of decision-making, is now a product of more than 60 years of development and experimentation, series of historical political and structural constraints, peppered by legal activism, economic and political crises. EU tends to be perceived as a technocratic machine solely aimed at grinding national
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differences through reckless market liberalization enforced by free-marketeering supranational bureaucracy tuned to the mantra of globalization. But one should not forget throughout the years EU became the most comprehensive experiment in political integration on the planet. It developed a complex operating mechanism that goes beyond European economic integration, one of its operating means but not the objectives. Indeed, of the main declared aims of the European Economic and Monetary Union, when launched as part of the single market package, was to provide for a final step in the political integration. Angela Merkel re-echoed this aim at the Leipzig Congress of CDU: "the task of our generation is to complete economic and monetary union and build political union in Europe step by step. That does not mean less Europe, it means more Europe."3 After the painstaking ratification of the Lisbon treaty, the effort was rather to forget the "f-word". In less than a year after its entry into force, from banished word "federal" became the favourite adjective for everybody from businesses leaders to national politicians. Its fairly impossible to understand the challenges that the European governance faces without understanding properly its operating mechanisms in both of their historical and functional contexts. We shall therefore analyze the transformation of the EU governance, first through the rationale of the EU integration, be it historical, economic or political. Secondly we will assess the EU institutional setting in more detail in the light of the transformation brought about the Lisbon treaty in order to see how the how the weight and functions of the decisionmaking actors in the EU developed over time. Thirdly, our task will be to study the disruptive and creative effect of the financial and economic crisis on the processes of EU governance. 2. Part I: From history to politics: rationale of the European integration European integration is driven by intertwined forces of history, economic theory and political voluntarisms that all impacted its evolution and shaped the mechanisms of its operation. It is useful to recall at least the few most determining. 2.1. History of politics, politics of history European integration finds traditionally its strongest structural legitimacy in the history. The horrors of the Second World War, climax of both nationalistic vicissitudes and military might, make European integration an impressive symbol of peace and novelty. Despite the numerous designs left by practical or theoretical efforts of Georges de Podiebrady, Victor Hugo, Immanuel Kant, Denis de Rougemont, Jean-Jacques Rousseau, Richard Nikolaus Coudenhove-Calergi, Aristide Briand, Gustave Stressman to name a few, first time an entirely pragmatic lesson for integration is taken from the war: to put industrial source of military might (embodied in coal and steel industries) under common management with further economic integration. European Coal and Steel Community was supplemented and expanded with the European Economic Community encompassing all other fields of production and transformation. The new effort of integration was happening in rather stark opposition to the previous known efforts to induce joint political control through diplomacy, as last attempted in the inter-war period by the ill-fated League of Nations.4
3

Merkel, A. (2011), "Speech at the Federal Congress of CDU", 14th November 2011, reported by Financial Times and Reuters 4 It is worth noting that one of the founding fathers of European Union and first president of the High Authority of the CECA, Jean Monnet, was the number two of the League of Nations, appointed in 1919 until his resignation of 1923. He there understood clearly the blockages in the institution that was deciding by unanimity and was therefore striving to promote the idea of the qualified majority voting in the Council.

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But as it often happens, the history is tainted by sins. One of the structuring original sins of the EU integration is clearly the relationship between two main actors of the European integration: France and Germany. Both depict themselves as motor of EU integration, but are often perceived as two-state directorate by other member-states, in particular when they act as in the crisis-management mode. Spat between president Sarkozy and PM Cameron during the 9th December 2011 summit is one of the most visible signs of disagreement with such form of dual leadership.5 But there is also a significant historical difference in the mutual perception of the partnership. In the national discourse for France the EU is Germany, or France with Germany and the terms are nearly used interchangeably.6 Germany, due to its federal structure and history bears more opening to the East and South and tends to fight for broader interest, sometimes also clearly against those of its first European partner. On the other hand its political preferences moulded in the tradition of decentralized government, fiscal prudence and export-oriented economy with traditionally high savings rate, seem to put Germany at stark odds with its Gallic neighbour.7 This effect is of course compounded more recently by divergent destinies: in 2002 both countries were running current account surplus and had similar levels of unemployment. Today unemployment in France stands at 10 % compared with German figure of 5,7%, the country was subject to a sluggish growth rate at about half of the Germany's and recorded double of the deficit as a proportion of the GDP if weighted against its eastern neighbour. A vivid example of transformative disagreement between the two countries was recently the creation of the Union for Mediterranean (UfM), whose original design by the French diplomatic service was substantively more restrictive than the final creation. The UfM in its final set-up was given much broader membership and remit and following the decisive pressure from Germany teaming up with the European Institutions.8 Ongoing debate on the role of the ECB, as a lender of the last resort or at least as a genuine market maker, is also reflecting the quite divergent fortunes of the historical couple. 2.2. Economics of the political integration Economic legitimacy of the European integration builds on the essential methodological shift brought about the EU "founding fathers" who "rejected the inventing of grandiose pseudofederal schemes equipped with no political will that led nowhere in terms of providing economic and social stability and were incapable of stopping the endemic European wars"9. In practice this meant to abandon efforts of brining the states together through the "highpolicies" (associated with the security and continued existence of the state such as defence or foreign policy), in favour of functionalist integration based predominantly on "low policies" (based on economic welfare). Economic dimension was underpinned, as in the case of many later options of the Economic integration (FTAs, Customs Union, Common market...), by the intertwined efforts to enhance
5

Sarkozy-Cameron spat reveals tensions, Ft.com, 24-10-2011, http://www.ft.com/intl/cms/s/0/c18eb27e-fe5c11e0-bac4-00144feabdc0.html and Britain's cold shoulder for Europe, Ft.com 09-12-2011, retrieved 05-03-2012, http://www.ft.com/intl/cms/s/0/0da05152-2222-11e1-acdc-00144feabdc0.html 6 One can simply check with the EU speeches of the main presidential hopefuls: Nicolas Sarkozy Toulon, 1st December 2011 and Francois Hollande, 22 January 2012 in Bourget 7 An useful account of the current divergences and respective positions of the two countries including the historical, economic and political background is given by Bertelsmann Foundation (2012), "What Does Europe Want. The Who and How of Resolving the Euro Crisis", Brussels: Bertelsmann Foundation 8 See for instance Emerson, M. (2008), "Making sense of Sarkozys Union for the Mediterranean", CEPS Policy Brief , No. 155, March 2008, p. 1. 9 Roy, J. (2007), "Reflections on Treaty of Rome and Today's EU", Jean Monnet/Robert Schuman Papers Special, April 2007.

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functional interdependencies (through positive and negative integration) and to face the globalization.10 This made the creation of the internal (common market) and external interface (common tariff, common commercial policy) the cornerstone of the success. On the other hand might have lead to atrophy or progressive other, non-exclusive functions of a trading bloc, namely the integration of economic policies. Necessity to complement the purely economic integration, driven by the liberalization of the markets and harmonization of standards with the political one became apparent in the 1980s, in particular in the first Delors tenure that provided the blueprint for the Economic and Monetary union. The main answer to the challenge was again relying on the functionalist argument - the common currency will enhance the mutual interdependence and force a political union to underpin it. 2.3. Politics of the economic integration The building block of the EU political architecture became the pooling of sovereignty, a mechanism by which the member states have given up ultimate control over several policy fields in order to exercise the power jointly. The traditional functions of market supervision (competition policy) and regulation had to be entrusted to the body neutral from the states and representing the common interest, with the sole right of initiative in all its exclusive competencies (see below) - the High Authority and later the European Commission. The Council of ministers, representing the executives of the Member states, remained sole in charge of passing the secondary legislation. This enhanced the early characteristics of the EU integration as an elitist project built on the "dialogue between the bureaucracies"11. European Parliament was at the origin composed of the delegates of the legislatures of the member states possessed minimal consultative and advisory powers. Treaty of Paris for its direct election (since 1952), but it's only in 1979 when this provision was finally implemented. This allowed for the institutional setting of the EU to start rebalancing the representation of the member states and the one of the citizens. This element of political architecture - the historical prevalence of 'transnational bureaucracy' over the 'transnational democracy' requires deeper explanation. Traditionally, the budgetary power is the angular stone of the parliamentary democracy. Parliament stands as the representative organ of the elector-taxpayer charged with overseeing the management of revenues of taxation. In that respect, the EU's situation became rather paradoxical: at its origins, it had more direct revenue to account, than today. Both in volume - national budgets increased by about 60 per cent in last 15 years, while EU budget declined as part of EU GNI, and in terms of genuinely own resources (direct revenues from levies or taxation). This can be attributed to the fact that the traditional own resources (customs duties, agricultural levies) decreased as the EU integration became more effective both internally (removal of barriers to free movement) as externally (integration of the EU in the world economy). The only other resource that was up to now only remotely based on taxation revenue is the VAT own resource (based on harmonized VAT base in each EU country), introduced in 1970 when the other resources run out, but due to its complexity was not introduced until 1980s. At this point EU had to call on GNI-based contributions of the Member states, established in 1998. Progressively therefore the EU budget shifted from more or less autonomous own resources to
10

Schuman, R. (2010), "Pour lEurope", 5th ed., Paris: Fondation Robert Schuman. "We have gained the conviction, by the demonstration of facts, that nations, far from being able to be self-sufficient, have become partners with each other; that the best way to serve one's own country is to assure the cooperation of others by reciprocal efforts and by sharing our resources." (translation by P.N.) 11 Avi, S. (1973), "The Vedel Report and the Reform of the European Parliament", Parliamentary Affairs, Vol. 27, Issue 1973dec, pp.159-170.

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resources dependent on the largesse of the Member states and giving the rise to the attitude of 'juste retour' as evidenced by the position taken by the UK since 1984 on its 'rebate' in contributions to the EU budget. Chart 1: Pyramid of economic integration

Source: own sources As Chart 1 clearly demonstrates, the customs duties revenue peaked in 1980 (at around 55% of revenues), agricultural levies at 65% in 1988. Decline in both was progressively substituted by the GNI resource that stands today at 75%. 12Therefore, from the traditional perspective a legitimacy of a directly elected body to oversee the budget and hold the executive power liable for its execution would be stronger in the EU's past than it's today. The fact that the European Parliament found itself in the budgetary procedure on the equal footing with the Council only with the Treaty of Lisbon, at the times when the financial contributions from the MS from the GNI-based resources is peaking seems can appear curious from that perspective. Nevertheless, since the Vedel report the matter of political legitimacy of the EU has been at the forefront of the concerns addressed in the consequent treaty change. The most significant transformation was brought by the Maastricht treaty, which introduced for the first time the procedure of co-decision, where in a certain number of crucial areas (transport, environment, consumer protection), EP's role in the legislative process would be equal to that one of the Council of ministers, although there are still about 70 fields where the Council decides on issues by unanimity. 2.4. Budgetary vs. Regulatory Powers Here comes for our understanding of the EU governance very useful the distinction between the budgetary impact and the regulatory impact of the EU. With 1,04% of the EU GNI, the EU can hardly stand a comparison with the resources at the disposal of the national government. In addition, series of studies demonstrated that the national budgets have grown
12

Begg, I. et allii (2008), "Financing of the European Union Budget, Study for European Commission", DG BUDG, 28th April 2008.

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over the last two decades at much higher pace than the EU's, reducing thereby the potential for EU impact. 13Therefore the redistributive functions of the budget are limited - besides its main redistributive functional elements in CAP, it builds on the principle of additionally which translates the focus on the lever effect it can bring to existing public or private investment. When approached through the prism of the regulatory power - the situation is clearly the reverse. The assessment of regulatory impact on the volume of national legislation adopted is problematic and strongly varies from field to field, but the most estimates range from 50 to 70% of national legislation being adopted as consequence of the EU. The implementation traditions are ostensibly different therefore it's useful to focus not on volume but on the scope of the legislation with additional proxy of its financial impact. The famous climate-package legislation, outcome of which entered into popular media as 20-20-20 targets, was adopted in the first-reading agreement in October 2008. The estimates for its EUwide impact varies from industries affected and previsions of the costs of the CO2 allowances translating into the overall cost for EU varies between 1-2,5% of EU GNI. While looking on specific sectors such as aviation the costs vary from - 20 bn (i.e profits to aviation industry European Commission)14 to IATA studies that projects 17,7 bn .15. Chart 2: Distribution of EU Own resources
EU Budget revenue 1971-2008 80 70 % of the revenue 60 50 40 30 20 10 0 Agricultural duties Sugar levies Custom duties VAT resource GNI-based resource

71

73

75

77

79

81

83

85

87

89

91

93

95

Source: European Commission, Financial Report 2008

3. Part II: Transformations of the EU Governance and the Lisbon Treaty The fact that the EU evolved progressively from the international organization to an unparalleled entity sui-generis is mainly due to its original mixture of inter-governmental and supra-national elements. If the Lisbon treaty could be considered as a climax of supranationalism by entrenching the community method as standard operational mechanism in virtually all areas of the EU competence, the raise of the European Council as pivotal institution in the crisis management of the Eurozone challenged this accepted wisdom.
13

A useful overview can be found in the following study: Deloitte Consulting / European Parliament Policy Department on Budgetary Affairs (2010), Brussels: European Parliament 14 European Commission (2011), DG CLIMA presentation to ICAO Council , 29-09-2011, http://ec.europa.eu/clima/policies/transport/aviation/docs/presentation_icao_en.pdf 15 See for instance: Bloomberg (2011), "New Energy Finance", EU-ETS Research Note, 25-10-2011

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97 19 99 20 01 20 03 20 05 20 07

19

19

19

19

19

19

19

19

19

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3.1. The European Commission: cornerstone of the supranational method European Commission, assisted in the early years by the judicial activism of the Court of Justice of the European Communities, played historically pivotal role in the EU integration. It doesn't have equivalent in any other international institution. Its independence is guaranteed by the treaties, and its first and ultimate objective is to "promote the general interest and take appropriate initiatives to that end"16. We can identify as the main powers entrusted to the commission the following: initiative, execution, supervision, and representation. Commission's monopoly in initiating legislation, has a notable exception in the Foreign Security and Defence Policy, in the area of Freedom, Security and Justice and in particular in the field of the Economic and Monetary Union.17 In all other areas, this monopoly translates not only into the crafting of the legislative proposal itself, but also into an obligation to follow a broad, formalized process of consultation of stakeholders, that for important pieces of legislation is summarized in the form of a green paper. In principle the lifecycle of a legislative proposal from its initiation to the implementation is about seven years. The monopoly of initiative also means that the Commission remains fully in charge of the proposal throughout the legislative process - it participates in the pre-legislative trialogues18, provides opinions on positions of both legislative branches and plays the role of arbiter (together with the presidency) in the conciliation procedure, but also retains its full right to withdraw at the proposal at any stage if it considers it has been altered beyond acceptable limits. As far as the origin of the legislative proposals19 that the Commission brings forward we should bear in mind that most of the proposal are natural consequence of EU obligations taken in international agreements or existing obligations under the treaties (about 30%). Only 2025% of the legislative proposals constitute a follow up of the requests of the Council, European Parliament resolutions or European Council initiatives or requests on behalf of social partners. About 30% arise from EU international obligations (free trade agreements, human rights conventions, World Trade Organisation protocols etc). As much as 20% of the legislation consists in updating the existing legislation (in particular related to the internal market and health and safety regulations), mainly via the procedure of recasting20. Finally, around 10 - 15% legislation arises from the obligations under the treaties or secondary legislation (mainly implementing measures). 3.2. Beyond the legislative process: delegated and implementing acts In the second function - executive, the Commission depends on the power of delegation from the legislative power (Council, Parliament). The execution of its delegated powers falls in the remit of a rather mysterious world of comitology. There was no provision in the EEC treaty
16

Article 17, Treaty on European Union, 2010/C 83/01 (consolidated version), new provision inserted by the Lisbon treaty 17 As residual consequence of de-pillarization. Pillars established by the Maastricht treaty in the Treaty on European Union, were abolished by the Lisbon treaty, nevertheless, this didn't lead to the fusion of the procedures and the right of initiative of the Member states was confirmed. It should be considered also power of initiative of the ECB in the framework of the Economic and Monetary Union. 18 Cooperation between institutions, in the context of legislative procedure in particular takes a form of tripartite meetings between Council, Commission and Parliament. This is an essential tool in particular in the case of first reading agreements, where it allows to negotiate compromise text before the position is taken by the Parliament (which is the first to vote on the legislative proposal). 19 European Commission (2001), European Governance. A White Paper, COM (2001) 428 20 Inter-institutional Agreement of 28 November 2001 on a more structured use of the recasting technique for legal acts, OJ C 77, 28.3.2002, p. 13

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related to the comitolgy, which appeared as a necessary complement to the legislative activity of the Council. But the functioning of the comitology does appear much less mysterious when compared with several national traditions delegation and execution of powers. In most of the member states we would find two sets of executive acts.21 First category is where the executive power acts in its own field of competence, typical form of such acts are ministerial decrees. Second category is the one where the executive power is clearly delegated by the legislator for non-essential parts of act and would take a form of legal decrees or ordinances. The Lisbon treaty integrated the same logic, separating the world of comitology into delegated acts (legal decrees) in the art. 290 TFEU, and implementing acts (ministerial decrees) in the art. 291 TFEU. This means in practice that European Commission controls both the beginning of the process - the legislative proposal - as well as its execution, when the act in question is adopted, through its implementation and adjustment. In the EU the need for such acts very clear: if the main act that sets the basic political choices, technical details and parameters would be too burdening for the legislative bodies to agree upon. The comitology procedure was first put into operation in order to deal with technical parameters of the common market organisation (regulation of the agricultural products) and its setting was not very far from the working groups of the Council, bringing together one representative on technical level per country. The Commission's pivotal role in the process was reflected by the fact that it presided the committees and had the powers over the agenda i.e the committees had to answer the question the Commission was asking with relation to the implementation of a specific legal act. It's easy to justify its progressive extension to the many fields that required a framework law to be in place but for its parameters to be flexible for adjustment, in order to reflect the evolution of market conditions (harmonization, liberalization), the scientific progress (authorization of substances, levels of pollutants, animal welfare), or evolution of resources (financial assistance to third countries). Daniel Gughn speaks about 80.000 acts being adopted under comitology procedure,22 which appears impressive in comparison with the ordinary EU legislation, with about 19462 acts currently in force.23 Let's put the figure into the context by having a quick look back at the distribution of the main legislative acts in force today. In this way we can also get a picture of what constitutes the main pillars (and most complex ones) of the EU regulation: Agriculture and Fisheries alone count 4088 acts, Single market issues (customs union, four freedoms, industrial policy and internal market) total 3333 acts and environment counts 1602 acts in force.24 When comparing back with the delegated acts, the difference is yet more striking in the recent years when the proportion of acts adopted is closer to 1:10 and in certain prominent fields even higher (environment, product labelling and marketing etc.). The Lisbon treaty maintained the committees in the case of implementing acts, where the oversight of the legislative powers is limited, but abolished them in the case where the Commission exercises its delegated powers. This streamlines the process with more responsibility being put both on the Commission for the proposal of implementing acts and on the legislative branches to scrutinize the process. Refurbished comitology procedure is clearly one of the fields where the role of the Commission was streamlined and reinforced. Nevertheless, issues are far from being settled. There is no automatic alignment of acts in
21

Ponzano, P. (2010), "Executive and delegated acts: situation after the Lisbon Treaty", Contribution to the Florence conference on the Lisbon treaty implementation at EUI, Florence 22 Guguen, D. (2011), Hijacking European Power, Brussels: ETI 23 Directory of European Legislation in Force, http://eur-lex.europa.eu/en/legis/20120201/index.htm, as of 0102-2012, counts made by the author. 24 One shall set aside 3480 acts in external relations that cover all the commercial policy agreements as well as bilateral agreements with non-member countries.

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force with the existing provisions. This of course opens an important battlefield: due to the difficulty to put line between the delegated and implementing acts, Commission find itself in an on-going struggle with the European Parliament. The stand-off is strategically important as the Parliament according to the Lisbon treaty doesn't get any substantive powers of scrutiny over the implementing acts, as opposed to the rights it enjoys with regard to the delegated acts.25 And, although the legislator might revoke the delegation of powers, this is much more complex matter when the act is considered to be improperly classified as implementing act. 3.3. Supervision and representation There is plethora of enforcement and supervisory powers entrusted to the Commission, but the main and the most prominent one, justified by the need to preserve the level playing field of the EU internal market, is the enforcement the competition rules. EU Competition law has its origins in the European Coal and Steel Community, an agreement that in essence aimed to prevent Germany from establishing dominance in the production in the two sectors that in case of Germany were seen as the main source of war effort - the coal and steel industries. It was for the first time that the competition rules were object of a multi-lateral treaty and enforcement ensured by a central authority independent of the member states. Regional organisations such as NAFTA or MERCOSUR do not provide for supranational authority to oversee the competition rules and in some aspects, it is only the WTO dispute settlement mechanism comes closest to this concept. The enforcement rules are particularly salient in the in the field of the concentration control (mergers, anti-trust) where the Commission possesses quasi-judicial power. As Ian S. Forrester explains: "the Directorate-General for Competition of the European Commission is unique within that institution in that its officials have the power to investigate, raid business premises and private homes, question witnesses, reach conclusions, demand concessions, impose penalties and enforce those penalties, in court if necessary."26 Finally, Commission also enjoys important functions of representation. Although with the emergence of the permanent presidency of the European Council and the creation of the High Representative, its powers in the diplomatic sphere were reduced, it still plays an important role in many other representation arenas. This applies in particular the negotiation of the international agreements. Upon the mandate given by the Council, European Commission negotiates on behalf of the Member States with third countries or even in other international organisations (WTO). Situation is even more important in the cases of mixed agreements i.e. where the agreement is signed both on behalf of EU and Member States (e.g. ACTA), where the Commission acts in coordination of the EU position. Since the entry into force of the Lisbon treaty in particular the European Parliament has often castigated European Commission in its quality of negotiator of international treaties. Parliament used its newly acquired right to give the consent to the international treaties to insist on issues from full disclosure of the documents relating to the negotiations (ACTA agreement) to outright renegotiation of the terms of the agreement (Swift agreement). It was not hesitant to use its powers to decline the consent to an agreement it felt was disadvantageous for the EU (Morocco fisheries agreement) or not providing sufficient guarantees on privacy issues (Swift agreement). In the past the only recourse against the agreements concluded by the Commission on behalf of the EU were the sometimes protracted court cases.
25

For instance, Commission believes that the country strategy reports (annually defined strategies in financing of assistance to the third countries) should be considered as implementing acts, refusing the European Parliament the right of scrutiny over them (other than in its capacity as budgetary authority). 26 Forrester, I. S., (2009), "Due process in EC competition cases: a distinguished institution with flawed procedures", European Law Review, 2009, Vol. 34, No. 6 / 817

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3.4. Court of Justice: virtuous logic of the internal market Before turning to the role of the legislature, we shall quickly analyse the impact on the EU integration of the institution with highest supranationalist credentials - European Court of Justice. Its legal activism, in absence of established treaty principles, advanced EU economic integration basically in three phases. In the 60s it was the direct effect and supremacy principles that helped to entrench the Economic integration represented by effectively functioning Customs Union. In the 70s with the progressive deepening of the internal market, ECJ developed doctrine on the issue of harmonization and mutual recognition that allowed Member states to strengthen the internal market. Finally, since the 80s the European courts had to establish a balance between the fundamental freedoms (economic) and fundamental rights as the EU was getting closer to more political union. As far as the two founding legal principles are concerned, Simon Hix argues that direct effect and the supremacy doctrine had transformed the EU from an international organisation to a "quasifederal polity"27. First principle emanates from the ruling Van Gend en Loos, which through the establishment of the direct effect principle ensures the application and effectiveness of European law in the Member States. 28 The second emblematic ruling, Costa vs ENEL, established the primacy of the EU over the national law, ensuring therefore the consistency of EU legal architecture through its precedence over the national law of the Member states. Once the doctrine was established preserving the integrity of the EU law, the second milestone lied in the advancement of the so called negative economic integration consisting in promotion of the efficiency of the internal market by suppressing the barriers to the circulation of goods, services, capital and workers. While the harmonization - i.e regulatory approximation in EU jargon - is a desirable process, it puts the administrative resources at a high strain and presents substantial implementation costs. In the Cassis de Dijon, ECJ established a doctrine of mutual recognition that a product lawfully marketed in one Member state and not subject to Union harmonization should be allowed to be marketed in any Member state. This led naturally to the reduction of information, transaction and compliance costs and helped to tackle remaining regulatory barriers between Member states. Jacques Pelkmans famously calls mutual recognition "a remarkable innovation facilitating economic intercourse across the borders"29. Final point that deserves our attention is the evolution of the free movement of persons in the light of ECJ jurisprudence. Since the inception of the European Communities, the EU law entrenched the free movement of labour, i.e workers, and further more controversial freedom of establishment. It' is symptomatic for instance that the common EU standards for maternity leave and pay are subsumed in the piece of EU legislation called "European Pregnant Workers Directive"30 that (in the new proposal) includes also new provisions for paternity leave (!). Since the early days the impact of the EU integration had to involve the matter of protection of worker's fundamental rights. Hence came the attention to the corpus of law related to the equal opportunities (in particular at work), field the EU played a unique levelling role across many member states. But the fundamental shift came when in the ECJ found itself in the obligation of integrating fundamental rights in order to ensure the effectiveness and efficiency of the application of its law. The first lesson came from the Solange judgement of the German
27 28

Hix, S., (2005), "The Political System of the European Union", 2nd Ed., London: Palgrave Macmillan, p. 123 Van Gend and Loos, v Nederlandse Administratis der Belastingen, [1963] ECR 1 29 Pelkmans, J. (2003), "Mutual Recognition in Goods and Services", ENERPRI Working Paper, N16 30 Or more correctly Directive on the Protection of pregnant workers and workers who have recently given birth or are breastfeeding - 92/85/EEC, amendment presented by the European Commission to the Council and Parliament in 2011

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Constitutional Court of Karlsruhe (Bundesverfassungsgericht) indicating that it maintains its full authority to review the application of the EU law in its respect for fundamental rights insofar this there is no equivalent protection in EU legal provisions to the one the citizens enjoy under the national law. The obvious way to remedy to such challenges of authority of the ECJ by the national constitutional court was to provide for such fundamental right at the EU level. This movement underpinned by the ECJ jurisprudence led progressively to the emergence of the EU citizenship and of the third pillar (Area of Freedom, Security and Justice) that consecrated the free movement of people both innovations brought by the Maastricht Treaty. The treaty of Lisbon represents another major innovation in this respect both by giving the EU its own Charter of Fundamental Rights a legal effect and by obliging the EU itself to accede to the European Convention on Human Rights. Three institutions were substantially transformed by the Lisbon treaty: the Council of the European Union, the European Parliament as two legislative branches of the EU and the European Council that was elevated to the rank of an EU institution. 3.5. Council of the European Union: a renewal? The Council of the European Union (also referred to as 'Council of Ministers') together with the European Commission is one of the oldest of the EU bodies. It is the working of this institution remains one of the most complex and interesting of the EU bodies. Historically it had to combine many functions and mitigate scores of conflicting interests, which certainly did not help in getting credentials of the most transparent EU organs. Nevertheless, it pulled up respectable efforts to make its workings more transparent and slimmed off some of its more arcane bodies to the newly created EU External Action Service. It works today in fifteen established configurations, some of them clustering up to four ministries per country. Three of its functions deserve our outmost attention: its presidency, intermediary working bodies and its General Affairs configuration. Rotating presidency is one of the most visible (and contested) institutional creations in the European Union. It consecrates the equality between the member states by giving every six months one of them in established order the right to moderate the debate. Since the entry into force of the Lisbon treaty the rotating presidency lost much of its lustre by prestigious functions in the foreign policy. Foreign policy functions are now conducted by the EU high representative who also chairs the meetings of the Foreign Affairs Council and is assisted in this tasks by its own machinery of European External action service, that many of the former Council personnel and structures. 31The other streamlining element that weakened the role of the rotating presidency is certainly the emergence of the European Council as an institution with a permanent president. Therefore, the presidency of the Council boils today down to a slightly illusory agenda setting function. It's difficult to hold that a country exercising the presidency truly sets the course of the EU for the next six months. It is both constrained by the Commission's 5-year work programme and its annual breakdown, including all on-going legislative work that hardly ever takes 6 months to be steered through the EU machinery, but also by the 'orientations' received from the European Council. In order to remedy to the agenda-setting frustration and in order to ensure coherency and consistency of EU policies steered through multiple presidencies, the presidencies work in trios together with the past and future presidency on a 18-month common programme, and cooperate closely beyond so
31

Many countries felt painfully about the loss of this prestigious element, especially attractive for a foreign minister of the country in presidency and the head of state or government who in effect was fulfilling the representation functions today divided between the high representative and the president of the European Council. This was in particular the case of Spain that took the reins of the EU after the entry into force of the Lisbon treaty, but remained in denial about the High representative prerogatives in the foreign policy.

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that the passing of the torch is as seamless as possible. In effect, it can be considered that the exercise of presidency lasts about a year, which includes half a year preparation of the programme, administrative strengthening or reshuffle of human resources at the most exposed ministries - at Foreign/EU affairs in its coordinating role and sectoral ministries most exposed to the agenda. It is understandably difficult to make proper assessment of the overall costs of glory of an EU presidency for a country: the additional administrative, logistical and communication effort (mainly towards its own citizens) tends to be minimized or maximized depending whether expense is seen as positive in an euro-enthusiastic country such as Poland or rather euro-sceptic such as UK. Overall the estimates would align at the figure of 100 million euro. Of course, by the implementation of the provisions of the Lisbon treaty regarding external representation, presidencies don't have to put resources in the coordination of the policies between EU member states abroad.32 At the infrastructural level, the Council's daily work is done through the committees, working groups and working parties. Most of their work feeds in the preparation of the sectoral Council meetings at the ministerial level, but many of them have also coordinating political role or feed directly to the workings of the European Council. Technicity of certain subjects paired with EU exclusive competences in the given field contributes to proliferation of such bodies: as the way of example agriculture and fisheries count nearly 30 of such working groups and one of the reasons why the Council cannot be praised for its transparency or rather intelligibility. On the other hand the whole Education/Youth/Culture/Sport cluster, where EU competence is limited does not count more than 5 of such groups. Some of them are standing long term bodies, with strictly defined scope such as working party sugar and isoglucose, others are created ad-hoc short term, with broad remit such as Ad Hoc working party on Economic Governance. It is up to the COREPER (Committee of Permanent Representatives) composed by the EU ambassadors of Member states to streamline their work prepare ultimately the council meetings. The COREPER I meetings bring together the deputyambassadors/permanent representatives in the work on politically less sensitive policies, or as we identified them earlier - low policies - agriculture, economic and social issues, while COREPER II the permanent representatives themselves would generally meet on the political, financial and foreign policy issues. Staggering amount of work is done by those preparatory organs that ultimately constitute "A" items for the Council meetings and are approved summarily, without debate, at the beginning of the ministerial gatherings. As on majority of the issues the Council is on equal footing with the Parliament, i.e legislative file follow the ordinary legislative procedure, known before Lisbon as co-decision, this raises the importance of the veto players in the Council - i.e. member states able to prevent adoption of an act. This makes the voting calculator is one of the essential tools in the decision-making in the Council. Under the weighted voting of the Council any legislative proposal needs to gather at least 255 votes out of 345 and majority of Member States. From 2014 when the new rules brought by Lisbon treaty enter into force the qualified majority is defined as 55% of the states representing at least 65% of the EU population. When after series of laborious bargaining and horse-trading the presidency indicates that is able to muster the qualified majority, the act is practically adopted. General affairs council (GAC in EU jargon, successor of yet more obscure GAERC33), composed by the ministers for European Affairs, appears as the pivotal organ of the institution. On one side it's the genuine agenda setter, having impact not only on the other Council configuration, but more importantly it became the preparatory body of the European
32

This task now lies with the High Representative and External action service. Estimate provided informally by the Danish presidency (January 2012). 33 General Affairs and External Relations Council - split into Foreign Affairs Council (FAC) chaired by the High representative and General Affairs Council chaired by the minister for EU affairs of the presidency country

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Council. It acts also as the main broker of the relations with the Commission and the European Parliament. 3.6. European Council: new vehicle of political decision-making? Lisbon treaty raised the European Council, one of the most powerful yet informal organ of the EU to the rank of an institution. Its informal, but regular existence dates back to December 1974, when upon the suggestion of then French President Valery Giscard d'Estaing, Heads of state and governments decided to meet regularly in European Council in order to discuss matters of highest importance. In the Maastricht treaty this role was defined as providing the EU with the "political impulse". Official recognition of the European council also opens an interesting perspective as its acts can be challenged at the European Court of Justice.34 The permanent 2,5 years presidency of the European Council, exercised currently by Herman van Rompuy allowed for the Council to acquire more flexibility as well as to streamline the process of its preparation. He musters his cabinet of some 14 people and shares the services with the Council. Although Lisbon treaty increased the frequency of its meetings from 2 to 4, aligning the letter with the practice, since the entry into force of the Lisbon treaty and under the pressure of the Economic crisis much more extraordinary meetings have taken place. It's not without significance that the first meeting convened by the newly appointed president of the European council took a form of an informal 'brainstorming' over the fate of Greece in place in Solvay library in Brussels on the 22nd February 2010. Since then, European Council confirmed its eminent role as crisis management mechanism. In principle the decisionmaking mechanism of the European Council is consensus, which amounts to tacit unanimity, where no member opposes the reached conclusion. But there are several determined cases, in particular the nomination of the president of the Commission, of the European Council, High Representative and President and members of Board of the ECB, where it acts by qualified majority. The main written outcome of the council is its conclusions. Although do not have the explicitly recognized legal value, they represent the most impactful political text in the EU. They are feeding back to the Commission that offers solutions to the expressed legislative wishes, and to the General Affairs Council which ensures their full follow-up. 3.7. European Parliament: closing the democratic gap? European Parliament appears clearly as one of the biggest beneficiaries of the Lisbon treaty. Reinforcement of its powers was seen as one of the most effective ways to reduce the democratic deficit of the EU. Its statutory authority was raised mainly at the level of scrutiny and authority over the European Commission, in its co-legislative powers, and power to provide the consent to international treaties (trade, accession) concluded by the EU. Besides the election of the president of European Commission, who remains to be proposed by the European Council, but which has to take into account the results of the elections to the European Parliament. Up to the Single Act of 1986, EP had only consultative role (except for budget) on the legislation proposed by the Commission and passed by the Council. Single act brought a procedure of cooperation whereby the Parliament was able to provide the Council with nonbinding requests for amendments, but the revolution brought by the Maastricht treaty through the emergence of co-decision. This method unaltered was transferred to the Lisbon treaty, but became the 'ordinary legislative procedure' and was generalized to virtually all legislative
34

With the exception of the acts concerning the CFSP.

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fields. This expansion was accompanied by the extension qualified majority vote to over forty new fields at the Council (instead of unanimity) in order to facilitate the decision-taking in an enlarged and more diverse Union. But it is for its new role in scrutinizing the international treaties concluded by the EU where the European Parliament yielded most important powers. The Lisbon treaty provides the Parliament, through the procedure of consent with the full-blown power of veto. It didn't hesitate to use it immediately after the Treaty of Lisbon entered into force when it rejected the so-called Swift agreement with the US. On the request from the United States, the Commission negotiated an agreement on provision of bank information stored in EU servers in Netherlands in order to assist in the fight against the organized crime and terrorism. Nevertheless the Parliament judged the guarantees of data protection in selection and transfer of the data to the American authorities to be insufficient and rejected the treaty. The treaty had to be renegotiated by the Commission on the terms set by the Parliament as the Council was entirely keen on adopting the agreement in its original terms. Similar situation appears to be returning with the debate about the controversial multilateral treaty designed to combat counterfeiting and IPR violations - ACTA, that has been signed by all the Member states as well as by the Commission on EU's behalf. The impact of such rejection can be very substantive, be it in the case of multilateral treaties or in bi-lateral trade agreements. 3.8. ECB: non-political politics of the Euro system Finally, in the margin of our analysis one non-political institution that was also raised to the institutional level by the Lisbon treaty deserves a mention - the ECB. Besides the 'institutional' laurels, the treaty brings only very limited modification to its statutes and missions designed to guarantee its full independence. But is at the level of its environment where we can see an interesting transformation - it consecrates the separate existence Eurosystem (ECB with European System of Central Banks) that defines the monetary policy of the Eurozone. This is parallel to the official acknowledgement of the Eurogroup35, composed of finance ministers of the Eurozone with permanent president elected for 2,5 years and includes as non-voting members the president of the ECB, commissioner responsible for Economic and Monetary Affairs and the Chair of the Eurogroup working Group.36 Eurogroup then provides a political control over Euro and related aspects such as those established in the Stability and Growth Pact an strengthened in its reviewed version. Although an independent institution, ECB has responsibilities towards the legislative authority. Although this aspect was entrenched in the treaties before Lisbon, it provides for a structured exchange arrangement established with the European Parliament and called "monetary dialogue". It entails a regular appearance37 before the Parliament of the ECB president in order to present a report his institution past activities and planned actions. 4. Part III: Financial and Economic Crisis: transformation of the EU governance As it was demonstrated previously, the Lisbon treaty transformed substantially the landscape of the EU decision-making, but some of the core policies, notably Economic and Monetary Union underwent only partial transformation, in absence of genuine political ownership. The banking brought an important threat to the loosely integrated financial markets in the EU. First line of defence was to restructure the control of to date rather lightly-regulated financial systems based on principles of mutual recogntion with low degree of risk-internalisation,
35 36

Article 137 TFEU, added by the Treaty of Lisbon to confirm an informal practice established since 1998 Which are Jean-Claude Juncker, Mario Draghi, Olli Rehn and Vittorio Grilli respectively 37 Currently, ECB president appears in European 4 times a year

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which appeared to be at the heart of the increased systemic instability. When the economic and financial crisis triggered a rapid deterioration of perspectives of refinancing sovereign debt of peripheral euro economies, in particular Greece it became apparent that that EU will have to muster response that is as much political as institutional. In this "economic equivalent of war", by the words of George Osborne, chancellor of exchequer, crisis catalysed some unexpected transformation that led to revisit the architecture of the EU. Two "parallel" treaties were born in the convulsions of the new era of European Economic Governance, accompanied by hoist of remedies brought by the EU secondary legislation. 4.1. Repairing EU financial setup: micro-financial regulation and assessment of systemic risks The financial crisis laid bare the real dangers of the policy options taken in the integration of the financial markets. In the 1980s, Europe started to witness a rapid evolution of capital flows to date captives of national markets and banking privileges. Desintermediation dented bank's priviledges, de-compartmentalisation of the European markets accompanied by intense deregulation that saw substantial increase of capital flows in the EU. But the tools of capital market integration - the home-country control, associated with mutual recognition and minimum harmonization of national laws led to substantial increase in systemic risks. Such situation stimulated the expansion of capital services provided cross-border, without parallel expansion of the responsibility for incurred economic risks in the host countries. The situation risks and benefit misallocation in the financial single market is similar to the one resulting from monetary union with loose economic (= fiscal) integration. Although the benefits of the common currency are enjoyed by all, the risks of free-riding were only partially contained by the Stability and Growth Pact. The both financial and sovereign debt crisis demonstrated unsustainability of such arrangements. As the option of renationalisation of the single financial market in order to safeguard national interest was for obvious reasons ruled out, the question remained how to enhance and streamline regulatory oversight at the EU level. EU devised an answer in the so called 'Lamfalussy framework', that implied action at four levels (1) legislative, (2) regulatory, (3) supervisory and (4) compliance.38 Legislative framework was built on the recommendation of the High level working group of Jacques Larosire on the creation of the European System of Financial Supervision. The ESFS rests on two pillars: micro-financial supervision through the network of three supervisory authorities (ESAs) of banking, insurance and securities sectors respectively39, and macro-financial oversight exercised by the European Systemic Risk Board. While the ESAs are focusing essentially on the stability of the individual financial institutions, ensuring that they have enough shock-absorbing capacity and an efficient risk-management system, ESRB's tasks are to focus on the EU as a whole, in both prevention and coordination. That is why the role is fully exercised with close association with ECB, whose president chairs ESRB and ensures both coordination with ESAs as well as international actors such as International Monetary Fund and Financial Stability Board. ECB President similarly to the situation of monetary dialogue engages with the European Parliament on regular exchange of view. European Commission 4.2. New build-up of the economic governance: prevention, mitigation, resolution
38

A good overview of the question is provided for instance by Teixeira, G. P. (2011), "The Regulation of the European Financial Market after the Crisis", in Della Posta, P., Talani, L. S., Europe and the Financial Crisis, London: Palgrave Macmillan, pp. 9-27 39 European Banking Agency (EBA), European Insurance and Occupational Pensions Authority (EIOPA) and European Securities and Markets Agency (ESMA)

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The Economic governance tools at the EU level then focused on prevention, mitigation and resolution aspects of the sovereign debt crisis. 4.2.1. Prevention first: flexing austerity muscles The preventive (and corrective mechanism) were progressively entrenched into the raft of proposals, dubbed in EU-jargon as "six-pack", referring to six measures that constitute the proposal: (1) two regulations governing the economic surveillance and excessive deficit procedure (review of Stability and Growth Pact), accompanied by directive on the further technical definitions relating to the excessive deficit procedure (2) two regulations on early warning procedure to detect macro-economic imbalances as a part of the surveillance process (for Eurozone and non-Eurozone members), (3) Regulation allowing for more effective procedures for surveillance and excessive deficit control aimed at Eurozone members and (4) directive on national budgetary frameworks aimed at enhanced quality and reliability of the data provided by member states, improved adjustment to the corrective requirements and finally to enhance the transparency of the budget process. As of March 2012, two additional pieces of legislation are being considered singling out the application of economic and budgetary surveillance and monitoring of national budget policies of member states that receive financial assistance under more stringent conditionality rules. The main remedy consisted in providing for more effective and long-term mechanism to discourage memberstates from running a deficit and therefore enhance the free-riding on the fiscally virtuous members An early warning mechanism now precedes the preventive system. It is based on a scoreboard devised by the commission, indicating the major sources of imbalances. The preventive mechanism now includes also the surveillance of expenditure developments, requiring the expenditure growth to be linked with clearly mid-term growth measures. On that level the mechanism became more proactive by requiring the member states to set out their mediumterm budgetary objectives (MTOs) as a part of stability and convergence programmes. The problem with the SGP was clearly not the lack of rules, but lack of political will to enforce them. Therefore the enforcement mechanism for the Eurozone countries underwent most important changes. Ultimately, shall the Member state fail to take a corrective action on the decision to sanction a member state can be adopted automatically, unless simple majority of Member states in the Eurozone is opposed in both cases of preventive action and correction of excessive deficit. Additional novelty is added to the fine system whereby members can be fined under preventive arm also for misrepresenting its data and under corrective arm when they fail to reduce the overall debt burden for the portion of deficit over 60% of GDP by 1/20th per year over three years. The main elements of the legislation were adopted under codecision procedure, but even the pieces where the Council was the sole legislator, by tying up the bundle of proposals together the European Parliament managed to have significant influence over the shape of the final act. One of its essential victories was the entrenchment of principle of reverse qualified majority vote as the sole mechanism to prevent sanctions to apply to the member state in breach of the corrective or preventive provisions. 4.2.2. Mitigating a "permanent" crisis? With the difficulties that Greece was facing in refinancing itself on the public markets in first half of 2010 a necessity for a solid mitigating mechanism grew stronger. But the no bailout clause was firmly entrenched in the treaties in order to prevent the abovementioned freeriding effect. If the first package provided to Greece was done nearly entirely on bilateral, adhoc basis, the procedure was burdensome and didn't provide any reassurance for the market.
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The first genuine systemic tool saw the day on the 9th May 2010 in the agreement of 27 to establish a special purpose vehicle financed by all the member states - EFSF complemented by European Financial Stabilisation Mechanism administered by the European Commission, with the use of EU budget as collateral. Because of the no-bailout clause the EU leaders had to stretch the EU treaties for the action to be considered legal (extending the interpretation of the article 122(2) ) and set the vehicle outside of the EU treaties. EFSF acts via issuance of bonds or other debt instruments in order to raise funds to lend to the stricken countries. Emissions of bonds were not made against a paid-in capital, but against guarantees given by the member states in proportion of their capital paid up to the ECB. As the system was heavily dependent on guaranteed AAA rating of the EFSF obligations, which can then be eligible for ECB refinancing operations, it suffered a confidence crisis on January 16th, 2012 three days after mass downgrade of several Eurozone sovereign bond issuers (France in particular), which put its S&P rating at AA+. 4.3.3. Towards legal certainty and resolution mechanism But clearly a temporary mechanism set up through the EFSF and EFSM proved to be insufficient and rather legally delicate. Insufficiency meant in the first instance that its contributing mechanism made it dependent on contingent guarantees themselves dependent on the rating standing of the participating member states.40 Furthermore its effective firepower was reduced by its participation at Irish, Portuguese and second Greek bailout. European Council acknowledged that the use of the mechanism was legally delicate, because it was set up according to the article 122 (2) TFEUas an emergency mechanism in rather flagrant contradiction with the no-bailout clause (article 125 TFEU). As the EFSF constituted solely a framework agreement, any modification was subject to the parliamentary ratification by all Member states. This happened in July 2011 when its guarantee commitments had to be increased to 780 bn euros and allow it to intervene exceptionally on primary and further also on secondary markets as well as to prepare the second Greek bailout. This led in several countries problematic political pressures an additional destabilizing factor that has to be taken into account. All elements therefore pointed to a need for a durable, legally sound and practical solution. This eventually emerged under the proposal for the establishment of the European Stability Mechanism - permanent crisis (sic) management mechanism. Decision by the European Council that was translated into an inter-governmental agreement. Nevertheless, this time the existence of the ESM was firmly linked to the EU treaties, which required a first modification of the EU treaties since the painstakingly ratified Lisbon treaty. This took form of a revision of the article 136 (3), procedure in which both Commission41 and European Parliament take a formalized albeit consultative part. Learning from the lessons of the past, ESM brought in several important innovations, many of them were in effect addressing systematically also the crisis resolution element. Firstly, of course ESM builds on paid-in capital instead of guarantees which brings its structure much closer to the international financing institutions 42. Secondly, the ESM now requires the inclusion of the collective action clauses that address the
40

This led to the need for over-guarantees by the Eurozone member states to the level of 120%, implying maximum issuance of 440/1.2=367 bn euros, further compounded by the stepping out as guarantors of the countries subject to bailout. EFSF also relies on keeping a cash reserve invested in high-quality reserve instruments. 41 See European Commission (2011), "Commission Opinion on the draft European Council Decision amending article 136 of the Treaty on the Functioning of the European Union with regard to a stability mechanism for Member States whose Currency is Euro", COM (2011) 70/3 42 Initial structure of ESM requires member states to subscribe a total capital of 700 bn euros, 80 in directly paidin capital and 620 bn euros in callable capital

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matter of holdout creditors in the crisis resolution. Thirdly ESM should not force the countries already in assistance to give it senior credit status, decreasing thereby the risk that national bondholders, being bumped by the ESM lending to a lower peg, would attempt to trigger credit-default swaps. Finally, ESM should be complemented by supplemental boost of the member states contributions to IMF, increasing its financial but also technical involvement.43 4.3.4. Emergence of the new governance mechanisms in the EU? Setting up an inter-governmental treaty for the sole benefit of the EU member states, pursuing an objective announced the EU treaties but laying outside of EU law is not a new practice. In the past, Schengen agreement and Prm convention dealing with the free movement of people and related aspects of police cooperation were set up with the similar aim and preconditions. First of them - the Schengen Agreement was finally incorporated into the acquis communautaire in 1997. An alternative to this solution, largely inspired by the experience of the Schengen was more extended use of the mechanism of the enhanced cooperation, which is tightly linked to the EU institutional and legal architecture. Enhance cooperation that allows under the Lisbon treaty to at least nine member states to engage in cooperation within the EU structures, but without the involvement of the other members. Since the entry into force of the Lisbon treaty this became a favourite tool to overcome several long standing impasses of the EU - notably of the linguistic regime for the patents44 and the divorce law. Finally one has to consider as well another decision-making method that was formally born with the fatal Lisbon strategy, aiming to make between 2000 and 2010 the EU the "most competitive and dynamic knowledge-based economy in the world". The strategy labelled Open Method of Coordination relying on the voluntary cooperation of the Member states. It relies on series of soft laws such as guidelines, indicators, benchmarking and exchange of the best practice. For Lisbon strategy, the method was considered to be failing, which was recognized at least partly in the design on the new growth strategy for the EU labelled EU 2020. The method itself saw a renewal with the establishment of the Euro Plus Pact, whose details were outlined in the Council Conclusions of 24/25th March 2010 and whose inception was corollary to the revision of the treaties with the view of setting up the ESM as well as with the six-pack on the economic governance. Its aim is clearly to complement the preventive structure of the six-pack, aiming at budgetary austerity and fiscal rectitude, with the resolution mechanism enshrined in ESM with a genuine strategy underpinning growth. Here can be found a first attempt, in very intergovernmental setting to bring about the genuine economic governance that goes beyond the traditional concept of single market envisioning progressive alignment venturing in the taboo policies of taxation, retirement or education. Since the first meeting in February 2010, as the crisis progressed, in spite of the adoption of measures for the enhancement of macroeconomic stability of the Eurozone enshrined in the six-pack, the EU leaders indicated their commitment to strengthen the economic governance by integrating them into EU treaties. The Commitment was explicitly worded as "qualitative step towards 'fiscal stability union'"45. This announced could have led to a first very substantive revision of the EU basic texts since 2007, in spite of well weighted treaty fatigue.
43

This is an additional 'procedural trick', as in many countries increase in IMF contributions is a simple decision of the government, but any modification of the contribution to ESM and therefore amendment of it would require parliamentary ratification. 44 The management costs of a patent across the EU would cost around 12.000 euros more than a US patent due to the need for translation in all languages of the member state in order to make attached IPR properly enforceable. Italy and Spain opposed to the current European Patent regime (English, French, German) to apply to the whole of the EU pushed European Commission to approve reinforced cooperation between EU members minus those two. 45 European Council (2011), "Conclusions. Meeting of 9th December 2011"

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The final decision taken by David Cameron at the European Council summit on 9th December 2011 was a clear indication that the UK will not take part at the treaty modification and therefore solutions have to be once again sought outside of the EU treaty framework. Another treaty outside EU law, but tightly linked to it was born under the working title of "fiscal compact". Chart 3: EU Economic Governance and Public Debt 2010-2011

Source: Eurostat (2012) The Treaty on Stability, Coordination and Governance, how the 'fiscal compact' came eventually onto the signing papers, did bring quantitatively little addition to the rules already established in the six-pack. Nevertheless it laid down several angular stones for the reinforced coordination of the economic policies with commitment to the ex-ante coordination of the debt issuance plans between its parties and Economic Partnership programmes for member states in excessive debt procedure. Second structural innovation is that its fiscal component, aimed at reining in the fiscal policies of member states through a "golden rule", is to be implemented by the member states at the constitutional level.46 Besides those innovations it also presents a formidable challenge for the decision-making at the EU level. One of the most acute problems lies in the use of the EU institutions. Although the six-pack is part of the EU law, and is enforceable by the European Commission with the assistance of the European Court of Justice, the former is absent in the provisions of the treaty. Therefore in the process of an infringement procedure sui generis, where member state fails to apply the automated deficit correction mechanism, it has to be another member state or several to bring the failing party of the treaty to the court. This clearly does little to improve on the concern about the
46

This already the case of some of the EU countries, in principal Germany with its "schuldenbremse" (art. 109, 115 and 143 of the German Basic Law) and France where a modification of articles of 32, 39 and 42 is under the consideration), Italy also inserted into its constitution (amendment to article 81) a balanced budget obligation.

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efficiency of the sanction and reduction of political influence. The advantage of the EU architecture is that the European Commission is bound to act as an honest broker in defence of the common rules, outside of any political pressures. 5. Conclusion: Europeanization of national politics and multispeed Europe Both the entry into force of the Lisbon treaty and outbreak and subsequent management at the EU level of the financial crisis brought about both substantive and substantial transformation of the decision-making in the EU. On the one side, the new treaty streamlined functions by entrenching called community method, which is translated into the term of ordinary legislative procedure, whereby commission proposes and Parliament adopts by majority acts jointly with the Council voting by qualified majority. This would simply be called other circumstances simply a federal majority method. But the treaty also brought into the process new actors such as European Council by giving it explicit legitimacy of an EU institution as well as National Parliaments. In addition, the financial crisis then acted as a catalyser of the inter-governmental approach, incarnated specifically by the European Council, gave birth in the time span of mere nine months to two new treaties, one set to prevent future crisis, second to mitigate it outcome, both set aside of the EU framework. It did complement the architecture by another rather weak intergovernmental mechanism governing the operation of the Euro Plus Pact. Since then, lot of ink was being spilled over whether the EU is drifting towards more intergovernmental structure, in spite of the clear need to be upgraded into a genuine political federation. Angela Merkel, at the inaugural speech to Einstein Promotion of the College of Europe tried to answer the challenge by retorting that the method we witness now is in fact a qualitatively new one: "Perhaps we can agree on the following description of this approach: coordinated action in a spirit of solidarity each of us in the area for which we are responsible but all working towards the same goal. That for me is the new Union method.47 Following the similar reasoning the president of the European Council, Herman van Rompuy attempted to reassure the federalists: "what we are going through is not a 'renationalisation of European politics', no it's the Europeanization of the national political life ". And ultimately with all the limits and all the limits and risks will make the European Project stronger"48 Such Europeanization was seen in the past rather as desired future outcome of the lengthy incremental process. The development economic crisis provided a useful catalytical moment, but it impact seems to be operating by the mechanism of creative destruction. Operating methods indeed tend to multiply, but they only reflect the incapacity of all member states to sustain equally the qualitative steps towards genuine political integration within the EU. Therefore, we should expect to see in the future the EU operating not only according to different methods, but more importantly in different configurations and following different rulebooks - the long time taboo subject of multi-speed Europe now returns to us with ever more urgency and necessity. References

47

Avi, S. (1973), "The Vedel Report and the Reform of the European Parliament", Parliamentary Affairs, Vol. 27, Issue 1973dec, pp.159-170.

Merkel, A., Speech by Federal Chancellor at the opening ceremony of the 61st academic year of the College of Europe in Bruges, 2 November 2010 48 Van Rompuy, H., Speech at the Humboldt University, Walter Hallenstein Institute for European Constitutional Law, Berlin, 6 February 2010

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Begg, I. et allii (2008), "Financing of the European Union Budget, Study for European Commission", DG BUDG, 28th April 2008. Bertelsmann Foundation (2012), "What Does Europe Want. The Who and How of Resolving the Euro Crisis", Brussels: Bertelsmann Foundation Bloomberg (2011), "New Energy Finance", EU-ETS Research Note, 25-10-2011 Della Posta, P., Talani, L. S., eds. (2011) "Europe and the Financial Crisis", London: Palgrave Macmillan Deloitte Consulting / European Parliament Policy Department on Budgetary Affairs (2010), "Creating greater synergy between national and European budgets", Brussels: European Parliament Emerson, M. (2008), "Making sense of Sarkozys Union for the Mediterranean", CEPS Policy Brief , No. 155, March 2008, p. 1. European Commission (2001), European Governance. A White Paper, COM (2001) 428 European Commission (2011), "Commission Opinion on the draft European Council Decision amending article 136 of the Treaty on the Functioning of the European Union with regard to a stability mechanism for Member States whose Currency is Euro", COM (2011) 70/3 European Commission (2011), DG CLIMA presentation to ICAO Council , 29-09-2011, European Council (2011), "Conclusions. Meeting of 9th December 2011" Forrester, I. S., (2009), "Due process in EC competition cases: a distinguished institution with flawed procedures", European Law Review, 2009, Vol. 34, No. 6 Guguen, D. (2011), Hijacking European Power, Brussels: ETI Hix, S., (2005), "The Political System of the European Union", 2nd Ed., London: Palgrave Macmillan, p. 123 Merkel, A. (2010), "Speech by Federal Chancellor at the opening ceremony of the 61st academic year of the College of Europe in Bruges", 2 November 2010 Merkel, A. (2011), "Speech at the Federal Congress of CDU", 14th November 2011 Pelkmans, J. (2003), "Mutual Recognition in Goods and Services", ENERPRI Working Paper, N16 Ponzano, P. (2010), "Executive and delegated acts: situation after the Lisbon Treaty", Contribution to the Florence conference on the Lisbon treaty implementation at EUI, Florence Roy, J. (2007), "Reflections on Treaty of Rome and Today's EU", Jean Monnet/Robert Schuman Papers Special, April 2007. Schuman, R. (2010), "Pour lEurope", 5th ed., Paris: Fondation Robert Schuman Van Rompuy, H. (2010), "Speech at the Humboldt University", Walter Hallenstein Institute for European Constitutional Law, Berlin, 6 February 2010

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5. European Union and single currency: on optimality or non-optimality of the Euro zone
Tomasz Brodzicki University of Gdansk, Faculty of Economics, Institute for Development Abstract: Economic and Monetary Union is an unprecedented event in the monetary history of Europe. The Euro zone since its creation 13 years ago expanded to 17 Member States and functioned relatively smoothly up to the outset of the global financial crisis. Only the severity of the subsequent Euro zone crisis showed the actual scale of structural, institutional and governance problems it had. The differences between its core and peripheral regions became more than evident. In the present chapter we discuss the optimality of the existing and the enlarged Euro zone. Despite of the progress made, Euro zone is far away from meeting the OCA criteria. Further enlargements, by increasing the overall internal diversity of the union, are likely to increase the gap. It seems however that even non-optimal monetary unions may function but at a significantly higher costs. In some cases the long term costs could even outweigh the benefits. The nominal convergence criteria are only partially consistent with the OCA theory, they are largely arbitrary and should be modified in the interest of the present Euro zone as well as of acceding states.

1. Introduction On 1 January 1999 eleven Member States of the European Union made an unprecedented move by getting rid of their national legal tenders and adopting a common currency euro. For the first time since the Roman Empire, a large portion of Europe started to share a common currency (de Haan et al. 2005). The first ten years of its functioning were relatively successful. The Euro zone expanded from original 11 to current 17 Member States increasing its internal heterogeneity. Nonetheless, there was some progress made towards fulfilling the theoretically established optimal currency area criteria. Imbalances, however, accumulated. The current crisis of the Euro zone which could be considered a first actual test of its coherence showed how non-optimal it actually was from the very beginning, both in terms of economic structures as well as in the governance domain. Apart from Denmark and the UK, which secured the opt-out clause, all new Member States of the European Union will eventually have to join the Euro zone. The entry is dependent on meeting the nominal convergence criteria. Several former communist countries have already entered the Euro zone. These are Slovenia (2007), Slovakia (2009) and Estonia (2011). Three further countries are currently within the ERM2 mechanism these are: Latvia, Lithuania and Denmark. The new Member States are not obliged to join the ERM2 mechanism immediately after accession to the EU and thus can delay the moment of adoption of the common currency. In the light of the recent Euro zone crisis most new Member States have adopted a hold-on strategy. This chapter looks first at introductory concepts. It than discusses the OCA criteria and their coherence with nominal convergence criteria of entry into the Euro zone. The optimality of the present Euro zone is discussed. The last section concludes and gives potential scenarios and recommendations. 2. Currency union as an exchange rate regime
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We would like to start this chapter by defining what constitutes the Economic and Monetary Union (EMU). One has to realize that we lack a clear definition of an economic union in the Treaty. The prominent Delors Report (1989) acknowledged however that it should consist of: a fully fledged internal market, cohesion or rules allowing for gradual cohesion of regions, strong competition policy as well as strict rules on economic policy coordination. Currency union (CU) can in turn be defined as an introduction of a system of irrevocablyfixed exchange rates with full convertibility (incomplete currency union) and/or introduction of a common currency (complete currency union). Creation of a common, supranational central bank follows, leading to monetary union. From the point of view of taxonomy of exchange rage regimes currency unions belong alongside truly fixed exchange rates, currency boards as well as dollarization (Euroisation), to a group of fixed currency arrangements (e.g. Bordo 2003, Frankel 1999). Frankel (1999) states that no single currency regime is best for all countries and that even for a given country it may be that no single currency regime is best for all time. Exchange rate regimes evolve and can be perceived as important policy choices along a certain continuum. To a large extent the costs-benefits analysis of a CU resembles the discussion between proponents of fixed versus floating exchange rates. The advantages of flexible exchange rates include automatic correction of external disequilibria by exchange rate movements (appreciation/ depreciation) and insulation against external shocks, avoidance of mistaken or distortionary determination of exchange rates as well as superior efficiency (no need for market interventions financed from reserves). On the other hand fixed exchange rate significantly reduces exchange rate risks, intensifies international trade, and imposes inflationary discipline on traditionally dovish states as long as they anchor themselves against stable currencies. As with any other regime choice, introduction of a common currency leads to numerous benefits and costs of micro , mezzo and macroeconomic nature over different time horizons. The most significant costs are directly and indirectly related to the loss of autonomy in the crucial area of monetary policy and control over exchange rate. The lack of independent policy could potentially magnify crises if they arise. The recent Euro zone crisis has shown another potentially destructive feature of monetary integration countries lose the capacity to issue debt in a currency over which they have full control (de Grauwe 2011). If market sentiment is favourable, weaker economies are able to issue or roll over debt at a lower overall cost. If market sentiment changes, however, a sudden loss of confidence of investors may, in a self-fulfilling manner, lead to default. As de Grauwe notes, monetary unions in the modern era of free capital flows seem to be prone to liquidity movements, liquidity crises and thus solvency crises (defaults). From introductory macroeconomics we know that in the very long run money is neutral. As an increase in money supply is absorbed by proportional increase in the level of prices (inflation), changes in nominal variables do not affect real side variables (such as productivity). Furthermore, in the long run absolute purchasing power parity principle holds real exchange rate returns to its equilibrium. By definition, if absolute PPP holds, real exchange rate will be constant. On the other hand, in the short run prices as well as wages are sticky (they do not fully adjust in due time) and thus nominal and real sides of the economy interact. Thus monetary policy as well as exchange rate have an impact on the real side of the economy. In the short run nominal exchange rates are quite volatile their volatility being non-desired due to adverse impact on intensity of trade flows. Relative version of the PPP principle (change in exchange rate related to discrepancy in inflation rates) better explains the short-term movements of the exchange rate.

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Keeping the above in mind and knowing the close links between exchange rate and monetary policy, the choice of the exchange rate regime is considered to be non-trivial. Generally speaking the choice of a fixed exchange rate regime diminishes the efficiency of monetary policy, fiscal policy however becomes more effective (for instance as can be shown in the textbook IS-LM-BP model). On the other hand, in a typical small open economy fully floating exchange rate makes fiscal policy ineffective in stimulating overall output increasing the role of monetary policy. The choice of an exchange rate regime thus requires many trade-offs and issues to be taken into account. These include among others: efficiency of fiscal versus monetary policy, the acceptable level of volatility of an exchange rate, insulation against external shocks, overall macroeconomic stability preferences with respect to inflation rates, unemployment rates, fiscal austerity, the degree of autonomy of a state, exchange rate pass through and other transmission channels. Fear of floating as well as fear of fixing frequently leads to deviation of actual exchange rate regime from the publicly announced exchange rate target. We thus have to distinguish de facto exchange regime from the jure exchange regime. The discrepancy obviously leads to lowering of credibility of monetary authorities of a given country with subsequent adverse effects. The Czech Republic and Poland have in recent years opted for a combination of floating exchange rate regimes (with possible interventions thus the so-called dirty floats) and inflationary targeting. According to some studies, it is the best available alternative for advanced transition economies. Acceding into the Euro zone they will have to enter and remain within the ERM2 mechanism for at least two years. ERM2 is classified as adjustable peg - an intermediate exchange regime, before fully fixing their currencies to euro in the currency union. 3. Optimal currency areas An Optimal Currency Area (OCA) can be defined as a group of countries (regions) for which it is economically sound to adopt a common currency or to set irrevocably-fixed exchange rates. In other words, the theory of OCA provides a list of criteria which should allow the economic benefits of fixing exchange rates to outweigh related economic costs. Two fully-integrated and completely homogenous economies both in terms of economic structure as well as of preferences can form an optimal currency area. Any deviation from symmetry can create a problem in a currency union with a single monetary policy and a single currency, especially when a significant shock occurs ejecting the economy from the long-run equilibrium. Asymmetric demand as well as supply shocks are of particular concern as they pose major challenges for the common central bank. The lack of autonomous monetary policy (inability to control interest rates) and inability to influence exchange rates can amplify the problems of crisis-stricken economy within a larger currency area thus other automatic or discretionary adjustment mechanisms which could allow the economy to return to the initial or new equilibrium are required. In fact the problem of a crisis-struck part of the currency union will soon become the problem of the whole union due to a typically high degree of mutual interdependence (contagion effect). Summing up, the OCA criteria minimize the threat of asymmetric shocks, minimize the threat of symmetric shocks with highly asymmetric effects and provide for efficient adjustment mechanism to potential shocks (bringing the economy to equilibrium).
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The OCA concept goes back to a highly influential paper of a later Nobel-prize winner Robert Mundell (1961). The concept was developed further with major contributions of McKinnon and Kennen among others. The set of traditional OCA criteria includes: high mobility of factors of production in particular labor mobility (Mundell 1961), high degree of mutual openness high intensity of trade in traded goods (McKinnon 1963), high degree of diversification of production and exports with similarity in the degree of diversification (Kennen 1969) this in fact implies that OCA should be formed by countries of similar size. Other criteria mentioned in the literature of the subject, which make the theory more nuanced (de Grauwe 2007), include, among others: synchronized business cycles, small differences in inflation rates and similar propensity to tolerate inflation similar levels of aversion to inflation (Haberler & Fleming), high degree of integration of both short and long-term financial markets (Ingram), low variability (volatility) of real exchange rates (Vaubel). Furthermore, the countries of the monetary union should agree how to deal with shocks (homogenous preferences), and if needed compensate each other in the case of an adverse shock through a system of fiscal transfers. In the commonality of destiny view sharing a common destiny should allow for better acceptance of the costs of operating within an OCA. The costs will sooner or later arise. Moreover, the common central bank should be strong and independent both in terms of goal-setting as well as instrument choice. Generally speaking countries with more independent central banks have lower average inflation rates (higher price stability) in the long-run, which has a positive impact on their long-run growth rates. In case of asymmetry of preferences (hawks versus doves) the common central bank should adopt the stance of the most hawkish national central bank in order to minimize the overall potential economic loss. Generally speaking hawkish economy will not be interested in creating a monetary union with a dovish economy if the common central bank will have preferences different from hawks. Furthermore, it will demand the dovish economy to provide a proof of its reliability and that it permanently attaches great importance to low inflation. The dove however can deceive the hawk about its actual preferences which could create significant problems when the truth is revealed within later on. In their famous work, Krugman and Obstfeld (2004) show that macroeconomic costs of a currency union (fixing exchange rates) decrease with the level of mutual integration, while the associated benefits of a currency union steadily increase. In other words, fixed exchange rate (currency union) is beneficial to highly integrated countries. At low levels of mutual integration the costs clearly outweigh the benefits. There exists however a certain threshold level of mutual integration, which if exceeded, makes the creation of a currency union sound and rational. The traditional theory of OCA was heavily criticized for many reasons. Generally speaking it places more emphasis on potential macroeconomic costs than microeconomic benefits. Furthermore, taking seriously the set of criteria provided, it is unclear which regions or countries form an OCA. Should assessment be made on the basis of all criteria taken together, (compound fulfilment of the criteria) or should they be considered separately (one at a time)? Can the criteria be arranged according to their decreasing or increasing significance? Should the criteria be met permanently or only within a certain period of time? It is moreover worth to note the incompatibility of certain criteria (Tavalas 1993, 1994) they are unlikely to be fulfilled simultaneously. For instance a smaller economy is likely to be more open (as proxied by the openness index) but simultaneously is likely to have less diversified structure of production/exports (which in a typical monopolistic competition set62

up is a function of its size). In addition, significant measurement problems arise with some of the criteria. Moreover, the decision upon entry of an economy to already functioning union modifies the balance of costs and benefits of countries already participating in the OCA and of potential candidates. External effects or externalities could thus be significant and should be taken into account. Some economists argue that despite of non-compliance before the accession, a country can be determined to membership in the currency union based on the long-term supremacy of benefits over costs (political will is more important than economic rationality). The new theories of optimal currency area stress the endogeneity of the OCA criteria (Frankel and Rose 1997). In the endogeneity view a given criterion does not have to be fulfilled ex ante (pre-accession) as it will be automatically met ex post. The accession itself moves the country closer to meeting the goal. Traditionally the endogeneity was discussed with reference to greater mutual openness due to the functioning of the so-called Rose effect positive impact of introduction of a common currency on the intensity of mutual trade relations. Other dimensions of endogeneity were added later on. These include: an increase in the degree of integration of financial markets (Baele et al. 2004), an increase the degree of symmetry of shocks and synchronization of business cycles (Artis and Zhang 1999) as well as an increase in flexibility of product and labour markets (Bertola and Boeri 2004). New theoretical models stress the importance of different aspects of similarity. These include for instance similarity of the transmission of potential shocks, similarity of economic policy responses to shocks as well as of the monetary policy transmission channels. It is worth to note however, that the current situation of Greece in the Euro zone could at least to some extent undermine the logic of endogeneity of OCA approach the entry of Greece was partly supported by this view. The country has not however converged but instead has deviated from the desired path. 4. Nominal convergence and OCA criteria In order to enter the Euro zone (the third and final stage of Economic and Monetary Union) the acceding EU Member State haves to meet the so-called nominal convergence criteria. The obligation was formalized by the Maastricht Treaty and amended Protocols. The criteria require the achievement of a high degree of price stability (inflation criterion), durability of convergence process (nominal long-term interest rates), sustainability of the government financial position (being outside of excessive deficit procedure with reference values for public debt and deficit in relation to GDP) and the observance of the normal fluctuation margins provided for by the ERM for at least 2 years without devaluing against the currency of any other Member State (please refer to a box beneath). Maastricht convergence criteria stability of prices (inflation target, HICP) nominal long-term interest rates budgetary deficit (not higher than 3 per cent of GDP)* public debt (not exceeding 60 per cent of GDP)* participation in Exchange Rate Mechanism (ERM II) for at least 2 years devaluation conditional on approval by other participants * formal excessive deficit procedure not opened against the Member State The detailed analysis shows that the criteria are in fact quite arbitrary and were not taken seriously from the very beginning (soft versus hard approach to fiscal criteria for instance)
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meeting of the criteria was stretched. Several current Member States of the Euro zone should not have entered the union as they didnt meet the criteria on a permanent basis (a requirement, which to a large extent, has been forgotten) or they played with the data (Greece). The logic of the Maastricht criteria on nominal convergence is frequently questioned. For instance de Grauwe (1996) asserts that the traditional OCA theory does not imply that prior convergence of inflation rates, interest rates and fiscal situation is neither a necessary nor a sufficient condition for the creation of successful functioning of monetary union. Countries with different rates of inflation may be structurally similar the difference may be due to the institutional determinants of central banks (eg degree of independence) or due to heterogeneity in policy preferences. In the same moment two countries having the same rate of inflation may be structurally different. Despite of nominal convergence in light of structural heterogeneity currency union will be a sub-optimal solution in that case. Hansen (2005) points out that the criteria are retrospective and not prospective and they are to a large extent arbitrary (reference values for public deficit/debt criteria). We can say that to a large extent nominal convergence criteria are inconsistent with the set of OCA criteria provided by theoretical literature. OCA theory puts emphasis on real or structural (and thus by definition long-term) convergence and the deepening of the integration process, while the Maastricht criteria focus on nominal (short-term) convergence. Furthermore, based on the experience of the present Member States, simultaneous fulfilment of all the criteria has proven to be very difficult with the window of opportunity for entry being very small indeed. It seems that political and not purely economic considerations played a role in their adoption. According to one of views present in the literature of the subject divergence and inconsistency lies in the political conditions - the decision about the introduction of euro was mainly politically motivated. Why were the OCA criteria omitted? Several arguments were put forward. Frequency of macroeconomic shocks would be largely reduced in the EMU (fewer errors in discretionary monetary policy) and they would be more symmetric. The functioning of the Rose effect would increase the intensity of trade within the Euro zone, in particular of intra-industry type. Overall level of differentiation would thus increase and the level of specialization would decrease. OCA criteria are therefore endogenous. The formation of the common market would increase the mobility of capital and of workers within the Euro zone itself. The exchange rate as an instrument of macroeconomic policy has lost importance in a world characterized by large international flows of capital. It was expected furthermore that other regulatory mechanisms such as the envisaged Stability and Growth Pact with the excessive deficit procedure would work reasonably well. In the light of the recent sovereign debt crisis that seemed particularly nave. The ultimate purpose of the Maastricht criteria was to provide for higher stability and credibility of the new common currency. In reality the initial credibility of euro was due to the participation of Germany and stemmed from the role of the German Mark (DM) in the international financial system. If the OCA criteria were used instead of the nominal convergence criteria the Euro zone would be restricted to the so-called core countries. PIIGS would have to remain outside. Would it be desirable outcome though? It would for sure lead to potentially harmful twospeed Europe scenario with potentially adverse effects for the process of European integration in the medium to long-run. On the other hand the union of the core countries would be more stable and credible in the financial markets. Still one has to bear in mind that the benefits of the currency union are the function of its size. The union restricted to the core countries only could have been too small. What consequences will the omission of the OCA criteria in the future? It has already created significant problems and this is likely to continue to do so in the foreseeable future. The
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Stability and Growth Pact (with Broad Economic Policy Guidelines, excessive deficit procedure) didnt bring the desired outcome as it was unfortunately dysfunctional from the very beginning. Increased flexibility resulting from its partial reform did not prove significant improvement in its performance. Only now greater fiscal austerity is becoming a necessity and the recent Fiscal Pact can make the excessive deficit procedure more reasonable. Stepping back for a moment, the current crisis of the Euro zone can in a way prove to be very beneficial from the long term perspective. It first of all can be considered as a first serious test for the integrity and optimality of the Euro zone. Secondly, it creates an opportunity to improve macroeconomic governance within the Euro zone and coordination of the Euro zone with other countries of the European Union. Further significant shocks including highly asymmetric shocks are likely to happen in the future each bringing the Euro zone closer to OCA as long as it is able to cope. The controllable or uncontrollable break-up of the Euro zone or of its part is however undesired but still a very likely scenario. 5. How optimal is the current Euro zone? As early as in 1999 Paul de Grauwe showed that only the core of the Euro zone can be considered close to meeting the OCA criteria. Inclusion of the so-called peripheral states greatly increases the real divergence (understood as the degree of differentiation of the growth rates of output and employment in a situation of asymmetric shock) requiring a large and highly unlikely flexibility of labour markets (the degree of real wage flexibility and the degree of labour mobility). In several studies Bayoumi and Eichengreen (1992, 1993, 1997) performed an analysis of the EU15 stating that the core Euro zone countries should include: Germany, France, the Benelux countries, Austria and Denmark. The others were considered peripheral and their accession should have been debated or at least delayed. By definition, optimal is the most desirable possibility under a certain expressed or implied restriction. Looking from this perspective we cannot grade the optimality of the currency area. Either you fulfil all the required criteria and you are judged optimal or you are non-optimal. In the highly asymmetric heterogeneous world, the OCA seems to be a purely theoretical concept. The world we live in is non-optimal with widespread asymmetries and heterogeneity. Symmetry is considered beautiful but extremely rare. The OCA could be thus considered an ultimate goal which however will never be met. It seems however reasonable to say that the further away you are from meeting the OCA criteria the larger and more probable will be potential costs associated with the introduction of a common currency. Optimality of the Euro zone has been heavily discussed in the literature of the subject. The outcome is quite simple the current zone is not an optimal currency area and hasnt been one since it was created. The first years of its existence were quite successful. However, the global financial meltdown after the collapse of the Lehman Brothers, with the subsequent recession and the current sovereign-debt crises showed the reality. The global crises of rather symmetric character proved to have highly asymmetric effects striking Member States of the Euro zone with various force. In particular the PIIGS the peripheral countries of the Euro zone have been affected with Greece on the verge of defaulting on its debts. As could have been expected, the extensive linkages and interdependencies within a single market made it a problem of the whole Euro zone, EU and to some extent a global crises. The default of several Euro zone countries through contagion could create unparallel global financial crises of magnitude significantly larger than the one resulting from the American subprime crises. The crisis has clearly shown the scale of the cracks in the structure of the Euro zone and the extent of deficiencies in its governance methods and regulations. It has also made evident the lack of political leaders able to make fast and hard decisions. Bordo and Jonung (2000) more
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than 10 years ago said that currency unions needed considerable political will to survive in the face of the adverse shocks. One should have expected them to arrive especially when the global economy seemed to have entered an era of turbulence (Greenspan 2007) with higher average inflation rates, more internal and external imbalances, greater risks and largely dysfunctional institutional set-up. After all, Economic and Monetary Union is not only an economic project but to a large extent a political one with strong external effects not restricted to Euro zone countries only. In a relatively recent report for European Commission Moneglli (2008) said that the Euro zone still being non-optimal currency area progressed towards meeting the criteria. With deeper integration, declining dispersion (for instance in inflation rates), fewer asymmetries, more synchronized business cycles, more smoothing and better shock absorption the potential costs were decreased and benefits enhanced. Moneglli (2008) however rightly pointed out that the launch of the euro still represented a very recent regime shift whose effects required more time to unfold. Furthermore, he acknowledged that it was extremely difficult to disentangle euro-related effects from effects of other global or European development. What are the major bottlenecks of the Euro zone? Its constituent countries are structurally different (in terms of size, structure of production, exports, overall level of development etc.), labour markets are quite rigid, international as well as intra-national labour flows (migration) are limited, coherence of macroeconomic policies can be questioned and finally an automatic fiscal transfers mechanism wasnt created due to the lack of political will. The excessive deficit procedure, which technically speaking was a right step, proved to be dysfunctional and the limits on the public deficit and debt were not obeyed. Significant imbalances accumulated. The OCA theory criteria do not send a clear signal. The Euro zone is therefore not an optimal currency area and is highly unlikely to be one in the future at least in the foreseeable future. Further widening of the Euro zone being only a matter of time may pull the Euro zone further away from the OCA. Accession of further EU Member States is automatic and conditional on meeting the nominal convergence criteria with the opt-out clause considered an exception to the general rule. New states acceding to the EU have to fulfil the Copenhagen-criteria (established in 1993) and thus can obtain only a temporary derogation from the third stage of EMU (introduction of a common currency). Still a non-optimal OCA may function, but at a higher costs, which can be very heavy from time to time as has been learned the hard way recently. Baldwin and Wyplosz (2009) point out at that the cost will arise mainly in the labour markets (unemployment) and may lead to significant political tensions. 6. Gaining optimality as a process In an excellent paper Hugh Rockoff (2000) looked at monetary history of the United States to answer a basic question: How long did it take the US to become an OCA? The present US is probably the closest to fulfilling the theoretical OCA criteria. According to Rockoff it took the US around 150 years from 1788 to 1930s. According to Wyplosz (1997), however, it emerged as a smoothly functioning currency area only after the WW II. Becoming an OCA can thus be considered a long-term and rather bumpy process. Within the period the US experienced several adverse asymmetric shocks (among its regions) as well as several symmetric shocks with asymmetric effects including the Great Depression. In that case, according to Rockoff, no region was immune to the crisis, but there were significant regional differences. It seems that having separate regional currencies would not bring a better result in fighting its consequences. On the other hand previous regional shocks were magnified by monetary reactions and wrong aggregate monetary policy decisions. Division into separate currency areas could have been a better solution then.
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Rockoff rightly points out that American case does not provide an excellent benchmark for EMU. Several aspects of the process should be taken into account though. An in-depth costs benefits analysis should be performed. Countries should be committed to a monetary union (political will and commonality of destiny). Furthermore, as asymmetry will persist and asymmetric shocks will occur, the correct institutional set-up should incorporate a system of inter-regional fiscal transfers and some form of deposit insurance, or regionally sensitive lender-of last-resort facilities. It is worth to note that a largely imperfect system (ESF, bail-out to Greece) was arranged in the Euro zone only when the actual crises struck. The actions taken are thus responsive and not pre-emptive. More strategic, long-term thinking is required in order to minimize the threats of destructive shocks that are going to happen in the future and guarantee more efficient and smooth functioning of the Euro zone. 7. Conclusions Introduction of euro can be still considered a very recent currency regime shift. Its full results, expressed through both cost and benefits, will unfold only in the very long run. Even then, it will be difficult to fully disentangle the effects of euro adoption from the positive and negative effects of other processes. Despite of the progress made since its creation, the current Euro zone does not fulfil the optimal currency area criteria. Its further enlargements in accordance with the rules enshrined in the Treaties can increase the disparity even further. Still, it is worth to stress that nonoptimal currency unions may function pretty well. Their functioning brings both benefits and costs which can become heavy at times especially when adverse circumstances occur. The further the currency unions are from the OCA, the larger could be potential costs. Asymmetric shocks as well as symmetric shocks with highly asymmetric effects due to structural heterogeneity are particularly worrisome. Especially if one takes the persistence of regionaldisparities and the path-dependent model of growth of European regions into account. Flexibility and ability to dynamically adjust to frequently changing turbulent environment is a necessity. Furthermore, creation of a currency union is a process itself and not a mere regime switchover. There is some support for endogeneity of OCA criteria, still in reality much more effort is required. Converging to the optimal currency area status in the presence of structural asymmetry is a lengthy process which could be quite rough depending on particular circumstances. Gradual deepening of the integration process is one of its most important aspects. The logic of functional spill-overs applies. The long run sustainability of the Euro zone will depend on structural convergence of its constituent regions and in particular between its core and peripheral countries. There is, after all, rationality in the OCA criteria debate. What are the prospects for the Euro zone? The status quo that has existed since it was created is unacceptable. Systemic flouting of the Stability and Growth Pact (despite of the criticism it got and the 2005 reform) unfortunately unwound the progress made since 1999 (Howarth & Loedel 2005). It more or less led to marginalization in the global arena, accumulation of significant imbalances and deepening of the problems only exacerbated by the crisis. Slight deviations (partial reforms) from the status quo are unlikely to bring a clear difference. The reforms discussed so far (including the Fiscal Pact) are simply insufficient. Even if the current Euro zone survives, the situation calms down, the lack of reforms will prove to be costly in the long-run. More structural, strategic in scope and depth reforms are required. Efficient mutual support and control mechanism must be introduced. In order to implement them political will is required with strong European leaders having a clear vision of the future

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and adequate authority. To a large extent the Euro zone and the EU are in severe governance and leadership crisis. If the solutions are not found and implemented fast, the uncontrollable demise of the Euro zone will materialize with a danger to the coherence of the whole EU project. The history of civilization brings us numerous examples of demise. After the initial turbulent period some sort of equilibrium would eventually emerged though the framework could be vary different from the one we have today. Other scenarios are possible as well including smaller Euro zone, the division of the Euro zone etc. however the economic and political costs could be vast. One of the most desirable outcomes could be enhanced integration of the whole (unlikely) or part of the Union (twospeed or multiple-speed Europe) towards some sort of European state (the famous United States of Europe could re-emerge). The argument that euro is a currency without a country would become obsolete. Deeper integration seems to be the only desired option for the Euro zone and the EU. The euro crisis will be overcome only with further radical steps towards fiscal and financial integration. Political unification is required as it would reduce national idiosyncrasies and occurrence of asymmetric disturbances of institutional origin. The absence of a political union will continue to make the Eurozone a fragile regime and in the long run its lack gives the Euro zone only a little chance of survival (de Grauwe 2006, 2007). As Angeloni and Shapir (2011) put it, the prospects for the euro are challenging but far from hopeless and note that, historically, political and economic unifications have typically progressed in times of crisis. The current Euro zone crisis can be looked upon as an opportunity to deeply reform the whole EU project and give the new boost to the process of economic and political integration in Europe. In fighting the current crisis we should not only take its economic costs but political ones as well the demise of the European Union could prove to be too costly. We fully support the stance of de Haan et al. (2005) that further enlargements of the Euro zone will lead to increase in its internal diversity and thus require a deep reform the ECB decision-making structures, modification of monetary-policy strategy and coordination mechanisms with fiscal policies within the Euro zone Member States. In addition, the logic of nominal convergence criteria should be reconsidered and potential modifications should be implemented in the long-term interest of the current and forthcoming Member States we fully agree with Wojcik (2008) on that issue. Furthermore, the Treaties should be amended in order to include a formal, transparent and structured path for potential exit of a Member States from the Euro zone. References Alesina, A. et al. (2002), Optimal Currency Areas, NBER Working Paper No. 9072. Angeloni, I. and Sapir, A. (2011), "The international monetary system is changing: what opportunities and risks for the euro?," Bruegel Working Papers no. 632. Baldwin, R. Wyplosz, Ch. (2004), The Economics of European Integration, New York: McGraw Hill. Bayoumi T. and Eichengreen, B. (1992), "Shocking Aspects of European Monetary Unification," NBER Working Papers no. 3949. Bayoumi, T. and Eichengreen, B. (1993), "One Money or Many? On Analyzing the Prospects for Monetary Unification in Various Parts of the World," Center for International and Development Economics Research (CIDER) Working Papers C9303. Bayoumi, T. and Eichengreen, B. (1994), "Monetary and exchange rate arrangements for NAFTA," Journal of Development Economics, Elsevier, vol. 43(1), pp. 125-165.
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Bayoumi, T. and Eichengreen, B. (1997), Shocking Aspects of European Monetary Unification. In: Eichengreen B, European Monetary Unification: Theory, Practice and Analysis. Cambridge Mass: MIT Press, pp. 73-109. Bordo, M.D. (2003), Exchange Rate Regime Choice in Historical Perspective NBER Working Paper No. 9654. Bordo, M.D.. and Jonung, L. (2000), "A Return to the Convertibility Principle? Monetary And Fiscal Regimes in Historical Perspective," Working Paper Series in Economics and Finance 415, Stockholm School of Economics. Bordo, M.D. and Jonung, L (1999), "The Future of EMU: What Does the History of Monetary Unions Tell Us?," NBER Working Papers no. 7365. De Haan, J. et al. (2005), The European Central Bank. Credibility, Transparency and Centralization, CESifo Book Series, Cambridge: The MIT Press. Howarth D., Loedel P. (2005), The European Central Bank? The New European Leviathan?, 2nd edition, Eastbourne: Palgrave Macmillan. Frankel, J. A. and Rose, A. K. (2001). "The Endogenity of the Optimum Currency Area Criteria". The Economic Journal Vol. 108, pp. 10091025. De Grauwe, P. (2006), On monetary and political union, CESifo series. De Grauwe, P. (2007), Economics of Monetary Union, 7th edition, Oxford: Oxford University Press. Greenspan, A. (2007), The Age of Turbulance. Adventures in a New World, New York: The Penguin Press. Hansen, J. D. ed. (2005), European Integration. An Economic Perspective.:, Oxford: Oxford University Press. Kenen, P. (1969), The Optimum Currency Area: An Eclectic View, In Mundell and Swoboda, (eds.), Monetary Problems of the International Economy, Chicago: University of Chicago Press. Krugman, P. and Obstfeld, M. (2004), International economics, Theory and Policy 5th edition, New York: Addison Wesley. McKinnon, R. (1963), Optimum Currency Areas. American Economic Review, Vol. 52, pp. 717-725. Mongelli, F.P. (2005), What is European Economic and Monetary Union (EMU) Telling us about the Optimum Currency Area Properties?, Journal of Common Market Studies, Vol. 43(3), pp. 607-35. Moneglli (2008), European economic and monetary integration and the optimum currency area theory, Economic Papers 302, February 2008. Mundell, R. A. (1961). "A Theory of Optimum Currency Areas". American Economic Review Vol. 51 (4), pp. 657665. Ricci, Luca A. (2008). "A Model of an Optimum Currency Area". Economics: the Open-Access, Open-Assessment E-Journal 2 (8): 131. Rockoff, H. (2000), How Long Did It Take the United States to Become an Optimal Currency Area? NBER Historical Paper No. 124. Rose, A. (1997), The Endogeneity of the Optimum Currency Area Criteria, Centre for Economic Policy Research, Discussion Paper Series no. 1473. Tavlas, G.S. (1993), The New Theory of Optimum Currency Areas, The World Economy, pp 663-685. Tavlas, G.S. (1994), The Theory of Monetary Integration, Open Economies Review, Vol. 5(2), pp 211-230. Wojcik C. (2008), Integracja ze strefa euro. Teoretyczne i praktyczne aspkety konwergencji., Warsaw: Wydawnictwo Naukowe PWN.
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Wyplosz, Ch. (1997), EMU: Why and How it Might Happen, The Journal of Economic Perspectives Vol. 11, pp. 3-22.

Acknowledgements 1. The paper was presented as a lecture to students of Economics at the Faculty of Social Science, Charles University in Prague in November 2011. I would like to thank Dr. Wadim Strielkowski for the invitation. 2. The paper is written within the Jean Monnet Project Specialized courses within the EU Economic Studies at the Faculty of Economics of the University of Gdansk (2009-2873) that is been carried out at the University of Gdansk and financed from the sources of the European Commission. The usual disclaimer applies. 3. I would like to thank Stanislaw Uminski for useful comments and suggestions on an earlier version of the paper.

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6. Regional Policy and Economic Development: the case study of Dresden Cluster
Jan Andr Technische Universitt Dresden Udo Broll Technische Universitt Dresden Abstract: Dresden is the third largest city in East Germany. Manufacturing in Dresden is specialised in the semiconductor industry. The industrial concentration in this high-tech industry is rather exceptional in an economically underdeveloped region like East Germany. This essay describes the evolvement and the growth consequences of this specialisation. It introduces a simple model of concentration advantage to formalise these developments.

1. Introduction Dresden is the core city of a metropolitan area in East Germany with around 750.000 inhabitants. With a distance from around 200-300 km to Berlin, Munich and Prague this is at present one of the most central places in the European Union. But, this geographical situation determines that Dresden is the most south-eastern agglomeration in East Germany. It is most distant from higher developed West Germany and up to the eastern enlargement in 2004 Dresden was one of the closest cities to the EU external borders. So for most of the 20 past years of unified Germany, Dresden was rather one of the most peripherical metropolitan areas of the country. However, economic development in Dresden after German reunification was not typically peripherical. Because of its fast economic expansion and its high-tech manufacturing Dresden was labelled most dynamic city in Germany in an INSM study from 2001 to 2006 (INSM, 2007). Other future rankings by the media have been also very optimistic for Dresden49. These good grading is interesting because the average ranking the other cities in Eastern Germany is usually far worse than for the average city in the West. Five years later some mean reversion has been noticed (INSM, 2010).50 The once fast growing high-tech-sector has shrunk significantly and this drags down city growth. But luckily, corporate problems in two major semiconductor companies in Dresden did not blow up the industrial concentration in this branch. The so-called Silicon Saxony51 remains still the biggest geographic concentration of microelectronics in Europe in 2011. This chapter is organised as follows. In section 2 we outline the industrial policy and the industrial development in Dresden after German Reunification which creates the exceptional result of a high-tech industry concentration in a low income region. In section 3 we present a small model which carves out one important reason behind lingering industrial concentration in semiconductor industry in Dresden. That may explain the survival of the microelectronics concentration after crisis and restructuring. In section 4 we talk about the growth consequences of this concentration. High growth in the Dresden semiconductor industry has spurred city economic growth considerably before 2005. Afterwards the city economy was
49 50

E.g. the ranking from finance journal Capital (2007). In 2010 Dresden ranks relatively uncomfortably in the second half like most other East German cities. 51 Saxony is the region around Dresden.

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negatively effected by this industry. But, the caused overall decline in growth seems to overstate the real economic consequences for Dresden. In section 5 we provide conclusion and discuss policy implications. 2. Regional industrial policy after German Reunification: Dresden Historically, Dresden was a very important hub for manufacturing, commerce and administration in the middle of Germany. Before 1945 its population size was under the biggest 10 cities of the country. Its metropolitan area was considerably more populated than today. It was one of the most important agglomerations in Germany. Furthermore, the region of Saxony with Dresden as its capital was after Berlin and the Rhine-Ruhr-area the third most important German manufacturing area. In difference to mono-structured other old industry centres52 manufacturing in Dresden was very diversified (Bramke, 1998). This diversification diminished in the years between 1945 and 1989, but essentially continued. The adjustment problem after 1989 was that overall industrial competitiveness had seriously deteriorated. With a productivity of around one third (Sinn and Sinn, 1993) of its western German competitors manufacturing in East Germany became virtually obsolete with the Reunification. Manufacturing in Dresden shrunk drastically at the beginning of the 1990ies. 75.000 jobs were lost in this sector. Most industrial structures closed down. Some previously important branches like optical industry and furniture industry completely vanished. The important engineering industries contracted strongly (Wolgast, 1997). The remaining manufacturing structure was internationally non-competitive and served mainly regional markets with food and construction materials production. On the other hand, human capital resources and scientific potential in Dresden remained impressive. Although there was need for some updating, Dresden had abundant skilled persons and ample research facilities. The city has a large technical university. Around there is a diversified bunch of other educational facilities with international reputation. Technically skilled persons were not in short supply. Furthermore, Dresden was a centre of applied industrial research in East Germany before 1989. The East German research in semiconductors was concentrated here. Despite of adjustment problems its research history and facilities gave the city a distinct research potential, and tied human capital. After 1989, regional industrial policy tried to maintain and to expand research potential through intensive funding.53 Despite its declining manufacturing the main aim of this strategy was also to hold human capital for this sector available. And new opportunities in manufacturing came, essentially in 1993. The former Siemens branch for semiconductor production54 expanded its production of microchips and decided to establish a one-billion- plant in Dresden with nearly 2.000 employees. Industrial policy sponsored this investment heavily with around 30 per cent coverage (Grundig et al., 2008). Dresden emerged as an important production site for the semiconductor industry in Europe. Together with this investment, numerous smaller firms in that came to Dresden. Some left after completion but a significant number remained because skilled workers were abundantly available in the city.
52

Dresden was very different to the coal and steel dominated Rhine-Ruhr area. It had also not so much textile industry which made the industrial change difficult in Saxony. Although, Dresden had plants of some very advanced companies in that time (e.g. Zeiss-Ikon) its production base was rather mixed than high-tech. 53 East German semiconductor research has been initially pursued in the public funded microchip company ZMD. Dresden became the second most important site for the Fraunhofer institution in the country. This is the most important public structure for industrial applied sciences in Germany. 54 East German semiconductor research has been initially pursued in the public funded microchip company ZMD. Dresden became the second most important site for the Fraunhofer institution in the country. This is the most important public structure for industrial applied sciences in Germany.

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A second anchor investment was launched in 1996. American microprocessor company AMD decided to establish another big plant in Dresden. With this decision, Dresden became one of the most important industrial concentrations of the semiconductor industry in Europe (Belitz and Edler, 1998). Furthermore, with the production sites of Siemens and of AMD Dresden manufacturing was relatively specialised in semiconductor production.55 Although both plants together never employed more than 10.000 persons, their heavy capital investments concentrated value creation in the once weak manufacturing sector of the city in that industry. At the 2004 heyday more than half of the citys manufacturing turnover came from the ITindustry with its most important activities in semiconductor production (Kluge, 2011). This industrial concentration was strengthened by some further capacity expansions of the main players before 2005. The result was an impressive manufacturing and overall growth from 1999 onwards (cf. chapter 4). Since that time the so called Silicon-Saxony56 describes itself as the most important industrial site for chip production in Europe (Silicon Saxony: 2006). Figure 1 shows an actual map of semiconductor industry activities in Saxony which are obviously concentrated in and around Dresden. The boom was over in 2005. Once relatively new, mass production facilities for microchips became outdated. Combined with an upswing in the volatile semiconductor industry output values fall significantly. In the 2005 slump, both big players managed to survive but not really recovered. So in the economic crisis of 2008/2009 production shrunk again strongly and the main production plant of the former Siemens branch bankrupted. A minor part survived. Likewise, the other big player AMD had severe problems, but their Dresden plant could be sold to financially sound new Arab owners.57 This contraction was paralleled by an expansion of the solar panel production in the region. Blessedly for Dresden, trained personal could relocate and did not leave.
55

After the exodus at the beginning of the 1990ies the city manufacturing was relatively weak, small and diversified. Hence, two large microchip plants in Dresden add up to a relative specialisation in semiconductor manufacturing. They are the biggest employers in manufacturing in the city. 56 The Silicon Saxony-association is a regional network based network of IT and solar industries. It estimates that actually around 1.500 with 43.000 employees are active in these sectors. Although distinct numbers for activities in Dresden are not available, the major activities are in and around the city. 57 They integrated the plant in their so-called GlobalFoundries activities in the semiconductor industry.

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Figure 1: Map of microelectronics/ICT in Saxony - Location of important producers

Source: Silicon Saxony, 2011 After the economic crisis the current situation of the Dresden industrial concentration seems to be consolidated. Industrial specialisation is still intact unlike many other heavily subsidized projects in this branch. Competitive problems in mass production caused a loss of industrial importance and employment. However, the updating of production facilities and of product sophistication has foregone. Dresdens semiconductor industry switches from prevalently mass production to a more diversified and differentiated product portfolio. Medium sized companies have emerged which are less dependent from the two big plants. Still these two big producers plan to renew their facilities with large investments. They do so in a much less generous ambience of public funding. All this may confirm the created concentration advantage of this branch that give Dresden a lasting advantage in the semiconductor manufacturing. 3. Why has Silicon Saxony survived? - A simple model of concentration advantage In section four, we are interested in the interaction between industrial policy, industrial concentration and economic integration. It can be argued that globalization has strengthened the role of industrial districts and furthered their development (cf. e.g. Fujita et al., 2001). This is also a phenomenon of European Integration (Baldwin and Wyplosz, 2009). Firms face increasing choices for locating their activities in places that provides the best business environment for their specific needs. The more markets are globalized, the more likely it is that resources will flow to more attractive regions or cities (cf. Porter, 1998). We offer a simple model to discuss the claim (for a more general discussion, see Broll et al., 2010). Suppose a risk-averse investor has some financial funds to invest in two regions in the same industry. How will the optimal allocation of funds between regions be affected by an increase in economic integration when there is a policy induced cost advantage in one region? In other words, given a comparative advantage of one location, does the degree of integration affect the distribution of investment between regions? To answer such questions we use a decision model of an investor under uncertain costs of production and doing business. We show that the integration of regional economies will tend to make the regional distribution of investment
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more concentrated, i.e. industrial concentration is endogenously induced by integration. Such an effect, i.e. path creation, exists even if there is only a small gap between the comparative costs of both regions. Suppose an industrial policy creates some expected cost advantages for one region. We show that if investors care about risk and if regions become more integrated, then the disparity of the regional distribution of investment, i.e. the concentration, tends to be magnified. Any interesting model of cluster must exhibit a tension between two kinds of forces: forces that tend to pull economic activity into a cluster or agglomeration, and forces that tend to break up such agglomerations or limit their size. In our case this is the degree of risk aversion and economic risk. An investor has one unit of capital as initial wealth which would earn Ri (i = 1, 2) as gross
% % return from investment in either region in a two-region framework. Let c1 , and c2 be random cost of production or transaction costs of doing business in region 1 and 2, respectively. Costs of production are risky since costs are based on different regulations, business environment, industrial policy, fiscal and tax policies. Uncertainty about the costs of production in different locations will lead to random differences in the net rates of returns of both regions.

For simplicity we assume a binormal distribution of the random variables, where

2

% E ( c1 ) = c > 0

and s i are denoting the expected production costs and, respectively, the variance of the transaction costs for region i = 1, 2 . The correlation coefficient r denotes the random costs between regions. In the model the correlation coefficient r is seen as a variable concerning adaption and innovation of the business environment between the regions. In our interpretation intensified integration or globalization is fostering this process, i.e. which means an increase in r .

We assume that there is an expected cost advantage of region 1, i.e. c1 < c2 . Although such an assumption seems to be ad hoc at this stage, its importance will become evident in the regional investment decision problem. The investor's degree of risk aversion is denoted by a > 0 . The investor maximizes the objective function

( /2) Var

and the decision variable s is the share of capital endowment that goes to region 1; the share

(1 - s ) goes to region 2.
R1 = R2 = R

E denotes expectation and Var the variance. We focus on the

correlation between both regions. Therefore we assume symmetry between the regions.58 Gross return from investment and the variance in costs in doing business are equal, that is,
2 2 2 and s 1 = s 2 = s . The objective function of the risk averse investor turns out to

be
U ( s ) = 1 - c2 + s ( c2 - c1 ) R - a 2 (1 - 2 s )(1 - s )(1 - r ) R 2s 2 ,

where
58

% % r = cov ( c1 , c2 ) s 2

, where cov denotes the covariance operator, and -1 r < 1 .

For a discussion in asymmetrically sized regions and for different framework, see Pontes (2005).
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Maximizing the objective function with respect to the share of investment to region 1, * optimum capital allocation s satisfies:
s* = c2 - c1 1 + 2 2a Rs 2 (1 - r )

. Given the impact of differences in expected costs of production and doing business, the distribution of investments depends also upon the degree of risk aversion of the investor, the variance of costs of production or location, gross return from investment and the level of correlation between region 1 and 2. In what follows we focus on the interaction between the degree of correlation and the regional distribution of investment. Our discussion can be summarized as follows. Proposition 1. Assume a risk averse investor and a two-region economy with symmetry except for expected production and transaction costs of doing business. The region 1 will arrive at geographical concentration even integration is non-perfect. Therefore, investment flows may become more concentrated. With c1 < c2 , we get s r > 0 . Full specialization in * favour of region 1, i.e. s = 1 , is obtained, when cost correlation between regions reaches the
*

critical level rc .

Given the region-specific difference in expected transaction costs due to industrial policy, agglomeration occurs in the region exhibiting the comparative cost advantage when market integration reaches a critical level. The economic reason is that a higher degree of correlation reduces the opportunity for diversification and, therefore, gives the regional cost advantage a greater weight. Figure 2: Regional concentration
s

12

rc

Source: own visualisation 4. Growth consequences of industrial concentration in the semiconductor industry The pattern of industrial concentration in the semiconductor industry had remarkable growth consequences for Dresden. Regrettably, data limitations prevent the presentation of the growth process from 1990 onwards. Data for the regional entity the free state of Saxony are available from 1991 onwards. Data for the city of Dresden begin three years later in 1994.
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Full data coverage for manufacturing in Dresden just start in 1996. At present it finishes in 2009. Because of the rarely used definition of metropolitan areas in Germany we can show data only on the regional level (Saxony) and for the city.59 We start in figure 3 with overall growth of gross domestic production in Saxony and in Dresden. Growth in Saxony was very strong in the early convergence process after unification which was spurred by a construction boom. The same was true for Saxony. This boom expired in the middle of the 1990s and for the next 10 years economic growth in Saxony was rather low. However, from 1999 to 2004 the situation in Dresden was different. The semiconductor industry expanded. Since 1999 this spurred overall growth of the city. The episode finished in 2005 and the city underperforms Saxony since then. Figure 3: Growth of Gross Domestic Production in Dresden and in Saxony

Source: Own calculations with Data from Arbeitskreis VGR, 2011) The difference of the manufacturing growth in Dresden and in Saxony is shown in figure 4. After 1995 the growth of the secondary sector declines in both areas with the contraction of the construction sector. Construction was so important in Saxony that only the construction industry (without construction materials mining and construction materials manufacturing) was bigger than manufacturing before 1998. Hence, the permanent shrinkage of the construction industry pressed growth in the secondary sector of Saxony close or under zero percent up to 2006. Also manufacturing suffered because it was strongly biased to construction materials production.
59

An often used concept for German regions with core-periphery-characterisation is the so called Raumordnungsregion (ROR). The Dresden ROR has around one million inhabitants. It covers the city, major parts of its metropolitan area and the peripherical regions around (see BBSR, 2011). In this context the ROR seems not very helpful because most of the industrial concentration is found in the city of Dresden. Excluded from the Dresden ROR are parts of the metropolitan area in the northeast and the smaller city of Freiberg in the southwest which have also important links to the Dresden semiconductor industry (cf. figure 1).

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Growth of Gross Domestic Production in the secondary sector and in its component group manufacturing60
Figure 4:

Source: Own calculations with Data from Arbeitskreis VGR, 2011 With its booming semiconductor production things evolved very different in Dresden. The foundation and expansion of the Siemens plant (from 1994) resulted in much higher manufacturing growth. In 1999, a new chip plant of AMD expanded the industrial concentration. The growth consequence was six years of around 20 per cent growth in manufacturing. In difference to Saxony Dresden could avoid secondary sector shrinking over the entire period. In contrast, the city saw an impressive growth of its industrial base from 2001 onwards. This growth story reversed with falling chip prices and outdated products in 2005. Saxon manufacturing grows years strong between 2006 and 2008. Traditional industries like car manufacturing or engineering expanded; not so the semiconductor industry in Dresden. The dominating mass producers Siemens/Infineon/Qimonda and AMD were confronted with a downturn in the chip business cycle and steadily falling output prices. After two years of zero growth in 2006 and 2007, Dresden manufacturing plunged one year before Saxony into the world recession 2008/09. How important the manufacturing contribution for Dresdens growth performance is shows figure 5. Main driver of high economic growth before 2005 was this expanding sector; main cause of low economic growth was its contraction especially in 2005 and 2008/09.
60

Data for manufacturing is only available for 1996 and 1998. Growth in 1997 and 1998 is interpolated from these two points.

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Figure 5: Contribution of economic sectors and branches to the growth of gross domestic production in per cent

A,B .primary sector, C,E mining and electricity, D manufacturing, F construction, G-I distribution and transportation, J, K private services, L-P public services Source: Kluge, 2011 Due to data limitations the description of Dresdens growth finished in the worst year 2009, which started with the bankrupt of Dresdens largest chip plant Quimonda in January. The size of the industrial district has diminished since 2004, because of big player problems. However, its current attractiveness seems not very damaged. Volatility of semiconductor prices resulted in lower production values for the large mass production, but didnt impact the industrial labour division that much. In 2011 and 2010 large new investments in this industry have been realized or announced.61 For the future, the volatility of the important semiconductor industry is going to cause a more volatile economic growth than elsewhere in Saxony. This may not depress mean growth prospects, because the industrial district seems intact and has already survived a major crisis. 5. Conclusions and policy implications In Dresden, the industrial concentration of semiconductor industry did not start from zero at the begin of the 1990ies. But given the difficult economic conditions and its peripherical situation the expansion of this branch in the city is rather exceptional. The essay shows that this success does not come only from generous subsidizing. The consistency and regeneration of this industry rather confirms that concentration advantage is successfully exploited in Dresden. A small model may describe how regional policy spurs industrial concentration because it helps to reduce transaction costs. The essay also describes the specific growth consequences this industrial concentration for Dresden. High economic growth in the initial phase of the establishment could not last forever. In addition, the city had attracted a very volatile industry. For this reason, the
61

GlobalFoundries expanded and renewed in capacities 2010. Infineon announced an expansion in closed down Qimonda facilities together with major investments in 2011.

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dynamics of city growth and its future perspectives have been overrated because of the fast growth period up to 2004. But, also the slump and the unfavourable growth of the city from 2005 onwards are probably not the begin of general decline. Probably they are more a sign of restructuring and again of volatility in the citys most important manufacturing sector. This may explain why Dresdens population is growing and Saxonys population is shrinking although the city relatively underperforms economically since 2005. References Arbeitskreis VGR (2011), Bruttoinlandsprodukt, Bruttowertschpfung in den kreisfreien Stdten und Landkreisen Deutschlands 1992, 1994 bis 2009. Internet: http://www.vgrdl.de. Baldwin R. and C. Wyplosz (2009), The Economics of European Integration, 3rd Ed., Maidenhead: McGraw-Hill. BBSR (2011), Anpassung der Raumordnungsregionen an die Kreisgebietsreformen in Sachsen-Anhalt 2007 und Sachsen 2008. Internet: http://www.bbsr.bund.de. Belitz, H. and D. Edler (1998), Gesamtwirtschaftliche und regionale Effekte von Bau und Betrieb eines Halbleiterwerkes in Dresden. Berlin: Duncker&Humblot. Broll, U., A. Rldan-Ponce and J.E. Wahl (2010), Spatial allocation of capital: The role of risk preferences. Spatial Economic Analysis, Vol. 5, pp.389-398. Bramke, W. (1998), Sachsens (Industrie)Gesellschaft in den Jahren der Weimarer Republik. in: Bramke, W. and U. He, ed., Wirtschaft und Gesellschaft in Sachsen im 20. Jahrhundert. Leipzig: Leipziger Universittsverlag, pp. 27-51. Capital (2007): Capital-Ranking: 60 deutsche Stdte im Test. Feri Institut Studie. Fujita, M., P. Krugman and A. Venables (2001), The Spatial Economy, Cities, Regions, and International Trade. Cambridge, MA: MIT Press. Grundig, B., C. Lemann, A.S. Mller, C. Pohl, J. Ragnitz, M. Reinhard, B. Schirwitz, H. Schmalholz and M. Thum (2008), Rechtfertigung von Ansiedlungssubventionen am Beispiel der Halbleiterindustrie, ifo Dresden Studien, Vol. 45, Dresden. INSM (2007), Stdteranking 2007. IW Consult Studie. INSM (2010), Stdteranking 2010. IW Consult Studie. Kluge, J. (2011): Wachstum und Beschftigung am Wirtschaftsstandort Dresden: Warum wchst Dresden langsamer als der Rest Sachsens? ifo Dresden berichtet, Vol. 5/2011, pp.11-19. Pontes, Jos Pedro, and John B. Parr (2005), A note on agglomeration and the location of multinational firms. Papers in Regional Science, Vol. 84, pp.509-518. Porter, M.E. (1998), On Competition. Boston, MA: Harvard Business School. Silicon Saxony (2006), 50 Jahre Mikroelektronik in Dresden. Dresden: Silicon Saxony. Sinn, G. und H. Sinn (1993), Kaltstart: Volkswirtschaftliche Aspekte der deutschen Vereinigung. Mnchen: DTV. Wolgast, R. (1997), Der Wirtschaftsstandort Dresden: Aspekte der Wirtschaftsentwicklung in der schsischen Landeshauptstadt, ifo Dresden berichtet, Vol. 2/1997, pp.16-20.

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7. Understanding and Evaluating the Architecture of the Euro Area

Eithne Murphy SEMRU (Socio-Economic Marine Research Unit), J.E. Cairnes School of Business and Economics, National University of Ireland Galway Abstract: This chapter is dealing with the evaluation of the adoption and implementation of the single European currency. The architecture of the whole process is discussed and main achievements and pitfalls are highlighted. 1. Introduction The Euro was established by the provisions of the 1992 Maastricht Treaty. It was introduced in non-physical form in 1999 (when all members irrevocably fixed their exchange rates) and notes and coins entered circulation in 2002. All member states of the European Union (EU), with a few notable exceptions, are under legal obligation to adopt the Euro, when they satisfy conditions for membership. Initially only the United Kingdom (UK) was given an opt out but this was later extended to Denmark after the Maastricht Treaty was rejected in a referendum by Danish citizens. Another non user of the single currency is Sweden, although there is some ambiguity as to the legal status of its exclusion. Effectively however, it has a de facto opt out. To date, the single currency (Euro) has been adopted by 17 of the 27 countries of the European Union (EU). Until the recent crisis in the Euro area, the expectation was that all more recently acceded members of the EU must eventually adopt the single currency. 2. Understanding the Criteria for Membership The criteria that aspirant member states had to satisfy in order to join the Euro all related to monetary and fiscal matters. Inflation was not to exceed the average rates of the three lowest inflation countries by more than 1.5 percentage points, while nominal interest rates could not be more than 2 percentage points higher than the average rates pertaining in the low inflation standard bearers. Fiscally government budget deficits and overall government debt were not to exceed 3 and 60 percent respectively of the countrys Gross Domestic Product (GDP). The practice of conservative monetary and fiscal policy by aspirant States was considered to be the necessary and sufficient condition to ensure their fitness to join. On joining the single currency, member states forfeited the right to pursue their own monetary policy and fiscally agreed to be bound by the terms of the Stability and Growth Pact, which mimic the fiscal rigours of the Maastricht criteria. In addition there was to be a punitive system of fines for recalcitrant countries that failed to redress fiscal transgressions with suitable speed. Politically, this proved to be impossible to enforce when the transgressors were the largest most powerful countries in the Euro area, notably Germany and France, whom the European Commission unsuccessfully attempted to fine in 2003 for breaching the terms of the Stability and Growth Pact. A notable feature of the European single currency was not just its emphasis on monetary and fiscal probity but how uninfluenced it was by the theory of optimal currency areas (OCAs)
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which forwarded criteria to indicate the suitability or otherwise of countries adopting a common currency. This theory was first advanced by Mundell (1961) and further developed by McKinnon (1963) and Kenen (1969). The essence of OCA theory is that countries should only share a common currency if their production and trade structures are sufficiently similar that they are unlikely to be subject to asymmetric shocks. The advantage of countries having similar business cycles is that it obviates tensions that could otherwise arise in the conduct of monetary policy in the event of countries experiencing contrasting economic fortunes. Alternatively, if such symmetry is not ensured, then a common currency will only work if there are mechanisms to deal with the economic and social consequences of an asymmetric shock. Such mechanisms are considered to be a high level of inter-country labour mobility (whereby those who lose jobs due to adverse economic developments can move to more prosperous areas in the monetary union to work) and/or high levels of inter-country capital mobility (with capital moving in the other direction into the less prosperous areas for the purposes of increased investment and employment). There is also a view that emphasises responding to negative shocks through wage and price flexibility. According to the latter perspective, the adverse output and employment effects of a negative demand shock in a currency union can be best mitigated by reductions in wages and prices. Effectively, this implies that despite being part of a monetary union, countries can still adjust their real exchange rates in order to restore competitiveness. Traditionally, currency unions have tended to be fiscal and/or political unions with centralised budgets. A centralised tax and transfer mechanism automatically transmits resources from richer to poorer regions and is part of the social compact that we have come to associate with citizenship. Citizenship aside, a centralised budget and an automatic transfer mechanism reduces the social cost of economically heterogeneous regions using the same currency. While OCA theory tends to focus on the potential macroeconomic costs of monetary union, the expected gains are microeconomic in nature. Removing exchange rate uncertainty should facilitate both international trade and international capital flows. Standard economic theory holds that both are conducive to increased economic prosperity. Furthermore, it was believed that the price transparency that would ensue from using a single currency would facilitate competitiveness to the advantage of the better informed consumer. None of these considerations appeared to inform who should or should not adopt the single currency. For a country such as Ireland for example, much of its trade was and still is conducted with non-euro countries, notably the UK and the US. The Irish economic cycle was also notably different to that of core euro countries, such as Germany and the Benelux countries. The same is true of Greece and Spain for whom supply shocks have a low correlation with those of the euro area in general (Korhonen and Fidrmuc (2001). Labour mobility among countries of the euro area is relatively low (at least in comparison to the US) and the nature of the welfare states in Europe has traditionally meant limited wage flexibility. Finally, the EU budget is small (around 1 percent of EU GDP) and has not been created in such a way so as to operate as an automatic stabilising force, since most of its expenditure is pre-programmed and goes on the Common Agricultural Policy (CAP) and the Structural Funds. There was broad agreement among economists, who tried to measure empirically if the EU of 15 (membership in 1995) was an OCA, that such was not the case. (See Bayoumi and Eichengreen, 1993, 1997, De Grauwe and Heens, 1993 and Beine et al, 2003). Now, it needs to be borne in mind that OCA considerations are only relevant to the issue of the optimal composition of a currency union if ones conception of the macro economy is Keynesian in nature. That is to say, that one subscribes to the view that markets have no innate tendency to settle at efficient full employment equilibrium, either because of rigidities in the market mechanism and/or because economic agents are prone to animal spirits which can lead to collectively irrational bouts of optimism or pessimism. In this instance, a country
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that joins a currency union is giving up an instrument of macro policy and, as such, its policymakers need to be acutely aware of the likelihood or otherwise of asymmetric shocks and the adequacy of the collective mechanisms to deal with them. An alternative perspective on the world is that of Monetarism, or in its more extreme form, New Classical/Real Business conceptions of how macro economies operate or could be made to operate. In this scheme of things, all agents are rational and markets, if not institutionally interfered with, will tend to efficient equilibrium. Consequently, the loss of a macro policy instrument such as monetary policy is of little consequence, since macro policy has no bearing on real economic variables such as employment and output. Furthermore, the composition of a currency union does not matter, since with sufficient price flexibility, any economy could adjust to any fixed exchange rate link with any currency. Of course, in order to reap the expected trade and investments benefits that come from removing exchange rate uncertainty, it would make most sense to join a currency union with countries with whom one has (or expects to have) a lot of trade and investment links. One argument that is made in favour of eventual adoption of the euro by 24 of the current 27 EU member states is that OCAs are endogenous. That is to say, that when countries adopt a single currency, their economic cycles start to synchronise and they subsequently develop the mechanisms to deal with asymmetric shocks. It has been argued that the political forces behind the euro, namely Chancellor Helmut Kohl of Germany and President Francois Mitterand of France, eventually envisaged a Political Union, with all the centralised fiscal responsibilities that such a union entails. To date, a Political Union with a large centralised budget still looks a very remote possibility and we would argue that the design of the single currency, in particular the rules governing monetary and fiscal policy, would appear to indicate that the economic architects of the single currency were governed by a Monetarist ideology, which down plays the macroeconomic costs of heterogeneous countries using the same currency and believes that markets, if not institutionally interfered with, tend to deliver efficient outcomes. 3. Design of Monetary and Fiscal Policy within the Euro area. By virtue of adopting a single currency, all member countries gave up the right to pursue an autonomous monetary policy. A single monetary policy was conducted on behalf of all member countries by the European Central Bank (ECB). The ECB was deliberately modelled on the German Bundesbank insofar as it is independent of Community institutions and member state governments (Article 107, Maastricht Treaty) and its primary objective is the maintenance of price stability (Article 105, Maastricht Treaty). Unlike monetary policy, fiscal policy is not centralised in the Euro area; that is to say, the Euro area is not a fiscal union. While fiscal policy is the preserve of national governments, on joining the single currency, all countries agreed to be bound by the conditions of the Stability and Growth pact, which is designed to enforce fiscal rectitude on Member states by obliging them to keep government deficits below 3% of GDP. The ECB is the most independent central bank in the world and its charter is the narrowest. (Even the US Federal Reserve has a more liberal charter). While its primary mandate under the Maastricht Treaty was to maintain price stability, it was also mandated to concern itself with economic and financial stability, provided that fulfilling the latter objectives did not in any way interfere with price stability. According to De Grauwe (2008a), the ECB essentially dropped the requirement that it should pursue other objectives in addition to price stability, effectively relegating responsibility for real levels of economic activity and employment to national governments. It set target inflation at 2 percent per annum and was relatively successful at achieving this target, since average inflation in the period 1999 to 2008 was 2.2
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percent. The institutional independence of the ECB and its narrow remit are supported by a Monetarist/New Classical view of how best to conduct monetary policy. According to Monetarists, there is no long run trade off between inflation and output (or employment). The Phillips curve is vertical. According to New Classical theory, there is not even a short run trade off between inflation and output, since rational economic agents do not suffer from money illusion and correctly anticipate the inflationary consequences of a loose monetary policy. The only way inflation can generate higher levels of economic activity is if it is unanticipated, and even then, the effect will only be temporary. Moreover, a profligate Central Bank that tries to spring such inflationary surprises on the public is doomed to failure, since its monetary permissiveness will be anticipated if it has a bad past record and thus nullified. According to this perspective, employment and output are determined by supply side factors such as technology and preferences for work and leisure. However, while monetary policy is an ineffective macro policy instrument as far as stimulating short or long run levels of economic activity is concerned, excessively lax monetary policy can do harm through its inflationary impact, which weakens the effectiveness of the price mechanism as an efficient allocator of resources. Therefore, the best a Central Bank can do is to operate in sober fashion with low targets for price inflation and not adopt responsibility for that over which it can exercise no benign influence. The euro area is also not a fiscal union in any recognisable sense. The overall budget of the EU is small relative to the level of economic activity (approximately 1 percent of EU GDP) and it is not designed to operate either as a cyclical stabiliser (during booms and recessions) or as a redistributive mechanism (socially and spatially). Effectively, fiscal policy remains the preserve of national governments. However, even as far as national fiscal policy was concerned, the Stability and Growth Pact, which established the broad parameters for the conduct of national fiscal policy, restricted the policy autonomy of national governments. Effectively, national governments had to commit to balanced budgets over the economic cycle and the maximum permissible deficit was 3 percent of GDP. To all intents and purposes, what this does is rule out the possibility that national governments can use fiscal policy in an activist way in the event of an economic downturn. The thinking behind such a conservative approach to fiscal policy has to be the view that fiscal policy (like monetary policy) is not effective in determining the real level of activity in an economy. The ideological basis for this view derives from the theory of Ricardian equivalence, which argues that higher levels of debt fuelled government expenditure will be cancelled out by lower levels of private spending. Key to this conclusion is the role of the rational agent who correctly anticipates the higher future taxes that will be necessary to pay for current fiscal profligacy and who responds by spending less and saving more. However, while expansionary national fiscal policy is deemed ineffective in terms of its ability to stimulate domestic economic activity, it can create negative economic consequences for other more fiscally sober nations. If the country running the budget deficit is large enough, its expansionary fiscal policy could push up interest rates within the currency union, thus dampening private demand elsewhere. Alternatively, its fiscal policy stance may force the central bank to monetise its debt in order to avoid the negative spillover impact on other countries that we have just described. Such monetisation would then lead to the other social bad of inflation. In order to avoid any of the above scenarios, the S&G pact not only allowed for a system of fines to be imposed on those countries breaking the rules, there was also a no Bailout clause included in the Maastricht Treaty. This meant that neither the ECB nor other member states would be permitted to bail out a bankrupt sovereign. The point of this clause was to act as a pre-emptive brake on national governments that might otherwise be tempted to operate its national fiscal affairs in an excessively spendthrift way.

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4. Other Relevant Areas of Policy The free movement of capital is one of the key principles of the single market and is underpinned by a belief system that assumes that capital will always go to where it is most profitable and presumably most productive. Unsurprisingly, by removing the costs and uncertainty associated with currency exchange, the creation of the euro accelerated the integration of financial markets in the euro area. However, bank supervision and responsibility for financial stability still rested with national regulators. Home country control guides the supervision of banks, that is to say, the authorities of the country where the bank has its head office is responsible for all its operations, domestic and international, while host country control applies as far as the financial stability of the banking system within a jurisdiction is concerned. As De Grauwe (2009, pp.185-86) points out, a flaw in this design structure is that the information that the national regulatory authority may need to ensure the soundness of the banks operating within its territory may not be forthcoming from the regulatory authority where the banks head office is located. Banks profited from this lack of regulatory oversight by massively expanding their balance sheets and taking on excessive risks. But of course the logic that supported such a decentralised light touch approach to regulation was that banks could be trusted to self-regulate and to not engage in excessively risky behaviour. Such a view is predicated upon a belief in the self-interested omniscient rationality of market participants and a failure to recognise the moral hazard that arises because of agents awareness that regulatory authorities will rarely allow financial institutions to fail, especially if they are large enough and pan-European enough. One area of policy that has remained effectively decentralised is social and wage policy. On the face of it, the decentralisation of social and wage policies in an environment where monetary policy is centralised appears anomalous, since divergent social policies among member states can also be a source of asymmetric shocks. Possibly, the architects of the euro envisaged a liberalisation of labour markets, which would be consistent with the view that unemployment tends primarily to be structural in nature and best rectified by the removal of perceived structural impediments, such as inappropriately high wages and/or excessive levels of social assistance for the unemployed. If this analysis was correct, then decentralisation of social policy, if it meant creating competitive pressures among countries to increase liberalisation of national labour markets, would serve as a buffer against the output and employment effects of asymmetric shocks. (One limitation of this perspective is that it fails to recognise any cyclical element to unemployment. Indeed, the conservative design of monetary and fiscal policy would point to this lack of recognition, as it effectively precludes euro wide or country specific macro stimulus). However, the more serious inadequacy of this institutional design is that it failed completely to envisage how the integration of financial markets and free capital mobility could actually facilitate perverse movements in the real exchange rate among countries using the single currency. Countries where nominal wages increased more than the average experienced a real exchange rate appreciation and vice versa for those countries where nominal wage growth was less than the average. To the extent that these real exchange rate developments did not reflect underlying changes in national productivity, the net effect was the loss (gain) of competitiveness by those countries which experienced the greatest real exchange rate appreciation (depreciation). Capital flows from the more competitive to the less competitive countries made possible the persistence of such imbalances. The end result of such national policy induced asymmetric shocks, aided and abetted by capital flows (unrestrained by exchange rate risk), is excessive private sector debt accumulation in some countries. However, it needs to be re-emphasised that failure to anticipate the potentially unsustainable private debt consequences of capital flows serves to

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highlight the myopic view of regulators and their underlying belief in the rationality of financial market participants. 5. Evaluating the Macro-architecture of the Euro Area According to a rule devised by John Taylor (1993), the optimal interest that a Central Bank should adopt is determined by the deviation of inflation from target inflation and output from capacity output. So if inflation is above target and output above capacity, the central bank should raise interest rates and vice versa when inflation and output are less than target. Applying the Taylor rule, De Grauwe (2009, p. 180) showed the wide divergence in optimal interest rates across countries of the euro area, reflecting the diverse performance of the economies that used the single currency. For booming economies such as Ireland in 2007, optimal interest rates were above 8 percent, whereas for France, Italy and the Benelux group of countries they were below 4 percent and for Germany, they were between 4 and 5 percent. Such divergences in optimal interest rates merely reflected the diverse economic performance of euro zone economies. However the nature of a monetary union is such that the one nominal interest rate applies across all member countries. Unsurprisingly nominal interest rates tended to be low since the inception of the euro, reflecting economic conditions in the larger euro member countries. Given the diverse inflation experience of countries across the euro area, this meant that real interest rates were exceptionally low in the higher inflation, fast growing peripheral economies of Ireland, Spain, Greece and Portugal. In the case of Ireland and Spain, the period from the inception of the euro up the financial crisis in 2008 was also one of massive inflation in the value of real estate. One of the causal factors was the cheap price of credit, albeit allied with historically easy access to such credit. The real estate bubbles in Ireland and Spain mirrored that in the United States, the unravelling of which led to the global financial crisis in Autumn 2007. The historical experience of asset bubbles raises the question as to the appropriate remit for Central Banks. For ex chairman of the Federal Reserve of the Unites States, Alan Greenspan, central banks should not target asset bubbles because they are too difficult to recognise in advance and, in any case, the macroeconomic consequences of such bubbles and subsequent crashes are limited if inflation is on target. Economists like De Grauwe (2008b) take a contrary view. First he disputes that asset bubbles cannot be identified and second, he claims that failure to address the emergence of such asset bubbles increases the fragility of the financial system with adverse spillover consequences for the real economy. He cites Kindleberger (2005) and Borio and Lowe (2002) for whom excessive growth in credit and large increases in asset prices are give away signals of an unsustainable asset bubble which threaten the stability of the financial system. De Grauwe (2009) also alludes to the fact that the ECBs target of 2 percent annual inflation was to be achieved by limiting the growth of M3 (broad money supply) to 4.5 percent per annum. In fact the mean annual growth in M3 from 1999 to 2008 turned out to be 7.4 percent but mean inflation remained at a modest 2.2 percent (see Figure 1). The above target expansion of M3 reflected an increase in the money multiplier as banks expanded their balance sheets with much investment in assets that experienced a credit induced increase in their values. The explosive expansion in bank assets was facilitated by new forms of funding for banks, such as increased leverage (debt to equity) and greater recourse to short term funding on the inter-bank wholesale market. While the latter was not a phenomenon unique to the euro zone, the removal of exchange rate risk and the integration of financial markets made it a problem that was particularly acute within the euro zone. (Figure 2 shows the explosive growth in the balance sheets of some of Europes top banks).

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Figure 1: Inflation and money growth in Euro zone

Source: European Central Bank, Monthly Bulletin In the meantime, the ECB could not be accused of failing to fulfil its brief, since that was restricted to consumer price inflation. According to ex head of the ECB, Jean Claude Trichet, the ECB executed its mandate impeccably. This obviously points to a flaw in the design structure of monetary policy in the euro area. According to De Grauwe (2010), one instrument of policy that the ECB did have, that it could have deployed to prevent the emergence of asset bubbles was minimum reserve requirements to control the growth of bank credit. He goes further and argues that it should have applied differential minimum reserve requirements in the different national banking systems, applying higher levels in countries where growth of credit was fastest and asset bubbles most obvious. Figure 2: European Financials Balance Sheets

Source: Bloomberg (2012) The counter-argument is that national financial stability was the responsibility of national regulators (this being an area of policy where policy was decentralised) and that any blame for failure to control the excessive growth of credit should be laid that the door of the national
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financial regulatory system. However with the benefit of hindsight, given the international spillover effects of private debt accumulation in a currency union with free mobility of capital, it was the responsibility of the Euro system to act. The flawed design architecture of the euro is obvious from the overly narrow remit of the ECB, with its exclusive focus on consumer price inflation, and the lack of a common financial regulatory regime for all countries using the single currency. The other major fixation of the architects of the single currency was the avoidance of fiscal imbalances. As can be seen from Table 1, for the Euro area (17 countries) as a whole, relatively small deficits were the norm, until the financial and economic crisis took its fiscal toll after 2008. The fiscal performance of member countries was more varied, with the Scandanavian countries, Ireland and Estonia showing government surpluses for most years until 2008. Even Spain experienced small deficits that translated into surpluses by 2005. Breaches of the 3 percent deficit ceiling were General Government Consolidated Debt perpetrated by the large core countries of the euro area, namely, Germany, France and Italy as well as some the currently struggling peripheral economies like Portugal and Greece (belatedly recognised in the latter case when more accurate statistics were used). Figure 3: Government debt to GDP across Euro Member States

Source: European Commission and AMECO From Table 2, we can see that the countries in substantial violation of the 60 percent to GDP general government debt threshold were Belgium and Italy when they acceded to the single currency in 1999 and Greece when it joined in 2001. All experienced a reduction in their government debt to GDP ratios after euro entry, although the dynamics of such reductions varied. In Belgium, the reduction was continuous year on year, until 2007, while for Italy and Greece, it appeared to stabilise in the mid part of the decade. In the Scandinavian countries, the debt dynamics were positive as was the case for Spain and Ireland. For many of the other countries, debt to GDP was relatively static, although in the case of Portugal, the debt dynamic was strictly upwards. Figure 3 shows how government debt to GDP varied across euro member states and how it changed over time. What stands from this visual representation is how the fiscal situation was relatively stable if not benign until 2007, after which no country escaped the adverse fiscal consequences created by the near collapse of the financial system, a collapse in no small part caused by its excessive exuberance and expansion in the decade leading up to 2007. Figure 4: Private and government liabilities in Euro zone (% GDP)
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Source: European Commission, AMECO and CEPS What the design architects of the euro did not anticipate, or if they did, what they did not foresee, were the adverse consequences of the excessive accumulation of private debt. As can be seen from figure 4, the combined extent of government debt is swamped by the debt obligations of the corporate and banking sector and matched by the household sector. At one level, taken on its own narrow terms, the Stability and Growth Pact was quite successful in enforcing sobriety on the public sector as far as its debt situation was concerned. But the failure to control private sector debt was matched by a failure to anticipate the emergence of private sector imbalances among countries using the euro and how that would impact on the sustainability of the single currency. A countys level of indebtedness in the aggregate is determined by the combined extent of foreign borrowing by the private and public sector. A country could have a low level of foreign indebtedness and a relatively high level of public sector debt, provided that its public sector debt is owed to domestic citizens. (Japan is a case in point). Arguably, this makes a country less vulnerable to the vagaries of international capital markets, which can cut off credit with as much alacrity as they once extended it. A manifestation of increasing indebtedness to foreign creditors is the running of consistent deficits on a countrys current account of the balance of payments (BOP). In any given year, such a deficit means that domestic spending exceeds domestic earnings and the only way that spending can be financed is through accessing foreign credit. Table 3 shows the varying position across countries of the EU and euro area using 3 year backward averages of the current account balance of the BOP as a percentage of GDP. I would assert that the seeds of the current position that the different countries of Europe find themselves in presently are explained more eloquently by BOP data than by any other indicator of national economic performance. Europe is characterised by its net savers and net borrowers. Europes consistent savers were the Scandinavian countries, the Benelux countries, Austria and Germany. Europes consistent borrowers were all the recent entrants to the EU, when it expanded eastwards in and after 2004, and the traditionally peripheral (both geographically and economically) countries of the euro, namely Greece, Portugal, Spain and Ireland. France and Italy occupy an intermediate position, with the former running BOP surpluses (albeit declining over time) until 2006, while Italy went from being a net external lender to borrower in 2002. Also notable is that the size of the deficits in these two countries in latter years is significantly smaller than for other more consistent borrowers. Of course this is not to imply that a deficit in the current account of the BOP is necessarily a bad thing. It is to be expected that countries at lower levels of economic development may run such deficits as part of the
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structural adjustment associated with economic catch up. This would be viewed as a win-win scenario (for borrowers and lenders) provided that such international borrowing was used for productive investment and resulted in sufficiently higher levels of economic activity that more than repaid the cost of the investment. However, for countries such as Ireland and Spain, such economic catch up had already occurred by the time of the euros inception and the extent and consistency of excessive national expenditure year on year should have set off warning bells about the sustainability of such borrowing. According the Frankel and Saravelos (2010), based on a literature review of 83 papers, the current account is the most frequently consistent indicator of crisis incidence. The question that requires answering is not simply the inadequacy of the rules governing the single currency area in spotting such imbalances, but whether the emergence of such external imbalances was precisely a consequence of adopting a single currency? First, interest rates were historically low making borrowing cheap, second there was no exchange rate risk to such foreign borrowing which presumably had an incentive effect, and third, foreign credit had never been so accessible due to the integration of European financial markets (itself a concomitant feature of adopting a single currency). To the extent that trade is intra-European, a deficit on the current account of the BOP for one country means a surplus for another. The profligacy of some had to be financed by the parsimony of others. Which raises the question as to what factors may have helped determine the savings and borrowing behaviour of Europes different nations? While this is a complex issue that can have many socio-economic and cultural determinants (such as demographics for example), one obvious proximate cause is a countrys competitiveness. In other words, the ease with which a country can compete and sell its goods internationally will have a major impact on whether it runs a surplus or deficit on its BOP. This is partly determined by the product composition of a countrys trade and the innovation associated with its tradeable sector but it is also determined by divergent cost dynamics across countries. Countries that experience relatively higher growth in costs can expect to lose competitiveness, which will manifest itself in BOP deficits. One indicator of loss (gain) of competitiveness is an appreciation (depreciation) of a countrys real exchange rate (RER). Notwithstanding the fixity of bilateral nominal exchange rates among countries now using the same currency, their RERs can differ quite substantially due to variations in domestic prices across these countries. There are different ways to measure RERs depending on the deflator used. Figure 5 shows changes in RERs across selected euro area countries, where the deflator is unit labour costs, while Table 4 shows the three year percentage change in real effective exchange rates among all EU countries using consumer prices as the deflator and relative to 35 other industrial countries. (The latter is a broader measure that takes into account non EU trade as well). Regardless of which deflator is used or how broadly or narrowly the real exchange rate is defined (from a trade weighted point of view), what clearly emerges is the deterioration in cost competitiveness of those countries that experienced BOP deficits compared to those that experienced BOP surpluses. Arguably, divergences in the real exchange rate of the euro countries would have been less extreme if nominal exchange rate flexibility had still existed (in other words if they had never joined the single currency), not least because the nominal exchange rate would have been expected to move in a contrary direction to domestic costs. Alternatively, more international co-ordination of wage formation across the euro area would have mitigated divergences in real effective exchange rates among euro member states. Instead, wage and social policy remained areas of national competence and real divergences grew over time, aided an abetted by private borrowing to sustain expenditure in the increasingly uncompetitive periphery. The real exchange rate is considered to be a good predictor of the incidence of economic crises (see Reinhardt et al, 1998) but it was not among the early warning indicators that might have served to indicate the emerging solvency crisis for some countries in the euro area.
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Figure 5: Relative unit labour costs* Index 1999 = 100

Source: OECD. * Unit labour costs compared to Euro Area, total economy, double export weights. 6. Where to from here? To be fair, EU member states have recognised the failure of economic governance in the euro area and have started to reform the process of economic surveillance. To this end, new rules have been enacted to strengthen the fiscal and economic surveillance of member states in an integrated way. This is commonly known as the Six Pack and legally consists of five new regulations and one directive that were enacted on 13 December 2011 (Official Journal of the European Union). Four of the regulations deal with fiscal issues while two address how to identify and respond to macroeconomic imbalances across the euro and broader EU area. In order to better co-ordinate policies of member states, a new monitoring cycle has been introduced, the European semester, a six month period every year when Member States policies (budgetary and structural) will be reviewed. The new legislation is designed to enhance surveillance but also improve enforcement through more rigorous and automatic application of penalties in the event of transgression. The objective of Regulation 1175/2011 (amending Regulation 1466/97) is to strengthen the surveillance of national budgets, while that of Regulation 1177/2011 (amending Regulation 1467/97) is to expedite and clarify the implementation of the excessive deficit procedure; that is to say, to specify the time limits for countries to take corrective action and the sanctioning mechanism that will apply if they fail to do so. In addition Regulation 1173/2011 indicates the actual financial sanctions that will pertain to countries that are deemed to have failed to have taken the necessary corrective actions. In addition, the new rules make the debt criterion of the Maastricht Treaty more operational than has been the case in the past. In other words, the country could be put into excessive debt procedure, even if its deficit is less than 3 percent of GDP, once its debt to GDP ratio exceeds the 60 percent reference level. These fiscal measures have been further strengthened by a new Fiscal Treaty that is due to be signed in March 2012 and take effect once it has been ratified by at least 12 member States. This new Treaty will require national budgets to be in balance or surplus, which effectively means that the annual government structural deficit can not exceed 0.5 percent of nominal GDP. Deviations from this rule will
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trigger automatic sanctions. (The UK and the Czech Republic, both non euro members, have refused to ratify this new treaty). While the above fiscal measures appear to be more of the same past medicine, albeit more strictly administered, Regulations 1174/2011 and 1176/2011 are effectively a new beast designed to identify, prevent and correct non-fiscal macroeconomic imbalances among member countries. The objective of these new regulations is to prevent the accumulation of excessive debt in the private sector, the financial sector or vis a vis foreign countries and to address competitiveness issues and financial and economic issues that can emerge when asset prices rise excessively. A new early warning system has been established based on 10 indicators of potential macroeconomic imbalance. Part of the macroeconomic imbalance procedure (MIP) is establishing threshold limits for each of the 10 indicators, the breaching of which could instigate further in depth country reviews and recommendations for corrective action. While the scoreboard of country performance on these indicators is not mechanically interpreted, since corrective action will depend on the number, the severity and the combination of breaches, as well as on other relevant economic information not covered by the indicative scoreboard, sanctions in the form of a financial penalty may apply to countries whose governments fail to take the action deemed necessary to correct these imbalances. The first publication of the Macroeconomic Imbalance Procedure (MIP) scoreboard was produced by Eurostat on 14 February 2012 and tables 2, 3 and 4 in this chapter are taken from that report (European Commission, 2012a). The threshold for the BOP indicator is +6% and -4% of GDP, for the real effective exchange rate, it is 5% for euro countries over a 3 year period, while for public sector debt, it is 60% of GDP. The other relevant indicators of external imbalance are: a countrys net international investment position (NIIP) as a percentage of GDP (-35% threshold), 5 year percentage changes in export market shares (-6% limit) and 3 year percentage changes in nominal unit labour costs (+9% ceiling for euro countries). Internal imbalances are considered to be private sector debt above 160% of GDP, annual private sector credit flows above 15% of GDP, year on year changes in deflated house prices above 6% and unemployment above 10%. (See European Commission 2012b to understand the economic rationale behind the selection of macroeconomic indicators). In addition to publishing the scoreboard on the MIP on 14 February, the European Commission has also published its first Alert Mechanism Report based on the MIP scoreboard, in which it identified 12 EU Member States whose macroeconomic situation needs to be analysed in more depth (European Commission, 2012c). While the new focus on private sector debt, asset price inflation and external imbalances is to be welcomed, it not clear how, in the absence of greater centralisation of economic policy, these imbalances will be effectively redressed. Furthermore, excessive focus appears to be on those imbalances that indicate a loss of competitiveness, as evidenced by the +6% threshold for BOP surplus but -4% for a BOP deficit. But, as indicated earlier, deficits in one Member State mean corresponding surpluses in others. Peripheral countries in the euro area lost competitiveness, not simply because of excessive domestic cost increases (including wages) but also because such cost increases were so low in surplus countries like Germany. Placing the burden on adjustment on the less competitive economies in the context of a single currency and the current economic climate inevitably means a liberalisation of labour markets and the weakening of social policy. A more equitable sharing of the burden across surplus and deficit countries or a greater centralisation of social policy, could by contrast, avoid such a race to the bottom for labour in the euro area. Also, it is not clear what Member States can do to limit international private capital flows and to prevent and/or redress excessive levels of private debt in a legal environment where the unrestricted international movement of capital is a central freedom of the single market. Central responsibility for controlling profligate lending by banks and the concomitant excessive accumulation of debt in particular Member States has
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to rest with the European Central Bank, since it has the effective tools to discipline such private sector behaviour. Furthermore, the fiscal rectitude built into the new measures presupposes that it was past fiscal profligacy on the part of some Member States that led to the external imbalances that subsequently emerged among euro countries since the single currencys inception. However, all the evidence seems to indicate that it was the private movement of capital and the absence of a centralised regulatory structure monitoring and controlling such flows that was the principal culprit. Obliging governments to follow a balanced budget rule means that in the event of a future (non-policy induced) negative asymmetric economic shock, the only policy tool available to governments, to ameliorate or otherwise address such shocks, is that of ever more structural adjustment of a labour market liberalising kind. Such polices may not even work, since they ignore the possibility that unemployment is not just structural but can also be cyclical and that one effective response to cyclical downturns is fiscal stimulus, especially in an environment where private demand is depressed. Allowing for some lee way on the national fiscal front is all the more necessary given the absence of a federal fiscal system at EU and euro level. Moreover, an EU and euro area that was anxious to avoid a race to the bottom would be one where the centralisation of the rules governing the single market and a central monetary policy were matched by the centralisation of rules governing social policy and a central fiscal policy of a federal kind. By contrast, the new legislative framework seems to reflect the view that sustainable growth and jobs can only be created by fostering international trade and competitiveness through increased market liberalisation and by strengthening economic coordination through simultaneous budgetary discipline. It is not unreasonable to assert that all these recently enacted new measures reflect a strengthened application of monetarist macroeconomic ideology, where the best that national governments can hope to do by way of facilitating improved national economic performance, is roll back the State and allow the market to do the rest. The open question, that only posterity will effectively answer, is whether stronger doses of what is essentially the same past medicine will deliver qualitatively different future economic outcomes to those of the past? It may seem a truism, but it is nevertheless important to emphasise, that it is the citizens of the EU and the euro area in particular, that will bear the consequences (whether benign or malign) of this ongoing macroeconomic experiment. References Bayoumi T. and Eichengreen, B. (1993) Shocking Aspects of European Monetary Integration in, Torres, F. and Giavazzi, F. (eds), Adjustment and Growth in the European Monetary Union, London: CEPR and Cambridge: Cambridge University Press. _____ (1997), Ever Closer to Heaven. An Optimum Currency Area Index for European Countries, European Economic Review, 41 (3-5), pp. 761-70. Beine, M., Candelon, B. and Sekkat, K. (2003), EMU Membership and Business Cycle Phases in Europe: Markov-Switching VAR Analysis, Journal of Economic Integration, 18, pp. 214-42. Borio, C. and Lowe, P. (2002), Asset Prices, Financial and Monetary Stability: Exploring the Nexus, BIS Working Paper, no. 114. De Grauwe, P. (2008a), The Euro at Ten: Achievements and Challenges, Paper presented at the Annual Meeting of the Austrian Economic Association in Vienna. De Grauwe, P. (2008b), Stock Prices and Monetary Policy, CEPS Working Document No. 304

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De Grauwe, P. (2009), Economics of Monetary Union, Oxford University Press, 8th edition. De Grauwe, P. (2010), The Financial Crisis and the Future of the Eurozone, Bruges European Economic Policy Briefings, BEEP, no. 21. De Grauwe, P. and Heens, H. (1993), Real Exchange Rate Variability in Monetary Unions, Recherches Economique de Louvain, 59/1-2. European Commission (2012a), Macroeconomic Imbalance Procedure Scoreboard, Headline Indicators, 30 January 2012, Statistical Information. European Commission (2012b), Scoreboard for the Surveillance of Macroeconomic Imbalances, Occasional Paper, 92. European Commission (2012c), Alert Mechanism Report, COM 2012 (68) Final. Frankel, J and Saravelos, G. (2010), Can Leading Indicators Assess Country Vulnerability? Evidence from the 2008-09 Global Financial Crisis, Harvard Kennedy School, mimeo. Kenen, R. (1969), The Theory of Optimum Currency Areas: An Eclectic View in Mundell, R. and Swoboda, A. (eds), Monetary Problems of the International Economy, Chicago: University of Chicago Press. Kindleberger, C. (2005), Manias, Panics and Crashes, 5th edition, New York: Wiley. Korhonen, I. and Fidrmuc, J. (2001), Similarity of Supply and Demand Shocks between Euro Area and the Accession Countries Focus on Transition , Australian National Bank, no. 2, Vienna. Mc.Kinnon, R. (1963), Optimum Currency Areas, American Economic Review, 53, pp. 717-25. Mundell, R. (1961), A Theory of Optimal Currency Areas, American Economic Review, 51. Official Journal of the European Union, Various Regulations. Reinhart, C., Kaminsky, G and Lizondo, S. Leading Indicators of Country Crisis IMF Staff Papers, Vol. 45 (1). Taylor, J. (1993), Discretion versus Policy Rules in Practice, Carnegie-Rochester Conference Series on Public Policy, 39, pp. 195-214.

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Table 1: General Government Surplus/Deficit as % of GDP

TIME GEO European Union (27 countries) European Union (25 countries) Euro area (17 countries) Euro area (16 countries) Belgium Bulgaria Czech Republic Denmark Germany (including former GDR from 1991) Estonia Ireland Greece Spain France Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta Netherlands Austria Poland Portugal Romania Slovenia Slovakia Finland Sweden United Kingdom 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-1.5 -1.5 -1.9 -1.9 0.4 1.1 -5.6 1.5 -3.1 -0.1 0.9 -4.5 -0.5 -1.5 -3.1 -2.2 -2.0 -3.5 6.1 -4.1 -6.4 -0.2 0.0 -5.3 -4.3 -3.5 -4.0 -6.5 5.1 1.5 0.5

-2.6 -2.6 -2.6 -2.6 -0.1 -1.2 -6.5 0.4 -3.8 0.3 -0.4 -4.8 -0.2 -3.1 -3.1 -4.4 -2.3 -1.9 2.1 -9.0 -5.8 -2.1 -0.7 -5.0 -2.9 -2.0 -2.4 -8.2 4.1 -1.3 -2.1

-3.2 -3.2 -3.1 -3.1 -0.1 -0.4 -6.7 0.1 -4.2 1.7 0.4 -5.6 -0.3 -4.1 -3.6 -6.6 -1.6 -1.3 0.5 -7.3 -9.2 -3.1 -1.5 -6.2 -3.0 -1.5 -2.7 -2.8 2.6 -1.0 -3.4

-2.9 -2.9 -2.9 -2.9 -0.3 1.9 -2.8 2.1 -3.8 1.6 1.4 -7.5 -0.1 -3.6 -3.5 -4.1 -1.0 -1.5 -1.1 -6.5 -4.7 -1.7 -4.4 -5.4 -3.4 -1.2 -2.3 -2.4 2.5 0.6 -3.5

-2.4 -2.5 -2.5 -2.5 -2.7 1.0 -3.2 5.2 -3.3 1.6 1.7 -5.2 1.3 -2.9 -4.4 -2.4 -0.4 -0.5 0.0 -7.9 -2.9 -0.3 -1.7 -4.1 -5.9 -1.2 -1.5 -2.8 2.8 2.2 -3.4

-1.5 -1.5 -1.3 -1.4 0.1 1.9 -2.4 5.2 -1.6 2.5 2.9 -5.7 2.4 -2.3 -3.4 -1.2 -0.5 -0.4 1.4 -9.3 -2.8 0.5 -1.5 -3.6 -4.1 -2.2 -1.4 -3.2 4.1 2.3 -2.7

-0.9 -0.9 -0.7 -0.7 -0.3 1.2 -0.7 4.8 0.2 2.4 0.1 -6.5 1.9 -2.7 -1.6 3.5 -0.4 -1.0 3.7 -5.1 -2.4 0.2 -0.9 -1.9 -3.1 -2.9 0.0 -1.8 5.3 3.6 -2.7

-2.4 -2.4 -2.1 -2.1 -1.3 1.7 -2.2 3.2 -0.1 -2.9 -7.3 -9.8 -4.5 -3.3 -2.7 0.9 -4.2 -3.3 3.0 -3.7 -4.6 0.5 -0.9 -3.7 -3.6 -5.7 -1.9 -2.1 4.3 2.2 -5.0

-6.9 -6.9 -6.4 -6.4 -5.8 -4.3 -5.8 -2.7 -3.2

-6.6 -6.6 -6.2 -6.3 -4.1 -3.1 -4.8 -2.6 -4.3

-2.0 0.2 -14.2 -31.3 -15.8 -10.6 -11.2 -9.3 -7.5 -7.1 -5.4 -4.6 -6.1 -5.3 -9.7 -8.3 -9.5 -7.0 -0.9 -1.1 -4.6 -4.2 -3.7 -3.6 -5.6 -5.1 -4.1 -4.4 -7.3 -7.8 -10.1 -9.8 -9.0 -6.9 -6.1 -5.8 -8.0 -7.7 -2.5 -2.5 -0.7 0.2 -11.5 -10.3

Source: Eurostat (2012)

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Table 2: General government debt, percentage of GDP

1999 113.6 77.6 15.8 58.1 61.3 6.5 48.0 94.0 62.4 58.9 113.0 59.3 12.5 22.7 6.4 60.8 57.1 61.1 66.8 39.6 49.4 21.7 24.1 47.8 45.7 64.3 43.7 2000 107.8 72.5 17.8 52.4 60.2 5.1 37.5 103.4 59.4 57.4 108.5 59.6 12.4 23.6 6.2 56.1 54.9 53.8 66.2 36.8 48.4 22.5 26.3 50.3 43.8 53.9 41.0 2001 106.5 66.0 23.9 49.6 59.1 4.8 35.2 103.7 55.6 56.9 108.2 61.2 14.1 23.0 6.3 52.7 60.9 50.7 66.8 37.6 51.1 25.7 26.5 48.9 42.5 54.7 37.7 2002 103.4 52.4 27.1 49.5 60.7 5.7 31.9 101.7 52.6 59.0 105.1 65.1 13.6 22.2 6.3 55.9 59.1 50.5 66.2 42.2 53.7 24.9 27.8 43.4 41.5 52.5 37.5 2003 98.4 44.4 28.6 47.2 64.4 5.6 30.7 97.4 48.8 63.2 103.9 69.7 14.7 21.0 6.1 58.6 67.6 52.0 65.3 47.1 55.7 21.5 27.2 42.4 44.5 51.7 39.0 2004 94.0 37.0 28.9 45.1 66.3 5.0 29.4 98.9 46.3 65.0 103.4 70.9 15.0 19.3 6.3 59.5 71.7 52.4 64.7 45.7 57.5 18.7 27.3 41.5 44.4 50.3 40.9 2005 92.0 27.5 28.4 37.8 68.6 4.6 27.2 101.2 43.1 66.7 105.4 69.4 12.5 18.3 6.1 61.7 69.7 51.8 64.2 47.1 62.5 15.8 26.7 34.2 41.7 50.4 42.5 2006 88.0 21.6 28.3 32.1 68.1 4.4 24.7 107.3 39.6 64.0 106.1 64.7 10.7 17.9 6.7 65.9 64.3 47.4 62.3 47.7 63.7 12.4 26.4 30.5 39.6 45.0 43.4 2007 84.1 17.2 27.9 27.5 65.2 3.7 24.8 107.4 36.2 64.2 103.1 58.8 9.0 16.8 6.7 67.0 62.3 45.3 60.2 45.0 68.3 12.8 23.1 29.6 35.2 40.2 44.4 2008 89.3 13.7 28.7 34.2 66.7 4.5 44.2 113.0 40.1 68.2 105.8 48.9 19.8 15.5 13.7 72.9 62.5 58.5 63.8 47.1 71.6 13.4 21.9 27.8 33.9 38.8 54.8 2009 95.9 14.6 34.4 41.5 74.4 7.2 65.2 129.3 53.8 79.0 115.5 58.5 36.7 29.4 14.8 79.7 68.0 60.8 69.5 50.9 83.1 23.6 35.3 35.5 43.3 42.7 69.7 2010 96.2 16.3 37.6 43.4 83.2 6.7 92.5 144.9 61.0 82.3 118.4 61.5 44.7 38.0 19.1 81.3 69.1 62.9 71.8 54.9 93.4 30.5 38.8 41.0 48.3 39.7 79.6

Belgium Bulgaria Czech Republic Denmark Germany Estonia Ireland Greece Spain France Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta Netherlands Poland Portugal Romania Slovenia Slovakia Finland Sweden UK

Source: European Commission (2012) Table 3: Current account balance in percentage of GDP, 3 year backward average
1999 5.3 0.1 -3.4 0.6 -0.8 -8.0 1.1 -3.3 -1.4 2.9 1.9 -1.1 -8.0 -10.7 9.3 -4.9 -4.8 4.6 -1.9 -5.0 -7.2 -5.6 2000 4.8 -3.5 -3.0 0.8 -1.2 -6.1 0.2 -4.7 -2.7 2.5 0.9 -1.3 -7.7 -9.4 10.3 -7.1 -7.1 3.1 -1.3 -5.8 -8.7 -4.8 2001 4.2 -5.2 -4.0 2.2 -1.0 -4.9 -0.3 -6.2 -3.6 2.1 0.4 -3.5 -7.1 -7.1 10.1 -7.5 -6.4 2.8 -1.1 -5.5 -9.8 -4.4 2002 4.0 -4.4 -5.0 2.3 0.1 -7.1 -0.7 -7.2 -3.7 1.5 -0.1 -4.1 -6.4 -5.2 10.8 -7.2 -4.6 2.4 0.4 -4.0 -9.6 -4.1 2003 3.8 -4.4 -5.5 3.0 1.3 -9.0 -0.5 -6.8 -3.6 1.2 -0.3 -3.1 -7.5 -5.5 9.1 -7.0 -1.5 3.6 1.2 -2.8 -8.3 -4.9 2004 3.7 -4.7 -5.4 3.0 2.9 -11.1 -0.5 -6.3 -4.0 0.8 -0.5 -3.7 -9.3 -6.5 10.2 -7.8 -2.2 5.3 2.2 -3.5 -7.7 -5.9 2005 2.9 -7.8 -4.0 3.6 3.9 -10.9 -1.4 -6.7 -5.4 0.3 -0.7 -4.4 -11.2 -7.1 10.5 -7.8 -5.9 6.9 2.0 -3.4 -8.4 -7.6 2006 2.3 -11.9 -2.7 3.4 5.3 -12.2 -2.5 -8.3 -7.2 -0.2 -0.9 -6.0 -16.0 -8.4 11.3 -7.6 -8.2 8.1 2.4 -3.8 -9.8 -9.1 2007 1.8 -18.1 -2.4 2.9 6.3 -13.8 -4.1 -11.2 -8.8 -0.7 -1.2 -8.2 -19.2 -10.7 10.7 -7.3 -8.3 7.8 2.8 -4.1 -10.4 -10.8 2008 0.6 -22.0 -2.8 2.4 6.7 -13.7 -4.8 -13.6 -9.5 -1.1 -1.9 -11.5 -19.4 -12.6 8.5 -7.3 -7.1 6.8 3.7 -5.5 -11.1 -11.8 2009 -0.6 -19.1 -2.9 2.5 6.5 -7.3 -4.6 -13.6 -8.3 -1.4 -2.0 -12.7 -9.0 -7.6 7.2 -4.9 -6.2 5.1 3.7 -5.5 -11.2 -9.7 2010 -0.6 -11.1 -2.5 3.9 5.9 -0.8 -2.7 -12.1 -6.5 -1.7 -2.8 -12.1 -0.5 -2.3 6.4 -2.1 -5.4 5.0 3.5 -5.0 -11.2 -6.6

Belgium Bulgaria Czech Republic Denmark Germany Estonia Ireland Greece Spain France Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta Netherlands Austria Poland Portugal Romania

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Slovenia Slovakia Finland Sweden United Kingdom

-1.2 -8.1 5.2 4.0 -0.9

-2.1 -6.2 6.1 4.0 -1.8

-1.9 -5.8 7.2 4.4 -2.3

-0.5 -6.5 8.2 4.6 -2.1

0.1 -7.4 7.2 5.6 -1.8

-0.8 -7.2 6.5 6.1 -1.8

-1.7 -7.4 4.8 6.8 -2.1

-2.3 -8.1 4.6 7.2 -2.6

-3.0 -7.2 3.9 8.1 -2.8

-4.7 -6.4 3.7 8.8 -2.4

-4.3 -4.7 2.9 8.4 -1.8

-3.0 -4.1 2.1 7.5 -2.1

Source: European Commission (2012). The current account covers all transactions that involve economic values occurring between resident and non-resident units. The basic components are exports minus imports of goods and services, net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). Table 4: Real effective exchange rates, percentage change over 3 years
1999 -6.6 Belgium 48.2 Bulgaria Czech Republic 6.0 -3.4 Denmark -9.1 Germany 9.8 Estonia -4.9 Ireland -4.1 Greece -5.7 Spain -7.5 France -2.2 Italy -5.0 Cyprus 16.6 Latvia 28.6 Lithuania -5.6 Luxembourg 6.8 Hungary 6.1 Malta -4.4 Netherlands -6.2 Austria 4.6 Poland -3.2 Portugal 30.4 Romania 3.1 Slovenia 2.8 Slovakia -7.3 Finland -9.0 Sweden United Kingdom 19.6 2000 -4.9 17.6 7.6 -4.2 -9.5 5.5 -8.5 -10.1 -3.2 -7.9 -5.9 -3.4 15.1 18.9 -2.2 2.9 1.8 -3.0 -5.5 12.3 -3.0 24.3 0.4 7.9 -7.2 -6.5 4.4 2001 -3.8 11.9 6.5 -3.5 -8.8 2.6 -2.2 -5.1 -2.1 -7.7 -5.6 -3.4 13.4 16.1 -1.5 12.3 -0.6 0.0 -4.9 20.1 -0.3 -1.1 -2.5 9.7 -4.7 -12.0 -2.3 2002 -1.9 15.3 20.5 -1.1 -5.8 4.0 4.4 -3.5 1.0 -3.9 -2.1 0.8 5.1 15.1 0.0 20.5 1.8 3.2 -3.2 19.2 2.3 15.6 0.3 15.9 -1.4 -7.7 -2.0 2003 5.3 14.0 14.9 8.1 5.1 9.3 17.6 9.1 8.9 6.6 8.8 8.1 -7.1 6.6 4.5 20.3 5.9 10.9 3.1 -4.6 9.6 -1.0 5.4 17.9 7.8 0.3 -7.6 2004 5.3 10.6 8.4 6.8 6.4 6.9 17.5 9.3 9.7 8.1 9.8 8.0 -6.9 4.1 5.8 17.6 7.4 7.2 3.7 -16.4 8.1 -1.5 4.6 26.8 5.7 10.3 -1.6 2005 4.9 8.9 3.7 4.2 4.8 6.9 12.0 6.8 7.9 6.0 7.0 6.8 -4.5 1.1 6.6 9.3 5.6 3.3 2.7 -1.6 5.3 16.2 1.7 27.4 2.5 3.9 -2.9 2006 1.5 11.3 11.5 -0.5 0.2 6.6 3.4 2.5 4.3 0.8 1.1 1.4 4.7 0.9 4.0 3.0 4.0 -1.1 -0.4 13.6 1.4 29.3 -0.7 19.6 -2.5 -2.5 3.0 2007 1.5 12.1 14.0 0.1 0.6 9.5 4.1 1.9 4.2 0.2 0.7 0.2 11.0 4.5 3.3 8.0 3.1 -1.0 -0.3 18.9 1.5 37.6 1.0 19.5 -1.4 -2.5 1.5 2008 4.4 20.4 24.3 3.3 2.5 15.2 8.1 4.0 6.2 2.7 3.3 2.7 24.1 12.4 4.0 9.1 6.8 0.7 1.1 15.8 2.7 10.5 4.3 26.4 2.5 -1.1 -10.4 2009 4.2 18.6 13.6 5.8 3.2 13.7 5.3 5.0 4.8 2.8 3.9 2.9 23.7 16.9 4.0 7.8 5.1 2.8 2.2 -4.0 1.3 -4.8 5.8 27.4 5.3 -8.4 -19.8 2010 1.3 10.4 12.7 0.9 -2.9 5.9 -5.0 3.9 0.6 -1.4 -1.0 0.8 8.5 9.1 1.9 -0.5 -0.6 -1.0 -1.3 -0.5 -2.4 -10.4 2.3 12.1 0.3 -2.5 -19.7

Source: European Commission (2012), Macroeconomic Imbalance Procedure Scoreboard, Headline Indicators, 30 January 2012, Statistical Information. Real effective exchange rates (REERs) aim to assess a country's competitiveness relative to its principal competitors in international markets. Changes in competitiveness depend on exchange rate movements as well as the relative changes in prices between the country and its trading partners. The REER used for the scoreboard takes account of exchange rate movements and consumer price developments for a country against a panel of 35 other countries (EU27 countries plus Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere.

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8. Impacts of climate change on environment and economic sectors in Europe

Mgr. Zuzana Cahlkov Global Change Research Centre, Academy of Sciences CR, v.v.i. Mgr. Barbora Du Global Change Research Centre, Academy of Sciences CR, v.v.i. Abstract: This study summarizes possible impacts on physical environment and economics induced by climate change across the Europe. Climate change is manifesting unequally across regions of the Europe and consequently, economic costs or benefits will depend on particular region or economic sector. Economic impacts of climate change are illustrated mainly on agriculture, but the article deals also with the impact of climate change on tourism and human health and economic damage from floods and sea level rise. Better understanding of ongoing trends in specific European regions brings stratification into zones according to its environmental and climatic conditions. Then, we must take into consideration mitigation and adaptation measures planned or adopted on European, as well as national or regional levels.

1. Introduction Global climate change62 is being considered as one of the most serious environmental challenges facing our civilisation. Considerable anthropogenic contribution to climate change is being generally accepted across the scientific as well as decision-making community. Human activity alters the climatic system mainly through the greenhouse gas emissions63, lesser through the changes in land use. Generally speaking, every economic sector or human activity influence global climatic system in some way. On the other hand, the changing global climate system has a consequent impact on human activities or individual economic sectors. And those economic activities and sectors will need in the future to adapt to these changes, if they do not want to pass a strong wave of stagnation and economic losses. The aim of this chapter is to summarize and underline the main trends of climate change patterns and their impact on selected economic sectors in Europe; on those that are expected to be influenced most seriously. We researched contemporary relevant studies dealing with the theme of economic impacts of climate change in particular sectors (e.g. agriculture: Olesen, Bindi 2002, Olesen et al. 2011, tourism: Amelung, Moreno 2009). We researched some other studies analyzing damages that have already occurred because of climate changes (e.g. Barredo 2009, UNEP 2004) and some others predicting expected economic losses in the future as well. Among the latter ones we consider to be a significant source Ciscar et al (2011) "Physical and Economic Consequences of Climate Change in Europe" which quantifies the
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For the purpose of this chapter we use simply term "climate change", that is defined as a change in the state of the climate that can be identified by changes in the mean and/or the variability of its properties, and that persists for an extended period, typically decades or longer. While Intergovernmental Panel of Climate Change (IPCC) does not distinguish, whether it is due to natural variability or as a result of human activity, UN Framework Convention on Climate Change emphasises that human activity altering composition of the global atmosphere in addition to natural climate variability (Salamon et al, 2007) 63 Main greenhouse gases, added to atmosphere by anthropogenic activity are: carbon dioxide (CO2 ), methane, ozone, freons, nitrous oxide and water vapour.

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effects of climate change in five categories (agriculture, coastal zones, river floods, human health and tourism). We used summarizing studies of the European Environmental Agency (EEA) and European Commission (EC) as well. Even if there is a vast amount of resources about economic impacts of climate change, we cannot say this when we are especially interested in the region of Europe. We have compiled both narrowly focused and general papers touching Europe with two aims: the first one is to organize the broad topic of economic impacts of climate change into logical frameworks for selected economic sectors and regions of Europe. The second one is to present specific results of different authors in one place. Our study can serve as an introduction to the topic of economic consequences of climate change. 2. Nature of the climate changes and the main trends Climate change is observed by means of meteorological measurement and recent observations show that since pre-industrial period (1750) the global mean temperature has increased by 0.8. Europe alone has warmed more - by 1.0 and future projections suggest temperature increase between 1.0 - 5.0 C (EEA 2008). Specifically it means changes in environment. Apart from rising up temperature in recent decades, climate change has been observed through sea level rise, change patterns of precipitation, changes of intensity of and frequency of weather extremes (EEA 2008). Consequently, these climatic trends cause changes in physical environment and threat economic sectors, that depends on the environment the most, such as agriculture, forestry, fishing, to some extend tourism and others. 2.1. Regional Vulnerability Consequences of climate change bring threats to vulnerable region in Europe, specifically Mediterranean basin, north-western and central-eastern Europe and the Arctic, coastal zones and areas prone to river floods (Isoard et al. 2010). These regions could suffer more from lesser ability to adapt to climate change and are at greater environmental risk. They have to pay higher costs to cope with consequences of particular negative effects of climate change. According to Report about the European Environment, particular areas vary in vulnerability to climate change (Isoard et al. 2010). Specifically, coastal zones are at threat due to sea level rise, and increased frequency of severe storm surges. Cities and urban areas continue to be vulnerable to heat waves - due to urban heat island effect, cities and areas in the lowland are at risk of flooding. Mediterranean basin are at serious risk of worsening water availability due to decrease of precipitation and summer heat waves. From the biogeographical point of view, Europe is divided into several regions determined by environmental, climatic, geological and other factors. Every region has its specific characteristic and trends of climate change brings different challenges and environmental changes (Table 1). 2.2. Interconnectedness between biogeographical regions and agriculture regional zones in Europe Biogeographical conditions in Europe influence conditions for running agriculture. These are determined by environmental and socio-economic factors. Environmental factors include climatic, soil conditions and vegetation types, socio-economic factor distinguish between market-oriented intensive or extensive farming, differing in size from large-scale, middle to small-scale. Not all authors use division strictly according to biogeographical zones, but generally, they base on them. Olesen, Bindi (2002) divide Europe into nine agricultural
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region, and newly Olesen et al. (2011) into thirteen environmental zones. These are based on environmental stratification according to Metzger et al. (2005)64 . Table 1: Regional vulnerability to climate change in Europe
Biogeographical region Characteristics vulnerability Arctic areas decreasing coverage of of the Affected regions/states (examples) ice Greenland65,
Arctic sea Coastal parts of France,

sea

North-Western Europe sea-level rise, increase of winter precipitation, river (maritime climate) flow and threats to coastal flooding

Germany, The Great Britain, Ireland

Sweden, Northern Europe less snow and ice cover, Norway, increased winter and Finland, Estonia, (boreal region) spring river flows, Lithuania, Latvia increased forest growth and prolongation of vegetation period and increase of precipitation Central and Eastern temperature a precipitation extremes risk of droughts and river floods Czech Republic, Poland, Hungary, Austria, Germany, Romania, Ukraine

Mountain areas

decrease of glacier mass, Alpine regions in melting of permafrost, Italy, France, upwards shift of plants Switzerland, Austria and animals continuing drying up due to decrease of precipitation, increased risk of forest fires, heat wavers, biodiversity loss South, South-East and South-West Europe (e.g. Italy), Balkan peninsula especially Greece, Iberian Peninsula

Mediterranean region

Source: Isoard et al. (2010) and own research. European Communities study about projected impact of climate change to EU regions operates with simplification and sorting EU regions into four region (Northern Europe, Mediterranean, Central and Eastern Europe, Western Europe). The main trends of climate changes in EU regions show changing patterns of climate events and possible positive or negative consequences for agriculture sector (see Figure 1).

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Environmental stratification is based on ecological factors like fauna, vegetation, geology and soil, geomorphology and climate. Advantage of this stratification is better and more accurate in distinction trends in particular regions. Environmental zones according to Metzger (2005) are Alpine North, Boreal, Nemoreal, Atlantic North, Alpine South, Continental, Atlantic Central, Pannonian, Lusitanian, Anatolian, Mediterranean mountains, Mediterranean north, Mediterranean south. This stratification enables to identify climate change more specifically. 65 Greenland is considered as a province of Denmark.

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Figure 1: Projected impacts from climate change in different EU regions

Source: European Communities (2008) Figure 1 shows that the one of the most serious limitation factor of climate change across all regions that has already caused negative effect to crop yield is threat of droughts, caused by changes in precipitation patterns. For example, droughts combined with extreme heat waves where large part of Europe were exposed to, caused the estimated reduction of 30% reduction in gross primary production of terrestrial ecosystems (Ciasis et al. 2005 in Olesen et al. 2011). Consequently it caused reduction of crop yields and incomes of farmers66. The second common trend is prolongation in growing season. Mainly for northern Europe, where crop yield is limited by cool temperature (Olesen et al 2011) it signifies positive trend for crop yield. On the other side, for south-east Europe and Mediterranean it means more negative trend due to decreasing of summer precipitation. Specifically, in Finland crop yields has been increased in last 10-20 years, whereas in Greece decreased (Olesen et al. 2011). 2.3. Between the environment and society: consequences for ecosystem services As we stated above, climate change is affecting physical environment and consequently supply of ecosystems services that are essential for human well-being. It is necessary to be aware that changes in ecosystem service could seriously affect functioning of human systems and cause large economic damages or support economic gains on the other side. These connections are highly underestimated. Schrter et al. (2005) worry that decrease supply of ecosystem services, such as declining soil fertility, water availability could increase vulnerability in many regions (Schrter et al. 2005). Olesen et al. (2011) claim when counting affects of climate change, in the case of agriculture, we must take into account not only direct effect (e.g. crop productivity, damages caused by extreme events), but also indirect effects that can be harmful for production too. To indirect effects can be included decreasing crop nutrition in soil, occurrence or weeds, pests, diseases, soil erosion. These harms are hardly accountable in some cases. And in total, they can contribute to increasing economic costs of climate changes impacts in many economic sectors. It results that economists should accept ecological factors such as adaptive capacity of ecosystems, resilience of ecosystems and supply of ecosystem services (Olesen et al. 2011; Schrter et al. 2005).
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Economic consequences of decreased crop production in 2003 will be specified in next chapter Economic consequences of climate change.

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3. Economic consequences of climate change Considerable progress in research on climate change during the last decade has brought up also many studies on their economic consequences. Any study dealing with this topic starts with some scenarios on future greenhouse gas emissions, possible warming and other aspects of climate change such as sea level rise or occurrence of extreme weather events. After the specification of assumptions, economic consequences are taken into consideration using a range of methodological approaches (Tol 2009). Quantitative estimates of economic losses caused by climate change usually work with the average temperature change and its consequences on the loss in gross domestic product. This surely is a simplification, evaluating the impact of climate change in the long run is an extremely complex issue, in which also demographic change and the dynamics of economic and technological development among others must be assessed (Ciscar et al. 2011). Based on different impact models, we get different estimates and scenarios of the future climate change, but there is no doubt that the consequences of climate change on world economy will be serious. Economic consequences of climate change are not expected to be the same everywhere in Europe. The resulting effects depend mainly on current climatic conditions, but also on the exact direction of change and the available resources and possible adaptation strategies to the changes (Olesen, Bindi 2002). Negative economic impacts of the climate change are expected particularly in the South-Eastern Europe and the Mediterranean, on the other side, the Northern Europe could gain economic benefits from climate change associated mainly with positive effects of the average temperature increase on agriculture (EEA 2008). The size of projected effects of climate change differs also according to the particular economic sector. Economic sectors such as agriculture and forestry, tourism or energy industries, but also other services dealing with e.g human health are considered to be especially vulnerable to the climate change. Extreme weather events, which are projected to increase in frequency and intensity in Europe (EEA 2008), cause direct economic losses, too. For Europe, river floods are the most common natural disasters causing currently the biggest economic losses (Ciscar et al. 2011), but also temperature extremes as heat waves or on the other hand freeze waves have a considerable impact on the economy, e.g. through increasing expenses on human health, air conditioning or energy. Climate change manifesting through the sea-level rise may effects coastal regions, where 43 % of the inhabitants of the European Union lived in 200767 (Eurostat 2010). The sub-sections to follow briefly develop possible economic consequences of climate change on chosen economic sectors or markets but also on non-market impact categories. Emphasis will be given especially on the part dealing with the impact of climate change on agriculture in Europe. The reason is that agriculture is particularly sensible to climate change and agricultural productivity and quality of cultivated crops are directly influenced by local climate variables and atmospheric CO2. 3.1. Agriculture As stated above, agriculture is an especially vulnerable sector with respect to climate change. Nevertheless it is not expected that climate change could have an important negative influence on the global food production (FAO 2007). World macro-regions, but also micro-regions will be affected differently, what will be important is just their possibilities to adapt to their specific situation. We can assume that adaptation possibilities are because of technological
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EU coastal regions: regions (NUTS 3) with a sea border, regions (NUTS 3) with more than half of its population within 50 km of the sea and Hamburg.

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development constrained especially in low-income developing countries that have neither necessary resources nor experienced political representation (Tol 2009). On the other side, after implementation of relevant adaptation measures the climate change could have a positive impact on agricultural production in developed countries, because of longer vegetation period (Rosegrant et al. 2008). This fact could lead to an even more open gap between developed and developing countries. Concerning Europe in the situation of highly mechanized agriculture and a very low share of agriculture on GDP in EU-27 (1.7% in 2010 according to Eurostat 2011), we cannot expect an important impact of the changes in agricultural production caused by climate change on the European economy (Olesen, Bindi 2002). Agricultural impacts of climate chase differ according to regions, an important factor is here the North-South gradient. Mostly negative aspects of climate chase are expected in the South and the South-East of Europe, the North of Europe can count even with positive aspects of climate change in the sense of warming and longer vegetation period for plants. On the other side, the expected climate change brings not only warming and longer vegetation period but also more extreme weather events as well as insecurity about regular access to water (Inglesias et al. 2007) with negative impacts on local farmers even in higher latitudes. Figure 2: Impact of the summer 2003 heat wave and drought on agriculture. Production (% reduction) and financial costs (mio. ) for 2003 relative to 2002 in 5 selected countries.

Source: COPA-COGECA 2003 in Olesen, Bindi (2004) We can illustrate the impact of extreme weather events on agriculture in Europe with the drought in July and August 2003, which affected a significant part of southern and central Europe. Cereal production in the EU compared to the year 2002 decreased by more than 23 million metric tonnes (Olesen, Bindi 2004). In Italy, the drought did cause decline in agricultural raw materials production by as much as 60% (depending on crop) and caused damage of EUR 5 billion (Rossi, Niemeyer 2010). Figure 2 shows the reduction in production of some agricultural commodities in 2003 relative to 2002 in France, Germany, Italy, Spain and Austria. We do not have the exact quantification of the agricultural damages due to heat wave in 2003 for Europe as a whole, but the estimate of total economic damages68 in Europe is about EUR 13 billion (UNEP 2004).
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Droughts did not impact agriculture only but also e.g. energy production and environment changes. In France, many nuclear plants had to be closed; the reactors could not have been properly cooled due to the rise of water

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In the paper of Ciscar at al. (2011), four climate scenarios are analyzed and there is a possibility that warming by 5.4C in 2080s could bring the decrease in crop yields by 10 %. Scenarios with smaller warming scenarios do not result in considerable impacts on EU yields. All scenarios indicate considerable regional differences in this characteristic. E.g., in the scenario with warming by 3.9C, in the South Europe the crop yields decrease by 12% and on the contrary - in the North Europe increase by 39 % (Ciscar et al 2011). It is expected that agriculture in Central Europe as well as in the Atlantic and Alpine zone will face risks related mainly to different distribution of precipitation during the year than it is nowadays (see above). Adaptation strategies ought to include measures for restricting spring floods and for containing and retention of water in the countryside in summer (Inglesias et al. 2007). Individual estimates of adaptation costs in agriculture differ considerably. Fischer et al. (2007) in their study estimate that adaptation costs only for irrigation could be in 2030 in Western Europe between EUR 161 to 966 million p.a., based on different scenarios (Fischer at al. 2007 in Osberghaus, Reif 2010). On the other hand, the IMF (2008) calculated costs of adaptation for irrigation expenditures between EUR 25 to 145 million p.a. in Western Europe in 2030 (IMF 2008 in Osberghaus, Reif 2010). Boselli et al. (2009) estimated costs for the same reason and in the same region, but for the year 2060 to be EUR 6.274 million p.a. (Boselli at al. 2009 in Osberghaus, Reif 2010). 3.2. Tourism According to the PESETA69 - Tourism Study (Amelung, Moreno 2009), tourism is not only one of the biggest and fastest growing economic sectors but also one of the most vulnerable economic sectors with respect to climate conditions. The intensity of tourist flows depends on other variables such as income of potential tourists and prices of transport and service as well. Nevertheless, the spatial pattern of tourist flows would be affected by climate change to a large extent, which would logically also cause changes in the spatial redistribution of income from tourism (Amelung, Moreno 2009). Climate change would lead to changes in the intensity of flows during the year, too. It is assumed that in Europe the most vulnerable regions are in the Mediterranean, where each year 120 million tourists from northern Europe are accepted, whose total expenses are about EUR 100 billion (EEA 2008). With warming and possible heat waves both the shift of main tourist seasons towards the spring and autumn and some - though not dramatic - decline in tourists are expected in southern Europe70. This decline will be caused by the shift of tourist destinations towards the north, so northern regions will on the contrary benefit on the climate change. Mountain areas with winter resorts will also be very influenced by climate change. Some traditional ski resorts such as Garmisch-Partenkirchen in Germany and Kitzbhel in Austria will face - according to models of snow cover duration - a reduction in the number of days with snow cover per year. This will have an impact on low-lying resorts especially (Viner, Maureen 1999). Adaptation mechanisms will be very important for the size of tourist flows changes in the European area. Especially institutional mechanisms such as summer vacation term will play a
temperature in rivers (UNEP 2004). It is also estimated that due to the heat wave approximately 30,000 people died in Europe in 2003. The heats also had serious environmental impacts, on water ecosystems and glaciers particularly, the mass of Alpine glaciers decreased by 5-10% in 2003 (UNEP 2004). 69 PESETA states for Projection of Economic impacts of climate change in Sectors of the European Union based on bottom-up Analysis.
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According to Ciscar et al. (2011) Southern Europe is the only region in Europe with decline in bed nights up to 4 % (differences compared with 2005).

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role in the choice of tourist destinations - if the term stays in the coming decades in the warmest months of the year, the decrease of the number of tourists bound for the Mediterranean will be probably more significant. 3.3. Human health Climate change will have a negative impact especially on the already disadvantaged and vulnerable populations in developing countries. The impact of climate change on human health can be either direct health problems tied with extreme weather events and heath waves or it can manifest itself indirectly as e.g. deterioration of access to safe drinking water. This can cause not only the increase of waterborne and foodborne diseases but also the spatial spread of infectious diseases to so far for them untypical destinations. Europe can be affected by the letter as well as by the increase of the risk of respiratory diseases resulting from changes in air quality and pollen distribution (WHO 2010), diseases resulting from extreme weather events (e.g. cardiovascular diseases). This can have an effect also on the European economy through increasing spending on treatment and prevention or through decreased economic activity of affected people. 3.4. Economic impacts of river floods and sea level rise The most common natural disasters in Europe are floods, which can be count - just as storms and temperature extremes - among weather and climate events. Given that the number of floods in Europe increased during the period 1998-2007 by about 65% compared with the 1980s (EEA 2008), the assumption that this increase was partly caused by climatic changes that have been occurring since the 80th (see above - increase in the average temperature, etc.) seems to be reasonable. Damages caused by extreme weather events in Europe have been showing an increasing trend and between 1998 and 2007 were estimated to be about EUR 13.7 billion per year (EEA 2008). Floods are the major item among these damages (Kundzewicz 2010), e.g. only floods that hit Europe during August 2002 in Central Europe caused losses of about EUR 16,8 billion (EEA 2008). Economic losses caused by floods in Europe in the period between 1970 and 2006 were analyzed in 2009 by Barredo. During that period, 122 floods were recorded in Europe. From this number, Barredo classified as major events only floods with losses larger than 1000 million in 2006 USD normalized values (losses adjusted for net changes in population, inflation and real per capita wealth). Those were just 27, that is 22% of the total number, but they caused 82% of the losses. Annual flood losses are in Figure 3. The sea level rise is one of the most disputed and the best-known impacts of climate change. Already in the 20th century, sea level rose between 10 to 25 cm; in the 21st century, further increase between 0.5 to 1 meter is expected (Nicholls, Mimura 1998). This would significantly affect coastal areas through sea floods and coastal erosion (Bosello, Roson, Tol 2010). Damages would be extensive in Europe, too. According to Ciscar et al (2011), it would impact up to 5.5 million people by the 2080s. According to the PESETA study, the damages in Europe could be between EUR 12 to 18 billion per year in 2080s (EEA 2008).

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Figure 3: Annual flood losses in Europe from major flood disasters normalised to 2006 values.

Source: Barredo 2009

3.5. Climate change policy and economic costs of measures on international and European level Negotiations concerning climate change policy measures started in Rio de Janeiro (1992) and led to UN Convention Framework on Climate Change, then developed in Kyoto (1997) and resulted in Kyoto Protocol. Additional negotiation were being held in Copenhagen (2009), Cancn (2010), Durban (2011). EU acts as a leader in effort to implement mitigation and adaptation measures to reduce strain of civilisation to global climate.71 Mitigation strategies concentrates on measures how to reduce greenhouse gas emission to avoid or rather mitigate climate change, while adaptation strategies looks for the measures how to adapt most vulnerable regions or adjust particular human activities. This strategy builds on fact that civilisation has been already facing inevitable or irreversible climate change, despite of proposing or already running mitigation strategies. Thus, it is widely accepted that efforts to reduce greenhouse gas emissions should be supplemented by policies and incentives to adapt to the impacts of climate change. According to OECD report concerning economic aspects of adaptation measures, providing critical assessment of adaptation costs and benefit is necessary. Apart from mix of economic and political instruments such as insurance, risk sharing, environmental market and pricing, public-private partnership, report calls for emphasise that it is not only economic, but also public policy challenge (Agrawala, Frankhauser 2008). In adopting adaptation strategies, it depends on particular economy sector and region, that vary across the Europe. Calculation costs of these measures is difficult to estimate, it varies from only soft arrangement, e.g. changes in crops variety, shifting sewing period to hard arrangement, e.g. changes in infrastructure in the case of irrigation system, land use or
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The most comprehensive information about climate change together with modelling various scenarios in future and recommendation for politicians is serving IPPC - Intergovernmental Panel on Climate Change, especially the last Fourth Assessment Report: Climate Change 2007. On European level, European Environmental Agency gathers and provides scientific information about environmental/climate change and design mitigation and adaptation strategies and its financial costs. Furthermore elaborates European Climate Change Programme to identify the most effective and cost-effective policy measures how to reduce negative effects of climate change (the last one completed in 2006).

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procurement against sea level rise. Even OECD study claims that estimation costs of adaptation measures "has been blossomed into industry", but are not very accurate. The estimations calculate with billions of dollars per annum within a few year, but the reliability of these estimations is very low (Agrawala, Frankhauser 2008). In the case of mitigation measures according to Kyoto protocol, states were agreed have to reduce greenhouse gas emission by 8% bellow 1990 during 2008- 012. Following after - 2012 emission scenarios, EU promotes target to increase maximum 2C above the pre-industrial level. Achieving this goal requires massive mitigation measures, to reduce more than 50% of the level greenhouse gas emission by 2050 in comparison to 1990 and acquire transition to low- emission (carbon) economy system72. EU suggest that it allows to adapt to climate change with acceptable social, economic and environmental costs. When we compare development of European society in past and present, climate change challenge shows progress in policy and decision-making field. While in past Europeans only reacted to changing patterns in weather or climate, present efforts were supported with adopting preventive approach and thinking in term of ten or hundreds year period towards the future. 4. Conclusions The aim of this chapter was to summarize and organize available information on economic impacts of climate change in Europe. Compilation of different resources allowed us to put together results of specific studies of relevant authors and bring some insight into the topic. Climate change will undoubtedly have an impact on environment and human society. The impact of climate change will have strong economic impact on different economic sectors. The size and form of that impact are regionally very differentiated, both from the point of view of macro-regions of the world and the regions in Europe. Our examples in the above text have been mainly from European regions. We discussed specific climate change trends with respect to biogeographical regions and regional agricultural zones in Europe. We illustrated economic impacts of climate change; we focused on agriculture but also dealt with the impact on tourism and public health and economic damage from floods and rising ocean levels. Some past examples of economic losses caused by climate change are provided as well as predictions for the future. Finally, we illustrated mitigation and adaptation measures for adjusting European economy to climate change trends. Estimating the extent of economic impacts of climate change for the future is very complicated because there are too many variables involved. However, efforts to understand and predict potential impacts are very valuable because the timely adoption of adaptation measures may reduce economic losses caused by climate change. References

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Aardenne, J. , Fernandez, R., et al. (2010), The European Environment: The State and outlook 2010: Mitigation climate change. Luxembourg: Publications Office of the European Union. Agrawala, S., Frankhauser, S. (2008), Economic aspects of adaptation to climate change. Cost, benefits and policy instruments. Paris:OECD Amelung, B., Moreno, A. (2009): Impacts of climate change in tourism in Europe. PESETATourism study. JRC Scientific and Technical Reports. Seville, Spain, pp. 5-55.

EU currently contribute around 12 % of annual global anthropogenic greenhouse gas emissions. In 2007, the EU agreed on an independent binding target to reduce its emissions by at least 20 % by 2020 compared to 1990 levels. This commitment would increase to 30 % if major emitting countries outside Europe made similar challenging commitments under a global climate agreement (Aardenne, Fernandez et al. 2010)

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Barredo, J.I. (2009), Normalised flood losses in Europe: 19702006. Natural Hazards and Earth System Sciences, Vol. 9, No. 1, pp. 97-104. Boeri, T., Denis, J. C. (1994), Transitional Unemployment. The Economics of Transformation, Vol. 22, No. 3, pp. 265290. Bosello R., Roson R. , Tol R. (2010), Economy-wide Estimates of the Implications of Climate Change: Sea Level Rise. Environmental & Resource Economics, Vol. 37, pp. 549 571. Ciscar, J.C., et al. (2011), Physical and economic consequences of climate change in Europe. PNAS - Proceedings of the National Academy of Sciences, Vol. 108, No. 7, pp. 2678-2683. European Comission (2006), The Europe Climate Change Programme: EU Action against Climate Change. Luxembourg: Publications Office of the European Union. European Communities (2008), Climate change: the challenges for agriculture", Brussels: Directorate-General for Agriculture and Rural Development, http://ec.europa.eu/agriculture/index_en.htm EEA (2008), Impacts of Europe' s changing climate - 2008 indicator-based assessment. Luxembourg: European Environment Agency, Publications Office of the European Union. Eurostat (2011), National accounts GDP. http://epp.eurostat.ec.europa.eu/statistics_explained/index.php/National_accounts_%E2%80% 93_GDP Eurostat (2010), Portrait of EU coastal regions. Statistics in focus 38/2010. 12. FAO (2007), Adaptation to climate change in agriculture, forestry and fisheries: Perspective, framework and priorities. FAO Inter-departmental Working Group on Climate Change, 24. Kundzewicz Z. W. et al. (2010), Assessing river flood risk and adaptation in Europereview of projections for the future. Mitigation and Adaptation Strategies for Global Change, Vol. 15, No 7, pp. 641-656. Iglesias, A. et al. (2007) Adaptation to climate change in the agricultural sector. Madrid: AEA Energy & Environment, Universidad de Politcnica Isoard, S. et al. (2010), The European Environment: The State and outlook 2010: Adapting to climate change. Luxembourg: Publications Office of the European Union Metzger, M.J. et al. (2005), A Climatic Stratification of Europe. Global Ecology and Biogeography, Vol. 14, pp. 549-563 Nicholls, J.N., Mimura, N. (1998), Regional issues raised by sea-level rise and their policy implications. Climate Research, Vol. 11, pp. 5-18. Olesen, J.E. at al. (2011) "Impacts and adaptation of European crop production system to climate change." European Journal of Agronomy, vol. 34, No. , pp. 96-112. Olesen, J.E., Bindi, M., (2004), Agricultural impacts and adaptations to climate change in Europe. Farm Policy Journal, Vol. 1, No. 3, pp. 36-46. Olesen, J.E.; Bindi, M.(2002), "Consequences of climate change for European agricultural productivity, land use and policy." European Journal of Agronomy, vol. 16, No. pp. 239-262. Osberghaus, D., Reif, C. (2010): Total Costs and Budgetary Effects of Adaptation to Climate Change: An Assessment for the European Union. ZEW - Zentrum fr Europische Wirtschaftsforschung / Centre for European Economic Research. Discussion Paper No. 10046. 41. Rosegrant M. W. et al. (2008), Climate Change and Agriculture. Threats and Opportunities. Deutsche Gesellschaft fr Technische Zusammenarbeit (GTZ). Rossi, S., Niemayer S. (2010), Monitoring droughts and impacts on the agricultural production: Examples from Spain, in Lpez-Francos A. (comp.), Economics of drought and drought preparedness in a climate change context . Zaragoza : CIHEAMIAMZ/FAO/ICARDA/GDAR/CEIGRAM/MARM, p. 35-40. Schrter, D. et al. (2005), Ecosystem supply and vulnerability to Global Change in Europe. Sciencexpress, vol. 27, October, pp. 1-10.

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Tol, R. (2009), The Economic Effects of Climate Change. Journal of Economic Perspectives, Vol. 23, No 2, pp. 2951. UNEP (2004), Impacts of summer 2003 heat wave in Europe. Environment Alert Bulletin No 4. Viner, D., Maureen, A. (1999), Climate change and its impacts on tourism. Report prepared for WWF-UK. Climatic Research Unit, University of East Anglia, 50. WHO (2010), Protecting health in an environment challenged by climate change: European Regional Framework for Action. Fifth Ministerial Conference on Environment and Health on Protecting childrens health in a changing environment. 9.

Acknowledgements This research was supported by the grants No CZ. 1.05/1.00/02.0073 and CZ 1.07/2.4.00/31.0056. The autors would like to express their gratitude for this support.

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9. Environmental policies of the EU: a case study of market-based instruments and internalization of environmental externalities from airborne pollution in the Czech Republic
Jan Melichar Charles University Environment Center Vojtch Mca Charles University Environment Center Milan asn Charles University Environment Center Abstract: Current set-up of economic instruments provides little incentive to abate air pollution generated by the Czech energy sector that predominantly uses coal as energy input. As a byproduct of energy production airborne pollution arises that imposes serious burden on society in the form of environmental externalities. External costs from coal power generation are considerable, ranging from 5.3 to 11.6 c/kWh. The current rates of emission charges and other economic instruments are too low, especially emission charges do not stimulate energy producers to any relevant abatement. Consequently, internalization rate accounting for emission charges and electricity tax does not exceed 6% of marginal external costs for any of the coal power plants under assessment. If we assume cross-subsidy for promotion of electricity from renewables as another internalization measure then the internalization rate attains up to 70%.

1. Introduction In this chapter we investigate marginal external costs of electricity production, marginal abatement costs for key air pollutants and compare them to pollution charges and ecological taxes in the Czech Republic to assess their effectiveness and contribution to external costs internalization. Regarding the assessment, the estimation of external costs followed up the ExternE methodology and the results have been derived in a European Commission (EC) funded integrated research project NEEDS.73 The assessment of abatement cost curves comes from RAINS model.74 The chapter is structured as follows the second part sketches key theoretical fundamentals of optimal taxation; the third part provides a brief overview of the Czech energy market, while fourth part introduces the methodology of calculation of external and abatement costs. The fifth part is devoted to estimation of marginal external costs for combustible energy technologies and abatement cost curves for airborne pollutants. The sixth part provides comparison of marginal external and abatement cost curves and with pollution charges. The seventh part deals with assessment of internalisation of external costs using environmental taxes and charges levied on emission and/or energy products as well as subsidies for
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New Energy Externalities Developments for Sustainability (NEEDS), EC 6th RTD framework programme project no. 502687, see www.needs-project.org for more details. 74 The Regional Air Pollution Information and Simulation (RAINS) is model developed by the International Institute for Applied Systems Analysis (IIASA). RAINS model calculates, for a given energy and agricultural scenario, the costs and environmental effects of user-specified emission control policies. More detailed information could be found at http://www.iiasa.ac.at/rains/review.

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renewable electricity generation. The last part summarizes the results and discusses the main obstacles to higher levels of internalisation. The scope of assessment is however, somehow limited. In particular, we do not look at external costs of the entire fuel-cycle of electricity generation, therefore external costs incurred as well as taxes and charges levied in upstream and downstream processes (e. g. mining) are not accounted for. We also refrain from including CO2 emission trading in EU in our assessment of abatement and internalisation. While ETS is seen as one of the influencing factors for choice of energy sources recent experiences from the first ETS trading period (2005-2007) show that little or no internalisation has taken place due to excessive total cap on emissions (i.e. over-allocation). 2. Theoretical fundamentals of optimal environmental taxation Presence of externalities75 involves deviations from the first-best neoclassical world in that the price mechanism takes care of socially optimal (Pareto efficient) resource allocation. In such situation market fails to ensure optimal allocation due to the fact the market prices no longer reflect social costs and benefits and therefore do not provide proper signals for economic agents. Presence of the externality could be avoided by making its external effect internal to the economic process (Mishan, 1971), or by introducing regulation. Internalization occurs on voluntary basis without an intervention of any authority. It involves either a gathering of interest between the supplier and the receptor of the external effect, or the creation of a market on which the externality is traded. The latter requires the assignment of property rights, after which negotiations will lead to the social optimum (Coase, 1960). A transaction which compensates for the receptors welfare effect due to the externality is then driver of the externality problem solution. However, as shown by Verhoef (op. cit.), the compensation does not necessary imply its optimization, because it may induce inefficient behaviour of the victims of the effect. Moreover, negotiation or merging interest need not happen at all, if the transaction costs are prohibitively high. To restore the efficient workings of the market mechanism then, government need to intervene. Externality problem might be then solved by regulation introduced by means of price-based, quantity-based or command-and-control instruments. The idea to regulate market by introducing additional taxes or subsidies that would reduce the activity generating externality in order to ensure efficient working of the market comes from Pigou (1920). By setting the tax/subsidy rate virtually any goal in terms of reduction (increase) in negative (positive) externality can be reached. An optimum is only reached at the point where reduction of marginal damage, i.e. benefit, equals to marginal reduction in private benefit induced, for instance, ceteris paribus by additional increase in abatement costs. At that point, (optimal) tax rate equals to marginal external costs generated by the activity concerned and marginal social costs, i.e. sum of marginal external and private costs, coincide with marginal private benefits. Such instrument is called Pigovian tax or subsidy. Pigovian taxes tend to be known today as pollution charges, and some examples of charges which approximate Pigovian taxes do exist. Hereinafter in the text, we call the Pigouvian tax as the
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An external effect exists when an actors (the receptors) utility (or profit) function contains a real variable whose actual value depends on the behaviour of another actor (the supplier), who does not take these effects of his behaviour into account in his decision making process, cf. Verhoef (2002: 197-214). Moreover one should distinguish technological external effects from pecuniary external effects. While the former presents real externalities that existence justifies an intervention to correct inefficient market workings, the later describes usual market situations in that utility or profit of one agent is influenced directly through price system and not directly. In the case of pecuniary externalities, there is no effect on efficient working of market and any intervention can be justified.

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optimal Pigouvian tax, although we acknowledge that this holds only in the first best setting with no need for tax revenues. In similar vein, we use here the optimal level of emission induced by the optimal Pigouvian tax, despite this emission level might differ from the level induced by the optimal tax defined in the second-best world. We discuss this point briefly below. A distinctive feature of pollution charges is that they should encourage the installation of pollution abatement (or control) equipment. Thus, it is possible to remove particulate matters and sulphur dioxides from stacks with precipitators and scrubbing equipment, to treat flue gases before they are emitted to air. In Figure 1 we plot a marginal external cost (MEC) curve that depicts the value of the extra damage done by pollution (measured in kilotonnes, kt) arising from the economic activity. We suppose that MEC curve is flat (horizontal), because for each additional tonne of pollutant discharged into the atmosphere, the damage costs increase by about the same amount. In reality it is likely to have a decreasing non-linear shape. The marginal abatement cost curve (MAC) is positively sloped, because the more pollution we abate, the higher the marginal cost of abatement. Figure 1: Optimal pollution: the abatement cost-external cost approach

Source: Pearce and Turner (1990) The optimal level of pollution in Figure 1 is where MAC = MEC, i.e. at point a where the actual economic benefits (marginal external costs avoided) from reducing emissions is equal to the marginal cost of reducing such amount of emissions. Finally, the optimal Pigovian tax is t*, which is equal to MEC at the optimal level of pollution and MAC at the same pollution level (Pearce and Turner, 1990). The second role of any tax is to raise public revenues. Unless a lump-sum tax is possible to implement, authority need to rely on distortionary taxes to ensure public revenues. The presence of distortionary taxes, i.e. the second best setting, however, violate conditions for Pareto optimality and also affect the first-best rule for correcting externality based on the Pigou rule. Sandmo (1975) is the first to acknowledge the presence of distortionary taxes in setting the optimal tax on polluting goods. He formulates so called additivity property of the optimal tax in that the Pigouvian rule enters the optimal tax formula for the polluting good additively (but still does not affect the optimal tax formulas for the non-polluting goods). Following his thoughts, the optimal environmental tax should consist of a revenue-raising, i.e.

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Ramsey term,76 and the externality correcting term, i.e. Pigovian, weighted by an inverse of marginal cost of public funds (MCPF).77 In other words, the optimal tax rate is a linear combination of the inverse elasticity rule and the marginal social damage. Marginal cost of public funds reflects the loss incurred by society in raising additional revenues to finance government spending. The larger disutility from reducing consumption due to a tax compared to utility due to additional tax revenue, the smaller weight has the Pigouvian component and the larger weight gets the Ramsey component in the optimal tax formulae as the objective of the tax is to collect revenues in the least distortionary way (Bovenberg and van der Ploeg, 1994). The authors also argue that whether the optimal environmental tax consists of both terms depends on the structure of the preferences and substitutability of non-polluting and polluting goods to leisure. If the preferences are separable, i.e. the quality of the environment does not influence households decisions about consumption and leisure, and non-polluting and polluting goods are equal substitutes to leisure, the Ramsey component is zero and the optimal tax on polluting good equals to the Pigouvian optimal tax weighted by inverse of MCPF. Bovenberg and de Mooij (1994) and Bovenberg and Goulder (1996) examine the relative size of the optimal second-best pollution within general equilibrium framework when consider a revenue-neutral tax reform (i.e. the revenue from polluting tax is used to reduce the distortionary tax). They find that the tax on polluting good not only affects the optimal consumption mix but also the labour/leisure choice. Increasing the tax on polluting good lowers the real after-tax wage, which lowers labour supply and thus exacerbates the distortions in the economy and raises the marginal social cost of emission abatement. As a consequence of increased social costs of abatement, the pollution tax must be lowered, i.e. set lower than the optimal rate of Pigouvian tax. They also found that whether the marginal cost of public funds is above or under unity depends only on the uncompensated wage elasticity of labour supply and on the labour taxation. In fact, MCPF is equal to unity, if the distortionary taxes are absent or if the labour supply is completely inelastic. In real conditions, in the case of positive labour tax, and if the uncompensated wage elasticity of labour supply is positive, the MCPF exceeds unity and thus the weight given to the Pigouvian term in the optimal tax formulae gets value smaller than the unity. Fuest and Huber (1999) then examine the optimal environmental tax for separable utility further and conclude that the optimal tax on polluting good may exceed the optimal Pigouvian rate, if non-polluting and polluting goods are gross substitutes (under commodity tax system) or if leisure and polluting good are gross complements (under labour tax system). All of these papers considered preferences that assumed either separability in labor supply, homotheticity or both while analysing the optimal environmental tax. Utilizing quite different perspective while examining the optimal environmental tax rate, Cremer, Gahvari and Ladoux (1998) investigate the polluting tax under the perspective of information about individual versus aggregate consumption available to the government. Cremer, Gahvari and Ladoux (2003) extend their analysis further towards the redistributive role of the polluting tax and conclude that the optimal polluting good tax rate must be below the marginal social damage.78
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Ramseys optimality condition for the simplest case requires that the tax levied on each consumption good should cause equal proportional reductions in the demand for each good. It results in Ramseys inverse elasticity rule that requires to tax less goods with higher price elasticity of demand (for the case of independent demands). 77 As further found by Sandmo (p. 92), since the Pigouvian tax component enters the formulae for the polluting consumption commodity only the fact that a commodity involves a negative externality is not in itself an argument for taxing other commodities which are complementary with it, nor for subsidizing substitutes. 78 In fact, the story on optimal taxation does not end at this point; since 80s, the debate on optimal environmental taxation has been closely connected to the double dividend hypothesis arguing that the optimal tax rate might be above the Pigouvian rate when the revenues raised by environmental tax would be used to cut some distortionary taxes.

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3. Czech energy sector overview Today, it is already two decades when the transformation of the Czech economy has been started. The economy has gone through the transformation from central planning economy to market based economy. The energy sector has also undergone the transformation over this period. The former energy monopolies have been restructured and partially privatized, the prices of fuels have been liberalised. The market reforms in the natural gas and electricity sector have introduced the competition on these markets and compliance with the EU energy directives. Table 1: Energy production, consumption, GDP and population
Indicator TPES (Mtoe) GDP (2000 bil. USD) TPES/GDP Population (millions) TPES/population Electricity Consump. (TWh) Electricity Generated (TWh) 1973 45.40 41.04 1.11 9.92 4.58 29.50 41.17 1980 47.23 48.67 0.97 10.33 4.57 37.90 52.66 1990 48.98 55.30 0.89 10.36 4.73 48.20 62.27 2000 40.41 56.70 0.71 10.27 3.93 49.40 72.91 2005 45.22 68.20 0.66 10.23 4.42 55.30 81.93 2010 42.33 77.62 0.55 10.48 4.04 .. 85.32

Source: OECD and IEA (2011) Energy market reforms, stricter emission regulations and energy investments have improved the Czech environmental performance in terms of classical airborne pollutants, greenhouse gas emissions, heavy metals and organic compounds. At the same time, energy efficiency has improved but remains still lower than the average in OECD Europe. Energy production, both electricity and heat is predominantly based on coal. The major sector consuming the largest amount of electricity is industry. Nevertheless, coal use is expected to fall in future. The difference will be made up with a mixture of gas, nuclear power and, to a lesser extent, oil. Figure 2: Gross electricity production, 1973 to 2010 (TWh)

Source: OECD and IEA (2011) In 2010, Czech energy intensity, as measured by TPES (Total primary energy supply) per capita, was 4.04 tonnes of oil equivalent (toe) per capita. This is 20% above the average for the OECD European countries. The Czech Republics TPES in toe over its national GDP (in thousands of 2000 US dollars PPP), was 0.55 toe per US$ 1,000. This was more than 70% higher than the average for OECD European countries. Table 1 shows the evolution of aggregate energy intensity figures and figures in energy production, consumption, GDP and population in the period of 1973-2010 (OECD and IEA, 2005).
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Concerning on power sector, coal-fired power plants are the dominant technology for Czech electricity generation. In 2010, coal-fired plants accounted for 58% of generation. Nuclear power is the only other major generating technology accounting for 32% of generation. In 2010, coal and nuclear combined accounted for 90% of all Czech electricity generation. The evolution of electricity generation by fuel type is shown from 1973 to 2010 in Figure 2. Net maximum electricity generating capacity of Czech power plants was 17.9 GW in 2009; see Table 2. Electricity is predominantly generated by main producers with 16.14 GW of installed capacity. Table 2: Net maximum electricity generating capacity (GW)
1990 Main Activity Producers Nuclear Hydro Wind Solar Combustible Fuels Autoproducers Hydro Combustible Fuels Capacity in Total 1.8 1.4 10.2 0.1 1.9 15.3 1995 1.8 1.4 9.1 0.0 1.5 13.8 2000 1.8 2.0 9.2 0.1 2.3 15.3 2005 3.8 2.0 0.03 9.3 0.2 2.1 17.4 2008 3.8 2.0 0.15 0.05 9.8 0.2 1.8 17.7 2009 3.8 2.0 0.19 0.47 9.6 0.2 2.0 18.3

Source: OECD and IEA (2011) Power plants that burn combustible fuels account for 60%, two nuclear power plants account for 24%, and hydro power plants account for 13% of installed capacity. 4. Methodology on External and abatement costs assessment 4.1. Valuation of external cost using ExternE methodology In late 1980s, first studies related to the energy external cost assessment has been introduced (see Hohmeyer, 1988; Ottinger et al., 1990). Most of these studies relied on a top-down approach, which means that total damage expressed in monetary units is aggregated for the entire country and then disaggregated among particular pollution sources. This approach however does not take into consideration local conditions and time variability of the damage caused by emissions from pollution source. Since 1991 the research project series under acronym ExternE (Externalities of Energy) has been launched by the European Commission. During the 90-ties significant progress was reached in the field of quantification of external costs (European Commission, 2005). By itself the ExternE methodology is based on a bottom up approach, so called IPA - Impact Pathway Analysis. IPA allows evaluation of external cost for a certain place and technology (thus taking into account local and regional meteorological conditions, population density, fuel specification, installed capacity). In the first step, IPA tracks all pathways of the particular pollutant from the point where is emitted to the affected receptor (peoples human health, agricultural production, ecosystems, and building materials. In the next step the relation between increase in pollutant concentration and physical impact on receptors is determined. For this purpose various concentration-response functions are used (e.g. increase in asthma attack as a consequence of higher ambient air concentration of particulate matters). Physical impacts are then transformed into monetary values using either market prices (if available) or as change in welfare due to damage to human health or
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environment expressed as willingness to pay (WTP) or willingness to accept (WTA) for such change. General approach of the ExternE methodology is similar (in terms of the entire fuel cycle) to the LCA (Life Cycle Analysis) where a site specific IPA is conducted for all stages of LCA. Considering generation of electricity in power plant then this is one part of many stages of LCA for which external costs are calculated. The operation part of electricity production is connected with up-stream (transport, mining, construction of power plant etc.) and downstream (electricity transport, waste disposal, decommissioning of power plant etc.) processes. 4.2. External cost calculation procedure Following the ExternE methodology and utilizing the newest updates and improvements to the method, the marginal external costs for the Czech power generation have been computed. For each type of main fuel, we have selected several reference power plants corresponding to the fuel mix of the Czech Republic. Implementing ExternE methodology in the Czech Republic was constituted on expressing the external costs for the most relevant fuel cycles. Because of the lack of primary data related to upstream and downstream processes, we have focused our analyses on the operation of power plant. Upstream and downstream processes were omitted from the analysis. Several branches of power generating technologies were analyzed because of their current and future importance to electricity production in the Czech Republic. For simplicity we present the results only for coal-fired power plants burning hard coal, brown coal or lignite79. We calculated and computed impacts of SO2, NOX, PPM10 and PPM2.5, NMVOC and heavy metals (Cd, As, Cr, Cr-VI, Ni, Hg, Pb) on human health (public health mortality and morbidity), crops (nitrates, sulfates, and ozone), building materials (corrosion by acid deposition), impacts of micropollutants on human health, biodiversity loss due acidification and eutrophication, and finally climate change impacts. For the external cost assessment of airborne pollutants, we used the assessment model EcoSenseWeb (version 1.3) that calculates the impacts in local, regional and hemispheric resolution. Considering climate change impacts, we have used default value 192000/t CO2equiv based on avoidance cost approach. 4.3. Abatement costs valuation procedure The marginal abatement costs curves for combustible sources of pollution were derived from the RAINS model. The Regional Air Pollution Information and Simulation developed by the International Institute for Applied Systems Analysis (IIASA) combines information on economic and energy development, emission control potentials and costs, atmospheric dispersion parameters and environmental sensitivities towards airborne pollution. The RAINS model estimates, for a given energy- and agricultural scenario, the costs and environmental impacts of selected emission control policies. A non-linear optimisation mode is generally used to identify the cost-minimal combination of emission controls meeting air quality targets, taking into account regional differences in emission control costs and atmospheric dispersion characteristics. The RAINS models the effects of sulphur dioxide (SO2), nitrogen oxides (NOX), ammonia (NH3), non-methane volatile organic compounds (VOC), and primary emissions of fine (PM2.5) and coarse (PM10-PM2.5) particles. The RAINS model also includes estimates of
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The external costs from nuclear power generation and other combustible technologies (natural gas, heavy oil, energo gas, biomass and biogas) are not reported here. The results from this fuel cycle could be found in Melichar and Havrnek (2009).

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emissions of relevant greenhouse gases such as carbon dioxide (CO2) and nitrous oxide (N2O). Emission control options in RAINS are achieved through the technical measures (end-ofpipes) that capture emissions at their sources before they can enter the atmosphere. Emission reductions achieved through these options neither modify the driving forces of emissions nor change the structural composition of energy systems or agricultural activities80. The RAINS contains databases with a large number of pollutant-specific end-of-pipe measures and assesses their application potential and costs. Thus, the RAINS model restricts the endogenous analysis to end-of-pipe control measures. The basic intention of a cost evaluation in the RAINS model is to identify the values to society of the resources diverted in order to reduce emissions in Europe. The central assumption for the RAINS cost calculation is the existence of a free market for abatement equipment throughout Europe that is accessible to all countries at the same conditions. Thus, the capital investments for a certain technology can be specified as being independent of the country. Simultaneously, the calculation routine takes into account several country-specific parameters that characterize the situation in a given region. The expenditures on emission controls are differentiated into: investments, fixed operating costs, and variable operating costs. From these three cost components RAINS calculates annual costs per unit of activity level. Next, these costs are related to tonne of pollutant abated. Some of the parameters are considered common for all countries. These include technology-specific data, such as removal efficiencies, unit investment costs, fixed operation and maintenance costs, as well as parameters used for calculating variable cost components like extra demand for labour, energy, and materials. Country-specific parameters characterize more closely the type of capacity operated in a given country and its operation regime. To these parameters belong: average size of installation in a given sector, plant factors, annual fuel consumption and/or mileage for vehicles. In addition, the prices for labour, electricity, fuel and other materials as well as the cost of waste disposal also belong to that category. For each emission scenario RAINS creates a so-called emission reduction cost curve. Such cost curves define - for each country and year - the potential for further emission reductions beyond a selected initial level of control and provide the minimum costs of achieving such reductions. For a given abatement level, a cost-optimal combination of abatement measures is defined. Cost curves are compiled by ranking available emission control options for various emission sources according to their cost-effectiveness and combining them with the potential for emission reductions determined by the properties of sources and abatement technologies. Based on the calculated unit cost, the cost curve is constructed first for every sector and then for the whole region (country), employing the principle that technologies characterized by higher costs and lower reduction efficiencies are considered as not cost-efficient and are excluded from further analysis. The marginal costs (costs of removing an additional unit of pollutant by a given control technology) are calculated for each sector. The remaining abatement options are finally ordered according to increasing marginal costs to form the cost curve for the country being considered. RAINS computes two types of cost curves:
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The change in structural composition could be model by the Greenhouse Gas and Air Pollution Interactions and Synergies (GAINS) also developed by IIASA, see http://gains.iiasa.ac.at

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 The total cost curve displays total annual costs of achieving certain emission levels in a country. These curves are piece-wise linear, with the slopes for individual segments determined by the costs of applying the various technologies. The marginal cost curve is a step-function, indicating the marginal costs (i.e., the costs for reducing the last unit of emissions) at various reduction levels (Amann et al., 2004). The national cost curve for the Czech Republic, the total and marginal abatement costs were derived for large combustible sources, i. e. for activities such as electricity and heat production, and technological processes. In order to estimate the national cost curve for SO2, NOX and PM2.5 for the Czech Republic, we have determined the emission scenario under which the cost curves are calculated. We have selected the scenario Official national energy projections with climate policies and national agricultural projections NAT_CLE_Aug04(Nov04) for which the marginal abatement cost curves were calculated. The results were calculated for 2000 using 4% discount rate. 5. Results 5.1. Marginal external costs of electricity production in combustible sources The marginal external costs for coal-fired power plant are in range between 5.3 and 11.6 c/kWh according to the type of coal fired in a boiler. Higher external costs are related to power plants combusting lignite of low quality (see Figure 3). The major external costs are attributed to human health climate change impacts, the damages due to building material corrosion, change in agricultural production, biodiversity loss and impacts of heavy metals are negligible. Figure 3: External costs for combustible-fired power plants (2011, c/kWh)

Source: Own calculations using EcoSenseWeb 1.3 Notes: HC hard coal, BC brown coal, LI lignite, BM biomass, number denotes installed capacity (MWel). External costs were also expressed in terms of unit cost per 1 tonne of classical pollutant emitted. Figure 4 depicts these results for SO2, NOX and PM emissions from high stack combustible sources. Particulate matters bring about the highest unit external costs; on per tonne basis amounting to 20,839 for PM10 and 20,151 for PM2.5. For NOX emissions we obtained damage about 9,530 per tonne. The external costs of SO2 emissions are comparable to NOX, we estimated the unit external cost for 1 tonne of SO2 in the amount of 9,680 in the 2010 price level.
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Figure 4: Unit external costs per tonne of classical pollutant (2011, /tonne)

Source: Preiss et al. (2008) 5.2. Marginal abatement cost curves for large combustible sources The marginal abatement cost curves for SO2, NOx and particulates are depicted in Figure 5 The marginal abatement cost curves for SO2 (dashed line) starts at 171.89 kt of SO2 (initial level of emission) and allows for emission reduction by 21.06 kt of SO2. The marginal abatement costs for the initial level of emission are about 503 for 1 ton of SO2 and the highest marginal abatement is estimated at 15,379 per ton. The average value for this national cost curve is 2,941 expressed in 2011 price level. Figure 5: Marginal abatement cost curves for SO2, NOX and PM (2011, /tonne)

Source: IIASA RAINS model The increasing step-wise function of marginal abatement cost for NOX emissions is depicted by light grey line in the graph. The initial level of emissions is 280.3 kt of NOX and technically feasible emission abatement is 79.29 kt of NOX. The marginal abatement costs start at 223 for 1 tonne of NOX and the highest marginal costs for NOX reduction amount to 41,027 . The average value is 4,825 . The last marginal abatement cost curve was derived for PM10 (depicted by dotted line in the graph). The initial level of PM10 emissions is 81.12 kt and technically feasible abatement is 19.59 kt of PM10. The marginal costs for the initial level of emission amount to 63 for 1
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tonne of PM10 and the highest marginal costs are 218,680 . The average value for this national cost curve is 11,655 . 6. Comparison of MEC, MAC and emission charges 6.1. Marginal external and abatement costs curves As discussed in the first chapter optimal level of pollution is to be found at the point where reduction of additional damage equals to additional increase in abatement costs. Hence, one needs to compare (marginal) external cost per unit of pollution with marginal abatement costs of such unit of pollution. Given the differences in both external costs and abatement costs of different pollutants this can only be done on pollutant per pollutant basis in spite of often synergic (or antagonistic) effects of various abatement measures affecting more than just one pollutant. In contrast to the classical illustration of optimal pollution the following graphs are somewhat different. While marginal-cost curve is positively sloped (because the more pollution we abate, the higher are marginal costs of abatement), marginal-benefit curve is flat horizontal since it seems plausible to adopt constant marginal effect as almost no thresholds in damage functions used in calculation of external costs is assumed at present. The following Figure 6 shows that at current level of sulphur dioxide emission (about 170 kilotonnes per year in 2006) we were emitting about 20 kilotonnes more than an optimum would be if the costs of abatement technologies for large pollution sources are considered. Interestingly, about of emission reduction is achievable at costs below 2000 /kilotonne, what compared to marginal benefit from reduction of external costs suggests around fourfold cost-effectiveness ratio. Only then the slope of the abatement cost curve starts to be steep and additional reduction relatively less cost effective. Figure 6: Optimal levels of emissions

Source: IIASA RAINS model (Amann et al., 2004), Preiss et al. (2008) and own calculations

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A very similar picture can be drawn in case of nitrogen oxides emissions. While about 280 kilotonnes are released annually, an optimum at intersection of marginal costs of abatement and marginal benefits of unit pollution reduction is below 205 kilotonnes annually. As in the previous case the abatement cost curve for large pollution sources becomes steep only close to the optimum level of pollution suggesting a high cost-effectiveness ratio for most of the emission reduction. In case of particulates (PM10) the optimal pollution level would mean about 18.5 kilotonnes lower emissions than actually has taken place with around 81 kilotonnes being emitted. This time the shape of abatement cost curve for large pollution sources is extremely steep around the optimum point but the reduction in total emissions to around 63.7 kilotonnes is achievable at abatement costs more than ten times lower than marginal benefit of such emission reduction. 6.2. Marginal abatement costs compared to emission charges We have demonstrated that current set-up of economic instruments provides little incentive to abate pollution. Current emission charges have too low rates and do not reap dynamic efficiency potential, see Table 3. Table 3: Air pollution charges (in EUR2011/tonne)
Pollutant SO2 NOX TSP NMVOC heavy metals Charge rate charges 41 32.5 122 81 813

Source: Air Protection Act Figure 7: Marginal abatement cost curves vs. current air pollution charges

Source: IIASA RAINS model (Amann et al., 2004), Preiss et al. (2008) and own calculations

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The current SO2 rate of 41 /tonne doesnt intersect lower end of abatement cost curve as shown in the following Figure 7. The intersection could happen, if the air pollution charge were 500 /tonne of SO2, i.e. twelve times higher than current rate. The same situation holds for the current NOX rate, 32.5 /tonne of NOX, for which the rate need to be 7 times higher in order to provide incentive to abate this pollutant. The current level of TSP charge, 122 /tonne TSP, will motivate polluters to abate only meagre 20 tonnes of PM10. 7. InternaliZation using market-based instruments To assess the internalisation of external costs the most straightforward approach is to compare estimated external costs and environmental taxes and charges levied upon the emissions of pollutants from electricity generation or upon the electricity consumption. In a first best situation a Pigovian tax (or subsidy) would have its rate equal to marginal external costs what will induce an optimal level of pollution. For this purpose we compare current level of external costs with current rates of air pollution charges, electricity tax as well as cross-subsidy for promotion of electricity generation from renewable sources charged at the top of consumer price of electricity. A summary overview of these price-based instruments is given in following Tables 4 and 5. Table 4: Air pollution charges Pollutant CZK/tonne EUR/tonne particulates 3 000 122 SO2 1 000 41 NOX 800 33 NMVOC 2 000 81 heavy metals 20 000 813 CO 600 24 NH3 1 000 41 CH4 1 000 41 PAHs 20 000 813 Source: Air Protection Act Table 5: Electricity tax and top-up for promotion of renewable electricity rates CZK/MWh EUR/MWh Electricity tax 28.3 1.15 RES-E top-up 40 15 Sources: Act no. 261/2007 Coll., Energy Regulatory Office In the following Figure 8 we provide the comparison of external costs and internalization rates for major coal fired power plants. We exclude external costs pertaining to climate change effects from total as these are to be internalised through EU emission trading scheme in the first place. The results, when only air pollution charges and electricity tax are accounted for, are rather unsatisfactory as the internalisation rate does not exceed 6% in any of the six coal-fired power plants assessed. The worst case is lignite firing power plant (LI_BM 105) with highest unit external costs and lowest internalisation rate.

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Figure 8: Internalization rates charges and taxes (without climate change effects)

Source: own calculations Note: marginal external costs are represented as dots and the right-hand vertical axis, internalization rate using pollution charges and electricity tax is represented using bars and the left-hand vertical axis. A substantially different picture arises when we assess the level of internalisation also by surcharge for promotion of renewable electricity (Figure 9). Then the internalization rate ranges between 20% and 70% of external costs (again without considering climate change related externalities). Hard coal fired power plant (HC_BC 800) scores the higher internalization rate (and lowest marginal external costs), the lowest internalization level again scores lignite fired power plant (LI_BM 105). To sum up our results suggest that the lower the marginal external costs are the higher is the internalization rate. This is due to effect of flat rates (i.e. per kilowatt-hour) of electricity tax and renewable electricity support surcharge. Figure 9: Internalization rates charges, taxes and RES surcharge (without climate change effects)

Source: own calculations This finding reveals an unsatisfactory setting of market based instruments in striving for optimality. In fact, the two instruments levied on the output can only provide incentive for more electricity from renewables but give no signal to fossil fuel fired generators as the only
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alternative for offsetting the tax/surcharge burden (aside from switching to renewables) is to produce less output, i.e. kilowatt-hours. If electricity producer reduces amount of pollution emitted while retaining the output unaffected they will only benefit in meagre reduction in pollution charges levied. One should however be aware of different nature and goal of market-based instruments that were considered as internalisation measures. While emission charge is a typical representative of Pigovian taxes it is not the case with electricity tax or cross-subsidy for renewable electricity. The intricate situation can be demonstrated on cross-subsidies for renewable electricity. The key variable in the formula set for calculation of feed-in tariff (and similarly for green bonus) is the investment payoff in specified period for particular renewable electricity generating technology regardless its environmental performance. Consequently, a subsidy is paid for biomass burning generator even if it has higher marginal external costs than comparable natural gas fired generator. With respect to energy taxation, the tax on output electricity as currently harmonised in Energy Taxation Directive only allows for facultative exemption of electricity generated from renewable sources or in highly efficient combined heat and power generators. 8. Conclusions In this chapter we undertake to assess external costs due to atmospheric emissions from electricity generation, what are the costs of abating major air pollutants, and whether emission charges and other economic instruments (energy taxation and subsidy-like measures) motivate to emission reduction and external cost internalization. The external costs for six large coal fuelled power plants were estimated to be between 5.3 and 11.6 c/kWh consisting dominantly by health impacts and climate change impacts. Remaining impact categories included in external cost quantification building material corrosion, change in agricultural production, biodiversity loss and impacts of heavy metals are of marginal importance. Next we demonstrate that current set-up of economic instruments provides little incentive to abate pollution. Based on GAINS model estimates we derive marginal abatement cost curves for three major air pollutants. By comparing abatement cost curves with unit external cost for each pollutant we demonstrate what the optimal abatement will be in first best setting. We then show that current emission charges have too low rates to stimulate any relevant abatement and consequently do not reap dynamic efficiency potential. In the similar vein we find that internalization rate does not exceed 6% of marginal external costs for any of the power plants in our assessment when accounting for emission charges and electricity tax only. This outcome changes completely with assuming cross-subsidy for promotion of electricity from renewables as internalization measure; then the internalization rate attains up to 70%. We however show that both electricity tax and renewable electricity cross-subsidy can hardly be taken as internalization measures. As output (quasi-)taxes they are more likely to promote energy efficiency (and renewable electricity generation) rather than directly affecting emission intensity of particular generation technology. References
Amann, M., Cofala, J., Heyes, C., Klimont, Z., Mechler, R., Posch, M., Schpp, W. (2004), RAINS Review 2004. The RAINS model. Documentation of the model approach prepared for the RAINS peer review 2004. Austria: International Institute for Applied Systems Analysis. Bovenberg A. L., de Mooij, R. A. (1994), Environmental Levies and Distortionary Taxation. The American Economic Review, Vol. 84, pp. 1085108. 124

 Bovenberg A. L., van der Ploeg, F. (1994), Environmental Policy, Public Finance and the Labour Market in a Second-Best World. Journal of Public Economics, Vol. 55, pp. 349390. Bovenberg, A. L., Goulder, L. H. (1996), Optimal environmental taxation in the presence of other taxes: general equilibrium analyses. American Economic Review, Vol. 86, pp. 9851000. Coase R. H. (1960), The Problem of Social Cost. Journal of Law and Economics, Vol. 3, pp. 1 44. Cremer, H., Gahvari, F., Ladoux, N. (1998), Externalities and optimal taxation. Journal of Public Economics, Vol. 70, 343364. Cremer, H., Gahvari, F., Ladoux, N. (2003), Environmental taxes with heterogeneous consumers: an application to energy consumption in France. Journal of Public Economics, Vol. 87, pp. 2791 2815. European Commission (2005), ExternE: Externalities of Energy, Methodological 2005 Update. European Commission, Directorate-General for Research. Luxemburg: Office for Official Publications of the European Communities. ISBN 92-79-00423-9. Fuest, C., Huber, B. (1999), Second-best Pollution Taxes: An Analytical Framework and Some New Results. Bulletin of Economic Research, Vol. 51, Issue 1, pp.3138. Hohmeyer, O. (1988), Social Costs of Energy Consumption, Berlin: Springer Verlag. Melichar, J., Havrnek, M. (2009), National Implementation of the ExternE: the Czech Republic. Paper n 5.1 - RS 1d. IP NEEDS: New Energy Externalities Developments for Sustainability. Luxemburg: European Commission. Mishan E. J. (1971), The postwar literature on externalities: an interpretative essay. Journal of Economic Literature, Vol. 9, pp. 128. OECD, IEA (2005), Energy Policies of IEA countries: The Czech Republic 2005 Review. Paris: International Energy Agency. OECD, IEA (2011), Electricity information 2011 with 2010 data. Paris: International Energy Agency. Ottinger, R. L., Wooley, D. R., Robinson, N. A., Hodas, D. R., Babb, S. E. (1990), Environmental Costs of Electricity, New York: Oceana Publications, Inc. Pearce, D., Turner, R. K. (1990), Economics of Natural Resources and the Environment, Baltimore: The Johns Hopkins University Press. Pigou A. C. (1920), The Economics of Welfare, London: Macmillan. Preiss, P., Friedrich, R., Klotz, V. (2008), Report on the procedure and data to generate averaged/aggregated data. Deliverable n 1.1 - RS 3a. IP NEEDS: New Energy Externalities Developments for Sustainability. Luxemburg: European Commission. Sandmo A. (1975), Optimal Taxation in the Presence of Externalities. The Swedish Journal of Economics, Vol. 77, No. 1, pp. 8698. Verhoef E. T. (2002), Externalities. in van der Bergh J. C. J. M., ed., Handbook of Environmental and Resource Economics. Chelterham: Edward Elgar, pp. 197214.

Acknowledgement This chapter is based on research carried out in the EC 6th RTD framework program project New Energy Externalities Developments for Sustainability (NEEDS), contract no. 502687 and the R&D project SPII/4i1/52/07 Modelling of Environmental Tax Reform Impacts: The Czech ETR Stage II (MODEDR) funded by the Ministry of the Environment of the Czech Republic, support for which is gratefully acknowledged.

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Authors index:
Dr. Jan Andr (jan.andrae@tu-dresden.de) is a Lecturer at Technische Universitt Dresden, Faculty of Business Administration and Economics, Chair for International Economics, 01062, Dresden, Germany. Dr. Tomasz Brodzicki (t.brodzicki@ug.edu.pl) is an Assistant Professor at the University of Gdansk, Faculty of Economics, Economics of European Integration Division, ul. Armii Krajowej 119/121, 81-824 Sopot, Poland as well as Research Fellow in the Institute for Development (Instytut Rozwoju). Professor Udo Broll (udo.broll@tu-dresden.de) is a Professor at Technische Universitt Dresden, Faculty of Business Administration and Economics, Chair for International Econonics, 01062, Dresden, Germany. Mgr. Zuzana Cahlkov (zuzana.cahlikova@gmail.com) is a Research Fellow at Global Change Research Centre AS CR, v.v.i., Blidla 986/4a, 603 00 Brno, Czech Republic. Mgr. Barbora Du (arobrab@centrum.cz) is a Research Fellow at Global Change Research Centre AS CR, v.v.i., Blidla 986/4a, 603 00 Brno, Czech Republic. Vojtch Mca (vojtech.maca@czp.cuni.cz) is a senior researcher at Charles University Environment Center, Jos Martho 2/407, 162 00 Prague 6, Czech Republic. Jan Melichar (jan.melichar@czp.cuni.cz) is a senior researcher at Charles University Environment Center, Jos Martho 2/407, 162 00 Prague 6, Czech Republic. Dr. Eithne Murphy () is a Researcher at SEMRU (Socio-Economic Marine Research Unit), J.E. Cairnes School of Business and Economics, National University of Ireland Galway. Mr. Petr Novak (petr@notreeurope.com) is a Policy Advisor to the European Parliament. Previously, he was a Personal Assistant to Andrzej Weloweyski, MEP and Andrew Duff, MEP. Dr. Wadim Strielkowski (strielkowski@fsv.cuni.cz) is a Lecturer at the Institute of economic studies, Faculty of social sciences, Charles University in Prague. Previously, he worked as the Research Fellow at the University of Nottingam, UK and as a Development and PR manager at CERGE-EI Prague. Milan asn (milan.scasny@czp.cuni.cz) is a senior researcher at Charles University Environment Center, Jos Martho 2/407, 162 00 Prague 6, Czech Republic. Prof. RNDr. Frantiek Turnovec, CSc. (turnovec@fsv.cuni.cz) is a Professor of Economics at the Institute of economic studies, Faculty of social sciences, Charles University in Prague. He was awarded a Jean Monnet Professorship for his advancements and teaching of European Economic Integration. In 2000 he created the course on Advanced Microeconomics of European Integration that provided the inspiration for this book.

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Advanced Economics of European Integration: Selected Issues

by Frantiek Turnovec, Wadim Strielkowski et al.

Published by the Charles University in Prague, Faculty of social sciences Smetanovo nb. 6, 110 01 Praha 1, Czech Republic www.fsv.cuni.cz

ISBN 978-80-87404-33-1

First edition, 127 pages

Prague 2012

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Copyright 2012 by Frantiek Turnovec, Wadim Strielkowski, Petr Novk, Tomasz Brodzicki, Jan Andr, Udo Broll, Eithne Murphy, Zuzana Cahlkov, Barbara Du, Jan Melichar, Vojtch Mca, and Milan asn

URL: http://ies.fscv.cuni.cz/en/syllab/JEM081/