Gerber Ie7e PPT 14

International Economics
Seventh Edition
Chapter 14
The European Union:
Many Markets into One
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Learning objectives (1 of 2)
14.1 Describe the major institutions and treaty
agreements of the EU.
14.2 Distinguish EU widening from EU

deepening.
14.3 Explain the obstacles to regional

integration agreements.
Learning objectives (2 of 2)
14.4 Give the economic rationale for each of
the three waves of deepening of the EU.
14.5 State two theories as to why the single

currency moved forward so quickly.
14.6 Analyze the EU’s single currency program

within the theoretical framework of an optimal
currency area.
Introduction: The European Union
• The EU is an economic union of 28 nations.
– More than 500 million citizens.
– Over $16,200 billion in GDP.
• Founded in 1957 as an FTA called the European Economic

Community (EEC).
– By late 1960s, had become a customs union and in the 1970s
was renamed the European Community (EC).
– In 1992, the EC became a common market, as a result of the
Single European Act.
– At the same time, the Treaty of European Union changed the
name to the European Union and began the process of forming
an economic union with a common currency.
The European Union
Editor:
Please insert the map of the EU from Chapter
14, page 335 in the proof edit.
The size of the European market
(1 of 2)
Population GDP GDP per
(US$, Capita (US$
Billions) PPP)
Original members (6)
Belgium, France, Germany, Italy, Luxembourg, 235.8 8,845 42,581
Netherlands
Entered 1973–1995 (9)
Austria, Denmark, Finland, Greece, Ireland, 166.9 6,073 38,878
Portugal, Spain, Sweden, United Kingdom
Entered 2004-present (13)
Bulgaria, Croatia, Cyprus, Czech Republic, 104.7 1,302 25,563
Estonia, Hungary, Latvia, Lithuania, Malta,
Poland, Romania, Slovak Republic, Slovenia
Total 507.4 16,220 37,852
The size of the European market
(2 of 2)
• The EU market is comparable to the NAFTA region.
– 507 million versus 484 million in population.
– $16,220 billion versus $20,644 in GDP;
▪ But as the value of the euro changes, the dollar value of its GDP does
also.
• There are three groups of countries in Table 14.1:

– Original 6 founding members;
– Most of the rest of Western Europe;
– Central Europe.
• In 2016 Great Britain voted to leave the EU. If it does, it will

not occur before sometime in 2019.
The EU and its predecessors (1 of 5)
• In 1957, the six founding members signed the Treaty of
Rome, creating a FTA and the EEC.
– Developed out of the European Coal and Steel Community
(1951) which had created free trade in coal and steel.
– In 1955, talks were launched to form an FTA and to discuss
collaboration on nuclear power for peaceful purposes.
▪ These talks led to the EEC and to the European Atomic Energy
Community (EAEC or Euratom).
• A central topic for debate and negotiation was the terms of

their political affiliation.
– Centralization versus autonomy: subsidiarity.
– Institutional structure.
• Subsidiarity principle leaves to individual nations the
policies that do not have a strong international
dimension and centralizes those that do:
– EU policies: Trade, competition, environment, regional
development, research and technology development,
economic and monetary union;
– National policies: Labor standards, health care, social
safety nets.
• The division is not perfect and is a source of

controversy.
• The institutional structure is designed around three
main institutions, although there are others of
importance:
– The European Commission, the primary executive body.
– The European Council of Ministers, the most influential
legislative body.
▪ Participants vary by topic: When labor issues are under
discussion, labor ministers meet; when it is financial matters,
ministers of finance, etc.
– The European Parliament, the largest legislative body, and
growing in influence.
▪ Members are directly elected by citizens and sit with members
from other countries that are in the same political party.
Total Votes Minimum Maximum
European Commission 28 1 1
Council of the European Union 352 3 29
European Parliament 751 6 96
• The Commission is one country-one vote; other institutions have

votes proportional to population.
• Council votes require a qualified majority of 55% of countries

representing at least 65% of the population.
• The Parliament and the Council jointly pass laws although the
Council acts independently of Parliament in some areas.
• The EU budget in 2014 was approximately $156 billion
(£142.6 billion).
– Equals less than 1 percent of EU GDP;
– Compare to national governments that spend 30 to 50 percent of GDP.
• Revenue is derived from three main sources:

– A payment from each country (the largest source of revenue);
– Tariffs on goods entering the EU;
– An EU share of national value added taxes.
• Expenditures are primarily directed to two main areas:

– Agricultural support and rural development, about 43 percent;
– Cohesion funds to support economic development, about 50 percent of the
budget.
Deepening and widening in the 1970s
and 1980s (1 of 4)
• Deepening: Increasing the degree of integration.
– Moving from an FTA to a customs union to a common
market to an economic union.
– Includes exchange rate coordination before the single
currency was adopted.
• Widening: Adding new members.

– Growing from 6 members to 28 in separate waves.
– Political events, such as the collapse of the Soviet
Union and the fall of the Berlin Wall played essential
roles.
and 1980s (2 of 4)
• In 1979, EC members linked their currencies.
– Exchange rates were fixed to each other in the European
Monetary System (EMS).
– The EMS created the exchange rate mechanism (ERM).
▪ At the center of the EMS was the European currency unit (ECU): a
weighted average of the value of the member’s currencies.
▪ Each member fixed their currency to the ECU; they could let it
float up or down, but only within a few percentage points before
they had to intervene to pull it back.
• The purpose was to prevent competitive devaluations.
and 1980s (3 of 4)
• The EMS worked relatively well until the fall of the Berlin Wall in
1989.
• West Germany quickly decided to re-unify.

– By 1991, it was spending large sums to repair and upgrade
infrastructure and raise productivity in the eastern part of the country.
– German bonds were in high demand, so investors needed German
marks: the demand for the mark rose.
• The challenge for other countries was to stay within the EMS band
when their currencies were demanded less.
– Choices: raise interest rates and hurt the economy, or fail to raise
rates and hurt the EMS.
– This is the frequent dilemma of pegged (fixed) exchange rates: focus
on the internal economy or the external?
and 1980s (4 of 4)
• The EMS crisis of 1992 was resolved in different
ways by different countries:
– France raised its interest rates and went into
recession;
– Italy and the UK abandoned the EMS and returned to
floating exchange rates;
– Spain devalued but stayed in the EMS.
• In response to the crisis, the allowable bandwidth

for currency fluctuations was changed from ±2.25
percent to ±15 percent.
The Single European Act (1 of 4)
• Before the EMS crisis, economic growth rates in the EC were relatively low
and the community seemed stagnant.
• In 1987, leaders adopted the Delors Report in an attempt to reinvigorate

the EC.
– The Single European Act, or the Single Market Program (SMP) included 279
steps towards the creation of a common market.
– The ‘four freedoms” were the basis of the SMP: Freedom of movement for
goods and services (outputs) and capital and labor (inputs).
• By 1992, the 279 steps had been achieved; the steps fell into three
separate areas:
– Elimination of physical barriers (borders);
– Elimination of technical barriers (harmonization of standards);
– Elimination of fiscal barriers (harmonization of taxes, subsidies, public
procurement).
• Economic gains from the SMP were expected to come
from two main sources:
– Increased competition;
– Economies of scale.
• The results would be achieved through:

– More trade, lower prices, increased firm concentration.
– These effects were observed and GDP rose 1-1.5 percent
over what it would have been.
• In addition, there was a strong convergence in income

levels.
• Implementation of the SEA was not without problems:
– Restructuring of firms and industries caused some less
efficient firms to close; this happened throughout the
manufacturing sector, in particular.
▪ Some industries, e.g., automobiles, fought this and obtained a
separate set of tax laws to discourage cross-border shopping.
– Harmonization of technical standards included more than
10,000 cases, some of which were culturally sensitive:
▪ Food product standards such as German beer, Italian pasta, rosé
wine, English sausages, etc.;
▪ Businesses wanted their existing standards to become the official
standard;
▪ Ultimately settled for mutual recognition as well as harmonization.
• Implementation of the SEA was not without problems:
– Value added taxes were impossible to harmonize.
▪ These are a major source of revenue in most countries and their
levels vary significantly;
▪ Ultimately agreed to a range with a minimum of 15 percent and a
maximum of 25 percent.
– Rules for public procurement were also impossible to
harmonize:
▪ Problems of government versus private firms in different
countries, historical degree of regulation of private firms;
▪ Particularly an issue in telecommunications, pharmaceuticals, rail
transportation and equipment, or other areas considered critical
to national prosperity.
Case study: The Schengen Agreement
• Eliminates passport controls as part of the move to a common market and
the four freedoms.
– Originally outside EU law, but incorporated into the EU laws in 1999.
– Includes non-EU members such as Norway, Switzerland, Iceland.
• Ireland and the UK have not accepted the agreement;
• Tensions have arisen with the entrance of Central European countries such
as Poland, Bulgaria, Romania, etc.
• Tensions are further heightened by the refugee crisis in the Middle East.
– Once a person gains admission to an Schengen country, they can move
relatively freely around the EU.
– This has created a political crisis in the EU.
The Maastricht Treaty (1 of 5)
• The Treaty on European Union was negotiated in 1991
in the Dutch town of Maastricht, hence it is often
called the Maastricht Treaty.
– Officially creates an economic union;
– Establishes a common currency, the euro, under the
monetary authority of the newly created European Central
Bank (ECB).
– Accomplishes a number of other lesser goals in the areas
of tax laws, health and safety, etc.
• At the time, there were 12 members of the EC, not the

current 28.
• The euro was introduced in stages:
– First stage: Lift restrictions on the movement of financial capital
within the EU (1990).
– Second stage: Creation of the European Monetary Institute,
which would eventually become the ECB.
– Third stage: Phased introduction of the euro beginning in 1999.
• The stages were intended to give countries time to prepare

and to meet the convergence criteria:
– A set of monetary and fiscal targets.
– Goal: Ensure that each member’s policies are balanced and
under control.
Goals Targets
1. Stabilize exchange rates Maintain currency within the ERM band
2. Control inflation Reduce it to less than 1.5 percent above
the average of the three lowest rates
3. Harmonize long-term Bring to within 2 percent of the average of
interest rates the three lowest rates
4. Reduce government Make less than 3 percent of national GDP
deficits
5. Reduce government debt Make less than 60 percent of national GDP
• The convergence criteria were intended to reduce macroeconomic
imbalances that might harm the euro or the joining countries.
• The criteria are controversial because:
– It is not clear why these targets were selected;
– Almost no countries consistently met the targets;
– If they can meet the targets, then they can do the same thing the euro does
without having to give up their monetary policy.
• Benefits of the single currency:
– Reduced cost of currency conversion: perhaps 0.4
percent of GDP saved.
– Reduce exchange rate uncertainty, causing more trade
and investment.
▪ Not much evidence here, since traders and investors can use
forward markets to hedge against currency fluctuations.
• Costs of the single currency:

– Loss of monetary policy.
– Cannot use flexible exchange rate as buffer against
external shocks.
• Reason for the euro is perhaps mostly political.
– After the lifting of capital controls in 1990 under the SMP,
speculation against individual country currencies became
possible and played a central role in the 1992 EMS crisis.
– This led to political frictions as countries that devalued
gained new businesses at the expense of other members.
• In addition, some feared that German reunification

would cause Germany to “look east;” the euro was a
way to keep Germany focused on the west.
Case study: The financial crisis of
2007-2008 (1 of 5)
• The banking and financial crisis that began in the U.S.
spread to Europe where many banks and other
financial firms had purchased U.S. assets that suddenly
lost value.
• In the EU, the banking crisis was severe;

– It also turned into a deep recession;
▪ The recession depressed tax revenue and required more
government spending on social programs;
▪ In addition, government were called on to bailout the banks that
held assets that had fallen in value;
– As government revenue fell and expenditures increased,
the banking crisis became a debt crisis in several countries.
2007-2008 (2 of 5)
2007-2008 (3 of 5)
• Large deficits in several countries rapidly increased debt levels to
unsustainable levels.
– Countries were expected to cut their deficits and reduce their debts.
– The European Central Bank was created with a “no-bailout clause”
which prohibits it from acting as a lender of last resort to indebted
governments.
• Countries lack an independent monetary policy and their own

exchange rate; they were forced to use contractionary fiscal policies
to try to balance their budgets.
– Recessions intensified.
– Countries with large deficits and debts were expected to cut prices
and wages: This is equivalent to a depreciation in the real exchange
rate and is called internal devaluation.
2007-2008 (4 of 5)
• Fears that some countries would be forced out of the euro led to
rapidly rising interest rates for countries with large debts.
– In 2012, the ECB publicly announced that it would do “whatever it
takes” to support the euro;
– This calmed the markets, interest rates fell, and debts became
sustainable, at least for the time being.
• The debate continues:

– Should indebted countries restore growth first, even if it means fiscal
stimulus? Where would they get the money if markets will not lend?
– Or, should they reduce the debt first, even if it means more stagnation
and recession? If GDP falls more, will debt become less sustainable
even if it is falling?
– This debate is often framed in terms of growth versus austerity.
2007-2008 (5 of 5)
• The crisis in the EU was worse than in the U.S. partly
because the former is not a fiscal union and the latter is.
– The U.S. government transfers resources from states doing well
to states not doing well.
▪ This happens via social security, unemployment insurance,
government contracts, Federal Deposit Insurance, highway spending,
and other expenditures.
– The EU has no similar mechanism.
▪ If the Greek government is bankrupt, then Greek retirees may not get
their pensions; unemployed Greeks will not have income supports,
there is no EU-wide bank deposit insurance, etc.
• The formation of a fiscal union in the EU is controversial

and unresolved.
Widening the EU (1 of 2)
• The fall of the Berlin Wall in 1989 and the
collapse of the Soviet Union in 1991 opened the
door to new members.
– Since 2004, 13 more countries joined.
• Membership requirements:
– Stable democracies;
– Market based economies;
– Formal adoption and implementation of the common
body of laws, called the acquis communautaire.
Widening the EU (2 of 2)
• Issues for the EU:
– The Common Agricultural Program (CAP) is an
expensive set of subsidies and many new members,
e.g., Poland, have large agricultural sectors.
▪ This would be a major issue if Turkey were to join.
– Governance institutions are not designed for 28
members: Decisions are harder to make and the
process is more cumbersome.
– Newer members are not as well off and the income
gap between new and old members is growing.
▪ Income gaps are associated with differences in the security
of property rights, rule of law, government efficiency, and
other core institutions.
Demographic challenges (1 of 2)
• Europe is aging relatively quickly.
– Population 65+ is projected to grow from 19 percent of the
population in 2015 to 28 percent in 2050.
– This raises costs of social programs, including health care,
pensions, long-term care.
– Some increased spending will be offset by decreases in
education spending, unemployment benefits.
• Migration is a partial solution but encounters several

obstacles:
– Cultural resistance to immigrants.
– Even large scale immigration would not offset the decrease in
the working age population.
Demographic challenges (2 of 2)
Population, 2015 Percent, Population, 2050 Percent,
(Millions) 2015 (Millions) 2050
Total 513.9* 100.0 507.2 100.0
By age category
Ages 0–15 79.6 15.5 72.6 14.3
Ages 15–64 337.9 65.8 291.5 57.5
Ages 65+ 96.5 18.8 143.1 28.2
• Population stops growing around 2029-2030;

• The working age population will fall by 46 million;
• The retired population (65+) will increase by a similar amount—46 million;
• Immigration of 46 million working people (about 9% of the total population in
2050) would make up the lost workers, but there would still be far more retirees.
The End

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International Economics

14.2 Distinguish EU widening from EU

14.3 Explain the obstacles to regional

14.5 State two theories as to why the single

14.6 Analyze the EU’s single currency program

• Founded in 1957 as an FTA called the European Economic

• There are three groups of countries in Table 14.1:

• In 2016 Great Britain voted to leave the EU. If it does, it will

• A central topic for debate and negotiation was the terms of

• The division is not perfect and is a source of

• The Commission is one country-one vote; other institutions have

• Council votes require a qualified majority of 55% of countries

• Revenue is derived from three main sources:

• Expenditures are primarily directed to two main areas:

• Widening: Adding new members.

• The purpose was to prevent competitive devaluations.

• West Germany quickly decided to re-unify.

• In response to the crisis, the allowable bandwidth

• In 1987, leaders adopted the Delors Report in an attempt to reinvigorate

• The results would be achieved through:

• In addition, there was a strong convergence in income

• Ireland and the UK have not accepted the agreement;

• At the time, there were 12 members of the EC, not the

• The stages were intended to give countries time to prepare

• Costs of the single currency:

• In addition, some feared that German reunification

• In the EU, the banking crisis was severe;

• Countries lack an independent monetary policy and their own

• The debate continues:

• The formation of a fiscal union in the EU is controversial

• Migration is a partial solution but encounters several

• Population stops growing around 2029-2030;

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