When Does Integration Pay?

1. When Does Integration Pay?

2. Europe has been rather spectacularly successful in its integration efforts. Many others have been far less successful. What makes for success?

3. Consider again the prices that play a role in a customs union integration scheme: P domestic P tariff P part count P world

4. In your groups, discuss the proximities of given price lines in the set and elasticities of supply and demand that will make integration successful. P domestic P tariff P prt cntrs P world

5. First, check elasticities The relative sizes of these gains depend on: 1. elasticities, the “flatness” of the curves. Ptar Ppcs Imports Imports

6. First, check elasticities Where they are relatively elastic (flat), the imports will be greater and gains go with more extensive trade. Imports Imports

7. Price spread in integration Gains are greatest when the difference is • small between partner and world. • great between partner countries and us. Ptar Ppcs c c Pw

8. Large gains here. Large imports at near world prices (far better than our prices) P domestic P tariff P part count P world

9. Small gains here. Small imports at prices near ours and way above world prices. P domestic P tariff P part count P world

10. European Monetary Union

11. European cooperation was strengthened by the decline of the Bretton Woods system. • Europe did not want to follow the US toward higher inflation. How does a fixed exchange rate help? • It allows for less trade uncertainty • It shows anti-inflationary commitment.

12. European cooperation was strengthened by the decline of the Bretton Woods system. • The Bretton Woods System was… • It was eliminated in 1973 by Richard Nixon, a man of uncanny economic instincts…

13. European cooperation was strengthened by the decline of the Bretton Woods system. • Europe did not want to follow the US toward higher inflation. How does a fixed exchange rate help? • It allows for less trade uncertainty • It shows anti-inflationary commitment.

14. See the history of progress toward a common European currency summarized in the box on p. 256 of Pugel. • Europe did not want to follow the US toward higher inflation. Members of the EEC worked toward eliminating large inflation rate differentials by mid 1980s and capital controls were lifted by 1987. • Single European Act, 1986, called for removing all internal barriers to trade, capital movements, and labor migration by end of 1992.

15. Maastricht Treaty signed at end of 1981. The famous conditions were established for the introduction of monetary union. • Countries sacrificed monetary sovereignty for prospective Euro (formerly “ECU”) membership.

16. Maastricht Treaty signed at end of 1981. The famous conditions were established for the introduction of monetary union. • Countries sacrificed monetary sovereignty for prospective Euro (formerly “ECU”) membership.

17. Budget deficit 3% of GDP or less. • Government debt 60% of GDP or less. • Inflation no more than 1.5% above the average rate of the three members with the lowest inflation. • Long-term interest rates no more than 2 percentage points above the average of the three members with the lowest rates. • Krugman’s confusion. Why demand monetary management to give up monetary sovereignty? • Hazing?

18. The convergence pattern of these criteria through the 90’s.

19. European countries strove valiantly to submit their sovereignty. So much did they desire to be a part of the Euro scheme!

20. Benefits of a common currency include ease in trading goods and assets over a common currency zone. It represents a big reduction in transactions costs. • Prestige of achieving the closer union of European economies. As a step toward political union? That is the dream.

21. The cost of union is the forgoing of monetary policy. • “In the face of market pressure against a currency, a central bank committed to the external goal of a fixed exchange rate must raise domestic interest rates, even if this means forgoing the internal goal of setting interest rates with an eye toward domestic economic conditions. The only way to maintain monetary independence is eithge to allow the currency to float or to have in palce controls on the international movement of capital.” (p, 311)

22. The cost of union is the forgoing of monetary policy. This has added to the structural unemployment problems facing the European countries over recent years. • Ten % is roughly normal for Europe.

23. The Feldstein View • For a more detailed discussion of the standard American view of the future collapse of the EU’s Monetary Union, see Martin Feldstein, “EMU and International Conflict,” in the Foreign Affairs Anthology. • Feldstein reviews the struggle, esp. between Germany and France, over whether to make unemployment or price stability top EU priority.

24. The Feldstein View • Feldstein is convinced that the first significant recession will bring serious conflict to Europe as countries regret the loss of monetary policy and secede from the Union.

25. The Euro as a New International Currency: A Dollar Substitute? • Klein concludes that widespread flight from the dollar to the Euro is unlikely, at least for the next few years. • But dollar flight to the Euro, in any major way, would cause the value of the dollar to fall dramatically. • The glut of dollars in the world that would result from a lack of willingness to hold it, could have major ramifications. What would they be?

26. The Euro as a New International Currency: A Dollar Substitute? • To review some of the issues that make the dollar a strong international currency, that give confidence that dollar flight to the Euro need not be a future disaster for that currency, see “The International Use of Currencies: The U.S. Dollar and the Euro,” by George S. Tavlas • Why do both the U.S. and the EU have strong interests in seeing the dollar and the Euro remain competitive currencies, without one dominating the other?

27. Why is Europe Forming a Monetary Union?

28. Make it easier for individuals and institutions to buy stocks and bonds in other European countries. • Cut transactions costs (roughly 0.4 percent of the GDP) for member participants. • Prevent competitive devaluations (to promote exports). Reducing the value of currency is inflationary.

29. Costs of a Single Currency • Loss of independent monetary policy (but all member countries have representation in monetary policy). • Fiscal policy within a member country could increase budget deficits and require government borrowing, putting upward pressure on interest rates. Increasing the money supply to avoid high interest rates would threaten inflation. So EU members agreed to avoid debt.

30. Loss of independent monetary policy (but all member countries have representation in monetary policy). Still, fiscal policy could be used by the EU to address regional imbalances in the currency union.

31. Labor Market Flexibility can also speed recovery when some region experiences recession. • If workers are mobile, unemployed or poorly paid workers can relocate to countries with higher labor demand. That will even out imbalances. • But cultural and linguistic differences hinder labor movements in Europe.

32. Wage adjustments are another important form of labor market flexibility. If workers accept lower wages in a recession, employers need not lay them off. They can also pass on the reduction in payroll costs through price reductions. Lower prices promote exports and encourage domestic consumption. This increase in demand speeds recovery. • But Europe has problems with wage flexibility through legislation and union practices preventing it.