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Economies Outside the United States, International Economics, Macroeconomics

The European Union (EU) includes twenty-seven countries and 490 million people. In 2005, the EU had a $13 trillion (€11 trillion) economy, a single market, and for some member countries, a single currency. A growing number of political and economic decisions are made on a pan-European level in Brussels.

The origins of the EU are usually traced to the European Coal and Steel Community (1952). Heavily regulated coal and steel industries of Germany and France were to be administered by a supranational authority. Economic benefits of supranational control over one sector of the economy were expected to lead to demands for supranational management of other economic sectors. But supranationalism, characterized by bureaucratic planning and regulation, could not produce economic growth.

Ludwig Erhard’s free-market reforms in West Germany in the late 1940s (see german economic miracle) provided an alternative model for development, and the resulting economic growth made a strong case for Europe-wide liberalization. The 1957 Treaty of Rome created the European Economic Community (EEC). The EEC abolished internal tariffs and quotas and established a customs union. The treaty made provisions for the eventual liberalization of movement of labor, services, and capital.

Despite the Treaty of Rome’s many imperfections, the economic interdependence between nations that it produced was believed to make future armed conflict less likely. As nineteenth-century French economic journalist Frédéric Bastiat stated, “When goods don’t cross borders, soldiers will.” Many of Europe’s early integrationists remembered the large trade barriers of the 1930s and the collapse of international trade that followed. The new principle of economic cooperation enhanced economic efficiency and resulted in improved living standards.

The supranationalists wished to enhance European integration through a top-down approach. Europe’s future social and economic development was to be managed and regulated from Brussels, the capital of Belgium. The Treaty of Rome, on the other hand, aimed at decentralization. European cooperation was to emerge “spontaneously” after barriers to interactions between social and economic actors were removed.

Development

Adam Smith
observed that efficiency gains are limited by market size. International trade increases market size. Multilateral trade liberalization through the General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization (WTO), made great headway after World War II, substantially increasing the volume of international trade. The WTO is premised on nondiscrimination: member countries provide all other WTO members the same access to their markets (see international trade agreements).

A customs union is an exception to the WTO rule. Members of a customs union may eliminate import duties on one another’s goods while maintaining a unified tariff on imports from other WTO countries. The EU itself started as a customs union among Belgium, Luxembourg, France, Italy, the Netherlands, and West Germany. The United Kingdom, Ireland, and Denmark joined in 1973. Greece joined in 1981, and Spain and Portugal in 1986.

In 1986, growing global competition caused the signing of the Single European Act (SEA) and the creation of the European common market. Worldwide economic liberalization exposed Europe as an overregulated area with high unemployment and low productivity and growth. The Single European Act liberalized restrictions on merchandise transport; government procurement; and movement of services, capital, and labor. Intra-European trade has expanded: in 1960, more than 60 percent of European trade was with non-EU members, while in 2003, two-thirds of all EU trade in goods was internal. But the act also increased the European bureaucrats’ power to create pan-European regulation, which reduces the possibility of policy competition within Europe.

In 1995, Austria, Finland, and Sweden became members of the EU. The Czech and Slovak Republics, Poland, Hungary, Estonia, Latvia, Lithuania, Slovenia, Cyprus, and Malta joined in 2004. Romania and Bulgaria followed in 2007.

On January 1, 1999, eleven members of the EU replaced their national currencies with a single currency, the euro (€). The monetary policies of the Eurozone members then ceased to be autonomous and are now set by the European Central Bank (ECB) in Frankfurt, Germany. The euro has reduced transaction costs and removed uncertainty created by exchange-rate fluctuations, and thus encourages additional intra-European trade and investment. However, the requirement that Eurozone members maintain the same monetary policy and the same interest rates deprives national governments of policy tools traditionally used to address their own macroeconomic problems (see monetary union).

In the past, when a country had a recession not shared by other EU countries, its central bank could expand the money supply, with the goal of boosting domestic demand and moderating the recession. With monetary policy turned over to the ECB, this kind of response is no longer possible. A common monetary policy will be useful for moderating only Europe-wide business cycle fluctuations. When European countries experience cyclical expansions and contractions at different times, the sacrifice of monetary autonomy may cost them a great deal. On the other hand, countries with loose monetary policies benefit because their governments may no longer inflate their currencies.

The EU also restricts fiscal autonomy of the member states. The growth and stability pact prohibits EU members from running an annual budget deficit of more than 3 percent of GDP. The pact is meant to ensure that fiscal irresponsibility of individual members does not endanger the stability of the single currency as a whole. However, the pact has no viable enforcement mechanism. Thus, when Germany and France violated its terms by running greater-than-allowed deficits, the EU Commission was unable to rein them in.

Another European project involves adoption of the European Constitution. The Constitution has caused much controversy. Some opponents argued that the constitution further distances the EU from the public. Others found the incorporation of the Fundamental Charter of Human Rights, which includes extensive welfare provisions, prohibitively expensive. The lack of reference to religion in general and Christianity in particular alienated the more culturally conservative members. In any case, the ratification of the Constitution is uncertain, in part because of its rejection in the French and Dutch referenda.

Harmonization

The “harmonization” debate epitomizes the tension between the two views of integration. The top-down centralists see harmonization throughout the European Union as necessary because, as they see it, the common market necessitates common rules and regulations. They also see harmonization as a way of ensuring the eventual political unification of the continent.

Others argue that it was the lack of political and economic uniformity that enabled Europe to thrive in the past. Harvard University historian David Landes writes:

Fragmentation gave rise to competition and competition favored good care of good subjects.. . . European rulers and enterprising lords who sought to grow revenues . . . had to attract participants by the grants of franchises, freedoms and privileges—in short, by making deals. They had to persuade them to come.1

Decentralized political entities such as the United States still provide laboratories of social policy. Like American states today, autonomous city-states in Europe in the past offered an assortment of potential freedoms to potential émigrés. Many émigrés brought knowledge and expertise that improved the societies they joined. The top-down social harmonization in which the EU engages may prove counterproductive. Enforcement of specific social agendas breeds resentment, creates negative-sum outcomes, and intensifies political struggles.

In the past, various governments in Europe tried to gain an edge over their competitors by reducing taxes. This tax competition kept the overall level of taxation in check, just as tax competition among various U.S. states keeps state taxation in check. Yet, there are those who would like to reduce what they call “harmful tax competition.”

An EU Parliament report put it bluntly. It may be necessary to harmonize business taxes, it argued, because

cutting taxes in one country raises the competitiveness and/or attractiveness of this country relative to others. The resulting flows of goods, capital—and also, possibly, high-skilled labor—is detrimental to partner countries in terms of economic activity and in terms of tax revenues.2

In the atmosphere of increasing harmonization of European economies, low taxation has emerged as the most effective way for producers in various European nations to stay competitive. Tax competition is especially important to poorer EU countries burdened with excessive EU regulation. Past beneficiaries of low taxation, such as the United Kingdom and Ireland, are also likely to continue to favor tax competition.

Regulation

During the 1990s, the EU increased its regulation of production, delivery, and sale throughout the union. Legislation on worker health and safety, working hours, and mandatory leave made Europe’s nonwage labor costs much higher than those in the United States and many other countries.

Some blame the governing structure of the union. The Brussels bureaucracy functions with minimal oversight by elected officials, turning out new regulations regardless of compliance costs. Over half of all regulations adopted by the British Parliament, for example, originate in Brussels. Even the former European commissioner for the internal market, Frits Bolkestein, has admitted that the EU has a “tendency to over regulate.”3 Some believe that regulations can sometimes correct market failure. But regulations also often create failure and exacerbate economic problems. The proponents of regulation are often European states with extensive welfare provisions that want to hobble competition from their less-regulated European competitors.

Overregulation complicates the EU’s enlargement into the Central and Eastern European countries. Western European labor regulations, designed for wealthy societies, reduce the competitiveness of workers in these less-productive countries and may cause prolonged periods of high unemployment there. In addition, the EU Commission estimates that by 2013, new members’ compliance costs with the EU environmental regulations alone will reach up to $144 billion (€120 billion). Those costs are likely to increase taxes and government debt throughout the region.

The system of quotas and subsidies presents another complicated problem. After the fall of communism, the Central and Eastern European countries adjusted to the market and became more productive. The EU now prevents them from producing “too much,” reprimanding Slovakia, for example, for exceeding its steel quota.

Protectionism and Redistribution

Participating countries benefit from their customs union only if their involvement creates more trade than it diverts (see international trade agreements). Imagine, for example, that EU countries continue to import petroleum from the Middle East, wheat from the United States, and stereo equipment from Asia. Imagine also that they specialize further in their own production. So, instead of producing both beer and wine, the British produce beer and the French produce wine, and they trade freely with one another. In such a case, trade is created and living standards rise. But if EU members now buy expensive German barley rather than cheap American wheat because of high external tariffs or low quotas, trade is diverted and members of the customs union may be worse off.

Most previous studies have concluded that the EU is a trade-creating customs union. Excessive harmonization and overregulation, however, reduce the benefits of belonging to the EU. The Common Agricultural Policy (CAP) and other restrictions on external trade create additional inefficiencies.

The CAP subsidizes the EU’s agricultural producers by about 54billion(€45billion)annuallyandkeepslowerpricedimportedproductsout.TheOrganizationforEconomicCooperationandDevelopment(OECD)estimatesthattheoveralllevelofEuropeangovernmentsupportforagriculturalproducerswas54 billion (€45 billion) annually and keeps lowerpriced imported products out. The Organization for Economic Cooperation and Development (OECD) estimates that the overall level of European government support for agricultural producers was 54billion(€45billion)annuallyandkeepslowerpricedimportedproductsout.TheOrganizationforEconomicCooperationandDevelopment(OECD)estimatesthattheoveralllevelofEuropeangovernmentsupportforagriculturalproducerswas130 billion (€108 billion) in 2005 (www.oecd.org). The EU subsidies often lead to overproduction of agricultural commodities, some of which are then “dumped” on the global markets, depressing their global prices and creating $20 billion (€17 billion) in losses for producers in low-income countries. At the same time, the CAP keeps agricultural prices within the EU artificially high, reducing the European standard of living. According to the British think tank Policy Exchange, “EU consumers currently pay 42 percent more for agricultural products than they would if the system were dismantled.” Less-well-off families, for whom food takes up a high proportion of household income, suffer disproportionately.

French economist Patrick Messerlin estimates that European trade protectionism as a whole costs Europe 5–7 percent of its annual GDP. Messerlin found that the average job saved through protectionism costs European taxpayers approximately $200,000 (€167,000) per year.

Other distributive programs (see redistribution) in the EU include the so-called structural and cohesion funds, which subsidize low-income regions. The funds distort resource allocation and limit the movement of labor into more productive economic activities. When the funds started to be disbursed in the mid-1970s, 44 percent of the EU population lived in regions qualifying for subsidies. By 1997, that had increased to almost 52 percent. The program had both failed to eliminate regional poverty and empowered special interests. Spain’s government, for example, threatened to block the entire EU enlargement rather than accept a reduction in its funds.

The EU’s redistributive policies will likely produce more negative-sum outcomes, discontentment, and tensions. The success of the European project may, therefore, lie in embracing a “voluntarist” Europe where individual states, businesses, and persons will be free to choose the nature and extent of their cooperation.

About the Author

Marian L. Tupy is a Policy Analyst at the Cato Institute’s Center for Global Liberty and Prosperity. He earned his B.A. in international relations and classics from the University of the Witwatersrand in Johannesburg, South Africa, and his Ph.D. in international relations from the University of St. Andrews in Great Britain.

Footnotes

David Landes, The Wealth and Poverty of Nations (London: Little, Brown, 1998), p. 36.