Growth Effects, Services and

Factor Markets Integration

Introduction into Economic System of the EU

Faculty of law, Belgrade

R.Baldwin and C.Wyplosz: The Economics of European Integration, Ch.7 and 8

J.Pelkmans: European Integration, Ch.7 and 9

Thursday, November 24 , 2014

18:00 – 20:25

Miroljub Labus

Five topics

1. From product market integration to the entire market

integration

2. Financial and other services

3. Free movement of capital

4. Free movement of labor

5. Growth effectsGoods

Services/

Financial

services

Capital

mobility/Accumulation

and growth

Labor

mobility/unemployment

1. Market services integration

Contribution of services to GDP

1. EU 17 (Millions of EUR)

2. From 1995Q1 to 2012Q2

-

500,000

1,000,000

1,500,000

2,000,000

2,500,000

Gross Value Added at market prices

Agriculture Manufacture Services

Breakdown of services

1. EU 17 (Millions of EUR)

2. From 1995Q1 to 2012Q2

-

500,000

1,000,000

1,500,000

2,000,000

2,500,000

Services in the Euro Zone

Entertaiment Insurance Real estate Communication

Professional Information Public service Whole/Retail

A list of services

Tourism

Consulting

Market research

Broadcasting

Postal services

Telecom

Electricity and gas

Transportation

Advertising

Construction

Audio-visual

Banking

Insurance

Government services

Education

Health services

Local communal services

Hotel services

Restaurants

Coffee shops

Entertainment

Internet services

Cleaning

Printing shops

Weather forecasting

Legal services…

Classification of services in the internal market

All servicesTradable Non-Tradable

•Government

services

•Public

education

•Public health

•Local services

Non-regulated

•Tourism

•Consultancy

•Market

research…

RegulatedNetwork-based services

•Broadcasting

•Postal

•Telecoms

•Gas and electricity…

Non-network

based services

Real

•Transport

•Advertising

•Audio-visual

•Construction,…

Financial

•Banking

•Insurance

•Investment

Consumer services

•Hotels, restaurants

•Health

•Education

•Entertainment

Services market integration

Cross-border services are not tangible and are not subject to tariffs

ToR had no specific principles on services market liberalization

In 1990 share of services in GDP was 48%, in 2012 it was 70%

Job creation in the services sector between 1980-90 amounts to 10 millions

compared to 3.5 millions job losses in the manufacturing

Tradable services are twice larger than non-tradable services

B2B services are less regulated than B2C services

Two principles were crucial to promote liberalization of services

◦ Free movements

◦ Freedom of establishments

They directly apply to “economic” (tradable) services

The main obstacle is related to the “general-good clause” (“fit and proper”), i.e. a

general clause that introduces a minimum standard of soundness of market behavior

of banks and insurance companies, that is implemented by national supervisory

boards

From freedom of services to financial market integration

European financial area

◦ Internal market for financial services

◦ Internal market for financial capital and money

◦ A single currency

◦ Fiscal and accounting approximation

For major types financial services

◦ Banking

◦ Insurance

◦ Investment

◦ Assets management

Banks in the EU provide most of the investment services

Banks and insurance companies can merge in EU across the borders

The EU case law extends policy of liberalization of goods to liberalization of services

◦ Mutual recognition principle (EU passport or license)

Financial market integration path

1957 The ToR

◦ Unclear, to many conditions

1986 Single European Act – Breakthrough

◦ The first major revision of the ToR

◦ Basic objective was to create a single market in goods by 1992

1992 Maastricht Treaty – codified four freedoms

◦ Impossibility trinity

Free movement of capital

Pegged exchange rates, and

National autonomy in macroeconomic policy

◦ Freedom for financial capital

Impossible trinity

Free

capital

flow

Monetary

autonomyHard peg

No financial

services

liberalization

Impossible trinity

Free

capital

flow

Monetary

autonomyHard peg

Financial services

liberalization +

EUR

Impossible trinity

Free

capital

flow

Monetary

autonomyHard peg

Financial

services

liberalization

Free float

threatens trade

Banking sector

HQ

Branches

Branches

SubsidiariesBranches

Banking sector in Serbia: Exposure to HQs

Italy

31%

Austria

27%

Greece

26%

France

12%

Others

4%

Deepening financial market after 1992

Wholesales

•Securities settlement

•Mutual fund directive

•Pension fund directive

Retail

•Payment directive

•Insurance directive

•Anti money laundering

directive

Supervision

•Financial conglomerate dir.

•Re-Insurance supervision

•Basel III directive

•Cooperation of supervisions

•EBA

Horizontal

•Accounting rules

Corporate restructuring

•European company

statute

•Takeover bid directive

2. Capital market integration

Growth Effects

European leaders have long emphasised two different pro-

growth aspects of European integration: allocation and

accumulation effects

Better allocation of capital was initial result of free trade

across Europe or goods market integration

Accumulation effects operate in a way that is

fundamentally different from the way allocation effects

operate;

They operate by changing the rate at which new factors of

production – mainly capital – are accumulated,

◦ Hence the name ‘accumulation effects’.

Verbal logic of growth

Growth in income per worker requires more output per worker

Nation's labor force can produce more goods and services year after year only if they have more and better 'tools' year after year

‘Tools' means capital broadly defined: Physical capital (machines)

Human capital (skills, training, experience) and

Knowledge capital (technology)

ERGO, rate of output growth is linked to rate of physical, human and knowledge capital accumulation.

Most capital accumulation is intentional and its annual addition is called investment

◦ Thus: European integration affects growth mainly via its effect on investment in human capital, physical capital and knowledge capital.

Verbal logic of growth: summary

•European

•integration

•Allocation

•effects

•Improved

•efficiency

•Better

•investment

•climate

•More

•investments

•Accumulation

•effects

•Higher

•output per

•worker

Solow diagram

Shows growth effects in a simple diagram

To simplify, start with whole EU as a single, closed

economy with fully integrated capital and labor markets

and the same technology everywhere.

Solow diagram

K/L

euros/L

GDP/L

Solow diagram

A

B

K/L

euros/L

GDP/L

s(GDP/L)

d(K/L)Y/L*

K/L*K/Lo

Io

Do

Depreciation

Investment

CE

D

B

K/L

euros/L

GDP/L

s(GDP/L)

d(K/L)

K/L’

GDP/L’

A

s(GDP/L)’

Y/Lc

Y/L’

Induced accumulation effect

Y/L*

K/L*

Technological progress (capital saving one)

Allocation effect

Integration induced investment rate rise

C

D

B

K/L

euros/L

GDP/L

s(GDP/L)

d(K/L)

K/L’

A

s’(GDP/L)

Y/L’Growth bonus

Y/L*

K/L*

Solow model with population growth

tt

tt

tt

tt

ttt

tttt

AA

LL

IS

YsS

IKK

LKFAY

)1(

)1(

)1(

),(

1

1

1

d

),(

1

11 ttttt LKFAsKK

d

)(1

11 tttt kfAskk

d

Factors of

growthkt+1 yt+1=f(kt+1)

Growth rate

f(kt+1)/f(kt)

s ↑ ↑ ↑

δ ↑ ↓ ↓

λ ↑ ↓ ↓

Low(high) level Faster(slower)

Per-capita terms

The four poor countries: Growth record befor Global recession

GDP per capita compared to

France

0%

20%

40%

60%

80%

100%

120%

140%

160%

1980 1984 1988 1992 1996 2000 2004 2008

Greece Ireland Portugal Spain

Catching-up

Spain Portugal

1986Greece1981

Ireland1973

What happened to the Irish Miracle?

What created the miracle?

1. Tax haven and inflow of foreign capital

2. Increased public spending and commitments

3. Increased private and public borrowing on the Euro market

4. Heavy investments in the real estate sector

...And what caused the crises?

1. Credit crunch and sudden stop of capital inflow

2. Fall of prices of real estate and increase in number of defaults

3. Expensive bailing-out of banks, unsustainable pensions and social

programs

4. Borrowing under unfavourable terms

5. Treat of defaults and bankruptcies

IMF SBA

What happened to Serbia?

Use the Solow diagram to analyses the following

situation:

1. Serbia’s K/L was pushed bellow its equilibrium by

war damage to its capital stock

2. EU granted ATP to Serbia that have two effects

1. It increases the efficiency of the Serbian economy

(allocation effect) and

2. It raises the Serbian investment rate (s) over next ten years

(accumulation effect)

Show where the Serbian economy would end up in the

long-run.

Post-war shock

Growth

GDP per capita in Serbia

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

What happened to Serbia after war damage

Recovery

What happened to Serbia after war damage

A*

B*

K/L

euros/L

GDP/L

s0(GDP/L)

d(K/L)

Y/L0

K/L*K/Lo

A0

B0

B’

C

D

Y/L’

K/Law

saw(GDP/L)

Y/Law

GDP/L’

3. Labor market integration

Population change by components, EU-27, per 1000 population

•Immigration has outperformed natural population change

since 1991.

Turning point

Reactions to

recession and

imbalances

Immigration density

Share of foreigners in the resident population, as of 1.1.2012.

0

10

20

30

40

50L

uxe

mb

ourg

Cypru

s

Latv

ia

Esto

nia

Sp

ain

Au

str

ia

Be

lgiu

m

Ire

lan

d

Ge

rma

ny

Gre

ece

Italy

Unite

d K

ing

do

m

Sw

ed

en

Den

ma

rk

Fra

nce

Ma

lta

Neth

erl

an

ds

Po

rtug

al

Slo

ve

nia

Czech

Rep

ublic

Fin

land

Hun

ga

ry

Slo

va

kia

Lith

uan

ia

Bu

lga

ria

Cro

atia

Rom

an

ia

Po

lan

d

Avera

ge

Non-EU foreigners EU foreigners

Source: Eurostat, YB2013

Immigration by origin

Main countries of origin of non-nationals, as of 1.1.2012.

Source: Eurostat, YB2013

0.0

0.5

1.0

1.5

2.0

2.5

Rom

ania

Po

lan

d

Italy

Po

rtuga

l

UK

Germ

any

Fra

nce

Bu

lga

ria

Neth

erla

nds

Sp

ain

Tu

rkey

Mo

rocco

Alb

an

ia

Chin

a

Ukra

ine

Russia

India

Alg

eria

US

A

Ecuador

Citizens of non-member countries Citizens of other EU-27 Member States

Age structure of the EU population in 2011

Age structure of the national and non-national populations

Source: Eurostat, YB2013

0

25

50

75

100

3% 2% 1% 0% 1% 2% 3%

Nationals Foreigners

Men Women

Age

100+

ECB: Unemployment in the euro zone

Shares in total labor force

ECB: Unit labor cost (compensation per employee and labour productivity)

Rate of growth

Labour market is regulated

Existing institutions differ from country to country

They are the outcome of a long, and often conflicting,

history

Various forms

◦ Collective negotiations

◦ Minimum wage legislation

◦ Unemployment insurance

◦ Payroll taxes

Collective negotiations

Social objective: protect workers from bosses’ excessive

powers

Economic impact: unemployment

The role of the degree of centralization

Plant level: induces some wage restraint

National level: induces some wage restraint

Branch level: less restraint

The integration and monetary union impact

◦ One big market: current degree of coordination in collective

negotiations decline

◦ One central bank: more wage discipline

Will trade unions respond by organizing at EU level?

Minimum wage legislation

Social objectives

◦ Protect the weakest

◦ Reduce inequality

Economic impact: unemployment of the least skilled

The integration and monetary union impact

◦ Enhanced competition favors low cost countries

◦ Accessions of CEECs sharpens this aspect

◦ Trade unions fear social dumping and call for harmonization of social norms

Unemployment insurance

Social objective: protect workers from a major risk

Economic impact: more unemployment

The integration and monetary union impact

◦ Asymmetric shocks create temporary unemployment

◦ Generous insurance may prolong the adjustment

◦ Pressure to reduce generosity, mainly duration, of benefits

◦ Trade unions fear social dumping.

Payroll taxes

Social objective: solidarity among workers in financing unemployment, health, retirement

Economic impact: raises cost of labor, or reduces wages, or both

The integration and monetary union impact

◦ Enhanced competition favors low cost countries

◦ Incentive to either reduce welfare payments or raise other taxes

◦ Politically difficult.

How to respond to deeper integration?

Deeper integration desirable because it enhances

competition on the good markets

More competition raises the economic costs of many

labor market institutions

A sharpening of the conflict between economic

effectiveness and social objectives

Existing arrangements are threatened by the present

crisis.

Three possible evolutions

Two-speed Europe

Deep reforms

Social harmonization

Possible evolution No.1

Two-speed Europe

◦ Some countries flex their labor markets, others retain

their highly social existing arrangements

◦ Firms and risk-taking individuals move to the most

flexible countries

◦ Welfare-conscious are attracted by welfare-magnet

countries

◦ Part of Europe grows fast with low unemployment,

another part grows slowly with permanently high

unemployment.

Two-speed Europe: already there?

Possible evolution No.2

Deep reforms

◦ Thatcher takes over Europe

◦ Labor market institutions made more flexible

◦ Labor taxes reduced.

Possible evolution No.3

Social harmonization

◦ The large countries export their welfare systems

through social norms applicable to all EU countries.

In the end

There is no better way, just different socio-economic

equilibria.