When Does Integration When Does Integration Pay?Pay?

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

Consider again the prices that play a Consider again the prices that play a role in a customs union integration role in a customs union integration scheme:scheme:

P world

P part count

P tariff

P domestic

In your groups, discuss the In your groups, discuss the proximities of given price lines in the proximities of given price lines in the set and elasticities of supply and set and elasticities of supply and demand that will make integration demand that will make integration successful.successful.

P world

P prt cntrs

P tariff

P domestic

The relative sizes of these gains depend on: 1. elasticities, the “flatness” of the curves.

Imports Imports

First, check elasticitiesFirst, check elasticities

Ptar

Ppcs

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

Imports Imports

First, check elasticitiesFirst, check elasticities

Gains are greatest when the difference is

small between partner and world.

great between partner countries and us.

c c

PtarPpcs Pw

Large gains here. Large imports at Large gains here. Large imports at near world prices (far better than our near world prices (far better than our prices)prices)

P world

P part count

P tariff

P domestic

Small gains here. Small imports at Small gains here. Small imports at prices near ours and way above prices near ours and way above world prices.world prices.

P world

P part countP tariff

P domestic

European European MonetaryMonetary Union Union

European cooperation was European cooperation was strengthened by the decline of the strengthened by the decline of the Bretton Woods system.Bretton Woods system.

Europe did not want to follow the US Europe did not want to follow the US toward higher inflation. How does a toward higher inflation. How does a fixed exchange rate help? fixed exchange rate help?

It allows for less trade uncertaintyIt allows for less trade uncertainty It shows anti-inflationary It shows anti-inflationary

commitment.commitment.

European cooperation was European cooperation was strengthened by the decline of the strengthened by the decline of the Bretton Woods system.Bretton Woods system.

The Bretton Woods System was…The Bretton Woods System was… It was eliminated in 1973 by Richard It was eliminated in 1973 by Richard

Nixon, a man of uncanny economic Nixon, a man of uncanny economic instincts…instincts…

European cooperation was European cooperation was strengthened by the decline of the strengthened by the decline of the Bretton Woods system.Bretton Woods system.

Europe did not want to follow the US Europe did not want to follow the US toward higher inflation. How does a toward higher inflation. How does a fixed exchange rate help? fixed exchange rate help?

It allows for less trade uncertaintyIt allows for less trade uncertainty It shows anti-inflationary It shows anti-inflationary

commitment.commitment.

See the history of progress toward a See the history of progress toward a common European currency common European currency summarized in the box on p. 256 of summarized in the box on p. 256 of Pugel. Pugel.

Europe did not want to follow the US Europe did not want to follow the US toward higher inflation. Members of the toward higher inflation. Members of the EEC worked toward eliminating large EEC worked toward eliminating large inflation rate differentials by mid 1980s inflation rate differentials by mid 1980s and capital controls were lifted by 1987.and capital controls were lifted by 1987.

Single European Act, 1986, called for Single European Act, 1986, called for removing all internal barriers to trade, removing all internal barriers to trade, capital movements, and labor migration capital movements, and labor migration by end of 1992. by end of 1992.

Maastricht Treaty signed at end of Maastricht Treaty signed at end of 1981. The famous conditions were 1981. The famous conditions were established for the introduction of established for the introduction of monetary union. monetary union.

Countries sacrificed monetary Countries sacrificed monetary sovereignty for prospective Euro sovereignty for prospective Euro (formerly “ECU”) membership. (formerly “ECU”) membership.

Maastricht Treaty signed at end of Maastricht Treaty signed at end of 1981. The famous conditions were 1981. The famous conditions were established for the introduction of established for the introduction of monetary union. monetary union.

Countries sacrificed monetary Countries sacrificed monetary sovereignty for prospective Euro sovereignty for prospective Euro (formerly “ECU”) membership. (formerly “ECU”) membership.

Budget deficit 3% of GDP or less.Budget deficit 3% of GDP or less. Government debt 60% of GDP or less.Government debt 60% of GDP or less. Inflation no more than 1.5% above the Inflation no more than 1.5% above the

average rate of the three members with average rate of the three members with the lowest inflation.the lowest inflation.

Long-term interest rates no more than 2 Long-term interest rates no more than 2 percentage points above the average of percentage points above the average of the three members with the lowest rates.the three members with the lowest rates.

Krugman’s confusion. Why demand Krugman’s confusion. Why demand monetary management to give up monetary management to give up monetary sovereignty?monetary sovereignty?

Hazing? Hazing?

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

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

Benefits of a common currency Benefits of a common currency include ease in trading goods and include ease in trading goods and assets over a common currency assets over a common currency zone. It represents a big reduction in zone. It represents a big reduction in transactions costs.transactions costs.

Prestige of achieving the closer union Prestige of achieving the closer union of European economies. As a step of European economies. As a step toward political union? That is the toward political union? That is the dream.dream.

The cost of union is the forgoing of The cost of union is the forgoing of monetary policy. monetary policy.

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

The cost of union is the forgoing of The cost of union is the forgoing of monetary policy. This has added to monetary policy. This has added to the structural unemployment the structural unemployment problems facing the European problems facing the European countries over recent years.countries over recent years.

Ten % is roughly normal for Europe. Ten % is roughly normal for Europe.

The Feldstein ViewThe Feldstein View

For a more detailed discussion of the For a more detailed discussion of the standard American view of the future standard American view of the future collapse of the EU’s Monetary Union, collapse of the EU’s Monetary Union, see Martin Feldstein, “EMU and see Martin Feldstein, “EMU and International Conflict,” in the Foreign International Conflict,” in the Foreign Affairs Anthology.Affairs Anthology.

Feldstein reviews the struggle, esp. Feldstein reviews the struggle, esp. between Germany and France, over between Germany and France, over whether to make unemployment or whether to make unemployment or price stability top EU priority. price stability top EU priority.

The Feldstein ViewThe Feldstein View

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

The Euro as a New International The Euro as a New International Currency: A Dollar Substitute?Currency: A Dollar Substitute?

Klein concludes that widespread flight Klein concludes that widespread flight from the dollar to the Euro is unlikely, from the dollar to the Euro is unlikely, at least for the next few years.at least for the next few years.

But dollar flight to the Euro, in any But dollar flight to the Euro, in any major way, would cause the value of major way, would cause the value of the dollar to fall dramatically.the dollar to fall dramatically.

The glut of dollars in the world that The glut of dollars in the world that would result from a lack of willingness would result from a lack of willingness to hold it, could have major to hold it, could have major ramifications. What would they be?ramifications. What would they be?

The Euro as a New International The Euro as a New International Currency: A Dollar Substitute?Currency: A Dollar Substitute?

To review some of the issues that To review some of the issues that make the dollar a strong international make the dollar a strong international currency, that give confidence that currency, that give confidence that dollar flight to the Euro need not be a dollar flight to the Euro need not be a future disaster for that currency, see future disaster for that currency, see “The International Use of Currencies: “The International Use of Currencies: The U.S. Dollar and the Euro,” by The U.S. Dollar and the Euro,” by George S. TavlasGeorge S. Tavlas

Why do both the U.S. and the EU have Why do both the U.S. and the EU have strong interests in seeing the dollar strong interests in seeing the dollar and the Euro remain competitive and the Euro remain competitive currencies, without one dominating currencies, without one dominating the other?the other?

Why is Europe Forming a Why is Europe Forming a Monetary Union?Monetary Union?

Make it easier for individuals and Make it easier for individuals and institutions to buy stocks and bonds institutions to buy stocks and bonds in other European countries.in other European countries.

Cut transactions costs (roughly 0.4 Cut transactions costs (roughly 0.4 percent of the GDP) for member percent of the GDP) for member participants.participants.

Prevent competitive devaluations (to Prevent competitive devaluations (to promote exports). Reducing the promote exports). Reducing the value of currency is inflationary.value of currency is inflationary.

Costs of a Single CurrencyCosts of a Single CurrencyLoss of independent monetary policy Loss of independent monetary policy

(but all member countries have (but all member countries have representation in monetary policy).representation in monetary policy).

Fiscal policy within a member Fiscal policy within a member country could increase budget country could increase budget deficits and require government deficits and require government borrowing, putting upward pressure borrowing, putting upward pressure on interest rates. Increasing the on interest rates. Increasing the money supply to avoid high interest money supply to avoid high interest rates would threaten inflation. So EU rates would threaten inflation. So EU members agreed to avoid debt.members agreed to avoid debt.

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

Labor Market Flexibility can also Labor Market Flexibility can also speed recovery when some region speed recovery when some region experiences recession. experiences recession.

If workers are mobile, unemployed or If workers are mobile, unemployed or poorly paid workers can relocate to poorly paid workers can relocate to countries with higher labor demand. countries with higher labor demand. That will even out imbalances. That will even out imbalances.

But cultural and linguistic differences But cultural and linguistic differences hinder labor movements in Europe.hinder labor movements in Europe.

Wage adjustments are another Wage adjustments are another important form of labor market important form of labor market flexibility. If workers accept lower flexibility. If workers accept lower wages in a recession, employers need wages in a recession, employers need not lay them off. They can also pass on not lay them off. They can also pass on the reduction in payroll costs through the reduction in payroll costs through price reductions. Lower prices promote price reductions. Lower prices promote exports and encourage domestic exports and encourage domestic consumption. This increase in demand consumption. This increase in demand speeds recovery.speeds recovery.

But Europe has problems with wage But Europe has problems with wage flexibility through legislation and union flexibility through legislation and union practices preventing it.practices preventing it.