Chapter 7: The European Union (latest revision 2009) Development of the European Union



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Chapter 7: The European Union (latest revision 2009)
1. Development of the European Union
The first half of the 20th century saw two World Wars in Europe fueled by the hostilities between France and Germany. At the end of World War II, there was a new “dream” on the part of many Europeans --- a united Europe. It was hoped that a united Europe would never again see the scourge of war. This dream of unity got its initial impetus when the United States embarked on the Marshall Plan (named for the American Secretary of State George Marshall). The Marshall Plan was a very large aid plan for Europe, given to both the victorious countries such as France and to the defeated countries such as Germany. This large aid plan required an organization to administer the aid money. So in 1948, the Organization for European Economic Cooperation (OEEC) was created and headquartered in Paris.

A more significant step in the creation of a European Union came in 1951 with the creation of the European Coal and Steel Community (ECSC). This was created because of the fear that the recovery of the German economy might lead to the revival of German militarism. In the ECSC, coal (the main fuel of the time) and steel could be sold without restriction in any of the member countries. In addition, there was a central authority (not controlled by the member countries) to make all decisions regarding coal and steel. Originally, the members of the ECSC were France, Germany, Belgium, the Netherlands, Luxembourg, and Italy.


The next major step in the creation of a European Union came in 1955 with the Treaty of Rome. This treaty established the European Economic Community (the EEC). To understand the EEC, we need to understand the various levels of economic integration. The lowest level of economic integration is called a Free Trade Area. In a Free Trade Area, goods and services can move freely between the countries with no tariffs or quotas. We will see several examples of free trade areas in this course. The next higher level of economic integration is called a customs union. A customs union is a Free Trade Area in which the member countries agree to have a common external tariff against the products of countries that are not members. So, for example, France and Germany would have the same tariff on products made in the United States. The next level of economic integration is called a common market. A common market is a customs union in which workers can move without restriction between the member countries and in which businesses can operate production facilities in any of the member countries. The highest level of economic integration is called an economic union. An economic union is a common market that also has a common currency. The United States is therefore an economic union of the 50 states. In Europe, the EEC, comprised of the six original members of the ECSC, completed the creation of a customs union by 1968 but did not complete the creation of a common market until 1993.

Notice that the European Economic Community (EEC) did not include Britain. Originally, Britain chose not to become a member. Instead, it led a rival organization, the European Free Trade Area (EFTA) that included itself, Sweden, Norway, Denmark, Austria, Switzerland, and Portugal. When Britain changed its mind and tried to join the EEC in 1961, it was vetoed by France. Finally, Britain was admitted in 1969. At that time, Ireland and Denmark also became members. In 1981, Greece became a member. And in 1986, Spain and Portugal were added as members. So by the early 1990s, there were 12 member countries in the European Economic Community. This means that there were no tariffs or quotas among these 12 countries and that the tariff for each of these countries against products from non-members was identical.


The next major step in the creation of the European Union was the Single European Act of 1987. This created a project to move to a full common market. As noted above, a common market requires the free movement of all goods and services, workers, and capital goods between the member countries. The Single European Act took until 1993 to implement. It brought about the elimination of all customs barriers at the borders of each member country. As of 1993, citizens of member countries would no longer need passports to enter other member countries, much as citizens of California do not need passports to enter Nevada. And goods could move between the countries without being stopped at the border. The Single European Act also brought some standardization of technical regulations between the member countries. Differences in these regulations had previously made it difficult to sell products outside one’s own country. Finally, the Single European Act brought about controls on the purchases of national and local governments. In the past, the national and local governments had tended to give preference to local companies in their purchases (only 2% of all government purchases had been made from companies in a different country.) This could no longer occur.

The creation of the common market expanded trade between the member countries considerably. But it did not lead to much internal migration. Most migration into the original 12 countries has come from Eastern Europe, Turkey, Pakistan, and North Africa. On the other hand, the creation of a common market did lead to a large amount of foreign direct investment within these 12 countries. Foreign direct investment is the owning and controlling of a company in another country. It has also led to a large number of mergers. Companies have merged to become larger in order to take advantage of the larger European market (see below).


In December, 1989, the European Union established the Social Charter, designed to create consistent labor laws in all member countries. Labor unions were protected by law and their right to engage in collective bargaining was guaranteed. (See Chapter 4 for a discussion of European labor unions.) Workers were given the right to be represented on the board of directors of companies and therefore to participate in decisions regarding the operation of the company. (For this reason, Britain did not sign the Social Charter.) This is called co-determination and was also discussed in Chapter 4. And finally, equal rights were guaranteed for men and women, including comparable pay for comparable work.
In 1991, the members signed the Treaty on European Union, known as the Maastricht Treaty (Maastricht is a small town in the Netherlands, near both Belgium and Germany). At that time, the name was changed from the European Economic Community to the European Union. The Maastricht Treaty created the conditions by which the member countries could move to a full Economic Union. An economic union is a common market in which there is also a common currency. We will discuss these conditions below. The treaty did not resolve a major political question: how much authority should go to the European Union and how much should be retained by the member countries? Europe is still wrestling with this question. (This question has also been a major one in the United States: how much authority should go to the federal government and how much should be reserved for the various states?)
In 1993, the European Union was expanded to 15 members as Austria, Sweden, and Finland joined. Then, in 2002, it was decided to expand the European Union again. Ten new members were admitted in 2004 --- Hungary, Poland, Estonia, the Czech Republic, Slovenia, Latvia, Lithuania, Slovakia, Cyprus, and Malta --- bringing the total to 25. Two more members were admitted in 2007 – Bulgaria and Rumania. There is still a debate about admitting Turkey. As of now, both the population and the land area of the European Union are considerably greater than those of the United States. The new European Union has 455 million citizens compared to 305 million for the United States. And the total Gross Domestic Product of the European Union is similar to that of the United States.
2. The Institutions of the European Union
Before analyzing the economic effects of the integration of Europe, we need to describe the basic institutions of the European Union. The main bureaucracy of the European Union is the European Commission. (For the United States, this would be the executive branch of government.) The Commission drafts proposals, sees that policies are implemented, manages the common policies of the European Union (in agriculture, fishing, energy, the environment, competition policy, and so forth – see below), controls the European Union’s budget (collecting and spending the funds – see below), enforces European Union law, and negotiates agreements on behalf of the entire European Union. Despite being sent by the member nations, the Commissioners are supposed to act independently of the governments of their nations. A new commission is appointed every five years. There is one commissioner from each member country. The President is presently Jose Manuel Barrosa of Portugal. His term (and the terms of the other current commissioners) runs until October 31, 2009. The 25,000 other people who work for the European Commission are permanent officials (bureaucrats -- but called functionaries).
The overall agenda of the European Union are determined by the Council of Ministers. This is composed of the President of the European Commission and the heads of government of the member nations, with each member country presiding as for a six month period. They meet up to four times a year. One might consider this analogous to a Board of Directors! In the new Constitution that was proposed, the six month rotation was to be eliminated. Instead, the 25 heads of state would choose a “president of Europe” to serve a 2 1/2 year term. But this Constitution was not ratified (see below).
Most day to day decisions are made by The European Council. This is the de facto legislature. Each member government sends one Minister to Brussels Belgium. The Minister chosen will be different depending on the issue to be discussed. This Minister has the authority to commit his or her home government. Much legislation must be approved by both the European Council and the European Parliament. But the European Council can also issue some regulations and directives that are binding on all citizens within the European Union. There are 321 votes possible in the European council. Countries with larger populations are accorded more votes. On some matters, 232 votes are required for a vote to be passed (72.3%). As this is constituted now, winning 232 votes requires at least 12 countries (and at least 62% of the population of the European Union). On other matters, votes must be unanimous. The Council has been set up so that the small countries have a disproportionate influence.
The European Union has a directly elected parliament called the European Parliament (in Strasbourg France, Brussels, and Luxembourg). With expansion, there are 732 members of the European Parliament who are directly elected in elections held every five years. This was a symbolic group in the past. But more recently, this has become more of a legislative body as is the United States Congress. At present, there are nearly 100 different political parties represented in the European Parliament. The European People’s Party – Christian Democrats and the European Democrats hold 267 seats (they would be considered the “center-right”) while the Socialist Group holds 201 of the 732 seats. The European Parliament is involved in legislation along with the European Council (on an equal basis). This is called “co-decision”. The European Parliament approves the European Union’s budget (see below) and provides supervision of the European Commission and the Council of Ministers.

It is typical that proposals begin with the European Commission. These will then be discussed with the European Parliament before being referred to the European Council. The European Council then accepts the proposals, amends them, or defeats them according to the voting scheme mentioned above.

The creation of a single currency also led to the creation of a European Central Bank. This went into operation in 1999 based in Frankfurt Germany. Like the Federal Reserve System in the United States, this has been designed to be relatively free of political pressures. The 6-person Executive Board of the European Central Bank and its President and Vice President (included among the six) are appointed for non-renewable eight year terms. The Governing Council includes the six Executive Board members as well as the governors of the national central banks of the twelve countries that are presently members of the European Monetary System (see below). These people meet in Frankfurt Germany every two weeks for the purpose of making policies concerning the money supply and interest rates. The European Central Bank is not under the control of either the European Parliament or the European Commission. This gives it an even greater degree of independence than the American Federal Reserve. The national central banks, such as the Bundesbank (Germany) and the Bank of France, still remain. But they no longer make monetary policy alone. The European Central Bank and the national central banks together are called the Eurosystem.

The European Central Bank has stated that its overall goal is price stability (an inflation rate of no more than 2% per year). The European Central Bank has accepted no responsibility for maintaining low unemployment rates in Europe. Despite this single stated goal, inflation rates within the European Union were higher than the 2% goal most of the time between 1999 and 2004. The money supply seems to have grown faster than the European Central Bank said that it would. This indicates that, despite its statements, the European Central Bank has indeed acted to reduce the high unemployment rates and to try to increase the slow rates of economic growth.
In 2004, the next step in European integration was attempted with the creation of a European Constitution. The passage of the Constitution required the unanimous vote of all member nations. In 2005, France and the Netherlands rejected the new constitution. A revised version was attempted. In 2008, this revised version was rejected by Ireland (the only country required to have a vote of the people). At this writing (2009), there is no European constitution.
3. The Budget of the European Union
The budget of the European Union is small. It typically amounts to about 1% of the GDP of the member states (and about 2 ½ % of the government spending of the member states). About 45% of the budget goes to the Common Agricultural Policy (described below). An additional third of the budget goes to what are called “Structural Measures” --- regional development programs and some income transfer programs. Some of these were mentioned in Chapter 6 as one of the ways that Ireland benefited from joining the European Union.

The money for this spending by the European Union comes from few sources. About 1/6 of the revenues come from the common external tariff on goods from countries outside the European Union. Another 40% of the revenues come from a surcharge on the value added tax. The value added tax (VAT) is common in European countries and is like a sales tax. 1.4% is added on to each country’s value added tax and that money is sent to the European Union. The rest of the money comes from what is called the “Fourth Resource”. This is a contribution from each member country so that every member country is contributing 1.27% of its GDP to the European Union. Today, the money is collected in Euros.



It is required that the European Union budget be balanced. The European Union does not issue debt on its own and therefore cannot borrow to finance a budget deficit.
4. The Economic Effects of European Integration --- Increased Trade
Most economists have long been supporters of free trade, a major aspect of liberal market capitalism. Accordingly, most economists supported the integration of Europe. Free trade has many beneficial effects. First, free trade forces a country to specialize in those goods or services for which it has a comparative advantage. This was discussed in Chapter 2. In being forced to specialize, people and capital goods move from production of goods and services for which productivity is relatively low to production of goods and services for which productivity is relatively high. The resulting increase in overall productivity causes the standard of living to increase. Second, by allowing the goods and services of other countries to be sold in a country, the supply of the goods and services increases. For example, there are more automobiles in both Germany and France when German automobiles can be sold in France and French automobiles can be sold in Germany. The increase in the supply causes the prices of these goods and services to be lower. Third, and related to the second point, opening to trade increases the amount of competition. Again German automobiles and French automobiles must compete with each other in all markets. More competition forces companies to make better products and to charge lower prices. Fourth, the opening of trade means that companies can often sell their products in a larger market. The larger market allows them to produce more goods or services. When they produce more goods or services, companies often are able to produce at a lower cost (a phenomenon known as economies of scale and mentioned in Chapter 3 as part of the increasing concentration of capital). Lower costs of production allow prices to be lower. This is the reason that the creation of a large European market led to so many mergers (companies combining to become larger). The net result of trade is that more goods and services are available, prices are lower, and the standard of living in the country is greater. Indeed, one recent study shows that if the European Union eliminated all of its tariffs against outsiders, its prices would be 20% lower and its GDP would be 6% greater than they are at the present time.

While trade benefits all of the member countries, it does not benefit every citizen of the member countries. Within each country, some people gain from greater trade and some people lose. Since trade forces countries to specialize in those products for which they have a comparative advantage, those who produce those specific products gain. Those who produce products in which the country has a comparative disadvantage are likely to lose. So within the European Union, people who produce capital intensive products like German automobiles or produce technology intensive products like computer software are likely to be “winners”. People who produce agricultural products such as French farmers or produce textiles or apparel products would likely be “losers”.



Economic integration acts to increase trade between the members of the European Union. That was one of the most important purposes in the creation of the European Union. But integration also may decrease trade between each member of the European Union and those countries that are not members. The most important non-member country is, of course, the United States. The increase in trade within the European Union is called trade creation. The decrease in trade with non-members such as the United States is called trade diversion. All estimates that have been made have shown that the value of trade creation from European integration far exceeds the value of trade diversion. So, European integration has been one major reason for the rapid economic growth of the European countries. The case of Ireland discussed in Chapter 6 is a clear example of this point.
5. The Economic Effects of European Integration --- Monetary Union
A. History of Monetary Union
The movement to a single currency was the most radical aspect of European integration. It took a long time to bring about. In 1979, the European Monetary System was created. This lasted until December 31, 1998. This system created fixed exchange rates among the participating countries. The central bank of each participating country agreed to intervene in the foreign exchange market to keep the exchange rates fixed. This means that the central bank agreed to buy or sell foreign money to keep the exchange rates stable. To illustrate this, let us suppose that inflation occurred in France causing French consumers to want to buy more German products. They would have needed more German marks. Their increased demand for these German marks would have caused the price of these German marks to increase. To keep the price (exchange rate) stable, the central banks of both France and Germany agreed to intervene in the foreign exchange market. Each central bank would enter the foreign exchange market and sell German marks to drive the exchange rate back down to the level agreed to. Germany would get the German marks to sell by creating them. After all, marks were money in Germany. France would get the German marks to sell from international reserves that it had accumulated in the past (or by borrowing from Germany). If the Bank of France sold German marks, the French people would have German marks and the Bank of France would have French francs. Since francs were money in France, the French people would have fewer francs. With fewer francs available to spend, the French people would have to spend less. Less spending by the French people would cause the French inflation to decrease.

For the first thirteen years of its existence, the European Monetary System worked well. But then, in 1992 and 1993, the European Monetary System hit a major crisis. The origin of the crisis began with the reunification of Germany in 1990 at a time when much of Europe was experiencing a recession. When (the former communist) East Germany and West Germany were reunified, West Germany was much richer and more productive than East Germany. In order to bring the two regions into greater balance, Germany undertook a major program of spending in the East. Fearing that this large increase in government spending would cause inflation in Germany, the German central bank responded by raising German interest rates. This increase in German interest rates attracted lending from people in the United States, Japan, and the rest of Europe. To lend in Germany, people had to buy German marks. Their buying of German marks again would cause the price of the German mark to increase. But the countries of Europe had agreed to keep their exchange rates fixed as part of the European Monetary System. In order to maintain a fixed exchange rate with the German mark, the central banks of countries such as Britain, France, Sweden, and Italy would have to either sell German marks in the foreign exchange markets or increase their own interest rates to match those of Germany. Selling marks would have decreased the money supply in Britain, France, and so forth (more German marks and fewer British pounds means less money to spend by the British). Given the recession that was going on in Europe at the time, a decrease in the money supply or an increase in their interest rates would have further decreased total spending in these countries and plunged these countries into greater recession. At first, the leaders of these countries pledged that they would do whatever was necessary to maintain the fixed exchange rates. But foreign exchange speculators (especially one George Soros) did not believe them. A speculator is one who tries to gain income by buying one currency and selling another, hoping that the price of the one bought will rise and the price of the one sold will fall. The speculator is gambling. A situation such as that of Europe in 1992 presented a great opportunity for these speculators. The great opportunity was to “bet” that the French Franc, British pound, Italian lira, and Swedish crown would lose value in relation to the German mark. That is, the speculators bet that these countries would not accept the unemployment that goes with a deeper recession and therefore would not maintain the fixed exchange rate. The speculators would “bet” by buying German marks and selling French francs, British pounds, Italian lira, Swedish crowns, and so forth. If the speculators were right and the fixed exchange rates were not maintained, they could make a great amount of money by selling their German marks back later for a higher price. If the speculators were wrong and the fixed exchange rates were indeed maintained, they could sell the German marks they bought at the same price and get their money back. There was no possible way that the German mark would go down in value. Either the speculators would win or they would break even. Not a bad deal for a gambler! Some of the countries did try to maintain the fixed exchange rates. It has been estimated that the Bank of England lost $7 billion of its reserves in just a few hours by this process. The Bank of England could not go on losing reserves at this rate. So after awhile, it abandoned the system of fixed exchange rates. Britain was no longer part of the European Monetary Union and, as of this writing, still uses the pound instead of the Euro. Another example was Sweden. At one time, it raised one of its interest rates to over 500%. But the speculators kept on selling Swedish crowns. Eventually, Sweden too was forced to abandon the system of fixed exchange rates. In a few months, the system of fixed exchange rates was over and a new system of floating exchange rates had begun. (This means that the countries would no longer agree to maintain the fixed exchange rates.) George Soros has made billions of dollars.
Later in the 1990s, most of the countries of Europe decided to try fixed exchange rates once again. Only this time, they decided to move to eliminate their national currencies entirely and create a common currency, the Euro. This way, their system could not be undone by speculators buying one of their currencies and selling another (just as speculators cannot sell a California dollar and buy a Texas dollar).

The program that was to lead to a single currency had actually begun in 1990. It began with an attempt of the national central banks to more closely coordinate monetary policy. Closer coordination would make it less likely that one country would have inflation while the others did not. This would reduce the need for central bank intervention in the foreign exchange markets. As we have just seen, this attempt failed in 1992 when Germany wanted a contractionary monetary policy with high interest rates while the other countries wanted an expansionary monetary policy with lower interest rates.



The next significant step in the direction of a monetary union came in 1994 with the creation of the so-called Maastricht criteria (once again, named for the small town in the Netherlands). The idea again was to ensure that the economies of the different member countries were on a similar path. Each country that wanted to be part of the European Monetary System agreed to ensure the following: (1) its inflation rate would not be more than 1.5% above the average inflation rate of the three member countries with the lowest inflation rates, (2) its long-term interest rates would be no more than 2 percentage points above the long-term interest rates of the three member countries with the lowest inflation rates, (3) its government budget deficit would be no more than 3% of GDP, (4) its national debt would be less than 60% of GDP, and (5) its exchange rate would be stable from 1997 to 1999. In 1999, 11 countries were admitted to the monetary union. These were Germany, France, Italy, Austria, Belgium, Finland, Ireland, Luxembourg, the Netherlands, Portugal, and Spain. In 2001, Greece joined, bringing the total number of member countries to 12 and covering more than 300 million people. It was agreed that these countries had met the Maastricht criteria (except for the national debt criterion which was waived). Britain, Sweden, and Denmark did not join. The European Monetary System also created a new money --- called the Euro. At first, this new money was just used as a unit of account. Records were kept in Euros as well as in the currency of the country. But there were no actual Euros circulating. That changed in 2002 when the Euro became a medium of exchange. Euro paper money and coins replaced the national money. They could do so because of the long period of fixed exchange rates. See the conversion rates below. The Euro now serves as money in 12 of the member countries just as the dollar serves as money in the 50 American states. (The Euro notes are identical in all countries. There are seven different notes in seven different colors. But each country issues its own coins. There are eight Euro coins --- 1,2,5,10,20, and 50 cents 1 Euro, and 2 Euros. One side of the coin is common to all countries. The other side of the coin displays some distinctive national symbol.) Getting this done on time was a major achievement. There were 14.5 billion bills to print and 51 billion new coins to mint. They were all ready at the end of business on December 31, 2001. Thanks to a major marketing campaign, people accepted the new money. By early January of 2002, Europe had accomplished the largest monetary conversion in world history without a hitch. The old paper money was burned as fuel or turned into agricultural compost. (Partly this conversion was facilitated by the fact that Europeans use cash cards – or debit cards – for a much broader range of purchases than do Americans.) The ten countries that have joined the European Union since 2000 are committed to adopting the Euro. As of this writing (2009), none has done so. Denmark, Sweden, and the United Kingdom still do not use the Euro.
Table 1 Conversion Rates of National Currencies into the Euro

Belgian Franc 40.3399 German Mark 1.95583

Spanish Peseta 166.386 French Franc 6.55957

Irish Punt 0.787564 Italian Lira 1936.27

Luxembourg Franc 40.3399 Dutch Guilder 2.20371

Austrian Schilling 13.7603 Portugal Escudo 200.482



Finnish Marka 5.94573
B. Advantages of Monetary Union
The main advantage of the creation of a single currency is that it eliminates the need for currency conversion. Previously, any German traveling in France or doing business in France would need to convert his or her German marks for French francs. This conversion took time and labor. That time and those workers are now free for other tasks. Estimates have shown that the cost of exchanging money is small – less than 1% of the GDP of the European Union.

The single currency also eliminates exchange rate uncertainty. Someone doing business in a member country no longer has to worry that a business deal that seemed profitable will turn unprofitable because of an unexpected change in the exchange rate. The elimination of currency conversion and exchange rate uncertainty should make trade easier and therefore bring the benefits of enhanced trade mentioned above.

The creation of a single currency also eliminates the need for each country to hold international reserves. Remember that, in the example above, the French central bank had to intervene in the foreign exchange market by selling German marks. The French central bank no longer has to hold reserves of German marks (or the money of any other member country) to be able to intervene. Holding these reserves entailed a cost that no longer exists.

The creation of a single currency also facilitates the creation of an integrated market. We can measure how well markets are integrated by the differences in the prices of the same products. In highly integrated markets, prices should be very similar. Prior to the introduction of the Euro, prices could vary greatly. For example, a hamburger from McDonalds could sell for $3.55 in Finland. The same hamburger sold for $2.00 in Greece. Since the introduction of the Euro, prices have converged significantly. This shows that the markets have become more integrated. (Studies of North America, for example, have shown significant price differences between Detroit Michigan and Windsor Ontario Canada, although these cities are only a few miles apart. National boundaries seem to matter greatly when there are different currencies.)

Finally, the creation of a single currency makes the Euro an important world currency. Other countries will hold some of their reserves in Euros. The greater importance of the Euro will increase the importance of the European economies. It may also stimulate business for European financial institutions.
C. Disadvantages of Monetary Union
The main disadvantage with the creation of a single currency is that it eliminates the use of exchange rate policy as a means of dealing with economic problems. As an example, a major hurricane hits Louisiana. The people of Louisiana have fewer goods to sell to the rest of the United States and need to buy more goods from the rest of the United States. If there were different monies, Louisiana would depreciate the Louisiana dollar. This would encourage more buying of Louisiana goods (by making their goods cheaper) and less buying by people in Louisiana of the goods of other states (by making those goods more expensive). Since Louisiana is part of the United States, there is no Louisiana dollar. Louisiana cannot adjust by depreciating its dollar. Instead, it has to adjust by either accepting greater unemployment or by accepting lower wages. Accepting lower wages requires that wages be able to fall easily. That is rarely the case. So the result is more likely to be unemployment. The amount of unemployment that must be endured depends on how mobile workers are. Louisiana workers can relatively easily move to other states like Texas where jobs might be available. It might be harder for French workers to move to Germany or vice versa as the cultures and the languages are quite different.

Other disadvantages of monetary union follow from the specifics of the Maastricht criteria. As mentioned, the European Monetary Union required that each member country keep its budget deficit below 3% of its GDP. Doing this eliminated the use of fiscal policy as a stabilization tool. As unemployment increased in Europe, the normal response would have been to increase government spending or reduce taxes (or both). But both would have increased the budget deficits to more than 3% of GDP and therefore reduced the prospect of a country being accepted into the European Union. (In addition, the country experiencing the budget deficit would have been subject to a fine of up to 0.5% of GDP.)



In addition, the monetary union took away from the countries the ability to use monetary policy to try to solve economic problems. Monetary policy has been basically controlled by the European Central Bank. The European Central Bank has been dominated by Germany and is noted for its limited growth of the money supply and corresponding high interest rates. As a result, the economic growth rates of the countries trying to meet the Maastricht criteria were lower throughout the 1990s than the growth rates of other countries, including the other European countries. Political systems are still national. The reaction of French and Italian citizen to the inability of their governments to use fiscal and monetary policies to reduce the high unemployment rates or stimulate growth has major political implications inside France or Italy.
Test Your Understanding

In 2005 and 2006, the price of oil rose greatly. Oil is a major cost of production in all industrial countries. So in all countries, costs of production increased, causing increases in prices of products (inflation). As we saw in Chapter 4, countries with highly centralized collective bargaining, such as Sweden, are more likely to take the inflationary impact of rising oil prices into account than countries with decentralized collective bargaining, such as Italy. Therefore, demands for wage increases should be more restrained in Sweden than in Italy, causing less inflation in Sweden than in Italy. Analyze the adjustments that would be necessary in both Sweden and in Italy assuming that they have different monies, the Swedish crown and the Italian lira. Then, analyze the adjustments that would be necessary in both Sweden and in Italy assuming that they have the same money, the Euro.


D. Conclusion about Monetary Union
From a purely economic point of view, it does seem that the benefits of changing to a common currency are small for most of the European countries. And the risk is significant. Giving up both monetary policy and fiscal policy may make it very hard to adjust to economic situations that may arise. Yet many European countries have chosen to give up their national currency and substitute the Euro. This would seem to indicate that there is a strong desire for the political integration of Europe and that monetary union is seen as a step toward this political integration.

6. The Common Agricultural Policy (CAP)
The Common Agricultural Policy of the European Union was first discussed in the chapter on Ireland. Europe maintains agricultural support programs similar to those found in the United States. There are two kinds of programs. One is a price floor. The European Union sets a minimum price by which certain agricultural products can be sold. This price is higher than the price that exists in the world market. This high price encourages farmers to grow more than they otherwise would with the result that Europe is now self-sufficient in food production. (Before the Common Agricultural Policy, Europe used to import about 20% of its food needs.) The high price also discourages buyers from buying. This generates a surplus of these agricultural products. This surplus is bought by the European Union and then stored at the expense of the European Union. (Remember that expenses for these agricultural programs comprise about half of the European Union budget.) Often the surplus is exported at low prices, with the loss taken by the European Union, not the farmers. Selling this surplus in world markets acts to drive the world price down, generating less income for farmers in poor countries who are also trying to sell their agricultural production in world markets.

The other program involves output restriction. Farmers are paid not to grow certain products. This, of course, raises the price of what is produced, but does not generate a surplus that has to be stored. As a result of these two programs, the European Union has some of the highest food prices in the world. And because the price paid for food inside the European Union is so high, there has to be a significant tariff on imported food. (Otherwise, food buyers would just buy the cheaper food from outside the European Union.)

Within the European Union, the Common Agricultural Policy generates winners and losers. Winners are the farmers found in Greece, Ireland, Spain, France, and Denmark. All the other countries are losers (farmers in these other countries produce products that are not supported by the Common Agricultural Policy). Winners are generally richer farmers while losers are poorer urban food consumers. So the policy is regressive. Despite there being so many losers, the Common Agricultural Policy has been maintained because it keeps the support of the farm interests for the European Union and therefore helps keep the European Union together.


7. European Union – American Economics Relations
The United States and the European Union are each others’ largest trading partners and foreign direct investment partners. (Foreign direct investment is the owning and controlling of a company in another country.) In we count both goods and services, almost 20% of all American imports came from the European Union and almost 22% of all American exports went to the European Union before the European Union was enlarged. As of 2005, about 23% of the exports of the European Union went to the United States and about 14% of the imports of the European Union came from the United States. (Each area buys about one-fifth of the others’ exports of high technology products.) By 2004, the foreign direct investment of the European Union in the United States totaled approximately $950 billion while the foreign direct investment of the United States in the European Union totaled approximately $1,035 billion. An estimated 5 to 7 million Americans owe their jobs directly or indirectly to European companies located in the United States and an equal number of European owe their jobs directly to American companies located in the European Union. Many of the brands that Americans are familiar with are European owned. Examples include DKNY (France), Sunglass Hut (Italy), Brooks Brothers (Italy), Mazola Oil (UK), Libby’s (Switzerland), Snapple (UK), Random House (Germany), Dove Soap, Slim Fast, and Vaseline (Netherlands), Pennzoil (Netherlands), Birdseye (Netherlands), Dreyer’s Ice Cream and Power Bars (Switzerland), Ben and Jerry’s (Netherlands), Shell (Netherlands), RCA (Germany), American Heritage Dictionary (France), Miller Beer (UK), Dr. Pepper and A&W Root Beer (UK), Dunkin’ Donuts (UK), Verizon (UK), DHL (Belgium), and so on. The largest food retailer in the Eastern United States is Royal Ahold (Netherlands). On the other hand, many of the brands that Europeans are familiar with are American owned. As just one example, Ford owned Volvo, Jaguar, Aston Martin, and Land Rover. So these two economic powers are obviously very important to each other.
When the Single Market was being created in the European Union in the 1990s, the United States became very concerned. The phrase in vogue at the time was “Fortress Europe”. While a good part of the trade for the European Union as a whole was with the United States, the vast majority (almost 2/3 on average) of the trade for individual countries of the European Union was with other countries of the European Union. The United States was concerned that with no tariffs between the 27 member countries of the European Union and a high common external tariff against the United States, the United States would be shut out of the European market. This fear has turned out to be unfounded. As time has gone on, the common external tariff of the European Union has decreased. The United States and the European Union together have been leaders in getting tariff reductions at the international trade negotiations. The United States has not been shut out of the European market at all.
In total, the relationship between the United States and the European Union has been quite amicable. It has certainly been more amicable than the trade relationship between the United States and Japan in the 1980s and the trade relationship between the United States and China presently. These are discussed in later chapters. But recently, the relationship between the United States and the European Union has become more strained. There have been trade disputes over several issues. Let us just look at a few of these issues.
1. The United States has had a program of tax breaks for subsidiaries of American companies that conduct export sales. In 2000, the World Trade Organization (WTO) found that these tax breaks were illegal. Since these tax breaks were not changed to the satisfaction of the WTO, in March of 2004 the WTO authorized the European Union to impose sanctions. The European Union then imposed a tariff of 5% on American exports totaling $4 billion. This tariff increased, reaching 14% by December of 2004. The tariff was removed in January of 2005 when it appeared that the tax breaks had been eliminated. But in February of 2006, the WTO ruled that the United States was still conferring illegal subsidies on exports. The European reimposed tariffs of 14% on $2.4 billion of American exports, beginning in May of 2006. The United States has complained about the reimposition of these tariffs.
2. The United States has gone to the World Trade Organization (WTO) to argue that European subsidies for Airbus are unfair. Airbus, which was a consortium of national aircraft companies, is now a private company owned by just two companies, 80% by the European Aeronautics, Defense, and Space Corporation (EADS) and 20% by British Aerospace Ltd. (BAE Systems). However it is still closely connected with European governments. In the past few years, Airbus passed Boeing as the world’s leading producer in aircraft production. It did this by producing low cost aircraft for the low cost airlines that arose in Europe (Ryan and EZJet are similar to Southwest and Jet Blue in the United States). The trade dispute began in 2000 when Airbus announced it would build the world’s largest passenger aircraft, the Airbus A380. The United States (acting mainly on behalf of Boeing) complained about a $3.2 billion loan to Airbus from the governments of France, Germany, Spain, and the United Kingdom. The United States also complained that European governments provided funds to the subcontractors on the Airbus project and provided funds for infrastructure necessary for the project. In all, the United States contended that Airbus had received about $13 billion in grants and another $26 billion in loans from European governments since its founding. The European Union (on behalf of Airbus) argued that Airbus had repaid most of the loans from the governments and that these loans were at commercial rates. Airbus also claimed (correctly) that Boeing also received huge subsidies from the American government in the form of military and space contracts, that the American government bought its airplanes only from Boeing, and that Boeing’ newest project, the 787 (a 250 seat airplane), is financed with a large tax break from the state of Washington. (Airbus is working on the A350 to compete with Boeing’s 787. This has the United States very worried.)
3. One of the most bitter trade disputes involved the European Union ban on the import of American meat treated with growth-promoting hormones. There is bitterness even though the amount of trade in dispute is small. The European Union argued that meat treated with growth-promoting hormones is a risk to the health and safety of European consumers. The United States argued that it is not. The World Trade Organization (WTO) sided with the United States. The United States responded with 100% tariffs on certain agricultural products from the European Union. The European Union responded by removing five of the growth hormones from its banned list. It claims that the United States is now violating WTO rules by maintaining the 100% tariffs. The United States holds its original position. The case is still being heard. (There are also several other cases involving bio-engineered foods.)
4. Some of the disputes have involved competition policy (known as the anti-trust law in the United States). The European Commission is responsible for competition policy in the European Union. In most cases, there has been agreement between the European Commission and the United States Department of Justice. But a major case highlighted the differences. General Electric (GE) offered to pay $43 billion to buy Honeywell International. GE and Honeywell do not generally produce the same products (that is, they are not generally competitors). GE produces large aircraft engines. Honeywell produced small and mid-size jet engines, air collision warning devices, and navigation equipment. The United States Department of Justice concluded that the merger would allow the single company to offer better products to companies such as Airbus or Boeing than either company could do alone. Since the United States Department of Justice believed that competition would be improved, it approved the merger. The one in charge of anti-trust policy for the entire European Union is called the Director General for Competition (DGC). His name was Mario Monti. He reviewed the merger and concluded that the merger would strengthen GE-Honeywell’s dominant position in the industry and that the merger would make competition more difficult for other producers of airplane equipment, such as Rolls Royce, possibly even forcing other competitors out of business. So the European Commission, on recommendation of the Director General for Competition, unanimously disapproved the merger (a vote of 20 to 0). Ultimately, the merger of GE and Honeywell did not occur even though both are American companies. The CEO of GE, Jack Welch, lost his position as a result. Between 1990 and 2004, the European Commission dealt with 2,508 mergers. Only 18 were disapproved. So this was a very special case.
5. A final case that we will discuss here involved Microsoft and the charge that it acts to stifle competition. In 2004, the European Commission fined Microsoft $612 million, ordered the company to disclose its code to competitors so that their products could be used on the Windows operating system, and required the company to offer a version of the Windows operating system without Windows Media Player. Microsoft appealed. In December of 2004, a European judge upheld the imposition of these sanctions. Microsoft appealed again, arguing its case in April of 2006. Several prominent people in the Bush administration and several leading Republican Senators took the side of Microsoft. Threats of a trade war were made. But so far, no trade war has materialized.
This section has shown some of the areas of disagreement between the United States and the European Union. It should be noted that on most matters, the two sides have managed to agree. They are also in the process of trying to create a regime that will harmonize their policies better. On the whole, the United States and the European Union are friends.

8. Summary and Challenges Facing the European Union
The European Union is one of the grand experiments of human history. In this chapter, we have examined the history of the development of the European Union, the arguments for the economic benefits from this union, and some of the institutions that have been developed thus far. From a group of warring countries, Europe is attempting to come together in ways that preserve national identity but maintain the peace. By increasing trade and allowing the free movements of people and of capital, European integration has raised the standard of living to unprecedented levels, creating an economy of the same magnitude as the United States. In a world in which the United States has been dominant, the new Europe could emerge as a competitor in the 21st century. With the shift to a common currency in 2002, this grand experiment took a very big step. For those familiar with the history of Europe, the experience of integration since the end of World War II has been an amazing time!
The European Union faces some serious challenges early in the 21st century. One major challenge is unemployment and the severe world recession that began in 2007. As we have seen, unemployment has been a serious problem in several European countries for many years. And the situation became much more serious following the severe world recession that began in 2007 (and is still continuing as of this writing). Unemployment threatens social cohesion. There have been serious protests in several European countries. The European Union has been having trouble achieving consensus as to how to handle the current severe world recession. A country such as Britain has desired a large increase in government spending programs. Countries such as France and Germany have resisted this. The countries agree on the need to provide new regulation of financial institutions. But they disagree as to how this should be accomplished. Without some kind of coordination among themselves (as well as with the United States), the policy response to the economic problem could be very limited and the recession could continue for many years to come.

Another major challenge comes from the new member countries. As was noted, ten new countries became members of the European Union in 2004. Two more countries became members in 2007. Turkey still wishes to become a member. Someday, perhaps Russia will want to join. The new member countries are significantly poorer than the original members. Many German companies have already located production facilities in Eastern Europe to take advantage of the cheaper labor. This has made some German companies more competitive internationally but could threaten some of the labor market institutions of Germany.

A related challenge is immigration. The Common Market allows anyone to move without restriction anywhere within the European Union (much as an American can move freely to any state). So far, nearly all of the migration of people has been of people from the poorer countries (such as Greece, Eastern Europe, and even Turkey) into the richer countries (such as Germany, France, Ireland, and Britain). This has created a “clashing of cultures” in areas that had been relatively culturally homogeneous. Although it is still small, the rise of Nazism in Germany is an ominous sign. Americans know full well the difficulties that can arise when attempting to integrate migrants into a dominant culture.

A final challenge that will be discussed here is political integration. Just how far are Europeans willing to go to promote political integration? The defeat of the new European constitution in France and in the Netherlands in 2005 (and the defeat of the revision by Ireland in 2008) show that people still are reluctant to give up sovereignty. Nonetheless, this could change. Young people in Europe are being called “Generation E”. This means that they are more likely to see themselves as European and less likely to see themselves as German or French than was true in the past. Several programs have been developed (known as Socrates, Leonardo da Vinci, and Youth) to allow students to study and volunteer in countries other than that of their birth. As the new generation comes into influence, the idea of a European identity (and therefore a European state) may gain greater acceptance.
The idea of European economic integration is based on some of the important principles of liberal market capitalism. However, the European Union itself, and the example of several of the European countries, present us with a model of capitalism that is different from liberal market capitalism. We have called this the Social Market Economy. Japan presents a somewhat different model of capitalism. Since the Japanese model has been basically copied in countries like Korea and Taiwan, we will call this the Asian Model of the Capitalist Market Economy. We turn to this model beginning in the next chapter.

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