Reference no: EM131737638

Case Scenario: THE ECONOMIC IMPACT OF THE EUROPEAN UNION

We now apply the tools developed in the previous three chapters to determine how the European Union will fare in the years ahead. First, some brief background. In 1957, the Treaty of Rome created the European Economic Community (EEC), colloquially known as the Common Market: the original members were Germany, France, Italy, Netherlands, Belgium, and Luxembourg. In 1973, the EEC expanded to include the UK, Ireland, and Denmark. In 1979, these countries formed the European Monetary System (EMS), which was aimed at closer monetary coordination. This group was joined by Greece in 1981, and Spain and Portugal in 1986. In 1992, the Maastricht Treaty paved the way for monetary union, and the European Community was renamed the European Union (EU). These 12 countries were joined by Austria, Finland, and Sweden in 1995, boosting the ranks of the EU to 15 countries. On May 2, 1998, 11 of these countries agreed to form a common currency that would go into effect on January 1, 1999. The UK, Denmark, and Sweden chose not to join the common currency, and Greece did not immediately qualify, since its budget deficit and inflation rates were too high, although it was permitted to join in 2001. Since a common currency meant common rates of inflation and common budget policies, it was also agreed at the signing of the Maastricht Treaty in 1992 that all countries would achieve the following three goals:

• Inflation rate of less than 3%

Ratio of budget deficit to GDP of less than 3%

• Ratio of national debt to GDP of less than 60%.

When the Maastricht goals were originally set in 1992, only one of the 15 countries satisfied all these criteria - and that was Luxembourg. The treaty appeared to be dead on arrival. However, that turned out not to be the case. The signatories viewed the provisions of the Maastricht Treaty seriously and took steps to meet at least the first two criteria (it was generally recognized that the debt ratio stipulation could only be met over an extended period of time). When the deadline arrived, Greece was the only country failing to meet these goals; as noted above, the UK, Denmark, and Sweden decided not to join the ranks of the common currency. Thus, on January 1, 1999, these 11 countries formed the European Monetary System, using a common currency - the euro - for paperless international transactions. Domestic currencies still circulated, but starting in 2002 euro bills and coins began to circulate alongside domestic currencies. Ten years after that, plans call for all domestic currencies to be phased out, at which point all vestiges of the Dmark, franc, guilder, escudo, etc., will be relegated to coin collectors and history books.

If in fact the EU is able to end the vicious and devastating wars that have plagued the continent over the past two millennia, the union will have been an accomplishment of major proportions, even if the economy does not improve. Nonetheless, the viewpoint du jour of most economists was that a single currency, monetary policy, and fiscal policy would boost the overall European growth rate significantly. As of 2003, there has been no evidence of such a development. The explanation of why European union should boost the growth rate depends on both demand-side and supply-side effects. On the demand side, some slight gains would accrue from removing the last vestiges of tariffs and terminating the costs associated with hedging foreign currencies. However, any such effects would be minimal, especially because most tariffs between the various European nations had already been sharply reduced in the years before 1999. Indeed, the biggest step was taken in 1958, when the original Common Market was formed; that set off an extended burst of rapid growth that lasted for 15 years. By comparison, the final tariff reductions in 1999 were of limited significance. Thus if the EU were to boost real growth significantly, the improvement would have to occur on the supply side: gains in productivity stemming from less government spending, lower tax rates, less government regulation, and more incentives for new technologies.

Also, to the extent that countries previously had large budget deficits and high inflation rates, the discipline imposed by the Maastricht Treaty would boost growth in those countries by curtailing deficits and inflation. One of the key concepts of the that Treaty was that in order for a common currency to work, all countries would need similar monetary and fiscal policies, which would lead to a similar rate of inflation. If one country had an inflation rate of, say, 2%, while another country had a rate of 7%, goods produced by the latter country would soon be priced out of European and world markets. Hence signatories of the Maastricht Treaty were required to reduce their inflation rates and budget deficit ratios. Political leaders of individual countries could then explain to their legislatures that, while such moves might not be politically popular at home, they were imposed by a pan-European authority, and were the price to be paid for receiving the benefits of greater Europe. At first, some progress did occur. Soon after the treaty was signed, the rate of inflation fell from 4% to 2% in Germany, from 3% to 1% in France, and from 5% to 2% in Italy.

The budget deficit ratios fell from 3.4% to 2.7% in Germany, 5.8% to 2.6% in France, and 10.0% to 2.5% in Italy. These are impressive gains and should not be denigrated. However, other major countries who were not signatories to the EMS also reduced their deficits sharply. Not only did the budget ratio move from a 4.4% deficit to a 2.3% surplus in the US, but it narrowed from a 7.9% to a 0.3% deficit in the UK. Faster world growth, low inflation, and declining interest rates played major roles. Thus much of the deficit reduction in the 11 countries who agreed to a common currency was due to beneficial worldwide economic conditions, notably the US boom; when recession occurred in the US, the deficit ratios in Europe started to rise again. Furthermore, the budget-slashing moves that did occur in generating these deficit reductions were not always well received. Partly as a result of these moves, the governments in France, Germany, and Italy initially shifted to the left, not only reducing the chances for further improvements in fiscal policy but jeopardizing the existing budget cuts. To boost productivity growth in Europe, countries must take further steps in the direction of a free market economy. In particular they need to implement the following policies:

• Hold real per capita government spending constant

• Reduce high marginal tax rates

• Provide incentives for research and development spending

• Restructure capital markets to encourage venture capital

• Reform old, outmoded business practices supported by archaic regulations

• Phase out restrictive practices by labor unions, and terminate restrictions that artificially boost wage rates above market levels.

Perhaps these steps will be taken in the future. However, the initial moves to reduce the deficit were not continued after 1999, and political talk centered on rolling back these steps, not extending them. As of 2003, the major improvement has occurred in the countries on the periphery - Ireland, Spain, Portugal, and Greece. Growth in the original Common Market countries was very sluggish in 2001 and 2002, although the US recession may have accounted for part of that decline. As of 2003, the jury is still out on the effectiveness of the EU. The two basic issues are both political. First, the increased level of bureaucracy in Brussels may interfere with productivity gains. Second, citizens may decide to overrule the terms of the Maastricht Treaty and in effect vote for bigger government budgets and higher taxes, which would also retard productivity. That issue is squarely in the hands of the voters: whether they want to increase or diminish the relative importance of the government sector. Until there is more definitive movement in the direction of free market economics by individual nations and the overall leadership in Brussels, the growth rate in Euroland is not likely to improve.