The European Union was created in 1993 as the most recent of a progression of institutions that embody a vision of regional integration laid out in a 1946 speech by Winston Churchill: “I see no reason why, under the leadership of the world organization, there should not ultimately arise the United States of Europe, both those of the East and those of the West, which will unify this Continent in a manner never known since the fall of the Roman Empire, and within which all its peoples may dwell together in prosperity, in justice, and in peace.”(3)

For nearly fifty years this image has guided a regional integration effort that has widened from six to fifteen nations and deepened from a narrow technical focus to an ambitious social, political, and economic agenda. The Treaty of Paris, signed in 1951 by France, Germany, Italy, Belgium, the Netherlands, and Luxembourg, founded the European Coal and Steel Community (ECSC).(4) The treaty not only pooled and centralized the production of coal and steel, it also introduced the High Authority, the Council of Ministers, the Court of Justice, and the Parliamentary Assembly, all of which remain part of the institutional framework of the much broader EU [that] has subsequently evolved.

The Treaty of Rome, signed in 1957 by the same six nations, established the European Atomic Energy Community (EURATOM), and the European Economic Community (EEC), which greatly expanded the scope of the ECSC treaty by calling for the dissolution of barriers dividing Europe, the improvement and equalization of living and working standards, the abolition of restrictions on international trade, the removal of obstacles to concerted action among governments, and the enhancement of peace and liberty through closer relations among states. In 1967, the executives of these three European communities were merged. The Single European Act, which went into effect in 1987, was designed to create by 1992 the “single European market” that had been envisioned in the Treaty of Rome but had not been realized, “an area without internal frontiers in which the free movement of goods, persons, services and capitals is ensured”. In 1993 the Treaty on European Union, signed at Maastricht the previous year, entered into force, renaming the expanding web of institutions the European Union.(5) This institutional structure is increasingly state-like with legislative, executive, and judicial branches (Parliament, Commission, Council of Ministers, and Court of Justice); economic institutions (Investment Bank, Central Bank, and Court of Auditors); and a variety of institutions that provide representation for the interests of various groups (Economic and Social Committee, Environmental Agency, Committee on Regions, Ombudsman, and many others). Meanwhile, Britain, Ireland, and Denmark had become members in 1973; Greece in 1981; Portugal and Spain in 1986; and Austria, Finland, and Sweden in 1995. As of 1999, eleven additional countries have applied for EU membership and several others have reached trade agreements with the EU which give them some of the advantages of membership.

Despite this growth, the future of the EU itself remains somewhat uncertain, because considerable opposition has arisen in many member countries as integration has deepened. A long-standing objection of critics is that European integration implies a substantial abdication of national sovereignty because it requires that national law be brought into accordance with EU law and because regional institutions are slowly eclipsing national ones as governing bodies. In fact, the Treaty on European Union was initially rejected by a national referendum in one member country and survived very close votes in several others. Its most controversial elements were the call for a common defense policy and, especially, a monetary union with a single currency that would replace national ones.

It has long been apparent that the continuing liberalization of trade in Europe required a considerably more stable monetary arrangement than the system of freely floating exchange rate that had existed among all developed countries since the demise of the fixed exchange rate system of Bretton Woods in the early 1970s. The most recent attempt at stabilization, the introduction of the currency called the euro, is discussed in greater detail later on. It illustrates that the dilemmas involved in trade, especially those concerning national sovereignty, carry over into the monetary arrangements required to facilitate it. Because of this concern over national sovereignty, not all the EU nations have joined the euro arrangement. Furthermore, because EU members fear that such intensive ties to nations with weaker economies would introduce too much instability, they established criteria for participation in the euro that many of the nations seeking EU membership would not meet. Regional integration is a strategy that attempts to maximize the benefits and minimize the costs of trade by very carefully selecting partners in trade and in the institutions that must accompany it.

The Mercantilist Roots of the EU

The presence of trade diversion makes it clear why outside nations typically see the mercantilist face of regional integration rather than its liberal face, which is turned inward. From their standpoint, regionalism not only furthers the classical mercantilist goal of protecting domestic industry, it does so through a classical mercantilist melding of foreign policy concerns with economic aims. Rather than erect trade barriers against all foreign competitors equally, the EU discriminates against nations outside the region, often because they are seen as a threat.

Indeed, from its beginnings, European unification has accelerated whenever threats from outside have been perceived. The early EC was designed to protect Europe against the Soviet military threat posed by a large army and aggressive doctrine as well as the American economic threat posed by large productive capacity and expansionist marketing plans. The Single Market initiative culminating in 1992.

Carlo DiBenedetti called it “a deadline not to be dead” was energized by the economic threat of rapidly growing productivity in Asia and the resulting “Euro-pessimism.” Again we see that nations turn in a mercantilist direction when their industries fear more competitive firms abroad and when their states fear the rising power of rivals. The EU’s goals are no different than those of Queen Elizabeth’s sixteenth-century industrial development or Japan’s postwar export promotion: its uniqueness lies in the regional emphasis of its mercantilism, which can be seen most clearly by contrasting liberal and mercantilist viewpoints on trade diversion.

Whereas liberal theory disapproves of trade diversion because it compromises efficiency, mercantilism finds it perfectly acceptable if it helps to achieve other national goals. Since many values and goals conflict with efficiency, nations may prefer to trade with one country rather than another for several reasons. First, a nation may divert trade in order to benefit an economy whose resulting prosperity produces greater side benefits for it. For example, for reasons of physical proximity and economic integration, Germany is much more likely to gain from the prosperity of France than it is from the prosperity of a nation–for example, Japan or the United States–that is thousands of miles away.

Second, trade diversion under regional integration is reciprocated: Germany diverts its trade toward France, and in exchange, France diverts its trade toward Germany. Third, most European nations are more comfortable with depending upon other Europeans than upon Japan or even the United States. Not only do they share more security concerns with their European neighbors but they also have more common views on issues that always arise in trade matters (e.g., dilemmas involving job security, welfare arrangements, and environmental protection). Furthermore, they can create regional institutions such as those of the EU to cope with whatever conflict may stem from differences in how they respond to trade dilemmas.

The liberal roots of the EU

Despite these undeniable mercantilist motivations, the EU is also deeply rooted in liberal ideas, especially the gains from trade promised by Ricardian theory. For example, the Cecchini report (1988) was instrumental in gathering support for the Single Market initiative by estimating trade gains resulting in a 35 percent boost in GDP. However, gains from specialization and enhanced competition are not the only benefits of the EU seen by liberal theorists.

Economies of scale, which have always been a strong motivation for the smaller countries of Europe, were especially visible in the ECSC. Because steelmaking requires large-scale plants and equipment that are efficient only when producing large volumes of output, a steel industry could never emerge in a small country unless a firm could be guaranteed access to the larger European market. The ECSC provided that guarantee in the form of the pledges by European governments not to interfere with free trade in these goods. The result was a key industry with production facilities scattered among different countries, each dependent on other nations to provide both demand for the final product and part of the supply capacity. A side benefit of this arrangement was the fulfillment of the liberal dream of an interdependence that would prevent war by making it suicidal.

In fact, the EU’s economic institutions were constructed for a political purpose. The mission of European integration, as stated in the preamble to the ECSC treaty, is to “substitute for age-old rivalries the merger of their essential interests; to create, by establishing an economic community, the basis for a broader and deeper community among peoples long divided by bloody conflicts; and to lay the foundations for institutions which will give direction to a destiny henceforward shared.” Thus, the ECSC was an innovative form of peace treaty, designed, in the words of Robert Schuman, to “make it plain that any war between France and Germany becomes, not merely unthinkable, but materially impossible.” In the aftermath of two devastating wars in the previous thirty years–which more conventional tools of international politics such as the European balance of power, the League of Nations, and international law could not prevent–European nations were willing to tolerate the erosion of national autonomy and self-sufficiency implied by interdependence in order to weaken the nationalism that had provoked so much violence.

The Political Roots of the European Union

Throughout its history, European integration has been seen as a means of escaping the liberal and mercantilist horns of trade dilemmas by providing a regional level of governance to deal with common problems that no single nation could solve. For example, the Common Agricultural Policy (CAP), born in 1962, embraced a concern with the distributional dilemma of trade that would have been at home in parliamentary debates of the eighteenth century: Its goals included “the assurance that those working in agriculture will enjoy a standard of living comparable to that enjoyed by workers in other sectors.” Because it was evident as early as 1951 that this motivation implied an ambitious institutional design, the Treaty of Paris went well beyond limited economic objectives to create the executive and legislative institutions that remain at the heart of the contemporary EU. Later, the Treaty of Rome’s social and political provisions–which included the creation of the Economic and Social Committee to provide a strong voice for workers, employers, consumers, and academics–made the EC much more than a mechanism for advancing free trade.

These arrangements were a direct outgrowth of the values and theories that influenced national economic policies in Europe, especially where working-class political parties of the left came to power – Labour in Britain, Social Democrats in Germany and Scandinavia, and Socialists in France, Italy, and Spain. Rooted in powerful trade union movements, those parties embraced values of egalitarianism that emphasized the welfare and security of workers and shared the conviction that it was safer to entrust these goals to the state than to free markets. They erected welfare states to provide institutional protection against the vagaries of markets that were quite distinct from the more laissez-faire arrangements in the United States. For example, vacations, maternity leave, and health insurance, which are all voluntary fringe benefits in the United States, are determined by law in most EU states.

Furthermore, because some constitutions list the right to work among human rights, the ability of firms to hire and fire workers is sharply constrained. When European national governments spend an average of 25 percent of GDP on social protection, it is hardly a surprise that an agreement to increase trade would include a provision to compensate those who would lose in the resulting dislocations. Indeed, the Social Fund, created in 1951 to finance worker retraining and relocation necessitated by the ECSC and now charged with aiding trade-damaged geographic regions, has become the second largest expenditure in the EU budget (behind agriculture).

The dilemmas posed by exchange-rate policy

Since the collapse of the European Monetary System’s Exchange Rate Mechanism(ERM) in 1992, exchange-rate policy has been at the center of the trade dilemmas concerning national sovereignty that have threatened to derail further integration. As traditional trade barriers have diminished, the trade-dampening effects of a system of multiple currencies have acquired increasing visibility. The most obvious effects are the simple transaction costs associated with currency exchanges: A consumer purchasing goods made in another country must pay the costs of exchanging the currency of his or her country for that of the nation in which the good was produced. Some costs are direct and visible, as when tourists pay a fee to a foreign-exchange broker; others are born by businesses and passed along invisibly to consumers. In the mid-1990s, currency conversion alone cost European business $15 billion per year, and transaction costs associated with currency exchanges have been estimated to waste 2 percent of the value of trade. Firms also had to maintain accounting systems and bank balances in several currency units simultaneously and cope with multiple currencies in legal contracts, taxation, and strategic planning.

Moreover, when currencies are traded freely in foreign exchange markets, natural variations in supply and demand cause their values to fluctuate unpredictably, sometimes in wild swings of sentiment. This uncertainty concerning future currency valuations represented a major risk for businesses trying to operate across the European market. Long-term production and marketing plans were complicated because firms could not predict costs and revenues that were denominated in different currencies. In particular, firms feared that an increase in the value of their nation’s currency would leave them suddenly uncompetitive elsewhere. This risk discouraged trade because firms preferred to plan for the relative predictability of their domestic market. Indeed, as tariff rates among European economies declined, this system of floating currencies came to have a greater trade-dampening effect than traditional trade barriers.

Thus, as a logical extension of the desire to increase trade, a single European currency to replace the fifteen national currencies has been a long-term goal of the EU for more than two decades. However, nations have strongly resisted giving up central elements of their national sovereignty: the rights to issue currency, to profit from the creation of a monetary asset, and to manage the economy by controlling the money supply. Any state harboring even a modicum of the mercantilist inclination to influence the economy–and all states do–would find the ceding of monetary policy to a regional authority an uncomfortable prospect. Moreover, a single currency would not be feasible until the various economies converged into a single market with similar levels of growth, inflation, and interest rates.

In the meantime, a less ambitious strategy was followed that preserved national currencies but restrained changes in their relative valuation. Early steps included a short-lived system of fixed exchange rates dubbed “the snake in the tunnel” in the mid-1970s. The European Monetary System (EMS), which launched the European currency unit (ECU) and included the Exchange Rate Mechanism (ERM), began operation in 1979. EU nations that joined the ERM pledged to maintain currency valuations within a mandated range much like a regional version of the fixed exchange-rate system created under Bretton Woods.

Whenever the value of their currency drifted beyond its agreed upon bounds, they were obligated to use foreign-exchange reserves to buy or sell currency until supply and demand were once again in balance at the accepted value. When such actions were ineffective, however, governments were further bound to alter domestic interest rates or other macroeconomic policies in order to stabilize the values of their currencies. It was expected that national economic policies and conditions would eventually converge, thus minimizing exchange-rate volatility and the need for governments to take extraordinary action to maintain their treaty obligations. In fact, however, different economic conditions in different countries–especially trade deficits, inflation, and interest rates inclined foreign exchange markets to push the value of national currencies in different directions. Furthermore, because the priorities of different governments conflict, they often adopt policies that become incompatible with their obligation to maintain stable exchange rates. Thus, monetary integration poses the dilemmas of national sovereignty and value trade-offs, which is why only seven nations joined the ERM at its inception, while three others joined more than ten years later.

These dilemmas were brought home even more dramatically in fall 1992 when the ERM shattered and the prospects for further European integration consequently dimmed. At the time, Germany was suffering high inflation while struggling to unify formerly communist East Germany with capitalist West Germany. To restrain further price increases, German monetary authorities maintained high interest rates to slow the economy’s growth. Meanwhile, both Britain and Italy, which were suffering high unemployment, sought low interest rates in order to accelerate growth. However, this disparity in interest rates induced British and Italian investors to transfer capital into Germany. As they sold investments denominated in the lira and the pound, the decreased demand for those currencies drove down their values while the higher yielding Deutsche mark increased in value.

Under the terms of the ERM, Britain was required to sustain the pound at a value above 2.78 Deutsche marks (DM), and Italy was bound to maintain a value of 1,000 lira at DM1.30. As the German central bank refused to lower its interest rates, both the pound and lira drifted to the bottom of their legal bands and finally sank beneath them. Britain spent more than $15 billion (half its total foreign-exchange reserves) to support the pound, and the Bundesbank spent nearly $50 billion to support the lira; but those sums were not enough. Italy was forced to acknowledge that it could not meet its treaty obligation to maintain the lira’s value and withdrew from the ERM. Britain raised interest rates from 10 percent to 15 percent in a last futile attempt to remain in conformity but eventually abandoned the effort and similarly withdrew from the ERM. The pound quickly fell to DM2.53 and the lira to DM1.18 per 1,000. The Spanish peseta was also devalued by 5 percent and the Irish punt and Portuguese escudo soon followed. A few months later, the French franc was supported by over $10 billion of intervention in a single afternoon before the effort was abandoned. The ERM collapsed in a hail of recriminations that undermined faith in the ability of the EU to simultaneously accomplish region wide goals while respecting differences in national-level priorities.

The ERM had succumbed to the same forces that had doomed the fixed exchange rate system of Bretton Woods twenty years before large capital flows that would destabilize currency values unless counter-acted by policies that were politically unacceptable. It also foreshadowed the Asian financial crisis five years later, which is described in the following chapter. Economists refer to this interaction among interest rates, exchange rates, and capital flows as the Mundell-Fleming constraint: A nation cannot simultaneously maintain unrestrained capital flows, a stable exchange rate, and independent monetary policy. Yet, the EU was committed to the free movement of capital by the Single European Act, the ERM mandated stable exchange rates, and domestic constituencies demanded monetary policies suitable to the unemployment and inflation conditions in their own country. In effect, to maintain the stable exchange rates that sustained free trade required nations to abandon the freedom to choose policies that would satisfy other goals, such as the reunification of Germany or the control of unemployment in Italy. Faced with this clear dilemma of national sovereignty, several governments chose policy independence over the regional arrangement to encourage trade.

In August 1993, the first attempt to rebuild the ERM acknowledged the Mundell-Fleming constraint, but accepted the primacy of national sovereignty. Nations were required to maintain their currencies only within a very wide band of 15 percent on either side of their central target, virtually an unmanaged float in comparison to the previous stringent requirement of 2.25 percent. The benefits of exchange rate stability for expanding trade were thus sacrificed in this interim agreement so that governments could use monetary policy and even currency devaluations to better achieve domestic goals. But the fear of the disruptive impact of exchange rates that were permitted to move as much as 30% made this only a temporary expedient, chosen over two even less attractive options.

The first, a return to a real fixed exchange rate system, was incompatible with independent monetary policy, even if it could be accomplished in the face of large scale flows of capital. The need for independent monetary policy could be minimized, of course, if economic conditions were similar across all countries. But to more closely align economic conditions implied even greater constraint on the policies that produced them (the budget deficits that produced inflation, for example) and even greater sacrifice of national sovereignty.

The second option, the preliminary plans for which had been underway for some time, was to proceed with full monetary union by adopting a single currency. This too required policy coordination, especially with respect to budget deficits which could now produce inflation community-wide, and sacrificed even more national sovereignty because it eliminated all independent monetary policy. However, this single currency option, later to evolve into the euro, not only offered a more permanent solution to exchange rate instability, it also transformed the national sovereignty problem that most irritated the French. France felt that the old ERM had degenerated into a system in which Germany would use its monetary policy to achieve its own goals –such as unification and the control of inflation–while the pressures of that decision would require that all other ERM members use its monetary policy to keep a stable link with the D-mark. Thus, Germany benefitted from a system that was being sustained by the sacrifice of national sovereignty by all the others. If European nations were to sacrifice economic independence, they preferred that it be surrendered to an independent Central Bank rather than to a long-time political, military and economic rival such as Germany.

So was born the European Monetary Institute, established in 1994, to be transformed into the European Central Bank in January 1999.

The European Central Bank

The European Central Bank‘s mission was to issue a single currency, the euro, and thus to determine monetary policy for the entire region. The Euro was launched as an accounting unit on January 1,1999 with 11 of the 15 EU nations participating (all but Britain, Sweden, Denmark, and Greece). Euro notes and coins are to be issued on January 1, 2002, and all national currencies of the participating countries will cease to be legal tender on July 1, 2002.

Such an unprecedented ceding of autonomy over monetary policy entailed major risks that required careful selection criteria of participating nations and strict limitations on the economic policies that could be enacted by them subsequently. Without monetary policies to insulate the national economies from the conditions prevailing in others, inflation and high interest rates induced by a budget deficit in one country could quickly spread to the others, for example. Thus, the Maastricht agreement established criteria for entry, the most constraining of which were that the budget deficit must be under 3% of GDP, the national debt under 60% of GDP, and inflation under 3.2%. In fact, these criteria were relaxed, with most nations qualifying only after obvious accounting tricks, but the effort to meet them did have a substantial constraining effect on national policies. Even more constraining is the “stability and growth pact” which requires that all participants continue to observe the 3% limit on budget deficits or face substantial fines.

In democracies where tax and expenditure levels are fiercely debated, the imposition of external controls undermines the ability of citizens to determine the most important policies of their governments. Moreover, the treaty explicitly forbids the European Central Bank to “seek or take instructions from Community institutions or bodies, from any government of a member state or from any other body”. These arrangements may also unwisely prevent national governments from stimulating the economy during recession, a concern given greater weight by the statutory goal of the ECB. Unlike the Federal Reserve in the United States, the ECB is not required to take employment or output levels into account, but only to maintain price stability, which it has defined as inflation under 2% a year. “In modern times, no major economy has hit such a target consistently over a run of years…

In short, a radically undemocratic institution has been charged to achieve, without compromise, an exceptionally demanding goal of virtually zero inflation”. And the public support for such a massive transformation in authority remains precarious, with the percentage of citizens reporting that they feel well informed about the EMU well under 50% in all eleven euro countries and under a third in eight of them.(9)

Clearly, the EU represents an extreme example of one resolution of the dilemma of national sovereignty raised by the desire to achieve the benefits of free trade. Of course, the EU has other goals as well, many of which are not shared by the regional integration schemes that have sprung up all over the world in partial emulation of the EU.

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