Transcript When Does Integration Pay?

When Does Integration Pay?
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Europe has been rather spectacularly
successful in its integration efforts. Many
others have been far less successful. What
makes for success?
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Consider again the prices that play a role
in a customs union integration scheme:
P domestic
P tariff
P part count
P world
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In your groups, discuss the proximities of
given price lines in the set and elasticities
of supply and demand that will make
integration successful.
P domestic
P tariff
P prt cntrs
P world
First, check elasticities
The relative sizes of these gains depend on:
1. elasticities, the “flatness” of the curves.
Ptar
Ppcs
Imports
Imports
First, check elasticities
Where they are relatively elastic (flat), the
imports will be greater and gains go with
more extensive trade.
Imports
Imports
Gains are greatest when the difference is
small between partner and world.
great between partner countries and us.
Ptar
Ppcs
Pw
c
c
Large gains here. Large imports at near
world prices (far better than our prices)
P domestic
P tariff
P part count
P world
Small gains here. Small imports at prices
near ours and way above world prices.
P domestic
P tariff
P part count
P world
European Monetary Union
European cooperation was strengthened
by the decline of the Bretton Woods
system.
 Europe did not want to follow the US
toward higher inflation. How does a fixed
exchange rate help?
 It allows for less trade uncertainty
 It shows anti-inflationary commitment.

European cooperation was strengthened
by the decline of the Bretton Woods
system.
 The Bretton Woods System was…
 It was eliminated in 1973 by Richard
Nixon, a man of uncanny economic
instincts…

European cooperation was strengthened
by the decline of the Bretton Woods
system.
 Europe did not want to follow the US
toward higher inflation. How does a fixed
exchange rate help?
 It allows for less trade uncertainty
 It shows anti-inflationary commitment.

See the history of progress toward a
common European currency summarized
in the box on p. 256 of Pugel.
 Europe did not want to follow the US
toward higher inflation. Members of the
EEC worked toward eliminating large
inflation rate differentials by mid 1980s
and capital controls were lifted by 1987.
 Single European Act, 1986, called for
removing all internal barriers to trade,
capital movements, and labor migration by
end of 1992.
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Maastricht Treaty signed at end of 1981.
The famous conditions were established
for the introduction of monetary union.
 Countries sacrificed monetary sovereignty
for prospective Euro (formerly “ECU”)
membership.

Maastricht Treaty signed at end of 1981.
The famous conditions were established
for the introduction of monetary union.
 Countries sacrificed monetary sovereignty
for prospective Euro (formerly “ECU”)
membership.
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Budget deficit 3% of GDP or less.
Government debt 60% of GDP or less.
Inflation no more than 1.5% above the average
rate of the three members with the lowest
inflation.
Long-term interest rates no more than 2
percentage points above the average of the
three members with the lowest rates.
Krugman’s confusion. Why demand monetary
management to give up monetary sovereignty?
Hazing?
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The convergence pattern of these criteria
through the 90’s.
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European countries strove valiantly to
submit their sovereignty. So much did they
desire to be a part of the Euro scheme!
Benefits of a common currency include
ease in trading goods and assets over a
common currency zone. It represents a
big reduction in transactions costs.
 Prestige of achieving the closer union of
European economies. As a step toward
political union? That is the dream.

The cost of union is the forgoing of monetary
policy.
 “In the face of market pressure against a
currency, a central bank committed to the
external goal of a fixed exchange rate must raise
domestic interest rates, even if this means
forgoing the internal goal of setting interest
rates with an eye toward domestic economic
conditions. The only way to maintain monetary
independence is eithge to allow the currency to
float or to have in palce controls on the
international movement of capital.” (p, 311)
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The cost of union is the forgoing of
monetary policy. This has added to the
structural unemployment problems facing
the European countries over recent years.
 Ten % is roughly normal for Europe.
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The Feldstein View
For a more detailed discussion of the
standard American view of the future
collapse of the EU’s Monetary Union, see
Martin Feldstein, “EMU and International
Conflict,” in the Foreign Affairs Anthology.
 Feldstein reviews the struggle, esp.
between Germany and France, over
whether to make unemployment or price
stability top EU priority.
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The Feldstein View
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Feldstein is convinced that the first
significant recession will bring serious
conflict to Europe as countries regret the
loss of monetary policy and secede from
the Union.
The Euro as a New International
Currency: A Dollar Substitute?
Klein concludes that widespread flight
from the dollar to the Euro is unlikely, at
least for the next few years.
 But dollar flight to the Euro, in any major
way, would cause the value of the dollar
to fall dramatically.
 The glut of dollars in the world that would
result from a lack of willingness to hold it,
could have major ramifications. What
would they be?
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The Euro as a New International
Currency: A Dollar Substitute?
To review some of the issues that make
the dollar a strong international currency,
that give confidence that dollar flight to
the Euro need not be a future disaster for
that currency, see “The International Use
of Currencies: The U.S. Dollar and the
Euro,” by George S. Tavlas
 Why do both the U.S. and the EU have
strong interests in seeing the dollar and
the Euro remain competitive currencies,
without one dominating the other?
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Why is Europe Forming a Monetary
Union?
Make it easier for individuals and
institutions to buy stocks and bonds in
other European countries.
 Cut transactions costs (roughly 0.4
percent of the GDP) for member
participants.
 Prevent competitive devaluations (to
promote exports). Reducing the value of
currency is inflationary.
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Costs of a Single Currency
 Loss of independent monetary policy (but
all member countries have representation
in monetary policy).
 Fiscal policy within a member country
could increase budget deficits and require
government borrowing, putting upward
pressure on interest rates. Increasing the
money supply to avoid high interest rates
would threaten inflation. So EU members
agreed to avoid debt.
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Loss of independent monetary policy (but
all member countries have representation
in monetary policy). Still, fiscal policy
could be used by the EU to address
regional imbalances in the currency union.
Labor Market Flexibility can also speed
recovery when some region experiences
recession.
 If workers are mobile, unemployed or
poorly paid workers can relocate to
countries with higher labor demand. That
will even out imbalances.
 But cultural and linguistic differences
hinder labor movements in Europe.
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Wage adjustments are another important
form of labor market flexibility. If workers
accept lower wages in a recession,
employers need not lay them off. They can
also pass on the reduction in payroll costs
through price reductions. Lower prices
promote exports and encourage domestic
consumption. This increase in demand
speeds recovery.
 But Europe has problems with wage
flexibility through legislation and union
practices preventing it.
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