European Union, Or Is It Disunion?

By Robert Strauss

Talk to Professor Geoff Garrett about the subject of European integration and you will hear a tale of drama, intrigue and passion more suited to a discussion of Italian opera than international economics.

Garrett draws upon such material as the tension between German Chancellor Helmut Kohl and Germany’s powerful Bundesbank, the climactic end of the Cold War in 1989, the street riots in Paris over government job cutbacks, the sudden collapse of the Italian lira and English pound in 1992 and the ongoing struggles of Eastern European countries to win acceptance into the European Union (EU).

“Developments over the past 15 years have transformed the way Western Europe works,” says Garrett, an associate professor of management whose research is primarily in international political economy and European integration. “On many important dimensions we are seeing something akin to the formation of a European federation of states among countries that have a long history of hostility and disagreement. It is a fascinating process to watch.”

For the moment, all eyes are on Europe’s upcoming transition to EMU — the formation of an Economic and Monetary Union with the creation of a single currency, the “Euro”, in 1999. Yet even as analysts are busy debating which of the 15 countries in the European Union will join EMU, Garrett is quick to point out that monetary union is only the latest development in the evolution of European integration. Two other events of major significance set the stage for EMU’s arrival.

The first, and one that is extremely important for business, was the creation of a large body of pan-European law. “Although this body of law has its roots in the Treaty of Rome signed back in 1957, the case law of the European Court of Justice (ECJ) that was developed between 1964 and 1979 has been critical,” says Garrett.

Unlike most international law, he adds, “ECJ decisions are binding and are followed by most member countries. The court has real authority to arbitrate in international disputes, which has been a boon for trade.”

The second major development was ratification of the Single European Act in 1987 and the subsequent move towards majority decision-making rule. “This is more or less without precedent,” says Garrett. “In the Security Council of the United Nations, for example, any permanent member can veto any decision it doesn’t approve of. But with the passage of the Single European Act, the rights of individual countries to block initiatives they don’t like were substantially reduced.”

The Single European Act heralded a renewed commitment towards a truly free market system in Europe, Garrett adds. “European leaders committed to going much farther, much faster, than ever before, and decided to do it by greatly reducing national sovereignty in the regulation of markets.”

But the momentum for European integration took an unexpected turn in 1989 with the end of the Cold War. “Suddenly enormous new problems and opportunities were created throughout the world,” says Garrett. “People worried that unification would lead to an aggressive, expansionist Germany. Germany was already the economic power; now it would be the political power as well. How do you deal with that?”

Moving north and east, there were other considerations. Because of their proximity to Soviet bloc countries during the Cold War, Austria, Finland, Norway, Sweden and Switzerland had chosen to remain neutral and outside the EU. That all changed post 1989. In the early 1990s, three countries — Austria, Finland and Sweden — did join the EU. Switzerland and Norway chose not to. The main reason the Swiss didn’t join, says Garrett, “is because they are notoriously protective of their national sovereignty; the Norwegians are as well, plus they have enormous oil reserves which makes it easier for them to go it alone.”

Still further east, applications for EU membership from Eastern European countries, led by the Visigrad Four — the Czech Republic, Hungary, Poland and Slovakia — have met with tacit resistance from the governments of Spain, Portugal, Greece and Ireland who worry that their privileged position on agriculture and development assistance will be threatened by competition from Eastern Europe. France has also expressed reservations. Germany, however, wants the Visigrad Four in.

And that’s just a preview of what’s to come. The anxieties over European integration are especially pressing now because of EMU’s timetable: Although a single currency is not scheduled to take effect until 1999, countries will be admitted to, or denied membership in, EMU based on data from 1997.

In an article last year in the Financial Times, Garrett assesses the economic consequences of EMU and its implications for EU member states. His research takes into account EMU’s convergence criteria — a set of requirements for entrance into EMU that are laid out in the Maastrict Treaty of 1992. The two key criteria are: a country’s budget deficit cannot exceed three percent of GDP; and public debt cannot exceed 60 percent of GDP. But these rules aren’t hard and fast, Garrett notes. Countries will be admitted or not, based on a ruling by a “qualified” majority as to whether sufficient progress has been made towards meeting the criteria.

In his article, Garrett talks about the potential costs of creating a single European currency and a single monetary policy for all EU members. He also looks at three other factors that will influence the domestic effects of joining: the extent to which countries’ central banks are already independent from political control, the extent to which their labor market institutions can coordinate the workforce to contain wage increases, and the extent to which countries trade with each other.

“This critically important economic initiative has very deep political roots that go back to more than a century of instability in Europe and, most importantly, the series of wars between France and Germany,” says Garrett. “What interests me is how the politics and economics fit together.

It’s very different from a corporate strategy view of Europe which looks at EMU’s impact on this or that type of multinational. At the same time, corporations do need to know what this new Europe will look like if they are to make informed decisions.”

Garrett was born in Australia, earned his BA at the Australian National University and his MA and PhD at Duke University. He taught at Oxford and Stanford before coming to Wharton in 1995.

His forthcoming book, titled Partisan Politics in the Global Economy, argues against the idea that globalization of the economy has fundamentally reduced national autonomy, suggesting instead that there are many ways to successfully compete and also retain national economic identity.

Below, he discusses key issues and important players in the move towards European integration.

EMU: Pros and Cons

“EMU makes a lot of sense for countries that are part of the European ‘core’, meaning those countries that do substantial trade with Germany and have symmetrical business cycles.

Governments from other countries might want to be in EMU for a different reason. Joining EMU, they feel, might actually reduce the power of the German Bundesbank over their economic policies. The bigger the monetary union and the more members in it, the less the monetary union is likely to be dominated by German-style concerns — price stability above all else.

In my article in the Financial Times, I speculated on the predicaments of different EU members. Participation in EMU is an easy decision for Austria, Germany, Luxembourg and the Netherlands. These countries already have delegated monetary authority to institutions that are insulated from political control, most importantly the German Bundesbank. As a result, the dislocations from the transition to monetary union would be small. Labor market institutions are also quite encompassing in these countries, and hence the labor market is likely to respond efficiently to EMU. Moreover, these countries form a tight trading bloc and their business cycles are highly correlated.

The UK is at the other end of the spectrum. The Bank of England continues to be heavily influenced by the government. British labor market institutions have become very fragmented following the Thatcher decade. The British economy is not well integrated into Europe in terms of trade and business cycles.

The bulk of EU members lie in between these two extremes. The most important case is France. The Bank of France is relatively independent but French labor market institutions are weak. Furthermore, intra-European trade is not so important for the French economy as for the members of the EU core.

I believe that there will be a monetary union in 1999. The political importance of maintaining the pace of European integration will overcome other misgivings. But this EMU will be small, comprising only France and the tight “DMzone” — Austria, Germany, Luxembourg and the Netherlands. Is that good? For the DM-zone, absolutely. They are the ones that should be in it. France fits into this category, but for political rather than economic reasons. Belgium ought to be in it as well because its economy is intimately tied to Germany’s. But Belgium radically violates the convergence criteria because it has the largest public debt of any European country. If you let Belgium in, it becomes very difficult to exclude anybody else.

The question for Europe is, will this small group of tightly-linked countries within a larger free trade area be a magnet that will attract other countries over time, so that perhaps in five years or so Italy, Spain and Portugal will join this monetary union? That’s the optimists’ view.

The pessimists’ view is no, there will be a big barrier created in Europe in the form of a small core of countries that is tightly integrated in almost all ways. These countries will probably attempt real foreign policy cooperation as well, which in the past has been impossible for Europe. Witness Bosnia, which has been a disaster for European foreign policy. The negative view says there will be a big barrier around this small European core and everyone else will lose.

The Italian government, for example, is scared. On the one hand, the Italian economy is not part of the EU’s economic core. But on the other hand, the Italian government desperately wants to be in EMU because not being in suggests second-class European citizenship. Italy doesn’t want to be excluded. Joining the EMU might also impose some much needed discipline on Italy’s domestic business environment. German leaders, however, view Italy as an undisciplined economy that could destabilize EMU. The French government has recently expressed similar views. Given these reservations, it is doubtful that Italy will be in the first wave of EMU, a body blow for one of the founding members of the EEC (as the EU used to be known).

For many people outside the EU core, the big issue is whether a small EMU will create a two-class system in Europe that could have damaging long-term consequences. I think that is more likely than the magnet theory that says the core moves first and everyone else will soon follow.”

Eastern European Countries: Outside Looking In

“Before the Eastern European countries can even think about EMU, they have to be admitted into the European Union.

Getting the Eastern European countries into the EU is extremely complicated because they are poor countries that are competitive in agriculture and cheap manufactured goods. The existing EU members who are also poor — led by Spain, Portugal, Greece and Ireland — currently receive substantial development aid from the wealthy north of Europe that they fear would get diverted to Eastern European countries if they were admitted to the EU.

The other group of countries that has reservations about expanding the EU includes France and Italy, with large and uncompetitive steel, textile and agricultural sectors. The clearest problem here concerns the Common Agricultural Policy, a complex system of agricultural subsidies to large but inefficient agricultural producers. At the moment, three quarters of the European Union budget is made up of agricultural transfers from countries that consume agricultural products to countries that produce them. The biggest producer is, and always has been, France, who of course wants this common agricultural policy to stay in place. It can’t stay in place if you give it to the Eastern Europeans.

Who is the big mover behind Eastern Europe’s acceptance into the EU? Germany. The German agenda is part political and part economic. First, Helmut Kohl believes that stabilizing Eastern Europe is essential to Germany’s future, and I think he’s probably right. The way to stabilize Eastern European countries is to bring them into the Western bloc. In addition, German companies were the first into Eastern Europe. They have by far the strongest foothold and as a result can only benefit from this process.

Ultimately the Eastern European issue pits Germany against most of the other Western European countries, including its perennial partner in EU affairs, France. The question is whether the political will of Helmut Kohl or his successor can make this work.

I think Eastern Europe will get into the EU but they will most likely come in as second-class citizens, at least initially. All the rules of membership will apply to them but in cases where they could do damage to existing members’ economies, they won’t get all the benefits. For example, they won’t get as much development assistance, now moving from the wealthy European countries to Spain, Ireland, Greece and Portugal. These four countries will agree to Eastern Europe’s entrance provided their own benefits aren’t cut. And the only way not to cut their benefits is either give very little to the East Europeans or have Germany pay for Eastern Europe.

Kohl’s inclination is to pay this price, but that is impossible at the moment considering the enormous debts his government has accrued as a result of rapid German unification.

Given these constraints, do the Eastern European countries really want to join the EU? The answer is yes, they want to join very badly. The governments from these countries think there would be economic benefits, which there probably would be. For example, their economies would become much more attractive to foreign investors because now you would be investing say, in the Czech Republic, but your firm could sell its goods and services with no trade barriers to Germany. So you don’t have to pay German costs to have access to the German market.

Also, the Eastern European countries hope that by joining the EU they will get some development aid from Germany.

Nonetheless, the whole Eastern Europe question is going slowly. Realistically, you won’t have even the four most developed Eastern European countries in the EU until well after 2000. The decision to let them in has to be made very slowly because agriculture is paramount to France, development assistance is critical to Spain, and both countries can make common cause with Italy on these issues. These are the three most influential countries in the EU apart from Germany.”

Helmut Kohl and the Bundesbank

“Germany has the strongest economy in Europe and a strong central bank, so it is very hard for anything to happen in Europe without Germany wanting it to happen.

But that hasn’t been a problem because Helmut Kohl has committed himself completely to the project of European integration. Obviously German reunification was even more important at the turn of the decade, but that happened relatively easily. Now creating a ‘European Germany’ is paramount to Kohl. He has to balance not only external constraints, like the opposition of some countries to Eastern Europe’s inclusion plus the differing opinions about what monetary union should look like, but also a serious domestic constraint, which is the German Bundesbank.

The Bundesbank has believed for a long time that Kohl always puts political objectives above economic prudence. And the Bundesbank is a very powerful actor in Europe. If the Bundesbank raises interest rates, that causes a recession on the whole continent, which is what happened in the early 1990s. The Bundesbank raised German interest rates as a way of punishing Kohl for reunifying Germany very quickly and in an extremely expensive manner. The result was a devastating recession throughout Europe.

The Bundesbank is mandated to care only about the inflation rate — i.e. price stability. If that means you have to live with a 10 percent unemployment rate, the Bundesbank says, ‘That’s okay. The government should deal with that, not us.’ It’s a remarkably powerful institution.

The historical reason that the Bundesbank was given this mandate was that Germans believe, probably rightly, that it was careless money, or hyperinflation, in the 1920s that led to political instability and gave rise to Hitler. As a result there is a shared national view in Germany that inflation is bad and that prices should be kept as stable as possible.”

No Power to the People

“The fascinating thing about EMU is that it has become extraordinarily unpopular with citizens, even though most government leaders — led by Kohl and President Jacques Chirac of France — are completely committed to it. Why is it so unpopular? Because the economics of it are very complex and the citizens don’t understand it. What they do understand is that back in the early 1990s they were promised that the Maastrict Treaty would make everybody in Europe better off.

Over the next five years, however, a lot of citizens suffered badly. While fixed exchange rates, in the form of the European Monetary System (EMS), were associated with lower inflation and higher growth in the 1980s, things looked very different in the early 1990s. Most European countries were going into a post-cold war recession, but the German economy was overheating as a result of government spending on German unification. Since Europe was tied together by the EMS, the other countries had to adopt German monetary policy, which was far too tight for them. Slower growth and rising unemployment were the logical consequences of this. Citizens began to realize that their governments had signed away an enormous amount of sovereignty at Maastrict. Then on black Monday, September 16, 1992, EMS all but fell apart in very dramatic fashion. The pound and the lira were both forced out of the system — heralding a year of currency instability and massive international capital movements in Europe.

Most people believe that the Bundesbank played a role in the crisis by hinting that the Italian and British economies should not be in a monetary union with Germany. The Bundesbank effectively told the currency markets that the lira and pound were overvalued and should float against the Deutsche Mark. Conversely, the Bundesbank propped up the franc.

The tightness of the French-German bond over monetary union is amazing. The French government has been prepared to sacrifice massive domestic hardship in the name of keeping monetary union alive. Essentially what this has meant is that the French government has adopted German economic policies at a time when those policies are terrible for the French people.

The fact that government leaders in both countries are willing to do this shows you the importance of these big political issues. The legacy of the pre-1945 era for France and Germany is clearly so powerful that the goal of trying to eliminate the possibility of another continental war is one they are prepared to pay almost any price to achieve. In France that has meant unemployment, massive strikes in the public sector and large scale rioting in the streets.

If you are attached to the Bundesbank, you do not have high inflation. But you may well have to endure high unemployment for long periods of time. France’s unemployment rate has been running at over 10 percent for a decade. But the French government is unwilling to do much about this because of its ties to Germany.”

The UK: A Conservative Approach

“Once you get to Britain, the politics of European integration dominate the economics almost completely. Margaret Thatcher was a committed anti-European from the outset but she had powerful opponents within the Conservative party. When John Major came along, he inherited a very divisive issue. Europe was an important reason Thatcher was toppled by her own party. Major himself has a reasonably sensible attitude towards Europe, which is that the UK might not like the direction Europe is taking but it’s better to be involved in the discussions than to be on the outside. Yet concerns about sovereignty are very powerful in Britain.

The issue of monetary union is further complicated in the UK because London is the center of the European financial system. The bankers are very worried that if monetary union goes ahead and the UK isn’t in it, they will lose their business. The center of European finance would most likely move to Frankfurt. So bankers want in, big time, and so do most competitive British manufacturers because of the stability in export markets this would bring.

The interesting question in Britain is, assuming the Conservative party gets defeated — which it will next year unless something unexpected happens — what will the Labour government will do? The Labour Party historically has been deeply anti-European, more so than the Conservatives. Britain only joined Europe in 1973, and two years later a Labour government held a referendum (which was narrowly defeated) on whether to leave.

Right now, government leaders on the continent are twiddling their thumbs and waiting until the British election that must take place by the middle of 1997. The Labour Party has made lots of pro-Europe noises while in opposition. Whether it delivers on this commitment will be a real test of whether it is in fact a “new Labour” Party, as its leader Tony Blair so vehemently maintains.”

View From the Boardroom

“Anyone who manages a European multinational is likely to be in favor of EMU. The biggest benefit is that it stabilizes the European economy and makes investment decisions much easier. Plus you don’t have to pay a commission every time you do a transaction in two currencies. Exporters in Europe should view this positively.

But business people in Japan and the U.S. have a different view. EMU will increase the clout of the DM-zone in international markets, perhaps tipping the balance of power in the trilateral world economy in Europe’s favor. The interesting point here is that when European integration started seriously in the mid-80s, business people and government officials in Tokyo and Washington were worried that this would create a ‘Fortress Europe’, locking out foreign producers. Fortress Europe didn’t transpire, but this fear was the stimulus for enormous inflows of investment from outside Europe, particularly into Scotland and Ireland. American and Japanese multinationals wanted to get into Europe before external barriers were raised.

But now there is the possibility that a united Europe might start manipulating the exchange rate in ways that would be bad for the U.S. currency — for example devaluing the Euro against the dollar, which clearly would hurt American exporters. This relationship would resemble that between the U.S. and Japan, with a united Europe an equal player in the system.

If you were an entrepreneur looking to start up a company in Europe, the effects of EMU would very much depend on where you wanted to locate. The classic pattern in recent years for Japanese and American investors has been to go to low labor cost areas of Europe that nonetheless are part of this European market. But things might be very different under EMU, depending on who is in and who is out.

What would happen under EMU if, for example, Ireland and the UK weren’t in the monetary union? You as an investor might be a little more reticent about setting up there. You might start to think more seriously about having a plant inside an EMU country because it should, all else being equal, have a smaller budget deficit and lower inflation rates.

But maybe England looks just as attractive because if you stay outside the system, you don’t have to follow the same economic policies as the insiders. You might think there is an advantage to being in a country that doesn’t follow German economic policy. After all, the monetary union works only as long as there is one economic policy that is good for all the countries.

Alternatively, if being outside EMU is an indication of second-class citizenship in Europe, perhaps investors will think twice before moving into such countries. For example, countries like Portugal, Spain, even Italy might become considerably less attractive to foreign investors if they are not in EMU. Investors might take this as a signal that the governments in these countries are not serious about creating ‘market friendly’ economic policies.

Thus, the potential ramifications of EMU are enormous, not only for European citizens, governments and companies but also for actors in the other two major economic blocs in the world economy. But when all is said and done, the economic effects of EMU will be determined by political decisions about the future of the European integration project. This is why studying the European Union is both fascinating from an intellectual standpoint and fundamental from the perspective of the business community.”

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