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Economic integration

INTRODUCTION


The Canada-US Free Trade Agreement has anchored our trading relationship on a stronger,
more open and rule-based approach. The conclusion of the North American Free Trade
Agreement (NAFTA) represented an opportunity to include Mexico in the relationship, to
resolve specific irritants between Canada and the US, and to ensure that Canada remained an
attractive location for foreign direct investment (FDI). The formation of NAFTA, then, illustrates
the motivation for forming preferential trade agreements (PTAs): to ensure market access, to
attract FDI, to improve efficiency through competition and specialization, and to apply a co-
operative approach to commercial policy.

At the same time, NAFTA and other PTAs, like the EU, CARICOM, MERCOSUR, CETA, ASEAN and
GCC, reflect the difficulty of moving trade liberalization forward at the multilateral level. Some
liberalization among a few partners becomes preferable to the agonizingly slow progress at the
level of the World Trade Organization (WTO). By improving growth prospects for their
members, PTAs also bring the benefits of increased exports for non-member countries, and
that is why the WTO sanctions their formation. The drawback is that PTAs tend to divert trade
from more efficient outside sources of supply to the now favored member country producers.
The question arises whether PTAs should be seen as welcome building blocks toward an
improvement of the multilateral trading system, or whether they constitute stumbling blocks
for WTO-sponsored efforts towards this end. It is too early to judge which of these views will
turn out to be more correct. Nevertheless, because the issue of increasing economic integration
is likely to occupy significant space in policy debates in many countries, a better understanding
of some key distinctions between different forms of PTAs is clearly needed.
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This paper reviews the various forms of economic integration, in particular the distinctions
between a Free Trade Agreement (FTA) like the North American Free Trade Agreement, and a
Customs Union (CU) like the one that preceded the present European Union. Based on the
economics literature we show the benefits that can be expected to derive from a PTA,
highlighting the key differences in this regard between FTAs and CUs. We conclude that the
economic benefits of a CU outweigh those of an FTA and discuss the implications of moving
from the latter to the former. While faster multilateral trade liberalization would be the best
economic outcome, progress at the WTO-level appears stalled. We argue that establishment of
a North American Customs Union (NACU) may be a desirable next (and possibly final) step in
the evolution of the continents economic integration. Economic integration is the unification
of economic policies between different states through the partial or full abolition of tariff and
non-tariff restrictions on trade taking place among them prior to their integration. This is meant
in turn to lead to lower prices for distributors and consumers with the goal of increasing the
combined economic productivity of the states.
The trade stimulation effects intended by means of economic integration are part of the
contemporary economic Theory of the Second Best: where, in theory, the best option is free
trade, with free competition and no trade barriers whatsoever. Free trade is treated as an
idealistic option, and although realized within certain developed states, economic integration
has been thought of as the "second best" option for global trade where barriers to full free
trade exist.

Economic theory shows free trade on a worldwide basis as the first best outcome, in as much
as it allows specialization and exchange to take place globally, thus leading to greater world
output and welfare. PTAs among a subset of countries are therefore a second best solution.
They create trade among their members as trade barriers fall, and they divert trade from
efficient non-member producers to members because of their privileged market access. It
should be noted that PTAs can take a variety of forms. These range from low-level integration
by means of FTAs or CUs to higher levels of integration, such as a common market, economic
(and monetary) union, or even economic and political union. A PTA also refers to two or more
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countries forming a union with lower tariffs (and other trade barriers) for goods and services
from member countries. FTAs eliminate tariffs on goods from members entirely, and CUs are
FTAs with a common external tariff.

More specifically, economic integration proceeds by agreements to:

abolish tariffs and import quotas among members (FTAs and sectoral FTAs).

establish common external tariffs and quotas (CUs).

allow free movement of goods, services and workers (Common Market).

harmonize competition, structural, fiscal, monetary and social policies
(Economic Union).

unify economic policies and establish supra-national institutions (Economic and
Political Union).

Thus three progressively higher levels of integration can be distinguished. The first level entails
modest integration by means of an agreement to apply symmetric preferential treatment of
imports and assign supporting functions and instruments to jointly operated institutions.
Examples would be NAFTAs commitment to eliminate tariffs among its members, its dispute
settlement provisions, and the various working groups and committees that serve to facilitate
trade and investment among the three partners. In the case of a CU, the agreement would
additionally involve a common external tariff applicable to non-members, which, in turn,
requires an understanding on how to apportion among the partners the tariff revenue
collected.

The second level of economic integration would be the harmonization of instruments over
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which the parties retain control, and through which, due to different national approaches,
obstacles to a common market exist. This could be the case in the area of migration of workers,
competition policy, and production standards. One example of such harmonization is the
European Single Act. Among other provisions this act applied the principle of mutual
recognition to product standards. More co-operation and supranational institutions, such as a
joint tribunal on competition policy, are also characteristic of this second level.
















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Objectives:

There are economic and well as political reasons why nations pursue economic integration. The
economic rationale for the increase of trade between member states of economic unions that it
is meant to lead to higher productivity. This is one of the reasons for the global scale
development of economic integration, a phenomenon now realized in continental economic
blocks such as ASEAN, NAFTA,SACN, the European Union, and the Eurasian Economic
Community; and proposed for intercontinental economic blocks, such as the Comprehensive
Economic Partnership for East Asia and the Transatlantic Free Trade Area.
Comparative advantage refers to the ability of a person or a country to produce a particular
good or service at a lower marginal and opportunity cost over another. Comparative advantage
was first described by David Ricardo who explained it in his 1817 book On the Principles of
Political Economy and Taxation in an example involving England and Portugal.
[3]
In Portugal it is
possible to produce both wine and cloth with less labor than it would take to produce the same
quantities in England. However the relative costs of producing those two goods are different in
the two countries. In England it is very hard to produce wine, and only moderately difficult to
produce cloth. In Portugal both are easy to produce. Therefore while it is cheaper to produce
cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade
that for English cloth. Conversely England benefits from this trade because its cost for
producing cloth has not changed but it can now get wine at a lower price, closer to the cost of
cloth. The conclusion drawn is that each country can gain by specializing in the good where it
has comparative advantage, and trading that good for the other.
Economies of scale refers to the cost advantages that an enterprise obtains due to expansion.
There are factors that cause a producers average cost per unit to fall as the scale of output is
increased. Economies of scale is a long run concept and refers to reductions in unit cost as the
size of a facility and the usage levels of other inputs increase.
[4]
Economies of scale is also a
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justification for economic integration, since some economies of scale may require a larger
market than is possible within a particular country for example, it would not be efficient
for Liechtenstein to have its own car maker, if they would only sell to their local market. A lone
car maker may be profitable, however, if they export cars to global markets in addition to
selling to the local market.
Besides these economic reasons, the primary reasons why economic integration has been
pursued in practice are largely political. The Zollverein or German Customs Union of 1867 paved
the way for German (partial) unification under Prussian leadership in 1871. "Imperial free
trade" was (unsuccessfully) proposed in the late 19th century to strengthen the loosening ties
within British Empire. The Economic Community was created to integrate France and
Germany's economies to the point that they would find it impossible to go to war with each
other.













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Types and Levels of Integration

As you might expect, there are varying degrees or levels of economic integration. Each type of
integration represents a particular level of economic integration. You can think of economic
integration being on a continuum in which no integration is at one end and complete
economic integration is at the other end.

Free trade agreements

Most efforts at economic integration occur today through the use of free trade agreements,
which are agreements entered into between countries regarding specific trade issues, such as
reduction of tariffs (a type of tax on imported or exported goods and services), and non-tariff
barriers between countries, such as quotas that limit imports. Trade agreements can be
bilateral (between two countries) or multilateral (between several countries). Countries that
are not a party to the agreement will be subject to higher tariffs and other trade barriers.

Free trade areas

A free trade area eliminates barriers to trade among the members such as tariffs and quotas.
Members of a free trade area make their own policies concerning trade with other countries
outside of the free trade area. You should note that a free trade area may be limited to
specific types of goods and services. The best example of a free trade area is NAFTA, the
North American Free Trade Agreement.

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Customs union
A customs union is formed by countries that not only eliminate trade barriers between the
members, but also have a unified trade policy with countries outside the union. For example,
a customs union will establish a common tariff that is applied to all imports coming into each
member country. The tariff revenues may be split among the members according to a formula
agreed to by the members. An example of a customs union is the Andean community
consisting of Bolivia, Colombia, Ecuador and Peru.

Common market

A common market has all the characteristics of a customs union but also eliminates barriers to
the movement of capital, labor and technology. Restrictions on immigration, emigration and
foreign investment between members are lifted. Mercosur (short for Mercado Comn del Sur,
or Common Market of the South) is a South American group of nations that is an example of a
common market.

Economic union

The highest level of economic integration occurs in economic unions. In addition to all of the
economic integration features found in common markets, members of an economic union
must be able to maintain consistency with monetary policy, fiscal policy, and tax policy. An
economic union also uses a common currency. You should note that an economic union
requires that member states give up a significant amount of their independent sovereignty.
The European Union is an example of an economic union.

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Customs Union (CU) and economic union

Customs Union (CU)
Economic integration is the process designed to eliminate discrimination among economic units
located within different political boundaries. The traditional categories include Free Trade Area
(FTA), Customs Union (CU), Common Market (CM), Economic Community (EC), and Complete
Economic Integration (CEI). The various categories delineate the degree to which barriers to
economic interaction are formally removed. In an FTA participating countries agree to remove
barriers to trade among each other. In a CU the member countries agree not only to remove
barriers to trade but also to set common levels of protection against all nonmember countries.
Examples of a CU include the 1940s Benelux countries agreement (among Belgium, the
Netherlands, and Luxembourg) and the Southern African Customs Union, signed in 1969 and
still in existence. The CM agreement goes a step further than a CU agreement by removing
barriers to movements of factors (essentially labor and capital) among members in addition to
the CU components. An EC represents an additional step toward complete economic
integration in that there is some degree of harmonization of national policies where community
policies and institutions take precedence over national policies. An example of the latter is the
Common Agricultural Policy of the European Economic Community.
A formal definition of a CU was provided by the General Agreement on Tariffs on Trade (GATT)
in 1952:
A customs union shall be understood to mean the substitution of a single customs territory for
two or more customs territories, so that (i) duties and other restrictive regulations of
commerce are eliminated with respect to substantially all the trade between the constituent
territories of the union and (ii) substantially the same duties and other regulations of
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commerce are applied by each of the members of the union to the trade of territories not
included in the union.
The implementation of a CU represents a reduction in protection between member countries,
but it keeps in place discriminatory policies against nonmember countries. Although the former
represents a clear movement toward less restricted trade and increased world welfare, the
discrimination against nonmembers represents a potential loss in world trade and welfare. Thus
whether a CU represents an overall movement toward less restricted trade and increased world
welfare depends on the relative strength of these two forces, which are typically discussed as
the static effects of economic integration under the categories of Trade Creation and Trade
Diversion.
Trade Creation refers to the shift from higher-cost domestic producers to lower-cost partner
producers. It is thus a shift from less efficient to more efficient production and is trade
expanding. It also reflects a gain in country welfare. Trade Diversion refers to the shift from
lower-cost nonmember suppliers to higher-cost partner suppliers, which takes place because of
the tariff faced by nonmember products. It thus represents a loss in efficiency and a decrease in
welfare. There are also accompanying consumption effects as consumers switch from domestic
products to the now cheaper import products. Whether or not the CU represents a movement
toward less restricted trade and enhanced welfare in the static sense depends on the relative
size of these two effects. Whether the overall effect is positive or negative depends on a
number of considerations, including the complementarity or competitiveness of the individual
economies, the size of transportation costs between member countries, the height of tariffs
before and after integration, the economic size of the member countries, and the elasticities of
supply and demand within the member countries. Empirical estimates of the static effects of
economic integration have generally been a net, though small, positive.
Economists tend to agree that the major benefits of economic integration occur because of the
dynamic effects associated with increased economic interaction between member countries.
These dynamic considerations include the benefits associated with a more competitive
economic environment, which reduces the degree of monopoly power that possibly existed in
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the preintegration environment. In addition, access to larger markets within the integrated area
may result in economies of scale in the expanding export sector as a result of both internal and
external economies of scale. The growing and more profitable economic environment may also
generate greater investment from both internal and external sources. Finally, there may also be
dynamic benefits resulting from increased economic interaction with other countries in terms
of increased access to technology, foreign institutions, and cultural factors.
According to the definition given by the General Agreement on Tariffs and Trade (GATT), a
customs union shall be understood to mean the substitution of a single customs territory for
two or more customs territories, so that:

1. Duties and other restrictive regulations of commerce are eliminated with respect to
substantially all the trade between the constituent territories of the union, and
2. Substantially the same duties and other regulations of commerce applied by each of the
members of the union to the trade territories not included in the union from non-
members.

Before the publication of Jocob Viners classic book The Customs Union Issue (1950), it was
generally believed that the formation of a customs union would foster economic welfare. Viner,
however, has shown that this view is not necessarily accurate and that the formation of a
customs union combines elements of free trade with elements of greater protection and may
either improve or worsen resource allocation and welfare, depending upon the respective
strengths of trade creation and trade diversion.

The effects of customs union can be studied in two parts:
1. Static effect
2. Dynamic effect
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1. Static effects involve a reallocation of resources among existing industries, using existing
supplies of the factors and existing technology. Some industries expand, others contract,
and consumers enjoy lower prices on certain products; otherwise everything goes on as
before.
2. Dynamic effects refer to certain developments like increased competition, stimulus to
technological changes, stimulus to investment and increased economies of scale that
make the union economy dynamic.

There are, broadly, two types of static effects namely, Production Effects and Consumption
Effects.

1. Production Effects: Production effects refer to the changes in the sources of supply or
production bases of a commodity resulting from the formation of the customs union. In
other words, production effects result from shifting purchases of a given commodity
from more expensive domestic to cheaper member-country sources of supply (positive
effect) and from shifting sources of supply from lower-cost foreign to higher-cost
member-country producers (negative effect). Production effects can be classified as
under:
i)Trade Creation Effects
ii)Trade Diversion Effects




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Determinants of production effects
i) Size of the Union: The larger the area of the customs union, the greater would be
the positive production effects. Other things being equal, a larger economic area
increases the potential scope for the internal division of labour. While a smaller
customs union may lead to useful shifts in some lines of production, the chances for
the reallocation of the production increase with the extension of the area. At the
same time, successive increases in the size of the union reduce the possibility of
trade diversion. However, it is also possible that the enlargement of an economic
area may increase trade diversion in creation fields. Tinbergen and others point out
that in the absence of a change in economic policies, this trade diversion will be
more than offset by enhanced trade creation.

ii) Height of Tariff: The height of tariff levels of the members before and after the union
and the height of the tariff levels of the export markets outside the union have an
important bearing on the effects of the union. The following three conditions
enhance the positive effects of the union: (a) If tariff levels were very high before
the formation of the union, the formation of the union would lead to substantial
trade creation because the removal of the tariff would tend to cause the
substitution of many low-cost sources of supply within the union for high-cost
domestic supplies. Obviously, under such a situation, the consumer gains would also
be very great, (b) The low tariffs within the union as against the outside world would
minimize trade diversion, by reducing the likelihood of excluding from the union
market the low-cost outside producers and (c) Low tariff levels in export markets
outside the union would favour the export sector of the union, facilitating faster
development of the union economy.

2.Consumption Effects: Jocob Viner has dealt only with the production effects (trade creation
and trade diversion) of the customs union.
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In the preceding section of this chapter, we have mentioned that a customs union may have
both positive and negative production effects. Similarly, a customs union may have both
positive and negative consumption effects.
As has already been mentioned, Jocob Viner who coined the terms trade creation and trade
diversion ignored the consumption effects. However, today, a number of writers use trade
creation in a broader sense to include both the positive production effects and the positive
consumption effects. Similarly trade diversion is also used in a broader sense to include both
the negative production effects and negative consumption effects.


Dynamic effects:
We have seen above the static effect of the customs union. The union has some important
dynamic effects, too. The dynamic effects of the customs union refer to some development
that increases the economic efficiency of resource utilization.
The main dynamic effects are as under:
1. Market structure
2. Internal economies of scale
3. External economies of scale
4. Technological change
5. Investment




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Economic union


Introduction

An economic union is a type of trade bloc which is composed of a common market with
accustoms. The participant countries have both common policies on product regulation,
freedom of goods, services and the factors of production (capital and labor) and a
common external trade policy. The countries often share a common currency.

Purposes for establishing an economic union normally include increasing economic efficiency
and establishing closer political and cultural ties between the member countries. Economic
union is established through trade pact.

At the December 2004 meeting in Frankfurt, CUTEG members discussed a draft definition of an
economic union (EcUn1) for statistical purposes. While the definition was agreed in principle,
the following conclusions were reached: While the definition of an EcUn should not include a
reference to a common monetary and fiscal policy, it can refer to the existence of
cooperation/coordination mechanism in these fields. Apply the same principles to the concept
of residence of an EcUn as used to define residence in a CU. The table provided by Eurostat
offers a good framework to use in the new BOP manual to illustrate the distinction between a
CU and an EcUn. The new BOP manual should make some reference to the importance of
proper metadata and documentation on the methodology applied in compiling national
contribution to CU and EcUn aggregates. The new BOP manual should also suggest that the
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relevant segments of the BOP statement for an EcUn are the current account, the capital
account, and direct investment, whereas the other categories are less relevant and meaningful
at an EcUn level. It is worth noting that the value for analysis of a fully fledged b.o.p. for an
EcUn is limited and may be prone to misinterpretation. Where some users of EcUn statistics
may still want to have these data, possibly as a contribution to flow-of-funds data, they should
be aware that the b.o.p. aggregate could be the result of divergent financial markets trends in
the economies included in the EcUn. In contrast to a CU, an EcUn would lack a common
monetary policy and would have limited financial integration. Developments in the BOP
financial account or international investment position (with the exception of foreign direct
investment) may therefore be hard to interpret.

In light of the above conclusions the following definition of an EcUn is proposed for
inclusion in the new BOP Manual.

For statistical purposes, an Economic Union (EcUn) is a union to which two or more economies
belong. EcUns are established by means of a formal intergovernmental legal agreement among
sovereign countries/jurisdictions with the intention of fostering greater economic integration.
In an economic union some of the elements associated with a national economic territory are
shared among the different countries/jurisdictions. These elements include

(1) the free movements of goods and services within the EcUn and a common tax regime for
imports from non-EcUn countries (free-trade zone);2) the free movement of capital within the
EcUn; (3) thefree movement of (individual and legal) persons within the EcUn. Also in an EcUn,
specific regional organizations are created to support the functioning of the EcUn under points
(1) to (3). Some form of cooperation/coordination in fiscal and monetary policy usually exists
within an EcUn.



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Economic Union territory

An economic union (EcUn) territory consists of the geographical territory of the economies
that comprise the EcUn, and the regional organizations that comprise the same or a subset of
the same economies and are set up to manage the functioning of the EcUn.



Data issues

For the purpose of macroeconomic coordination/cooperation, EcUns formulate specific data
requirements including balance of payments statistics, which help assess aspects such as the
degree of integration of the EcUn internal market or share of trade with countries outside the
EcUn. In these instances, since the EcUn balance of payments data are compiled through the
aggregation or consolidation2 of national contributions, it is important that the EcUn member
countries strictly follow international agreed standards and provide adequate metadata
describing their methodology.

2 There are two approaches for compiling an EcUn balance of payments. The aggregation
approach consists of adding up net national transactions to obtain the EcUn net transactions
with economies outside the EcUn (because on a net basis intra-EcUn transactions cancelout).
The consolidated approach consists of aggregating gross transaction of the member economies
with partner economies outside the EcUn area. This approach allows for an EcUns balance of
payments statement to be compiled on a gross (credits and debits) basis. Also, specific
statistical techniques might be employed to aggregate national data, such as modelling to deal
with asymmetries assessed within intra-EcUn data. At the EcUn level, the current account, the
capital account, and direct investment are relevant for monitoring economic performance of
the EcUn. However, as different currencies continue to coexist, and the respective monetary
authorities set their monetary policy objectives in terms of developments of monetary
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variables, interest rates, and exchange rates, the portfolio and other investments categories are
usually less meaningful at the EcUn level.


Definition :

An agreement between two or more countries that allows the free movement of capital, labor,
and all goods and services, and involves the harmonization and unification of social, fiscal, and
monetary policies.













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1. The two pillars of Economic and Monetary Union (EMU)


The launch of the single-currency in January 1999 marked the beginning of a new era in the
process of European economic integration. It was the start of the third and final stage of
Economic and Monetary Union (EMU) as established by the Maastricht Treaty. This Treaty,
which could be considered as an economic constitution for Europe, provides the legal
foundation for Economic and Monetary Union based on two pillars. On the one hand, the single
monetary policy, and the creation of a federal monetary authority. On the other, the
enhancement of the economic policies of the Community and economic policy coordination.
The European Council - which assembles the Heads of State of the European Union- at its
meeting in Hanover in 1988, established a High level Committee for the study of Economic and
Monetary Union. Following the preparatory work of this Committee, which I had the honour of
chairing, the Treaty envisages a parallelism between the two pillars of EMU. Despite these
provisions, it is today very clear that there is a notable imbalance between the economic and
monetary components, to the severe detriment of the former. In order to illustrate this
situation, I shall now briefly outline the institutional arrangements which make up the two
pillars.

1.1 The new monetary policy framework

Since the start of stage three of Economic and Monetary Union, the countries of the euro-area
share not only a single currency but also a single monetary policy. The responsibility for
conducting monetary policy has been assigned to the Euro system. This is Euro lands new
monetary authority, and like the American Federal Reserve System, it is a federal institution. At
its centre is the European central bank (the ECB), based in Frankfurt, Germany. The National
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central banks of the euro-zone countries are the second part of the equation. As a reminder,
the countries of the euro-zone are Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg,
the Netherlands, Austria, Portugal, Finland and, since January, Greece. Albeit decentralised in
its organisation, the Eurosystem has a totally supranational character. It has been given the
clear mandate by the Maastricht Treaty to maintain price stability. In addition, the Treaty grants
full
independence to the ECB and all members of the Eurosystem, and it enshrines the above in a
text of constitutional nature, rather than in ordinary legislation. The decision making body of
the Eurosystem is the Governing Council of the ECB. This Council comprises the six members of
the ECBs Executive Board and the twelve Governors or Presidents of the participating national
central banks. Decisions are made on a one person/one vote basis. However, it is important to
note that members of the Governing Council do not represent their country or even their
national central bank: they are appointed in an individual capacity. The Council conducts
monetary policy in accordance with conditions in the euro area as a whole. The Eurosystem was
established in the model of the Bundes bank, to the point that the wording of its statutes is, in
part, almost an exact copy of those of the German central bank. Thus the pre-eminence of price
stability. In addition, unlike the Fed, the Euro system has given itself a quantified definition to
its objective : a year-on year consumer price increase of below 2%. While the Euro system is
also required to support economic growth this is only to the extent that such support does not
compromise its primary objective. The ECB is still a very young institution, barely two years old
now, which operates on largely uncharted territory. Despite its brief existence the ECB has
already had to face its first tests. At the beginning of its mandate, in the wake of several
emerging market crises, European growth was experiencing a significant slowdown. Then last
year the long depreciation of the euro and rising import and energy prices introduced
considerable inflationary pressures into the euro-zone. This would have been a turbulent and
difficult childhood for any central bank, but it gave the ECB the chance to prove both its anti-
inflationary credentials and its willingness to respond to economic developments in a pragmatic
way. For me, the ECB has often been the target of unjustified criticism. No central bank is
infallible, but the ECB and the Eurosystem is a solid institution and so far has been doing good
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work. Notwithstanding this overall positive assessment, let me just point out a couple of
aspects of the monetary setting which I think might still be improved upon :

First, I am afraid that the 2% limit, even if understood as a medium-term target, may prove on
some occasions overambitious, particularly if monetary policy is to sustain employment in
times of slow economic growth. There are several factors which have a sizeable impact on
prices. Two examples would be the exchange rate and indirect taxes, upon which the ECB can
exert little influence. The Treaty gave a mandate to the Euro system to safeguard price stability,
which the Governing Council of the ECB decided to specify in a quantified
definition. This chosen target may be too low and therefore create a bias towards excessive
caution. Second, the ECB Governing Council, which today comprises 18 members, is already
rather large compared to the equivalent American or British committees. The European Union
will enlarge to the East in the coming years, and as soon as new members will fulfil the
corresponding economic criteria, they will also adhere to EMU. One or two of the EU countries
that initially decided to stay out of Monetary Union Denmark, Sweden and the UK- might also
join. Therefore Euroland is bound to grow in the future, and if the one member/one vote
principle that currently guides decision making remains unchanged, the Governing Council of
the ECB will become far too large to execute monetary policy in an effective and timely manner.
One possible reform would be to implement a rotating system among the national central bank
governors or alternatively the creation of constituencies of Member states. Whatever the
resolution, the system will have to be reformed if the euro-area is to expand without
compromising the efficiency of its decision making process. Obviously there is always room for
improving any institutional setting, but as I have said, the new monetary policy framework is a
very consistent one.
Let me now turn to the economic components of EMU.




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1.2 The economic pillar of EMU

Economically, EMU is the final step of the Single market, and thus built on a number of
existing elements such as :

the common European market, characterised by free circulation of persons, goods,
services and capital,
competition policy, which is conducted at the federal level by the European
Commission,
and, structural and regional policies, focused at helping less developed regions to catch
up with the richer areas of the Union.

The introduction of the Economic Union pushed further progress in the single market and called
for a reinforcement of existing common policies. However, unlike the Monetary Union, the
Economic Union did not require the pooling of further sovereignty nor the creation of any new
supranational institution. Rather, Economic and Monetary Union necessitates further co-
ordination of national economic policies. This was the strongest novelty introduced by the
Economic Union as envisaged in the Treaty. While monetary policy has been assigned to a
federal institution the conduct of nearly all economic policies remains decentralised within the
Member states. Fiscal policy, regulation of product and labour markets, taxation, social and
employment policy... all remain the preserve of national and regional actors. This is by no
means a handicap : it is actually desirable for some policy competences to be assigned at a
lower level of governance. One can take as an example the case of wage settlements, which
should take into account productivity developments at the regional or even local level, or public
expenditure, which should reflect differing preferences, systems and traditions. The abolition of
national currencies also makes it desirable that euro-area countries keep a certain discretion
with regard to their fiscal policies. In this way, they are able to respond to national cyclical
developments.

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However, when implementing both micro and macro-economic policies euro-area countries
cannot neglect the new interdependencies created by the advent of the single-currency. It is
not only the stability or the credibility of the euro which is at stake, national and infra-national
actions have a direct impact on the welfare of all participating countries. Individual budgetary
decisions (especially those of large countries) affect common macroeconomic variables, mainly
area-wide inflation and the exchange rate. Any change in these variables will in turn have an
effect on the interest rate moves taken by the European central bank. The same holds true for
structural policies which affect the non-inflationary growth potential of the euro-zone.

Furthermore, given the small size of the federal budget, less than 1.3% of the zones GDP, the
definition of a consistent policy-mix at the euro area level can only be carried out through solid
coordination of national policies. In the field of structural reform, greater coordination between
national governments may be a source of support for what at times might prove politically
difficult measures. The multilateral commitment to common objectives, along with peer
pressure, stimulates the implementation of reform programmes agreed at the European level.

The Treaty establishes several instruments which serve to enhance economic policy
coordination, a necessary parallel to Monetary Union. At the heart of these instruments is the
Broad Economic Policy Guidelines. These include an annual general assessment of economic
developments and policy options, as well as a large set of general and country specific policy
recommendations. They are adopted by the Council of Economic and Finance ministers, on the
basis of a proposal of the European Commission. Member States thus commit themselves to
ensure the consistency of their national policies with these Broad Economic Guidelines.
Throughout the year, the Council of Economic and Finance ministers assesses the development
of national policies and may issue recommendations whenever it finds that a Member State
seriously deviates from the commonly approve guidelines. However, even if Member States are
expected to follow these peer-recommendations, they are not in any sense binding. The Treaty
also established a procedure for avoiding excessive public deficits.

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This procedure was further enhanced, before the introduction of the euro, by the Stability and
Growth Pact. The Pact forbids Member States deficits from exceeding 3% of their GDP. This
rule was necessary to avoid conflict between the common monetary policy and national fiscal
policies. In addition, Member States adopted, in signing the Stability Pact, the objective of a
balanced budget over the medium-term. In this context, the Council of ministers also carries
assessments, known in the European jargon as multilateral surveillance. Nevertheless, as long
as they respect the 3% deficit rule, Member States retain ample room for manoeuvre, and can
thus both approach this medium-term objective at their own pace and define budgetary
policies as they deem appropriate. The European Council added several mechanisms to
improve this institutional framework, but the Economic

Policy guidelines and the Stability Pact still remain the principal elements. All participating
actors have gradually learned to work within this setting and it has, thus far, functioned rather
smoothly. However, it is my view that this institutional set-up has failed to achieve the
minimum degree of policy coordination desired. Policy actors have failed to use the existing
instruments of coordination to their full potential. This is especially true for the Economic Policy
Guidelines. Although these guidelines have fostered fruitful common assessments of
appropriate policy measures and the exchange of best-practice, a real culture of economic
coordination has yet to develop, and national objectives too often overshadow the common
interest. As for the Stability Pact, it is a necessary constraint to ensure a minimum of fiscal
discipline, but its rules-based approach is inadequate to articulate an appropriate overall policy-
mix for the euro zone. The aggregate fiscal policy stance, and thus the policy-mix, is still the by-
product of individual decisions taken solely within the perspective of national circumstances. In
addition, the Pact it is too synthetic an instrument to provide sufficient assessment of the
soundness of public finances. For instance, it does not take into account implicit liabilities (such
as those resulting from pension commitments) or the nature of expenditure, giving the same
treatment to investment and consumption.

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The Economic components of EMU are not yet up to the task. I believe that tackling the
remaining weaknesses of the Economic pillar is of upmost importance for the future.
I will come back to this later. Let me first


























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2. The structural transformation of Euro land

draw your attention to the major structural changes that have taken place in Europe since
the launch of EMU. These are mainly the result of two concurrent factors: the transformative
forces unleashed by the single currency and the increasing efforts of policy-makers to
implement regulatory and structural reforms.


2. 1 The impact of the euro on the European economy

a) The single-currency environment

One of the main goals of the Single Market program, launched by the Commission in 1985, was
to foster competition amongst European economies, and in particular within those sectors
which had thus far been sheltered by either physical, technical or fiscal barriers. The euro has
injected new momentum into this process. On the one hand, it exerts disciplining pressure on
the participating Member States since they are no longer able to compensate structural
weaknesses or economic policy failures through a devaluation of their national currency. On the
other hand, it brings about major changes at the microeconomic level, creating new
competitive pressures.
The most visible evidence of this is the wave of mergers and acquisitions that is has swept
across Europe. These increased three-fold from 1997 to 1999 reaching a volume of 1.5 billion
dollars, nearly half of which corresponded to cross-border alliances. There are two factors
behind this : first the reduction in the cost of acquisitions triggered by the single-currency and
the revolution in financial markets, and second, the removal of existing barriers to cross-border
mergers.

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The euro not only intensifies competitive pressures, it is also finally making Europe a genuinely
single market. Companies of all sizes are shifting from national to European strategies as old
economic boundaries disappear. In sectors such as telecommunications or energy, liberalisation
and international competition have already led to significant efficiency gains and lower prices
for consumers. The coming introduction of the euro banknotes and coins is likely to add to this
process by increasing the transparency and comparability of prices which is still somewhat
blurred by the existence of national currencies.

b) Emergence of euro-area wide financial markets

Notwithstanding the changes induced in economic relations by the euro, by far the single
currencys most fundamental impact has been on the operation of the European financial
sector. Actually, EMU is transforming Europes financial markets more quickly than anticipated
by all but the most fervent euro-enthusiasts.
Bond markets The first, and perhaps most notable example has been the rapid integration of
government bond markets. The process started at the beginning of the final stage three of EMU
when all euro area governments redenominated their outstanding debt stocks in euros. Since
then, all new issues have also been made in euros. Moreover, bonds issued by any euro-area
government are equally free of currency risk and equally eligible as collateral at the ECB.
International bond issuance is nowadays split more or less evenly between the euro and the
dollar. Even more impressive has been the growth observed in Europes corporate bond
market. Corporate euro denominated issuances increased more than 300% in 1999 compared
to 1998 and maintained roughly the same level in 2000 despite worsening market conditions.
Currently, US multinationals raise as much money in the euro bond market as in the dollar
market. These recent developments of European bond-markets make it easier for European
companies to raise funds and thus provide more efficient financing opportunities for investors.
Restructuring and consolidation of the financial sector.

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The introduction of the euro has also fostered substantial restructuring and consolidation of the
European financial sector. Equity markets in Europe, even if the volumes traded are still low by
American standards, are growing and changing rapidly. The first pan-European equity market
has already been created : Euronext, the result of the merger of the Paris, Amsterdam and
Brussels stock exchanges. While other cross-border merger attempts have not come to fruition,
as was the case of the proposed merger of the Deutsche Brse and the London Stock Exchange,
they are nevertheless revealing evidence of the existing pressure on European stock and
derivatives exchanges to form cross-border alliances. Financial intermediaries are also going
through a process of consolidation. For the most part, mergers and acquisitions of financial
institutions have up to now occurred between national players, although there are already
some examples of cross-border merger activity. This is likely to intensify in the near future.
Consolidation of financial institutions is, in turn, closely linked to the progressive shift from the
traditional European model of universal banking to a predominantly market based financial
system. Improving financial supervision and the regulatory environment.

The changes taking place in the financial sector, driven mainly by the introduction of the euro,
but also by globalisation and technological advances, give rise to new challenges for regulatory
authorities. The emergence of large pan-European financial institutions, for instance, has far-
reaching implications for prudential regulation. To ensure financial stability, new developments
need to be matched by increased cooperation and coordination between national and
European authorities. In addition, markets for financial services are still too segmented due to
persistent differences in national rules. The resulting costs, in terms of efficiency, growth and
employment, are still one of Europes major drawbacks : all remaining legal barriers preventing
further market integration should be dismantled.





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2.2 The momentum for structural reform


Let me now turn to what is usually perceived as Europes major weakness : namely its economic
rigidities. It is certainly true that Europes structural handicaps have tended to hold it back in
terms of growth. However, the rhetoric in this field seems to be out of sync with the reality of
the profound changes that have been taking place recently. In fact, policy-makers across
Europe are now focusing more than ever on overcoming these economic rigidities. At the
Lisbon summit in April last year, the EU Heads of State established an ambitious agenda of
comprehensive structural reform for the next decade. The agreed strategy sets quantified
targets and clear goals for economic and social reform. It includes concrete action to :

attain higher employment rates, especially for women,
increase investment in research, education and long-life learning,
modernize social protection,
prepare the transition to a knowledge economy and society,
achieve sound and sustainable public finances,
speed up liberalization (notably of transport, energy and public procurement),
speed up the integration of European financial markets and enhance access to
venture capital.


The European Council endorsed its commitments with the adoption of a new method of
coordination that in the model of the Economic Policy Guidelines, is based on the establishment
of common benchmarks, peer pressure at the European level and the exchange of best
practices.
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The Heads of State also agreed to devote a summit every Spring to take stock of the progress
made, drawing on economic and social indicators, and thus to give renewed political guidance
to the process. The summit that took place this last week-end in Stockholm (23-24 mars) was
the first of these follow-up summits. It is still too early to assess whether the Lisbon strategy
will be a success, and even more difficult to tell if the New economy is finally arriving in
Europe. We cannot but understand, when assessing recent developments, that improvements
will come slowly in several areas. For instance, the delays witnessed in the adoption of an EU-
wide patent or the ever cumbersome financial market regulations. However, there are many
signs that the Lisbon strategy has put Europe on the right track. Labour market reforms have
been introduced in a number of countries (for instance in France, Spain and the Netherlands, to
name but a few). There is also a widespread implementation of both flexible labour practices
and active employment policies. Low wage settlements in Germany despite falling
unemployment, also point to an improved labour market. All these factors have surely played a
role in the labour-intensive nature of European growth. In line with the objectives set in Lisbon,
the EU has created some 2.5 million jobs in the year 2000.

Another field were Member states are making considerable progress is fiscal reform. Most
euro-area countries recently adopted comprehensive tax reduction plans which include cuts in
social security contributions and personal income taxes. These come into effect this year and
should strengthen the supply side of the economy. Albeit to a lesser extent, a few countries
have also revised benefit systems so as to increase employment incentives. Fiscal reform has
been especially important in Germany. The alleviation of the tax on banks capital gains from
the sale of industrial shares, along with the development of corporate-bond markets, provided
a shock to the system of industrial cross-holdings. This entrenched and long-standing system, in
which banks are the main shareholders of the corporations to which they lend, is progressively
giving way to market-based practices such as desintermediation or securitisation. Finally, in
Stockholm, the European Heads of State have also addressed the reforms required to create
more integrated and efficient financial markets. The European Council has adopted a resolution
endorsing the Report of wise men on the regulation of European securities markets, which
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intends to set the basis for a more flexible regulatory environment. A key innovation will be the
creation of a Securities Committee which will assist the Commission in improving existing
legislation. Another, more technical, committee will also be established so as to develop the
details of regulations and directives which, from now on, should be more focused on
framework principles.



















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Conclusion


There are many regional trade agreements (RTAs) in the world .We also distinguish FTAs, customs
union, common market, economic union. RTAs in general increase welfare through trade creation, but
the discriminatory nature of an RTA may make the net welfare effect negative. Increased popularity of
Regionalism rather than Multilateralism may be bad for the world economy. EU is most successful and
powerful economic integration scheme; many CEE countries want to join; EUs political decision process
needs to be revised.
















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Biblography


www.wekipdia.com

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