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International perspective: structural changes and the integration of Europe.

EUROPE IS NOW in a stage of flux. After forty years of integration and the emergence of institutions and arrangements propelling this process, centered on the European Economic Community, Europe has now reached another important turning point -- the Maastrich Treaty. Ratification (or nonratification) of this treaty and its implementation will determine the character, speed and direction of further advance.

The Maastrich Treaty aims to create among the members of the Economic Community (EC) a monetary union, a single central bank and a single currency. It also expands modestly the powers of the European Parliament and endeavors to move toward a common foreign and defense policy as an integral part of the process of economic and political integration.

Following the Danish and French referenda and the financial storm that forced the U.K. and Italy to abandon the quasi-fixed EC monetary arrangement (ERM), it has become fairly clear that the original deadline for ratification by the twelve EC members will not be met. The best that can be hoped for now is ratification by the twelve by the spring or summer of 1993. In addition, the Treaty probably will be complemented by an additional protocol reaffirming the principle of subsidiarity (i.e., no matters that can be dealt with by national governments will be taken on by the European Commission). Moreover, various provisions introducing more flexibility will be added, resulting in the whole document merely providing basic guidelines, subject to a variety of exemptions.

As a result of these developments, what probably will emerge in Europe will be three to five different groupings with different institutional, trade, finance and political (as well as military) arrangements among themselves and with other countries. The nature of these arrangements, the factors propelling them, and their impact on the changing architecture of Europe can be seen best by looking at the way the forces of integration in Europe have been working in the past and by examining the elements of continuity as well as the centrifugal pressures.

The process of integration can be divided into four periods characterized by different economic, political and institutional features. The first period lasted until the early 1970s; the second covered the years until the mid 1980s; the third period is coming to an end; and the fourth period is about to begin.


During the first phase, Europe in effect comprised three groupings. They were the European Economic Community (EEC), the European Free Trade Association (EFTA) and the remaining countries. The EEC, set up by the Treaty of Rome of 1957, together with the Steel and European Community and Euratom set up in 1951, was a political-economic grouping. Based in effect on the French-German axis designed to achieve a permanent reconciliation between the two countries, it also comprised Italy and the three Benelux countries. Its aim was to create an "ever closer union of the peoples of Europe" by free movement of goods, services, capital and labor, and by increasing political and administrative coordination through newly created common institutions (the Court of Justice, the Commission, the Council of Ministers and the Assembly) to which members agreed to transfer some of the attributes of their sovereignty.

The EFTA group, comprising the UK, Ireland, the three Scandinavian countries, Austria and Switzerland, was created in 1957 as a counterpart to EEC. Its aim was merely to establish free trade among the members and to achieve a higher degree of freedom of trade with the EEC and other countries.

The remaining countries (i.e., southern European countries other than Italy) continued to act individually, pursuing their interest in conditions dominated by two world super powers, the U.S. and the Soviet Union.

The split of Europe into two main groupings reflected different philosophies and political, economic, and social aims and was accompanied by frictions and tensions among them. The distinguishing features of the EEC during this period in the economic area were a successful creation of a customs union, the agreement on a common external trade policy, a common agricultural policy, and a gradual but slow move towards removal of nontariff barriers. Further advance would require coordination of a variety of micropolicies, and in macropolicy what was necessary was a move towards monetary union. In the political area, this period was characterized by a search for mutually acceptable principles guiding the relationships of the Community's institutions and member governments and the nature of the Community.

In the economic field the EEC was very successful, but in the political area the progress was very slow indeed. No progress was made in the field of foreign and defense policy, and it was agreed, following French pressures, that the group was to be an association of the member states and that all important decisions had to be agreed upon unanimously (i.e., right of veto).

The EFTA record during this period was also quite satisfactory, with the exception of the UK whose performance in terms of output, productivity, and external trade fell short of that of the EEC and most other EFTA members. However, the dynamism displayed by the EEC, its growing bargaining power and importance in Europe and the world caused the EFTA members and above all the UK to consider that on balance the benefits from full freedom of trade with the EEC and coordination of micro policies would be advantageous to them. Joining the EEC would not only impart its dynamism but would enable them to reap gains of trade creation, economies of scale and of greater spending on research and development.


The second period of European integration and structural changes, which lasted till the early 1980s, differed significantly from the first period. In political terms the EEC underwent a marked widening, its membership rising from six to twelve. EFTA contracted, losing three members (the UK, Denmark and Ireland to EEC) while three previously independent South European states (Greece, Spain and Portugal) also joined EEC. As a result, the EEC has come to dominate Europe, with EFTA playing a smaller role. However, it must be stressed that the behaviour of the two groupings had been influenced to a considerable extent by the geopolitical balance of power between the U.S. and the Soviet Union.

During this period there was little progress in changing the character of the EEC, its institutions, the relationship among the members and rules governing them. Likewise EFTA continued to be concerned entirely with foreign trade and access to the EEC and other markets.

The lack of progress in the political area was due to economic difficulties and, after the admission of the UK, Denmark and Ireland in 1972, disagreements about the size of budgetary contributions, the Community's income from other sources and the role of a common agriculture policy. Also there were profound differences of views about the nature and the further development of the Community and the move toward political unity. These were reflected in the draft Treaty on European Union being changed merely to a "Solemn Declaration."

Economically, that was a disappointing period. No serious attempt was made to coordinate monetary and/or fiscal policy. On the microlevel in the trade area, the share of intra-Community trade in the total of their trade stagnated at around 46 percent, pointing to a loss of impetus arising from trade creation. As far as macroeconomic performance is concerned, the growth in total output during this period at around 2 percent per annum in the enlarged EEC was not significantly different from that in the EFTA. The growth of trade with nonmembers also lost its momentum, such exports growing slower than the total world trade and indicating that integration within the EEC and EFTA and of the two communities in the world economy made no further advance. Stagnation of trade reflected the fact that new market barriers outweighed new liberalization measures. In retrospect this period is regarded as one of Eurosclerosis, exchange rate instability, high inflation, and no significant move towards convergence.


The two main characteristics of the third stage are the passing of the Single European Act (SEA) in 1985 and of the yet-unratified Maastrich Treaty in 1991.

The most important institutional change contained in the SEA is the introduction of the qualified, or weighted, majority voting with the exception of fiscal matters, those relating to free movement of persons, and rights and interests of employees. It is also worth pointing out that the SEA restated the objective of creating a European Union, of moving toward common foreign policy and emphasized the aim of "the progressive realization of economic and monetary union."

In retrospect there is no doubt that the SEA, helped by the boom in the U.S. and Japan, reinvigorated the European economy, accelerating the rate of growth in output, productivity and investment. The advance has been due to the removal of obstacles hindering the four freedoms. It covered harmonization of standards, the acceptance of a single document for exports and imports, mutual recognition of rules and regulations, and coordination of some taxes and some tax rules, all of which helped establish a "level playing field." There has also been a considerable advance to areas such as control of mergers, opening of public purchases to competitive tenders, and coordination of rail and road transport. Freedom of capital movement was introduced by all members by 1991, with the exception of Greece and Portugal, which were allowed temporary derogation. Agreement to allow freedom of movement of persons was signed by Germany, France, and Benelux in 1990 but is yet to be ratified. Most of the 300 or so specific measures have now been translated into Community directives and have either been incorporated or are about to be included in national legislation. In sum, the Single European Market will for practical purposes be virtually fully in operation by the beginning of 1993, having provided a very marked stimulus to production, trade, investment and productivity.

The second important measure in the third period is the Maastrich Treaty, first proposed in 1989, agreed to in December 1990 but still to be ratified. Of the basic changes it proposes, those containing specific provision for the creation of a Monetary Union are most important. Other changes cover modest expansion of the powers of the European Parliament, increasing cooperation and coordination of foreign and defense policy, and provisions covering common policy towards immigration, asylum, drugs, crime and other issues.


The Maastrich proposals for monetary union are a logical complement of the Single European Market. They merely reintroduce the elements that the original six members, in accordance with the Rome Treaty, tried to put into operation in the form of the Werner Plan for Monetary Union. The main economic reasons for monetary union were spelled out in the 1989 Delors Report. They are: (1) the abolition of exchange controls leads to potential instability in the absence of irrevocably fixed exchange rates; (2) irrevocably fixed exchange rates and the absence of transaction costs are necessary conditions for reaping advantages of a single market; and (3) monetary union will enable European countries to contain the dominance of Germany by having a jointly managed Central Bank.

Monetary Union, as envisaged as the Maastrich Treaty, is to be achieved in three stages. In Stage I, which started on July 1, 1990, all members must abolish all exchange controls, join the Exchange Rate Mechanism with its narrow band margin (2 1/4 percent each side of parity) and improve their policy coordination. In Stage II, to begin in 1994, governments will begin to achieve greater convergence measured by movement towards a sustainable fiscal position, the relative size of debt, and the behavior of interest rates, inflation and exchange rate stability. In Stage III, which would start from 1997 but not later than 1999, members eligible for membership will irrevocably fix their exchange rates and later introduce a single currency. Other members will join later once they fulfil the necessary conditions. The UK, however, has retained the right not to join the Monetary Union.

During Stage II ultimate responsibility for policy decisions will remain with national governments. Exchange rate realignments would be allowed but only in exceptional circumstances. All central bank financing of public spending must come to an end before Stage II, and all central banks must become independent of governments by the beginning of Stage III.

At the beginning of Stage II the Committee of the Central Bank Governors, now in existence, would be replaced by the European Monetary Institute (EMI), managed by a Council made up of Governors of the Central Banks and a President appointed by the European Council. Its task would be to strengthen cooperation in the field of monetary policy, facilitate the use of the ecu and prepare instruments and procedures for carrying out a single monetary policy in Stage III.

The EMI would be replaced by a European Central Bank (ECB) at the beginning of Stage III, when together with members' central banks it would become the European System of Central Banks. Its basic function would be to formulate and implement a monetary policy aiming at price stability (but not foreign exchange policy, which will be determined by the Council), conduct foreign exchange operations, hold and manage foreign exchange reserves and facilitate and assist the operations of a payments system.

The precise quantitive targets for the five convergence criteria that members must meet to qualify for membership in the Stage III are as follows: Inflation using the consumer price index in the full year preceding examination must be within 1 1/2 percent of the three lowest EC rates; the currency must remain within the narrow fluctuating bands without severe tension for at least two years before; the interest rate on long-term government bonds must be during the preceding year less than 2 percent above the average of the long-term interest rates in, at most, the three countries with the lowest inflation rate; the government deficit must not exceed 3 percent of GDP; and, finally a ratio of public debt to GDP must not exceed 60 percent. Also there is a requirement that the government's deficit must not exceed government investment (the golden rule of public finance).

In evaluating the progress towards convergence some discretion is allowed, especially with regard to the fiscal position where a "satisfactory pace" of improvement is needed.

Whether or not the convergence criteria and other conditions are fulfilled will be determined by the Commission and the European Monetary Institute, who will report to the Council of Economics and Finance Ministers. They in turn will report to the Council whether a majority of members have fulfilled the necessary conditions and if it is appropriate to move to Stage III. Stage III, however, must begin, regardless of the question of majority vote, not later than January 1, 1999. Thus, even if only a small number of members fulfil the necessary conditions, the EMU will come into effect at that time.

In Stage III all official reserves will be pooled and managed by ESCB, which would take responsibility for the formulation and implementation of monetary policy and for official intervention in foreign exchange markets.


Monetary Union as envisaged in the Maastrich Treaty raises important questions about the viability and feasibility of such an arrangement among the members of the European Community. In the ultimate analysis the issues are encapsulated in the question, "What are the necessary and sufficient conditions for the establishment of a viable monetary union and to what extent can they be found at present among members of the European Community?"

The answers to this question can be grouped under two broad headings. The first is the degree of convergence of economic fundamentals that must exist before a monetary union is embarked upon, the degree of openness of the various economies and their independence by way of trade, the degree of price and wage flexibility and labor mobility, and the extent to which various external shocks will have a different impact on various members. The second heading is the degree of power, if any, that independent monetary policy, (i.e., money supply, interest rate and exchange rate policies) gives to governments to select a desired mix of inflation and employment.

With respect to the convergence, openness, interdependence, prices, and wages, labor mobility and the impact of external shock, there is no doubt that there has been a marked trend towards reduction in divergence among the member states. The behavior of the fundamentals specified in the treaty indicate that five countries satisfy virtually all of them, that three countries fulfil about half of them and that four of them only one or none of them. The countries that satisfy all or virtually all conditions are Germany, France, the Netherlands, Denmark and Luxembourg. The three countries fulfilling some of these are Belgium, the UK and Ireland. Those fulfilling none or one or two are Spain, Italy, Greece and Portugal.


While all countries are open in the sense that exports account for more than 30 percent of the GNP, those in the first group have much higher rates, especially the small ones, and a much greater proportion of their trade is with each other. Such guesstimates as can be made indicate that the countries in the first group have a somewhat greater degree of labor mobility but wage and price flexibility is low in all countries. What recent events have shown is that some types of external shocks, such as the reunificating of Germany, which bear directly on the large and dominant countries, have powerful indirect effects on other countries through the mechanism of the exchange rate system, compelling them to have interest rates significantly higher that they would deem desirable.

As regards the second heading, i.e., the power of independent monetary and exchange rate policy, the answer depends on the view taken whether or not there exists a trade-off between employment and inflation and whether changes in nominal exchange rates have durable effects on real exchange rates, output and external accounts.

Here it is worth pointing out that, except in the short term and possibly in the case of structural underutilization, there is no trade-off between inflation and unemployment; independent monetary policy merely allows governments to choose the rate of inflation, Likewise, there are considerable doubts if changes in nominal exchange rates, except in the short run, have durable effects on real exchange rates, especially in the case of open economies, because short-term changes in real wages tend to be offset fairly rapidly by changes in money wages. It follows therefore that the decision to join or not to join a monetary union will depend on the perception of the state of the economy and the size and duration of the trade-off as well as political pressures influencing such perceptions. These political pressures also cover the transfer of sovereign powers, which may in fact be limited or nonexistent.


The September financial storm in Europe has, apart from its political aspects, emphasized a number of factors bearing on future developments. There are: (1) the need for a much greater degree of convergence; (2) the importance of different effects of an external shock, e.g., Germany reunification, on various members; (3) the importance of trade integration; (4) the significance of the relative size of different economies and their cyclical and structural position; and (5) the perception of the extent of trade-offs between inflation and unemployment and the different degrees of preference behind them. These factors are now influencing the development of monetary relations in Europe.

What has emerged so far as far as European monetary relations are concerned is what has been described as "variable geometry," i.e., overlapping to a different degree of integrated grouping. There is already a main grouping centered around the economically dominant country, Germany, comprising countries with similar economic performance, a large degree of interdependence and similar perceptions of how economies work. In addition to Germany, the countries in this group include France and Benelux and possibly Denmark. For them economic (and also political) conditions favor the establishment of a monetary union.

The second grouping, comprising the seven remaining countries in Table 1, displays marked differences as far as the performance of fundamentals is concerned. Furthermore, some of them such as the UK have a different perception of the way the economy works, especially with respect to the trade-off between inflation and unemployment and the character of the present downswing. Virtually all countries in this grouping from an economic point of view do not appear ready to become members of an informal or formally created monetary union and are unlikely to reach this position in the immediate future. They will have to readjust their policies, including exchange rates and exchange controls, before they will be in the position to commit themselves to a monetary union.

This view implies that further advance towards monetary integration in Europe will be a multitrack or a two-speed or three-speed approach, primarily because of economic reasons.

Apart from the existing EC members, some of the prospective new applicants, i.e., Austria, Switzerland and Sweden, may join the first grouping. In addition, the remaining members of EFTA have not and will probably not wish to apply for membership. Being members of the Single European Market, they will have every incentive to join the second grouping, although they may wish to develop monetary links in the form of a basket.

The fourth group will be the countries with an Association Agreement with the EC. They will not share in the Single European Market with all four freedoms, and it remains to be seen how their monetary (and exchange rate) policies will link them to the central group and the principal constellations around it.

The fifth group will comprise those countries that will seek special Association Agreements and will be given special treatment. This group can be expected to comprise less advanced countries of Eastern Europe, such as the Baltic Countries, Rumania, Bulgaria and Albania.


While interaction between political and economic forces will affect the pace of further changes in the institutional framework, the impact of the Single Market with its freedom of movement of goods, services, and capital and labor and absence of physical, technological, legal and fiscal obstacles can be expected to have a powerful and positive impact on further economic integration. What the years ahead will see is the Single Market, with no obstacle as regards free movement of goods, services, capital and labor, and comprising twelve present EC members and six EFTA members with a population of 370 million and GNP representing about 30 percent of the world GNP. Furthermore this group will be linked with three Central European Countries: Czechoslovakia, Hungary and Poland with a population of 62 million. (This new grouping compares with the North American Free Trade Area with population of 350 million and GNP accounting for some 31 percent of the world's total.) That the absence of trade barriers will provide a powerful stimulus to growth in productivity and total output in the European grouping is quite certain. If gains in productivity so generated in the next ten years approximate those the EC members achieved in the first and second stages of their integration, they would raise output by about 1 percent per annum, increasing the growth potential to some 4 percent per annum.

This rate of advance would reflect the benefits of comparative advantage, division of labor, economies of scale and research and development. These gains can be expected to be reinforced by growing links with Central and Eastern European Countries.


Whether or not the Maastrich Treaty is ratified by all members of the European Community and implemented, it will certainly be an important landmark in the process of European integration. It is likely to result in the emergence of overlapping groupings, which through Single Market arrangements will increase their interdependence and cause them to adopt policies leading to convergence and growing emphasis on the benefits of a single monetary and exchange rate policy.

T.M. Rybczynski is an economic consultant and visiting professor, City University, London, and formerly Economic Advisor to Lazard Bros. & Co., Ltd. This paper is adapted from one presented at The 34th Annual Meeting of The National Association of Business Economists September 13-16, 1992, Dallas, TX.
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Author:Rybcynski, T.M.
Publication:Business Economics
Date:Jan 1, 1993
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