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The single European market and the real economy.

The Single European Market and the Real Economy

THE EXPERIENCES of military defeat and the occupation of one's country confer depths of feelings whose complexity can be difficult to appreciate for those who have not been so affected. The Second World War was a determining force behind the establishment of the European Economic Community and its related bodies, the European Coal and Steel Community (ECSC) and Euratom. By binding their economies together, the EEC was intended to make future war between France and Germany impossible, so ending at least three centuries of conflict. The other founding members also had recent experience of occupation, but their inclusion was peripheral rather than central. The refusal of the United Kingdom to become a founding member likewise had its roots in the Second World War, reinforced by attitudes engendered by being an English-speaking island with an open-sea tradition.

The concept behind the binding of France and Germany through trade was the Ricardian one of comparative advantage, facilitated by the different structures of those countries' economies, notably in the balance between agriculture and industry. The Treaty of Rome that established the Community in 1957 was much concerned with the problems of adjustment arising from the integration of the continental economies, and established provisions to deal with them. Thus, agriculture was to be the subject to a policy of structured pricing to ease the unemployment problems that would otherwise arise as the sector adjusted to its new competitive position. This policy was to be achieved by means of intervention buying by the Community, financed by a budget drawn from value added tax levied by the member states. The Common Agricultural Policy still has this form, although the principle is slowly giving way under the triple pressures of cost, irrelevance and international trade. Again, all trade relations were to be conducted centrally by the European Community in reflection of the concept of a common market. Within the Community itself, rules were established governing competition and the granting of assistance by member states to their respective industries. The basis of the latter was again the elimination of disruptions of competition within the community as a whole. At the same time, however, a structure for regional aid was established to assist disadvantaged areas.

EARLY STAGES

The early years of the Community were optimistic. By

The early years of the Community were optimistic. By the 1960s the major European economies had largely recovered from the effects of the war, but still had levels of GDP per head some 50 percent behind that of the United States. The average growth rate of the Community countries however was high -- some 5 percent per annum -- and their economies were stimulated by the new tariff-free area; trade between the member states grew rapidly. This success prompted the United Kingdom to reappraise its interests, a result largely of pressure from manufacturing industry. An application for membership was made and was supported by five of the six member states. The intransigence of the president of the sixth (General de Gaulle of France) rendered the application a failure, but the attempt sponsored the first international collaborative venture in European high technology, Concorde. This venture was followed by others involving several countries and led directly the establishment of Airbus Industries in the latter part of the decade and the spread of its associated technologies to all member states of the Community.

General de Gaulle having departed, the Community was enlarged in 1973 to include the UK, Ireland, Denmark and Greece. The economic advantages of being part of the larger grouping now seemed manifest. The member states' economies were clearly successful and still growing relatively rapidly. Backward regions such as the south of Italy were showing signs of industrial rejuvenation based on new industries, such as cars and synthetic fibers, which required European-scale markets for economic production. The agricultural policy was bearable (and could make farmers wealthy). Above all, the political focus for economic, industrial and trade affair was increasingly moving to Brussels. Moreover, some major industries were already largely pan-European -- chemicals, fibers, aerospace -- and others would follow. It was critical therefore to be able to influence Brussels policy.

Although the pressures were already evident, the uncertainties and instabilities that have marked economic life during the past fifteen years had not set in in 1973, and the simplistic nature of the reasoning behind enlargement can therefore be excused. The logic, however, persists and is relevant to the problems that will face Europe after 1992.

STAGNATION

The Community was tested in the 1970s, as recession coincide with enlargement. Overcapacity in key industries illuminated significant differences in competitiveness between member states, no longer cushioned by growth. The fragility of the pan-European aspect of these industries' structures was quickly apparent, as member states resorted to state subsidies to defend their industries against superior competition. The result was the perpetuation of overcapacity and damage to the more efficient, and hence unsubsidized, producers.

Under these conditions, the Community's economic goals stagnated. Border controls were manipulated to provide de facto protection, from both Community and non-Community countries. The failure of the member states to develop Europeanwide public procurement policies, flexibly harmonized standards (those that did exist tended to be of a dirigiste and foolish nature, such as the definition of a sausage), and genuine open markets became increasingly visible, as did the character of the Community as a collection of sovereign states gathered together as subsidiaries to what appeared to be evolving as little more than an elaborate free trade agreement.

Two developments in the latter part of the 1970s prevented the trends inherent in this situation from taking root. The first of these was largely the work of the Vice President of the Commission responsible for industrial policy, Viscomte Etienne Davignon. Following extensive negotiations, Davignon sponsored agreements with the steel and synthetic fibers industries whereby producers in Europe agreed to reduce their capacity to bring it into balance with anticipated demand. In a more unified market such a process would have occurred as a result of market forces. The willingness of certain member states to subsidize their capital intensive industries precluded such a process, even though many of these subsidies were in violation of Articles 85 and 92 of the Treaty of Rome, which forbid the use of state aids where the result is to distort competition within the Community. The synthetic fibers industry was particularly badly affected: the product is relatively undifferentiated and cost levels therefore have a strong effect on setting prices. By 1982, the Italian fibers industry, whose productivity was half that of the German and two-thirds that of British industries, had received some $ 2.6 billion of aid, much of its conferred in subtle forms. The effect on the rest of the European industry would have been catastrophic without the Davignon Agreement.

The effectiveness of the Community's policies towards member states subsidies was significantly changed by Davignon's interventionist restructuring. The Community works largely by consent. for internal reasons, some countries have particular difficulty in fulfilling their obligations in this respect; Italy is among them. The vigor with which cases are pursued by members of the Commission and their staff is therefore critical to the prosecution of Community policies. In the field of state aids, this vigor increased markedly in the early 1980s. In spite of fierce political opposition, the Commission succeeded in terminating state aid for fibers, and in establishing its authority to suppress or modify subsidies and regional aid in other areas. Most complex and significant of these was the unravelling of support for the steel industry, which was accompanied by a fundamental restructuring of acute political sensitivity. The authority established by the Commission in this area has had a fundamental influence on the ability of the Community to function as an integrated market.

The second development -- the Cassis de Dijon case of 1979 -- concerned the limitation of the power of a member state to forbid the sale in its territory of goods legally on sale in another, on the grounds that they do not meet the requirements of a local regulation. Cassis de Dijon is a mild liqueur that, when mixed with white wine, forms an attractive aperitif, Kir. It was (and is) widely consumed in France, but not in Germany, where the sale of Cassis was forbidden on the grounds that it was insufficiently alcoholic to be classed as a liqueur. The manufacturers of Cassis took their case to the European Court, which ruled that Germany's action was contrary to Article 30 of the Treaty of Rome, since Cassis was legal in its country of manufacture, was not injurious to the "health and life of humans, animals or plants" and could not therefore be refused entry under Article 36 of the Treaty), and should therefore be treated as such in other member states. Although its scope was limited, the case was a landmark in the history of the Community, and has opened the way for the integration of the market without full harmonization of standards, overcoming an otherwise impossible impediment.

These developments were of course modest and must be seen in the context of stagnation that afflicted the Community until the mid-1980s. Nevertheless, they represented positive aspects in an otherwise negative period, and formed an essential preude to the preparation of the 1985 White Paper "Completing the Internal Market" and the Single European Act of 1987, which set the target date for completion of the end of 1992 and adopted majority voting in place of the previous unanimity rule in order to facilitate that achievement.

THE 1992 PROGRAM

The Commission's program is now roughly half completed, but much remains to be done. The structure of the Community remains sclerotic. Although goods may circulate freely between member states, they are still subject to border controls. Value added tax and excise duties differ markedly across borders, rendering such checks essential to avoid fraud. Under Article 115 of the Treaty, importation may be disallowed altogether if the Commission has agreed that such imports would damage producers in the recipient country. Differences in technical standards mean that products have to be specially adapted in order to sell in differnt member states. Although this does not usually inhibit trade, it adds substantially to costs. In several member states, road transport is strictly regulated; in most of the Community air transport remains very substantially so. Free trade in services is very limited; professional qualifications are not recognized outside their home territory. Public procurement occurs still on a largely national basis, resulting in a suboptimal balance between supply and demand in several major industries. The proposals for completing the single market address these points.

BORDER CONTROLS

The program for the real, i.e., nonfinancial, economy covers five areas. The best known of these is that concerning the elimination of border controls, including those for passports, and an associated simplification of documentation. It is doubtful, however, whether this proposal will be implemented in full, because it requires the harmonization of value added and excise taxes if it is to function effectively, and proposals to execute such harmonization are meeting with strong opposition in certain member states. Moreover, border checks are an effective way of controlling terrorism, of which the Community has bitter experience. (1) Finally, there is opposition from the European textile industry, whose quotas under the multifiber arrangement operate at member state level. this opposition is particularly strong among producers in the Mediterranean countries, whose markets are more heavily protected than those in the north and who therefore have more to lose. Conversely, however, the northern countries may gain from the resulting more equitable distribution of competitive pressure from low cost non-European imports, most of which is currently born by them.

As the most visible manifestation of the 1992 program, the elimination of border controls is psychologically the most important in persuading the citizens of Europe to think of themselves -- and hence to conduct their business -- as part of an integrated market. Its economic effects, however, are likely to be minor. There will of course be a cost benefit, because costs are de facto being reduced, but it is small in relation to that of the other aspects of the programs. Even after applying a dynamic factor to the traditional comparative static models of gains from trade, studies undertaken for the European Commission place the benefit at only 0.4 percent of GDP, with figures for individual industries ranging from 0.4 percent of turnover for office machinery to 3.5 percent for metal production and processing. Reduction in consumer prices has been estimated at only -0.4. percent.

TECHNICAL STANDARDS

A much more significant proposal is that requiring the harmonization of technical standards. Although the Cassis de Dijon judgment did much to prevent member states banning imports on the grounds that they did not meet local regulations, it left a major area of exclusion by permitting such bans where the regulations referred to health and safety. This obstacle is particularly serious for certain industries, notably pharmaceuticals, engineering, foodstuffs and precision and medical equipment, and it adds substantial costs also to other industries, such as motor vehicles. In the latter case, however, the penalty is mitigated because the different standards pertaining in each European country also serve to control the structure of the market in that country. Imported vehicles must be adapted to meet local requirements, a task that can be undertaken effectively only by the manufacturer. The relationship between price and market segmentation can therefore be maintained at a unique level in each country, a factor that leads to substantial price differences for the same product in different member states. (The Japanese motor industry exploited this phenomenon very effectively to gain market entry in the early 1970s, using the difference between the segmented price structure and free market prices to give substantial discounts to dealerships and customers.) The European Commission has found differences of some 50 percent between the prices of cars in the UK and Belgium, the most expensive and cheapest markets respectively. Its surveys of other industries suggest similar discrepancies: for instance, 75 percent between West Germany and Belgium in pharmaceuticals.

The harmonization of technical standards and the consequent elimination of technical barriers to trade will be difficult to achieve. The gains offered at Community level are offset by loss of competitive advantage at member state level by individual firms. the integrated market is meaningless, however, without technical harmonization, and the political pressure for its achievement is substantial. This pressure assumes that the removal of technical barriers will result de facto in an integrated European market for the products concerned. This assumption is possibly optimistic.

Technical barriers are only one of three types of constraint on the achievement of an integrated market (ignoring frontier barriers, which are of a different generic nature). Differences due to custom and culture are widespread in Europe, a product of the continent's long and diverse history. For example, nine languages are in common use in the Community [2]; packaging, instructions and labelling must reflect this in order to be comprehensible to the relevant consumers. Cultural and language differences also have a marked effect on advertising, promotion, color and style, requiring different approaches in different countries. Furthermore, two of the member states drive on the left hand side of the road, the other ten on the right. Vehicles have to be specially adapted for these two states (or vice versa), an unintentional barrier but one where the cost of harmonization would far outweigh any benefit obtained. The same is true of electrical plugs, where harmonization of the several different systems (of wide ranging quality) in the Community would incur costs in rewiring buildings that would be greatly in excess of any benefit from standardization. Domestic appliance manufacturers will have to continue to provide for this situation, and, as with vehicles, markets will continue to be segmented by nationality and to have their own price structures.

TAXES AND DUTIES

Differences in national price structures will be diminished to some extent through the harmonization of value added taxes and excise duties. Such harmonization is essential if border controls are to be removed without the development of smuggling on a commercial scale of goods from low tax and duty member states for resale in those where duties and taxes are high. The differences in VAT and excise duties at present are considerable, and some are politically sensitive. To encourage sobriety, for instance, Denmark, Ireland and the UK impose heavy duties on alcoholic beverages. The remaining nine member states take a more liberal view (for wine and beer, less so for spirits) and impose negligible duties. Although the puritan policies for the former are not noticeably the more successful of the two, they are deeply rooted; their abandonment would cause grave disquiet. Similarly, in contrast to the citizens of other member states, the British pay no VAT on food, fish, childrens' clothing, books and newspapers. To impose VAT on such worthy items while reducing it on alcohol would not be seen as a constructive move by the British opinion-forming class and would be politically difficult, particularly for a government which sets high store by Victorian values and the work ethic. Similar problems occur in other member states.

The present proposals for the harmonization of VAT and excise duties envisage two broad bands of tax or duty to which member states would adhere within a range of 5 to 6 percentage points. In addition to their cultural and political implications, the proposals impose huge difficulties for Denmark and Ireland, which would lose 27 percent and 10 percent of their indirect tax receipts, and 9.5 percent and 4.4 percent of their total tax revenue, respectively. For most other member states, the effect is broadly neutral. [3]

If the integrated market is to become a reality, a solution will have to be found to this problem. The difficulties are not insurmountable. Solutions under discussion include: (1) the setting of minimum rates only so that member states wishing to charge more could balance the advantages against the economic penalties of so doing; (2) the grouping of duties into three geographic areas to permit the continuation of high duties in Denmark, Ireland and the UK without incurring an excessive flow of goods into these countries from lower duty areas, the lowest duty area being the most remote (the Mediterranean); and (3) the marking of goods so that the tax or duty paid on them is that pertaining in their country of origin irrespective of where they are sold. Whichever system is finally chosen, however, the complications are bound to carry a cost and will be a source of friction for some years to come.

SERVICES

A further and very substantial area of liberalization addressed by the Commission proposals is that of services: (1) banking and financial services, where liberalization is bound up with the move towards the liberalization of capital; (2) business and professional services, ranging from accountancy and consultancy to advertising; and (3) telecommunications and transportation. The problems are very similar to those posed by technical barriers, particularly in telecommunications, where incompatibility of systems is a major obstacle to the exploitation of the new digital switching technologies that enable telecommunications and computers to be mutually enhancing. In the areas of financial, business and professional services, the obstacles are largely legislative (apart, that is, from the questions of economic management) and are likely to be overcome after appropriate negotiation. Transportation poses more difficult problems involving regulation of road transport (passenger as well as freight); member state promotion or otherwise of rail transport; and the deregulation of air transport.

Member state policies towards transport vary widely, from the market orientation of the UK and Netherlands to the regulated, cost-benefit approach of France. Achievement of a coherent policy by 1993 seems unlikely, although continuous progress is being made. There is far to go. road freight transport is still regulated on a largely national basis; cabotage, whereby an operator from one country can do business within another, is largely forbidden. Moves to liberalize this situation meet stiff political opposition. One visible manifestation of progress however will be the establishment by the year 2000 of a network of high speed passenger rail links across Europe, based on differing national technologies but interlinked and stimulated by the opening of the Channel Tunnel between England and France. Average speeds will be between 140 and 180 mph (220 to 300 kph). In France, where the first such line has been in operation since 1981, air travel on the routes affected has fallen by 85 percent. This shift is significant not only for its psychological impact in a European context, but also for the future development of European air transport, the liberalization of which is currently constrained not only by continental misgiving over the U.S. experience, but also by acute air traffic congestion, the product in part of the absence of a single European air traffic control system. The development of the latter is now under discussion.

PUBLIC PURCHASING

Perhaps because identification with them is easy, these first four areas of the Commission's proposals are those that attract public debate. The fifth area, public procurement, has a narrower canvas and its effects are further removed from everyday life. However, although the quantitative gains from integrating the European market in this area are estimated at only 0.5 percent of GDP, the structural consequences are profound.

Public purchasing, by governments and public enterprises, amounts to some 15 percent of the Community's GDP. With the exception of aerospace, it is conducted predominantly on a national basis; domestic suppliers are given preference over those from other Community (or non-Community) countries. The results are threefold: (1) Costs to the purchasers are higher because they restrict their purchasing to high priced local products, ignoring lower priced products available from other countries; (2) prices of these domestically sourced goods are higher than they would otherwise be because of the absence of effective competition from other countries; and (3) the supplying industries are inefficiently structured because of the absence of competition and the limited size of the markets available to them. A side effect of the latter result is to inflict uneconomically low levels of capacity utilization on certain of the supplying industries.

The integration of the European market in public procurement (which is already required by the Treaty of Rome, but ignored) would bring substantial changes to the structure and cost levels of the industries affected. In telephone exchanges, for instance, R&D costs are currently much inflated by the multiplicity of seven digital technologies in use, five of which were developed under public purchasing protection. The price per line in Europe is in consequence some 2.5 to 5 times higher than it is in the U.S. [4] Major restructuring, however, through mergers and cooperation agreements, is already underway. This restructuring will be stimulated by the liberalization of public procurement, giving rise to the possibility that the present eleven producers may be reduced in time to four (the U.S. level), or even less. In railway locomotives, Europe has sixteen producers; the U.S. has two. Rationalization will be difficult because of the inbuilt differences between the national railway systems and the close relationship between the systems and local manufacturers. Restructuring could raise capacity utilization by an estimated 50 percent and reduce unit costs by 20 percent. Similar effects may be seen in other heavy engineering sectors, such as industrial boilers and generators, and in the nonaerospace areas of defense procurement (aerospace is already pan-European). [5]

RESTRUCTURING

Restructuring will not, of course, be confined to those sectors concerned with public procurement. The Commission anticipates similar development throughout manufacturing, particularly in those industries affected at present by technical barriers to trade. The thinking is conventional. The integration of the market will facilitate the realization of substantial economies of scale, and this will result in a restructuring of the industries into a much smaller number of much larger units, stimulated by progressive cost reductions reflected through competitive pressure on prices, whose lower levels will lead in turn to growth in demand. These effects are estimated to add 2.1 percent to GDP and to reduce consumer prices by 2.3 percent in the medium term. With some optimism, the Commission also expects another 850,000 jobs to be created. The GDP effect is thus some five times more powerful than that from the removal of frontier controls, and four times more than that from the liberalization of public procurement. Politically, it will further reinfroce the authority of Brussels over the member states, since national anti-trust policies will become unrealistic.

These results, however, ignore the relationship between the structure of demand and the level of GDP per head, and must be questioned. In particular they assume that consumers will prefer to spend less per unit and choose from a limited range of goods that are suboptimal to their needs, rather than spend more per unit to choose from a much wider range of goods in order to match their expenditure more closely to their tastes and requirements. This assumption is obsolete. Current evidence from the OECD countries overwhelmingly supports a trend towards the latter and away from the former as GDP per head rises. Moreover, this trend is not confined to consumer goods. Rising GDP per head is reflected in rising labor costs and a decreasing ability of capital investment to absorb them in a context that is financially viable. Manufacturers of capital and intermediate goods are therefore tending increasingly to concentrate on design and quality in order to achieve market share in "niche" markets, rather than compete on cost in commodity type markets. Given the sophistication of Europe and its high labor (and social) costs, it seems probable that the rationalization resulting from the integration of the European market will follow these trends. In place of the monolithic structures envisaged by the Commission, a multitude of smaller manufacturers is likely to remain, exploiting economies of scale by specializing in narrow market segments, but on a European-wide basis. To them will be added new operations in the form of inward investment from non-Community countries, a trend already evident in the consumer durables sector. Benefits will still accrue to a significant degree, but in a different and possibly more attractive way.

Because both scenarios are positive, the difference might appear to be relatively unimportant. It may not, however, be so.

PROBLEMS OF ADJUSTMENT

The beneficial effects identified by the European Commission as a result of the integration of the European market are essentially medium term. The process of adjustment required to achieve them is omitted from the calculations. The cost of this adjustment -- in effect an opportunity cost for the restructuring of the Community -- could be considerable, particularly in sectors where the number of producers is being sharply reduced in response to new opportunities for the exploitation of economies of scale. Such a process will entail the creation of overcapacity situations, with consequent closures of less economic plants and of less successful competitors. This process will create political pressure at member state level from those losing their jobs; governments will then be under pressure to take steps to avoid such circumstances and mitigate their consequences through combinations of state aids and protectionism. The increase in inward investment from non-Community countries that is already a feature of the development of the single market will intensify such pressure.

In the free trading countries of the Community, primarily Germany and the UK, this pressure may be resisted, reflecting the consumer orientation of their economic regimes and the tendency for inward investment to establish itself in these locations. The cultures of other member states, however, are more inclined towards mercantilism. They will find it tempting to resort to subsidies, structured if possible to comply with the demands of the Treaty of Rome, and to press for active use of the instruments of international trade to protect the European market. This is the specter of Fortress Europe.

The two main trade instruments are antidumping duties and safeguards action, the latter based on Article XIX of the GATT. Article XIX is at present rarely used, because it is nonselective (it has to be applied equally to all trading partners, irrespective of their role in causing disruption) and because affected countries can demand compensation. For sound reasons, both these limitations are under review in the Uruguay Round; an unintended consequence of a revised, selective, Article XIX will be to facilitate its misuse in pursuit of national gain.

It is in this context that the authority established by the Commission in the early 1980s in the field of state aids becomes so important, as does the integrity (well established to date) of the Community's External Relations Directorate, which is responsible for international trade regulation.

Provided the institution of the Community hold, and provided there are no major exchange rate disturbances and no undue aggravation from an external power, Fortress Europe should not develop. There is, however, a weak link that emanates from the Franco-German roots of the Community.

In reflection of the West German constitution, East German (GDR) goods are permitted free entry into West Germany, but not into the rest of the EEC. With the dismantling of the internal barriers, GDR goods will be able to penetrate widely within the Community. As the GDR is a centrally planned (and communist) country, these goods are not sold at market prices. The result of their import can therefore be excessively disruptive.

Political reconciliation with the GDR is very important to Germany; much may be conceded to achieve it. As Europe's largest and most efficient economy, sacrifices can be afforded, even that of agreement to a mercantilist Europe, should be other member states demand it as a condition for a continuation of the trade arrangement with the GDR. At the moment fortunately the prospect seems remote. The other states might instead demand that Germany choose between her past and her future. However, the problem (which is real, and not the product of conspiracy theory) is indicative of the kind or pressures to which the nascent integrated Europe will be prone. Given the past three centuries of its history, however, they are perhaps minor.

FOOTNOTES

(1) The British are also concerned about the spread of rabies from unchecked animals, a source of unseemly amusement to their continental colleagues.

(2) Excluding active minority tongues such as Catalan, Gaelic and Welsh.

(3) Lee Pearson and Smith; Institute of Fiscal Studies Report No. 28 (1988).

(4) Source: INSEAD

(5) Source: W.S. Atkins.

REFERENCES

[1.] European Economy, March 1988: The Economics of 1992, Commission of the European Communities.

[2.] Paulo Cecchini, The European Challenge: 1992 The Benefits of a Single Market, Gower Press 1988.

[3.] J.A. Kay et al., 1992: Myths and Realities, London Business School 1989.

[4.] Michael Calingaert, The 1992 Challenge from Europe. The Development of the European Community's Internal Market, National Planning Association, 1988.

[5.] Oxford Review of Economic Policy, Vol. 5, No. 2, Summer 1989, Oxford University Press.

[6.] Victoria Curzon Price, 1992: Europe's Last Chance? Institute of Economic Affairs, 1988.

[7.] Research on the Cost of New Europe: Basic Findings, Volumes 1 and 3, Commission of the European Communities, 1988.

[8.] Stephen Woolcock, European Mergers: National or Community Controls? Royal Institute of International Affairs, 1989.

[9.] De Anne Julius and Stephen Thomsen, Inward Investment and Foreign-owned Firms in the G-5, Royal Institute of International Affairs, 1989.
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Date:Oct 1, 1989
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