Hochschule fr Technik und Wirtschaft Berlin Masters in International and Development Economics

The European Union:

A story of integration

Melanie Paz Glen 27/01/2012

THE EUROPEAN UNION: A STORY OF INTEGRATION

The principle underpinning the European Union is well established: Europeans better hang together or [most assuredly] they will hang separately. Wim Kok, a former Prime Minister of The Netherlands

Regional integration is not a new phenomenon. Through history, many examples of unions, associations, pacts and commonwealths can be found. However, this practice has gained a lot of importance in the last decades: not only have different integration schemes been developed, but also the amount of regional trade agreements has increased as well as their weight in the political, monetary and trade fields1. The European Union is certainly the biggest success story in the realm of international integration and international politics. It does not stop to amaze that all these European nations, which in the past always recurred to the use of force to solve their misunderstandings, have come to a point where they spend their days working around laws and institutions aiming at building stronger ties. This has resulted in the creation of a political entity at the most advanced stage of integration, with links that cannot be easily dissolved. Nevertheless, the current economic and financial crisis that the member countries are facing has tremendously shaken the basis of the Union, up to the point where analysts question if the project, as presently conceived, will be able to survive. Further integration in new areas such as a common fiscal policy, as well as increased cooperation between the stronger and the weaker economies inside the EU, will play a key role in keeping the European Union story alive. A brief achievements story After the two destructive world wars that took place in the last century, some European countries believed that the best solution to achieve an everlasting peace would be by making Germany and France, the main belligerent countries; cooperate in economic and political terms. By building an increasingly interdependent and competitive global environment, the countries security and well-being would be assured. However, these countries were looking for more than just peace. The war left Europe worn out, with its main industries affected; therefore, they were aiming for solutions to their economic problems as well. For instance, some raw materials were located in one country whilst their processing industries were in another. In order to solve these situations, in the year 1950, the French Foreign Minister Robert Schuman proposed a potential union of Europe, in which the first step would be the integration of the coal and steel industries (the two elements necessary to make war weapons) of Western Europe. The next year, the European Coal and Steel Community (ECSC) was created with the signature of the Treaty
Notes from Regional Integration course Winter Semester 2012. Master in International and Development Economics. Professor Christiane Hardenberg. December 2012.
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of Paris by six members: Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. In 1957 the European Economic Community arose, creating a common market among the member nations, with no tariffs or impediments to the flow of labor and goods. It aimed to continue economic growth and avoid the protectionist policies of pre-war Europe. In 1992 the integration efforts advanced further with the signature of the Maastricht Treaty, which came into force in 1993 and gave the community its current name: the European Union. It consisted on three pillars dealing with economic, social and environmental policies; a common foreign and security police; and cooperation in criminal matters. It also set out guidelines for the creation of a single currency. The objective behind the creation of a single currency was to increase trade among the Euro zone members and also build stronger and closer ties among the European countries. At this point, currency and economic changes were mainly driven by the fact that the American and Japanese economies were growing faster than Europes, especially after the new developments in the electronics area. Having a single currency was a sign of advancing towards a further integration stage: the European Economic and Monetary Union (EMU). The Maastricht Treaty established the criteria that member countries had to comply with in order to participate in this monetary union and adopt the Euro as their currency. The purpose behind the convergence criteria was to ensure that the created currency would not lose value within the Eurozone even if new member states were added. In 1997, an agreement was signed among all the members of the European Union in order to preserve the stability of the currency. This Stability and Growth Pact was an agreement on fiscal monitoring, so those countries that adopted the Euro continued to meet the Maastricht convergence criteria. In 1999, the common currency was introduced in a non-physical form. As a central monetary institution, the European Central Bank was put in place with the main mandate of ensuring price stability of the Euro. The bank notes and coins of each individual country were still used as legal tender until the Euro bank notes and coins were introduced in January 1st, 2002. Currently, the European Union is comprised by 27 member states, 17 of which are part of the Economic Monetary Union. It has developed a single market through a standardized system of laws which apply to all the members. Within the Schengen area passport controls have been abolished. In general, the European Union policies aim to ensure the free movement of people, goods, services, and capital, enacts legislation in justice and home affairs, and maintains common policies on trade, agriculture, fisheries and regional development. Key achievements in the economic and political areas are a reflection of the main forces driving integration in the European Union. And it has been primarily a policy-driven

process. In this sense, the EU is a product of regionalism: even though the predecessor of the EU, the European Economic Community (EEC) was only an economic institution, its present shape as a political entity developed out of more than five decades of economic integration efforts. The ideology behind has been that, as the region integrated more and more in economical terms, it was necessary that it did it politically as well. But, will economic growth and political security continue determining whether the European Union stalls in its integration project or moves forward? Some consider the further enlargements as moving forward. But integration is more than just enlargement. Just by allowing new countries to take part, does not imply that there will be stronger integration among them; in fact, this could lead to increased cooperation only among certain core economies like those in the Eurozone, while the rest take part in a kind of confederation scheme. Most certainly, the motor for further integration will be its capacity to cooperate in those areas where lack of consensus exist, in particular, fiscal and economic policy. The European Monetary Union (EMU) holds a strange status: a centralized monetary authority (European Central Bank) without fiscal capacity. There is a mis-match, where economic decisions taken on a purely national basis by national politicians interact with monetary decisions taken on a Euro-wide basis by the European Central Bank. The ECB can set interest rates, but individual member countries cannot print money or devaluate their currency to help things work somehow more smoothly when their economy is not doing so well. This lack of consensus about the correct macroeconomic formula for Europe compromises any further progress in integration, and particularly in a time of crisis, this can be perceived as a conflict of interests. A monetary union should come along with a fiscal union to be able to work well. And this is the main lesson learned from the current Financial Crisis. As previously mentioned, when the EMU was created, it had strict convergence criteria in order for countries to be able to participate. Which were these criteria towards these countries had to converge? Well, to begin with, the inflation rate and the nominal long-term interest rate could not be higher than 1.5 and 2 percentage points respectively, than the average of the three members with the lowest inflation. Regarding the Government finances, the deficit to Gross Domestic Product (GDP) ratio could not be higher than 3% and the Debt to GDP ratio could not be above 60% at the end of the previous fiscal year. In terms of the exchange rate, the country applying should have adhered to the exchange rate mechanism under the European Monetary System for two years without having devalued its currency in this time2. Those economies that complied with these figures have enjoyed the benefits of a shared currency and uniform monetary policy ever since. However, aside from these unenforced targets (convergence criteria); the group has never had a common approach to fiscal
2

European Union official website. Introducing the euro: convergence criteria. [online]. Available at: http://europa.eu/legislation_summaries/other/l25014_en.htm [accesses January 12 2012].

policy. Simple numerical limits are too basic to manage the entire fiscal policy. Besides, it are does not make sense to apply the same rules, every year, to different countries with its own particularities. They thought that these criteria would be enough, but the thresholds initially applied were violated, and no enforcement mechanism existed that could be put in ed place, and of course, if you allow for any type of exceptions, the rules completely lose their meaning. In terms of Debt to GDP ratio, the Eurozone is in clear violation of the Maastricht criteria: Maastricht even though under the Stability and Growth pact the countries agreed on ensuring that their debt would not exceed 60% of their GDP, the ratio is clearly higher and increasing for the 17 Euro zone countries, moving from 79.3% in 2009 to 85.1% in 20103. And the violation gets bigger when looking at the particular cases. Graph 1 shows that at the top of the debtors group is Greece with 142.8% of government debt to GDP ratio, then comes Italy with 119%, Belgium with 96.8%, Ireland with 96.2%, Portugal with 93%, Germany 96.2%, with 83.2%, France with 81.7% and Hungary with 80.2%4. No wonder why the Stability and Growth Pact does not work: those that enforce it are the same that commit the sin.

Graph 1. Debt as percentage of GDP 2009 2009-2010

Source: Eurostat. 2012.

Eurostat TGM Table. General Government Gross Debt as percentage of GDP. [online]. Available at: Available http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&language=en&pcode=tsieb090&plugin=1 [accessed 20 January 2012]. 4 Ibid.

How could this happen in the first place? How could these countries reach these levels of debt, up to the point of having a Sovereign Debt Crisis? Going back to the very beginning, it is important to remember that even though the European Central Bank is the only one that has the authority to print and manage the Euro, each individual country in the EMU can issue its own debt, and run its own governmental budgets. Another important element to understand the current crisis is the fact that among Europe, Germany is the country with the strongest economy and the lowest cost of borrowing. Because of this, banks lent money to the country very cheaply and felt at ease because they were sure Germany would always repay. What happened was that these banks assumed that this would also happen with the rest of the Eurozone, that is, they believed that all the other members would be as good at repaying as Germany. This of course included the weaker economies in the zone, and countries like Greece, Portugal, Italy, and Ireland had the possibility of running into debt at the same interest rates as Germany, just because they had the same currency. In this framework of access to money at low cost, several countries went into substantial debt: it allowed them to reduce the taxes imposed to their citizens and create a social safety net, thus generating an artificial sense of wealth and prosperity. It was clear that these countries were spending more than the revenues they had, but some, like Greece and Italy, managed to cover their deficit and debt levels by using complicated credit derivatives structures. Then, by the end of 2009, investors started to fear the possibility of a sovereign debt crisis: the countries were not only borrowing in excess, but they were also facing difficulties to finance further deficits and pay the already existing debt levels. All these situations, together with a wave of downgrading of European government debt, created panic in the financial markets. In countries like Ireland, Portugal, Greece, Spain and Italy a crisis of confidence arose, which took the shape of widening bond yield spreads between them and other European Union members, particularly Germany. Most analysts wondered and still wonder if these countries will actually be capable of paying such a big debt, and there is surely a negative effect on confidence when the probabilities for five countries to default is so high, particularly when one already has (Greece). Spend Less Owe Less Grow the Economy? The crisis has brought to light problems that will certainly require a structural shift in the way the European Union operates. The region leaders have continuously mentioned in all of their discourses that the euro will be preserved, no matter what needs to be done, including a more homogeneous approach to spending and taxes across the European Union. Moving towards a stronger fiscal integration could imply the rewriting of existent treaties, a procedure that could be particularly long not to mention cumbersome. However, after a

summit held in December 2011, 26 European leaders approved the creation of a new fiscal compact5. The fiscal compact focuses on how the European Commission can sanction debt-sinners. Its principal objective is to attach the Eurozone economies into tighter fiscal rules, which implies keeping their deficits lower than three percent of the Gross Domestic Product (GDP) and their debt-to-GDP ratios under 60 percent. The draft also includes the so called golden rule, that is, the requirement of maintaining their primary deficits under 0.5 percent of GDP over the economic cycle. Until now, the impression could be that nothing has changed; that these are the old convergence criteria included in the Maastricht Treaty. But there are changes, particularly related to the enforcement mechanism: those countries that do not meet the mentioned targets can be taken to the European Court of Justice, the European Unions highest court. If one of the parties considers that one of the other contracting parties has failed to meet the conditions, it can present the case to the Court. The European Commission may as well, on behalf of the contracting parties, bring the case before the Court. This is a clear attempt to apply much stricter and more automatic sanctions on those that break the rules. This fiscal compact is said to be the most important precondition towards restoring the regular functioning of financial markets. Policy-makers should implement the necessary adjustment measures in order to correct their excessive deficits and move to balanced budgets in the coming years, otherwise, they will be fined. The argument behind is that it will support public confidence in the reliability of policy actions and thus improve the overall economic opinion. However, what would happen to one of these countries if their European counterparts enforced a penalty to their Government? That would only make the deficit even bigger and complicate the situation. This further strong austerity agenda represents a lack of understanding of the real problem. The European Union leaders have focused on making sure that these countries budget deficits do not increase, but that is only one side of the problem. There are other causes behind the crisis, and they are related to the different levels of competitiveness between what can be called the core and the periphery of the Euro zone. This competitiveness gap is at the root of the massive cross border debts, and the peripheral (weaker) economies do not need deeper austerity to solve their situation. A balanced solution with increased financing and structural changes, particularly in the labor market, would be more assertive. The boom, not the slump, is the right time for austerity at the Treasury said John M. Keynes in 1937. Cutting government expenditures in an already depressed economy will only depress the economy further, and Greece and Ireland are clear examples. These countries had to apply strong fiscal austerity in order to receive emergency loans, and as a
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European Council. European Council concludes discussion on the new fiscal compact. [online]. Available at: http://www.european-council.europa.eu/home-page/highlights/european-council-concludes-discussion-onthe-new-fiscal-compact [accessed January 12, 2012]

consequence they have suffered strong economic falls, with real GDP in both countries going down strongly. Indebted economies risk a downward spiral in which fiscal tightening harms growth, putting further pressure on public finances. Increasing taxes reduces the income available, thus reducing the domestic demand component of the GDP. Furthermore, enterprises are less willing to invest as they see that a higher share of their profits is taken away from the Government, depressing the aggregate demand as well. On the other side, cutting expenditures can lead to a more unequal distribution of income among the population, and this in time affects growth, as people that benefited before from transfers will have a lower income, which implies less consumption from their side. Consequently, a strong fiscal consolidation can freeze growth, and lead the economies into further recession. Opposite to what is being implemented and discussed, if the leaders of the problematic European countries want to stimulate their aggregate demand, government spending is an important tool towards building the framework for economic growth. Massive unemployment and a depressed economy in these countries are the real problems and austerity should wait until a strong recovery is put in position. In this sense, structural reforms should be conducted to increase competitiveness. Improved productivity at the domestic level can make the products and services offered in the international markets more competitive, and this external demand can fill the voids left by contractionary policies via increased exports. A new definition of North-South Cooperation Besides revealing structural problems in the design of the Union, the current financial crisis has brought along some important questions about its future: how to deal with those members that do not behave in a responsible way, thus generating instability and posing liabilities for the other countries in the Eurozone? What happens when an economic crisis spreads out affecting the members in different ways? These questions are also related to issues of cooperation and shared responsibility. It is clear that the countries facing excessive debt have a very important role to play in order to solve the chaos in which they got themselves. But let us not forget that these countries belong to a bigger scaffold and that everything that happens to them has an effect on the other economies of the Euro zone and the European Union. It is a Union after all: problems should be solved in a coordinated manner, and those countries in a stronger position should support those facing difficulties. After all, isnt that what cooperation is all about? For many decades, the richer economies of the so-called North have helped the poorer economies of the South. The main goal of this North-South cooperation has been to help underdeveloped countries achieve higher levels of growth through the exchange of resources, technology, and knowledge. From a general perspective, this concept would not apply to the cooperation that takes place within the economies of the European Union,

as they are all considered rich and developed. But a closer look might reveal that a sort of North-South Cooperation is taking place among the northern European nations, as the stronger members of the union are being forced to help the less competitive members that have spent beyond their means. In May 2012, the European Financial Stability Facility (EFSF) was created by the Euro zone member countries in order to safeguard the financial stability of the region. The way in which it operates is by providing financial assistance to Euro area member states. This assistance is linked to strict policy conditionalities which are agreed between the Government in need and the European Commission. In the case of Ireland, for example, the conditions include the strengthening of the banking sector, fiscal adjustments aiming at the correction of their excessive deficit by the year 2015, and also the application of growth enhancing reforms, particularly to the labor market (European Financial Stability Facility, p. 6. 2012). This is in a way similar to the aid assistance given to peripheral developing countries from the developed core, which is also subject to conditionalities. Cooperation and assistance in this case is not for poor underdeveloped economies, but for the new periphery conformed by those that once were the rich north. And the future? Stronger cooperation and integration are indeed very important points in the agenda if the Euro project plans to survive in the long term. However, the European Union has a long road to walk towards full recovery. From an objective perspective, the economic situation in the Euro area is bad. Most analysts indicate that the region will face a recession this year. The markets are still averse to debt issued by the new periphery and there is no clear outlook on how these countries will solve their deficit and growth problems. But the economic recovery is not the only challenge. Even though exiting the financial and economic crisis is an immediate priority, the European Union will continue to be confronted with crucial challenges over the next decade, such as the population ageing and future enlargements. Europes ageing population was already a challenge before the financial crisis. The 2009 Ageing Report of the European Commission indicates that the effects of this demographic problem are expected to impact some European countries within the next ten years and have long-term consequences for Europe. With progressively low fertility and mortality rates, increased life expectancy and the baby-boomers generation beginning to retire, the ratio of dependent people over 65 to working-age persons will rise sharply to 1:2 in the next twenty years and will put pension systems under extreme pressure. Social security's long-term sustainability will also be challenged by the decreasing workforce. Furthermore, already as of 2020, labor growth will have a negative contribution to growth potential in the European Union. As a result, the average potential growth will fall below 2% per year

(European Commission Report, 2009). According to Robert Holzmann from the World Bank the impact of the financial crisis pales compared to demographic problems6. The future enlargement of the EU poses a challenge as well. The Euro adoption by most Member States in coming years should have a positive impact on the internal market, but the increase in size and diversity implies raises questions about the sustainability of this project, and the degree of integration that can be achieved. If managing 27 countries in the Union and 17 in the Euro zone has so many complications, a Europe of 35 countries will be a real challenge.
one cannot plead for federalism and at the same time for the enlargement of Europe. It's impossible. There's a contradiction. We are 27. We will obviously have to open up to the Balkans. We will be 32, 33 or 34. I imagine that nobody thinks that federalismtotal 7 integrationis possible at 33, 34, 35 countries Nicolas Sarkozy, French President

Perhaps the most possible scenario for the European Union project in the upcoming years involves a stable evolution towards further integration. However, this progress can be slowed down by the lack of strong governance and of a diligent and committed leadership, elements required to respond in a timely and effective manner to potential crisis. A way of measuring success in regional integration efforts is to compare whether the acquired achievements match the initial stated goals. The European Union project has certainly avoided until now the emergence of a Third World War and improved the prosperity of its members. At the same time, the current situation the Union is facing puts in evidence the importance of cooperation and integration in sensitive areas such as fiscal policy. The signature of the Fiscal Compact represents the interest of the European leaders in the survival of the Union and of the Euro project. However, signing a treaty does not mean integration. That is only the zero-base point, the initial promise without which the process could not begin. Real integration only comes with the implementation of this promise, which implies a patient and long process of discussing and creating common policies and regulations. It is the sum of these policies and rules that in time will create the bridge between stronger integration desires and reality. What will history books in 100 years say about the reality of the European Union? For example, about what happened after the crisis, on how they coped with the demographic problem and, if stronger cooperation is still a reality after the adhesion of new members? The history of this Union has shown that sometimes crisis can lead to stronger integration. Hopefully this will also be the case this time.
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European Commission Economic and Financial Affairs. [online]. Available at: http://ec.europa.eu/economy_finance/een/014/article_8881_en.htm [accessed 20 January 2012]. 7 th Comment made during a debate with students at the University of Strasbourg in November 8 , 2011.

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