Global Business homework
bakliy
chapter8.pdf
L E
A R
N IN
G O
B J E
C T
IV E
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After you have read this chapter you should be able to:
1 Describe the different levels of regional economic integration.
2 Understand the economic and political arguments for regional
economic integration.
3 Understand the economic and political arguments against regional
economic integration.
4 Explain the history, current scope, and future prospects of the world’s
most important regional economic agreements.
5 Understand the implications for business that are inherent in regional economic
integration agreements.
part 3 Cross-Border Trade and Investment
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8 c h a p t e r
Regional Economic
Integration
NAFTA and Mexican Trucking opening case
W hen the North American Free Trade Agreement (NAFTA) went into effect in 1994, the treaty specified that by 2000 trucks from each nation would be allowed to cross each other’s borders and deliver goods to their ultimate destination. The argument was that
such a policy would lead to great efficiencies. Before NAFTA, Mexican trucks stopped at the bor- der, and goods had to be unloaded and reloaded onto American trucks, a process that took time and cost money. It was also argued that greater competition from Mexican trucking firms would lower the price of road transportation within NAFTA. Given that two-thirds of cross-border trade within NAFTA goes by road, supporters argued that the savings could be significant. This provision was vigorously opposed by the Teamsters Union in the United States, which represents truck drivers. The union argued that Mexican truck drivers had poor safety re- cords, and that Mexican trucks did not adhere to the strict safety and environmental stan- dards of the United States. To quote James Hoffa, the president of the Teamsters: “Mexican trucks are older, dirtier and more dangerous than American trucks. American truck drivers are taken off the road if they commit a serious traffic violation in their personal vehicle. That’s not so in Mexico. Limits on the hours a driver can spend behind the wheel are ignored in Mexico.” Although they did not state so explicitly, the Teamsters were also clearly motivated by a desire to protect the pay and employment opportunities for American truck drivers. Under pressure from the Teamsters, the United States dragged its feet on im- plementation of the trucking agreement. Ultimately the Teamsters sued to stop implementation. An American court rejected the union’s arguments and stated the country must honor the treaty. So did a NAFTA dispute settlement panel. This panel ruled in 2001 that the United States was violating the NAFTA treaty and gave Mexico the right to impose retaliatory tariffs.
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276 Part Three Cross-Border Trade and Investment
Mexico decided not to do that, instead giving the United States a chance to honor its commitment. The Bush administration tried to do just that, but was thwarted by opposition in Congress, which approved a measure setting 22 new safety standards that Mexican trucks would have to meet before en- tering the United States. In an attempt to break the stalemate, in 2007 the U.S. government set up a pilot program under which trucks from some 100 Mexican transportation companies could enter the United States, provided they passed American safety inspections. The Mexican trucks were tracked, and after 18 months, that program showed that the Mexican carriers actually had a slightly better safety record than their U.S. counterparts. The Teamsters immediately lob- bied Congress to kill the pilot program. In March 2009 an amendment at- tached to a large spending bill did just that. This time the Mexican government did not let the United States off the hook. As allowed to under the terms of the NAFTA agreement, Mexico im- mediately placed tariffs on some $2.4 billion of goods shipped from the United States to Mexico. California, an important exporter of agricultural products to Mexico, was hit hard. Table grapes now faced a 45 percent tariff, while wine, almonds, and juices will pay a 20 percent tariff. Pears, which primarily come from Washington State, faced a 20 percent tariff (4 out of 10 pears that the United States exports go to Mexico). Other products hit with the 20 percent tariff include exports of personal hygiene products and jewelry from New York, tableware from Illinois, and oil seeds from North Dakota. The U.S. Chamber of Commerce has estimated that the current situ- ation costs some 25,600 U.S. jobs. The U.S. government said it would try to come up with a new program that both addressed the “legitimate concerns” of Congress and honored its commitment to the NAFTA treaty. What that agreement will be, however, remains to be seen, and as of early 2010, there was no agreement in sight. • Sources: “Don’t Keep on Trucking,” The Economist , March 21, 2009, p. 39; “Mexico Retaliates,” The Wall Street Journal , March 19, 2009, p. A14; J. P. Hoffa, “Keep Mexican Trucks Out,” USA Today , March 1, 2009, p. 10; “The Mexican-American War of 2009,” Washington Times , March 24, 2009, p. A18; and J. Moreno, “In NAFTA Rift, Profits Take a Hit,” HoustonChronical.com , November 12, 2009.
Introduction In this chapter we will take a close look at the arguments for regional economic in- tegration through the establishment of trading blocs such as the European Union and the North American Free Trade Agreement. We will discuss the difficult process of forming such blocks and using them as an institutional means for lowering the barriers to cross-border trade and investment between member states. The opening case illustrates some of the promise and problems associated with integrating the
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Chapter Eight Regional Economic Integration 277
economies of different nations into regional trading blocs. The NAFTA provision to remove barriers to trucking across borders was meant to encourage greater effi- ciencies, with the lower costs benefitting the citizens of all three signatory coun- tries. However, as described in the case, political opposition has stymied any attempt to implement this aspect of NAFTA. By 2009 Mexico was imposing retalia- tory tariffs on imports of U.S. goods, as allowed for by the treaty, in an attempt to get the Americans to honor their commitment. Doing so will not be easy, however, given the strong opposition from the well-connected Teamsters Union in the United States. By regional economic integration we mean agreements among countries in a geographic region to reduce, and ultimately remove, tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other. The past two decades have witnessed an unprecedented proliferation of regional trade blocs that promote regional economic integration. World Trade Organization members are required to notify the WTO of any regional trade agreements in which they partici- pate. By 2010, nearly all of the WTO’s members had notified the organization of participation in one or more regional trade agreements. The total number of regional trade agreements currently in force is around 400. 1 Consistent with the predictions of international trade theory and particularly the theory of comparative advantage (see Chapter 5) agreements designed to promote freer trade within regions are believed to produce gains from trade for all member countries. As we saw in Chapter 6, the General Agreement on Tariffs and Trade and its successor, the World Trade Organization, also seek to reduce trade barriers. With 153 member states, the WTO has a worldwide perspective. By entering into regional agreements, groups of countries aim to reduce trade barriers more rapidly than can be achieved under the auspices of the WTO. Nowhere has the movement toward regional economic integration been more successful than in Europe. On January 1, 1993, the European Union (EU) formally removed many barriers to doing business across borders within the EU in an at- tempt to create a single market with 340 million consumers. However, the EU did not stop there. The member states of the EU have launched a single currency, the euro; they are moving toward a closer political union. On May 1, 2004, the EU ex- panded from 15 to 25 countries and in 2007 two more countries joined, Bulgaria and Romania, making the total 27. Today, the EU has a population of almost 500 million and a gross domestic product of €11 trillion, making it larger than the United States in economic terms. Similar moves toward regional integration are being pursued elsewhere in the world. Canada, Mexico, and the United States have implemented the North American Free Trade Agreement (NAFTA). Ultimately, this promises to remove all barriers to the free flow of goods and services between the three countries. While the implemen- tation of NAFTA has resulted in job losses in some sectors of the American economy, in aggregate and consistent with the predications of international trade theory, most economists argue that the benefits of greater regional trade outweigh any costs. South America, too, has moved toward regional integration. In 1991, Argentina, Brazil, Paraguay, and Uruguay implemented an agreement known as Mercosur to start reduc- ing barriers to trade between each other, and although progress within Mercosur has been halting, the institution is still in place. There are also active attempts at regional economic integration in Central America, the Andean region of South America, Southeast Asia, and parts of Africa. While the move toward regional economic integration is generally seen as a good thing, some observers worry that it will lead to a world in which regional trade blocs compete against each other. In this possible future scenario, free trade will exist
Regional Economic Integration Agreements among countries in a geographic region to reduce, and ultimately remove, tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other.
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278 Part Three Cross-Border Trade and Investment
within each bloc, but each bloc will protect its market from outside competition with high tariffs. The specter of the EU and NAFTA turning into economic fortresses that shut out foreign produc- ers with high tariff barriers is worrisome to those who believe in unrestricted free trade. If such a situation were to materialize, the resulting decline in trade between blocs could more than offset the gains from free trade within blocs.
With these issues in mind, this chapter will ex- plore the economic and political debate surround- ing regional economic integration, paying particular attention to the economic and political benefits and costs of integration; review progress toward re- gional economic integration around the world; and map the important implications of regional eco- nomic integration for the practice of international business. Before tackling these objectives, we first need to examine the levels of integration that are theoretically possible.
Levels of Economic Integration Several levels of economic integration are possible in theory (see Figure 8.1). From least integrated to most integrated, they are a free trade area, a customs union, a com- mon market, an economic union, and, finally, a full political union. In a free trade area, all barriers to the trade of goods and services among member countries are removed. In the theoretically ideal free trade area, no discriminatory
LEARNING OBJECTIVE 1 Describe the different levels of regional economic integration.
figure 8.1
Levels of Economic Integration
Customs union
Common market
Economic union
Political union
NAFTA
X Level of integration
X
Free trade area
EU 2003
A n o t h e r P e r s p e c t i v e
Economic Integration in the Classical World Traditionally, the success of the Roman Empire has been explained by economic historians as an example of cen- tralized, forced reallocation of goods. Recent scholarship, though, suggests that there was not a single empire-wide, centralized market for all goods, but that local markets were connected and that most exchanges were voluntary, based on reciprocity and exchange. Ancient Rome had an economic system that was an enormous, integrated con- glomeration of interdependent markets. Transportation and communication took time, and the discipline of the market was loose. But there were many voluntary economic con- nections between even far-flung parts of the early Roman Empire. (Karl Polanyi, The Livelihood of Man [New York: Academic Press, 1977]; and Peter Temin, “Market Economy in the Early Roman Empire,” University of Oxford, Discus- sion Papers in Economic and Social History)
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Chapter Eight Regional Economic Integration 279
tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade between members. Each country, however, is allowed to determine its own trade poli- cies with regard to nonmembers. Thus, for example, the tariffs placed on the products of nonmember countries may vary from member to member. Free trade agreements are the most popular form of regional economic integration, accounting for almost 90 percent of regional agreements. 2 The most enduring free trade area in the world is the European Free Trade As- sociation (EFTA). Established in January 1960, EFTA currently joins four countries— Norway, Iceland, Liechtenstein, and Switzerland—down from seven in 1995 (three EFTA members, Austria, Finland, and Sweden, joined the EU on January 1, 1996). EFTA was founded by those Western European countries that initially decided not to be part of the European Community (the forerunner of the EU). Its original mem- bers included Austria, Great Britain, Denmark, Finland, and Sweden, all of which are now members of the EU. The emphasis of EFTA has been on free trade in industrial goods. Agriculture was left out of the arrangement, each member being allowed to determine its own level of support. Members are also free to determine the level of protection applied to goods coming from outside EFTA. Other free trade areas in- clude the North American Free Trade Agreement, which we shall discuss in depth later in the chapter. The customs union is one step farther along the road to full economic and political integration. A customs union eliminates trade barriers between member countries and adopts a common external trade policy. Establishment of a common external trade policy necessitates significant administrative machinery to oversee trade relations with nonmembers. Most countries that enter into a customs union desire even greater eco- nomic integration down the road. The EU began as a customs union, but has now moved beyond this stage. Other customs unions around the world include the current version of the Andean Community (formally known as the Andean Pact) between Bolivia, Colombia, Ecuador, Peru, and Venezuela. The Andean Community established free trade between member countries and imposes a common tariff, of 5 to 20 percent, on products imported from outside. 3 The next level of economic integration, a common market has no barriers to trade between member countries, includes a common external trade policy, and allows fac- tors of production to move freely between members. Labor and capital are free to move because there are no restrictions on immigration, emigration, or cross-border flows of capital between member countries. Establishing a common market demands a significant degree of harmony and cooperation on fiscal, monetary, and employment policies. Achieving this degree of cooperation has proven very difficult. For years, the European Union functioned as a common market, although it has now moved beyond this stage. Mercosur, the South American grouping of Argentina, Brazil, Paraguay, and Uruguay (Venezuela has also applied to join), hopes to eventually establish itself as a common market. An economic union entails even closer economic integration and cooperation than a common market. Like the common market, an economic union involves the free flow of products and factors of production between member countries and the adop- tion of a common external trade policy, but it also requires a common currency, har- monization of members’ tax rates, and a common monetary and fiscal policy. Such a high degree of integration demands a coordinating bureaucracy and the sacrifice of significant amounts of national sovereignty to that bureaucracy. The EU is an eco- nomic union, although an imperfect one since not all members of the EU have ad- opted the euro, the currency of the EU; differences in tax rates and regulations across countries still remain; and some markets, such as the market for energy, are still not fully deregulated.
Free Trade Area A group of countries committed to removing all barriers to the free flow of goods and services between each other, but pursuing independent external trade policies.
European Free Trade Association (EFTA) A free trade association including Norway, Iceland, Liechtenstein, and Switzerland.
Customs Union A group of countries committed to (1) removing all barriers to the free flow of goods and services between each other and (2) the pursuit of a common external trade policy.
Common Market A group of countries committed to (1) removing all barriers to the free flow of goods, services, and factors of production between each other and (2) the pursuit of a common external trade policy.
Economic Union A group of countries committed to (1) removing all barriers to the free flow of goods, services, and factors of production; (2) the adoption of a common currency; (3) the harmonization of tax rates; and (4) the pursuit of a common external trade policy.
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280 Part Three Cross-Border Trade and Investment
The move toward economic union raises the issue of how to make a coordinating bureaucracy accountable to the citizens of member nations. The answer is through political union in which a central political apparatus coordinates the economic, social, and foreign policy of the member states. The EU is on the road toward at least partial political union. The European Parliament, which is playing an ever more important role in the EU, has been directly elected by citizens of the EU countries since the late 1970s. In addition, the Council of Ministers (the controlling, decision-making body of the EU) is composed of government ministers from each EU member. The United States provides an example of even closer political union; in the United States, inde- pendent states are effectively combined into a single nation. Ultimately, the EU may move toward a similar federal structure.
The Case for Regional Integration The case for regional integration is both economic and political. The case for integra- tion is typically not accepted by many groups within a country, which explains why most attempts to achieve regional economic integration have been contentious and halting. In this section, we examine the economic and political cases for integration and two impediments to integration. In the next section, we look at the case against integration.
THE ECONOMIC CASE FOR INTEGRATION The economic case for re- gional integration is straightforward. We saw in Chapter 5 how economic theories of international trade predict that unrestricted free trade will allow countries to special- ize in the production of goods and services that they can produce most efficiently. The result is greater world production than would be possible with trade restrictions. That chapter also revealed how opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. Chapter 7 detailed how foreign direct invest- ment (FDI) can transfer technological, marketing, and managerial know-how to host nations. Given the central role of knowledge in stimulating economic growth, opening a country to FDI also is likely to stimulate economic growth. In sum, economic theo- ries suggest that free trade and investment is a positive-sum game, in which all par- ticipating countries stand to gain. Given this, the theoretical ideal is an absence of barriers to the free flow of goods, services, and factors of production among nations. However, as we saw in Chapters 6 and 7, a case can be made for government intervention in international trade and FDI. Because many governments have accepted part or all of the case for intervention, un-
restricted free trade and FDI have proved to be only an ideal. Although international institutions such as the WTO have been moving the world to- ward a free trade regime, success has been less than total. In a world of many nations and many political ideologies, it is very difficult to get all countries to agree to a common set of rules.
Against this background, regional economic in- tegration can be seen as an attempt to achieve ad- ditional gains from the free flow of trade and investment between countries beyond those attain- able under international agreements such as the WTO. It is easier to establish a free trade and in- vestment regime among a limited number of adja- cent countries than among the world community.
Political Union A central political
apparatus that coordinates economic,
social, and foreign policy.
LEARNING OBJECTIVE 2 Understand the economic and political arguments for regional economic integration.
A n o t h e r P e r s p e c t i v e
Economic Integration and the EU Worker Being a citizen of a country that is regionally integrated, such as the countries of the European Union, may have benefits related to career development. From an employer’s perspective, workers are more mobile. They can move from Spain to Finland, Latvia to France, and never have to think about work permits and, depending on the countries, currencies. In addition, labor and commercial law is be- coming integrated across the EU. The mobility and flexibil- ity of such employees may be attractive to a U.S. MNE as well, because it could use them in many markets.
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Chapter Eight Regional Economic Integration 281
Coordination and policy harmonization problems are largely a function of the number of countries that seek agreement. The greater the number of countries involved, the more perspectives that must be reconciled, and the harder it will be to reach agree- ment. Thus, attempts at regional economic integration are motivated by a desire to exploit the gains from free trade and investment.
THE POLITICAL CASE FOR INTEGRATION The political case for re- gional economic integration also has loomed large in several attempts to establish free trade areas, customs unions, and the like. Linking neighboring economies and making them increasingly dependent on each other creates incentives for political cooperation between the neighboring states and reduces the potential for violent conflict. In addi- tion, by grouping their economies, the countries can enhance their political weight in the world. These considerations underlay the 1957 establishment of the European Commu- nity (EC), the forerunner of the EU. Europe had suffered two devastating wars in the first half of the 20th century, both arising out of the unbridled ambitions of nation- states. Those who have sought a united Europe have always had a desire to make an- other war in Europe unthinkable. Many Europeans also believed that after World War II, the European nation-states were no longer large enough to hold their own in world markets and politics. The need for a united Europe to deal with the United States and the politically alien Soviet Union loomed large in the minds of many of the EC’s founders. 4 A long-standing joke in Europe is that the European Commission should erect a statue to Joseph Stalin, for without the aggressive policies of the former dicta- tor of the old Soviet Union, the countries of Western Europe may have lacked the incentive to cooperate and form the EC.
IMPEDIMENTS TO INTEGRATION Despite the strong economic and po- litical arguments in support, integration has never been easy to achieve or sustain for two main reasons. First, although economic integration aids the majority, it has its costs. While a nation as a whole may benefit significantly from a regional free trade agreement, certain groups may lose. Moving to a free trade regime involves painful adjustments. For example, due to the 1994 establishment of NAFTA, some Canadian and U.S. workers in such industries as textiles, which employ low-cost, low-skilled labor, lost their jobs as Canadian and U.S. firms moved production to Mexico. The promise of significant net benefits to the Canadian and U.S. economies as a whole is little comfort to those who lose as a result of NAFTA. Such groups have been at the forefront of opposition to NAFTA and will continue to oppose any widening of the agreement. Thus, as we saw in the opening case, the Teamsters Union in the United States has vigorously opposed the implementation of a trucking agreement in the treaty. A second impediment to integration arises from concerns over national sover- eignty. For example, Mexico’s concerns about maintaining control of its oil interests resulted in an agreement with Canada and the United States to exempt the Mexican oil industry from any liberalization of foreign investment regulations achieved un- der NAFTA. Concerns about national sovereignty arise because close economic in- tegration demands that countries give up some degree of control over such key issues as monetary policy, fiscal policy (e.g., tax policy), and trade policy. This has been a major stumbling block in the EU. To achieve full economic union, the EU introduced a common currency, the euro, controlled by a central EU bank. Although most member states have signed on, Great Britain remains an important holdout. A politically important segment of public opinion in that country opposes a common currency on the grounds that it would require relinquishing control of the country’s
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282 Part Three Cross-Border Trade and Investment
monetary policy to the EU, which many British perceive as a bureaucracy run by foreigners. In 1992, the British won the right to opt out of any single currency agreement, and as of 2010, the British government had yet to reverse its decision, nor did it seem likely to.
The Case Against Regional Integration Although the tide has been running in favor of regional free trade agreements in recent years, some economists have expressed concern that the benefits of regional integration have been oversold, while the costs have often been ignored. 5 They point out that the benefits of regional integration are determined by the extent of trade creation, as op- posed to trade diversion. Trade creation occurs when high-cost domestic producers are replaced by low-cost producers within the free trade area. It may also occur when higher-cost external producers are replaced by lower-cost external producers within the free trade area. Trade diversion occurs when lower-cost external suppliers are replaced by higher-cost suppliers within the free trade area. A regional free trade agreement will benefit the world only if the amount of trade it creates exceeds the amount it diverts. Suppose the United States and Mexico imposed tariffs on imports from all coun- tries, and then they set up a free trade area, scrapping all trade barriers between them- selves but maintaining tariffs on imports from the rest of the world. If the United States began to import textiles from Mexico, would this change be for the better? If the United States previously produced all its own textiles at a higher cost than Mexico, then the free trade agreement has shifted production to the cheaper source. According to the theory of comparative advantage, trade has been created within the regional grouping, and there would be no decrease in trade with the rest of the world. Clearly, the change would be for the better. If, however, the United States previously imported textiles from Costa Rica, which produced them more cheaply than either Mexico or the United States, then trade has been diverted from a low-cost source—a change for the worse. In theory, WTO rules should ensure that a free trade agreement does not result in trade diversion. These rules allow free trade areas to be formed only if the members set tariffs that are not higher or more restrictive to outsiders than the ones previously in effect. However, as we saw in Chapter 6, GATT and the WTO do not cover some nontariff barriers. As a result, regional trade blocs could emerge whose markets are protected from outside competition by high nontariff barriers. In such cases, the trade diversion effects might outweigh the trade creation effects. The only way to guard against this possibility, according to those concerned about this potential, is to increase the scope of the WTO so it covers nontariff barriers to trade. There is no sign that this is going to occur anytime soon, however; so the risk remains that regional economic integration will result in trade diversion.
Regional Economic Integration in Europe Europe has two trade blocs—the European Union and the European Free Trade Association. Of the two, the EU is by far the more significant, not just in terms of membership (the EU currently has 27 members; the EFTA has 4), but also in terms of economic and political influence in the world economy. Many now see the EU as an emerging economic and political superpower of the same order as the United States. Accordingly, we will concentrate our attention on the EU. 6
EVOLUTION OF THE EUROPEAN UNION The European Union (EU) is the product of two political factors: (1) the devastation of Western Europe during two world wars and the desire for a lasting peace, and (2) the European nations’ desire
LEARNING OBJECTIVE 3 Understand the economic and political arguments against regional economic integration.
LEARNING OBJECTIVE 4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.
Trade Creation Trade created due to
regional economic integration; occurs when
high-cost domestic producers are replaced
by low-cost foreign producers in a free
trade area.
Trade Diversion Trade diverted due to
regional economic integration; occurs when
low-cost foreign suppliers outside a free trade area
are replaced by higher- cost foreign suppliers in a
free trade area.
European Union An economic group of
27 European nations; established as a customs union, it is moving toward economic union; formerly the European Community.
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Chapter Eight Regional Economic Integration 283
to hold their own on the world’s political and economic stage. In addition, many Europeans were aware of the potential economic benefits of closer economic integra- tion of the countries. The forerunner of the EU, the European Coal and Steel Community was formed in 1951 by Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands. Its objective was to remove barriers to intragroup shipments of coal, iron, steel, and scrap metal. With the signing of the Treaty of Rome in 1957, the European Community was established. The name changed again in 1994 when the European Community became the European Union following the ratification of the Maastricht Treaty (dis- cussed later). The Treaty of Rome provided for the creation of a common market. Article 3 of the treaty laid down the key objectives of the new community, calling for the elimination of internal trade barriers and the creation of a common external tariff and requiring member states to abolish obstacles to the free movement of factors of production among the members. To facilitate the free movement of goods, services, and factors of production, the treaty provided for any necessary harmonization of the member states’ laws. Furthermore, the treaty committed the EC to establish common policies in agri- culture and transportation. The community grew in 1973, when Great Britain, Ireland, and Denmark joined. These three were followed in 1981 by Greece, in 1986 by Spain and Portugal, and in 1996 by Austria, Finland, and Sweden, bringing the total membership to 15 (East Germany became part of the EC after the reunification of Germany in 1990). Another 10 countries joined the EU on May 1, 2004, 8 of them from Eastern Europe plus the small Mediterranean nations of Malta and Cyprus. Bulgaria and Romania joined in 2007, bringing the total number of member states to 27 (see Map 8.1). With a population of almost 500 million and a GDP of €11 trillion, larger than that of the United States, the EU through these enlargements has become a global superpower. 7
POLITICAL STRUCTURE OF THE EUROPEAN UNION The economic policies of the EU are formulated and implemented by a complex and still-evolving political structure. The four main institutions in this structure are the European Commission, the Council of the European Union, the European Parliament, and the Court of Justice. 8 The European Commission is responsible for proposing EU legislation, implementing it, and monitoring compliance with EU laws by member states. Headquartered in Brussels, Belgium, the commission has more than 24,000 employees. It is run by a group of commissioners appointed by each member country for five-year renewable terms. There are 27 commissioners, one from each mem- ber state. A president of the commission is chosen by member states, and the president then chooses other members in consultation with the states. The entire commission has to be approved by the European Parliament before it can begin work. The commis- sion has a monopoly in proposing European Union legislation. The commission makes a proposal, which goes to the Council of the European Union and then to the European Parliament. The council
Treaty of Rome The 1957 treaty that established the European Community.
European Commission Body responsible for proposing EU legislation, implementing it, and monitoring compliance.
L’Oreal Chief Executive Officer Lindsay Owen-Jones and L’Oreal Deputy Chief Executive Officer Jean-Paul Agon attend a press conference to announce that L’Oreal was buying Body Shop International, renowned for its ethical hair and skin products. L’Oreal, the world’s leading cosmetics company, bought Body Shop for £652 million pounds (€940 million; $1.143 billion). The European Commission reviews acquisitions such as this between competitors.
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284 Part Three Cross-Border Trade and Investment
cannot legislate without a commission proposal in front of it. The commission is also responsible for implementing aspects of EU law, although in practice much of this must be delegated to member states. Another responsibility of the commission is to monitor member states to make sure they are complying with EU laws. In this polic- ing role, the commission will normally ask a state to comply with any EU laws that are being broken. If this persuasion is not sufficient, the commission can refer a case to the Court of Justice. The European Commission’s role in competition policy has become increasingly important to business in recent years. Since 1990 when the office was formally as- signed a role in competition policy, the EU’s competition commissioner has been steadily gaining influence as the chief regulator of competition policy in the member nations of the EU. As with antitrust authorities in the United States, which include the Federal Trade Commission and the Department of Justice, the role of the competition commissioner is to ensure that no one enterprise uses its market power to drive out
Portugal
España
Andorra
France
Luxembourg Č eská republika
Monaco Italia
Slovenija Hrvatska
Österreich Liechtenstein
Polska Belarus’
Ukraïna
Moldova Slovensko
Magyarország
Deutschland
R.
Rossija
Sakartvelo
e
Haïastan
Latvija
Lietuva
Eesti
Suomi Finland
Norge
Sverige
Danmark
United Kingdom
Ireland Éire
Ísland
Nederland
Belgie Belgique
România
Bǎlgarija
Ellada
Malta
Türkiye
Srbija
P.J.R.M. Città del
Vaticano Shqipëria
Crna Gora
San Marino
Suisse Schweiz Svizzera
Bosna i Hercegovina
Açores (P)
Madeira (P)
Canarias (E)
G u
a d
e lo
u p
e (
F )
M a
r ti
n iq
u e
(F )
Réunion (F)Brasil
Guyane (F) Suriname
Kypros Kibris
map 8.1
Member States of the European Union in 2010
Source: The European Union; http://europa.eu/abc/european_countries/index_en.htm.
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Chapter Eight Regional Economic Integration 285
competitors and monopolize markets. The commissioner also reviews proposed merg- ers and acquisitions to make sure they do not create a dominant enterprise with sub- stantial market power. 9 For example, in 2000 a proposed merger between Time Warner of the United States and EMI of the United Kingdom, both music recording companies, was withdrawn after the commission expressed concerns that the merger would reduce the number of major record companies from five to four and create a dominant player in the $40 billion global music industry. Similarly, the commission blocked a proposed merger between two U.S. telecommunication companies, World- Com and Sprint, because their combined holdings of Internet infrastructure in Europe would give the merged companies so much market power that the commission argued the combined company would dominate that market. Another example of the commis- sion’s influence over business combinations is given in the accompanying Manage- ment Focus, which looks at the commission’s role in shaping mergers and joint ventures in the media industry. The European Council represents the interests of member states. It is clearly the ultimate controlling authority within the EU since draft legislation from the com- mission can become EU law only if the council agrees. The council is composed of one representative from the government of each member state. The membership,
M a n a g e m e n t F O C U S
The European Commission and Media Industry Mergers
In late 1999, U.S. Internet giant AOL announced it would merge with the music and publishing conglomerate Time Warner. Both the U.S. companies had substantial operations in Europe. The European commissioner for competition, Mario Monti, announced the commission would investigate the impact of the merger on competition in Europe. The investigation took on a new twist when Time Warner subsequently announced it would form a joint venture with British-based EMI. Time Warner and EMI are two of the top five music publishing companies in the world. The proposed joint venture would have been three times as large as its nearest global competitor. The European Commission now had two concerns. The first was that the joint venture be- tween EMI and Time Warner would reduce the level of com- petition in the music publishing industry. The second was that a combined AOL–Time Warner would dominate the emerging market for downloading music over the Internet, particularly given the fact that AOL would be able to gain preferential ac- cess to the music libraries of both Warner and EMI. This would potentially put other online service providers at a dis- advantage. The commission was also concerned that AOL Europe was a joint venture between AOL and Bertelsmann, a German media company that also had considerable music publishing interests. Accordingly, the commission announced it would undertake a separate investigation of the proposed deal between Time Warner and EMI.
These investigations continued into late 2000 and were resolved by a series of concessions extracted by the European Commission. First, under pressure from the com- mission, Time Warner and EMI agreed to drop their proposed joint venture, thereby maintaining the level of competition in the music publishing business. Second, AOL and Time Warner agreed to allow rival Internet service providers access to online music on the same terms as AOL would receive from Warner Music Group for the next five years. Third, AOL agreed to sever all ties with Bertelsmann, and the German company agreed to withdraw from AOL Europe. These developments alleviated the commission’s concern that the AOL–Time Warner combination would dominate the emerging market for the digital download of music. With these concessions in hand, the commission approved the AOL–Time Warner merger in early October 2000. By late 2000 the AOL–Timer Warner merger had been com- pleted. The shape of the media business, both in Europe and worldwide, now looked very different, and the European Commission had played a pivotal role in determining the out- come. Its demand for concessions altered the strategy of several companies, led to somewhat different combinations from those originally planned, and, the commission believed, preserved competition in the global media business.
Sources: W. Drozdiak, “EU Allows Vivendi Media Deal,” Washington Post, October 14, 2000, p. E2; D. Hargreaves, “Business as Usual in the New Economy,” Financial Times, October 6, 2000, p. 1; and D. Hargreaves, “Brussels Clears AOL-Time Warner Deal,” Financial Times, October 12, 2000, p. 12.
European Council The ultimate controlling authority within the EU.
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however, varies depending on the topic being discussed. When agricultural issues are being discussed, the agriculture ministers from each state attend council meetings; when transportation is being discussed, transportation ministers attend, and so on. Before 1993, all council issues had to be decided by unanimous agreement between member states. This often led to marathon council sessions and a failure to make progress or reach agreement on commission proposals. In an attempt to clear the resulting logjams, the Single European Act formalized the use of majority voting rules on issues “which have as their object the establishment and functioning of a single market.” Most other issues, however, such as tax regulations and immigration policy, still require unanimity among council members if they are to become law. The votes that a country gets in the council are related to the size of the country. For ex- ample, Britain, a large country, has 29 votes, whereas Denmark, a much smaller state, has 7 votes. The European Parliament, which now has 732 members, is directly elected by the populations of the member states. The parliament, which meets in Strasbourg, France, is primarily a consultative rather than legislative body. It debates legislation proposed by the commission and forwarded to it by the council. It can propose amendments to that legislation, which the commission and ultimately the council are not obliged to take up but often will. The power of the parliament recently has been increasing, al- though not by as much as parliamentarians would like. The European Parliament now has the right to vote on the appointment of commissioners as well as veto some laws (such as the EU budget and single-market legislation). One major debate waged in Europe over the past few years is whether the council or the parliament should ultimately be the most powerful body in the EU. Some in Europe expressed concern over the democratic accountability of the EU bureau- cracy. One side argued that the answer to this apparent democratic deficit lay in in- creasing the power of the parliament, while others think that true democratic legitimacy lies with elected governments, acting through the Council of the European Union. 10 After significant debate, in December 2007 the member states signed a new treaty, the Treaty of Lisbon , under which the power of the European Parliament is increased. Ratified by all member states by the end of 2009, the treaty makes the European Parliament the co-equal legislator for almost all European laws. 11 The Treaty of Lisbon also creates a new position, a president of the European Council, who will serve a 30-month term and represent the nation-states that make up the European Union. Under the treaty, the European Commission will be reduced to 18 members, with a rotation system that ensures that every member state has regular and equal membership. The Court of Justice, which is comprised of one judge from each country, is the supreme appeals court for EU law. Like commissioners, the judges are required to act as independent officials, rather than as representatives of national interests. The commission or a member country can bring other members to the court for failing to meet treaty obligations. Similarly, member countries, companies, or institutions can bring the commission or council to the court for failure to act according to an EU treaty.
THE SINGLE EUROPEAN ACT Two revolutions occurred in Europe in the late 1980s. The first was the collapse of communism in Eastern Europe. The second revolution was much quieter, but its impact on Europe and the world may have been just as profound as the first. It was the adoption of the Single European Act by the member nations of the European Community (EC) in 1987. This act committed member countries to work toward establishment of a single market by December 31, 1992.
European Parliament
Elected EU body that consults on issues
proposed by the European Commission.
The Treaty of Lisbon
Treaty signed in 2007 that made the European
Parliament the co-equal legislator for almost all
European laws and also created the position of
the president of the European Council.
Court of Justice Supreme appeals court
for EU law.
Single European Act
A 1987 act, adopted by members of the European
Community, that committed member
countries to establishing an economic union.
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The Single European Act was born of a frustration among members that the com- munity was not living up to its promise. By the early 1980s, it was clear that the EC had fallen short of its objectives to remove barriers to the free flow of trade and invest- ment between member countries and to harmonize the wide range of technical and legal standards for doing business. Against this background, many of the EC’s promi- nent businesspeople mounted an energetic campaign in the early 1980s to end the EC’s economic divisions. The EC responded by creating the Delors Commission. Un- der the chairmanship of Jacques Delors, the commission proposed that all impedi- ments to the formation of a single market be eliminated by December 31, 1992. The result was the Single European Act, which was independently ratified by the parlia- ments of each member country and became EC law in 1987.
The Objectives of the Act The purpose of the Single European Act was to have one market in place by December 31, 1992. The act proposed the following changes: 12
• Remove all frontier controls between EC countries, thereby abolishing delays and reducing the resources required for complying with trade bureaucracy.
• Apply the principle of “mutual recognition” to product standards. A standard developed in one EC country should be accepted in another, provided it meets basic requirements in such matters as health and safety.
• Open public procurement to nonnational suppliers, reducing costs directly by allowing lower-cost suppliers into national economies and indirectly by forcing national suppliers to compete.
• Lift barriers to competition in the retail banking and insurance businesses, which should drive down the costs of financial services, including borrowing, throughout the EC.
• Remove all restrictions on foreign exchange transactions between member countries by the end of 1992.
• Abolish restrictions on cabotage—the right of foreign truckers to pick up and deliver goods within another member state’s borders—by the end of 1992. Estimates suggested this would reduce the cost of haulage within the EC by 10 to 15 percent.
All those changes were predicted to lower the costs of doing business in the EC, but the single-market program was also expected to have more complicated supply-side effects. For example, the expanded market was pre- dicted to give EC firms greater opportunities to ex- ploit economies of scale. In addition, it was thought that the increase in competitive intensity brought about by removing internal barriers to trade and in- vestment would force EC firms to become more ef- ficient. To signify the importance of the Single European Act, the European Community also de- cided to change its name to the European Union once the act took effect.
Impact The Single European Act has had a sig- nificant impact on the EU economy. 13 The act pro- vided the impetus for the restructuring of substantial sections of European industry. Many firms have shifted from national to pan-European production and distribution systems in an attempt to realize scale economies and better compete in a single market.
Creation of a single financial services market in the European Union has taken longer than expected due to member states’ differing regulations and the significant amount of inertia involved in getting people to accept this change.
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The results have included faster economic growth than would otherwise have been the case. However, nearly two decades after the formation of a single market, the reality still falls short of the ideal. For example, as described in the accompanying Country Focus, it has been hard work to establish a fully functioning single market for financial services
Creating a Single Market in Financial Services
The European Union in 1999 embarked upon an ambitious action plan to create a single market in financial services by January 1, 2005. Launched a few months after the euro, the EU’s single currency, the goal was to dismantle barriers to cross-border activity in financial services, creating a continent-wide market for banking service, insurance ser- vices, and investment products. In this vision of a single Europe, a citizen of France might use a German firm for ba- sic banking services, borrow a home mortgage from an Italian institution, buy auto insurance from a Dutch enter- prise, and keep her savings in mutual funds managed by a British company. Similarly, an Italian firm might raise capi- tal from investors across Europe, using a German firm as its lead underwriter to issue stock for sale through stock exchanges in London and Frankfurt. One main benefit of a single market, according to its ad- vocates, would be greater competition for financial ser- vices, which would give consumers more choices, lower prices, and require financial service firms in the EU to be- come more efficient, thereby increasing their global com- petitiveness. Another major benefit would be the creation of a single European capital market. The increased liquidity of a larger capital market would make it easier for firms to borrow funds, lowering their cost of capital (the price of money) and stimulating business investment in Europe, which would create more jobs. A European Commission study suggested that the creation of a single market in fi- nancial services would increase the EU’s gross domestic product by 1.1 percent a year, creating an additional €130 billion in wealth over a decade. Total business invest- ment would increase by 6 percent annually in the long run, private consumption by 0.8 percent, and total employment by 0.5 percent a year. Creating a single market has been anything but easy. The financial markets of different EU member states have his- torically been segmented from each other, and each has its own regulatory framework. In the past, EU financial ser- vices firms rarely did business across national borders be- cause of a host of different national regulations with regard to taxation, oversight, accounting information, cross-border
takeovers, and the like, all of which had to be harmonized. To complicate matters, long-standing cultural and linguistic barriers complicated the move toward a single market. While in theory an Italian might benefit by being able to pur- chase homeowners’ insurance from a British company, in practice he might be predisposed to purchase it from a lo- cal enterprise, even if the price were higher. By 2010 the EU had made significant progress. More than 40 measures designed to create a single market in finan- cial services had become EU law and others were in the pipeline. The new rules embraced issues as diverse as the conduct of business by investment firms, stock exchanges, and banks; disclosure standards for listing companies on public exchanges; and the harmonization of accounting standards across nations. However, there had also been significant setbacks. Most notably, legislation designed to make it easier for firms to make hostile cross-border acquisi- tions was defeated, primarily due to opposition from German members of the European Parliament, making it more difficult for financial service firms to build pan-European opera- tions. In addition, national governments have still reserved the right to block even friendly cross-border mergers be- tween financial service firms. For example, Italian banking law still requires the governor of the Bank of Italy to give permission to any foreign enterprise that wishes to pur- chase more than 5 percent of an Italian bank—and no for- eigners have yet to acquire a majority position in an Italian bank, primarily, say critics, due to nationalistic concerns on the part of the Italians. The critical issue now is enforcement of the rules that have been put in place. Some believe that it will be at least another decade before the benefits of the new regulations become apparent. In the meantime, the changes may im- pose significant costs on financial institutions as they at- tempt to deal with the new raft of regulations.
Sources: C. Randzio-Plath, “Europe Prepares for a Single Financial Market,” Intereconomic, May–June 2004, pp. 142–46; T. Buck, D. Hargreaves, and P. Norman, “Europe’s Single Financial Market,” Financial Times, January 18, 2005, p. 17; “The Gate-keeper,” The Economist, February 19, 2005, p. 79; P. Hofheinz, “A Capital Idea: The European Union Has a Grand Plan to Make Its Financial Markets More Efficient,” The Wall Street Journal, October 14, 2002, p. R4; and “Banking on McCreevy: Europe’s Single Market,” The Economist , November 26, 2005, p. 91.
3 C o u n t r y F O C U S
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in the EU. Thus, although the EU is undoubtedly moving toward a single marketplace, established legal, cultural, and language differences between nations mean that imple- mentation has been uneven.
THE ESTABLISHMENT OF THE EURO In December 1991, EC mem- bers signed a treaty (the Maastricht Treaty ) that committed them to adopting a common currency by January 1, 1999. 14 The euro is now used by 16 of the 27 member states of the European Union; these 16 states are members of what is often referred to as the euro zone. It encompasses 330 million EU citizens and includes the power- ful economies of Germany and France. Many of the countries that joined the EU on May 1, 2004, and the two that joined in 2007, will adopt the euro when they fulfill certain economic criteria—a high degree of price stability, a sound fiscal situation, stable exchange rates, and converged long-term interest rates. The current members had to meet the same criteria. Establishment of the euro has rightly been described as an amazing political feat with few historical precedents. Establishing the euro required participating national governments not only to give up their own currencies, but also to give up control over monetary policy. Governments do not routinely sacrifice national sovereignty for the greater good, indicating the importance that the Europeans attach to the euro. By adopting the euro, the EU has created the second most widely traded currency in the world after that of the U.S. dollar. Some believe that ultimately the euro could come to rival the dollar as the most important currency in the world. Three long-term EU members, Great Britain, Denmark, and Sweden, are still sit- ting on the sidelines. The countries agreeing to the euro locked their exchange rates against each other January 1, 1999. Euro notes and coins were not actually issued until January 1, 2002. In the interim, national currencies circulated in each of the 12 coun- tries. However, in each participating state, the national currency stood for a defined amount of euros. After January 1, 2002, euro notes and coins were issued and the na- tional currencies were taken out of circulation. By mid-2002, all prices and routine economic transactions within the euro zone were in euros.
Benefits of the Euro Europeans decided to establish a single currency in the EU for a number of reasons. First, they believe that businesses and individuals will realize significant savings from having to handle one currency, rather than many. These sav- ings come from lower foreign exchange and hedging costs. For example, people going from Germany to France no longer have to pay a commission to a bank to change German deutsche marks into French francs. Instead, they use euros. According to the European Commission, such savings amount to 0.5 percent of the European Union’s GDP, or about $55 billion a year. Second, and perhaps more importantly, the adoption of a common currency makes it easier to compare prices across Europe. This has been increasing competition be- cause it has become easier for consumers to shop around. For example, if a German finds that cars sell for less in France than Germany, he may be tempted to purchase from a French car dealer rather than his local car dealer. Alternatively, traders may engage in arbitrage to exploit such price differentials, buying cars in France and re- selling them in Germany. The only way that German car dealers will be able to hold on to business in the face of such competitive pressures will be to reduce the prices they charge for cars. As a consequence of such pressures, the introduction of a com- mon currency has led to lower prices, which translates into substantial gains for European consumers. Third, faced with lower prices, European producers have been forced to look for ways to reduce their production costs to maintain their profit margins. The introduction
Maastricht Treaty Treaty agreed to in 1991, but not ratified until January 1, 1994, that committed the 12 member states of the European Community to adopt a common currency.
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of a common currency, by increasing competition, has produced long-run gains in the economic efficiency of European companies. Fourth, the introduction of a common currency has given a boost to the development of a highly liquid pan-European capital market. Over time, the development of such a capital market should lower the cost of capital and lead to an increase in both the level of investment and the efficiency with which investment funds are allocated. This could be especially helpful to smaller companies that have historically had difficulty borrowing money from domestic banks. For example, the capital market of Portugal is very small and illiquid, which makes it extremely difficult for bright Portuguese entrepreneurs with a good idea to borrow money at a reasonable price. However, in theory, such companies can now tap a much more liquid pan-European capital market. Finally, the development of a pan-European, euro-denominated capital market will increase the range of investment options open to both individuals and institutions. For example, it will now be much easier for individuals and institutions based in, let’s say, Holland to invest in Italian or French companies. This will enable European investors to better diversify their risk, which again lowers the cost of capital, and should also increase the efficiency with which capital resources are allocated. 15
Costs of the Euro The drawback, for some, of a single currency is that national authorities have lost control over monetary policy. Thus, it is crucial to ensure that the EU’s monetary policy is well managed. The Maastricht Treaty called for establishment of the independent European Central Bank (ECB), similar in some respects to the U.S. Federal Reserve, with a clear mandate to manage monetary policy so as to ensure price stability. The ECB, based in Frankfurt, is meant to be independent from political pressure—although critics question this. Among other things, the ECB sets interest rates and determines monetary policy across the euro zone. The implied loss of national sovereignty to the ECB underlies the decision by Great Britain, Denmark, and Sweden to stay out of the euro zone for now. Many in these countries are suspicious of the ECB’s ability to remain free from political pres- sure and to keep inflation under tight control. In theory, the design of the ECB should ensure that it remains free of political pres- sure. The ECB is modeled on the German Bundesbank, which historically has been the most independent and successful central bank in Europe. The Maastricht Treaty prohibits the ECB from taking orders from politicians. The executive board of the bank, which consists of a president, vice president, and four other members, carries out policy by issuing instructions to national central banks. The policy itself is determined by the governing council, which consists of the executive board plus the central bank governors from the 17 euro zone countries. The governing council votes on interest rate changes. Members of the executive board are appointed for eight-year nonrenew- able terms, insulating them from political pressures to get reappointed. Nevertheless, the jury is still out on the issue of the ECB’s independence, and it will take some time for the bank to establish its credentials. According to critics, another drawback of the euro is that the EU is not what economists would call an optimal currency area. In an optimal currency area, simi- larities in the underlying structure of economic activity make it feasible to adopt a single currency and use a single exchange rate as an instrument of macroeconomic policy. Many of the European economies in the euro zone, however, are very dissimi- lar. For example, Finland and Portugal have different wage rates, tax regimes, and business cycles, and they may react very differently to external economic shocks. A change in the euro exchange rate that helps Finland may hurt Portugal. Obviously, such differences complicate macroeconomic policy. For example, when euro econo- mies are not growing in unison, a common monetary policy may mean that interest
Optimal Currency Area
One where similarities in the underlying structure
of economic activity make it feasible to adopt
a single currency.
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rates are too high for depressed regions and too low for booming regions. It will be interesting to see how the European Union copes with the strains caused by such divergent economic performance. One way of dealing with such divergent effects within the euro zone might be for the EU to engage in fiscal transfers, taking money from prosperous regions and pump- ing it into depressed regions. Such a move, however, would open a political can of worms. Would the citizens of Germany forgo their “fair share” of EU funds to create jobs for underemployed Portuguese workers? Some critics believe that the euro puts the economic cart before the political horse. In their view, a single currency should follow, not precede, political union. They argue that the euro will unleash enormous pressures for tax harmonization and fiscal transfers from the center, both policies that cannot be pursued without the appropriate political structure. The most apocalyptic vision that flows from these negative views is that far from stimulating economic growth, as its advocates claim, the euro will lead to lower economic growth and higher inflation within Europe. To quote one critic:
Imposing a single exchange rate and an inflexible exchange rate on countries that are characterized by different economic shocks, inflexible wages, low labor mobility, and separate national fiscal systems without significant cross-border fiscal transfers will raise the overall level of cyclical unemployment among EMU members. The shift from national monetary policies dominated by the (German) Bundesbank within the European Monetary System to a European Central Bank governed by majority voting with a politically determined exchange rate policy will almost certainly raise the average future rate of inflation. 16
The Experience to Date Since its establishment January 1, 1999, the euro has had a volatile trading history against the world’s major currency, the U.S. dollar. After starting life in 1999 at €1 5 $1.17, the euro steadily fell until it reached a low of €1 5 $0.83 in October 2000, leading critics to claim the euro was a failure. A major reason for the fall in the euro’s value was that international investors were investing money in booming U.S. stocks and bonds and taking money out of Europe to finance this investment. In other words, they were selling euros to buy dollars so that they could invest in dollar-denominated assets. This increased the demand for dollars and de- creased the demand for the euro, driving the value of the euro down. The fortunes of the euro began improving in late 2001 when the dollar weakened, and the cur- rency stood at a robust all-time high of €1 5 $1.54 in early March 2008. One reason for the rise in the value of the euro was that the flow of capital into the United States had stalled as the U.S. financial markets fell. 17 Many investors were now taking money out of the United States, selling dollar-denominated assets such as U.S. stocks and bonds, and purchasing euro-denominated assets. Falling demand for U.S. dollars and rising de- mand for euros translated into a fall in the value of the dollar against the euro. Furthermore, in a vote of confidence in both the euro and the ability of the ECB to manage monetary policy within the euro zone, many foreign central banks added more
A n o t h e r P e r s p e c t i v e
What to Do about Greece? Since its establishment in 1994, no member nation of the European Union (EU) has skated as close to insolvency as Greece, which in early 2010 announced its national deficit had soared to nearly 13 percent of gross domestic product. Under pressure from the EU, the Greek government crafted a stringent austerity program that includes sales tax hikes on alcohol, tobacco, and fuel; a tax on luxury goods; and deep wage cuts for civil servants. These moves persuaded the EU to announce it would support Greece with a bailout, if needed. The bailout, should it occur, would be the first in EU history. (Stephen Castle and Niki Kitsantonis, “E.U. Endorses Greek Austerity Efforts,” The New York Times, March 4, 2010, www.nytimes.com)
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euros to their supply of foreign currencies. In the first three years of its life, the euro never reached the 13 percent of global reserves made up by the deutsche mark and other former euro zone currencies. The euro didn’t jump that hurdle until early 2002, but by 2004 it made up 20 percent of global reserves. Currency specialists expected the growing U.S. current account deficit, which reached 7 percent of GDP in 2005, to drive the dollar down further, and the euro still higher over the next two to four years. 18 In 2007 this started to occur, with the euro appreciating steadily against the dollar from 2005 until early 2008. Since the euro has weakened somewhat, reflecting concerns over slow economic growth and growing budget deficits among several EU member states, particularly Greece, Portugal and Spain (see the accompanying Coun- try Focus for more details). Nevertheless, in early 2010 the exchange rate, which stood at €1 5 $1.35, was still strong compared to the exchange rate in the early 2000s. While the strong euro has been a source of pride for Europeans, it does make it harder for euro zone exporters to sell their goods abroad.
ENLARGEMENT OF THE EUROPEAN UNION A major issue facing the EU over the past few years has been that of enlargement. Enlargement of the EU into Eastern Europe has been a possibility since the collapse of communism at the end of
Crisis in the Euro Zone
When the euro was established, some critics worried that free-spending countries in the euro zone (such as Italy) might borrow excessively, running up large public-sector deficits that they could not finance. This would then rock the value of the euro, requiring their more sober brethren, such as Germany or France, to step in and bail out the prof- ligate nation. In early 2010, this worry was fast becoming a reality as a financial crisis in Greece rocked the value of the euro. The financial crisis had its roots in a decade of free spending by the Greek government. The government ran up a high level of debt to finance extensive spending in the public sector. Much of the increase in spending could be characterized as an attempt by the government to buy off powerful interest groups in Greek society, from teachers and farmers to public employees, rewarding them with high pay and extensive benefits. To make matters worse, the government misled the international community about the level of its indebtedness. In October 2009 a new gov- ernment took power and quickly announced that the 2009 deficit, which had been projected to be around 5 percent, would actually be around 12.7 percent. The previous gov- ernment had apparently been cooking the books. This shattered any faith that international investors might have had in the Greek economy. Interest rates on Greek government debt soared to 7.1 percent, about 4 per- centage points higher than the rate on German bonds.
Two of the three international rating agencies also cut their ratings on Greek bonds and warned that further downgrades were likely. The main concern now was that the Greek government might not be able to refinance some €20 billion of debt that matured in April or May 2010. A further concern was that the Greek government might lack the political willpower to make the large cuts in pub- lic spending necessary to bring down the deficit and re- store investor confidence. This raised the specter that either the IMF, or the European Central Bank with the sup- port of Germany and France, would have to step in and bail out the Greek government, imposing fiscal discipline on the country in return for loans that would keep the country from defaulting on its debt. Nor was Greece alone in having large public-sector defi- cits. Three other euro zone countries—Spain, Portugal, and Ireland—also all had large debt loads, and interest rates on their bonds also surged as investors sold out. This raised the specter of financial contagion, with large-scale defaults among the weaker members of the euro zone. If this did occur, the EU and IMF would most certainly have to step in and rescue the troubled nations. With this possibil- ity, once considered very remote, investors started to move money out of euros, and the value of the euro started to fall on the foreign exchange market.
Sources: “A very European Crisis,” The Economist , February 6, 2010, pp. 75–77; and L. Thomas, “Is Debt Trashing the Euro?” The New York Times , February 7, 2010, pp. 1, 7.
3 C o u n t r y F O C U S
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the 1980s, and by the end of the 1990s, 13 countries had applied to become EU mem- bers. To qualify for EU membership the applicants had to privatize state assets, de- regulate markets, restructure industries, and tame inflation. They also had to enshrine complex EU laws into their own systems, establish stable democratic governments, and respect human rights. 19 In December 2002, the EU formally agreed to accept the applications of 10 countries, and they joined May 1, 2004. The new members include the Baltic countries, the Czech Republic, and the larger nations of Hungary and Poland. The only new members not in Eastern Europe are the Mediterranean island nations of Malta and Cyprus. Their inclusion in the EU expanded the union to 25 states, stretching from the Atlantic to the borders of Russia; added 23 percent to the land- mass of the EU; brought 75 million new citizens into the EU, building an EU with a population of 450 million people; and created a single continental economy with a GDP of close to €11 trillion. In 2007, Bulgaria and Romania joined, bringing total member ship to 27 nations. The new members were not able to adopt the euro until at least 2007 (and 2010 in the case of the latest entrants), and free movement of labor between the new and exist- ing members was not allowed until then. Consistent with theories of free trade, the enlargement should create added benefits for all members. However, given the small size of the Eastern European economies (together they amount to only 5 percent of the GDP of current EU members) the initial impact will probably be small. The big- gest notable change might be in the EU bureaucracy and decision-making processes, where budget negotiations among 27 nations are bound to prove more problematic than negotiations among 15 nations. Left standing at the door is Turkey. Turkey, which has long lobbied to join the union, presents the EU with some difficult issues. The country has had a customs union with the EU since 1995, and about half of its international trade is already with the EU. However, full membership has been denied because of concerns over human rights issues (particularly Turkish policies toward its Kurdish minority). In addition, some on the Turk side suspect the EU is not eager to let a primarily Muslim nation of 66 million people, which has one foot in Asia, join the EU. The European Union for- mally indicated in December 2002 that it would allow the Turkish application to pro- ceed with no further delay in December 2004 if the country improved its human rights record to the satisfaction of the EU. In 2004 the EU agreed to allow Turkey to start accession talks in October 2005, but those talks are not moving along rapidly, and the nation will not join until 2013, if at all.
Regional Economic Integration
in the Americas No other attempt at regional economic integration comes close to the EU in its boldness or its potential implications for the world economy, but regional economic integration is on the rise in the Americas. The most significant attempt is the North American Free Trade Agreement. In addition to NAFTA, several other trade blocs are in the offing in the Americas (see Map 8.2), the most significant of which appear to be the Andean Community and Mercosur. Also, negotiations are under way to establish a hemisphere-wide Free Trade Area of the Americas (FTAA), although cur- rently they seem to be stalled.
THE NORTH AMERICAN FREE TRADE AGREEMENT The govern- ments of the United States and Canada in 1988 agreed to enter into a free trade agree- ment, which took effect January 1, 1989. The goal of the agreement was to eliminate
LEARNING OBJECTIVE 4 Explain the history, current
scope, and future prospects of the world’s most important regional
economic agreements.
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294 Part Three Cross-Border Trade and Investment
all tariffs on bilateral trade between Canada and the United States by 1998. This was followed in 1991 by talks among the United States, Canada, and Mexico aimed at es- tablishing a North American Free Trade Agreement for the three countries. The talks concluded in August 1992 with an agreement in principle, and the following year the agreement was ratified by the governments of all three countries. The agreement became law January 1, 1994. 20
NAFTA’S Contents The contents of NAFTA include the following:
• Abolition by 2004 of tariffs on 99 percent of the goods traded between Mexico, Canada, and the United States.
• Removal of most barriers on the cross-border flow of services, allowing financial institutions, for example, unrestricted access to the Mexican market by 2000.
• Protection of intellectual property rights.
NAFTA MERCOSUR Andean community Central America Caribbean community
Continental Commerce
map 8.2
Economic Integration in the Americas
Source: The Economist , April 21,
2001, p. 20. Copyright © 2001 The
Economist Newspaper Ltd. All
rights reserved. Reprinted with
permission. Further reproduction
prohibited. www.economist.com
North American Free Trade Agreement
(NAFTA) Free trade area between Canada, Mexico, and the
United States.
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Chapter Eight Regional Economic Integration 295
• Removal of most restrictions on foreign direct investment between the three member countries, although special treatment (protection) will be given to Mexican energy and railway industries, American airline and radio communications industries, and Canadian culture.
• Application of national environmental standards, provided such standards have a scientific basis. Lowering of standards to lure investment is described as being inappropriate.
• Establishment of two commissions with the power to impose fines and remove trade privileges when environmental standards or legislation involving health and safety, minimum wages, or child labor are ignored.
The Case for NAFTA Proponents of NAFTA have argued that the free trade area should be viewed as an opportunity to create an enlarged and more efficient pro- ductive base for the entire region. Advocates acknowledge that one effect of NAFTA would be that some U.S. and Canadian firms would move production to Mexico to take advantage of lower labor costs. (In 2004, the average hourly labor cost in Mexico was still one-tenth of that in the United States and Canada.) Movement of production to Mexico, they argued, was most likely to occur in low-skilled, labor-intensive manu- facturing industries where Mexico might have a comparative advantage. Advocates of NAFTA argued that many would benefit from such a trend. Mexico would benefit from much-needed inward investment and employment. The United States and Canada would benefit because the increased incomes of the Mexicans would allow them to import more U.S. and Canadian goods, thereby increasing demand and making up for the jobs lost in industries that moved production to Mexico. U.S. and Canadian con- sumers would benefit from the lower prices of products made in Mexico. In addition, the international competitiveness of U.S. and Canadian firms that move production to Mexico to take advantage of lower labor costs would be enhanced, enabling them to better compete with Asian and European rivals.
The Case against NAFTA Those who opposed NAFTA claimed that ratifica- tion would be followed by a mass exodus of jobs from the United States and Canada into Mexico as employers sought to profit from Mexico’s lower wages and less strict environmental and labor laws. According to one extreme opponent, Ross Perot, up to 5.9 million U.S. jobs would be lost to Mexico after NAFTA in what he famously char- acterized as a “giant sucking sound.” Most economists, however, dismissed these num- bers as being absurd and alarmist. They argued that Mexico would have to run a bilateral trade surplus with the United States of close to $300 billion for job loss on such a scale to occur—and $300 billion was the size of Mexico’s GDP. In other words, such a scenario seemed implausible. More sober estimates of the impact of NAFTA ranged from a net creation of 170,000 jobs in the United States (due to increased Mexican demand for U.S. goods and services) and an increase of $15 billion per year to the joint U.S. and Mexican GDP, to a net loss of 490,000 U.S. jobs. To put these numbers in perspective, employ- ment in the U.S. economy was predicted to grow by 18 million from 1993 to 2003. As most economists repeatedly stressed, NAFTA would have a small impact on both Canada and the United States. It could hardly be any other way, since the Mexican economy was only 5 percent of the size of the U.S. economy. Signing NAFTA re- quired the largest leap of economic faith from Mexico rather than Canada or the United States. Falling trade barriers would expose Mexican firms to highly efficient U.S. and Canadian competitors that, when compared to the average Mexican firm, had
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296 Part Three Cross-Border Trade and Investment
far greater capital resources, access to highly educated and skilled workforces, and much greater technological sophistication. The short-run outcome was likely to be painful economic restructuring and unemployment in Mexico. But advocates of NAFTA claimed there would be long-run dynamic gains in the efficiency of Mexican firms as they adjusted to the rigors of a more competitive marketplace. To the extent that this occurred, they argued, Mexico’s economic growth rate would accelerate, and Mexico might become a major market for Canadian and U.S. firms. 21 Environmentalists also voiced concerns about NAFTA. They pointed to the sludge in the Rio Grande River and the smog in the air over Mexico City and warned that Mexico could degrade clean air and toxic waste standards across the continent. They pointed out that the lower Rio Grande was the most polluted river in the United States, and that with NAFTA, chemical waste and sewage would increase along its course from El Paso, Texas, to the Gulf of Mexico. There was also opposition in Mexico to NAFTA from those who feared a loss of national sovereignty. Mexican critics argued that their country would be dominated by U.S. firms that would not really contribute to Mexico’s economic growth, but instead would use Mexico as a low-cost assembly site, while keeping their high-paying, high- skilled jobs north of the border.
NAFTA: The Results Studies of NAFTA’s impact to date suggest its initial effects were at best muted, and both advocates and detractors may have been guilty of exag- geration. 22 On average, studies indicate that NAFTA’s overall impact has been small but positive. 23 From 1993 to 2005, trade between NAFTA’s partners grew by 250 per- cent. 24 Canada and Mexico are now the number one and two trade partners of the United States, suggesting the economies of the three NAFTA nations have become more closely integrated. In 1990, U.S. trade with Canada and Mexico accounted for
Many workers in the United States initially believed that NAFTA would take away their jobs as employers looked for cheaper labor in Mexico. However, a 1996 study by researchers at the University of California–Los Angeles concluded the impact on jobs was a net gain of 3,000 for the United States in the first two years of the NAFTA regime.
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Chapter Eight Regional Economic Integration 297
about a quarter of total U.S. trade. By 2005, the figure was close to one-third. Canada’s trade with its NAFTA partners increased from about 70 percent to more than 80 per- cent of all Canadian foreign trade between 1993 and 2005, while Mexico’s trade with NAFTA increased from 66 percent to 80 percent over the same period. All three countries also experienced strong productivity growth over this period. In Mexico, labor productivity has increased by 50 percent since 1993, and the passage of NAFTA may have contributed to this. However, estimates suggest that employment effects of NAFTA have been small. The most pessimistic estimates suggest the United States lost 110,000 jobs per year due to NAFTA between 1994 and 2000—and many econo- mists dispute this figure—which is tiny compared to the more than 2 million jobs a year created in the United States during the same period. Perhaps the most significant impact of NAFTA has not been economic, but political. Many observers credit NAFTA with helping to create the background for increased political stability in Mexico. Mexico is now viewed as a stable democratic nation with a steadily growing economy, something that is beneficial to the United States, which shares a 2,000-mile border with the country. 25
Enlargement One issue confronting NAFTA is that of enlargement. A number of other Latin American countries have indicated their desire to eventually join NAFTA. The governments of both Canada and the United States are adopting a wait-and-see attitude with regard to most countries. Getting NAFTA approved was a bruising po- litical experience, and neither government is eager to repeat the process soon. Never- theless, the Canadian, Mexican, and U.S. governments began talks in 1995 regarding Chile’s possible entry into NAFTA. As of 2008, however, these talks had yielded little progress, partly because of political opposition in the U.S. Congress to expanding NAFTA. In December 2002, however, the United States and Chile did sign a bilateral free trade pact.
THE ANDEAN COMMUNITY Bolivia, Chile, Ecuador, Colombia, and Peru signed an agreement in 1969 to create the Andean Pact. The Andean Pact was largely based on the EU model, but was far less successful at achieving its stated goals. The integration steps begun in 1969 included an internal tariff reduction program, a com- mon external tariff, a transportation policy, a common industrial policy, and special concessions for the smallest members, Bolivia and Ecuador. By the mid-1980s, the Andean Pact had all but collapsed and had failed to achieve any of its stated objectives. There was no tariff-free trade between member countries, no common external tariff, and no harmonization of economic policies. Political and economic problems seem to have hindered cooperation between member countries. The countries of the Andean Pact have had to deal with low economic growth, hyperinflation, high unemployment, political unrest, and crushing debt burdens. In addition, the dominant political ideology in many of the Andean countries during this period tended toward the radical/socialist end of the political spectrum. Since such an ideology is hostile to the free market economic principles on which the Andean Pact was based, progress toward closer integration could not be expected. The tide began to turn in the late 1980s when, after years of economic decline, the governments of Latin America began to adopt free market economic policies. In 1990, the heads of the five current members of the Andean Community—Bolivia, Ecuador, Peru, Colombia, and Venezuela—met in the Galápagos Islands. The resulting Galápagos Declaration effectively relaunched the Andean Pact, which was renamed the Andean Community in 1997. The declaration’s objectives included the establishment of a free trade area by 1992, a customs union by 1994, and a common market by 1995. This last
Andean Pact A 1969 agreement between Bolivia, Chile, Ecuador, Colombia, and Peru to establish a customs union.
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298 Part Three Cross-Border Trade and Investment
milestone has not been reached. A customs union was implemented in 1995, although until 2003 Peru opted out and Bolivia received preferential treatment. The Andean Community now operates as a customs union. In December 2003, it signed an agree- ment with Mercosur to restart stalled negotiations on the creation of a free trade area between the two trading blocs. Those negotiations are currently proceeding at a slow pace. In late 2006, Venezuela withdrew from the Andean Community as part of that country’s attempts to join Mercosur.
MERCOSUR Mercosur originated in 1988 as a free trade pact between Brazil and Argentina. The modest reductions in tariffs and quotas accompanying this pact reportedly helped bring about an 80 percent increase in trade between the two countries in the late 1980s. 26 This success encouraged the expansion of the pact in March 1990 to include Paraguay and Uruguay. In 2006, Venezuela signed a member- ship agreement, although this has yet to be ratified and it may take years for Venezuela to become a full member. The initial aim of Mercosur was to establish a full free trade area by the end of 1994 and a common market sometime thereafter. In December 1995, Mercosur’s members agreed to a five-year program under which they hoped to perfect their free trade area and move toward a full customs union—something that has yet to be achieved. 27 For its first eight years or so, Mercosur seemed to be making a positive contribution to the economic growth rates of its member states. Trade between Mercosur’s four core members quadrupled between 1990 and 1998. The combined GDP of the four member states grew at an annual average rate of 3.5 percent between 1990 and 1996, a performance that is significantly better than the four attained during the 1980s. 28 However, Mercosur had its critics, including Alexander Yeats, a senior economist at the World Bank, who wrote a stinging critique of the pact. 29 According to Yeats, the trade diversion effects of Mercosur outweigh its trade creation effects. Yeats pointed out that the fastest-growing items in intra-Mercosur trade were cars, buses, agricultural equipment, and other capital-intensive goods that are produced rela- tively inefficiently in the four member countries. In other words, Mercosur coun- tries, insulated from outside competition by tariffs that run as high as 70 percent of value on motor vehicles, are investing in factories that build products that are too expensive to sell to anyone but themselves. The result, according to Yeats, is that Mercosur countries might not be able to compete globally once the group’s exter- nal trade barriers come down. In the meantime, capital is being drawn away from more efficient enterprises. In the near term, countries with more efficient manufac- turing enterprises lose because Mercosur’s external trade barriers keep them out of the market. Mercosur hit a significant roadblock in 1998, when its member states slipped into recession and intrabloc trade slumped. Trade fell further in 1999 following a financial crisis in Brazil that led to the devaluation of the Brazilian real, which immediately made the goods of other Mercosur members 40 percent more expensive in Brazil, their largest export market. At this point, progress toward establishing a full customs union all but stopped. Things deteriorated further in 2001 when Argentina, beset by economic stresses, suggested the customs union be temporarily suspended. Argentina wanted to suspend Mercosur’s tariff so that it could abolish duties on imports of capi- tal equipment, while raising those on consumer goods to 35 percent (Mercosur had established a 14 percent import tariff on both sets of goods). Brazil agreed to this re- quest, effectively halting Mercosur’s quest to become a fully functioning customs union. 30 Hope for a revival arose in 2003 when new Brazilian President Lula da Silva announced his support for a revitalized and expanded Mercosur modeled after the
Mercosur Pact between Argentina,
Brazil, Paraguay, and Uruguay to establish a
free trade area.
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Chapter Eight Regional Economic Integration 299
EU with a larger membership, a common currency, and a democratically elected par- liament. 31 As of 2010, however, little progress had been made in moving Mercosur down that road, and critics felt that the customs union was, if anything, becoming more imperfect over time. 32
CENTRAL AMERICAN COMMON MARKET, CAFTA, AND CARICOM Two other trade pacts in the Americas have not made much progress. In the early 1960s, Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua attempted to set up a Central American Common Market. It collapsed in 1969 when war broke out between Honduras and El Salvador after a riot at a soccer match between teams from the two countries. Since then the six member countries have made some progress toward reviving their agreement (the five founding members were joined by the Dominican Republic). The proposed common market was given a boost in 2003 when the United States signaled its intention to enter into bilateral free trade negotiations with the group. These cumulated in a 2005 agreement to establish a free trade agreement between the six countries and the United States. Known as the Central America Free Trade Agreement, or CAFTA, the aim is to lower trade barriers between the United States and the six countries for most goods and services. A customs union was to have been created in 1991 between the English-speaking Caribbean countries under the auspices of the Caribbean Community. Referred to as CARICOM, it was established in 1973. However, it repeatedly failed to progress toward economic integration. A formal commitment to economic and monetary union was adopted by CARICOM’s member states in 1984, but since then little progress has been made. In October 1991, the CARICOM governments failed, for the third consecutive time, to meet a deadline for establishing a common external tariff. Despite this, CARICOM expanded to 15 members by 2005. In early 2006, six CARICOM members established the Caribbean Single Market and Economy (CSME). Modeled on the EU’s single market, the goal of CSME is to lower trade barriers and harmonize macroeconomic and monetary policy between member states. 33
FREE TRADE AREA OF THE AMERICAS At a hemisphere-wide Summit of the Americas in December 1994, a Free Trade Area of the Americas (FTAA) was proposed. It took more than three years for the talks to start, but in April 1998, 34 heads of state traveled to Santiago, Chile, for the second Summit of the Americas where they formally inaugurated talks to establish an FTAA by January 1, 2005— something that didn’t occur. The continuing talks have addressed a wide range of economic, political, and environmental issues related to cross-border trade and in- vestment. Although both the United States and Brazil were early advocates of the FTAA, support from both countries seems to be mixed at this point. Because the United States and Brazil have the largest economies in North and South America, respectively, strong U.S. and Brazilian support is a precondition for establishment of the free trade area. The major stumbling blocks so far have been twofold. First, the United States wants its southern neighbors to agree to tougher enforcement of intellectual property rights and lower manufacturing tariffs, which they do not seem to be eager to em- brace. Second, Brazil and Argentina want the United States to reduce its subsidies to U.S. agricultural producers and scrap tariffs on agricultural imports, which the U.S. government does not seem inclined to do. For progress to be made, most observers agree that the United States and Brazil have to first reach an agreement on these cru- cial issues. 34 If the FTAA is eventually established, it will have major implications for
Central American Common Market A trade pact between Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua, which began in the early 1960s but collapsed in1969 due to war.
Central America Free Trade Agreement (CAFTA) The agreement of the member states of the Central American Common Market joined by the Dominican Republic to trade freely with the United States.
CARICOM An association of English-speaking Caribbean states that are attempting to establish a customs union.
Caribbean Single Market and Economy (CSME) Unites six CARICOM members in agreeing to lower trade barriers and harmonize macroeconomic and monetary policies.
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300 Part Three Cross-Border Trade and Investment
cross-border trade and investment flows within the hemisphere. The FTAA would open a free trade umbrella over 850 million people who accounted for some $18 tril- lion in GDP in 2008. Currently, however, FTAA is very much a work in progress, and the progress has been slow. The most recent attempt to get talks going again, in November 2005 at a summit of 34 heads of state from North and South America, failed when oppo- nents, led by Venezuela’s populist president, Hugo Chavez, blocked efforts by the Bush administration to set an agenda for further talks on FTAA. In voicing his opposition, Chavez condemned the U.S. free trade model as a “perversion” that would unduly benefit the United States, to the detriment of poor people in Latin America whom Chavez claims have not benefited from free trade details. 35 Such views make it unlikely that there will be much progress on establishing a FTAA in the near term.
Regional Economic Integration Elsewhere Numerous attempts at regional economic integration have been tried throughout Asia and Africa. However, few exist in anything other than name. Perhaps the most signifi- cant is the Association of Southeast Asian Nations (ASEAN). In addition, the Asia- Pacific Economic Cooperation (APEC) forum has recently emerged as the seed of a potential free trade region.
ASSOCIATION OF SOUTHEAST ASIAN NATIONS Formed in 1967, the Association of Southeast Asian Nations (ASEAN) includes Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam. Laos, Myanmar, Vietnam, and Cambodia have all joined recently, creating a regional grouping of 500 million people with a combined GDP of some $740 billion (see Map 8.3). The basic objective of ASEAN is to foster freer trade between member countries and to achieve cooperation in their industrial policies. Progress so far has been limited, however. Until recently only 5 percent of intra-ASEAN trade consisted of goods whose tariffs had been reduced through an ASEAN preferential trade arrangement. This may be changing. In 2003, an ASEAN Free Trade Area (AFTA) between the six original members of ASEAN came into full effect. The AFTA has cut tariffs on manufacturing and agricultural products to less than 5 percent. However, there are some significant exceptions to this tariff reduction. Malaysia, for example, refused to bring down tariffs on imported cars until 2005 and then agreed to only lower the tariff to 20 percent, not the 5 percent called for under the AFTA. Malaysia wanted to protect Proton, an inefficient local carmaker, from foreign competition. Simi- larly, the Philippines has refused to lower tariff rates on petrochemicals, and rice, the largest agricultural product in the region, will remain subject to higher tariff rates until at least 2020. 36 Notwithstanding such issues, ASEAN and AFTA are at least progressing toward establishing a free trade zone. Vietnam joined the AFTA in 2006, Laos and Myanmar in 2008, and Cambodia in 2010. The goal was to reduce import tariffs among the six original members to zero by 2010, and to do so by 2015 for the newer members (al- though important exceptions to that goal, such as tariffs on rice, will persist). ASEAN also recently signed a free trade agreement with China. This went into ef- fect January 1, 2010. Trade between China and ASEAN members more than tripled during the first decade of the 21st century, and this agreement should spur further growth. The agreement between ASEAN and China removes tariffs on 90 percent of traded goods. 37
LEARNING OBJECTIVE 4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.
Association of Southeast Asian
Nations (ASEAN) An attempt to establish a free trade area between
Brunei, Cambodia, Indonesia, Laos,
Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam.
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Chapter Eight Regional Economic Integration 301
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302 Part Three Cross-Border Trade and Investment
ASIA-PACIFIC ECONOMIC COOPERATION Asia-Pacific Economic Cooperation (APEC) was founded in 1990 at the suggestion of Australia. APEC cur- rently has 21 member states including such economic powerhouses as the United States, Japan, and China (see Map 8.4). Collectively, the member states account for about 55 per- cent of the world’s GNP, 49 percent of world trade, and much of the growth in the world economy. The stated aim of APEC is to increase multilateral cooperation in view of the economic rise of the Pacific nations and the growing interdependence within the region. U.S. support for APEC was also based on the belief that it might prove a viable strategy for heading off any moves to create Asian groupings from which it would be excluded. Interest in APEC was heightened considerably in November 1993 when the heads of APEC member states met for the first time at a two-day conference in Seattle. Debate before the meeting speculated on the likely future role of APEC. One view was that APEC should commit itself to the ultimate formation of a free trade area. Such a move would transform the Pacific Rim from a geographical expression into the world’s largest free trade area. Another view was that APEC would produce no more than hot air and lots of photo opportunities for the leaders involved. As it turned out, the APEC meeting produced little more than some vague commitments from member states to work together for greater economic integration and a general lowering of trade barriers.
Asia-Pacific Economic
Cooperation (APEC)
Made up of 21 member states whose goal is to
increase multilateral cooperation in view of
the economic rise of the Pacific nations.
Russia
United States
Canada
Mexico
Peru
Chile
China
Thailand Vietnam
Malaysia Papua
New Guinea
Brunei
Singapore
Philippines
Chinese Taipei Hong Kong, China
I n d o n e s i a
Japan Korea
Australia
New Zealand
New Caledonia
Member
Nonmembers
APEC Members
map 8.4
APEC Members
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Chapter Eight Regional Economic Integration 303
However, significantly, member states did not rule out the possibility of closer economic cooperation in the future. 38 The heads of state have met again on a number of occasions. At a 1997 meeting, member states formally endorsed proposals designed to remove trade barriers in 15 sectors, ranging from fish to toys. However, the vague plan committed APEC to doing no more than holding further talks, which is all that they have done to date. Commenting on the vagueness of APEC pronouncements, the influential Brookings Institution, a U.S.-based economic policy institution, noted that APEC “is in grave danger of shrinking into irrelevance as a serious forum.” Despite the slow progress, APEC is worth watching. If it eventually does transform itself into a free trade area, it will probably be the world’s largest. 39
REGIONAL TRADE BLOCS IN AFRICA African countries have been ex- perimenting with regional trade blocs for half a century. There are now nine trade blocs on the African continent. Many countries are members of more than one group. Although the number of trade groups is impressive, progress toward the establishment of meaningful trade blocs has been slow. Many of these groups have been dormant for years. Significant political turmoil in sev- eral African nations has persistently impeded any meaningful progress. Also, deep suspi- cion of free trade exists in several African countries. The argument most frequently heard is that because these countries have less developed and less diversified economies, they need to be “protected” by tariff barriers from unfair foreign competition. Given the preva- lence of this argument, it has been hard to establish free trade areas or customs unions. The most recent attempt to reenergize the free trade movement in Africa occurred in early 2001, when Kenya, Uganda, and Tanzania, member states of the East African Community (EAC), committed themselves to relaunching their bloc, 24 years after it collapsed. The three countries, with 80 million inhabitants, intend to establish a cus- toms union, regional court, legislative assembly, and, eventually, a political federation. Their program includes cooperation on immigration, road and telecommunication networks, investment, and capital markets. However, while local business leaders wel- comed the relaunch as a positive step, they were critical of the EAC’s failure in practice to make progress on free trade. At the EAC treaty signing in November 1999, mem- bers gave themselves four years to negotiate a customs union, with a draft slated for the end of 2001. But that fell far short of earlier plans for an immediate free trade zone, shelved after Tanzania and Uganda, fearful of Kenyan competition, expressed concerns that the zone could create imbalances similar to those that contributed to the breakup of the first community. 40 Nevertheless, in 2005 the EAC did start to imple- ment a customs union, although many tariffs remained in place until 2010. In 2007, Burundi and Rwanda joined the EAC.
Focus on Managerial Implications
Currently the most significant developments in regional economic integration are occurring in the European Union and NAFTA. Although some of the Latin American trade blocs, ASEAN, and the proposed FTAA may have economic significance in the future, the EU and NAFTA currently have more profound and immediate implications
LEARNING OBJECTIVE 5 Understand the implications
for business that are inherent in regional economic
integration agreements.
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for business practice. Accordingly, in this section we will concentrate on the business implications of those two groups. Similar conclusions, however, could be drawn with regard to the creation of a single market anywhere in the world.
Opportunities The creation of a single market through regional economic integration offers signifi- cant opportunities because markets that were formerly protected from foreign compe- tition are increasingly open. For example, in Europe before 1992 the large French and Italian markets were among the most protected. These markets are now much more open to foreign competition in the form of both exports and direct investment. None- theless, to fully exploit such opportunities, it may pay non-EU firms to set up EU subsidiaries. Many major U.S. firms have long had subsidiaries in Europe. Those that do not would be advised to consider establishing them now, lest they run the risk of being shut out of the EU by nontariff barriers. Additional opportunities arise from the inherent lower costs of doing business in a single market—as opposed to 27 national markets in the case of the EU or 3 national markets in the case of NAFTA. Free movement of goods across borders, harmonized product standards, and simplified tax regimes make it possible for firms based in the EU and the NAFTA countries to realize potentially significant cost economies by centralizing production in those EU and NAFTA locations where the mix of factor costs and skills is optimal. Rather than producing a product in each of the 27 EU countries or the 3 NAFTA countries, a firm may be able to serve the whole EU or North American market from a single location. This location must be chosen care- fully, of course, with an eye on local factor costs and skills. For example, in response to the changes created by EU after 1992, the St. Paul, Minnesota-based 3M Company consolidated its European manufacturing and distribu- tion facilities to take advantage of economies of scale. Thus, a plant in Great Britain now produces 3M’s printing products and a German factory its reflective traffic control mate- rials for all of the EU. In each case, 3M chose a location for centralized production after carefully considering the likely production costs in alternative locations within the EU. The ultimate goal of 3M is to dispense with all national distinctions, directing R&D, manufacturing, distribution, and marketing for each product group from an EU head- quarters. 41 Similarly, Unilever, one of Europe’s largest companies, began rationalizing its production in advance of 1992 to attain scale economies. Unilever concentrated its pro- duction of dishwashing powder for the EU in one plant, bath soap in another, and so on. 42 Even after the removal of barriers to trade and investment, enduring differences in culture and competitive practices often limit the ability of companies to realize cost economies by centralizing production in key locations and producing a stan- dardized product for a single multi-country market. Consider the case of Atag Hold- ings NV, a Dutch maker of kitchen appliances. 43 Atag thought it was well placed to benefit from the single market, but found it tough going. Atag’s plant is just one mile from the German border and near the center of the EU’s population. The company thought it could cater to both the “potato” and “spaghetti” belts—marketers’ terms for consumers in Northern and Southern Europe—by producing two main product lines and selling these standardized “euro-products” to “euro-consumers.” The main benefit of doing so is the economy of scale derived from mass production of a stan- dardized range of products. Atag quickly discovered that the “euro-consumer” was a myth. Consumer preferences vary much more across nations than Atag had thought. Consider ceramic cooktops; Atag planned to market just 2 varieties throughout the EU but has found it needs 11. Belgians, who cook in huge pots, require extra-large burners. Germans like oval pots and burners to fit. The French need small burners and very low temperatures for simmering sauces and broths. Germans like oven
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knobs on the top; the French want them on the front. Most Germans and French prefer black and white ranges; the British demand a range of colors including peach, pigeon blue, and mint green.
Threats Just as the emergence of single markets creates opportunities for business, it also pres- ents a number of threats. For one thing, the business environment within each group- ing will become more competitive. The lowering of barriers to trade and investment between countries is likely to lead to increased price competition throughout the EU and NAFTA. For example, before 1992 a Volkswagen Golf cost 55 percent more in Great Britain than in Denmark and 29 percent more in Ireland than in Greece. 44 Over time, such price differentials will vanish in a single market. This is a direct threat to any firm doing business in EU or NAFTA countries. To survive in the tougher single- market environment, firms must take advantage of the opportunities offered by the creation of a single market to rationalize their production and reduce their costs. Oth- erwise, they will be at a severe disadvantage. A further threat to firms outside these trading blocs arises from the likely long-term improvement in the competitive position of many firms within the areas. This is particu- larly relevant in the EU, where many firms have historically been limited by a high cost structure in their ability to compete globally with North American and Asian firms. The creation of a single market and the resulting increased competition in the EU is begin- ning to produce serious attempts by many EU firms to reduce their cost structure by ra- tionalizing production. This is transforming many EU companies into efficient global competitors. The message for non-EU businesses is that they need to prepare for the emergence of more capable European competitors by reducing their own cost structures. Another threat to firms outside of trading areas is the threat of being shut out of the single market by the creation of a “trade fortress.” The charge that regional economic integration might lead to a fortress mentality is most often leveled at the EU. Although the free trade philosophy underpinning the EU theoretically argues against the cre- ation of any fortress in Europe, occasional signs indicate the EU may raise barriers to imports and investment in certain “politically sensitive” areas, such as autos. Non-EU firms might be well advised, therefore, to set up their own EU operations. This could also occur in the NAFTA countries, but it seems less likely. Finally, the emerging role of the European Commission in competition policy sug- gests the EU is increasingly willing and able to intervene and impose conditions on com- panies proposing mergers and acquisitions. This is a threat insofar as it limits the ability of firms to pursue the corporate strategy of their choice. The commission may require significant concessions from businesses as a precondition for allowing proposed mergers and acquisitions to proceed. While this constrains the strategic options for firms, it should be remembered that in taking such action, the commission is trying to maintain the level of competition in Europe’s single market, which should benefit consumers.
regional economic integration, p. 277 free trade area, p. 278 European Free Trade Association (EFTA), p. 279
customs union, p. 279 common market, p. 279 economic union, p. 279
political union, p. 280 trade creation, p. 282 trade diversion, p. 282
Key Terms
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European Union, p. 282 Treaty of Rome, p. 283 European Commission, p. 283 European Council, p. 285 European Parliament, p. 286 Treaty of Lisbon, p. 286 Court of Justice, p. 286 Single European Act, p. 286 Maastricht Treaty, p. 289
optimal currency area, p. 290 North American Free Trade Agreement, p. 294 Andean Pact, p. 297 Mercosur, p. 298 Central American Common Market, p. 299 Central America Free Trade Agreement (CAFTA), p. 299
CARICOM, p. 299 Caribbean Single Market and Economy (CSME), p. 299 Association of Southeast Asian Nations (ASEAN), p. 300 Asia-Pacific Economic Cooperation (APEC), p. 302
Summary
This chapter pursued three main objectives: to ex- amine the economic and political debate surround- ing regional economic integration; to review the progress toward regional economic integration in Europe, the Americas, and elsewhere; and to distin- guish the important implications of regional eco- nomic integration for the practice of international business. The chapter made the following points:
1. A number of levels of economic integration are possible in theory. In order of increasing integration, they include a free trade area, a customs union, a common market, an economic union, and full political union.
2. In a free trade area, barriers to trade between member countries are removed, but each country determines its own external trade policy. In a customs union, internal barriers to trade are removed and a common external trade policy is adopted. A common market is similar to a customs union, except that a common market also allows factors of production to move freely between countries. An economic union involves even closer integration, including the establishment of a common currency and the harmonization of tax rates. A political union is the logical culmination of attempts to achieve ever closer economic integration.
3. Regional economic integration is an attempt to achieve economic gains from the free flow of trade and investment between neighboring countries.
4. Integration is not easily achieved or sustained. Although integration brings benefits to the
majority, it is never without costs for the minority. Concerns over national sovereignty often slow or stop integration attempts.
5. Regional integration will not increase economic welfare if the trade creation effects in the free trade area are outweighed by the trade diversion effects.
6. The Single European Act sought to create a true single market by abolishing administrative barriers to the free flow of trade and investment between EU countries.
7. Sixteen EU members now use a common currency, the euro. The economic gains from a common currency come from reduced exchange costs, reduced risk associated with currency fluctuations, and increased price competition within the EU.
8. Increasingly, the European Commission is taking an activist stance with regard to competition policy, intervening to restrict mergers and acquisitions that it believes will reduce competition in the EU.
9. Although no other attempt at regional economic integration comes close to the EU in terms of potential economic and political significance, various other attempts are being made in the world. The most notable include NAFTA in North America, the Andean Pact and Mercosur in Latin America, ASEAN in Southeast Asia, and perhaps APEC.
10. The creation of single markets in the EU and North America means that many markets that were formerly protected from foreign competition are now more open. This creates
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Chapter Eight Regional Economic Integration 307
major investment and export opportunities for firms within and outside these regions.
11. The free movement of goods across borders, the harmonization of product standards, and the simplification of tax regimes make it possible for firms based in a free trade area to realize potentially enormous cost economies by centralizing production in those locations
within the area where the mix of factor costs and skills is optimal.
12. The lowering of barriers to trade and investment between countries within a trade group will probably be followed by increased price competition.
Critical Thinking and Discussion Questions
1. NAFTA has produced significant net benefits for the Canadian, Mexican, and U.S. economies. Discuss.
2. What are the economic and political arguments for regional economic integration? Given these arguments, why don’t we see more substantial examples of integration in the world economy?
3. What effect is creation of a single market and a single currency within the EU likely to have on competition within the EU? Why?
4. Do you think it is correct for the European Commission to restrict mergers between American companies that do business in Europe? (For example, the European Commission vetoed the proposed merger between WorldCom and Sprint, both U.S. companies, and it carefully reviewed the merger between AOL and Time Warner, again both U.S. companies.)
5. How should a U.S. firm that currently exports only to ASEAN countries respond to the creation of a single market in this regional grouping?
6. How should a firm with self-sufficient production facilities in several ASEAN countries respond to the creation of a single market? What are the constraints on its ability to respond in a manner that minimizes production costs?
7. After a promising start, Mercosur, the major Latin American trade agreement, has faltered and made little progress since 2000. What problems are hurting Mercosur? What can be done to solve these problems?
8. Would establishment of a Free Trade Area of the Americas (FTAA) be good for the two most advanced economies in the hemisphere, the United States and Canada? How might the establishment of the FTAA impact the strategy of North American firms?
9. Reread the Management Focus “The European Commission and Media Industry Mergers,” then answer the following questions:
a. Given that both AOL and Time Warner were U.S.-based companies, do you think the European Commission had a right to review and regulate their planned merger?
b. Were the concessions extracted by the European Commission from AOL and Time Warner reasonable? Whose interests was the commission trying to protect?
c. What precedent do the actions of the European Commission in this case set? What are the implications for managers of foreign enterprises with substantial operations in Europe?
Use the globalEDGE Resource Desk (http://global EDGE.msu.edu/resourcedesk/) to complete the following exercises:
1. The enlargement of the European Union into Eastern Europe has brought together countries
with different levels of economic development. Choose two long-term EU member countries and two newer members. Compare and contrast the macroeconomic situation in these countries by analyzing each country’s primary economic
Research Task http://globalEDGE.msu.edu
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308 Part Three Cross-Border Trade and Investment
The European Energy Market
For several years now the European Union, the largest re- gional trading bloc in the world, has been trying to liberalize its energy market, replacing the markets of its 27 member states with a single continent-wide market for electricity and gas. The first phase of liberalization went into effect in June 2007. When fully implemented, the ability of energy producers to sell electricity and gas across national borders will in- crease competition. The road toward the creation of a single EU energy market, however, has been anything but easy. Many national markets are dominated by a single enterprise, often a former state-owned utility. Electricitie de France, for example, has an 87 percent share of that country’s electricity market. Injecting competition into such concentrated markets will prove difficult. To complicate matters, most of these utilities are vertically integrated, producing, transmitting, and selling power. These vertically integrated producers have little interest in letting other utilities use their transmission grids to sell power to end users, or in buying power from other producers. For the full benefits of competition to take hold, the EU recognizes that utilities need to be split into generation, transmission, and marketing companies so that the business of selling energy can be separated from the businesses of producing it and transmitting it. Only then, so the thinking goes, will indepen- dent power marketing companies be able to buy energy from the cheapest source, whether it is within national borders or elsewhere in the EU, and resell it to consumers, thereby pro- moting competition. For now, efforts to mandate the de-integration of utilities are some way off. Indeed, in February 2007 national energy ministers from the different EU states rejected a call from the European Commission, the top competition body in the EU, to break apart utilities. Instead the energy ministers asked the commission for more details about what such a move would
accomplish, thereby effectively delaying any attempt to de- integrate national power companies. In mid-2008, they reached a compromise that fell short of mandating the unbundling, or de-integration, of national energy companies due to powerful opposition from France and Germany among others (both nations have large vertically integrated energy companies). The response of established utilities to the creation of a single continent-wide market for energy has been to try to acquire utilities in other EU nations in an effort to build sys- tems that serve more than one country. The underlying logic is that larger utilities should be able to realize economies of scale, and this would enable them to compete more effec- tively in a liberalized market. However, some cross-border takeover bids have run into fierce opposition from local politi- cians who resent their “national energy companies” being taken over by foreign entities. Most notably, when E.ON, the largest German utility, made a bid to acquire Endesa, Spain’s largest utility, in 2006, Spanish politicians sought to block the acquisition and keep ownership of Endesa in Spanish hands, imposing conditions on the deal that were designed to stop the Germans from acquiring the Spanish company. In re- sponse to this outburst of nationalism, the European Commis- sion took the Spanish government to the European Union’s highest court, arguing that Madrid had violated the commis- sion’s exclusive powers within the EU to scrutinize and ap- prove big cross-border mergers in Europe. Subsequently, Enel, Italy’s biggest power company, stepped in and pur- chased Endesa.
Sources: “Power Struggles: European Utilities,” The Economist , December 2, 2006, p. 74; “Anger Management in Brussels,” Petroleum Economist , April 2006, pp. 1–3; R. Bream, ”Liberalization of EU Market Accelerates Deal-making,” Financial Times , February 28, 2007, p. 4; “Twists and Turns: Energy Liberalization in Europe,” The Economist , December 8, 2007, p. 76; and “Better than Nothing?” The Economist , June 14, 2008, p. 80.
closing case
indicators available from the most recent version of Eurostatistics Data for Short-Term Economic Analysis, a statistical book published periodically by Eurostat. Prepare a short report describing the similarities and differences between the two groups of countries.
2. The establishment of the Free Trade Area of the Americas could be a threat as well as an
opportunity for your company. Identify the countries participating in the negotiations for the FTAA. Are there any countries in the Americas not participating in the negotiations? What are the main issues covered in the negotiation process?
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Case Discussion Questions 1. What do you think are the economic benefits of
liberalizing the EU energy market? Who stands to gain the most from liberalization?
2. What are the implications of liberalization for energy producers in the EU? How will the environment they face change post-liberalization. What actions will they have to take?
3. Why is the de-integration of large energy companies seen as such an important part of any attempt to liberalize the EU energy market?
4. Why do you think progress toward the liberalization of the EU energy market has been fairly slow so far?
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