SESS0026 Political Economy of European integration

Introduction

In 1985, the European Commission (EC) published a White Paper on Completing the Internal Market where they proposed 282 specific measures to implement the Single Market Program  (SMP) (Mayes et al., 1994). Badinger (2007) argues that these measures had strong effects on European Union (EU) manufacturing industries, reducing their markups from 38 to 28% and increasing their productivity. The paper presents EU membership’s effects on growth, trade, and competitive dynamics in the domestic economy. Then, it investigates the effects of EC’s White Paper on Italy and the UK manufacturing sector and concludes that the empirical evidence validates the BE-COMP model, regardless of whether the increase in competition was anticipated or not.

Theoretical framework

EU membership is argued to lead to an increase of imports and exports at a lower price through the reciprocal removal of non-discriminatory and frictional barriers, a medium-run, but not long-run, increase of growth due to a better allocation of resources and, finally, a higher consumption at a lower price, mark-ups, and sales per firm due to an increase in competition and market size.

With regards to trade, Home country’ participation to the Single Market (SM) includes the  reciprocal removal of non-discriminatory and frictional barriers. The removal of the former either increases or decreases Home’s welfare by decreasing goods’ home prices, increasing total and Partners’ imports and decreasing those from the rest of the world (RoW). By assuming neither imperfect competition nor imperfect returns, when Home enters the SM, they will reciprocally remove the non-discriminatory tariff with their Partners, while keeping it on the RoW. As the border fixed price of the good has increased for the Partners, the duty- free access boosts the total exports supplied by the Partners in Home (Smith’s certitude) and, therefore, by shifting down the supply curve, sets a new equilibrium at a lower price and higher quantity. RoW, who now perceives a decrease in the competition price of the good,  decreases their exports (Harberler’s spillover). The new equilibrium leads to an ambiguous welfare effect since it is not possible to assess a priori whether the “trade creation” of liberalisation offsets or not the “trade diversion” caused by discrimination (Viner’s ambiguity). As opposed to non-discriminatory tariffs, the removal of frictional barriers is argued to have the same price-quantity effects but to increase welfare as lower prices do not affect government’srevenue.

Moreover, EU membership increases Home’s medium-run growth through a positive  allocation effect and investment inflow, but does not affect the long-run one. First, by assuming a constant fraction of capital stock depreciation and investment rate, European integration leads to a ‘induced capital formation’ as, by making the European resources more efficiently allocated, it raises output and, thus, investment. This increase in investment, also known as allocation effect, results in a higher equilibrium capital stock and, consequently, higher output and income per worker. However, although growth of output increases, its  effect is temporary due to the diminishing returns of physical labour being outstripped by capital depreciation (Solow model). Second, European integration may also raise the investment rate by making investment safer and, therefore, increase capital stock, output per worker and medium-run growth. Third, due to constant marginal returns of knowledge capital, joining the SM may lead to technological progress and, therefore, increase long-run growth as the inflow of new investment would not be outstripped by capital depreciation (Romer’s model). However, the current literature still provides limited evidence to support the latter claim.

Finally, due to an increase in market size and competition, participating to the SM leads to a new long-run equilibrium at a lower price and mark-up and higher output and sales per firm (BE-COMP model). By assuming economies of scale (downward-sloping average cost, flat  and sales-independent marginal cost and zero profits in the long-run), EU membership enlarges Home’s market and, by increasing competition, leads to a lower price and mark-up. However, as too many firms are now present in the market, some fail due to negative profits  whereas others survive as they become more efficient. Assuming the Union avoids perfect or partial collusions, state aids or mergers, this industrial restructuring lasts until the exact number of firms who can break-even remains in the market and, therefore, price, quantity and mark-ups converge to the new long-term equilibrium where profits equal 0.

Italy and the UK

By analysing 745 Italian manufacturing companies between 1982 and 1993, Bottasso et al. (2001) investigate whether firms’ productivity and mark-ups were affected by the SMP implementation (1988-1993). As Figure 1 shows, the empirical evidence validates the BE- COMP model. First, between the announcement of the White Paper (1985) and the SMP implementation (1988), firms’ productivity grew from 0.005 to 0.015 as firms anticipated

White Paper’s effect on increased competition, thus shifting the BE curve downwards. Total sales and consumption consequently increased by 20% between 1985 and 1990 and moved the economy from A to B (Pilat etal., 2006). Second, during the SMP implementation (1988- 1992), firms’ mark-ups were reduced by 11%, decreasing from a 17.7-23.4% interval to a 7.1-12% one. As shown by a shift from B to C, in light of an increase in total sales and, thus, competition, firms had to charge a lower price and therefore reduced their mark-ups. Lastly,  despite of the lack of clear data (i.e. number of manufacturing firms between 1985-1995), a 3% decrease of the share of the Italian manufacturing sector in total employment was registered after 1992 (Pilat etal., 2006). Assuming a decrease of share of manufacturing in total employment suggests a reduction of manufacturing firms, the economy therefore moved to the new long-run equilibrium D through an industrial restructuring as some firms became   more efficient whether others failed due to negative profits.

Figure 1: White Paper’s anticipated effect in Italy

Griffith (2001) presents a similar analysis for the UK manufacturing sector during 1980-1996 and reaches similar conclusions. Indeed, during the SMP implementation (1988-1992), labour productivity increased by almost 3%, mark-ups decreased from 18 to 9% whereas total sales and consumption went up by 10% (Pilat etal., 2006). As SMN’ effects on competition and market size were non-anticipated, the UK manufacturing economy therefore shifted from A to B to C after 1988 (Figure 2). Moreover, the share of manufacturing in total employment decreased by 5% between 1990 and 1992, suggesting an industrial restructuring and a shift of the economy to the new long-run equilibrium D (Ibid.). However, two main differences between the UK and Italian case can be highlighted. First, UK manufacturing firms did not anticipate White paper’s effects on competition and, therefore, they increased productivity and total sales only after SMP implementation (1987-1992). The non-anticipation effect may be explained by the strong UK Euroscepticism in the 1980s that made manufacturing firms unsure of whether they UK would have joined the SM or not (Startin, 2015). Second, productivity rates, markups and total sales seem to have changed simultaneously after 1988, suggesting less rigid stages in the BE-COMP analysis.

Figure 2: White Paper's non anticipated effect in UK

Conclusion

The paper presented EU membership’s effects on growth, trade, and competitive dynamics and concluded that EC White Paper’s effects on Italy and the UK validate the BE-COMP model, regardless of whether the increase in competition was anticipated or not. Two main limitations can be highlighted. First, the UK-Italy BE-COMP modelling is incomplete as the  number of foreign manufacturing firms entering the domestic market was not assessed due to lack of data. Second, the claim suggesting less rigid stages in the UK economy after SMP implementation cannot be conclusive due to Griffith’s binary division of time as prior- and post-SMP-implementation and, therefore, requires further research.

Bibliography

Badinger, H. (2007). Has the EU's single market programme fostered competition? Testing for a Decrease in Mark‐up Ratios in EU Industries. oxford Bulletin of Economics and statistics, 69(4), 497-519.

Bottasso, A., & Sembenelli, A. (2001). Market power, productivity and the EU Single Market Program: Evidence from a panel of Italian firms. European Economic Review, 45(1), 167-186.

Griffith, R. (2001). Product market competition, efficiency and agency costs: an empirical analysis (No. 01/12). IFS Working papers.

Mayes, D. and P. Hart (1994) The Single Market Programme as a Stimulus to change: comparisons between Britain and Germany, Cambridge University Press: Cambridge

Pilat, D., Cimper, A., Olsen, K. B., & Webb, C. (2006). The changing nature of manufacturing in OECD economies.

Startin, N. (2015). Have we reached a tipping point? The mainstreaming of Euroscepticism in the UK. International Political Science Review, 36(3), 311-323.

Q3

Introduction

The main argument of the paper is twofold. First, Ukraine is not currently able to enter the   Eurozone as they do not meet the monetary convergence criteria due to divergent medium-  term inflation targets and National Bank of Ukraine (NBU)’s non-complete independence.   Second, it would not be optimal for Ukraine to join the Eurozone prior to a more Eurozone- aligned restructure of their production and trade structures. I rely on 3 main assumptions.

First, I assume Russian invasion of Ukraine has not occurred and, therefore, economic judgments are made solely on the assessment of data and events prior to 2021. Second, I exclusively focus on Optimum Currency Area (OCA) criteria of labour mobility, production diversification and openness due to the economic nature of the piece and I do not consider their criticisms and more modern views. Third, when I report data on the EU, it must be assumed that relevant data on the Eurozone were not found.

Convergence Criteria

Based on the coronation theory, the Maastricht convergence criteria present 5 entry conditions to join the Eurozone which deal with monetary and fiscal discipline. The 3 monetary convergence criteria state that 1) the inflation rate should not exceed the average rate of the three lowest-inflation-rates EMU countries by more than 1.5%, 2) long-term interest rates should not exceed the average rate of the three lowest-inflation-rates EMU countries by more than 2% and that 3) applicants should have been members of the European Exchange Rate Mechanism (ERM) for at least two years. The 2 fiscal convergence criteria claim that 1) budget deficit should not exceed 3% of GDP and 2) public debt should not exceed 60% of GDP.

The paper argues that Ukraine does not currently meet the monetary convergence criteria but  does fulfil the fiscal ones. In 2021, Ukraine registered a 9.4% inflation, which is considerably higher than the 1.33% average of the three lowest-inflation-rates countries, Greece, Malta and Portugal (World Bank, 2022a). Even if one or more countries were to be excluded from the analysis due to specific factors that affect their inflation (European Commission, 2008), it is improbable, if not impossible, that Ukraine would meet criteria 1) as their inflation rate exceeds the 2.4% average Eurozone inflation rate by 7% (World Bank, 2022a). Moreover, due to high inflation and, therefore, low international credibility, Ukraine does not meet criteria 2) and 3) as their 2021 11.34% long-term nominal interest rates exceed by more than 2% the 0.75% long-term nominal interest rates of Greece, Malta and Portugal (European Central Bank (ECB), 2022) as well not being an EMS member for 2+ years. On the other hand, Ukraine meets the fiscal convergence criteria as, in 2021, their national debt represented 48.9 % of the GDP while their 1.6% budget deficit does not exceed 3% of the GDP (World Bank, 2022b; World Bank, 2022c).

The reason behind the monetary non-suitability of Ukraine is twofold. First, theNBU presents a 5% medium-term inflation target that differs from ECB’s 2% one and, therefore, leads to higher inflation (Girchenko et al., 2020). Second, theNBU still needs to achieve complete independence and, therefore, credibility due to political pressure and lack of  transparency, openness and delegation (Podtserkovnyi et al., 2020). On the other hand, Ukrainian fiscal suitability relies on Ukrainian national debt criteria that, according to Art. 18 of the Budget Code of Ukraine, state that the amount of debt should not exceed 60% of the GDP (Girchenko et al., 2020). Therefore, fiscal criteria are met due to symmetry between European and Ukrainian regulation, while monetary ones are not due toNBU’s monetary preferences and non-complete independence.

OCA Theory

I now investigate whether Ukraine would benefit from joining the Eurozone by assessing the impact of asymmetric shocks on the Ukrainian economy through 3 economic OCA criteria.

The first criteria states that, assuming that capital is mobile, an OCA requires high labour mobility between countries as it offsets asymmetric shocks’ effects by shifting productions factors. Due to their high and flexible labour mobility, Ukraine’s entry in the Eurozone is argued to mitigate both temporary and permanent asymmetric shocks in the Union. As the current proportion of Ukrainians who live in the EU (2.7%) is higher than the labour mobility of both the EU (0.6%) and US (1.5%) (Smit etal., 2020; Libanova, 2019), Ukraine’s entry would significantly increase the average European labour mobility and, therefore, incentivise the reallocation of production factors during asymmetric shocks. Moreover, due to highly flexible Ukrainian labour mobility, both permanent and temporary asymmetric shocks would be offset as around 65% of Ukrainian labour migrants express their intention to return home  in the long run while 23% planto live in the new country (Ibid.).

The second criteria argues that dissimilar and non-diversified production and trade commodity structures increase the asymmetry of a shock as countries are affected in divergent ways. Due to the lack of production structure and trade dissimilarity indexes between Ukraine and the Eurozone, a more qualitative and indirect approach is used. First, Ukraine presents anon-diversified production structure which is highly dissimilar to the Eurozone’s (Sozanskyy, 2018). The former strongly relies on the production of raw materials such as food, wood, paper and metallurgical production (Ibid.) while the latter, despite some   internal divergences, mostly focuses on capital goods such as machines, tools, and equipment (Botta, 2014). Second, the trade commodity structure of Ukraine, which mostly exports low    processed products such as iron (19.9%), cereals (18%) and minerals (10.7%) and imports mineral fuels (17.8%) and machinery (11.2%) (Malyarets etal., 2021), differs from the Eurozone’s one, which trades mostly manufactured goods. Moreover, as shown by Barseghyan et al. (2019), Ukraine presents stronger trade similarities with Eastern European countries, showing a trade dissimilarity index of 0.37 with Armenia, 0.33 with Georgia and   0.44 with Turkey, compared to EU countries such as Latvia (0.62) or Lithuania (0.63).

Therefore, although conclusive statements cannot be drawn due to the lack of direct comparative data, if Ukraine joined the Eurozone, asymmetric shocks are forecasted to be large and frequent due to their dissimilar and non-diversified production and trade structures.

Finally, the third criteria claims that a high share of economic activity devoted to international trade offsets the importance of an independent exchange rate as competition equalises foreign and domestic goods’ prices. In this regard, Ukraine and the Eurozone are argued to form an OCA. First, both countries present a strong trade openness, being the total Ukrainian and Eurozone 2021 trade respectively 83 and 90% of GDP (World Bank, 2022d).  Moreover, since the creation of the Deep and Comprehensive Free Trade Areas in 2016, the  EU has become Ukraine's largest trading partner, representing 39.5% of their trade, and Ukraine is among Eurozone’s main trading partners, accounting for 1.2% of the European trade (European Commission, 2022). Lastly, Ukraine has also aligned its legislation to the EU's in areas such as competition and technical barriers and, therefore, strongly limited its reliance on exchange rate depreciation since 2016 (Girchenko et al., 2020).

Conclusion

The paper argues that Ukraine cannot currently join the Eurozone as they do not meet the monetary criteria and should not prior to a more Eurozone-aligned production and trade commodity re-structure. Two main limitations are highlighted. First, the lack of direct data that compare Ukraine’s and Eurozone’s production and trade dissimilarities prevents the paper from drawing conclusive results on whether the trade diversification criteria is met. Second, the EU, rather than the Eurozone, statistics on labour mobility and trade with Ukraine may lead to non-accurate and slightly misleading conclusions.

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Botta, A. (2014). Structural asymmetries at the roots of the eurozone crisis: What's new for industrial policy in the EU?. PSL Quaterly Review, 67(269), 169-216.

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European Commission, (2014). Convergence Report 2014. Directorate-General for Economic and Financial Affairs. Available at:

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Girchenko, T. D., Serdiukova, O. I., & Gongalo, N. (2020). Macro-level comparison of the banking system in Ukraine and Poland. Zeszyty Naukowe Politechniki Poznańskiej. Organizacja i Zarządzanie.

Libanova, E. (2019). Labour migration from Ukraine: key features, drivers and impact. Economics and Sociology, 12(1), 313-328.

Malyarets, L. M., Otenko, V. I., Otenko, I. P., & Chepeliuk, M. (2021). Assessment the development of the commodity structure а country's exports and imports (case study of Ukraine). Montenegrin Journal of Economics, 17(4), 7-16.

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