For the past few months global attention,
especially in the international financial media, has been focussed on
the eurozone. The reasons are obvious. The group of countries that make
up the European Union together constitute the largest economy in the world.
Instability within it – which now seems inevitable, no matter how the
current problems of countries like Greece, Ireland, Portugal and possibly
Spain and Italy are dealt with – will have huge repercussions in the rest
of the world.
And of course the story of the economic union is itself a compelling one,
unique in the history of the past two centuries: how countries that had
been quite recently torn apart by war and strong economic nationalism
came together in progressively more intense ways, culminating in the common
currency of the eurozone. There is no question that this was always a
remarkable project, and the extent to which economic union proceeded apace
without political merger always seemed unbelievable to some observers.
Whether one sees the creation of the eurozone as a tribute to idealism
with respect to regional co-operation, or a reflection of the triumph
of political will over economic barriers, or simply as a desperate response
of a group of countries to the currency volatility created by mobile capital
flows, really does not matter. The point is that it has been a fascinating
experiment. For at least a decade, its apparent stability called into
question a belief that was axiomatically held by many economists: that
monetary union is difficult if not impossible without fiscal federalism
underpinned by more comprehensive political union.
In fact the European Union, and within it the eurozone, was the culmination
of the century-long drive in Europe towards greater integration, punctuated
by wars, other conflicts and instabilities, but proceeding regardless
of those hurdles. The initial driving force of such a union may well have
been political, but there were always explicit recognition of clear economic
benefits. These were argued to emerge mostly from the reduced transaction
costs of all cross-border economic activities, including trade in goods
and services. In addition, the stability provided by a single currency
served to reduce risk in a world of very volatile currency movements driven
by mobile capital flows. This was seen to be an additional inducement
to invest in productive activities, especially in ''peripheral'' European
countries that would not otherwise have access to international capital
on such favourable terms. This is why, despite the recent difficulties
of several economies in the eurozone, the list of countries lining up
to join it is still long and shows no sign of dwindling.
But there are also significant costs of such union, which are becoming
especially evident now. The most obvious is the loss of two major macroeconomic
policy instruments: the exchange rate and monetary policy, which can otherwise
be used to prevent an economy from falling into a slump. In addition,
the ''Stability and Growth Pact'' that emerged as part of the Maastricht
Treaty that laid down the conditions for common currency also specified
strict fiscal limits that effectively also tied up fiscal policy. Of course
these have been observed more in the breach, especially by the larger
European economies, but they did operate to constrain fiscal policy to
a significant extent as well.
These in turn affect the ability to respond to imbalances. For example,
Greece could have tried to use a combination of exchange rate devaluation
and lower interest rates to stimulate demand, increase income and reduce
unemployment, as well as prevent the external deficit from deteriorating.
Of course this is not foolproof, as many countries know, but trying to
adjust without such instruments is that much harder. Instead, Greece,
Ireland, Spain and other similar economies are being forced into an even
more painful ''internal devaluation'' by forcing prices to come down through
a terrible mixture of fiscal austerity, unemployment and deflation, which
in fact makes the debt burden worse.
All these have been widely commented upon in the context of the current
crisis, and the inherent rigidities of an economic regime that does not
allow currency devaluation as a response to widely varying prices and
external imbalances have generally been seen as the basic factors behind
the current crisis. But strangely, hardly any commentaries on the matter
get into the more basic question: how could such imbalances be created
and persist in the first place?
This is probably the more important question, because it points to a disturbing
conclusion: that the entire process of European economic integration actually
created much less actual integration than was expected. In fact, the Single
Market that was launched in 1994 was intended to do away with all trade
barriers as well as all restrictions on capital and labour flows. The
purpose was to create a single unified market, in which prices would be
equalised across member countries.
These prices that were to be equalised were of both goods and services,
and of labour, since workers could also freely move between countries.
But even till date labour does not really move freely across European
borders despite the removal of official restrictions. Of course it is
well known that labour mobility is not that simple, especially where there
are different languages and cultures. In fact it is rare to find wage
equalisation across regions even within national boundaries, as we know
well in India. Similarly, because many services like personal services
are still not so easily traded, their prices need not get equalised either.
But there is no such constraint when it comes to a single market for goods.
The typical expectation whenever trade barriers are reduced or removed
is that trade arbitrage will ensure uniform prices, or in other words,
countries will keep exporting or importing goods until their prices are
equalised. This also forms the basis of all trade theory, with all the
policy conclusions that are then drawn from it. In Europe, with relatively
low transport costs across many countries, there was no a priori reason
for this not to happen.
Bu remarkably, this did not happen. This is the real surprise of the European
economic project, and is the mother of all the other problems. There is
much talk of faster productivity changes in Germany resulting in lower
export prices that effectively outcompeted the production of workers in
Greece and Spain, and so on. But if the Single Market were actually functioning
properly, prices would have been equalised across the region.
In fact, price differences of a large basket of goods are large across
different European countries (and even within them) and have not only
persisted but in some cases even increased. This continues despite cases
of individual trade arbitrage: it is common to find householders in Geneva,
Switzerland cross the border into France to pick up their household supplies
in the cheaper supermarkets of France, just as migrant hawkers peddle
goods like watches whose prices vary dramatically across different European
cities.
How can this happen? Why did the Single Market in Europe not force price
equalisation? This is not an easy question to answer, especially as surprisingly
little research has concentrated on this issue. But the growing concentration
of both production and retail activities, with the associated proclivity
to price to particular markets and charge ''what the market will bear''
in each location, may have played a role.
In any case, this gives us an important insight into the process of economic
integration: that even in the most favourable conditions, it is not necessary
that reduction/removal of trade barriers will lead to price equalisation.
This in turn forces us to rethink many of our other conclusions about
the effects of open trade.
Obviously, we still understand relatively little about the effects of
removing trade restrictions, since many of the actual outcomes are quite
different from what is predicted by standard theory or even by what seems
like common sense. In this way, as in so many others, the current experience
of the eurozone is instructive for the rest of the world.