Jason L. Saving

English

Research Papers in Economics

INSIDE:
Natural Gas Pricing:
Do Oil Prices
Still Matter?
•
Foreign Exchange
Policy and Banking
Reform in China
Issue 4 July/August 2005
Economic integration is a key theme of the global era in which we live
today. Perhaps the single most important example of such integration in
recent decades is the European Union.
From the ashes of the wartime years, six core European nations forged a
confederation that gradually grew to encompass 15 members and then 25. As
the EU evolved into an economically freer and more integrated group of
nations, the overall European economy has grown to the point where it rivals
that of the United States (Chart 1).
Globalization and
Monetary Policy
European Economic Integration:
A Conflict of Visions
FEDERAL RESERVE BANK OF DALLAS
Southwest Economy
(Continued on page 2)
(Continued on page 12)
. . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . 
Globalization is one of the most debated and
analyzed phenomena of our time. Declining trade
barriers and advances in technology have made it
possible for consumers in the United States and
around the world to purchase a variety of goods
and services that would have been impossible a
generation ago. 
Cheaper imports have contributed to higher
standards of living, but the growth of trade has
also been associated with job losses as production
shifts toward lowest cost producers. Freer flows of
capital have made it easier for investors to seek
out high returns and diversify their portfolios.
International capital flows have also made it easier
for businesses to raise funds for investment pro-
jects by making them less dependent on domestic
institutions. Inflows of foreign capital have helped
raise living standards in emerging market
economies and have also increased the pressure
on these countries’ governments to pursue sound
fiscal and monetary policies. The Evolving European Union
FINLAND
SPAIN
SWEDEN
NORWAY
FRANCE
PORTUGAL
DENMARK
POLAND BELARUS
UKRAINE
IRELAND
AUSTRIA
ITALY
GERMANY
HUNGARY
ROMANIA
BULGARIA
CZECH REPUBLIC
SLOVAKIA
GREECE
NETH.
BELGIUM
YUGOSLAVIA
ALBANIA
MOLDOVA
LITHUANIA
LATVIA
ESTONIA
LUX.
BOSNIA
and
HERZ.
CROATIA
SLOVENIA
SWITZERLAND
MACEDONIA
ICELAND
RUSSIA
UK
MALTA
Initial core (1957)
Middle years (joined 1973–95)
Newest members (joined 2004)
CYPRUS
TURKEY
A further step toward economic inte-
gration was at stake on May 29, when
French voters cast their ballots on a pro-
posed European constitution. The debate
had been framed in cataclysmic terms,
with proponents arguing that a French
rejection could be a “fatal blow” to fur-
ther European integration. Proponents
went on to say that there was no Plan
B—implying the French either must
approve the proposed constitution or bear
responsibility for what former EU Presi-
dent Romano Prodi called “the end of
Europe.”
French voters rejected the constitu-
tion by a 10-point margin, and the Dutch
followed suit three days later with an
even more resounding rejection of the
document. Yet the EU did not end. In-
deed, it could not end because its exist-
ing treaties and regulations remain in place
indefinitely unless superseded by a new
governing structure. So in a very real
sense, the EU to which French and Dutch
voters awoke in June was the same
Europe to which they had awoken the
month before.
In and of itself, the proposed consti-
tution would have little effect on the
overall European economy. Indeed, pri-
mary author Valéry Giscard d’Estaing de-
scribes its economic provisions as a “tidy-
ing-up” of existing guidelines, rather than
a renewed effort at economic reform. But
the debate that has broken out in the
wake of the French and Dutch referen-
dums does have important implications
for Europe’s economic future and, by ex-
tension, the economic future of the United
States. The question is simple: To what
extent and in what manner should Euro-
pean integration continue? 
European Economic Integration
(Continued from front page)
FEDERAL RESERVE BANK OF DALLAS   SOUTHWEST ECONOMY   JULY/AUGUST 2005 12The debate that has
broken out in the wake of
the French and Dutch
referendums on the
proposed constitution has
important implications for
Europe’s economic future
and, by extension, the
economic future of the
United States.
The Benefits of
Economic Integration
Economists generally support eco-
nomic integration because it eliminates
certain inefficiencies. When states in a
common market choose different tax and
labor policies, for example, workers and
businesses have an incentive to move
from states where taxes are high to states
where they are low. Similarly, those who
receive government subsidies have an in-
centive to move from states where subsi-
dies are low to states where they are high.
This migration punishes socially progres-
sive states by simultaneously raising the
amount they must spend and reducing the
tax revenue available to meet their oblig-
ations.
Some believe this competition goes
too far.  The Organization for Economic
Cooperation and Development recently
concluded that the developed world
should eliminate “harmful tax competi-
tion” between states. German Chancellor
Gerhard Schröder echoed these concerns
in a European Union context, arguing
that low tax rates in its newly admitted
Eastern members constitute “unfair tax
competition.” French President Jacques
Chirac even coined a new term—“social
dumping”—to describe the process by
which laissez-faire states import workers
and businesses from more highly regu-
lated EU members.  
Economics textbooks reveal the solu-
tion to this apparent dilemma. If compe-
tition between states for individuals and
businesses is undesirable, such competi-
tion can be reduced or even eliminated
through common economic policies.
Simply compel all members of a federa-
tion to offer the same business climate
and social safety net, and neither indi-
viduals nor businesses will migrate in
search of something that better suits their
needs. This would relieve the fiscal pres-
sure on high-benefit states and thereby
strengthen what is often called “social
Europe.” Further economic integration, in
other words, is the answer.
But there is more than one kind of
economic integration. The North American
Free Trade Agreement provides a useful
example in this regard. When NAFTA
was debated in the early 1990s, many
unions felt the treaty should impose U.S.
labor and environmental laws on Mexico.
Business groups vigorously disagreed,
arguing that such a requirement would
weaken the competitive forces NAFTA
was intended to unleash. The argument
was not so much over whether to integrate
the U.S. and Mexican economies but how
to integrate them.
Much the same rhetoric has been
heard in the debate over the European
constitution. As Chirac said in mid-April,
the EU faces a conflict of visions on how
to further integrate members’ economies.
“The first,” he said, is “to go with the
Anglo-Saxon and Atlantic liberal current”
of low tax rates and flexible labor mar-
European Union GDP Grows Steadily
Billions of 2000 U.S. dollars
Chart 1
NOTE: Data are adjusted for purchasing power parity.
SOURCE: Organization for Economic Cooperation and Development.
0
2
4
6
8
10
12
’04 ’02 ’00 ’98 ’96 ’94 ’92 ’90 ’88 ’86 ’84 ’82 ’80 ’78 ’76 ’74 ’72 ’70 ’68 ’66 ’64 ’62 ’60
FEDERAL RESERVE BANK OF DALLAS   SOUTHWEST ECONOMY   JULY/AUGUST 2005 13kets. “That is not what we want. The sec-
ond solution is that of a humanist and
therefore organized Europe,” he conclud-
ed, that can “stop the drift toward eco-
nomic ultra-liberalism.”
So it is not economic integration per
se that is being debated, because a uni-
formly low-tax Europe with flexible labor
markets would be just as integrated as a
Europe that embraces uniformly high tax
rates and inflexible labor markets. Rather,
the question is what sort of further eco-
nomic integration Europe will pursue.  
If the European economy would be
equally productive under either approach,
economics would have little to say about
these two visions. But this is not the case.
It may be true that individuals and busi-
nesses could not escape a uniformly high-
tax, high-benefit Europe through migra-
tion. But individuals could reduce their
workweek or leave the workforce en-
tirely, and businesses that would barely
survive under a low tax burden would
fail if confronted by a higher one. Such
individuals and businesses would simply
cease to exist as far as production is con-
cerned, becoming either welfare recipi-
ents or bankrupt enterprises.
Those are the unspoken economic
stakes behind the conflict of visions. In
essence, integration along British norms
would propel EU members toward a
future of high growth and low unem-
ployment, while integration along German
norms would drag EU members toward
low growth and high unemployment.
Liberalization Versus
Economic Integration
Does the evidence support the notion
that high-tax, high-benefit economies fare
worse than freer economies? A compari-
son of Europe and the United States sheds
light on this question.
Over the past two decades, the U.S.
economy has grown at an annual rate of
3.2 percent, while the French economy
has grown by barely 2 percent per year
(Chart 2). Except for a brief spike fol-
lowing reunification in the early 1990s, the
German economy has fared even worse.
Unemployment is a good indicator of
labor market flexibility, and here, too, the
evidence is clear. U.S. unemployment has
fallen from 8 percent to 5 percent over the
past two decades, while the French and
German rates have averaged about 10 per-
cent (Chart 3). Although observers com-
monly point to the current economic per-
formances of France and Germany as
proof of the “Eurosclerosis” that besets
Old Europe, it is this sustained difference
that suggests something more fundamental
is at work here. That fundamental “some-
thing” boils down to competitiveness.
The various organizations that evalu-
ate the extent to which countries are
economically free uniformly conclude
that the United States is freer than all or
most European nations. Perhaps the most
well known of these evaluations is pub-
lished jointly by the Fraser Institute and
the National Center for Policy Analysis. It
ranks the United States as the world’s
third freest economy, with Germany 22nd
and France 44th.  Rankings published by
the Heritage Foundation and IMD Inter-
national reach similar conclusions.
Why does the U.S. fare so well in
these surveys? Simply put, America offers
a lower tax burden and a more flexible
labor market than France and Germany.
The United States has fewer regulations
governing the hiring and firing of workers
and fewer  governing the number of hours
an employee can work. This increases the
value of workers in the eyes of firms and
thereby helps keep unemployment low—
and production high. Low tax rates have
a similarly laudable effect on the U.S.
economy by facilitating business creation
and fostering business growth.
If it is well understood that inflexible
labor markets and high taxes cost jobs and
retard growth, why do some EU member
states seek to impose them at the Euro-
pean level? The answer may lie in the
distributional consequences of this choice.
If it’s assumed that France and Germany
will not abandon the policies that en-
courage businesses and workers to flee
those countries, the consequences of those
policies can be mitigated by compelling
nearby states that would otherwise attract
those disgruntled workers and businesses
to adopt the same policies. Businesses
and workers for whom the economic cli-
mate is particularly oppressive might leave
the EU entirely, but that is a much more
costly decision than simply slipping from
one European state to another. On net,
the more highly regulated European eco-
nomies may gain, even though the EU as
a whole loses. 
Recent evidence points to the same
conclusion. Last year the European Union
considered a proposal to introduce free
trade in services across its member states.
1
With free trade having been a core idea
behind the EU’s formation, and with the
service sector having grown to the point
where it now accounts for 70 percent of
European output, free trade in services
would seem like an almost automatic ex-
tension of the ever-closer union that EU
policymakers say they seek. Yet the pro-
posal was rejected.
In arguing against it, one European
head of state decreed that the continent
France, Germany Usually Trail United States in GDP Growth
Percent
Chart 2
SOURCES: Bureau of Economic Analysis; Organization for Economic Cooperation and Development.
–6
–4
–2
0
2
4
6
8
10
12
Germany (West Germany before 1990)
France
United States
’04 ’03 ’02 ’01 ’00 ’99 ’98 ’97 ’96 ’95 ’94 ’93 ’92 ’91 ’90 ’89 ’88 ’87 ’86 ’85 ’84 ’83 ’82
FEDERAL RESERVE BANK OF DALLAS   SOUTHWEST ECONOMY   JULY/AUGUST 2005 14Britain and the Netherlands, that believe
the European economy should become
less highly regulated. How can further
economic integration simultaneously sat-
isfy these two competing visions? The
simple answer is that it can’t. 
As British Prime Minister Tony Blair
put it, “Should Europe embrace globali-
zation and try and make it work for us, or
should we try and ward it off?” That is the
question on which the economic future
of the EU now rests.
—Jason L. Saving
Saving is a senior economist in the
Research Department of the Federal
Reserve Bank of Dallas.
Notes
1 Information about the proposal can be found at http://europa.eu.int/
comm/internal_market/services/docs/services-dir/com-2000-
888/com-2000-888_en.pdf.
2 For more information on the so-called Lisbon strategy, see
http://europa.eu.int/growthandjobs/index_en.htm. 
“must not become a free trade zone,” a
statement consistent with the vision that
Europe must achieve economic integra-
tion without further economic liberaliza-
tion. But it is not consistent with the
agenda to which a unanimous EU agreed
in Lisbon, where Europe committed to
having the world’s most dynamic and
fastest-growing economy by 2010.
2
French Prime Minister Dominique de
Villepin opined in late June that European
leaders must either lead the charge to
protect social Europe or else “we resign
ourselves to making our continent a vast
free-trade area governed by the rules of
competition.” Whether to accept or resist
the “rules of competition,” and the pros-
perity those rules bring, is indeed the
choice Europe now confronts.
The Conflict of Visions
These facts by no means imply that
European integration to date has been a
mistake. As mentioned elsewhere in this
article, European integration has facili-
tated a remarkable rise in Europe’s stan-
dard of living. Nor do they shed light on
whether Europe should or should not
voluntarily sacrifice economic growth to
achieve social goals it deems important.
If Europeans wish to be less prosperous
in the future so they can be more equal
today, economics cannot call the wisdom
of that decision into question. But eco-
nomics can reveal its consequences. 
Consider Singapore and the Soviet
Union, and the conflict of visions be-
comes clear. Singapore is generally con-
sidered the freest economy on the planet
(even more so than the United States), and
its economic growth has been consistent-
ly strong. Yet the country has no formal
structure anchoring it to the world econ-
omy beyond a strong business climate
and membership in organizations like
the World Trade Organization that pro-
mote business activity.
On the other hand, the Soviet Union
is generally considered to have been one
of the least free economies, and it exhib-
ited weak economic growth for most of
its history. Yet its member states were
linked with a high degree of economic
integration.
The point is that economic integra-
tion does not promote economic growth
in and of itself. Only economic liberal-
ization can do that. If the 25 members of
the EU were to agree to integrate along
French or German norms, the fact that
the federation had achieved further eco-
nomic integration would not save its eco-
nomy from sliding into the night.
From an economic perspective, then,
the ultimate fate of the European consti-
tution is less important than the compet-
ing visions of the European future the
ratification debate has exposed. On one
side are countries, led by France and Ger-
many, that believe the European econ-
omy should become more highly regu-
lated. On the other are countries, led by
French and German Unemployment Climb, While U.S. Rate Falls
Percent
Chart 3
SOURCES: Bureau of Labor Statistics; Eurostat.
0
2
4
6
8
10
12
14
’05 ’04 ’03 ’02 ’01 ’00 ’99 ’98 ’97 ’96 ’95 ’94 ’93 ’92 ’91 ’90 ’89 ’88 ’87 ’86 ’85 ’84 ’83 ’82
France
Germany
(West Germany before 1990)
United States
FEDERAL RESERVE BANK OF DALLAS   SOUTHWEST ECONOMY   JULY/AUGUST 2005 15

European economic integration: a conflict of visions

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European economic integration: a conflict of visions

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