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Economic Integration

There are 4 stages to economic integration; a free trade area, customs union, common market and monetary union. The benefits of closer economic integration is to gain from comparative advantages in international trade as well as to benefit from economies of scale.

Trade Groupings

Free Trade Area 
A free trade agreement is where countries remove internal tariffs and quota restrictions in the area whilst still permitting trade barriers to non-member countries.

Customs Union
A customs union is similar to a free trade agreement except members cant set-up their own individual external tariffs but a common external tariff is established (note – a customs union need not have a common currency). The reason for a customs union is to further promote trade between member countries. Trade creation may follow as countries are able to specialise more and hence can gain from comparative advantage. Lower prices should prevail in custom unions due to economies of scale and because inefficient domestic production of goods will cease as cheaper goods can be imported without the expense of tariffs.

However the prices may still be high due to the common external tariff, therefore the larger the trading bloc the better in terms of economic efficiency. Trade diversion may occur whereby a country may divert trade away from more efficient non-member countries (due to the external tariff) towards inefficient member countries. There aren’t usually many benefits from trade diversion.

A common market integrates the economies further with common tax rates across the bloc, as well as similar laws and regulations governing production, employment and trade. The factors of production are also allowed to move freely in a common market. There should also be a common procurement policy for the government to purchase goods and services so that it doesn’t give special treatment to domestic firms.

The final step to economic integration is a complete economic and monetary union which includes a fixed exchange rate with a common or central monetary policy. To complement this fiscal union is also advised, whereby taxes and policies on government spending are harmonised.

European Union 
The EU is the largest and most well-known examples of economic integration between countries. The roots of the EU stem from 1950 when the French foreign minister Schuman proposed that France and West Germany should amalgamate their coal and steel resources. Although the EU shows economic integration and has many economic benefits (as well as detractions) it is also a matter of politics and a large reason for such a push for a closer Europe was to prevent any more wars that had plagued the continent in centuries before. 

In 1951 the European Coal and Steel Community was created, its members were Belgium, France, West Germany, Italy, Luxembourg and the Netherlands. In 1957 these 6 nations went on to form the EEC (European Economic Community) which was more commonly known as the Common Market. 

The EU incorporated many different countries across the continent and increased access amongst the millions of citizens, thus creating a larger market. However population terms in itself does not tell much for effective demand and supply (demand and supply which is backed up by real purchasing power). However problems can arise if converting a countries currency into US dollars as the official exchange rate may be distorted due to the flow of hot money, or other factors which make GDP inconsistent with official economic data. 

SEM (Single European Market)
Once the EEC was created in 1957, member countries began to work on creating a single market which allowed to free flow of goods, services, people and capital between member countries. This idea is known economically as a common market whereby there are no barriers to trade. At present the EEC was a customs union where internal tariffs and other barriers to entry were removed and there was a common tariff applicable to non-member countries.

The initial focus with the EEC was coal and steel and an introductory focus on the CAP (Common Agricultural Policy) to protect farmers and make food as cheaply as possible, as well as to secure domestic food production in the event of an outbreak of war. 

The SEM was fully operational by 1993 as border controls were removed or reduced, and non-tariff barriers to trade (quotas and quality control standards) were removed from within the EU. Most passport and custom control checks have been removed within the EU making it easier for people to move around the EU and allowing greater transition of labour.

Benefits of the SEM:

Transaction Costs
The Treaty of Rome had removed tariff barriers internally within the EU but non-tariff barriers still prevailed and were even increased as nations looked to protect domestic production and employment. The removal of tariffs and border controls is likely to have reduced the costs to the government and for firms producing and exporting/importing goods and services. However it is difficult to quantify the benefits of the removal of transaction costs.
Economies of Scale
The opening of a larger market should allow firms to exploit economies of scale more fully which should lead to a more efficient use of resources and hence increase productive efficiency; this will only occur if trade creation is stronger than trade diversion.
Improved communication and transportation systems throughout Europe, helping to link countries up (for example the Eurotunnel; connecting Britain with Western Europe) has helped to increase economies of scale.
Increased Competition
Firms have increased competition as they are now also facing competition from other European firms, which may be larger and more dominant than they are. It is argued that this should lead to more efficient production, and hence a decrease in X-inefficiencies and an increase in productive efficiency, benefiting society (these are the same arguments put forward for privatisation). 
However economies of scale and increased competition has led to mergers and acquisitions resulting in large multinational firms which may create monopolies, potentially leading to higher prices for consumers as well as greater inefficiencies. This is where the European Commission comes in; it is a competition watchdog, with a remit to prevent monopolies occurring within Europe that would cause detriment to consumers.
When looking at who benefits the most from the Single European Market it is important to look at varying comparative advantages within the EU. Most EU countries have labour which is expensive compared to capital, and these countries tend to have similar balances between industries. Therefore EU countries where labour is cheaper, for example Eastern and Southern European countries may benefit from increased demand due to lower costs. Countries which have a different comparative advantage within the EU are likely to benefit the most.
Also countries which have the largest barriers to trade are likely to gain most from the abolition of tariffs and non-tariff barriers.
The Single Currency Area (Eurozone)
The idea of the monetary union came about in 1979 with the launch of the EMS (European Monetary System). An aspect of this system was the ERM (Exchange Rate Mechanism), countries which choose to adopt the ERM agreed to maintain their exchange rates within a range of plus or minus 2.25% against the European Currency Unit (ECU - the average of ERM member countries). When the UK operated within the ERM it was permitted a larger fluctuation range of 6%. During EMS, 11 realignments of currencies occurred between 1979 and 1987, but the conditions under which they could occur became more strict to reduce the number of times they occurred. 
Capital controls were also removed under EMS but most countries limited the movement of financial capital across borders during the initial period, hence allowing them to use monetary policy independently of other EMS countries. Eventually these capital controls were phased out over the lifetime of EMS.
In 1989 the Delors Plan was released which proposed EMU (European Economic and Monetary Union) along with the single currency (euro) and the ECB (European Central Bank) to administer monetary policy within the EMU (the group of countries which adopted the euro as their domestic currency, and hence forfeited the ability to control monetary policy independently). 
The Maastricht Treaty brought about the European Union and introduced the single currency along with a common foreign, defence and security policy to integrate European countries further. To have a single currency it was believed that EMU countries would need to have similar economic characteristics to make any monetary policy relevant and sufficient for all member countries. A convergence criteria was established and (in theory) to adopt the euro a country had to meet these criteria.
The EMU was a separate proposal to the formation of the Eurozone, but paved the way for it. The EMU locked in exchange rates between countries, but each member country initially held on to their individual national currency until the Eurozone was formed later.
Convergence Criteria
Inflation - the first criteria was to have an inflation rate that was no more than 1.5% higher than the average of the 3 countries in the EMS with the lowest inflation rate. This is because countries with high inflation rates may argue for high interest rates to reduce inflation, whereas countries with lower inflation would argue for lower interest rates. However it was also debated whether there ought to have been an inflation target, as a benefit of joining the EMU was that it would cure inflation by removing the ability to administer fiscal policy nationally.
Interest and Exchange Rates - interest rates were to be no more than 2% higher than the average of the 3 EMS members with the lowest interest rate and that each country wishing to join the EMU had to be within the permitted band of the ERM for at least 2 years without realignment. 
Fiscal Policy - it was argued that if members of the EMU had large variations in unemployment rates there would be a need for fiscal transfer between member states which may be opposed politically. However there was no official target for unemployment as a convergent requirement. The target was instead set that the budget deficit had to be smaller than 3% of GDP and that national debt couldn't be greater than 60% of GDP(economists consider a level above this as unsustainable, however during the current Debt Crisis over the last few years (2010-2013), national debt has been much higher than this in many countries including EMS members).
In 1999 exchange rates between countries were locked and no further realignments were permitted. The ECB was also established and set a common interest rate throughout the union.
The Euro Area (Eurozone)
The euro came into effect as the national currency of Belgium, Spain, Germany, France, Ireland, Italy, Greece, Luxembourg, the Netherlands, Austria, Portugal and Finland on 1st January 2002, as these countries were deemed to have met the Maastricht criteria (including the convergence criteria). When evaluating the costs and benefits of the eurozone the arguments proposed for a fixed exchange rate against a floating regime are often heard, this is because the euro area was effectively a fixed exchange rate regime. An optimal currency area occurs when a group of countries are better off with a single currency.
Benefits of a Single Currency:
Monetary efficiency gain - this has the effect of increasing trade between member countries. It is also believed that there will be increases in economies of scale and greater comparative advantages. Transaction costs are reduced as a result of a single currency; firms no longer have to buy a foreign currency if they want to export or import goods/services to a country within the single currency bloc. For example a French firm wishing to export wine to Germany, no longer has to spend money purchasing Deutschemarks with Francs, because both countries use euro’s. This saves money as there is no longer the fee of converting, as well as the varying exchange rates which may not have the same purchasing power. There is also a reduction in uncertainty because a firm no longer has to estimate how the exchange rate will fluctuate in order to evaluate when it’s best to transfer money. Therefore there may be increased trade as firms are less hesitant to spend and invest because the currency won’t float.
The benefits will be exacerbated if the single currency bloc contains countries which trade heavily with each other. For example 50% of the UK's exports go to the eurozone, therefore there may be large benefits in terms of monetary efficiency gains if the UK joined the euro (however there also many costs, as well as political considerations to take into account).
Costs of a Single Currency:
Within a single currency, each sovereign government no longer has the ability to administer unique and tailored monetary policy to benefit its country. Therefore each country has to be able to deal with external shocks in a similar way otherwise the medicine administered by the Central Bank may only help some countries whilst damaging others. This is why it is important that the business cycles of economies that are part of the single currency are well attuned. 
Nobel Prize winner Paul Krugman has suggested that the higher the degree of integration, the lower the costs and the higher the benefits of a single currency. This can be seen in the cost/benefit diagram below. If integration is less that t* the costs from joining the single currency are greater than the benefits. If this analysis was done prior to joining the union it could be concluded that it would be beneficial for an economy not to join the union under this situation. Conversely if the degree of integration is larger than t* then benefits exceed costs and hence it would be beneficial for an economy to adopt the single currency.
However it is difficult to evaluate the costs and benefits and put a definitive number on it. It is also difficult to judge to what degree of integration has occurred. The procedure can be further complicated as the costs are mainly macro (the devolution of monetary powers) but the benefits are mainly micro (seen in individual markets). 
Some argued that the benefits of the single currency were only experienced during the initial phase of the introduction of the euro, and that there were very little future gains to be had. It was also argued that countries which didn't adopt the euro, still benefited (almost as substantially) as much as Eurozone members. 
Page last updated on 15/04/14