Lectures on the macroeconomics of the European Union notes on European integration.pdf · Lectures on the macroeconomics of the European Union These are lecture notes on some key

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University of Bern Course: The Economics and Politics of European Integration Academic year: 2004-05 Apostolis Philippopoulos Email: [email protected] March 20, 2005

Lectures on the macroeconomics of the European Union

These are lecture notes on some key issues of international macroeconomics where the focus will be on the macroeconomics of the European Union. In addition to undergraduate references, there are references for further, more advanced reading.

LECTURE 1: EXCHANGE RATE POLICY REGIMES The debate about the attractiveness of alternative nominal exchange rate regimes is old. Choices include flexible exchange rates, a target zone for the exchange rate, fixed exchange rates and a single currency. Here, we will focus on the main advantages and disadvantages of fixed and flexible exchange rates. For surveys, see e.g. Blanchard (2002, chapter 21.4), Krugman and Obstfeld (1994, chapter…) and De Grauwe (1994). For more advanced references, see Drazen (2000, chapter 12.2-3), Obstfeld and Rogoff (1996, chapters 8 and 9) and Garber and Svensson (1995, HIE3). Advantages of flexible exchange rates:

(i) Monetary policy independence. Having one more policy instrument to stabilize the economy is always useful. But, is this policy instrument effective? Medium run versus short run. In the medium run, money is neutral (recall the vertical slope of the AS curve). In the short run, monetary and exchange rate policies matter in general, while the particular results depend on the degree of capital mobility, the type of nominal fixity, etc (popular short-run models with nominal fixities are the Mundell-Fleming and Dornbusch’s overshooting model). See Blanchard (2002, chapters 20.4-5 and 21.1) and De Grauwe (chapter 2) about effectiveness of exchange rate policy. For graduate reading on feedback stabilization policy in an open economy, see Aizenmann and Frenkel (1985, AER), Friedman (1990, HMonE2) and Alogoskoufis (1994).

(ii) The foreign exchange market clears without costs of intervention policies (e.g. management of nominal interest rates and selling/buying foreign reserves). Note that policy intervention can affect the exchange rate via the portfolio channel and the expectations channel. The former is a direct channel. The latter affects the exchange rate even if intervention does not actually take place (see e.g. the target zone model).

(iii) Under flexible exchange rates, by construction there are no speculative attacks and exchange rate crises. By contrast, exchange rate commitments are always susceptible to speculative attacks and balance of payments

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crises. See e.g. Blanchard (2002, chapter 21.2). [Note: There are three classes of models that study exchange rate regime collapses (see e.g. Obstfeld and Rogoff (1996, chapters 8-9) and Drazen (2000, 12.3)). In the first one, fixed exchange rates inevitably collapse simply because the fundamentals are inconsistent with the exchange rate regime. This is mechanical. In the second class of models, it is optimal to abandon the exchange rate commitment when things “get really bad” and stabilization becomes the main issue (this is the debate on credibility versus stabilization). In the third class of modes, there can be multiple expectations about devaluation. If the high expectations prevail, there is a speculative attack and the crisis becomes self-fulfilling.] Policy lesson: the exchange rate commitment or target must be consistent with economic fundamentals or the so-called fundamental equilibrium exchange rate. Defending a disequilibrium exchange rate (because it provides an anchor to private inflation expectations and nominal contracts, because of political prestige, etc) is futile and costly. See Williamson (1993, EJ).

Advantages of fixed exchange rates:

(i) Fixed exchange rates can help to avoid competitive devaluations. See Krugman and Obstfeld (1994, chapter …) and Drazen (2000, chapter 12). This is a prisoner’s dilemma problem between national policymakers. In general, if there are cross-country spillovers, decentralized national (monetary and fiscal) policies are inefficient; hence, the arguments for international cooperation of monetary policies. Technical surveys include Obstfeld and Rogoff (1996, chapter 9.5.5), Drazen (2000) and Persson and Tabellini (1995, HIE3). This issue is further studied below.

(ii) Fixed exchange rates can help high-inflation countries to gain anti-inflation credibility and break the vicious cycle of inflation-depreciation. The theoretical model behind this argument is the Barro-Gordon (1983) model of stagflation. If this is the case, a regime of fixed exchange rates can offer an institutional resolution to the inefficient outcome of high inflation and low employment. [Note: other institutional resolutions include the appointment of an independent and conservative central banker, or optimal contracts for central bankers. If institutions cannot resolve the credibility problem, then we are left with endogenous reputational mechanisms, which emphasize the role of reputation via repetition in enforcing a Pareto superior outcome.] See Obstfeld and Rogoff (1996, chapter 9.5). See also e.g. Alogoskoufis (1994), Svensson (1997, AER) and Walsh (1998, AER?). How do fixed exchange rates work? A high-inflation country can fix its exchange rate against the currency of a low-inflation country. Or, in a more general setup, as Giavazzi and Pagano (1988, EER), Giavazzi and Giovannini (1988, in “The EMS” edited by Giavazzi et al.) and Giavazzi (1988, EER) have shown, with a fixed exchange rate, inflation in excess of the EMS average will lead to a real exchange rate appreciation, which is costly and hence reduces the country’s incentive to inflate. See De Grauwe (1994, chapter 2). Whatever the mechanism is, the general result is that high-inflation countries “import the credibility” of low-inflation countries (but do low-inflation countries lose?) These arguments become stronger if,

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in addition to credibility problems, there are also political business cycles (see Alogoskoufis, Lockwood and Philippopoulos (1992, EJ)). Note that this institutional resolution presupposes that the exchange rate regime is itself credible and sustainable. This is a big assumption since (as we said above) fixed exchange rate regimes cannot be fully credible. In this case, stronger institutional arrangements (e.g. abolishing the domestic currency and adopting the currency of a low-inflation country, or joining a Monetary Union with low-inflation countries) can potentially solve the credibility problem of high inflation countries. See below.

(iii) Excessive exchange rate volatility may be bad for economic activity. See e.g. Blanchard (2002, chapter 21.3). This is when movements in exchange rates (or asset prices in general) do not reflect movements in fundamentals (this happens when there are rational bubbles or irrational behavior). Actually, there is empirical evidence that economic fundamentals have little explanatory power and forecasting ability at least when we use standard macroeconomic models of exchange rate determination (for technical surveys, see e.g. Frankel and Rose (1995, HIE3)). In this case, policy intervention in the foreign exchange market may increase market efficiency.

(iv) If shocks are mainly financial or money-demand, fixed exchange rates can stabilize output and other real variables better than flexible exchange rates (this is Poole’s IS-LM model in an open economy).

Extra References: Non-technical: See the special issue of The Annals, American Academy of Political and Social Science, January 2002, edited by G. Tavlas and M. Ulan. For policy in LDCs: See the special issue of the Journal of Development Economics, December 2001.

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Apostolis Philippopoulos Email: [email protected] March 20, 2005

LECTURE 2 : MONETARY UNIONS AND THE EMU The problem of sustainability and credibility of fixed exchange rates may force countries to opt for stronger institutional mechanisms as a way of gaining credibility for anti-inflation policy and avoid speculative attacks. This implies giving up completely control of the domestic currency. See De Grauwe (1994), Drazen (2000, chapter 12.4) and Blanchard (2002, chapter 21.4). For instance, countries may replace domestic currency by a foreign currency (the so-called “dollarization”), or join a monetary union (MU) like the EMU. In a Monetary Union (MU), countries adopt a single currency with a single central bank. The economic arguments for a single currency are similar to those for fixed exchange rates. In addition, there are benefits from lower transaction costs and higher predictability from moving to a single currency. The higher the volume of trade, the higher are such benefits. See De Grauwe (1994, part I). Also, a single currency can facilitate a truly integrated European market in goods, factors and services (see Drazen, 2000, p. 554-5). It can also help to promote political integration (see Drazen, 2000, chapter 12). These issues are further studied below. The main economic cost of a single currency is the complete loss of autonomous monetary policy. On the other hand, this would not be a big problem if the conditions for an “optimum currency area” were met. See e.g. De Grauwe (1994, part I), Drazen (2000, 12.4) and Obstfeld and Rogoff (1996). Namely, that the economies are hit by symmetric shocks. Nevertheless, lack of symmetricity across countries becomes less important when: (a) prices and wages are flexible, so that relative prices can adjust through changes in prices rather than changes in nominal exchange rates (b) factors are mobile internationally (c) there are fiscal transfers across regions being hit by asymmetric shocks (see fiscal federalism). This is the theory of optimum currency areas as first developed by Mundell and McKinnon. This analysis has come under criticism (see e.g. De Grauwe, (1994, chapter 2), and Tavlas, 2003, mimeo)). Incomplete and complete MUs. See e.g. De Grauwe (1994) and Drazen (2000, 12.4). Incomplete MUs (national currencies exist, but exchange rates are fixed - fully or less than fully): Benefits and costs. See De Grauwe, 1994, part II. Problems include: (a) the credibility problem inherited in pegged exchange rates and the danger of speculative attacks; (b) determination of system-wide monetary policy. This is the so called 1−n problem (see Giavazzi and Giovannini (1987) and Giovannini (1989)). In a system of 1−n countries, there are only 1−n exchange rates so one monetary policy authority is free to set its policy independently. Asymmetric solutions (where there is a leader or anchor country, like the US in the Bretton Woods system or West Germany in the EMS years) and symmetric solutions (where countries decide jointly and cooperatively interest rates and money stocks). For the EMS, see De Grauwe, chapter 5. Given these problems, the question is, How to move on? Two ways: either

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backwards to flexible exchange rates, or forward to a full MU with a single currency. For the advantages of a single currency over “irrevocably” fixed exchange rates, see De Grauwe, chapter 7. If we decide to move to a complete MU with a single currency, what is the best transition strategy? Gradualist strategy, or shock strategy? Complete MUs (single currency): Benefits include elimination of transaction costs thanks to a common currency; reduction in price uncertainty and increase in allocative efficiency; on the other hand, there is only weak evidence that a MU stimulates growth. The main cost is the complete loss of monetary policy independence. As said above, this can be a problem when nominal wages are rigid, labor mobility is limited and there are market differences across countries. On the other hand, recall that exchange rate policy is ineffective anyway in the medium run; also, not only exchange rate policy can be ineffective, it can also do more harm than good in the hands of domestic politicians. The European case and the EMU: Europe has decided to move forward to a MU (the EMU) and a single currency by following the three-stage gradualist approach of the Maastricht Treaty. In addition, not all countries have to join at the same time. Their accession depends on the convergence criteria (at the time of the Maastricht Treaty, these criteria were strict reflecting the fear of Germany that high inflation countries will destabilize its stable economy). The Council (based on a report by the Commission) decides whether a country can join or not. In the transition to a full monetary union during the EMS, the Maastricht Treaty specified rules for the right to adopt the single currency: (i) not excessive budget deficits; 3% budget deficit; (ii) not excessive public debts; 60% public debt; (iii) low inflation rates; domestic rate should not exceed by more than 1.5% the rate of the three best performing member countries; (iv) the exchange rate should stay at least two years before the entrance to the union within pre-specified boundaries; (v) long term domestic interest rates during the previous year should not on average exceed by more than 2% the rate of the three best performing member countries. If countries met these convergence criteria, then they could (but not should) join the single currency and the full monetary union managed by the ECB. Europe is the boldest example of heterogeneous countries forming a MU. Here is the calendar: On January 1, 1999, 11 European Union countries initiated the EMU by adopting the single currency, the euro, and assigning the formulation of monetary policy to the ECB based in Frankfurt. Two years later, Greece joined as the twelfth member of EMU. In May 2004, ten more countries will join the EU and eventually become members of the EMU. The ten countries are the Check Republic, Cyprus, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. Notice that Denmark, Sweden and the UK are members of the EU but not of the single currency. Most economists seem to believe that the main benefits from the EMU are political rather than economic. See Drazen, chapter 12. 4. For a recent survey of the costs and benefits of the EMU, see Tavlas (2003, mimeo).

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LECTURE 3: INTERNATIONAL INTERDEPENDENCE AND COOPERATION (GENERAL LESSONS)

As is known, in the presence of spillovers or externalities, decentralized (non-cooperative) decisions lead to an inefficient allocation of resources. This general result also applies to the international economy and may justify international cooperation. The EU in general, and the EMU in particular, are forms of international cooperation (see below for details). See Drazen (2000, 12.5). (a) General theoretical lessons: Definition of externality: the action of one economic agent j affects the welfare of other economic agent(s) ji ≠ and there are no markets to take that into account. This leads to an inefficient allocation of resources. The generic form of such market failures is the standard prisoner’s dilemma problem. Thus, the equilibrium strategy is to play non-cooperatively but this is inefficient. For instance, with public goods, each agent is better off if all contribute to the provision of the public good than if all do not, and each is better off if he, or she, does not pay for the good (free riding). In equilibrium, everybody does the same, and so there is too little provision of the public good. The stronger the spillover effect (externality) from one agent to another, the stronger the arguments against decentralized decision-making. The type of inefficiency of a decentralized system (and hence what one should do to improve upon market outcomes) depends on the type of spillover effect, and specifically on whether the spillover effect from one agent to another is positive or negative. The general game theoretic result is that when there are positive (resp. negative) spillover effects, players’ actions increase (resp. decrease) when we switch from a non-cooperative to a cooperative equilibrium. See e.g. Cooper and John (1988, QJE). (b) Examples of externalities in the international economy: In the presence of international public goods (e.g. defense and security, environmental quality, border control, macroeconomic stability, health, etc), each country attempts to free ride on other countries’ contribution to the international public good. There are also policy externalities, namely externalities generated by national policy-making. For instance, countries attempt to affect (i.e. to turn them in their favor) the terms of trade via tariffs. Or they go for competitive exchange rate devaluations. Or they go for tax cuts to attract mobile tax bases. Or they bail out policies to export own debt problems. Also, non-cooperation can be related to the tendency to follow too contractionary monetary policy in the presence of an adverse shock, or too expansionary monetary policy in the opposite case (see below). In all these cases, regional or national governments attempt to exploit the international spillovers for the their own benefit. But this is self-defeating (standard prisoner’s dilemma problem). Cooperation means abstaining from doing so (Persson and Tabellini, 1995, HIE, p. 1978).

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As said above, to specify the form that international cooperation should take, it is necessary first to identify the channel of transmission and the type of cross-border externality (namely, whether it is positive or negative). In the case of international trade, tariffs generate a negative cross-border externality (if Germany imports watches from Switzerland, and if Germany imposes tariffs on imports, this hurts the Swiss. And the opposite.) Hence, it is welfare improving to reduce tariffs. In the case of factor mobility, tax cuts generate a positive cross-border externality. Hence it is welfare improving to increase taxes. In the case of environmental standards, we have a positive cross-border externality. Hence it is welfare improving to increase pollution regulations.1 In the case of an inflationary shock, an individual country has an incentive to reduce money growth too much, which leads to real exchange rate appreciation and benefits the other country. Thus, we have a negative externality, so it is better to go for smaller action (smaller decrease in money growth). Therefore, non-cooperative policy is too contractionary. In the case of a recessionary shock, an individual country has an incentive to increase money growth too much, which leads to real exchange rate depreciation and hurts the other country. Again, we have a negative externality, so it is better to go for smaller action (smaller increase in money growth). Therefore, non-cooperative policy is too expansionary. See P+T, 1995, sections 7-8, for monetary policy coordination. (c) Modeling details: (i) Non-cooperative policies are modeled as a Nash game. (ii) Cooperative policies are modeled by assuming that a social planner chooses jointly all national policies so as to maximize the sum of the all countries’ utility functions. Or cooperation can be modeled as a bargaining solution where the so-called threat point is the non-cooperative solution. (d) It is important to note that international cooperation can sometimes be counter-productive in the sense that it decreases, rather than increases, total welfare (see e.g. Drazen, 2000, chapter 12.5, and P+T, 1995, p. 1978, section 3.2, etc). If policymakers attempt to maximize social welfare, cooperation is always productive. If they don’t, we are in a third best situation, so that cooperation may weaken or exacerbate the other domestic policy distortions and thus become counter-productive. For instance, if national governments have an incentive towards time inconsistent behavior, and thus face a credibility problem, the lack of international coordination may act as a disciplinary device; or cooperation can enable national governments to collude at the voters’ expense; or tax competition reduces the government’s temptation to overtax capital; or cooperation can weaken the government’s resolve to fight inflation, etc. In all these cases, competition can lead governments closer to the first best. Also, note that although total welfare can increase because of cooperation, it is possible a small country to be worse off in cooperation than in non-cooperation. Non-cooperation can dominate a cooperative outcome in which the bargaining power is small, say proportional to size, from the viewpoint of a small economy. This

1 Public good spillover effects have received more attention by the literature on local public goods and finance rather than by the literature on international economics (Persson and Tabellini [1995, p. 1998] also admit this). The inclusion of interesting spillovers (in addition to tax spillovers) seems to be a promising area for research and economic policy (see Inman and Rubinfeld [1996] for a rich menu of spillover effects).

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possibility depends on strategies being strategic substitutes so that the reaction functions are negatively sloped (see Drazen, 2000, p. 565).

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LECTURE 4: INTERNATIONAL TAX COMPETITION

This is an application of the above lecture on international interdependence. (a) In an integrated world economy, and if national authorities are free to choose their own fiscal policies by being concerned about the welfare of their own citizens, they have an incentive to compete for internationally mobile tax bases. The most popular example of fiscal competition is via capital taxes: in the benchmark story/model, each national government has the incentive to cut capital tax rates to attract internationally mobile capital. In equilibrium (Nash), this leads to inefficiently low tax rates, which in turn can lead to too small public sectors and an inefficient allocation of resources.2 Technically, this happens because the spillover effect across countries is positive. That is, an increase in country’s j capital tax rate stimulates growth in country ji ≠ . Again this is self-defeating (prisoner dilemma problem). See e.g. Persson and Tabellini (1992, 1995), Razin and Sadka (1999), Sorensen (2000) and the paper in … International Tax and Public Finance. It is not clear however how big the welfare gains from cooperation are.3 (b) Note that tax competition can have implications, not only for the size of public sector, but also for its composition. For instance, tax competition can increase the tax burden on relatively immobile factors, like labor (see e.g. Sorensen, 2000). It can also cause a drop in redistributive transfers and cause a bias in favor of policies benefiting mainly mobile capital. This has distribution effects. (c) Tax reductions is not the only way through which national governments compete for internationally mobile factors. Infrastructure and stability (good things), but also favors from the state and tax evasion (bad things), are other ways of competing for mobile capital. See e.g. Sorensen (2000). See also The Economist, June 16th 2001. Actually, few economists believe that further tax reductions would do much to boost investment and attract capital. In much of the world, taxes have been cut and political risks have declined already, so that the main reason for moving capital about now is investment performance. Nevertheless, it is fair to claim that the complexity of taxation opens up endless opportunities to reduce the amount of tax big companies pay, and increased economic integration (globalization) makes things even easier because there is the threat to move abroad.

2 In a Nash equilibrium, each country chooses its own tax rate to maximize its own utility function subject to its budget constraint and by taking as given other countries’ tax rates and ignoring the effects of its own tax policy on choices in other countries (see e.g. Inman and Rubinfeld, 1996). 3 The (quantitative) economic gains from international cooperation seem to be small (see e.g. Persson and Tabellini, 1995, p. 1977, Sorensen, 2000, and Mendoza and Tesar, ????). On the other hand, Inman and Rubinfeld (1996, p. 318) argue that decentralized tax inefficiencies are economically important.

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LECTURE 5: FISCAL FEDERALISM If cross-country spillover effects are substantial and uncoordinated national policies are inefficient, there are good arguments for international cooperation. Then, the policy question is “cooperation, at what level?”. There is international cooperation at inter-governmental level and international cooperation at supra-national or federal level (although the distinction cannot be that sharp, so we study them separately only for analytical convenience). (a) First, at inter-governmental level. National governments agree to coordinate their policies, although national policies are still implemented by national institutions under national law and continue to be determined to a large extent by national policymakers. Then the question is how to enforce a cooperative outcome (see Drazen, 2000, p. 575). There are endogenous and exogenous solutions (again, the distinction cannot be that sharp but we study them separately for analytical convenience). The former emphasizes the role of reputation via repetition in enforcing a cooperative solution. The latter emphasizes the role of international institutions in supporting a cooperative outcome. Examples include multi-lateral fixed exchange rate systems (Bretton Woods and EMS; see P+T, 1995, section 10); the creation of area agreements like the EU and NAFTA; the policy rules of the Maastricht Treaty and the Stability and Growth Pact;4 reliance on international financial institutions like the IMF and the World Bank; institutions to encourage cooperation like the OECD. See Drazen, 2000, 575-7 and P+T, 1995, sections 6 and 10 for international institutions in fiscal and monetary policy. Second, there is international cooperation at supranational or federal level. Now, it is supranational or central or federal authorities that choose policy directly. Examples include the European Central Bank (P+T, 1995, section 10) and common (federal) policies (see the literature on fiscal federalism). This builds upon the principal-agent model of relations and contracts (see Persson and Tabellini (1995, HIE, p. 1976). [In domestic monetary policy formation, voters delegate the choice of policy to the legislature or the executive, who in turn delegate the choice of policy to the central bank. Such delegation can reduce the inefficiencies of non-cooperative policy making. The same hierarchical principal-agent approach can be helpful in international problems.] The design of international institutions shapes the policy outcomes as well as the distribution of gains from cooperation (P+T, 1995, p. 1976).5

4 Arbitrary international policy rules can work as a cooperative device and hence reduce the inefficiencies resulting from decentralized decision making. This is a form of international cooperation. Again, this is a second-best argument. An example is the policy rules of the Maastricht Treaty and the Stability and Growth Pact. Such arbitrary rules seem to be based on the presumption that e.g. national policymakers have short-time horizons or are office motivated (see models of political business cycles). 5 On the politics of fiscal federalism, see e.g. Baldwin [1995], Persson and Tabellini [1994], Inman and Rubinfeld [1997], Dixit and Lonregan [1998].

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Key tasks in international cooperation: (i) Specify the extent of cross-country spillovers. (ii) Identify the benefits from cooperation. (iii) Design transfer policies to compensate the losers. See below. (b) The optimal degree of federalism depends on the tradeoff between local (national) decisions and central (federal or supra-national) decisions. Centralized decisions benefit from better internalization of externalities, economies of scale (especially in the provision of global public goods) and better credibility. Also, although bargaining at an international level is possible, imperfections in the bargaining process prevent the emergence of an efficient bargaining outcome (see Quigley and Rubinfeld [1997]). For instance, day-to-day informal agreements between governments are less credible than a federal constitution. This is clearly the case in the EU where coordination of fiscal policy can be attained better at a Community level than at an inter-governmental level (see e.g. redistributive policy below). Decentralized decisions benefit from better information, accountability and monitoring and also greater diversity of preferences. See also below. In Europe, the institutional setup is between full decentralization and full federalism [see e.g. Dewatripont et al. (1995) and Alesina and Wacziarg (1999)]. On many issues, policies are still selected in a decentralized way (the economic press repeatedly argues that “member countries play the nationalist game”). Difficulties in getting agreements on policy issues are particularly obvious in the areas of structural funds and the CAP, where national interests are the main concern. On the other hand, on many other issues, “Europe” is taking over with European institutions implementing policies to internalize cross-border externalities and promote integration within the region. Alesina and Wacziarg (1999) argue that Europe “has already made significant strides towards being a federal state” and “is more than a simple area of policy coordination or inter-governmental cooperation”. (c) An example of federal policy: redistribution. A case where federal policy does better than inter-governmental cooperation is redistribution to those in need (see e.g. Quigley and Rubinfeld [1997]).6 For instance, federal policy can provide insurance against country-specific shocks by ex post redistributing resources via transfer payments from regions facing positive shocks to regions facing negative shocks. Note that for this to correspond to insurance, the shocks should be as likely to affect one country as another, so that ex ante there is no presumption of being a loser or a gainer. There is a rich literature on the role of federal policy in allocating risk and providing social insurance (see, e.g., Persson and Tabellini [1996a, 1996b] and Alesina and Perotti [1998]). A second example of redistributive policy has to do with promoting economic growth. The EU budget (see Structural Funds) transfers resources ex ante from the richer to poorer countries and regions to help the latter to grow. Specifically, federal transfers are used to ensure the provision of minimum levels of key public goods and services (e.g. roads, airports, environment and education) which are believed to promote growth. The official argument in the EU, is that "equality and reduction of social

6 Generally speaking, redistribution should take place at the highest possible level of government; see e.g. Dixit and Lonregan [1998].

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conflicts are necessary for the viability of European integration" (see Dewatripont et al. [1995]). However, transfers may distort recipient countries' incentives (e.g. moral hazard behavior, rent seeking, corruption, etc). See Drazen, 2000. (d) The assignment of policy responsibilities between the national and supranational levels of government, and the issue of representation of member-countries to the supranational government, are the two big dimensions of constitutional design in federal economies [see the special issue of the EER, 1996 (vol. 40, no. 1) and Inman and Rubinfeld (1997)]. At first sight, the assignment principle appears to be simple: “constitutionally assign national public goods to the central authorities and local public goods to the local authorities”. However, application of this principle requires the specification of the extent of cross-country spillover effects or externalities, and this is not a trivial task. Even the reach of a given activity’s spillover effect is disputable, and then application of the assignment principle becomes political (see I+R, 1997, pp. 95 and 101-5). The issue of representation is even more complex. Representation can vary from the case in which each of the member-countries sends its own representative to the central government, to the case in which all countries vote for one central representative [see e.g. Inman and Rubinfeld (1997)]. However, if the same incentives that lead states to adopt inefficient decentralized policies will also lead their elected representatives to adopt inefficient central government policies (see Inman and Rubinfeld [1996, p. 328]), what can be done? A federal constitution can assign responsibilities to central and local governments and specifies representation to the central government. Then, some questions are (see Inman and Rubinfeld [1997, p. 101-105]): How assignment and representation affect efficiency? What is the optimal combination of assignment and representation? A constitutional solution is to assign residence-based taxation to the lower tier governments and allocate source based taxation to the central government. To sum up, in a world with imperfections, the optimal regime is intermediate between full centralization and full decentralization (see e.g. Piketty [1996], Gilbert and Picard [1996], Seabright [1996] and Caillaud et al. [1996] for federal tax/transfers that internalize cross-jurisdiction externalities). Simply put, each type of government does what it can do best. This seems to be the case in federal countries, like the USA and Canada. In Europe, there is a considerable debate about (i) whether the assignment of policy responsibilities between federal and national levels of government is the right one; (ii) whether EU institutions are merely agents of the member states, or whether they are autonomous actors in their own right [see e.g. George and Bache (2001) from the point of view of the political science]. (e) Is a federation stable? Whatever the new order of fiscal hierarchies and fiscal assignments, it must be a credible and enforceable one (see the comment by Inman on Quigley and Rubinfeld [1997]). Here are some questions. (a) When should a country join a federation or an international agreement, stay together or break apart? (See e.g. the US and its role in the Kyoto agreement.) Is it better to be able to renegotiate? Is it better to go for immediate coalition formation or gradual coalition formation? (b) Can a federal constitution survive the pressures of domestic politics? Is the federal or

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central government willing and able to implement its assigned policies? (c) What are the effects of greater economic integration and factor mobility? (i.e. globalization). If it leads to the equalization of policies across countries (see Bolton and Roland [1997]), this may defeat the purpose of seeking independence. See below. (d) Can greater economic integration survive without a supra-national political institution? Recent history (at least in Europe) seems to indicate that greater economic integration leads to greater fragmentation of nations. However, small nations benefit from greater economic integration, only when there is a supra national authority to enforce some rules of the game. So a minimum degree of political integration is needed to sustain economic integration (see Bolton et al. [1996]). All these issues are related to the "design of European integration" (see below).

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LECTURE 6: FREE TRADE AND THE SINGLE MARKET Free trade in goods and services has benefits and costs.7 The same applies to a Single Market (a customs union with mobility of goods, services and factors of production). Let us start with benefits. In neoclassical economics, trading is a positive-sum game benefiting both participants in exchange. This is taken to mean the aggregate welfare gain, typically expressed in percent of GDP, arising from openness to trade and factor mobility. At an applied level, the general belief among economists is that there is a gain from trade in goods, while the importance of gains from international capital market integration is rather overrated.8 In addition, there can be significant benefits from externalities as those identified by the theory of endogenous long-term growth. For instance, an integrated global economy can take better advantage of economies of scale, R&D, etc. Also, international economic integration provides returns to scale in the provision of non-rival public goods, whose per capita cost decreases with the number of agents that finance them (e.g. security, defense, environmental quality). A higher international economic integration can also reduce average trading costs. On the cost side, increased international economic integration generates winners and losers. The benefits from integration are not equally distributed among all members. When nations integrate, not necessarily all participants are better off. See below for further details. Also, capital and labor mobility leads to the equalization of national policies across nations and therefore does not allow the satisfaction of different preferences, interests, culture and history.

7 See e.g. Alesina et al. [1995], Bolton et al. [1996] and Alesina and Spolaore [1997] for a survey. 8 About trade liberalization and economic performance, see e.g. the papers included in the Policy Forum published in the Economic Journal, September 1998. Although the gains from trade in goods are also questionable, the reasonable argument why trade liberalization is good for growth is that import substitution becomes a failed strategy over time. About international capital market integration and economic performance, see e.g. the papers included in the Symposium on Global Financial Instability published in the Journal of Economic Perspectives, Fall 1999.

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LECTURE 7: THE STABILITY AND GROWTH PACT The Stability and Growth Pact (SGP) is a form of international policy cooperation. The SGP has accomplished many good things. It has enhanced credibility of national fiscal policies. It has reminded governments to avoid policies that can jeopardize financial stability. It has made information on countries’ fiscal positions more available. It has signaled that the euro area takes seriously the commitment to a stable macroeconomic environment. It has increased international cooperation in a world with cross-country spillovers. It is however believed that there is need to review the SGP (see below why). This short note will remind the rationale for the SGP, its current problems, the main reform proposals and will close with a reform proposal from the Greek side. But it is useful to start by recalling what we know about fiscal policy. I. What it is The Stability and Growth Pact (SGP) has two arms: The Excessive Deficit Procedure and the Mutual Surveillance Procedure. The Excessive Deficit Procedure is initiated under one of the two scenarios: (i) a government deficit exceeds 3% of GDP; or (ii) government gross debt exceeds 60% of GDP unless the level of debt is “sufficiently diminishing and approaching the reference value at a satisfactory pace” (in other words, the debt should not be allowed to increase when it is higher than 60%). So far, the rules have attached greater importance to the deficit ceiling than the debt one.

Nevertheless, even a government deficit is not considered to be excessive under (i), if the excess over the 3% level is an “exception, temporary and limited in size”. An exceptional deficit is one that results from unusual events beyond the country’s control and/or severe downturn; a severe downturn is one that involves output declines of at least 0.75% of GDP. See below for details.

The Mutual Surveillance Procedure provides information on fiscal policies and is designed to give early warnings if risks exist of a member country running an excessive deficit. This involves the submission of standardized programs that form the basis for the monitoring of the fiscal performance of member countries.

Should a country miss the deficit target by a significant margin, or fail to submit an acceptable (stability and convergence) program, the ECOFIN Council may decide whether a deficit is considered to be “excessive” and issue an early warning, acting on the recommendation from the Commission (i.e. the determination of whether the excess is sufficiently limited in size is at the discretion of the Council). An annual fall or real GDP by more than 2% should be considered as “abrupt” and a fall between 0.75 and 2% could be considered to be so after a judgement by the Council.

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If countries do not take measures (see below) to eliminate an “excessive deficit” as recommended by the Council, they may have to pay a penalty (to pay an interest-free deposit of 0.2-0.5% of GDP, which is converted into a fine if deficits persist). No sanctions apply to the case of high debt. However, penalties are only in theory so far (to be checked ?). In practice, there is only pressure for reforms: the Ecofin issues an “opinion” that can include a negative assessment.

Since 2001, member-countries have been encouraged to aim at medium-term budgetary positions “close to balance or surplus” (although not stated explicitly, this is believed to be a target for cyclically adjusted budget balances) and to take into account government investment and other related factors including their medium-run budgetary position (for details, see e.g. Eichengreen, 2004, p. 6). Specifically, countries have to improve their cyclically adjusted budget by at least 0.5% of GDP per year with one-off measures being considered on a case-by-case basis. Temporary measures should be replaced by structural reforms.

Then, within the fiscal constraints imposed by the SGP, and self-chosen national laws on fiscal policy, each member country has autonomy over its fiscal policy.

But to be able to evaluate the SGP, we should recall some lessons for fiscal policy (and economic policy in general).

II. What we know about fiscal policy

The main lessons are: (a) Fiscal policy is mainly used to improve resource allocation (by providing infrastructure and public goods); to redistribute income; and to stabilize the economy. (b) The main focus of the SGP has so far been on the stabilizing role of fiscal policy (But why? Is it because monetary policy is no longer available?). By stabilization policy, we mean counter-cyclical policy. (c) Focusing on stabilization policy, the common view is that discretionary policy (however we model it) is “unattractive”. If fiscal policy operates with lags so that it is hard to time it over the cycle, or if it is difficult to distinguish between rule-like and discretionary behavior in the form of electoral cycles, rent seeking etc, it is better to rely more on automatic stabilizers (which are modeled as passive rules). (d) This is particularly true in countries like Greece with credibility problems and political distortions where discretionary policy should be regarded with great skepticism. (e) Automatic stabilizers are not negligible in the euro area, especially in countries with relatively large public sectors (less so in the US). III. Rationale of the SGP Why do we need exogenous constrains on policy-making, like those implied by the SGP? Deficits are not bad per se. Deficits get bad and chronic, only when the budget-making process is dominated by discretionary fiscal policy and political distortions. In cases like this, there is a rationale for exogenous policy constraints. This is a typical second-best argument.

Specifically, the SGP is believed to be a second-best mechanism that: (i) It imposes a fiscal discipline to those member countries with political distortions and chronic fiscal imbalances. (ii) It takes care of cross-country fiscal

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externalities. That is, it is a form of international fiscal coordination like tax harmonization. IV. Performance of the SGP so far As said, the SGP has accomplished many good things. However, there is critique that: (a) The medium-term budgetary objective is still open(?), although it is believed that a balanced budget in cyclical adjusted terms is the idea. (b) The SGP has encouraged pro-cyclical rather than counter-cyclical stabilization policy. Pro-cyclicality has been encouraged because countries are forced to tighten fiscal policy in a downturn, without having to loosen policy in an upturn. Hence, automatic stabilizers do not work and this exacerbates instability. Also fiscal restraint in booms has not been rewarded. (c) The SGP has given more attention to current deficits than to government debt and sustainability. (d) It is not clear what a satisfactory pace of debt reduction means (1% or 3%?). This should depend on economic conditions. (e) The suggested feedback policy rules aiming at debt reduction are not clearly specified. (f) The SGP rules have been too rigid and do not take into account the long-run position of individual member-countries. For instance, if a member-country needs public investment and structural reforms to improve resource allocation, short-term deficits may be an optimal policy inter-temporally. This is especially the case in countries that are below the EU average and in which public investment can play the role of an engine for endogenous growth. V. Reform proposals (general) There is no shortage of reform proposals. A general view is that we should look for modifications of the current rules that improve their effectiveness and legitimacy but without changing their main character. Set-up costs are too high, so it is better to build on the present framework. Here, are the most popular reform proposals (main ideas): (i) Formulate the budget balance objective explicitly in cyclically adjusted terms so as to allow automatic multipliers to work. So far the medium-term objective is open although it is recognized that a balanced budget in cyclical adjusted terms is the idea. But there is need to agree on how to compute the cyclically adjusted balance (the idea is that it is an estimate of what the budget deficit would be if the economy were operating at its natural rate). (ii) Focus more on the debt position of countries and long run sustainability, especially those problems relating to an ageing population. But we have to agree on how to compute debt sustainability. (iii) Focus more on public investment needs (also known as the golden rule) and real convergence. But we have to agree on how to identify productive and non-productive government expenditure. (iv) Focus more on institutional reforms (e.g. reform of the budgetary process, reform of the pension scheme, reform of the labor market, reduction of unnecessary regulation, etc). But evaluation of reforms is subjective and political. (v) Delegation of national fiscal policies to an EU body like the ECB. But this seems to be undesirable from the viewpoint of national governments. Whatever the new fiscal rules might be, the general principles seem to be: (i) Rules need to be forward looking and consistent with long run sustainability of

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public finances. (ii) Rules should not change when they start to bite especially for the large economies. This undermines the credibility of the SGP. (iii) Rules should not be too rigid, or ignore the economic situation and needs of individual countries, because they will gradually become unsustainable. (iv) Rules should be simple and understood by the general public. (v) It is necessary to coordinate national budget timetables; to discuss common measures; to improve exchange of information; to improve data availability so as to cost-benefit various government activities. (vi) Decisions (on sanctions) should be moved from the political level to other levels to increase credibility of the enforcement of fiscal rules. VI. Reform proposals (specific) My own view is that we should support a strong SGP to recognize that sound public finances and fiscal discipline are necessary for a successful economic and monetary union. In addition, fiscal rules - like those implied by the SGP - are particularly useful to those countries in which chronic public finance problems are mainly due to discretionary policies and political distortions. In a second-best world, fiscal rules cannot make stabilization harder. That was also the case with the EMS some years ago (exchange rate rules did not make disinflation costlier). In this case, I believe the following:

(a) Debt position: We should agree on the general principle that reduction of

government debt should be a priority both at national level and the EU as a whole. We have to clarify what we mean by a satisfactory pace of debt reduction.

(b) Budgetary position: We should support a cyclically adjusted budget balance as a medium term objective. We should also continue to support a deficit ceiling of 3%. Question: will the focus shift from budget positions to debt positions?

But SGP rules should also depend on economic conditions. These state-contingent SGP rules should be made clear and public information. This is to make the Pact not too rigid and help its sustainability. For instance, (c) Countries with debt ratios less than the 60% ceiling could be given the

possibility of small temporary deviations from a cyclically adjusted budget balance. This is to reward debt sustainability.

(d) Countries that undertake public investment and institutional reforms in their effort to converge could be given the possibility of small temporary deviations from a cyclically adjusted budget balance.

(e) Countries hit by unusual asymmetric shocks, or characterized by unusual events, could be given the possibility of small temporary deviations from a cyclically adjusted budget balance.

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LECTURE 8: THE DESIGN AND ARCHITECTURE OF EUROPEAN INTEGRATION

1. Introduction: Europe still at a crossroads Europe is still at a crossroads. Chapter 1.1 in Dewatripont et al. (1995). Opportunities for further cooperation, integration and enlargement are still there, but there are problems and it is widely agreed that current institutions are inadequate to meet the challenges of these opportunities present. Four challenges are:

(a) The size of the EU. This is the issue of enlargement. Today the EU has 15 members and is expected to expand in 2004 by 10 new members. Most of these countries have different economic and political structures. Enlarging the EU makes it more heterogeneous. Conflicts. Pressure on activities like the Structural Funds and the CAP. Why enlargement?

(b) The scope of integration. Widening integration to more areas. Should we

extend common policy-making to areas like defense, foreign policy, etc? This is related to the confusion about the division of responsibility between the Union and the states. It is expected to become worse with enlargement.

(c) Depth of integration. Should we deepen integration in the existing areas of

cooperation? In the areas of Union competence, there has been only limited transfer of national sovereignty to the EU. This leads to problems of enforcement and efficiency. First, the Union relies on member states to put EU law and policy into effect. This is lax and uneven. Second, many decisions require unanimous agreement. States veto decisions to increase their bargaining power in other areas. Use of majority rule could work better.

(d) Legitimacy of the EU institutions. Making supra-national institutions more

accountable. Mainly this relates to the Commission and the Council. These are only indirectly accountable to the public. The European Parliament is the only directly elected European institution (since 1979) but its power is rather limited.

The big challenge is to find a mix of commitment and flexibility. The former is needed to take advantage of the benefits of cooperation and integration. The latter is needed to create more room for choice in a increasingly heterogeneous Union. Need for an institutional reform (see chapter 3). Questions: Should we push for wider and deeper integration? But fears that this will threaten national sovereignty, heterogeneous preferences and being overruled by majority views.

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2. Suggested strategies for the design of integration (see 1.2, 1.3). Suggested strategies include: First, Europe a la carte (3.1.1). This is the most flexible model where members have complete freedom to choose forms of cooperation. No minimum degree of integration exists. Problems: Conflicts and instability. Bad history. Second, the US of Europe (3.1.2). Supra-nationalism. Problems: It fails to recognize heterogeneity. Third, multi-speed integration (3.1.3). Problems: it provides limited flexibility by not allowing some countries to move on to deeper integration or others to stay away from it. Fourth, core and periphery groups (3.1.4). Problems: how to distinguish first-class

citizens? Politically unstable.

The above strategies are outdated.

Fifth, “flexible integration” or “enhanced cooperation” (see chapter 3.2). Namely, to develop a dual structure that includes (a) a common base in which all member countries have to participate (b) a possibility of open partnerships that allows groups of countries to integrate further along policy dimensions outside the common base without obliging all countries to participate. The common base is the minimum requirement for participation in the EU. It should be a take-it-or-leave-it deal to members and potential enters. Actually, it seems that this is the idea of the Amsterdam Treaty and the Nice Treaty. 3. The importance of externalities The distinction between the common base and open partnerships depends on the pattern of international spillover effects and externalities. This is absolutely essential in order to specify and preserve the gains and costs of cooperation. When externalities are present, open partnerships should not interfere with the proper working of the common base, or hurt non-participating countries and other existing partnerships. Also, non-participating countries should not adopt policies that hurt the members of an open partnership. All these issues should be discussed before a partnership is formed. Non-participating countries should have a say in the formation and operation of open partnerships in areas where the spillover effects are strong and negative. See chapter 3.3 and chapters 6 and 7. The European Council could make decisions (p. 62). Some examples (see chapter 3.3):

(i) Efficient overall integration (3.3.1). Open partnerships are not desirable. (ii) Efficient open partnerships (3.3.2). An open partnership between A and B

is preferred by all countries, A, B and C. (iii) Inefficient bundling across… (3.3.3). If countries are heterogeneous

enough, requiring every country to participate in every form of cooperation is a straightjacket that leads to complicated and sub-optimal bargains. Allowing separate open partnerships would be more efficient.

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(iv) Open partnerships and the distribution of the gains form cooperation (3.3.4).

(v) Closed partnerships (3.3.6). A partnership between A and B exerts a negative externality on country C.

(vi) Free riding (3.3.7). A partnership between A and B exerts a positive externality on country C. Free riding should be prevented through rules of good conduct for non-participants.

4. Defining the common base Chapter 4. The common base should include policy areas for which the gains of cooperation are large for all members of the EU. Once a policy area is part of the common base, member countries should accept a transfer of sovereignty to the EU institutions. It is better to be pragmatic and take a minimalist approach (p. 79). A natural starting point for the common base is the Single Market. Then, the common base should include all those elements of integration necessary for a properly functioning Single Market (i.e. a customs union with mobility of goods, services, people and capital). It should include abolishment of barriers to trade in goods and services or barriers to mobility of productive factors. 5. Free trade and the Single Market See lecture notes. 6. What does a Single Market require? If we agree on the desirability of a Single Market, then the question is what other areas of policy we need to preserve and enforce a well-functioning Single Market? Thus, it is recommended that other policy areas should be included in the common base if they are necessary to make the Single Market function efficiently and be politically viable (p. 81). The efficiency requirement stresses complementarities between free trade and other policy areas. See chapter 5. Political viability on the other hand may require the compensation of losers from free trade. It is believed that free trade is good for Europe as a whole. However, some participants may become worse off. This can justify transfer programs. Then, the following policy areas appear to be candidates for the common base: (a) a Common Agricultural Policy (CAP) and the Structural Funds program (see 4.2). (b) Tax coordination (see 4.3). (c) The Social Chapter and Social policy (see 4.4.). (d) Macroeconomic policy and EMU (see 4.5). (e) Social insurance (see 4.6). (f) Common foreign and security policies, justice and common affairs. [Note: Dewatripont et al (pp. 100-1) argue that the “common base” should consist of: (i) the Single Market inclusive of trade policy plus aspects of competition, regulatory and industrial policy that are already under the EU (ii) a reformed version of the CAP, (iii) the Structural Funds program, (iv) harmonization of VAT, (v) a mild form of coordination over capital income taxes, especially in the presence of high capital mobility, and (vi) a mechanism for coordinating monetary policy to avoid competitive

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devaluations. In other words, whether one should include the Single Currency or the Social Chapter into the common base is debatable. See chapter 4. ] Therefore, the general idea is to narrow the common base to a well-defined set of areas, strengthen the commitments to this common base, and then allow new forms of cooperation with the states that wish to do so. This differs from solutions like hard-core and a periphery group (first-class and second-class countries). 7. How to enforce the rules of the common base Chapter 5. Mainly legal procedures. Four steps are important to improve things (pp. 121-3): (i) To increase the supply of information about EU law and state law. (ii) Help citizens to defend their rights under EU law. (iii) Improve transparency and publicity of EU institutions. (iv) Reform EU institutions. For instance, the role of commissioners as their own state representatives weakens the power of the Commission to enforce EU law. (v) Sanctions against violations of the EU law should be made credible (fees and temporary exclusion from benefits). 8. Open Partnerships Chapter 6. Open Partnerships (OP) require three sets of control rights: (a) the ability to identify and then the power to deal with cross-country externalities (b) the power to decide entry and exit rules (c) the power to administer the partnership. We study them in turn. (a) In the presence of externalities, the decision to set up an OP is a matter of common interest to all EU members. This is because OP can give rise to both positive and negative externalities to non-participants. Examples include monetary policy, environmental policy, common border controls, defense, etc (chapter 6.1.1). (b) The entry-exit rules (see chapter 6.1.2) (c) Administration of OPs (chapter 6.1.3). Each OP should have its own administration either run by the Commission or by an independent bureau. Costs and benefits of centralized decisions. The desirable model depends on the type of OP: for large ones, the administration should be handled by specialized bodies like the ECB. A specific example of an OP is a monetary union (complete with a single currency, or incomplete without a single currency). A monetary union provides a good example how to deal with externalities, who has the power to decide the entry rules and who administers the OP. Denmark, Sweden and the UK have an opt-out choice. 9. (Selected) History (1945-today) See chapter 2. Main references : Dewatripont M. et al. (1995): Flexible Integration: Toward a More Effective and Democratic Europe, Monitoring European Integration no. 6. Center for Economic Policy Research, London. George S. and I. Bache (2001): Politics in the European Union. Oxford University Press, Oxford.

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LECTURE 9: ECONOMIC UNION ENLARGEMENT To understand a union enlargement, one has to understand why the outsiders want to join and why the incumbents want to have them. The theory of the optimal number of nations is an application of the theory of clubs. (a) Clubs. See Drazen (2000, chapter 9). There are benefits and costs from adding a new member. The resulting tradeoff in membership determines the optimal number of club members. See lecture notes for the basic model of clubs, where the tradeoff is between congestion problems and sharing the fixed cost of public goods. (b) The optimal number of nations. See Drazen (2000, chapter 14.6). Now the tradeoff in membership becomes more complex. From the point of view of existing members, the benefits include: (i) Sharing the fixed cost of international public goods. That is, a large jurisdiction can benefit from economies of scale in the provision of public goods. (ii) A more stable political landscape (in Europe). (iii) Enlargement helps to internalize externalities reflected e.g. in tax competition, etc. These benefits increase with the number of members. The costs include: (i) Congestion problems. (ii) It is harder to get agreements on various issues. (iii) New members will absorb a fraction of federal transfers. (iv) A large jurisdiction cannot satisfy specific tastes/preferences if policies are harmonized or get single or uniform. Note that diversity of preferences is becoming increasingly important because it is believed that centralized uniform decisions reduce each state’s ability to determine its most favorable bundle of public goods and so lead to conflicts originating from differences in preferences, culture and history (see e.g. Alesina et al. (1995) and Bolton et al. (1996)). An example of single, uniform policy is tax harmonization. These costs increase with the number of members. To sum up, as Baldwin [1995] points out, to understand an EU enlargement, one must understand why the outsiders want to join and why the incumbents want to have them. This can be understood on three grounds: (I) economics, (ii) low politics and (iii) high politics. (c) In general, the EU enlargement will reduce the power of existing members in the European Council, Parliament and Commission. This can become worse if the pre-entry position or promises of candidate members differs from their post-entry position, in the sense that once becoming a member one has the incentive to renege and use its veto power. This is a commitment problem (see Heinemann, 2002). Actually, it is believed that the Treaty of Nice offered the opportunity to incumbents to adjust voting schemes (in the European Council and the European Parliament) in their favor so as to restrict the newcomers’ post-entry power. Thus, the Treaty of Nice increased both the absolute number and the relative share of EU-15 seats in an enlarged EU Parliament. It is less obvious what is the case in the Commission (see Heinemann, 2002).

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LECTURE 10: “GLOBALIZATION” What does “globalization” mean? And is it really a new phenomenon? Most economists prefer to use the term international economic integration (IEI). According to Rodrik [2000], this is less trendy than the term “globalization” but it has a more clear and distinct meaning at least to economists. It is also not accompanied with the value judgements - positive or negative - that the term globalization seems to trigger. If we accept this, then international economic integration (i.e. the development of free trade and factor mobility) is not a new phenomenon. It has just intensified recently due to abolishment of capital controls and barriers to migrate, as well as the new (automation and information) technology. As said above, increased international economic integration generates winners and losers. The benefits from integration are not equally distributed among all members. When nations integrate, not necessarily all participants are better off. However, the main concern of those who protest against globalization has to do with the size and composition of public sector. In particular, it is believed that higher IEI will lead to the shrinkage of public sector and, in particular, diminish its ability to engage in social security and welfare-state type activities. The fear that higher IEI imposes additional constraints upon the effectiveness of government intervention, as well as the size and composition of public sector, is consistent with various macroeconomic models. For instance, higher capital mobility is associated with less effective policies in the early Keynesian models of open-economy macroeconomics. A well-known example is the following trilemma: fixed exchange rates, perfect capital mobility and monetary policy autonomy are inconsistent; one has to sacrifice one of the three, and autonomy of national monetary policy is the most obvious candidate.9 But the main concern about increased IEI has to do with fiscal policy competition and its consequences.10 In an integrated world economy, and if national authorities are free to choose their own fiscal policies by being concerned about the welfare of their own citizens, they have an incentive to compete for internationally mobile tax bases. The most known example of fiscal competition is via tax cuts (race to the bottom). Tax competition can have implications, not only for the size of public sector, but also for its composition. For instance, tax competition can increase the tax burden on relatively immobile factors, like labor.11 To sum up, IEI leads to a more efficient allocation of resources world-wide. However, gains from increased IEI can be unevenly distributed across countries and across different economic-social groups within each country.

9 This describes the conduct of monetary policy in the ERM. See e.g. Persson and Tabellini [1995]. 10 For survey papers on fiscal competition, see e.g. Persson and Tabellini [1995], Razin and Sadka [1999] and Sorensen [2000]. 11 See e.g. Sorensen [2000].

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The post-war experience until the early 1990s Rodrik’s [1998] econometric work shows that, during the postwar time-period until the early 1990s, higher openness led to higher volatility in domestic output and consumption (which is what protesters against globalization claim), which in turn led to larger public sectors, especially in social security and welfare-state spending (which is the opposite of what protesters claim). In his study, the causality runs from openness to risk and to government spending. Thus, at least until the early 1990s, there is no evidence that higher IEI put additional constraints on the size and composition of public sector. By contrast, the evidence is that public spending was a risk-reducing instrument, which was more heavily used in open economies. Therefore, between 1960 and 1990, which was a period of increased openness, public expenditure grew fast in most OECD economies. Also, Tanzi and Schuknecht [2000] provide evidence that during this period differences in public expenditures across countries were almost completely due to differences in spending on subsidies and cash transfers. In particular, between 1960 and 1980 subsidies and cash transfers as a share of GDP more than doubled to over 20 per cent of GDP, equivalent to 50 percent of total government expenditures. By 1990, in the big-sized government countries, subsidies and transfers had increased to almost 31 percent of GDP. However, after 1980, although the expansionary trend continued, it was at a much slower pace (see below for the past decade). Therefore, during the postwar period till the early 1990s, there is no empirical support for the theoretical prediction that increased openness leads to smaller public sectors. This does not mean the theory is wrong. It just means that, despite increased openness, it was still possible - both economically and politically - to follow independent fiscal policies and take measures to reduce poverty and inequality. To put it another way, openness does not necessarily constitute a binding constraint on the conduct of national fiscal policies. The experience since the early 1990s Several things have changed since the early 1990s. First, there has been a change in government spending patterns. As Tanzi and Schuknecht [2000] report, the previous trends have been changed and most countries have started to curtail state involvement. In particular, there is a pressure for reduction of welfare state type activities (see e.g. Atkinson [1999a, 1999b]). In the UK, for instance, the top rate of income tax has been reduced to 40 percent, and state pensions are linked to prices, not earnings – which means they will become of small importance over the next decades. As Atkinson points out, this is not only on the grounds of budgetary costs (i.e. tax burden); there is also the belief that the welfare state in itself is bad for growth and jobs. But is the increased IEI that has caused these changes in government spending patterns? Therefore, the evidence is still inconclusive. Second, most countries seem to experience a rising inequality. For instance, in the US, the UK and a number of OECD countries (but not in France or Canada).12 There is also evidence that there is a significant shift toward non-labor income; however the implications of this for the distribution of personal income is not yet clear mainly 12 See e.g. Atkinson [1999] and the references cited there.

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because people and firms have income from different sources (see e.g. Atkinson [1999b]). The economic press argues that there has recently been a rise in inequality (see e.g. the special issue of The Economist on “The New Wealth of Nations” on June 16, 2001).13 Third, the link between inequality and globalization is inconclusive (see e.g. Atkinson [1999b]). On the one hand, Wood [1998] shows that in developed countries the rise in labor market inequalities has been partly caused by globalization. This is because in OECD countries there is a shift in demand away from unskilled in favor of skilled workers. On the other hand, and for the same reason, globalization and expansion of manufacturing exports have reduced inequality in less developed countries. To complicate things even more, the shift in demand away from unskilled to skilled workers has more to do with the introduction of new automation and information technology rather than globalization as such. Also, even among developed countries the experience is different: in most EU countries there is no a rise in earnings dispersion mainly because of effective minimum wage protection. Therefore, the evidence is still inconclusive.

13 Should we worry about inequality? Inequality is not bad per se since it can just reflect greater economic efficiency. However, inequality should be a cause for concern, when: (i) opportunities are not genuinely equal; (ii) even if opportunities are initially equal, the gained power is abused to take the lion’s share in subsidies and transfers, raise prices, exclude competitors or win competitions for political favors. It is hard to argue that these two conditions are met. This is especially true in less developed countries where many of the rich prosper through gaining favors from the state (see e.g. the special issue in The Economist on June 16th 2001). Note that this is only on the grounds of efficiency. Morality is an additional, different issue. See below for more details.

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REFERENCES (selected) Alesina et al. (1995): … European Economic Review. Alesina A. and R. Wacziarg (1999): Is Europe going too far? Carnegie-Rochester

Conference Papers on Public Policy, 51, 1-42. Alogoskoufis G. (1994): … , in The Handbook of International Macroeconomics,

edited by F. van der Ploeg, Blackwell. Baldwin R. (1995): The eastern enlargement of the European Union, European

Economic Review, 39, 474-481. Bolton et al. (1996): …, European Economic Review. Bolton and Roland (1997): …, Quarterly Journal of Economics. Casella A. and B. Frey (1992): Federalism and clubs, European Economic Review,

36, 639-646. Dewatripont M. et al. (1995): Flexible Integration: Toward a More Effective and

Democratic Europe, Monitoring European Integration no. 6. Center for Economic Policy Research, London.

Drazen A. (2000): Political Economy in Macroeconomics. Princeton University Press, Princeton, New Jersey.

De Grauwe P. (1997): The Economics of Monetary Integration. Oxford University Press.

Eijffinger S. and J. de Haan (2000): European Monetary and Fiscal Policy. Oxford University Press, Oxford.

Frankel J. and A. Rose (1995): … , in Handbook of International Economics, vol. 3, edited by G. Grossman and K. Rogoff. North-Holland. Amsterdam.

Garber P. and L. Svensson (1997): … , in Handbook of International Economics, vol. 3, edited by G. Grossman and K. Rogoff. North-Holland. Amsterdam.

George S. and I. Bache (2001): Politics in the European Union. Oxford University Press, Oxford.

Heinemann F. (2002): The political economy of EU enlargement and the Treaty of Nice, European Journal of Political Economy, 19, 17-31.

Inman R. and D. Rubinfeld (1996): .., Journal of Public Economics, 60, 307-334. Inman R. (1997): A Comment on “Federalism as a device for reducing the budget of

the central government”, by J. Quigley and D. Rubinfeld, in Fiscal Policy, edited by A. Auerbach. The MIT Press, Cambridge, Mass.

Inman R. and D. Rubinfeld (1997): The political economy of federalism, in Perspectives on Public Choice, edited by D. Mueller. Cambridge University Press, New York.

Obstfeld M. and K. Rogoff (1995): Foundations of International Macroeconomics, MIT Press.

Persson T. and G. Tabellini (1995): Double-edged incentives: Institutions and policy coordination, in Handbook of International Economics, vol. 3, edited by G. Grossman and K. Rogoff. North-Holland. Amsterdam.

Quigley J. and D. Rubinfeld (1997): in Fiscal Policy, edited by A. Auerbach. MIT Press, Cambridge, Mass.

Razin A. and Sadka E., editors, (1999): The Economics of Globalization: Policy Perspectives from Public Economics, Cambridge University Press, Cambridge.

Rodrik D. (2000): How far will international economic integration go? Journal of Economic Perspectives, 14, 177-186.

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Tsoukalis L. (2003): What Kind of Europe? Oxford University Press.

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Lectures on the macroeconomics of the European Union notes on European integration.pdf · Lectures on the macroeconomics of the European Union These are lecture notes on some key