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VOL. 1, NO. 5
MAY 2006
EconomicLetter
Insights from the
FEDERAL RESERVE BANK OF DALLAS
Integration and Globalization:
The European Bellwether
by Jason L. Saving
As technology and freer
The European Union owes its very existence to the economic
trade integrate economies,
integration that defines today’s increasingly global economy. From the
the European Union
ashes of World War II, six core European nations forged a coal-and-steel
stands at a policy
community designed to foster industrial competitiveness. Over time, the
crossroads. Two
nations realized that a common market would best promote European
conflicting strategies of
growth, and the mission gradually broadened to include the general goal
integration are
of ever-closer union.
facing off to see which will
Successive waves of integration raised membership to 15 coun-
guide Europe’s future.
tries a decade ago, then to 25 today, with Turkey and several other nations
eager to join in the near future (see map). Along the way, Europe has
seen significant increases in its standard of living as it became economically freer and more integrated.
Creating a common market has
brought benefits. At the same time, it
has meant exposure to worldwide
competition, which creates difficulties
for nations with high taxes and inflexible labor markets. EU members maintain less competitive economic policies than the United States, and globalization has exacerbated the consequences of these policies for their
economies. Some analysts question
whether further economic liberalization offers the best path to future
prosperity, advocating instead greater
policy coordination to bring taxes,
regulations and other measures into
even closer alignment.
Should EU members integrate
their economies in a way that resists
global economic pressures? Or should
they embrace globalization through
greater economic freedom, with each
nation vying to compete effectively in
the world economy? As technology
and freer trade integrate economies,
the EU stands at a policy crossroads.
Two conflicting strategies of integration are facing off to see which will
guide Europe’s future. The stakes are
nothing less than the continued
advance of globalization and its consequences for national and regional
economies.
The European Union Today
Creating a common market
Iceland
has brought benefits.
At the same time, it has
Joined 1973–1995
Sweden
Joined 2004
Finland
meant exposure to
Norway
worldwide competition.
Russia
Estonia
Denmark
Latvia
Ireland
Lithuania
United
Kingdom
Belarus
Netherlands
Belgium
Poland
Germany
Luxembourg
Czech
Republic
Ukraine
Slovakia
France
Switzerland
Austria
Moldova
Hungary
Slovenia
Portugal
Spain
Romania
Croatia Bosnia
and
HerzeGovina
Italy
Serbia
and
Montenegro
Bulgaria
Albania
Macedonia
Greece
Turkey
Cyprus
Malta
EconomicLetter 2
FEDERAL RESERVE BANK OF DALLAS
precise placement of particular countries, few would dispute the overall
conclusion that Europe’s economy is
less free than the United States’.
The consequences are evident in
broad measures of economic performance. Over the past decade, for example, the U.S. economy has grown at
an annual rate of 3 percent—relatively
healthy by postwar standards (Chart
2). In contrast, the EU has grown by
barely 2 percent a year, a rate disappointing to economists and policymakers alike. The U.S. doesn’t grow
faster than every European nation in
every year, but it does better than
most EU members most of the time.
The unemployment rate also
shows America’s edge in economic
performance. In the U.S., it has hovered around 5 percent for most of the
decade, a rate many economists consider close to full employment (Chart
3). In contrast, Europe’s relatively
inflexible labor markets have pro-
Increasing mobility
for goods, labor and
capital entails greater
exposure to global
economic pressures.
Chart 1
EU Economies Trail in Economic Freedom
U.S. and EU-15 economic freedom
Index value
8.5
EU-15
{
8
7.5
7
6.5
ur
g
Au
str
ia
De
n
Ne mar
k
th
erl
an
ds
Fin
lan
d
Ge
rm
an
y
Be
lgi
um
Sw
ed
en
Sp
ai
Po n
rtu
ga
l
Fra
nc
e
Gr
ee
ce
Ita
ly
bo
an
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Lu
xe
m
Ire
l
U.
K.
6
U.
S.
Integration’s Costs and Benefits
Economic integration is the
process through which nations lessen
the economic significance of their borders. It can take the form of pacts—
such as the North American Free
Trade Agreement and the World Trade
Organization—that reduce tariffs and
other barriers, letting goods and services move more freely. It can take the
form of investor protections that foster
capital mobility or visa programs that
help firms find willing workers. When
goods, services, capital and labor can
move to where they are most efficiently employed, economies can grow at
faster rates than they otherwise could.1
But increasing mobility for goods,
labor and capital entails greater exposure to global economic pressures.
When nations in a common market
choose different labor policies, for
example, those who receive government benefits have an incentive to
move from less generous nations to
more generous ones. When tax policies differ, workers and businesses
have an incentive to move from hightax nations to low-tax ones.2 High-tax,
high-benefit nations find themselves in
a squeeze, simultaneously facing increases in the amount they must
spend and reductions in the tax revenue available to meet their obligations. The more economically integrated the world, the greater this penalty
becomes because firms, workers and
capital can search for greener pastures
more readily than ever before.
Does this apply to Europe? Let’s
look at the competitiveness of Europe’s
15-nation core compared with the U.S.
(Chart 1). The Fraser Institute compiles an annual ranking of economic
freedom, based on such factors as size
of government, legal structure and
security of property rights, access to
sound money, freedom to exchange
with foreigners, and regulation of
credit, labor and business. The latest
readings show that the United States
eclipses any current EU member. Past
years also reflect this pattern. While
some economists may question the
SOURCE: The Fraser Institute.
FEDERAL RESERVE BANK OF DALLAS
3 EconomicLetter
Chart 2
EU Has Relatively Low Growth
U.S. and EU-15 real output
Index, 1995 = 100
145
140
135
U.S., 1995 prices
130
125
120
EU-15, 1995 prices
and exchange rates
115
110
105
100
95
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
SOURCE: Organization for Economic Cooperation and Development.
Chart 3
EU Has Relatively High Unemployment
U.S. and EU-15 unemployment
Percent
11
10
9
EU-15
8
7
6
U.S.
5
4
3
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
SOURCES: Bureau of Labor Statistics (U.S.), EuroStat (EU).
EconomicLetter 4
FEDERAL RESERVE BANK OF DALLAS
duced an unemployment rate 3 to 5
percentage points higher. Unemployment rates in France and Germany
remain around 10 percent, despite
several initiatives over the past few
years to deal with the issue.
Perhaps the single most telling
statistic is productivity—the amount of
output per hour worked. Largely
dependent on the extent to which
government policies foster a dynamic
economy, productivity has grown by
roughly 2.5 percent annually in the
U.S. over the past decade but only 1.4
percent in Europe (Chart 4).
It has not always been so. In the
heady days of postwar reconstruction
and the formation of the common
market, some economists spoke of a
permanent productivity advantage for
Europe. Now, an emerging consensus
holds that labor and tax policies have
combined with the relatively sluggish
introduction of new technologies to
produce a sustained productivity
deficit for the European economies.
Commentators may point to the
current economic performance of
France and Germany as proof of the
“Eurosclerosis” that besets the continent’s major economies, but a snapshot in time can’t tell the whole story
of economic fundamentals or future
prospects. It is the sustained differences that suggest something more
fundamental—namely, a gap in competitiveness—has been at work here.
Globalization and Growth
Europe once kept pace with the
United States. Tracking GDP back to
the early 1970s shows that Europe
managed to keep up with the U.S.
until diverging markedly in the 1980s
(Chart 5). This raises an interesting
question. If more competitive economic policies enabled the U.S. to outperform Europe in the 1980s and 1990s,
why didn’t they also enable us to outperform Europe before then?
The answer boils down to one
word: globalization.
In earlier decades, the world simply wasn’t as global as it is today. The
consequences of high taxes and inflexible labor markets weren’t especially severe in the low-tech, lowmobility 1960s and 1970s. As globalization heated up in the 1980s and
1990s, the cost of these policy decisions—in lost output, slower job creation and forgone productivity—
became plain for all to see.
Empirical evidence supports this
globalization story. The U.S. leads all
25 EU members in the Harvard Business School rankings of national policies that foster innovation (Chart 6A ).
The entire EU, on the other hand,
does worse than the U.S. on the World
Bank’s measure of labor-market policies that inhibit growth (Chart 6B).
Business-climate indicators paint a
similar picture: For example, an entrepreneur can create a new U.S. firm in
five days, but it requires an average of
37 days to start one in the EU. Such
data indicate the U.S. should participate
more fully in the global economy, and
a globalization index devised by A.T.
Kearney and Foreign Policy magazine
does indeed show the U.S. ahead of
all but one EU member (Chart 6C ).
The underlying message is as simple as it is accurate: Nations that offer
more competitive economic environments will reap greater benefits from a
more open world economy.
Globalization places a premium
on economic freedom and gives
nations greater incentive to engage in
policy competition aimed at liberalizing their economies. But some worry
that policy competition has gone too
far. A recent report from the Organization for Economic Cooperation and
Development, for example, concludes
that the developed world should eliminate the “harmful tax competition”
that tempts firms to move in search of
better business climates. A few months
ago, the finance minister of Germany’s
new coalition government echoed this
concern when he urged the 10 newest
EU members to raise taxes in the
name of fairness.
Can economics contemplate a
means to thwart cross-border policy
Chart 4
EU Has Low Productivity Growth
U.S. and EU-15 productivity
Index, 1995 = 100
125
U.S.
120
115
110
EU-15
105
100
95
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
SOURCES: Bureau of Economic Analysis (U.S.); Statistical Office of European Communities (EU);
Haver Analytics.
Chart 5
Europe Didn’t Always Lag the U.S.
U.S. and EU-15 real output
Index, 1970 = 100
300
U.S., 2000 prices
250
200
EU-15,*
2000 prices
150
100
50
’71
’74
’77
’80
’83
’86
’89
’92
’95
*Purchasing power parity.
SOURCE: Organization for Economic Cooperation and Development.
FEDERAL RESERVE BANK OF DALLAS
5 EconomicLetter
’98
’01
’04
Chart 6
U.S. Bests EU in Globalization
A. Innovation Policy Index
Index value (100 = best)
100
80
60
40
20
U.
S
th
erl .
an
ds
Fin
lan
d
Fra
n
Ge ce
rm
an
y
Au
str
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Be
lgi
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Ne
U.
K.
Ire
lan
d
Sp
a
De in
nm
ar
Sw k
ed
en
Ita
Po ly
rtu
ga
G l
Lu ree
xe
c
m e
bo
ur
g
NA
0
SOURCE: Harvard Business School.
B. Labor Rigidity Index
Index value (100 = best)
100
80
60
40
20
NA
d
th um
erl
an
ds
Fin
lan
Sw d
ed
en
Au
str
Ge ia
rm
an
y
Ita
Po ly
rtu
ga
l
Sp
ain
Gr
ee
ce
Lu Fran
xe
ce
m
bo
ur
g
lan
lgi
Ne
Ire
Be
K.
ark
nm
De
U.
U.
S.
0
SOURCE: The World Bank.
C. Globalization Index
Index value (100 = best)
100
80
competition? Yes. A federation could
impose minimum tax rates and labor
standards—or even mandate a single
set of tax rates and labor standards—
so no nation could “unfairly” undercut
another and “poach” workers and
businesses.3 Under this view, Europe
would need an integration that discourages rather than encourages further liberalization.
At times, the EU has done exactly
that. In the mid-1990s, Sweden had to
raise its farm subsidies as a condition
for EU entry. In early 2004, the EU
forced the Czech Republic to adopt
labor-market regulations the country
deemed onerous. And in January
2006, Poland fought a pitched battle
with European leaders to keep its tax
rates below what EU leaders wanted.
In each case, countries shared the
goal of binding economies together
but diverged over the terms.
Some analysts have cast the great
continental debate as a contest between
Europhiles desperate to bind EU countries together and Euroskeptics determined to maintain national sovereignty. But integration per se need not be
the issue. After all, a uniformly low-tax
Europe with flexible labor markets
would be just as integrated as a Europe
with uniformly high tax rates and inflexible labor markets. The key question centers on the kind of integration
Europe ought to undertake. Should it
pursue an integration that fosters free
markets and the economic growth
they bring, or should it pursue an
integration in which member states
band together to resist the economic
consequences of high taxes and heavily
regulated labor markets in a global era?
60
40
20
NA NA
U.
S.
th
erl
an
d
s
De
nm
ar
Sw k
ed
en
Au
str
ia
Fin
lan
d
U.
K.
Fra
Ge nce
rm
an
Po y
rtu
ga
l
Sp
ain
Ita
ly
Gr
ee
ce
B
Lu elg
xe ium
m
bo
ur
g
Ne
Ire
lan
d
0
SOURCE: A.T. Kearney.
EconomicLetter 6
FEDERAL RESERVE BANK OF DALLAS
What Will the Future Hold?
What are the prospects for further
liberalization? Last year, the EU considered a proposal for free trade in services. With goods now accounting for a
dwindling portion of the EU economy,
free trade in services would seem a
logical step for a federation dedicated
to providing a common market across
Europe. Yet, the specter of increased
competition from Eastern Europe’s
cheap labor undermined public support. Bowing to opposition in several
countries, the EU adopted only minimal changes in its services trade policies. More recently, a months-long
drama featuring massive street protests
forced the French government to withdraw a proposal to increase labor market flexibility with a probationary
employment period during which
young workers would enjoy fewer
benefits and less job security.
These incidents are balanced by
signs favorable to reform. Current
European Commission President José
Manuel Barroso has spoken movingly
of the need for Europe to further liberalize its economy to better compete
in the global marketplace. And to give
just one example where this is happening, Germany has renegotiated
labor contracts in a few high-cost sectors and has discussed limiting labor’s
historic influence over corporate strategy. These and other events within
the EU suggest Europe’s future policy
direction is far from decided.
The EU stands at a crossroads as
it debates further economic liberalization. Some EU members wish to preserve and even expand Europe’s social
protections, so that workers can have
much-needed security in an era of
ever-more-rapid change. Other EU
members want Europe’s economy to
become more flexible, so that economic growth can equal and perhaps
even exceed that of the U.S.
Europe can’t simultaneously satisfy these competing visions. Either the
EU must liberalize its economy to
compete in a globalized world, knowing its workers will have to retrain
faster—and become more highly educated—than ever before. Or EU nations
can band together to resist further liberalization, knowing that unemployment will become more prevalent and
economic growth will remain slow.
The European Union has a clear
choice, but the challenge of globalization is an issue for every economic
entity on every continent, including
the United States. U.S. labor markets
may be somewhat more flexible than
Europe’s, and the U.S. economy
somewhat more open. But make no
mistake: In areas ranging from steel to
softwood lumber to clothing to autos,
the U.S. faces pressure to ward off
globalization rather than embrace it.
With technologies knitting economies closer and policies aligned
toward openness, globalization has
advanced steadily in the postwar era.
Future policy choices in the European
Union, United States and other entities
will determine whether the world
continues its progress toward increasing economic integration.
The European Union
Saving is a senior economist in the Research
Department of the Federal Reserve Bank of
Dallas.
has a clear choice, but
Notes
globalization is an
1 See
the challenge of
International Economics: Theory and
Policy, by Paul R. Krugman and Maurice
Obstfeld, 7th ed., Addison-Wesley, 2005, for
an overview of this and other economic issues
relevant to the global economy.
2 See “A Pure Theory of Local Expenditures,”
by Charles M. Tiebout, Journal of Political
Economy, vol. 64, no. 5, 1956, pp. 416 – 24,
for more on this phenomenon.
3 “A Single Welfare Benefit Level for Europe?
Efficiency Implications of Policy Harmonization
in a Federal System,” by Jason L. Saving,
Southern Economic Journal, vol. 70, no. 1,
2003, pp. 184 –94, contains a more rigorous
examination of the conditions under which
economic integration can be harmful rather
than helpful.
FEDERAL RESERVE BANK OF DALLAS
issue for every
economic entity on
every continent,
including the
United States.
7 EconomicLetter
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EconomicLetter
is published monthly
by the Federal Reserve Bank of Dallas. The views
expressed are those of the authors and should not be
attributed to the Federal Reserve Bank of Dallas or the
Federal Reserve System.
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