Economic Unions

Abstract

Economic unions are a natural response to the realities of globalization and represent one stage in the process of economic integration. In theory, nations move from free-trade agreements to form customs unions and then common markets before forming economic unions. In practice, however, the path is not always that clear. Economic unions often are characterized by a common currency and centralized bank, in which case they are sometimes referred to as economic and monetary unions. The best example of a contemporary economic and monetary union is the European Union (EU). In many ways, the EU is a living laboratory for observing the effects of macroeconomic policy cooperation on regional growth and cross-border economic, trade, and investment ties.

Overview

Globalization brings with it many changes. From a business point of view, globalization increases the marketplace in which a business can sell its goods and services. On the other hand, globalization often makes doing business more difficult, requiring, for example, the management of an international supply chain, dealing with the intricacies of managing an international workforce, or marketing to different cultures. In addition, globalization affects not only businesses; it also affects the countries within which a business operates. Before globalization, most countries were able to be economically self-sufficient and did not rely on international trade or imported goods to survive. However, with increasing globalization comes an increasing reliance on the goods and services of other countries. Thus, while an international company can market its goods and services in other countries, those other countries can market their own goods and services locally to the new company. To help facilitate the economic realities of globalization, a number of nations are forming economic unions.

An economic union is a type of common market that permits the free movement of capital, labor, goods, and services. Economic unions harmonize or unify their social, fiscal, and monetary policies (often including having a united currency). Examples of economic unions include:

• The African Union,
• Andean Community (Comunidad Andina),
• Arab Maghreb Union (Union du Maghreb Arabe),
• Association of Caribbean States,
• Association of South East Asian Nations,
• Caribbean Community,
• Commonwealth of Independent States,
• East African Community,
• European Union, and
• Pacific Community.

Although in practice, the path from national economic self-sufficiency to economic integration varies from situation to situation; in general, there are four stages to this transformation:

• Free-trade agreements,
• Customs unions,
• Common markets, and
• Economic unions (Holden, 2003).

These stages are summarized in Figure 1.

Free-Trade Agreements. The first stage toward economic integration is represented by the free-trade agreement. Free trade is the exchange of goods and services between countries or sovereign states without high tariffs, non-tariff barriers (e.g., quotas), or other inhibiting requirements or processes. Free trade does not apply to capital or labor. Free trade agreements (also referred to as preferential trade agreements) eliminate import tariffs and quotas between the signatories to the agreement. They may apply to all aspects of international trade between the signatories or may be limited to a few sectors. Often, free-trade agreements include formal mechanisms that are to be used to resolve disputes. The primary advantage of the free-trade agreement is that it liberalizes trade among the member nations. However, free-trade agreements otherwise place few limitations on the member nations. In order for a free-trade agreement to properly function, it must also include rules of origin that apply to all third party goods imported from outside the free-trade area.

Customs Unions. The next stage in economic integration comprises the development of customs unions. Customs are duties or taxes that are imposed by a country, sovereign state, or common union on imported goods. In some situations, duties or taxes may also be imposed on exported goods. Customs unions remove internal trade barriers and require participating states to harmonize external trade policies. Part of this harmonization includes the development of a common external tariff. These are shared customs duties, import quotas, preferences, or other non-tariff barriers imposed by a customs union or common market on imports to any or all countries in the union or market. Common external tariffs are actually a simple form of economic union. Customs union may prohibit the use of trade remedies with the union and may also negotiate multilateral trade initiatives. Because all goods imported into a customs union are subject to the same tariff no matter their point of origin, custom unions have no need for rules of origin as required in free-trade agreements. However, in order to gain the benefits of a customs union, participating nations must by necessity relinquish their right to establish an independent trade policy. As a result, member nations also experience some restriction of foreign policy.

Common Markets. The third stage in economic integration is the development of a common market. This is a group of countries or sovereign states within a geographical area with a mutual agreement to permit the free movement of capital, labor, goods, and services among its members. Although common markets promote duty-free trade for the member nations, they impose common external tariffs on imports from countries that are not members. Common markets have unified or harmonized social, fiscal, and monetary policies. This feature of common markets severely limits the ability of member nations to implement independent economic policies. However, common markets offer gains in economic efficiency that could not otherwise be realized. Because of the nature of common markets, both labor and capital can move within the area of the common market, leading to a more efficient allocation of resources than could otherwise be achieved.

The Economic Union. The fourth stage in economic integration comprises the economic union. This is a type of common market which permits the free movement of capital, labor, goods, and services. Economic unions harmonize or unify their social, fiscal, and monetary policies. When economic unions also have a common currency with a concomitant central bank for all member states, they may be referred to as economic and monetary unions. Economic unions include significant harmonization of policy among the member states, particularly the formal coordination of monetary and fiscal policies, and labor market, regional development, transportation, and industrial policies.

Applications

The European Union. Arguably, the best known economic union is the European Union (EU) comprising twenty-eight different sovereign states in Europe by 2013. According to the Delegation of the European Commission to the United States, the roots of the EU trace back more than fifty years ("Economic & Monetary," 2007). The EU started as a "customs union that allowed trade to move freely among its member states" (p. 1). The EU facilitates the flow of labor, capital, goods, and services by providing a single market among the member states. The EU went a step further and became an economic and monetary policy with "coordinated fiscal policies and a common currency, the euro" (p. 1). In many ways, the EU is a living laboratory for observing the effect of macroeconomic policy cooperation on regional growth and cross-border economic, trade, and investment ties.

The roots of the modern EU began in 1970 with the publication of the first feasibility report for a European monetary union. At this time, much of Europe was suffering from stagnant and unstable economies. In 1973, the gold standard was broken up, and in 1979, the European Monetary Standard was established. These steps paved the way for economic and monetary union in Europe. In 1989 and 1992, the Delors Report and the Maastricht Treaty respectively set out a single currency for the EU. In 1999, member states of the EU entered the first stage of becoming an economic and monetary union by more closely coordinating economic policies and beginning to dismantle the barriers to the free movement of capital within the EU ("Economic & Monetary," 2007).

In 1994, the second stage toward becoming an economic and monetary union was entered. At this time, the EU liberalized the movement of capital and payments to non-EU countries. Member states of the EU also adopted a budget and debt ceilings and instituted a monitoring system. In 1998, Austria, Belgium, Germany, Finland, France, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain qualified to join the European economic and monetary union and adopt its currency parities. In 1999, the third stage was entered, and the euro was introduced. At this time, monetary authority in the euro zone was transferred to the European System of Central Banks. Also in 1999, eleven of the euro area member states fixed their exchange rates and adopted the euro. In 2001, Greece became a member of the euro area. In 2002, euro notes and coins were introduced within the euro area. In 2013, Croatia also joined the euro area ("Economic & Monetary," 2007).

Monetary Policy. Most people associate the creation of the euro with the transformation of the EU to being an economic and monetary union. However, this is only the tip of the iceberg. Underlying the euro is an entire infrastructure of economic policies intended to integrate the economies of member states, maintain low and stable inflation and interest rates, foster sustained economic growth, and improve competitiveness and productivity. Because the success of the EU is dependent on the efforts of the member states, they have agreed by treaty to address economic policies as a common concern. Accordingly, member states have agreed to the Stability and Growth Pact, which requires the central government within each member state to maintain an annual budget with a deficit of no greater than three percent of the gross domestic product and to maintain a public debt of less than sixty percent of the gross domestic product. The European Central Bank, an independent bank with a governing board that represents all euro area member states, determines and implements the monetary policy for all nations in the euro area.

Monetary policy for members of the EU that are not members of the euro area, on the other hand, is set by their national central banks. Similarly, government budgets and structural policies for labor, pensions, and capital markets continue under the jurisdiction of individual EU member states whether or not the state belongs to the euro area ("Economic & Monetary," 2007). Member states within the euro area are required to pay a financial penalty or face other sanctions if they do not meet these requirements of the pact (barring exceptional circumstances). Although member states that do not belong to euro area are also required to avoid excessive deficits, they do not face sanctions if they do not or cannot comply.

Advantages of the Euro. Despite prognostications of failure, the EU's experiment with becoming an economic and monetary union has been successful. Before the EU became an economic and monetary union, inflation in Europe was as high as 10 percent in some European countries. By 1998, however, inflation had dropped to 1.5 percent and has remained under 2 percent across the euro area. In addition, the introduction of a common currency has resulted in benefits not only for businesses, consumers, and travelers, but also for Europe in general and for the world economy. Since the implementation of the euro as a common currency, doing business in member states has become easier for businesses, consumers, and travelers. Because of lower inflation rates and more sound public finances, both businesses and consumers are faced with less economic uncertainty than before. In addition, businesses are no longer faced with exchange rate risks when doing business within the euro area. The use of the common euro also reduces requirements for paperwork and transaction costs resulting from the use of multiple currencies. Having a common currency also reduces corporate accounting requirements because there are fewer transactions involving multiple currencies.

The new economic environment within the European economic and monetary union also makes investment more attractive to foreign entities due to the lower costs of doing business and obviates the necessity for travelers of exchanging currency. As a result, member states have become more attractive tourist destinations. Similarly, lower interest rates also make it easier for euro area companies and consumers to borrow money ("Economic & Monetary," 2007). Banks, insurance agencies, and pension funds also have greater flexibility in the types of financial services they can offer because they are no longer affected by fluctuating exchange rates. The use of the euro also allows consumers, wholesalers, and traders to compare prices more easily. This leads to greater competition and a resultant lowering of prices.

The movement of the EU to become an economic and monetary union has also resulted in benefits for Europe in general. By banding together in the common euro area, member states are better protected from crises in the international economy. For example, member states can adjust more easily to fluctuations in external exchange rates with other currencies including the U.S. dollar and the Japanese yen. The transition to becoming an economic and monetary union has also given the EU a more prominent place in international institutions such as the G-8, the World Bank, and the International Monetary Fund ("Economic & Monetary," 2007). In addition, the establishment of the euro area has led to greater trade within the area. This has resulted in higher employment in the manufacturing and service industries and has also stimulated economic growth and expanded the tax base. In addition, the establishment of the euro area has impacted the world economy. This move has resulted in a stronger, more competitive economy in Europe with greater price and exchange rate stability and lower interest rates.

Opting Out. Not all member states of the EU are part of the euro area. For example, Denmark negotiated an opt-out clause in the treaty allowing it to retain its own national currency. Member states of the EU, however, have committed to adopt the euro once they meet certain criteria. First, member states desiring to join the euro area must have an inflation rate no more than 1.5 percent greater than the three best-performing EU member states for the previous year. In addition, the national budget deficit for the applying member needs to be less than 3 percent of the nation's gross domestic product and the ratio of its debt to its gross domestic product cannot exceed 60 percent. The national exchange rate for the applying member also needs to have been within predefined margins for the past two years. Interest rates within the applying state can be no higher than two percentage points above those of the three best performing EU member states during the previous year ("Economic & Monetary," 2007).

In early 2010, eurozone member Greece began imposing measures to rein in its expanding public debt. Greece was only one of a number of EU countries with substantially unbalanced budgets. The global financial crisis was creating massive demand for public services, and very high levels of unemployment limited those countries' ability to raise revenues. The European Central Bank, following the lead of German chancellor Angela Merkel, demanded deep austerity measures in Greece, Ireland, Portugal, Italy, and Spain in return for bailouts to prevent national insolvency. Resistance by recession battered populaces pitted economically strong Germany and to some extent France against the eurozone's weaker but still important members. As the political situation in Greece became increasingly unstable and stock markets globally began to sink, the U.K. urged a solution be found more rapidly. Ratings agencies downgraded not only Greece, Portugal, and Spain (all reduced to junk bond status), but also Italy, Belgium, France, and Austria. By 2013, stock markets had bounced back, though the weaker EU members remained fragile and Cyprus joined the list of troubled eurozone countries.

In the aftermath of the crisis, El-Erian (2013) warned that the euro was fragmented, freely circulating in some areas of the eurozone and trapped by capital controls in others. The euro was also subject to flight, especially to Switzerland and the United States. Neo-Keynesian Hetzel (2013) concluded that the ECB should purchase as many government securities as necessary to drive growth in aggregate nominal demand and commit to structural reform, allowing the inflation rate of affected countries to exceed 2 percent. The U.K., though financially regulated chiefly from Brussels, retained its own currency, and fears arose that resentments might negatively impact the financial services sector there (Dale, 2013). The role of Germany, though critical to sustaining its poorer sister countries in the eurozone, was not free from criticism. German wealth was undoubtedly the product of a culture of financial prudence, with an emphasis on savings, and repeated demands for bailouts from what it deemed profligate nations was met with resentment. As Greeley (2013) pointed out, however, German euros were invested aggressively — and profitably — in the very countries it later accused of reckless borrowing. In other words, the euro flowed from weaker countries to stronger countries, and EU policy did not adequately foster a return trip of euros to weaker countries in the form of growth.

Conclusion

Economic unions are a natural response to the realities of globalization. As nations develop and begin to interact more with their neighbors, free-trade agreements are often developed to eliminate tariffs between parties and to reduce other, non-tariff barriers to trade. As interaction and interdependency increase, customs unions form to impose a common external tariff in addition to the benefits of a free-trade agreement. When the benefits of a customs union become insufficient to promote trade at the level desired by the participating parties, common markets may be developed. These provide the benefits of a customs union along with free movement of capital and labor as well as some policy harmonization. The next step in responding to increasing globalization is the development of an economic union. This provides not only the benefits of a common market, but also establishes common economic policies and institutions for the member states. A further refinement on the economic union is the economic and monetary union that also gives the member states the benefit of a common currency and centralized bank. The best example of an economic and monetary union is the EU.

Terms & Concepts

Common External Tariff (CET): Common external tariffs are a simple form of economic union that implies shared customs duties, import quotas, preferences, or other barriers imposed by a customs union or common market on imports to any or all countries in the union or market.

Common Market: A group of countries or sovereign states within a geographical area with a mutual agreement to permit the free movement of capital, labor, goods, and services among the members. Although common markets promote duty-free trade for the member nations, they impose common external tariffs on imports from countries that are not members. Common markets have unified or harmonized social, fiscal, and monetary policies.

Currency: Money that is circulated and generally accepted for the exchange of goods or services within a given jurisdiction. Domestic governments typically set their own currency and penalize individuals or businesses under its authority that do not accept it. Although currency is technically only legal within a given jurisdiction, some countries informally accept the currency of another country or countries. Resources for two or more countries can also be pooled to make an international currency accepted by all parties to the agreement.

Customs Union: An agreement between two or more nation states to impose a common external tariff, remove trade barriers, and reduce or eliminate customs on trade among members of the union. These unions generally place the common external tariff on imports from countries outside the group, but do not allow free movement of capital or labor among the member countries.

Customs: Duties or taxes that are imposed by a country, sovereign state, or common union on imported goods. In some situations, duties or taxes may also be imposed on exported goods.

Economic Union: A type of common market that permits the free movement of capital, labor, goods, and services. Economic unions harmonize or unify their social, fiscal, and monetary policies. When economic unions also have a common currency with a concomitant central bank for all member states, they may be referred to as economic and monetary unions.

Free Trade: The exchange of goods and services between countries or sovereign states without high tariffs, non-tariff barriers (e.g., quotas), or other onerous requirements or processes. Free trade does not apply to capital or labor.

Globalization: Globalization is the process of businesses or technologies to spread across the world. This creates an interconnected, global marketplace operating outside constraints of time zone or national boundary. Although globalization means an expanded marketplace, products are typically adapted to fit the specific needs of each locality or culture to which they are marketed.

Gross Domestic Product (GDP): The total market value of all final goods and services produced within the borders of a country during a given period of time. The gross domestic product includes the total consumer, investment, and government spending in addition to the value of exports minus the value of imports.

Labor: The sum of all human physical and mental effort that is used to produce goods or services. Although labor includes the application of knowledge to produce goods or services, it does not apply to the knowledge itself.

Monetary Policies: The regulation of the supply of money and interest rates by the central bank (e.g., the Federal Reserve in the United States) of the country or union to control inflation and stabilize currency.

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Suggested Reading

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Bainev, V., & Vinnik, V. (2015). Approaches to harmonizing the industrial policy of countries in the customs union and common economic space. Problems of Economic Transition, 57(10), 66–79. doi:10.1080/10611991.2014.1119565. Retrieved December 28, 2016, from EBSCO online database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=112900785&site=ehost-live&scope=site

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