3.4. Economic Integration

Syllabus Content

Forms of economic integration - preferential trade agreements; trading blocs & monetary union

Economic Integration

‘What is a trade agreement?

A trade agreement is a contract/agreement/pact between two or more nations that outlines how they will work together to ensure mutual benefit in the field of trade and investment. Such trade agreements may involve co-operation in the field of R&D, the lowering of import duties to be levied on the other partners’ exports, guaranteeing any investments made by the partner(s) in the home market, co-operation on the tax front, etc.

Source: http://www.exporthelp.co.za/marketing/agreements.html, accessed Friday 18^th September 2015

Difference between Bilateral and multilateral agreements

The main difference between multilateral and bilateral free trade agreements (FTA) is the number of participants. Multilateral trade agreements involve three or more countries without discrimination between those involved, whereas bilateral trade agreements consist between two countries.

Multilateral negotiations are the most effective way of liberalizing trade in an interdependent global economy, because concessions in one bilateral or regional deal may undermine concessions made to another trading partner in an earlier deal. It is also important to mention that under multilateral trade agreements, regional trade arrangements take place and examples of this are the North American Free trade Agreement (NAFTA) and the European Union (EU). The most important organization concerning multilateral negotiations, agreements and contracts is the WTO. This organization owns a unified package of agreements to which all members are committed and enforces global rules for international trade. The most important requirements are to reduce barriers to trade between nations and to secure that member nations are acting within the predetermined rules. The General Agreement on Tariffs and Trade (GATT) is the basic multilateral contract between WTO members (Farm Foundation, 2002, ITCD online 2004, Carbaugh, 2004).

A quite practical advantage that relates to bilateral (FTA) is that they are quicker and easier to negotiate than multilateral agreements, because only two parties are included in bilateral negotiations. Furthermore bilateral FTA’s are a significant driver for trade liberalization, although multilateral agreements are more extensive.

Source: http://www.grin.com/en/e-book/118385/multilateral-and-bilateral-trade-negotiations, accessed Friday September 18, 2015

Preferential Trade Agreements

‘A trade pact between countries that reduces tariffs for certain products to the countries who sign the agreement. While the tariffs are not necessarily eliminated, they are lower than countries not party to the agreement. It is a form of economic integration’

Source: http://www.businessdictionary.com/definition/Preferential-Trade-Agreement-PTA.html#ixzz3m3hzow9n

‘Participation in preferential trade agreements (PTAs) has grown rapidly in recent years. In 1990, there were only about 70 PTAs in force. Thereafter, PTA activity accelerated noticeably; by 2010 the number of PTAs in force was close to 300 (see Figure 1). The average WTO member is party to 13 PTAs. PTA activity has transcended regional boundaries and levels of economic development. One half of the PTAs currently in force are not strictly "regional" with the advent of cross-regional PTAs being particularly pronounced in the last decade. Two thirds of all PTAs in force are between developing countries, about a quarter are between developed and developing countries, and the remainder between developed countries only.

Source: http://www.voxeu.org/article/preferential-trade-agreements-and-wto, accessed Friday September 18^th 2015

Different types of trading bloc

‘Trade agreements/trading blocs come in different forms, involving increasing levels of co-operation. Examples include:

Free Trade Areas (FTA) – This is the simplest kind of trading bloc and incorporates a two or more countries that have agreed to eliminate tariffs and other barriers to trade amongst members, but individually each country retains its own tariffs on imports from other non-member countries. Perhaps the best example of a FTA is the North American Free trade Area (NAFTA). Click here to read more about NAFTA.
Customs Union – A Customs Union goes one step further than an FTA in that it abolishes all tariffs amongst member countries, while members agree to a single, external tariff on goods imported from outside the Customs Union. Revenue generated by the Customs Union is shared amongst members based on a specific formula. The South African Customs Union (SACU) is one of the oldest Customs Unions still in place.
Common Market – In a Common Market, like with a Customs Union, a common tariff is placed on imports from other non-member countries, while no tariffs are exist on goods produced by one member country and sold in the other member country’s. The main additional difference between a Customs Union and a Common Market is that with the latter, the free movement of labour and is capital is also permitted. In other words, any restrictions on immigration, emigration and cross-border investment (amongst member countries) are abolished. The current European Union developed from the European Economic Community, a form of Common Market. The Common Market for Eastern and Southern Africa (COMESA) and the Caribbean Community – formerly the Caribbean Community and Common Market (CARICOM) are perhaps the two best examples of Common Markets.’ So a common market eliminates internal barriers, adopt common external barriers and allow free movement of resources among member countries
Economic Union – eliminate internal barriers, adopt common external barriers, allow free movement of resources among member countries and a uniform set of economic policies.

Source: http://www.exporthelp.co.za/marketing/agreements.html, accessed Friday, September 18^th 2015

Stages of Economic integration around the world

https://en.wikipedia.org/wiki/Trade_bloc

Trade Blocs

Task 1:

How might the NAFTA agreement have produced significant benefits for the Canadian, Mexican and US economy?
There are numerous economic arguments for regional economic integration. Given these arguments, why don't we see more integration in the world economy?
How should a US firm that currently exports to only ASEAN countries respond to the creation of a single market in this regional grouping?

Trans-Pacific Partnership failure may be China’s gain, Asia’s lossMany Asian economies will benefit less under a China-led trade pact than they would have done under the now-doomed TPP, analysts argue

Vietnam becomes seventh nation to adopt new Trans-Pacific PartnershipBecomes seventh nation to formally adopt the renewed Trans-Pacific Partnership

The main advantages for members of trading blocs

Free trade within the bloc

Knowing that they have free access to each other's markets, members are encouraged to specialize. This means that, at the regional level, there is a wider application of the principle of comparative advantage.

Market access and trade creation

Easier access to each other’s markets means that trade between members is likely to increase. Trade creation exists when free trade enables high cost domestic producers to be replaced by lower cost, and more efficient imports. Because low cost imports lead to lower priced imports, there is a 'consumption effect', with increased demand resulting from lower prices.

Economies of scale

Producers can benefit from the application of scale economies, which will lead to lower costs and lower prices for consumers.

Jobs

Jobs may be created as a consequence of increased trade between member economies.

Protection

Firms inside the bloc are protected from cheaper imports from outside, such as the protection of the EU shoe industry from cheap imports from China and Vietnam.

The main disadvantages of trading blocs

Loss of benefits

The benefits of free trade between countries in different blocs are lost.

Distortion of trade

Trading blocs are likely to distort world trade, and reduce the beneficial effects of specialization and the exploitation of comparative advantage.

Inefficiencies and trade diversion

Inefficient producers within the bloc can be protected from more efficient ones outside the bloc. For example, inefficient European farmers may be protected from low-cost imports from developing countries. Trade diversion arises when trade is diverted away from efficient producers who are based outside the trading area.

See: EU Sugar Case

Retaliation

The development of one regional trading bloc is likely to stimulate the development of others. This can lead to trade disputes, such as those between the EU and NAFTA, including the recent Boeing (US)/Airbus (EU) dispute. The EU and US have a long history of trade disputes, including the dispute over US steel tariffs, which were declared illegal by the WTO in 2005. In addition, there are the so-called beef wars with the US applying £60m tariffs on EU beef in response to the EU’s ban on US beef treated with hormones; and complaints to the WTO of each other’s generous agricultural support. During the 1970s many former UK colonies formed their own trading blocs in reaction to the UK joining the European common market.

See: The EU

Trade Creation and Trade Diversion (HL only)

Take the customs union as the example to analyze the effects of the economic integration. It has two kinds of effects: trade creation and trade diversion.

Trade Creation

It occurs when some domestic production in a nation that is a member of the customs union is replaced by lower-cost imports from another member nation (assuming that all economic resources are fully employed before and after formation of the customs union). It increases the welfare of member nations because it leads to greater specialization in production based on comparative advantage.

Illustration of trade creation

With Tariff, the nation’s production surplus (gains AGJC) increases while the consumer surplus decreases (loses AGHB), the deadweight loss is the total of protection effect (CJM) and consumption effect (NHB). It reduces the national welfare.

The formation of a customs union, no tariff, it can increase the national welfare, it is the total of protection effect and consumption effect (deadweight loss is eliminated).

A trade-creating customs union also increases the welfare of non-members because some of the increase in its real income spills over into increased imports from the rest of world.

Trade Diversion

It occurs when lower-cost imports from outside the customs union are replaced by higher cost imports from a union member.

Illustration of Trade Diversion

With free trade, domestic consumption of X is 70 (domestic supply 10X while the imports 60X);
With tariff, domestic consumption of X is 50 (domestic supply 20X while the imports 30X);
Form of a trade-diverting customs union, domestic consumption of X is 60 (domestic supply 15X while the imports from the member 45X)
Within the trade-diverting customs union, the imports are less than free trade, leading to trade diversion (the loss)

Trade diversion reduces welfare because it shifts production from more efficient producers outside the customs union to less efficient producers inside the union. Instead of importing from the most efficient exporter at price of $1, the customs union places a tariff on imports from non-partner countries. This causes the price of the most efficient producer to rise to $2 (S1 + T). Therefore, the customs union country will now import from one of its partner country that is a less efficient producer, but because the tariff is placed on the product from the non-partner country, is now considered cheaper (price = $1.50). Thus, trade has been diverted away from the most efficient producer outside the customs union to a less efficient country within the customs union.

Trade diversion worsens the international allocation of resources and shifts production away from comparative advantage.

Trade Creation and Trade Diversion

Task 2

After a promising start, MERCOSUR, the major Latin American trade agreement, has faltered and made little progress since 2000. What problems do you think has impeded MERCOSUR’s development? Can the countries do anything to re-ignite greater regional integration?
Why did many textile jobs apparently migrate out of the United States in the years after the establishment of NAFTA?
Who gained from the process of readjustment in the textile industry after NAFTA? Who lost?
With hindsight, do you think it is better to protect vulnerable industries such as textiles, or let them adjust to the painful winds of change that follow entering into free trade agreements? What would the benefits of protection be? What would the costs be?

Monetary Union

In the case of a Monetary Union, member countries agree to use a single currency or to fix their rates of exchange for the respective currencies. Essentially, a Monetary Union includes a Common Market Area, with a common currency administered by a common central bank. The difference between a common market and monetary union is that a Monetary Union involves far greater integration and co-operation amongst member countries. The best example of a monetary union is the Eurozone member states in which member countries have agreed to use a new, single currency – the euro! There are many other Monetary Unions in place – click here to learn more.

The main features of European Economic and Monetary Union (EMU) include:

A single European currency

The Euro (€) was first introduced in 1999, and national currencies were finally scrapped in 2002. The framework of rules for entry into the Eurozone was laid down in the Maastricht Treaty in 1992. This treaty also created the rules for membership of the European Union (EU) in general.

The euro-system

The euro-system has two elements - the European Central Bank (ECB), which is responsible for all monetary policy in the eurozone (euro area), and the National Central Banks (CBs) of the 19 member countries. Other European countries are free to join the euro area if they meet the criteria laid down in various treaties. The two most important criteria for entry are that the applicant country has demonstrated price stability, and that its public finances are well managed.

Co-ordination of macro-economic policies

Co-ordination of policy was designed to enable the original 12 economies of the euro area to converge. A key feature of this was the Stability Pact, which involved members agreeing to keep their economies stable, and keeping their budget deficits under control. The agreed limit for a deficit was that it must be no more than 3% of GDP. This restriction was designed to prevent any unnecessary fiscal stimulus, which might de-stabilize the economy, even in the face of high unemployment. However, several countries, including Germany, France, and most notably, Greece, have broken this rule, and this has cast serious doubts about the ability of the euro area to maintain this rule.

The European Financial Stability Facility

The EFSF was formed to help stabilize the European economies after the financial crisis, recession and sovereign debt crisis, and now forms a key element of the reformulated euro-system.

The fiscal compact

In attempt to prevent EU countries from running up further debts, the majority of the EU states signed a fiscal compact, which opened up their domestic budgets to collective scrutiny. It remains to be see how successful this measure will be, and whether its leads to a full fiscal union.

Single interest rate

The ECB sets interest rates across the whole Eurozone-19, and no single National Central Bank has the ability to alter interest rates itself.

Asymmetric inflation target

The ECB sets an asymmetric target rate for inflation of 2% - in other words, the inflation target is not symmetrical, as in the UK, where intervention should occur at rates 1% above and 1% below the target rate.

Current Eurozone convergence criteria based on Maastricht Treaty (1992)

ECB and the Eurosystem

The advantages of joining the Euro

1. Reductions in currency risk – this will enhance trade and investment flows between accession countries and the rest of the Euro Zone.

2. Reduction of transaction costs and increased price and cost transparency in markets

3. Lower interest rates – which will boost capital investment and promote long-term growth

4. Higher investment and trade will help to speed up the process of real economic convergence

5. Politically important symbol of their commitment to Europe

6. Discipline against inflation - Members cannot take the easy option (devaluation) to get out of economic difficulty.

Disadvantages of joining the Euro

It is important for the accession countries to enter the single currency with strong economic fundamentals – some economists argue that a period of consolidation is required for most of these countries before they become better prepared for irrevocable Euro entry.

1. ERM constraint: Having to spend two years inside the ERM II may prove to have a de-stabilizing effect on the accession countries – particularly due to the high rate of capital inflows (putting upward pressure on their currencies)

2. Loss of monetary policy autonomy: As they settle into the Single Market – it makes sense for them to retain some monetary policy autonomy e.g. in setting interest rates and retaining the option of exchange rate adjustments

3. Budget deficits: Many of the accession countries have high budget deficits – they might come under pressure to reduce these fiscal deficits by cutting government spending / raising taxes – which will be politically unpopular and which will hit short term economic growth

4. Concentrate first on the supply-side: In the near term, the accession countries might be better suited focusing on supply-side economic reforms designed at raising productivity and promoting entrepreneurship rather than becoming too obsessed with joining the Euro. This will improve the flexibility of their economies and will strengthen the ability to cope with shocks to economic activity and employment.

5. Harder for the ECB to set rates: The arrival of newcomers to the Euro, with their generally higher rates of growth than in Western Europe, will also complicate the work of the European Central Bank when they join the Eurozone. The ECB is responsible for setting the single official interest rate for the euro, no easy task considering the different level of economic development already inside the bloc. A single currency area of twenty nations, possibly more is far removed from the concept of an optimal currency zone.