www.nejtillemu.com/lepagefortress.htmFortress Europe
Why customs unions lead to economic decline
by Henri Lepage
From The European Journal
There has been a resurgence of protectionist demands from vested interest groups during the last few months. France in particular has established itself as the leading player in the anti-globalisation campaign. I believe that the reasons for this are relatively straightforward and stem directly from the way the EU organises its international trade.
To understand this, it is useful to recall that regional trade agreements can be divided into two rough categories: free trade agreements, such as NAFTA, and customs unions, such as the European Union.
Members of a free trade area typically maintain their own tariffs on goods originating outside the area, whereas members of a customs union establish a common tariff on goods originating from non-member states.
Crucially, the establishment of common external tariffs usually commits customs unions to setting up common political and administrative institutions.
This is at the root of our current problems.
Economists like to ponder the pros and cons of pursuing a regional approach to trade liberalisation in addition to a multilateral approach (such as through the World Trade Organisation.)
Given the smaller number of players involved, regional trade agreements often help promote trade liberalisation at a faster pace than may be possible at the multilateral level. They also provide impetus for those outside the agreement to work towards multilateral reforms so that they are not left behind other countries that take advantage of freer trade with regional partners.
Though free trade agreements are generally viewed as more trade friendly than customs unions, this need not always be the case.
The European common market in its original incarnation was a powerful engine not only for liberalising trade and bringing more business competition within Europe, but also for forcing some member countries to reduce the grip of government over industry. This was especially the case in statist France.
Even socialist governments finally could do nothing else but submit themselves to the will of Brussels and to the European Court of justice's power to sue and fine national governments. The single market helped deregulate state monopolies and allowed for increased competition in regulated industries.
Similarly, regional trade agreements are generally understood to provide more benefits than costs if they are 'trade creating', rather than 'trade diverting'.
Trade diversion as defined by economists occurs when preferential treatment causes a country to replace imports from the rest of the world with imports from a free trade association member country.
The same analysis also applies to international investment decisions. Economic theory teaches that trade diversion is more likely to occur with customs unions than with free trade agreements.
Yet, though intra-European trade grew much faster than trade with regions outside the EU, most studies show that over the last few decades more trade was created in total than was lost; on balance the Single Market was a success.
Unfortunately, this may no longer be the case. I believe that once a customs union is accompanied by the creation of common political institutions, a day unavoidably comes when it falls into the trap of a 'fortress' mentality.
Since a customs union requires the existence of common political institutions, problems will usually start once tariffs and quantitative obstacles to trade have been reduced to zero.
At first, all seems well. Differences in taxes and regulations become a major factor influencing intra-zone business competition. Corporations tend to move to member countries with the most favourable tax and regulatory structures. The consequence of a successful customs union is thus to introduce competition between legal systems.
But like all producers, bureaucrats particularly those from countries with the highest tax rates and regulatory burden - do not like competition. When businesses move towards lower tax areas, governments lose revenue and their capacity to spend is reduced.
Heavy spenders feel threatened and bureaucrats lose much of their power to influence the distribution of economic rents. Thus a new discourse sets in denouncing the danger of a 'race to the bottom and the threat that unbridled competition poses to the future of modern welfare systems.
The call is invariably for a level playing field implying that people should pay the same taxes and bear the same welfare cost burden everywhere. The political priorities of the customs union - in our case the EU progressively shift from free trade to creating the conditions for fairer trade.
While still loudly emphasising the gains brought about by a more competitive economy, politicians call for the unification and harmonisation of the rules of the competitive game - not exactly the same thing. Their claim is joined and supported by short-sighted business lobbies for whom it is less costly to fall prey to political correctness than to vocally endorse a public spending reduction agenda.
This is exactly the story of the European Union. A big change occurred following the Maastricht Treaty in 1991 and its implementation over the following years. The emphasis moved from increasing market competition through lowering quantitative obstacles to trade to 'organising' competition through common policies and harmonised regulations.
A paradigm shift occurred that led to the displacement of the 'one market agenda engraved in the 1986 Single European Act, which was intended to be completed in 1992. What took its place was a new 'Level-playing-field' philosophy for which economic integration implies not only the absence of physical obstacles to trade within the EU, but also the enforcement of unified rules, standards and taxes by a stronger central European government.
As Pascal Salin, a professor of economics at the University of Paris-Dauphine, has masterfully explained, fair trade does not require competitors to pay identical taxes, or to bear the same amount of welfare contributions.'
Why not ask for the flattening down of hills and mountains they increase the costs of companies located in Alpine areas relative to those of their competitors located in flat lands? Is it not unfair they should incur higher transport costs due to an accident of geography?
Why not ask Spanish tomato growers to compensate Dutch farmers for the lack of sunshine in the Netherlands? After all, are not free heating and lighting unfair commercial advantages?
The legal and tax environment is part of the comparative advantages or disadvantages enjoyed by national businesses. The imposition of a uniform legislation all throughout the European Union may seem 'fair' to those who have more difficulties to withstand the competition from foreign products because they pay higher taxes or are subjected to tighter regulations. But it is surely 'unfair' to companies located in low-tax countries deprived of the local competitive advantage they previously enjoyed.
Under the guise of equalising competitive conditions all over the Union, the Maastricht Treaty deeply altered the nature of the Common Market. It transformed Europe into a cartel of states built around a set of common policies. The intra-European competitive process was reduced and market penetration by foreign companies was made more difficult than it would have been bad the EU stuck to the original 1986 Single European Act.
The Maastricht compromise thus made European institutions and politics much more prone to a 'fortress' mentality. Those who already long ago feared that the natural outcome of a customs union process would be to divert trade liberalisation efforts towards the formation of rival regional trade blocks are being proved right.
This fortress mentality was made even worse as a natural consequence of the launch of the euro on 1 January 1999. Economic and Monetary Union deprives profligate governments of one important means for compensating their mistakes and bad policies - they no longer control a currency which they can inflate away to pay their way.
The only way individual nation states can raise funds is through the use of taxation. Differences in taxes and legislation hence have more bearing than ever on the competitive position of economic actors.
As a consequence the public and private national interests pushing for a European neo-protectionist policy have become even more vocal.