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| A Union of Twenty-Five Members: What Difference Does It Make? |
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April-June 2004 |
The enlargement of the European Union (EU) is a major institutional and historical event. But does it really make a difference in economic terms? Trade and financial integration between the 15 "old" members and the 10 "new" ones has now existed for quite a while. The CEPII's computable general equilibrium model MIRAGE confirms that, aside from agriculture, full integration of the new member states in the Single market will have little direct impact on the old EU members, but a rather big one on the new ones. The fears that EU enlargement will lead to large, negative effects on the labour market in the EU15, by means of massive relocations and hiring policies penalising low-skilled workers, appear to be ungrounded. By contrast, the MIRAGE model, which is based on imperfect competition, stresses the large impact associated with the change in the market structures of the new members.
The MIRAGE model also points out the important terms-of-trade changes to be expected from enlargement. Indeed, a depreciation of the newcomers' currencies is needed to re-balance foreign trade. But why should the trade account be brought back into balance when capital is flowing in? This hot topic has been studied from several points of view by the CEPII. As far as current account sustainability is concerned, if large deficits are a natural product of economic catching up, in some cases they are running at dangerously high levels. On the one hand, the bright growth outlook of these countries bodes well for their ability to pay off foreign debt. On the other hand, the massive inflows of FDI which have so far financed the deficit are likely to fall off in the medium term, and are bound to be replaced by more volatile (and therefore riskier) types of foreign capital inflows. Moreover, external deficits are highly correlated with government ones (the so called "twin deficit" phenomenon), reinforcing the case for sound fiscal policies. However, excessively tight fiscal policies might stall the catch up process, which in turn would raise the debt-to-GDP ratio. For the time being, in order to keep attracting FDI, most of the new EU members have chosen to cut corporate taxes. They have therefore made the choice of trying to sustain the "twin deficit" scenario. The success of this strategy will depend on the elasticity of capital inflows to corporate taxes. The CEPII's research on this issue shows that this elasticity is non-linear. Hence, the strategy is risky in that it implies large tax cuts. It is perhaps riskier for new member states, which will have to compensate the losses in public revenue, than for the "old" member states, which on the whole need the new members to catch up rapidly, both to enhance EU growth and to help the EU budget.
The sustainability of the "twin deficit" strategy will of course depend much on the exchange rate regime. One important implication of EU enlargement is the open door to euro area enlargement. The new EU members do not have the legal possibility to opt-out of euro membership. However, the timing of euro area enlargement is rather tricky. To begin with, the quick adoption of the euro may not be appropriate, for a number of reasons. The CEPII has looked at the type of trade carried out by these countries. Inter-industry trade remains relatively important, although it is declining. Intra-industry trade is rising rapidly. However it is essentially vertical trade, with new members exchanging low-quality goods for high quality ones produced in the old EU members. Such a trade structure is a potential source of asymmetric shocks, which would make a common monetary policy quite complicated. A further hurdle to adopting the euro lies in the provisions included in the Maastricht treaty. In particular, the ERM II arrangement looks very much like the fixed exchange rate regimes that were hit by various crises in the 1990s and the early 2000s. A key factor in reducing the risks would be for the new members to choose appropriate central parities on entering the ERM II. Such parities would ensure real exchange rate equilibrium. However, equilibrium exchange rate estimations run by the CEPII, using different methods, show the new members to be currently experiencing great heterogeneity regarding real exchange rate misalignments.
That said, EU membership is going to foster institutional convergence. Research carried out at the CEPII stresses the role of such convergence for integration through trade and investment. On the whole, being part of the EU will therefore facilitate the sustainability of the "twin deficit" strategy, provided that it is coupled with an appropriate monetary strategy. |
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