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Unity with diversity in the European economy: the Community's Southern frontier

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Executive Committee

Chairman Anthony Loehnis

Vice-Chairman Sir Adam Ridley

Governors Professor Giorgio Basevi Dr Paul Champsaur Honor Chapman Guillermo de la Dehesa Romero Michael Emerson

Jeremy Hardie Sarah Hogg Kate Mortimer Sheila Drew Smith Sir Douglas Wass






Officers

Director Professor Richard Portes

Assistant Director Stephen Yeo

Director of Finance and Research Administration Wendy Thompson

31 January 1990






Unity with diversity in the European economy: the Community's Southern frontier

Edited by

CHRISTOPHER BLISS

and

JORGE BRAGA DE MACEDO

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First published 1990

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British Library Cataloguing in Publication DataUnity with diversity in the European economy:the Community’s southern frontier.1. European Community countries. Economic integration

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I. Bliss, C. J. (Christopher John), 1940–II. Macedo, Jorge Braga de337.142

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Contents

List of figures List of tables Preface List of conference participants Foreword

Michael Emerson and Richard Portes

page xi

xiii xvii

xviii XiX

1 Introduction Christopher Bliss and Jorge Braga de Macedo 1

1 Enlargement and integration 1 2 Unity with diversity 2 3 Adjustment and compensation 4 4 Trade liberalization and catching up: another U curve? 5 5 The European car market: a specific case of adjustment 6 6 Financial liberalization and integration 7 7 Spain: the least 'Southern' country 9 8 Greece: the most 'Eastern' country 12 9 Portugal: where East meets West 13

10 Soft budgets revisited 16 11 Unity, diversity and the policy domain 17

2 Adjustment, compensation and factor mobility in integrated markets Christopher Bliss 18 1 Introduction and outline 18 2 The effects of reform and redistribution 22 3 Principles for allocating the Structural Funds 28 4 Identification and addressing 35 5 Relations with the outside world 43

vii






viii Contents

6 Factor mobility and the regions in an enlarged Single Market 45 7 Conclusions and policy 48

Discussion Michael Emerson 53

3 Integration and the competitiveness of peripheral industry Paul R. Krugman and Anthony J. Venables 56 1 Market access and manufacturing competitiveness: defining

the issues 57 2 A model of trade liberalization 59 3 Oligopoly 62 4 Monopolistic competition 64 5 Variable costs 66 6 Factor abundance and comparative advantage 71 7 Concluding remarks 73

Appendix: Numerical simulations 75

Discussion Andre Sapir 76

4 The market for cars in the enlarged European Community Alasdair Smith 78 1 Introduction 78 2 The model 79 3 Data and model calibration 80 4 Simulation of policy changes 85 5 Conclusions 96

Appendix: The model 97

5 Financial market integration, macroeconomic policy and the EMS William H. Branson 104 1 Introduction and summary 104 2 Current account balances: the world and Europe 107 3 Capital markets and risk premia III 4 Interaction with the monetary system 113 5 The constraint on monetary policy 114 6 The role of financial intermediaries 118 7 Structural reform in the financial sector 123 8 An integrated EC fiscal system? 126






Contents IX

6 Macroeconomic adjustment and entry into the EC: a note Paul R. Krugman 131 1 General considerations 131 2 Long-run exchange-rate effects of integration 133 3 Expectations and the real exchange rate in the medium term 135 4 Money and exchange-rate policy 137 5 Conclusions 139

Discussion of chapters 5 and 6 Vitor Gaspar 141

7 Spain and the 'EC cum 1992' shock Jose Viiials et al. 145 1 Introduction 145 2 The Spanish economy on the eve of EC membership 148 3 Adjustment to the 'EC cum 1992' shock 195 4 Policy responses 220 5 Conclusions 226

8 Economic integration in the enlarged European Community: structural adjustment of the Greek economy Louka T. Ka,tseli 235 I Introduction 235 2 The structure of the Greek economy 238 3 Effects of trade and capital market liberalization on the

Greek economy 282 4 The policy challenge in the 1990s 298

Appendix: Labour market adjustment 305

9 External liberalization with ambiguous public response: the experience of Portugal Jorge Braga de Macedo I Introduction 2 Domestic constraints on integration policy 3 Wage flexibility and labour mobility 4 Trade liberalization and competitiveness 5 Banking regulation and competition 6 Fiscal adjustment in a frozen public sector 7 Monetary and exchange-rate policy 8 Conclusions

310 310 313 319 324 333 336 342 348






x Contents

10 Soft budgets, hard minds: stray thoughts on the integration process in Greece, Portugal and Spain Dani Rodrik 355

Index 361






2.1 3.1 3.2 3.3 3.4 3.5 3.6 3.7 6.1 6.2 7.1

7.2 7.3 7.4

7.5 7.6 7.7 7.8 7.9

8.1 8.2

8.3

8.4 8A.l

Figures

The adjustment game Oligopoly: output and trade Oligopoly: profits and welfare Monopolistic competition: output and trade Output and trade when wages are flexible Relative wages Output and trade when manufacturing is labour-intensive Relative wages when manufacturing is labour-intensive Open-economy equilibrium The monetary consequences of expected appreciation Spain: relative real unit labour costs measured in a common currency, 1970-86 Labour costs - competitiveness, 1970-86 Spain: deviations from covered interest parity, 1982-85 Peseta and Eurodollar 3-month deposit interest rates, 1982-89 Stock market capitalization, 1983-88 Annual stock rotation, 1983-88 The peseta real exchange rate, 1979-89 Spain: deviations from covered interest parity, 1982-89 Spanish interest rates and foreign-exchange reserves, 1982-89 Greek trade and current account deficits, 1970-88 Greece: ratios of surplus on invisibles to trade deficit and of non-debt financing to the current account, 1970-88 Deviations of Greek interest rates from covered interest parity, 1980-88 Greece: net private short-term capital inflows, 1980-88 The determination of employment

xi

page 41 63 64 67 69 70 72 73

135 138

160 161 180

182 193 194 204 213

216 281

281

295 296 305






xii Figures

9.1 Portugal and the Ee: investment and catching up, 1970-88 314 9.2 The Portuguese incremental capital-output ratio, 1970-88 315 9.3 Portugal: labour share, 1973-88 322 9.4 Portugal: wage and output adjustment, 1973-88 323 9.5 Portugal: indices of competitiveness, 1976-88 325 9.6 Portugal: erosion of the crawling peg, 1977-88 345






3.1 3.2 4.1 4.2 4.3 4.4 4.5

4.6 4.7 4.8 4.9 5.1 5.2 5.3 5.4

6.1 7.1

7.2

7.3

7.4

7.5 7.6

Tables

Peripherality and per capita GDP Hypothetical effects of lowering trade barriers The European car market in 1988 Iberian integration NTB reduction (Iberian integration base) Tax harmonization (on rate of 26.5%) Removal of national VERs (Iberian integration and Ee NTB reductions in base) Removal of national VERs and Japanese expansion into Ee Replacement of national VERs by an Ee VER Removal of European VER Removal of European VER with integrated markets World current accounts, 1990 OEeD Europe current accounts, 1990 OEeD Europe current accounts, 1987-90 Sources of funds for US manufacturing firms, by asset class 1970-84 Spanish macroeconomic developments, 1980-88 The components of Spain's current account balance, 1964-85 Evolution of Spanish manufacturing trade prior to Ee membership Geographical structure of Spanish manufacturing trade, 1978-85 Revealed comparative advantage in Spanish industrial trade by geographical areas, 1985 The structure of Spanish industrial value added, 1978-85 Size distribution of the number of plants in Spanish manufacturing, 1985

page 57 59 82 87 88 89

90 91 93 94 95

107 108 110

122 136

149

150

152

153 155

156






xiv Tables

7.7 Relative effort in R&D and sectoral structure of Spanish R&D expenditures, 1983-85 158

7.8 The financial structure of private Spanish industrial firms, 1985-86 159

7.9 Comparative public sector structures, 1973-88 162 7.10 Goverment spending comparisons, Spain and EC4, 1985 163 7.11 The structure of Spanish taxation in 1985 164 7.12 Selected infrastructure indicators in the EC and Spain,

circa 1985 166 7.13 The percentage of Spanish firms with local constraints,

1968-87 168 7.14 Spanish factor prices and productivity, 1965-88 169 7.15 The distribution of unemployment in Spain, 1976-88 174 7.16 Spain: the probability of entering unemployment and its

expected duration, 1976-88 176 7.17 Covered interest-rate differential between the peseta and the

Eurodollar, 1982-85 180 7.18 Comparative measures of outputs and costs in banking,

1984-88 184 7.19 The comparative profitability of EC banking industries,

1985-86 186 7.20 Indices of concentration in the Spanish banking sector,

1980-88 187 7.21 Spanish money, bond and stock markets, 1982-88 190 7.22 Spain's macroeconomic performance, 1985-88 196 7.23 Foreign direct investment in Spanish manufacturing and

sectoral performance, 1985-88 197 7.24 Changes in Spain's commercial protection derived from EC

membership, 1986-93 201 7.25 Spain's external accounts adjustment, 1985-88 202 7.26 Spanish savings and investment, 1985-88 205 7.27 Spanish manufacturing trade after accession by branches,

1985-88 206 7.28 Post-accession changes in Spain's net exports to the EC 207 7.29 Simulated sectoral effects on Spain of the 'EC cum 1992'

shock 208 7.30 Covered interest-rate differentials between the peseta and the

Eurodollar, 1982-89 214 8.1 The structure of Greek public expenditure, 1958-87 246 8.2 Greece: the structure of government expenditure on goods

and services, 1958-86 248 8.3 Greece: the structure of public revenues, 1958-87 250






Tables xv

8.4 Greece: structural deficits and fiscal impulses, 1959-88 253 8.5 Central government gross public debt, 1982-88 254 8.6 General government net debt interest payments, 1982-88 255 8.7 Greece: number of firms, employment and concentration

ratios by industrial sector, 1984-86 257 8.8 Rates of return in Greek industry, by large, small and overin-

debted firms, 1980-86 258 8.9 Profitability and debt-equity ratios for Greek industry,

1979-86 260 8.10 Greek capacity utilization rates, all industries, 1969-80 261 8.11 Degree of industrial inefficiency in selected Greek industries,

1973-80 262 8.12 Consolidated balance sheet of the Greek monetary system:

end-of-period balances, 1970-88 265 8.13 Employment shares and growth rates in the Greek economy,

by occupational status and industry, 1983-87 271 8.14 Greek unemployment: rate, structure and duration, by age

and sex, 1981-86 273 8.15 Wage flexibility in the Greek labour market, 1970-86 275 8.16 Structure of Greek manufacturing exports by two-digit

industrial classification, 1981-86 277 8.17 Greece: capital-labour ratio by two-digit industry, 1980-86 278 8.18 Similarity ofEC imports from Greece and various groups of

developing countries, 1986 279 8.19 Trade overlap coefficients between Greek exports and

imports, 1980-86 280 8.20 Greek nominal protection rates, by broad categories,

1974-85 283 8.21 Nominal effective protection in Greece as a percentage of

import prices, 1970-82 284 8.22 Greece: industrial terms of trade, 1973-89 285 8.23 Greece: average import penetration, 1960-86 286 8.24 Greece: export propensity ratios, 1981-86 287 8.25 Greece: trade competitiveness by sector and period, 1974-86 288 8.26 Estimated trade effects on employment and real wages in

Greek industry, 197&-84 289 8.27 Determinants of Greek price-cost margins, 1973-80 292 8.28 Participation by major Greek banks in commercial business

exceeding limits imposed by the EC's Second Directive, 1987 294

8.29 Deviations of Greek interest rates from covered interest-rate parity, 1980-88 295






xvi Tables

8.30 Effects of interest rate and wage rate movements on Greek employment and capital accumulation, 1962-85 297

8.31 Greece: real effective exchange rates, calculated from relative consumer price indices (REER1) and unit labour costs (REER2), 1981-89 300

8A.1 Econometric evidence regarding employment of permanent civil servants (EK) as a fraction of total wage employment (E), 1970-87 306

9.1 Growth cycles in Portugal and the twelve, 1970-90 317 9.2 Portugal: sectoral financial balances, 1970-90 320 9.3 Portugal: direction of trade, 1970-85 326 9.4 Portugal, industry characteristics, 1983 327 9.5 Portugal: simulated welfare gains from the Single Market 328 9.6 Structure of value added in Portugal and the EC, 1977-86 330 9.7 Direction of Portuguese trade in manufactures, 1985-87 330 9.8 Intra-industry specialization in Portugal's total trade,

1983-87 330 9.9 Portuguese trade and industrial structure, 1977-86 331 9.10 Foreign direct investment in Portugal, 1980-88 332 9.11 Structure of foreign direct investment in Portugal, 1985-88 332 9.12 Portugal: decomposition of changes in the total debt-income

ratio, 1970-88 337 9.13 Portugal: seigniorage tax revenue, 1976-88 339 9.14 Portugal: decomposition of the change in the domestic debt-

income ratio, 1976-88 340 9.15 Portugal: estimated revenue from implicit intermediation

tax, 1978-88 342 9.16 Effective crawl bias and real interest differentials, 1984-88 343 9.17 Portugal: indices of competitiveness, 1970-88 344 9.18 Simulating the escudo fixed to the D-mark, 1986-88 347






Preface

This volume contains the proceedings of the concluding conference of a research project on 'Economic Integration in the Enlarged European Community', conducted under the auspices of the Centre for Economic Policy Research. The conference was hosted by the European Cultural Center at Delphi on 26-27 October 1989. Our thanks are due to Pericles Nearhou for making available the facilities of the European Cultural Center, and to Litsa Florentis at the Center and Ann Shearlock at CEPR for their work in organizing the conference.

Financial support for the project was provided by the Commission of the European Communities, the German Marshall Fund of the United States, the Secretaria de Estado de Comercio of the Spanish Ministerio de Economia y Hacienda, the Fundaci6n Banco Exterior de Espana, and the Instituto do Comercio Externo de Portugal, whose support we gratefully acknowledge.

Paul Compton and Sarah Well burn at CEPR have been responsible for guiding this volume to press rapidly and efficiently, keeping contributors and editors to a very tight production schedule. Our thanks are due to them and to John Black of the University of Exeter, whose work as Production Editor has been invaluable.

Christopher Bliss Nuffield College, Oxford

and Centre for Economic Policy Research

Jorge Braga de Macedo Commission of the European Communities

Universidade Nova de Lisboa and Centre for Economic Policy Research

15 January 1990

xvii






Conference participants

Christopher Bliss Nuffield College, Oxford, and CEPR William Branson Princeton University and CEP R Christina Corado Universidade Nova de Lisboa Michael Emerson Commission of the European Communities and CEP R Nicholas Floros University of Athens Vitor Gaspar Universidade Nova de Lisboa and Ministry of Finance, Lisbon Konstantine Gatsios Fitzwilliam College, Cambridge, and CEPR Nicholas Glytsos Centre of Planning and Economic Research, Athens Jordi Gual Instituto de Estudios Superiores de la Empresa, Barcelona, and

CEPR Alexis Jacquemin Commission of the European Communities Nicholas Karavitis University of Athens Louka Katseli University of Athens and CEP R Nickolina Kosteletou University of Athens Leslie Lipschitz International Monetary Fund Jorge Braga de Macedo Commission of the European Communities,

Universidade Nova de Lisboa and CEPR Luis Mafias Repsol SA Carmela Martin Universidad de Madrid Jackie Morin Commission of the European Communities David Newbery Churchill College, Cambridge, and CEPR Joan Pearce Commission of the European Communities Richard Portes CEPR and Birkbeck College, London Dani Rodrik Harvard University and CEP R Andre Sapir Universite Libre de Bruxelles and CEP R Alexander Sarris University of Athens Alasdair Smith University of Sussex and CEP R Anthony Venables University of Southampton and CEPR Jose Vifials Banco de Espana and CEP R Stavros Zographakis University of Athens

xviii






Foreword

MICHAEL EMERSON and RICHARD POR TES

Territorial enlargement versus deepening of the integration process: the European Community has been persistently concerned, if not at times tormented by this dialectic. It was true of the first enlargement in the 1970s. So also in the 1980s, as the Community decided more ambitiously than in the previous decade to enlarge and deepen both at the same time. Greece joined in 1981, and Portugal and Spain in 1986. Thus the second enlargement saw the Community's divergences in terms of level of development widen considerably. Notwithstanding, 1985 saw the Commission advocate a new push to complete the Single Market in the eight years to follow.

Already by 1988 the agenda lengthened further, with renewed consideration being given to monetary union. Spain then joined the European Monetary System in 1989. Also in the late 1980s the issue of further enlargement was being posed again, this time by Turkey in 1987 and Austria in 1989; and the broader question of EC-EFTA ties became prominent. At the close of the decade the Community's future relationship with Eastern Europe came explosively to the top of its priorities.

The present study has attempted to throw light on the economics of this dialectic between widening and deepening. The questions of concern to the politicians have been quite clear. Put in a neutral way, could the relatively weak economies of the new, geographically peripheral Member States withstand the double shock of accession and completion of the Single Market? Worse, might their economies be driven into relative depression, as was seen in the Mezzogiorno after Italian unification? Or better, might the double shock enable these countries to accelerate their modernization? Do economic principles point to a pre-determined outcome? If not, what are the conditions for securing the better outcome? What should be the responsibilities of national and Community authorities in this process?

At the outset of the research programme reported here, there was no

xix






xx Foreword

self-evident answer to these questions. Economists were variously able to point both to divergence as well as convergence theorems. On the right, Adam Smith optimists presumed that the invisible hand would secure advantage for all. On the left, Kaldorian pessimists feared for the progressive immiserization of the weak and peripheral regions. The fundamental issue was quite open.

It is for the editors, Christopher Bliss and Jorge Braga de Macedo, to draw together the conclusions of the various studies in a comprehensive manner. For our part, we draw attention selectively to some of the main points that emerged at the programme's concluding conference in Delphi in October 1989.

One fundamental conclusion is that in fact no simple paradigm, be it that of the Adam Smith optimists or the Kaldorian pessimists, prevailed. It all depends. This may sound like banal agnosticism or the well-known story of the two-handed economist. But the conclusions are in fact a good deal more dramatic.

The degree of indeterminacy in the likely outcome is not a small margin surrounding a neutral centre point. Rather, several arguments point to a wide possible range of positive or negative impacts. Since these can accumulate, the range of overall possible outcomes may indeed be between brilliant achievement and big difficulties. Four examples of this type - the arguments that can go either way - may be picked out.

First comes an argument from the analysis of industrial organization and the location of investment, as set out by Paul Krugman and Anthony Venables. A small, peripheral and previously protected economy stands to make particularly large gains in economic welfare as a result of integrating with a large, efficient economy. The relatively low wage may also then attract investment from the core. On the other hand, there will be some tendency for industry to concentrate nearer to the core region, partly because of the higher amount of protection relinquished by the peripheral economy. It seems difficult to know a priori on which side the balance of advantages will fall.

Second is an argument well known in the literature about the sequencing and design of programmes of measures to remove market distortions. A first-best solution is usually seen as coming from a comprehensive improvement of product and factor markets. If instead only partial reforms are undertaken while other pronounced market distortions remain, then the size of the likely gains may be highly uncertain, and the partial reforms might even bring overall losses.

In the case of EC enlargement and completion of the internal market, the accent is on the liberalization of the markets for tradable goods and services and internationally mobile capital. Labour markets are little






Foreword xxi

affected: external mobility is assured, but internal rigidities are not directly attacked. In addition, public goods and services and many aspects of financial market regulation are not directly affected. Thus the externally imposed reforms are indeed only partial. The country studies for Greece, Portugal and Spain analyse the extent to which these countries are so far succeeding or failing with their internal measures to assure overall coherence of their policies addressed to product and factor markets.

Third is a related argument which has a more institutional character. The issue is whether the Member States can secure support from the Community institutions in the pursuit of national policy objectives. Comments at the conference by Konstantine Gatsios used the example of competition policy, where the Commission has an independent capacity to rule national subsidies illegal. If national governments and the Commission pursue consistent objectives, for example to secure higher efficiency in enterprises earlier benefiting from state support, the Member State can derive enhanced credibility for its own policy. But if the Member State and the Commission are working at cross purposes, the confusion perceived by the private sector can be very costly for the economy.

Fourth is an argument relating to the structural funds, which is set out in the paper by Christopher Bliss. Widely differing impacts are possible. In the worst case the beneficiary, whether government or private sector interests, is induced to pursue rent-seeking strategies rather than advances in productivity to complement the funds' contribution to improving infrastructure or the stock of labour skills. In the best case the beneficiary pursues these complementarities, and more broadly the nation is encouraged to raise its level of ambition in responding to the challenges of integration into the EC and modernization.

The accumulation of these four arguments points out both opportunity and risk. If all four factors can be turned positively, their combination can become not just a set of policy improvements, but rather a comprehensive and credible regime change, so perceptions of the economic attractiveness and prospects of a country may be quite transformed. Synergies are created. In the contrary case, there may be a failure in the processes of competition, with severe costs and delays before the resources of nonviable enterprises are redeployed more efficiently. The three country studies portray Spain as coming closer to the former model, Greece closer to the latter, with Portugal occupying a somewhat ambiguous position in between.

These were major themes at the conference. There were also several issues that might have been expected to emerge strongly, but did not in






xxii Foreword

fact do so. These instances of 'the dog that did not bark' may offer clues that will help in identifying the key determinants of success or failure in the integration process. Here we give five important examples.

First, participants did not call for massive expansion of the structural funds. As suggested above, it is quality that will be decisive, at the already planned substantial quantity. Efforts should focus on proper targeting and implementation of structural fund policies and complementary measures at national level.

Second, although at the onset of the research we had expected crossborder labour migration in the Community to be a prominent theme, in the event it played a relatively minor role in the studies and the conference. There was considerable discussion of the problems of national labour markets, but international mobility of labour between the South and North of the existing Community drew much less attention than the integration of goods and capital markets.

Third, although the Brussels compromise of February 1988 has surely not resolved the Community's problems with the Common Agricultural Policy - if only because of its effects outside the EC - the CAP went virtually unmentioned in the conference papers and discussions. It is clearly of major significance for the economic structures of the recent entrants, and for intra-EC resource transfers, but it may perhaps be taken in its current form as a datum in assessing how the integration process will work over the next several years.

Fourth, the often acrimonious disputes over 'harmonization' and Brussels-imposed uniformity in the approach to 1992 also did not feature in our meeting. These issues - the details of taxes, standards and regulations - are perhaps more significant to the more developed countries in the Community. They will have relatively little bearing on the success or failure of the integration process for Greece, Portugal and Spain.

Finally, we heard little of the arguments over fiscal rules and macroeconomic policy coordination that have become so important since the Delors Committee Report. Of course policy choices with regard to the EMS, particularly for Greece and Portugal, were major future themes, as was the progressive loss of monetary policy autonomy, but there was much more attention to the domestic constraints on and problems of fiscal policy than to any rules that might be prescribed centrally.

These are the lessons we drew from the conferences and the research programme it summarized. Their importance is much enhanced by current developments in Eastern Europe. The work presented here illuminates the key issues underlying the interplay between widening and deepening in the existing European Community. It suggests the relevant questions in examining possible forms of association with the Eastern






Foreword XXlIl

countries, as well as others that have indicated their desire for closer attachment to the Community. The experience of Greece, Portugal and Spain may also help to interpret and guide the development policy choices of the Eastern countries.

Moreover, there is little doubt that beyond the widening-deepening dialectic there lies ahead for the Community a similar and fundamental tension between North-South and East-West integration. We may hope that the research reported in this volume will contribute to understanding and perhaps to resolving these tensions. We commend it to the reader.






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