A strange story

THE MENU DISPLAYED outside a cafe near Leinster House, Dublin, the seat of Ireland's Parliament, reflecting the country's budget crisis, on December 8.-PETER MORRISON/AP

The real surprise of the European economic project is the absence of price equalisation across the region.

FOR the past few months, the attention of the world, especially the financial media, has been focussed on the eurozone. The reasons are obvious. The European Union countries constitute the largest economy in the world. Instability within the union which now seems inevitable, no matter how the current problems of countries such as Greece, Ireland, Portugal and possibly Spain and Italy are dealt with will have huge repercussions in the rest of the world.

And, of course, the story of the economic union is itself a compelling one, unique in the history of the past two centuries: how countries that had been until quite recently torn apart by war and strong economic nationalism came together in progressively more intense ways, culminating in the common currency of the eurozone. There is no question that this was always a remarkable project, and the extent to which economic union proceeded apace without political merger always seemed unbelievable to some observers.

Fascinating experiment

It really does not matter whether one sees the creation of the eurozone as a tribute to idealism with respect to regional cooperation or as a reflection of the triumph of political will over economic barriers or simply as a desperate response of a group of countries to the currency volatility created by mobile capital flows. The point is that it is a fascinating experiment. For at least a decade, its apparent stability called into question a belief that was axiomatically held by many economists: that monetary union is difficult, if not impossible, without fiscal federalism underpinned by a more comprehensive political union.

In fact, the E.U., and within it the eurozone, was the culmination of a century-long drive in Europe towards greater integration, punctuated by wars, other conflicts and instabilities but proceeding regardless of those hurdles. The initial driving force for such a union may well have been political, but there was always explicit recognition of the clear economic benefits. These benefits, it was argued, would emerge mostly from the reduced transaction costs of all cross-border economic activities, including trade in goods and services. In addition, the stability provided by a single currency would serve to reduce risk in a world of volatile currency movements driven by mobile capital flows.

This was seen to be an additional inducement to invest in productive activities, especially in peripheral European countries that would not otherwise have access to international capital on such favourable terms. This is why, despite the recent difficulties of several economies in the eurozone, the list of countries lining up to join it is still long and shows no sign of contracting.

But there are also significant costs of such a union, which are becoming especially evident now. The most obvious one is the loss of two major macroeconomic policy instruments the exchange rate and monetary policy that can otherwise be used to prevent an economy from falling into a slump. In addition, the Stability and Growth Pact that emerged as part of the Maastricht Treaty and laid down the conditions for a common currency specified strict fiscal limits that effectively tied up fiscal policy. Of course, these have been observed more in the breach, especially by the larger European economies, but they did operate to constrain fiscal policy to a significant extent.

These in turn affect a country's ability to respond to imbalances. For example, Greece could have tried to use a combination of exchange rate devaluation and lower interest rates to stimulate demand, increase income, reduce unemployment and prevent the external deficit from deteriorating. These measures are not foolproof, as many countries know, but trying to make adjustments without such instruments is that much harder. Instead, Greece, Ireland, Spain and other similar economies are being forced into an even more painful internal devaluation by forcing prices to come down through a terrible mixture of fiscal austerity, unemployment and deflation, which in fact makes the debt burden worse.

All these have been widely commented upon in the context of the current crisis. And the inherent rigidities of an economic regime that does not allow currency devaluation as a response to widely varying prices and external imbalances have generally been seen as the basic factors behind the current crisis. But, strangely, hardly any commentaries on the matter get into the more basic question: how could such imbalances be created and persist in the first place?

This is probably the more important question because it points to a disturbing conclusion: that the entire process of European economic integration created much less actual integration than was expected. In fact, the Single Market that was launched in 1994 was intended to do away with all trade barriers and all restrictions on capital and labour flows. The purpose was to create a single unified market in which prices would be equalised across member-countries.

These prices that were to be equalised were of both goods and services, and of labour since workers could also freely move between countries. But labour has not really been moving freely across European borders despite the removal of official restrictions. It is well known that labour mobility is not that simple, especially where there are different languages and cultures. In fact, it is rare to find wage equalisation across regions even within national boundaries, as one knows well in India. Similarly, because many services such as personal services are still not so easily traded, their prices need not get equalised either.

But there is no such constraint when it comes to a single market for goods. The typical expectation whenever trade barriers are reduced or removed is that trade arbitrage will ensure uniform prices, or in other words, countries will keep exporting or importing goods until their prices are equalised.

This also forms the basis of all trade theory, with all the policy conclusions that are then drawn from it. In Europe, with relatively low transport costs across many countries, there was no a priori reason for this not to happen.

But, remarkably, this did not happen. This is the real surprise of the European economic project and the mother of all the other problems. There is much talk of faster productivity changes in Germany resulting in lower export prices, which effectively outcompeted the production of workers in Greece and Spain, and so on. But if the Single Market were actually functioning properly, prices would have been equalised across the region.

In fact, price differences of a large basket of goods are huge across different European countries (and even within them) and have not only persisted but even increased in some cases. This continues despite cases of individual trade arbitrage: it is common to find householders in Geneva, Switzerland, crossing the border into France to pick up their household supplies in the cheaper supermarkets of France, just as migrant hawkers peddle goods such as watches whose prices vary dramatically across different European cities.

How can this happen? Why did the Single Market in Europe not force price equalisation? This is not an easy question to answer as surprisingly little research has concentrated on the issue. But the growing concentration of both production and retail activities with the associated proclivity to charge what the market will bear' in each location may have played a role.

In any case, this gives one an important insight into the process of economic integration: that even in the most favourable conditions it is not necessary for the reduction in/removal of trade barriers to lead to price equalisation. This in turn forces one to rethink many other conclusions that have been made about the effects of open trade.

Obviously, one still understands relatively little about the effects of removing trade restrictions since many of the actual outcomes are quite different from what is predicted by standard theory or even by what seems like common sense. In this way, as in so many others, the current experience of the eurozone is instructive for the rest of the world.