European economic policy

European Coal and Steel Community: July 23, 1952

Then==>
European Economic Community (EEC) (AKA treaty of Rome): March 25, 1957
Then ==>
1992 Maastricht Treaty: the Euro currency

Main European union trends:

§ Widening: enlargement of members
Will other countries leave the EU (…) or will the EU enlarge to other countries (e.g. in the
Balkans) ?
§ Deepening: Policy integration
E.g. The EU response to the Covid-19 crisis (Next Generation EU) is a significant step
forward in the process of EU integration, but it also entails new (political) challenges

European union VS Rest of the World

• The EU accounts today for around 7% of the world population, but around 22% of world
GDP (19% without the UK), similar to the US, and China.
• But it also accounts for 50% of total welfare expenditure in the world…
• The EU generates between 20 to 25% of world trade flows (not including intra-EU trade,
in which case the number increases to 35%)
• Through its single currency, the Euro, the overall size of EU financial markets is about
120% of the US one, with 50% of world bank assets

Bottom Line: The EU is one of the three large markets of the world, the largest trading
partner, and a key player in financial markets, with the most advanced welfare system and
living standards.
Much work is needed to preserve and improve on all this!

Origins of the European union:

 In 1957, six founding members signed the Treaty of Rome, leading to the creation of
the European Economic Community (EEC).
 The Six were: Belgium, France, Italy, Luxembourg, Netherlands, and West Germany.
 The Treaty of Rome was a far-reaching document: it laid out virtually every aspect of
economic integration implemented up to the 1992 Maastricht Treaty.
The European union objectives and goals:

----Treaty of Rome---

EU economic integration - the founding principles

The Treaty’s first intention was to create a unified economic area = an area where firms and
consumers located anywhere in the area would have equal opportunities to sell or buy goods
and services throughout the area, and where owners of labour and capital should be free to
employ their resources in any economic activity anywhere in the area.

 This entails:
– “4 fundamental freedoms”: free flow of goods, services, workers and capital;
– Common policies where necessary;
– Community ‘acquis’: the development of a body of law harmonising rules and
procedures throughout the area.
Main elements:
 Free trade in goods internally => then gradually extended to services
 Common trade policy with the rest of the world:
Customs Union as a resulting model (vs. Free Trade Areas)
 Labour and capital market integration:
free movement of workers
free movement of capital

 Common competition policy to ensure undistorted competition:

– state aids are mostly prohibited
– anti-competitive behaviours monitored by Commission
 Exchange rate and macroeconomic coordination finally leading to the Euro single
currency area
 Other policies agriculture, regional spending, environment, energy… progressively
expanded with the various Treaties building on the Treaty of Rome.

Omitted elements (excluded)

 Social policy: social harmonization very difficult politically
– nations have very different sensitivities on what types of social policies should be
dictated by the government
 Not clear that European economic integration demands harmonization of social policies:
– national wages would adjust to offset any unfair advantage (if lower social
standards meant lower production costs, long term result would be higher wages
that offset the advantage, i.e. if workers have to pay for private health
insurance/education).
 Tax policy: like social policy, tax policy directly touches the lives of most citizens and it is
the outcome of a national political compromise. This is a hot issue now!

EU law – supranational legal system

When nations explicitly cede their right to make certain judicial decisions to a common
tribunal. The decisions of the common tribunal are directly effective in each party nation,
and have priority over decisions taken by national courts. The EU law is Supranational.

§ Main principles:
– direct effect: EU law can create rights which EU citizens can rely upon when they go
before their domestic courts;
– primacy: Community law has the final say (e.g., highest German court can be overruled)
so that it cannot be altered by national, regional or local laws in any member state;
– autonomy: system is independent of members’ legal orders.
Supranational vs Intergovernmental
Supranational: the EU laws govern
Intergovernmental: the individual countries hold power in this domain

Policy tools: the EU law

Treaties are the “primary” source of European Union law: a sort of “mobile” constitution (e.g.
they define the role and competencies of the various EU institutions)

“Secondary” sources of EU law are:

- Regulations: the most powerful form of EU law, immediately binding for every member
state as literally published in the Official Journal of the European Union
- Directives: define mandatory goals, but the legislative actions for implementing these
goals are left to the member states (normally with a time deadline and the obligation to
report to the Commission).
- Decisions: also binding, but very specific in their application, normally referring to single
member states, institutions or companies.
- Recommendations and opinions: have no binding force, usually they provide
interpretations for the application of regulations, directives and decisions.

The “big 5” EU institutions

There are many EU institutions but the core ones involved in the legislative process are 5:
– the European Commission;
– the Council of the European Union;
– the European Parliament; (the only one directly voted by European citizens)
– the European Council; principal of conferral> composed by heads of member states
– Court of Justice of the European Union.
Another very important EU institution (responsible for the common monetary policy) is the
European Central Bank (ECB). The crisis saw the birth of another EU institution, the European
Stability Mechanism (ESM).

The EU Court of Auditors oversees the correct execution of the EU budget. The Economic and
Social Committee (CES) and the Committee of Regions (CoR) are consultative bodies.

The European Commission

• Can be seen as the executive-bureaucratic arm of the EU.
• Promotes the general interest of European integration, in light of the Treaties.
• Develops proposals for new laws and policies: “powers of initiation”.
• Oversees the execution of adopted laws and policies: “powers of implementation” .
(e.g. the Commission can take to the Court of Justice any member state, corporation or
individual that acts against the EU law)
• Has a key role in managing EU finances: collection of revenues, proposal of yearly EU
budget and administration.
• Represents the EU in international organizations like the World Trade Organization.
• Oversees the accession process for new members.
• Headed by a College of Commissioners with 27 members, one for each country
• The College serves a five year term.
• Each commissioner is responsible for a different area of policy (e.g. environment, trade,
regional policy, external relations…)
• In charge of negotiating trade matters with third nations on behalf of EU members
• The College is headed by a President:
– Distributes portfolios among Commissioners
– Sets the agenda of the Commission and chairs the meetings
– Represents the Commission when dealing with other EU institutions or national
governments

The Council of the European Union

• Consists of national government ministers, who meet in 10 different “councils”
(configurations), depending on the topic under discussion.
• One of the most important configurations is the “General Affairs”, bringing together all
the EU European affairs ministers to discuss issues related to internal EU affairs,
sensitive policies and new laws, preparing the meetings of Heads of State and
Government.
• The “Economic and Financial Affairs Council” (Ecofin) brings together the economics
and finance ministers.
• The relevant EU Commissioner also attends the meetings.
• The frequency varies depending on the configuration, from once per month (Ecofin…) to
once every six months (Agriculture…).
• Extraordinary meetings, beyond the agenda of the Presidency, can be set should the
need arise.
 • Presidency is held in turn by each member state for a period of 6 months (changes in
January and July every year), now Croatia.
• Together with the Parliament, the Council of Ministers is a key decision-making actor. It
discusses, amends and approves (or not) new laws which are proposed by the
Commission
• The Council deliberates with:
- Simple majority: for procedural issues
- Unanimity: (agreed by all members) only needed for changes in the Treaties,
matters of political sensitivity (e.g. taxation) or if the Council wants to change a
Commission proposal against the opinion of the Commission
- Qualified Majority Vote (QMV): most common mode. To be successful, a proposal
must win a double majority of at least 55% of member states (15/27) and 65% of
total population.

The European Parliament

• Besides the Council of Ministers, the European Parliament is the other decision maker of
the European Union.
• It is the only EU institution whose members are directly elected by citizens of the
member states.
• Co legislates with the European council on all basic trade legislations
• It has a single chamber with 705 members (MEPs) elected for 5 years (renewable) in
common European elections + the President.
• Each country gets a number of seats according to a “degressive proportionality
principle”, i.e. per capita deputies are lower for larger countries .
• Germany has the highest number (96) of Members while Malta, Cyprus, Estonia,
Luxembourg have the lowest (6)
…/…
Degressive proportionality

Less than 45° angle

• The Members of the European Parliament sit in political groups – they are not
organised by nationality, but by political affiliation.
• There are currently 7 political groups in the European Parliament.
• 25 Members are needed to form a political group, and at least one-quarter of the
Member States must be represented within the group. Members may not belong to
more than one political group.
• Some Members do not belong to any political group and are known as non-attached
Members.

• Formally, European Parliament’s offices are located in three different countries

(Protocol n. 6 of the TFEU):
• Administrative headquarters are in Luxembourg.
• Parliamentary committees, where laws are instructed / amended, meet in Brussels for
two-three weeks every month.
• However ordinary plenary sessions, where formal laws are approved, take place in
Strasbourg for 3-4 days every month, which means that deputies and staff have to move
there temporarily.
• Very inefficient and costly arrangement… Kind of “history joke” and certainly a good
example of compromises within the EU.
• The European Parliament is chaired by a President (David Sassoli at the moment) who is
elected by MEPs for a period of two years and a half (renewable).
• It works through permanent and ad-hoc Parliamentary Committees: e.g. environment,
budget etc.
• The actual powers of the European Parliament in the EU decision-making process have
increased a lot over time: after the Lisbon Treaty, most EU laws are approved jointly by
the European Parliament and the Council, i.e. the so-called “ordinary legislative
procedure”.
 • Plus, it has a supervisory power on other EU institutions, e.g. it can force the resignation
of the College of Commissioners. It also ‘audits’ the Commissioner-candidates at the
time of their appointment
• Notably, the President of the ECB reports only to the Economic and Monetary Affairs
Committee of the European Parliament.

The European Council

• It consists of the Heads of State or Government of the EU member states, plus the
President of the EU Commission.
• It meets at least two times per year, normally in December and June.
• It is not one of the EU's legislating institutions, so it does not negotiate or adopt EU laws.
However, because of the principle of conferral, it is the European Council that sets the
EU's policy agenda, traditionally by adopting 'conclusions' during meetings which
identify issues of concern and actions to take.
This is not a
For instance, in the conclusions of December 2019: “In the light of the latest available science
law, just an
and of the need to step up global climate action, the European Council endorses the objective of
objective
achieving a climate-neutral EU by 2050, in line with the objectives of the Paris Agreement.”

Co legislates with the EU parliament on all basic trade legislations

• According to the Lisbon Treaty, the European Council has now a President, elected by
the Council with qualified majority, for two years and a half (renewable once)
• The president convenes, prepares and chairs the meetings (before this used to be done
by the temporary president of the Council of the European Union)
• Ensures the continuity of the Council work
• Represents the European Union at the international level
• Enhances the consensus among member countries
• Reports to the EU Parliament after the Council meetings

--- EU Institutions and decision making ---

Court of Justice of the European Union
• Ensures that national and European laws meet the terms and spirit of EU Treaties.
• Ensures that EU law is equally, fairly and consistently applied in all member states.
• It does so by:
• Ruling on the “constitutionality” of EU law
• Giving opinions to national courts about EU law
• Making judgments in disputes involving EU institutions, member states,
individuals and corporations

--- EU Chronology and Enlargement ---

The early steps: 1945-1957
- At the end of WWII, EU leaders wanted to avoid a new similar tragedy => nationalism
had to be defeated by creating something like the United States of Europe.
- This was in the interest of everybody, from France to the USA, for different reasons.
- The USA offered financial assistance if countries agreed on a joint program for economic
reconstruction = the Marshall Plan (1948):
o The OEEC (now OECD) administered this aid and prompted trade liberalization.
- As Cold War got more war-like, West German rearmament became necessary.
- But strong and independent Germany was a scary thought for many, including many
Germans.
- Widespread feeling: best to embed an economically and militarily strong West Germany
into a supranational Europe.
Two crucial steps were:
• European Coal and Steel Community (Treaty of Paris, 1951): Belgium, France, Germany,
Italy, Netherlands and Luxembourg (the ‘Six’) place their coal and steel sectors under
the control of a supranational authority => controlling German rearmament;
• European Economic Community (Treaty of Rome, 1957): riding on the success of the
ECSC, the Six committed to form a customs union with four fundamental freedoms and
common policies.

Situation by the late 1960s:

These were two trading areas
The outsider countries were inclined to join the bigger trading area
What happened between these two trading areas:
Evolution to two concentric circles: domino effect 1
- Falling trade barriers within the EEC and within EFTA lead to discrimination.
- The GDP (i.e., potential market size) of the EEC much larger than that of EFTA (and EEC
incomes were growing twice as fast)
- Thus, the EEC club was far more attractive to exporters and this lead to new political
pressure for EFTA nations to join the EEC.
- The UK applied for membership in 1961 and Denmark, Ireland, and Norway also
followed since they would otherwise face stronger discrimination (other EFTA nations
did not apply because of political reasons).

Denmark, Ireland, and UK joined in 1973 while Norwegians said no in a referendum.

Deeper circles: Domino effect II

- Thanks to positive political developments, Greece joined in 1981, Spain and Portugal in
1986.
- Deeper integration in EC12 strengthened the ‘force for inclusion’ in remaining EFTA
nations.
- European Economic Area (EEA) initiative (1989) was launched to extend single market
to remaining EFTA nations.
- The fourth enlargement (1995) adds Austria, Finland, Sweden and leads to the EC15
(later called EU15).
- EEA was referred to as the “Norwegian option” in Brexit talks, i.e. you are part of the
single market, with 4 freedoms, but not a member of the EU. It applies to Norway,
Iceland, Liechtenstein, and (with some caveats) to Switzerland.
 USSR collapses
 Division of Europe was cemented by the Berlin Wall (1961). This changes at the end of
the 80s:
- end of 1989: democracy in Poland, Hungary, Czechoslovakia; fall of the Berlin wall
- 3 October 1990: German re-unification.
- end of 1990: independence of Estonia, Latvia and Lithuania;
- end of 1991: the USSR itself breaks up.
 The Cold War ends and, with it, the military division of Europe ends.

Reuniting east and west Europe

n At first, no promise of eventual membership but ‘Europe Agreements’:
- technically ‘Association Agreements ‘(see lecture on Common Commercial Policy)
i.e. free trade agreements with promises of deeper integration and some financial
aid.
n 1993: EU sets the Copenhagen criteria for accession of CEECs:
- political stability of institutions that guarantee democracy, the rule of law, human
rights and respect for and protection of minorities;
- a functioning market economy capable of dealing with the competitive pressure
and market forces within the Union;
- acceptance of the Community ‘acquis’ (EU law in its entirety) and the ability to take
on the obligations of membership.
n Copenhagen summit (2002) says CEEC nations plus Cyprus and Malta join in 2004 (5th
enlargement). Romania and Bulgaria follow in 2007.
n The Copenhagen criteria still apply today. The next slide explains the procedure by
which any European country can become member of the EU.

EU Membership criteria and procedure

If a country wants to join the EU, these are the steps :
Potential 1) The country should be “European” (art. 49 TEU) and should sign an Association
candidat agreement with accession clause.
e 2) The country should meet the first two “Copenhagen criteria”:
Candidate - Political: stable institutions guaranteeing democracy, rule of law, human rights,
country minorities.
- Economic: a functioning market economy.
Acceding 3) The country should incorporate the “Community acquis”, i.e. EU law in its entirety, (the
country third “Copenhagen criterion”) currently divided into 35 different policy fields (chapters)
-such as transport, energy, environment - each of which is negotiated separately.
Member 4) The Accession Treaty. Drafted by the Commission, voted by EU Council and EU
country Parliament; ratified by all the Member States + the Acceding Country.
 Association
Agreements

Potential Candidate
• political: stable institutions guaranteeing
‘Copenhagen criteria’ democracy, rule of law, human rights,
minorities;
I and II • economic: a functioning market economy

Candidate country

• Bilateral National Programmes for the adoption of the ‘acquis’:

Incorporation of the priorities for each country and highlight the main instruments and
Community acquis financial resources available to close the chapters of the accession
negotiations effectively.
• Pre-accession Assistance (special line of EU budget)

Acceding country

• Drafted by the European Commission, voted by EU Council

and EU Parliament
Accession Treaty
• Ratified by all the Member States + the Candidate Country

Membership
Membership criteria and procedure

 Throughout the negotiations, the Commission monitors the candidate's progress in

applying EU legislation and meeting its other commitments, including any benchmark
requirements.
 This gives the candidate additional guidance as it assumes the responsibilities of
membership, as well as an assurance to current members that the candidate is meeting
the conditions for joining.
 The Commission also keeps the EU Council and European Parliament informed
throughout the process, through regular reports, strategy papers , and clarifications on
conditions for further progress.

The EU enlargements
 The enlargement of the EU is not over.
Click here to have an updated state of play of the latest ongoing negotiations
 The enlargement also deeply changed the institutional working of the European Union,
given the higher number of countries / variety of interests / economic development. As
such, it required the EU to reform its institutions, ultimately through the Lisbon Treaty
(signed in 2007, into force in December 2009).
 Due to the challenges posed by 2004 enlargement, notwithstanding the commitments
made to the countries already in the process, the European Council (December 2006)
agreed on considering carefully the EU’s capacity to integrate new members: the EU
should be more cautious in assuming any new commitments.

The case of Turkey

 Turkey is a candidate country as of today. It applied for membership in 1987, and it was
declared eligible in 1997 (i.e. it satisfies the political and economic Copenhagen criteria).
 Turkey involvement with the EU goes back to 1959 and includes the Ankara Association
Agreement of 1963, for the progressive establishment of a Customs Union, then
completed in 1995 => EU and Turkey have free trade among themselves and share the
same structure of tariffs with respect to the rest of the world.
 Accession negotiations started in 2005, and are currently stuck until Turkey agrees to
apply the Additional Protocol of the Ankara Association Agreement to Cyprus, i.e.
extending the four fundamental freedoms to Cyprus.
 This is clearly a ‘formal’ excuse for a process of accession that has, on both sides, many
(changing) difficulties…
-- The theory of FTA (free trade agreement) and CU (custom union) --

Free trade area VS Custom union

Free trade area: countries part of this agreement trade freely amongst themselves, but then
each individual country has their own foreign trade policy

Custom union: countries part of this agreement trade freely amongst themselves just like in a
FTA, but also have a common foreign trade policy

Theory of Economic Integration

The theory of economic integration studies how intermediate situations between pure
protectionism and free trade affect efficiency in the use of resources for every country.

Two typical arrangements are studied: Free Trade Areas (e.g. NAFTA), Customs Unions (e.g. EU)

Fundamental hypotheses:
 perfect competition
and
Price = marginal cost
Homogeneous good
Price taker (when firms must accept prevailing prices as they do not have
a large enough market share to influence market price on its own)

 “small country” The country is so small such that its impact in supply, and hence also
price, is negligable
One country model – hypotheses

Consider one country H producing one homogeneous good (e.g., apples)

• perfect competition in goods and factor markets
• insignificant transport costs and balanced current account
• Balanced trade => imports=exports
• upward sloping domestic supply SH
• pH = internal equilibrium price of country H; pw = world prices < pH
• World supply Sw (perfectly elastic supply => having a supply which is horizontal and L
shaped, meaning that the supplier, at the right price, would be willing to produce an
infinite n° products)

Types of tariffs:
We will look at Specific tariff (Pw + T)

There are two types of tariffs

 Prohibitive - Autarky (when the tariffs are high enough that the imports are 0)
 Non-prohibitive (some imports but less than free trade)
Demand curve (consumer) Leftover money customers were willing to
pay, but didn’t have to because the price
was set to be lower

Expenditure: P*Q

Supply curve (producer) Min. price producer is willing to

sell (the marginal cost)

Producer surplus

Producer tot revenue: P*Q

Variable cost of production

(The one country model assumptions can be found above)

Free trade:
Autarky VS Free trade – welfare surpluses

With autarky

Non-prohibitive tarif VS Free trade – welfare surpluses

Non-prohibitive tariff tools
We can distinguish three main tools through which protectionism can be implemented:
- Tariffs (specific or ad valorem)
- Quotas (i.e. quantitative restrictions to imports (amount that can be imported))
- Non-Tariff Barriers (NTBs), e.g. safety standards

Non Tariff Barriers are determined by the set of rules that each country imposes to regulate
industrial production methods, safety standards, environment, consumer protection, etc.
e.g ovetto kinder in USA

A numerical example
Trade policy: the multilateral framework

The EU’s common trade policy operates at two levels:

1. The EU negotiates its own bilateral trade agreements with countries or regional
groups of countries.
2. Within the World Trade Organisation (WTO), the EU is actively involved in
setting the rules for the multilateral system of global trade.

The WTO began life on 1 January 1995, but its trading system is half a century older.

Since 1948, the General Agreement on Tariffs and Trade (GATT) had provided the rules for the
system.

From ITO to GATT, from GATT to WTO

• The first attempts to create an international agency dedicated to the management of
worldwide trade issues originated in the post-World War II in line with the creation of
the IMF and the World Bank (Bretton Woods Conference).
• In 1946, a project was also put forward to create an International Trade Organisation
(ITO). During the negotiations on the ITO, 23 countries reached an agreement to reduce
about 45,000 different tariffs in place at the time, limited to manufacturing products
(goods) but affecting about 1/5 of the world’s total trade.
• The combined package of trade rules and tariff concessions became known as the
General Agreement on Tariffs and Trade (GATT) and entered into force in January 1948.
The 23 countries became founding GATT members.
• In 1950, the United States (Truman Presidency, Dem) announced that it would NOT
seek Congressional ratification of the ITO: the project was effectively dead.
• Even though it was provisional, the GATT thus remained the only multilateral instrument
governing international trade from 1948, until the World Trade Organisation (WTO)
was established in 1995.

WTO
• International organization
• Member States with formal admission procedures
• Capabilities not limited to goods but also services and general trade issues
• Binding mechanism of dispute settlement
WTO: the four key principles
1. Reciprocity. WTO members have symmetric rights and obligations, and should obtain
mutually beneficial reductions of trade barriers, therefore setting up a multilateral
system of trade liberalisation.
2. Consensus. Any decision taken within the WTO requires unanimity of all the
participating countries. Inefficient? countries often negotiate in coalitions centred
around the main trading partners (historically USA, EU, Canada, Japan, now also BRICs)
3. Tariff bindings. Once a tariff reduction has been negotiated and accepted, it becomes
“bound” at the negotiated rate (sanctions if it is increased).
4. Non-discrimination. Two clauses:
1. The National Treatment (NT) rule requires that once foreign products enter into
an importing country, they should be accorded a treatment equal to the one
guaranteed to similar national products (e.g. same tax treatment);
2. The Most-favoured-nation (MFN) treatment states that all WTO members should
receive by a given home country the same treatment as the one accorded to the
partner country that receives the best (most favoured) treatment. Therefore, if
enforced, the MNF clause should guarantee the tariff rate on any given product
to be uniform across trading partners, at the lowest level.
The “classic” theory of Economic Integration – Tariff structure

tMFN
- The most favoured nation tariff agreed within the WTO negotiations. This is the ‘basic’
tariff that every country applies to all others within the multilateral set of rules of the
WTO (in accordance to the non-discrimination principle). The EU being a customs
union, its MFN tariff towards third countries is the same for all Member States, and it is
known as the EU Common External Tariff (CET)
Examples: applies to US, China, Brazil, Australia, etc

tFTA (0)
- The tariff agreed within a bilateral negotiation (via Association Agreement) between the
EU and a third partner country aimed at establishing a Free Trade Area. This tariff is an
exception to the non-discrimination principle: as such it has to be authorized by the
WTO, and can only be set at a rate of zero (Art. XXIV of the GATT agreement).
- The zero tFTA applies only to goods whose origin is from the partner country (Rules of
Origin are a constitutive part of the FTA agreement)
Examples: applies to Tunisia, Egypt, Chile, Mexico, S. Korea, etc…

tGSP< tMFN
- The Generalized Scheme of Preferences is a formal system of exemptions from the MFN
principle (covering about 66% of tariff lines), with the idea of introducing reduced MFN
tariffs for a list of developing countries. These lists have a temporary nature (e.g. for
the EU 10 years, current one started in January 2014) and have to be approved by the
WTO.
Examples: applies to Indonesia, India, etc.

tGSP+< tMFN
- The “GSP+” enhanced preferences implies deep cuts or full removal of tariffs for the
same product categories as in standard GSP. This can be granted to countries which
ratify and implement international agreements on human rights, labor rules,
environmental issues and good governance. Eligible countries have to be “vulnerable”,
i.e. low share of total GSP imports (below 2%), and low diversification (7 largest sections
of GSP accounting for more than 75% of their exports)
Examples: applies to Sri Lanka, etc.
tEBA(0)
- The Everything but Arms initiative is a special exemption granted by the EU within the
GSP system, aiming at granting to the least developed countries (LDCs) a zero-tariff
access to the EU for all their products but arms. It has a permanent nature.
Examples: applies to Bangladesh, Congo Dem. Rep., etc.

The “classic” theory of Economic Integration – Tariff structure

• When declared to customs in the Community, goods must generally be classified

according to the Combined Nomenclature or CN (click here to see it). Imported and
exported goods have to be declared stating under which subheading of the
nomenclature they fall. This determines which rate of customs duty applies and how the
goods are treated for statistical purposes.
• The CN is based on a classification of products known as the HS Nomenclature: it
comprises about 5,000 commodity groups which are identified by a 6-digit code and
arranged according to a legal and logical structure based on fixed rules common to all
countries in the world.
• The CN of the EU integrates the HS Nomenclature and comprises additional subdivisions
and legal notes specifically created to address the needs of the Community.
• So tariffs are set for every single detailed product classified in the HS nomenclature (e.g.
“men’s cotton shirts” - 610510, are different from “women’s cotton shirts” – 610610, or
from “men’s artificial fibers shirts” - 610520 , etc.)
• To get an idea of the tariff structure of the European Union, click here to access the
TARIC database
• Some products have relatively high tariffs amidst generally low tariff levels, known as
tariff ‘peaks’, i.e. an ad valorem tariff > 15% (e.g. sports footwear in the EU – 640411,
16.90%)

Regional Integration Agreements (RIAs) – Another excuse to break the MFN

• RIAs are groupings of countries formed with the objective of reducing barriers to trade
between members of the group
• They constitute a driving force of globalization, and are permitted by the WTO rules
under article XXIV of GATT
• EU is a prominent example of RIA
• As of January 2020, 303 RIAs are in force (see full list here)
• Almost all countries are nowadays members of a RIA, with more than 1/3 of global
trade taking place within RIAs
• Two main modes: “Free Trade Areas” vs. “Customs Unions”
 Free trade areas and Customs Union

H P H P H P

Rest of Rest of Rest of

the the the
World World World

Protectionism Free Trade Area H-P Customs Union H-P

Countries maintain
individual tariffs TH, TP
with the RoW and
between themselves
e.g. Mongolia, Somalia,
Mauritania
Countries maintain individual
tariffs TH, TP with the RoW
but liberalize trade between
themselves
NAFTA (Us, Canada, Mexico)
Countries agree on a unique
Common External Tariff with the
RoW and liberalize trade
between themselves
European Union - 1969

The need for rules of origin in Free Trade Areas

Rules of origin: only goods that have “origin” in P can freely enter in H. How to assess this? Only
goods whose value-added is mostly created in P are said to have “origin” in P
 The Economics of Free Trade Areas

7 cases:
Case n1:
Assumptions:
FTA: Both H and P have prohibitive tariffs and P is big enough to supply all demand from H
Case n2:
Assumptions:
FTA: Both H and P have prohibitive tariffs but P is not big enough to supply all demand from H
Case n3:
Assumptions:
FTA: Non prohibitive tariff in H, Prohibitive tariff in P, and P is big enough to supply all the
demand from H
Case n4:
Assumptions:
FTA: H has a non prohibitive tariff, P has a prohibitive tariff, and P is not large enough to
produce all of H’s demand
CET= Common external tariff

Case n5:
Assumptions:
CU: Prohibitive tariff in both H and P
Case n6:
Assumptions:
CU: non-prohibitive tariff in H and a prohibitive tariff in P
Case n7:
3 important notes on case n7:
1. Supply curve = Average cost curve
2.

3.

Assumptions:
Both H and P have prohibitive tariff
Outcome of situations depending on the 3 tariff statuses before the CU is created:

• If country H is not producing the good before the CU but only importing from RoW at
pW, then the CET will imply a negative trade diversion to a more expensive source of
imports (country P)

• If instead country P is not producing the good before the CU, there will be a production
reversal from H to P. Consumers in H will benefit from trade creation, but those in P will
suffer from “trade suppression”, as cheap imports from RoW are replaced by less
efficient internal production

• If no country is producing the good before the CU, we might observe a “perverse
specialization” in a large though less efficient country, which captures the whole market
just due to a market-size advantage...

Comparing FTA case n3 to CU case n2:

Under standard assumptions(perfect competition, small countries, etc…….), Free Trade Areas
are normally more efficient than Customs Unions.
  In H trade creation effects (1 and 2) are clearly larger under FTA (top) than CU (bottom)
agreements, while trade diversion (3) is smaller. This is because CET>pFTA
 In P the FTA generates only positive effects (indirect trade deflection 4) with no
reallocation of resources, while the CU yields a positive effect but a redistribution of
resources from consumers to producers (5)

The RoW improves its access to members’countries markets under FTA (P starts importing the
quantity EQP>AB previously imported by H), while the situation is worse under CU (imports AB
from H are substituted with EF produced in P, which stays close to international markets).

Free Trade Areas vs. Customs Unions: which one to choose?

1. Customs unions can generate greater welfare effects for member countries by increasing
their bargaining power on the global stage (i.e. removal of the “small country” hypothesis),
leading to favourable trade agreements.
2. Customs Unions however imply a political cost of negotiations, which grows with the size
and heterogeneity of the CU, thus generating a trade-off with different optimal solutions
depending on the specific case
The European Union:

Stats:
The EU is the world’s biggest trader, accounting for more than 40% of global trade. In
particular:
- 2/3 of EU exports are to other EU nations; and up to 3/4 if also considering EFTA nations
and Turkey;
- after Europe, North America and Asia are the EU’s main markets;
- Africa, Latin America and the Middle East are not very important as EU export
destinations.

USA single biggest export market for the EU.

China biggest exporter to the EU. Overall BRICs account for 17% of imports and 19% of exports

Member States have quite different trade patterns, due to geography and history (e.g. colonial
ties). As a share of imports:

Manufactured goods account for almost 90% of EU exports, with big role of machinery and
transport (about 50%)

On import side, 2/3 of spending on manufactured goods

EU is a big importer of fuel (about 1/5 of total imports)

EU trade policy: broad goals and means
For most of its life, EU external trade policy meant negotiating:
- reciprocal tariff cuts in FTAs with other Europeans (e.g. EFTA);
- reciprocal tariff cuts with non-European nations in the GATT/WTO;
- unilateral tariff preferences for developing nations. (thanks to the GSP)

This started to change with a 2006 landmark communication from the Commission known as
Global Europe: it identified ASEAN, Korea, India and Mercosur as priority partners for new
FTAs.
There was also a shift towards deep and comprehensive agreements that covered issues such
as investment, public procurement, competition, IPR enforcement and regulatory convergence
issues (to be dealt with FTAs since the WTO agenda does not include them).

EU institutions for trade policy

• The customs union was the EU’s first big step towards economic integration. A customs
union requires political coordination as it defines the external dimension of the Union.
• The Treaty of Rome granted supranational powers to the EU’s institutions: ‘exclusive
competence’, i.e. the EU has exclusive power to set the trade policy with third nations
(individual Member States cannot sign independent trade agreements).
• In the twentieth century, the EU’s power on trade policy was basically limited to tariffs.
As the range of important trade barriers broadened, the competence of the EU has
been extended (e.g. to foreign investment, services, property rights): big step forward
with the Lisbon Treaty (2009).
• The European Commission has the task of negotiating trade matters with third nations
on behalf of the Member States. The Commission has also the right of initiative on, for
example, trade agreements. Plus, it also supervises the implementation of such
agreements.
• A big change from the Lisbon Treaty is that the European Parliament is now co-
legislator with the Council on all basic EU trade legislation (e.g. grating GSP preferences,
imposing anti-dumping measures).
• Negotiations are conducted by the Commission in accordance with specific mandates
defined by the Council and the Parliament (called ‘Directives for Negotiation’). Such
directives are approved through ‘ordinary legislative procedure’.
• The Council must adopt any agreements negotiated by the Commission after the
Parliament has given its consent. Parliament cannot amend in this case (but has
influence through veto power).
• National parliaments might also need to ratify in case of deep and comprehensive
agreements touching upon sensitive issues, e.g. consumers’ safety, dispute settlement
bodies etc. (so-called Mixed Agreements)
The operational framework
2 main dimensions:

1. the neighbourhood dimension, or “proximity policy”, which concerns the countries

close to Europe, and aims at strengthening the EU trade and political relations with the
“ring of friends” i.e. countries surrounding the EU from Ukraine to Morocco.
=> Mostly via Association Agreements

2. the enhanced EU sphere of influence as a global partner promoting peace, security,

development etc.
=> Mostly via Cooperation Agreements, although less and less so lately!

Both cooperation and association agreements involve free trade and cooperation, but
Association Agreements pursue wider and deeper initiatives on different policy areas (e.g.
respect of human rights and democratic principles). In certain cases, they prepare for future
membership of the EU by containing an ‘accession clause’.
Share the same set of rules
The EU “Pyramid of preferences”

The pyramid of preferences ranks the preferential relationships of the EU with the various
countries in the world according to a decreasing degree of preference.

The top of the pyramid expresses the maximum preferential treatment that the EU can grant to
another country, i.e. the membership of the EU. At the bottom of the pyramid: the MFN tariff
(i.e. the default CET) applied by the EU when no specific preferences are granted but the ones
agreed within the WTO rules.
Existing agreements: ring of friends

Enlarged Single Market through European Economic Area Agreement with Norway, Iceland,
Liechtenstein + EU-Swiss bilateral accords (EU and Single Market like two concentric circles)

• 10 Euro-Med Association Agreements: asymmetric bilateral FTAs, since the EU cuts

tariffs to zero faster than partners, plus financial and technical assistance, services and
FDI. Slow progress due to Arab Spring turmoil
• Long-term goal of a comprehensive Euro-Mediterranean FTA (Barcelona Process 1995,
re-launched in Paris in 2008)

Existing agreements: ring of friends

• So far we have depicted a “hub-and-spoke” system: the EU is the hub for a number of
trade deals. Exporters in partner countries depend heavily on the EU as an export
market, while each partner is negligible for the EU as a whole.
• Turkey adopts the EU CET, so it is essentially in customs union with the EU (except for
agricultural goods), although it has no say in the determination of the CET.
• EFTA nations have been following the EU in signing similar FTAs (e.g. with the Med
countries), and Turkey is doing the same lately.
 Balkans: the EU has granted preferential trade access on asymmetric basis over time. In
particular, several “Stabilization and Association Agreements” have been signed, involving
cooperation in view of future membership of the Union, as for Croatia. Albania,
Macedonia, Montenegro and Serbia are already candidates.

EU as Global Partner: non-regional FTAs

The EU is always open to Deep and Comprehensive FTAs involving FDI, services, protection of
intellectual property rights etc.
In recent years, the EU has signed a number of these deals (via cooperation or association
agreements), e.g. Mexico, Chile, South Africa, South Korea, Japan. FTA with Canada (CETA)
under ratification.
Current focus:
• Work on FTAs with Australia, New Zealand, Philippines and Indonesia… Asia-Pacific
region identified as crucial.

Single market policy

Setup of the single market:
With the Rome Treaty (1957), the member States decided:
– to remove trade barriers between them,
– to set up a Customs Union (1968),
– to start the process of forming a Single Market (or common market).
In a single market, economic frontiers between member States are eliminated and the so-called
four fundamental freedoms: (i.e. free circulation of people, services, capital and goods) would
be guaranteed.

Definition of single market:

• Market integration is a situation such that the flows of products, services and factors
between countries are on the same terms and conditions as within countries.
• Products, services and factors can be traded between distinct markets or countries
just as they are within a country, and thus the resulting common area can be referred
to as a single market.
• In the single market price differences eventually arising among countries should be no
more than the cost of transportation plus related transaction costs.
Implementing the single market:
In order to maximise the gains from market integration, two dimensions of potential
costs/distortions have to be eliminated, namely:
1. Market fragmentation caused by:
a. Non-tariff barriers (NTBs)
b. The absence of a regulatory framework
2. Negative macroeconomic spill overs.

Regulatory framework, fragmented markets, Macroeconomic coordination

fighting market fragmentation:

• Fragmented markets derive essentially from the presence of NTBs, i.e. restrictions to
trade that originate from the existence of production standards or licensing regimes: a
way to protect local markets. These restrictions have to be removed to guarantee the
implementation of the four fundamental freedoms.
• However, since many activities are non-tradable (e.g. transport services or retail
banking), an adequate regulatory framework has to be in place to guarantee also the
right of establishment, i.e. the possibility for every national of a member State to
exercise its own economic activity in another member State, in a level playing field equal
for all the economic agents operating within the Union.

The need for macroeconomic coordination:

• Negative macroeconomic spillovers can arise for countries participating in an
integrated market.
• For instance, countries may try to boost their competitiveness via competitive
devaluations of their currency (“beggar thy neighbour” policies)
• This has created incentives for macroeconomic coordination, leading to European
Monetary System and European Monetary Union (why we have the Euro)

The institutional design

• In the Treaty of Rome: a programme for the approximation of their national
legislations. But limited progress, due to the application of the unanimity voting rule on
all issues related to the single market.
 • In 1979 a judgment of the Court of Justice, known as the “Cassis de Dijon” case,
established the principle of mutual recognition of national rules: the legislation of
another member State is equivalent in its effects to domestic legislation. This helps in
eliminating most NTBs in place.
• In other words, every member State is obliged to accept on its territory products which
are legally produced and marketed in another member State.
• However mutual recognition is not enough, if a truly single market (i.e. with common
rules and principles, maximizing economies of scale) has to be established. From here,
the need to create an effective approximation of national legislation, removing the
unanimity rule.
• In 1985 the Commission published a White Paper on the completion of the internal
market (the so-called Cecchini Report) and identified 282 legislative measures needed
to remove obstacles to trade and guarantee the right of establishment within the
Community, thus putting forward a programme for the effective finalization of the
European Single Market by the end of 1992.
• In particular, the White Paper identified and proposed to dismantle two main
categories of obstacles :
• cost-increasing barriers: (e.g. delays at borders, customs administration, or the
need to comply with different national technical regulation and standards);
• market entry restrictions: all measures preventing the right of establishment or
trading across frontiers in certain service industries (e.g. insurance or electricity)
or professions, or the entry in some regulated markets (e.g. civil aviation, public
procurement).
• As discussed, achieving the 1992 single market objective requires also the political will
from the member States as a package of 282 directives or regulations has to be
approved in a relatively short period of time.
• Therefore, the 1985 Milan European Council which endorsed the Commission’s White
Paper on the completion of the internal market, also found a political agreement on the
Single European Act (SEA), which came into force in 1987.
• According to the SEA, all the decisions on measures aiming to establish the internal
market, have to be taken by qualified majority at the Council, consulting the European
Parliament.
Note 1: Unanimity was still required for measures relating to fiscal provisions, freedom of
movement for persons and the rights and interests of workers
Note 2: co-decision of the EU Parliament has then been introduced in 1993 with the Maastricht
Treaty. This then became the ordinary legislative procedure on all EU acts according to the
Lisbon Treaty.

• At the same time, a Council Resolution of 1985 implemented a new system for technical
harmonisation and standardisation.
• The harmonisation directives would, from then on, focus on the essential demands of
health, safety and environmental protection at the European level (general principles)
• Defining technical standards is left since then to specialised bodies such as CEN
(European Committee for Standardisation), CENELEC (European Committee for
 Electrotechnical Standardisation) and ETSI (European Telecommunications Standards
Institute), and other specialised Committees eventually set up at this purpose.
• From here on comitology started to emerge, as another important part of the decision-
making process of the EU.

Is the single market delivering?

• The Community legislation governing the setup of the single market is largely in the
form of directives (framework laws).
• But directives require the adaptation of the national legislation via transposition
measures from the EU framework law to the national laws.
• This transposition has not been straightforward, leading to delays in the
implementation of the single market or an uneven playing field.
• For these reasons, on the one hand the EC regularly monitors the extent of the
transposition deficit, forcing non-complying countries to accelerate in the
implementation of EU legislation (via fines that could be imposed by the Court of
Justice)
• On the other hand, the most controversial legislation (e.g. new rules on banking) takes
the form of regulation, as these are directly enforceable in each Member State to the
letter, from the moment they are published on the Official Journal of the European
Union (OJEU).

The “incompleteness rate" records, EU-wide, the number of outstanding directives, which one
or more Member States have failed to transpose, as a percentage of the total number of Single
Market directives. It measures the extent to which the Single Market is not yet a reality in the
areas covered by those directives.

The “transposition deficit" shows the percentage of Single Market directives not yet
completely notified to the Commission by the Member States in relation to the total number of
directives that should have been notified by the mandatory deadline.

To calculate the transposition deficit of each Member State, the Commission includes:
• directives for which no transposition measures have been communicated
• directives considered to be partially transposed by Member State after it notified some
transposition measures
• directives considered to be completely transposed by Member State, but for which the
Commission has opened an infringement proceeding for non-communication and the
Member State has not notified new transposition measures after the latest procedural
step taken by the Commission
"Infringement proceedings" cover all cases where transposition is presumed not to comply
with the directive it transposes or where Single Market rules are presumed to have been
incorrectly applied.

Medium-term growth effects: the Solow diagram

Consumption per worker

Example of Germany and Japan after the war: Since they had little capital as most of it was
destroyed during the war, the first investments yielded a high rate of return (metaphor of the
first tractor in a farm compared to the 5th tractor). Hence, they were growing at a higher rate
compared to countries such as the USA. This is because, the USA had diminishing rate of return
due to its already high level of capital, plus they had to allocate most of its re-investments into
covering depreciating assets.
In theory countries meeting diminishing rates of return can start to re-invest at a higher rate,
hence shift the curve (see below) upwards. However, this will lead the country to eventually
meet diminishing rates of return once again in the future.
New better production function: (allocation effect)

= f’
(K/L)
=f
(K/L)

• Integration improves the efficiency of the European economy by encouraging a more

efficient allocation of resources: this static gain (allocation effect) shifts the GDP/L
curve, i.e. there is an upward shift in the underlying production function, from f to f’
(more output per worker is produced for any given K/L ratio)
• The shift up in the GDP/L curve also shifts up the investment curve since the fixed
investment rate now applies to higher output and so generates a higher inflow of
investment for any given K/L ratio.
• Schematically: integration → improved efficiency → higher GDP/L → higher investment-
per-worker → economy’s K/L ratio starts to rise towards new, higher equilibrium value
→ faster growth of output per worker during the transition from the old to the new K/L
ratio.
This is the so-called medium-run growth bonus from European integration.

• Can economic integration lead to permanently higher growth rates?

‘Qualified’ Yes:
Ø If the rate of technological progress is positively affected by market integration
Ø If tough competition as induced by the closer integration of the single market
leads to continuous productivity gains
Ø If structural reforms boost the potential growth of the involved countries
 Competition policy
• Economic integration determines an increase of competitive pressure on firms  need
to restructure, M&A and “survival of the fittest” in the enlarged market (fewer, bigger,
more efficient firms).
• Founders of the EU understood that such pressure would create incentives for firms to
collude and for national governments to subsidize companies in trouble.
• Anticipation of such unfair practices could reduce political support for economic
integration in all nations.
• Thus, the Treaty of Rome already included broad prohibitions on private and public
policies that distort competition, maintained over time with refinements…

Competition policy: structure of EU legislation

Antitrust
• Art. 101 of the Treaty on the Functioning of the EU (TFEU)
Collusive behaviour restricting competition
• Art. 102 of the TFEU
Abuse of dominant position
Control on concentrations (Mergers and Acquisitions)
• Merger Regulation 139/2004
State Aid
• Art. 107-109 of the TFEU

The framework of EU Competition policy

• The Commission ensures the correct application of EU competition rules. To do this, it
has a wide range of inspection and enforcement powers, e.g. to investigate businesses,
hold hearings, impose fines and grant exemptions. Governments also have a duty to
notify in advance any planned support for business (State aid).
• The Commission decides independently on cases, i.e. no role for Council or Parliament.
Parties can bring EC decisions to the EU’s General Court (previously “Court of First
Instance - CFI”) for judgment, with appeals going to the European Court of Justice
• Nonetheless, some of its enforcement functions have been undertaken by national anti-
trust authorities of the Member States since 2004 (as a function of the community
dimension of the case). This allows national competition authorities and national courts
to apply and enforce Art. 101 and 102 of the TFEU.

Community Dimension
• The EU legislation not only identifies the legal instruments to be used in order to
guarantee the effectiveness of competition in the single market, but it also defines its
scope of application.
 • The Treaty in fact states that EU rules apply only when a competition issue concerns
practices which are capable to “affect trade between Member States” where “trade”
covers all cross-border economic activities.
• The latter can be considered the criterion defining the so-called Community Dimension,
marking the boundary between the European and the national competition legal
frameworks.
• EU competition policy applies to the behaviour of undertakings with a certain amount
of market power in the relevant market.

Definition of “undertaking”
Undertakings are the subjects of competition law and they usually refer to: companies.

However, the concept embraces a company, partnership, sole trader or an association whether
or not dealing with its members. A single individual may be an undertaking in circumstances
where he has an impact on the market in a capacity other than that of a consumer.
e.g. world class opera singers (in RAI/Unitel 1978), lawyers (in Wouters , 2002), sporting clubs
(Distribution of packages tour during the 1990 World Cup, 1992).

The relevant market definition

• The definition of the correct dimension of a market is a tool to identify and define the
boundaries of competition between firms, with the objective to identify market
power.
• Generally it is in the interest of defendant undertaking to describe the market as
broadly as possible (so as to claim that there is a lot of competition), and for the
Commission to define it narrowly (so as to say that there is not enough competition).
• Two dimensions of boundaries: product and geographic
1. A relevant product market comprises all those products and/or services which
are regarded as interchangeable or substitutable by the consumer, by reason of
the products' characteristics, their prices and their intended use (the principle of
substitutability).
2. The relevant geographic market comprises the area in which the undertakings
concerned are involved in the supply and demand of products or services, in
which the conditions of competition are sufficiently homogeneous.

The relevant market definition: product market

• The assessment of demand substitution entails a determination of the range of products
which are viewed as substitutes by the consumer. One way of making this
determination can be viewed postulating a hypothetical “Small but Significant Non-
transitory Increase in Price” (SSNIP test) and evaluating the likely reactions of
customers to that increase.
 • The question to be answered is whether the customers would switch to readily available
substitutes in response to an hypothetical small (in the range 5%-10%), permanent
relative price increase (above the current level) in the products being considered.
• If substitution would be enough to make the price increase unprofitable because of the
resulting loss of sales, additional substitutes are included in the relevant market.

e.g.1) Crossed priced elasticity of demand

If a 10% price increase for pasta pushes customers to buy more rice so that the price increase is
unprofitable (due to the decrease in demand for pasta towards rice), then the two products are
substitutes and belong to the same relevant market

If the 10% price increase for bananas is profitable, that means that consumers keep on buying
bananas even tough they are more expensive.
Therefore no other fruit is a substitute, and banana is a relevant market on its own.

The relevant market definition: geographic market

Consumers’ preferences may be such that geographic and cultural (e.g. linguistic) barriers are
relevant.
For example, the relevant geographic market was defined by the Commission regional in retail
banking (BAI/Banca Popolare di Lecco, 1993) and world-wide in oil (e.g. BP Amoco/Arco and
Exxon/Mobil, 1999).
As a rule of thumb, the size of the market is inversely related to the product’s transportation
costs relative to the value of the product: a product with a high value and a low transportation
costs will have a large geographical market and vice-versa as in Napier Brown-British Sugar
(1988) where the UK constituted a separate market.

For example, Airbus and Boeing is a duopoly in a world-wide market.

Agreements between undertakings

Prohibited agreements (Article 101 of the TFEU)
The following shall be prohibited as incompatible with the common market: all agreements
between undertakings, decisions by associations of undertakings and concerted practices which
may affect trade between Member States and which have as their object or effect the
prevention, restriction or distortion of competition within the common market, and in
particular those which:

a) directly or indirectly fix purchase or selling prices or any other trading conditions;
b) limit or control production, markets, technical development, or investment;
c) share markets or sources of supply;
d) apply dissimilar conditions to equivalent transactions with other trading parties,
thereby placing them at a competitive disadvantage;
e) make the conclusion of contracts subject to acceptance by the other parties of
supplementary obligations which, by their nature or according to commercial usage,
have no connection with the subject of such contracts.

Also: Any agreements or decisions prohibited pursuant to this article shall be automatically void

Prohibited agreements and concerted practices

Fines and immunity

Undertakings in breach are liable to be fined up to 10% of the turnover of the entire group of
companies worldwide and for all products.
Since it might be very difficult to find evidence (the “smoking gun”) of a cartel in a market, the
Commission waits for information coming from the market, handled by a whistle-blower.
A leniency programme encourages firms to inform the Commission about their infringements.
The first undertaking to submit evidence that is sufficient for the Commission to launch an
inspection, or enables it to find an infringement, receives full exemption from its fine (total
immunity)

Abuse of dominant position

• Dominant position per se is not a problem: if a firm has 90% of (relevant) market share it
might simply reflect superior products and/or efficiency.
• However dominance may tempt the same firm to extract extra profits from suppliers or
customers, or create barriers to entry to other firms => abuse its dominant position.
• The ‘abuse of dominant position’ is illegal under EU law
Two main forms of abuse:
a) Exploitative abuse: conduct whereby the dominant undertaking takes advantage of its
market power to exploit its customers (e.g. charging excessively high prices);
b) Exclusionary abuse: conduct whereby the dominant undertaking prevents or hinders
competition on the market by excluding its competitors by other means than competing
on the merits of the products or services it provides.

Prohibited practices
Commitments to avoid fines
• Contrary to the legislation on agreements, there is no opportunity for an exemption:
abuses cannot be approved or ‘exempted’.
• However, most investigations into suspected infringements are resolved with
‘commitment decisions’.
• The Commission drops the case and imposes no fines in exchange for a commitment
from the company under investigation to implement measures to stop the presumed
anti-competitive behaviour and restore normal competitive market conditions.
• If the Commission, after consulting market participants (market test), finds these
commitments sufficient, it takes a decision to make them legally binding.
• If the companies breach commitments they can be fined.

Definition of concentration: Mergers and Acquisitions

• The concept of concentration covers any operation which results in two or more
previously independent undertakings being replaced by a single undertaking (via
either a merger or an acquisition).
• The determination of the existence of a concentration is based upon de facto, rather
than mere legal criteria, focusing on the concept of control.
• Concentrations can be: horizontal, vertical or conglomerate (firms that are involved in
totally unrelated business activities).
• Concentration is a natural outcome of European integration. Combining the activities of
different companies might help in developing new products more efficiently or in
reducing production or distribution costs.

The anticompetitive effects of concentrations

• Unilateral effects. The most direct effect of the merger will be the loss of competition
between the merging firms. For example, if prior to the merger one of the merging
firms had raised its price, it would have lost some sales to the other merging firm.
• Coordinated effects. A merger in a concentrated market increases the likelihood that
firms are able to coordinate their behaviour in order to increase their profits (e.g. price-
fixing cartels forbidden by art. 101 of the TFEU).
An ad hoc Regulation for concentrations
• Differently from agreements and abuses of dominant position, concentrations among
firms are not explicitly disciplined in the Treaty.
• In 1989 the first Merger Regulation based on art. 308 of the TEC (today art. 352 of the
TFEU).
• In 2004 the Merger Regulation was updated (n. 139/2004) and the Commission
published Guidelines on the assessment of both horizontal mergers and non-horizontal
mergers.
• According to the Regulation:
“A concentration which would significantly impede effective competition, in the
common market or in a substantial part of it, in particular by the creation or strengthening of
a dominant position, shall be declared incompatible with the common market.”

Concentrations: Remedies
• The Commission is aware of the benefits linked to merging processes and for this reason
there may be actual negotiation between the parties and the Commission on the
conditions for compliance with competition principles.
• Remedies proposed by the undertakings must be clear-cut and entirely remove
competition concerns, and have to be implemented effectively within a short period.
• Thus, the most effective way to restore competition is to create the conditions for the
emergence of a new competitive entity or for the strengthening of existing
competitors.

Why controlling State aids

• A State aid is an advantage conferred on a selective basis to undertakings by public
authorities.
• By giving certain firms or products favoured treatment to the detriment of other firms
or products, state aid seriously disrupts normal competitive forces.
• Very often, public subsidies only delay the inevitable restructuring of operations
without helping the recipient to return to competitiveness.
• Unsubsidised firms who must compete with those receiving public support may
ultimately run into difficulties endangering the jobs of their employees.
• The entire market will suffer from state aid, and the general competitiveness of the
European economy is jeopardized.
• However State aids can also constitute an instrument of structural development policy
when certain legitimate objectives of economic growth cannot be attained solely by the
interplay of market forces.

State aids: the role of the Commission

• The Commission (supranational and independent authority) has the exclusive authority
for scrutinising whether the state aid schemes of EU governments are compatible with
the Common Market.
 • The Commission's role is to monitor proposed and existing state aid measures by
Member States to ensure that they are compatible with EU state aid legislation and do
not distort intra-community competition.
• All new state aids are illegal unless notified by the government to the Commission and
approved by it.
• The Commission has the power to require that aid granted by Member States which is
incompatible with the common market be repaid by recipients to the public authorities
which granted it.

______________________________________________________________________________
Part 2
The size of the EU budget
Public expenditure in the EU budget corresponds to only about 2% of the sum of the public
expenditure implemented through the national budgets, or the whole EU Budget is only 20%
of the public budget of countries like Italy or France.

However:
• cost of the EU Institutions (administrative expenditure): around 6%. That is, 94% of the
EU budget goes to fund concrete activities in the different areas of EU policy.
• the EU budget does not finance activities typically covered by national budgets (e.g.,
welfare, healthcare, military), hence resources are concentrated on key policy areas for
which the EU has competence
• the EU budget amounts to an expenditure of less than 80 cents per EU citizen per day….
Is the EU worth a coffee each day?

Rationale for EU budget – reasons for having the EU

• Revenues. The EU budget is financed either directly, from levies paid by individual
taxpayers, or indirectly, via contributions paid by the member states. Thus EU resident
taxpayers are the ultimate resource for the money available to the EU budget.
• Expenditures. Most of the EU budget is spent in EU countries (some 10% of the total
goes to non-EU countries).
The rationale for the EU budgetary expenditure lays in a ‘double market failure’, i.e.
when private market (first failure) and the national public authorities via the national budgets
(second failure) would provide a suboptimal amount (subsidiarity principle).

Example 1: Transport
First market failure: the private sector would not supply the optimal quantity (some less
populated routes would not be covered) => national governments intervene.
Second market failure: trans-European networks benefit all countries (positive
externalities). Single countries alone would invest in a sub-optimal way, i.e. too little, because
they do not reap all the benefits (e.g. a tunnel between France and Italy benefits Spain as well)
=> role for EU-level expenditure activated within the EU budget.

Example 2: Research and development

First market failure: companies do not capture the whole benefits of their R&D (other
firms and society at large could benefit as well) thus suboptimal quantities produced by the
market => national governments intervene (R&D subsidies).
Second market failure: EU-level research networks are more efficient and benefit all
countries (positive externalities)
=> role for EU

MFF (multi annual financial framework) and Yearly Budget

• The EU annual budget is set within a Multiannual Financial Framework (MFF), which
currently covers a period of 7 years.
• MFF gives guidelines for both revenues and expenditures, i.e. how to broadly allocate
money within each yearly budget document, and where to source the money from.
• The EU budget is subject to an annual adoption procedure which, starting from the
sums agreed within the MFF, fixes in detail the annual authorized expenditure for the
year for any single policy item.

From articles:
• “The MFF shall ensure that Union expenditure develops in an orderly manner and within
the limits of its own resources. It shall be established for a period of at least five years.
The annual budget of the Union shall comply with the multiannual financial framework.
• The Council, acting in accordance with a special legislative procedure, shall adopt a
regulation laying down the MFF. The Council shall act unanimously after obtaining the
consent of the European Parliament, which shall be given by a majority of its
component members.
• The MFF shall determine the amounts of the annual ceilings on commitment
appropriations by category of expenditure and of the annual ceiling on payment
appropriations. The categories of expenditure, limited in number, shall correspond to
the Union’s major sectors of activity.”

• The MFF is not the budget of the EU.

• It is a mechanism for ensuring that EU spending is predictable and at the same time
subject to strict budgetary discipline. It defines the maximum amounts (‘ceilings’)
available for each major spending area (‘heading’) of the Union’s budget.
• The MFF was introduced in 1988 within the “Delors I package”
• The MFF de facto sets political priorities for future years and constitutes therefore a
political as well as a budgetary framework (‘in which areas should the EU invest more or
less in the future?’).
 • The European Parliament and the Council (the ‘budgetary authorities’) have to agree
each year on the annual budget for the subsequent year. The annual budget adopted
typically remains below the overall ceiling of the MFF.

The annual budget procedure

1) Proposal. The European Commission prepares the draft budget, and submits it to the
Council and Parliament in year t-1 (e.g. 2013)
2) Adoption. The budgetary authorities, the Council and the EU Parliament, amend and
adopt the draft budget by December of year t-1
3) Execution. The European Commission is the main responsible for implementing the
budget in year t (2014)
4) Technical control. The European Court of Auditors audits in year t+1 the EU accounts
(2015, on the 2014 budget) and then issues a verdict on the accounts, as well as on the
underlying transactions down to the final beneficiary.
5) Political clearing. Discharge is the final approval of the EU budget for a given year
(following the audit and finalisation of the annual accounts), by March of year t+2 (2016,
for the 2014 budget). Discharge is granted by Parliament on a recommendation from
the Council. Discharge equates to approval by the representatives of the EU citizens (the
Parliament) of how the Commission implemented the budget in that financial year, and
the closure of that budget.

• The EU budget procedure resembles very closely the national procedure in terms of
democratic legitimacy and power separation.
• The five phases and the division of powers across institutions ensure both the
democratic character of any expenditure (that is, any coin spent has been authorised by
direct citizens’ representatives) and the correct functioning of the system of checks and
balances, proper to any developed democracy.

The budget procedure

• If, at the beginning of a financial year, the budget has not yet been definitively adopted,
a sum equivalent to no more than one twelfth of the budget appropriations for the
preceding financial year may be spent each month (art. 315 TFEU).
• The EP votes the budget discharge by qualified majority (50%+1 of the EP members)
and, in case the political clearing is not given, it can cast, by overqualified majority (66%
+1 of the EP members) a vote of non-confidence, which leads to the dismissal of the
Commission.
Pros and cons of MFF set-up
Pros:
• Determines the maximum levels per entry and per year of any expenditure
• Allows for multi-annual planning
• Is a great instrument for fiscal discipline at the EU level
Cons:
• Shifts power away from EP to the Council
• Has become relatively rigid (same structure since 30 years)
• Unanimity rule: singular national benefit rather than value added for the EU

Budgetary principles
• Unity: all expenditures and revenues must be found in one document (i.e. the budget).
• Universality: total budget revenue covers total budget expenditure, no earmarking thus
no use of a specific revenue (e.g. VAT provisions from France) to finance specific
expenditure (e.g. agricultural policy).
• Annuality: one yearly budget within the multi-annual programming period.
• Specification: every committed expenditure has to have a definite scope and purpose.
The budget is divided into sections, titles, chapters, articles and items.
• Unit of account: the budget is denominated in Euro.
• Equilibrium: art. 310 (TFEU) reads “The revenue and expenditure shown in the budget
shall be in balance”. Any deficit or surplus should be corrected by an increase or
reduction of the member states’ contributions.

Comment on the “equilibrium” principle (equilibrium principle)

• The EU budget must always be balanced in each and every year
• Total lack of inter-temporal flexibility: no deficit, no debt. Hence the EU budget cannot
be used as a tool for fiscal policy (smoothing the effects of the business cycle on the
economy, e.g. by increasing expenditure when the economy slows down). Next
Generation EU does that, but outside of MFF… more on this later!
• This requirement is the result of a politically conscious choice of limiting the financial
autonomy of the EU. Member States wanted to prevent the EU institutions from
misusing a non-balanced budget as an additional budgetary resource (that is, the EU
could borrow to spend instead of levying resources from MSs).
• Again this is a reflection of the principle of conferral: the source of legitimacy of the EU
is in the Member States, and thus only the Member States decide how much to tax /
redistribute resources among themselves, not a supra-national authority (at least for
the time being….)
• This rigidity of the EU budget clearly limits the growth potential of the EU as a whole.
A solution to the “annuality” principle (annuality)
This principle means that expenditure entered in the budget is authorised for one financial year
only, which runs from 1 January to 31 December.
In order to reconcile this requirement with the necessity of engaging in multi-annual
operations, two types of expenditures in the EU budget:
– commitment appropriations: the expenditure committed by the EU in a given year
with respect to operations that can be carried out over a longer period of time;
– payment appropriations: the expenditure effectively incurred by the EU in a given year
in meeting the commitments of that and/or previous years.

The two differ because multi-annual programmes and projects are usually committed in the
year they are decided, while paid over the years as implementation progresses.

Expenditures
Historically, 5 main areas of expenditure:
1. Agriculture: Common Agricultural Policy (details next lecture)
2. Structural: aimed at fostering convergence and cohesion by supporting investments in
poorer regions and countries
3. Internal policies: money spent inside the EU for other purposes (no agricultural or
structural), e.g. research, student mobility, energy, trans-European transport networks
4. External policies: pre-accession assistance to candidate members, European
Neighbouring policies, humanitarian aid, development cooperation
5. Administration: cost of running the EU Commission and all the other institutions of the
Union (overall about 55,000 people staffed, really not much)

Evolution of Expenditure
 Tiny budget in early years, mostly spent in administration
 Steady growth in budget over time, but always below 1.2% of EU GDP (max level
reached in 1993)
 Agricultural expenditure started in 1965 and soon dominated the budget, peak of 92%
in 1970
 Cohesion spending grew significantly from the 80s, with parallel decline in the relative
importance of agriculture
 Increased external expenditure for the enlargement process + more spending on
research and internal policy for growth in the 90s
 Cohesion + Agriculture: around 80% of total
 Administration: around 6-7% of total

MFF 2014-2020: Overview

 • “Single Market, Innovation and Digital”: research and innovation, SMEs
competitiveness, ERASMUS program, connecting Europe in terms of energy, transport,
telecommunications
• “Cohesion, Resilience and Values”: resources for less developed regions and Member
States
• “Natural Resources and Environment”: agriculture, rural development, fisheries,
environment and climate change
• “Migration and Border Management”: policies related to external borders, asylum and
migration, justice
• “Security and Defence”: internal security and common defence
• “Neighbourhood and the World”: enlargement, neighbouring policy, development
cooperation

Revenues
4 sources of “own resources” (i.e. sources of revenues to which the EU is legally entitled
through the Treaties):
Ø 1 “traditional” own resource (TOR):
– Custom duties on imports
Ø VAT resource
Ø GNI resource
Ø Plastic own resource
Other resources (around 1% of total): tax on EU staff remuneration, fines paid by companies
violating competition rules, bank interests etc.

Revenues: traditional own resource

• 1 “traditional” own resource (TOR):
• Custom duties on imports from outside the EU stemming from the Common External
Tariff (CET), both for agricultural and non agricultural goods
• Until 2017 there was another resource: sugar levies, then abolished
• This is the first and most complete expression of the financial autonomy of the EU =>
these resources go to the EU budget automatically
• Custom duties are collected by national customs authorities and transferred directly to
the EU coffers (Member States keep a collection fee equal to 25% of the total amount).
• In the 1970s and 1980s, TORs used to represent about 50% of the EU budget revenues;
they have been steadily decreasing since. Now they represent only about 15% of the EU
budget revenues.
• Their decrease is due to two reasons: the increase in the absolute size of the EU budget,
and the reduction of the EU tariff revenues as a result of the enlargements and trade
liberalisation (WTO)

Revenues: the VAT resource

 • Essentially, every time you purchase a good (and pay VAT), a part of the tax goes to
the EU budget.
• It is computed by applying a common EU VAT rate (today 0.3%) to a VAT base commonly
calculated, i.e., harmonized, across each EU country.
• In general terms: [Tax revenue=Tax rate * Tax base]
• This implies: [Tax base=Tax Revenue / Tax rate]
• The harmonized VAT base is obtained as the ratio between the VAT revenues of the
country and the weighted average rate of VAT applied in the country (since countries
apply different VAT rates to different goods).
• 0.3% of the harmonized VAT base is transferred to the EU budget.
• If the calculated VAT base exceeds 50% of the country’s GNI, the common VAT rate is
applied only to 50% of the GNI (max ceiling).
• The VAT own resource makes up around 12% of total revenues.

Revenues: the GNI resource

• The GNI resource, or ‘fourth’ resource, was introduced as a marginal resource in 1988:
its amount is equal to the difference between the total expenditure and the revenues
raised by the first three other resources => equilibrium principle: the budget must be
balanced !
• The same percentage is levied on each Member State’s GNI, established in accordance
with Union rules. The rate is fixed during the budgetary procedure (currently around
0.7-0.8%). A reduction has been granted to: Denmark, Germany, Netherlands, Sweden,
and Austria.
• The GNI resource has ensured financial sufficiency for the EU, by calling on national
governments to close the gap between increasing expenditures at the EU level and
dwindling revenues. The transfer has to be included each year in the Member States’
national budget laws.
• The GNI resource went from 10% of total resources in 1988 to about 73%: as a result,
the resources for the supranational EU policies are largely in the hands (and thus the
willingness to contribute) of the EU governments loss of financial autonomy for the
EU Institutions.

Revenues: the plastic own resource

• Introduced in January 2021, with the 2021-2027 MFF.
• National contribution based on the amount of non-recycled plastic packaging waste.
• A uniform call rate of €0.80 per kilogram applied to the weight of plastic packaging
waste that is not recycled.
• Mechanism to avoid excessive contributions from less wealthy Member States, below
EU average GNI per capita. They get back €0.80 paid on a number of kilos equal to
3.8*country population (of 2017). That is, no contribution for up to 3.8 kilos per citizen.
• It is a resource, but it also works as an incentive mechanism for states to reduce
pollution.
Net balance issue
 • The issue of burden-sharing of the net financing or net balances, has become in the last
few years an unavoidable stumbling block of nearly every EU negotiations. The issue is:
am I receiving from the EU Budget more than what I am contributing?
• Net balances are not a policy objective per se, but a simple outcome of policies. This
issue is more political than economic.
• An accounting system is a zero-sum game where the gain of one player always comes at
the expense of another. This comes in contradiction with a fundamental feature of the
European political project, which aims at creating a positive-sum game, notably through
the realization of common projects through the EU budget.
• Instead of opposing Member States, the European project aims at uniting them, which
some proponents of a juste retour concept sometimes forget.

Assessment: equity
There seem to be several inconsistencies in the system:
• The corrections negotiated on the revenue side partially undo the impact of certain
expenditure policies. It appears inconsistent that Member States benefiting from
redistributive packages to poorer regions (e.g. IT or ES) have to pay more for corrections
granted to richer countries such as Germany and the Netherlands.
• The VAT resource has a regressive impact (poorer countries tend to bear a relatively
large share), not entirely solved by the 50% capping (benefiting some of the richest
countries like Luxembourg or Ireland)
• Keeping 25% of custom duties as collection fee is arguably too much and favours big
entry points of EU: Belgium (port of Antwerp), Netherlands (Rotterdam, Amsterdam),
Denmark (Copenhagen)

Assessment: autonomy and transparency

• The financing system is both opaque and very complex. As a result, it is almost
impossible for EU citizens to ascertain who effectively bears the cost of financing the EU.
• The financial autonomy of the EU is limited. The two largest sources of revenue – the
VAT- and, in particular, the GNI-based own resources – display many of the
characteristics of national contributions and are often perceived as such.
• They are provided by national Treasuries and are presented as an expenditure item in
national budgets. This inevitably creates a tension which poisons every EU budget
debate.

MFF 2021-2027 and Next Generation EU

 MFF 2021-2027 works in the standard way, and it is 2% bigger than 2014-2020. It is
about 1.26% of EU GNI.
 Next Generation EU comes on top of that, for the sole purpose of addressing the
COVID-19 crisis
 The EU Commission is allowed to borrow on the market 750 billions
 Funds have to be borrowed and spent by 2026, and repaid by 2058
 70% of funds to be used in 2021-2022
  Around 30% of the total expenditure will target climate-related projects
 20% invested in the digital transformation
 Even though part of the funds are spent through the MFF categories (see previous
chart), they are legally distinguished from the MFF, being treated as “external assigned
revenues” (i.e., exception to the equilibrium principle)
 Up to 360 billions can be used to provide “loans” to member states
 Up to 390 billions can be used to provide “grants” to member states (either through
standard MFF programs, or through RRF… see next slide)
 Allocation across countries based on: population, GDP per capita, unemployment,
impact of COVID-19
 To clarify: if Germany gets a “loan” from the EU Commission, this amount contributes to
German public debt and has to be repaid by Germany
 If Germany gets a “grant”, this does not contribute to German public debt, and is repaid
by the EU Commission using its own resources
 Since Germany contributes to the own resources of the EU Commission, part of the
received grant is actually also repaid by Germany itself
 In other words, the net amount of money received is lower than the grant if you are a
net contributor to the MFF

Recovery and Resilience Facility (RRF) is the main part of NGEU

 This accounts for 360bn of loans and 312.5 of grants
 Countries need to prepare national recovery and resilience plans for 2021-2023. These
will need to be consistent with the country-specific recommendations and contribute to
green and digital transitions.
 Disbursements approved by Council with qualified majority, upon reaching targets
 According to Commission’s guidelines, money should be spent in:
- Power up: future-proof clean technologies and renewables.
- Renovate: improvement of energy efficiency of public and private buildings.
- Recharge and Refuel: sustainable, accessible and smart transport, charging and
refuelling stations and extension of public transport.
- Connect: fast rollout of rapid broadband services to all regions and households,
including fibre and 5G networks.
- Modernise: digitalisation of public administration and services, including judicial
and healthcare systems.
- Scale-up: increase in European industrial data cloud capacities and the
development of the most powerful, cutting edge, and sustainable processors.
- Reskill and upskill: adaptation of education systems to support digital skills and
educational and vocational training for all ages.

Next Generation EU: Financing

  Headroom: ceiling on commitment appropriations raised to 1.46% of GNI (0.2% on top
of 1.26% of MFF, to be used as guarantee for EU Commission borrowing)
 New Own Resources are foreseen to allow the EU Commission to pay back the loans
related to Next Generation EU
 Current state of the art:
- Non-recycled plastic packaging waste based contribution – 1 January 2021
- Carbon border adjustment mechanism – to be introduced by 1 January 2023 –
That is, a tariff on goods produced in countries with less stringent environmental
regulation
- Digital levy – to be introduced by 1 January 2023 – That is, a tax on multinational
digital players like Amazon and Google
- EU Emissions Trading System based own resource (possible extension to aviation
and maritime) – That is, part of pollution tax paid by firms
- Working on introducing other new own resources, possibly a financial transaction
tax, and a common consolidated corporate tax base.

Agriculture
The call for a policy:
• The origins of the Common Agricultural Policy (CAP) relate essentially to the transition
of the post-war European economy from an economy based on agriculture to one
based on industry and services.
• The growing labour demand coming from the post-war booming industrial sector was
creating increasing pressures for a potentially massive outflow of people from the rural
areas towards the new urban industrial centres.
• But Europe needed a strong and healthy agricultural sector => call for a policy
• The memory of food shortages over WWII was still vivid.
• Uncertainty: agricultural production differs from other sectors of the economy since it is
more weather and climate dependent.
• EU farmers in principle generate a positive externality by supplying public goods which
cannot be provided by the market alone: rural communities, natural resources,
environmental protection, animal welfare, high-quality and safe food, health of citizens,
in one word “multi-functionality”

Intervention: find ways to accompany this transformation (from agriculture to industry and
services), while protecting the multifunctional role of agriculture. => an ad hoc policy
• The Treaty of Rome (1957) defined the general objectives of a common agricultural
policy. The principles of the Common Agricultural Policy (CAP) were set out at the Stresa
Conference (1958).
• In 1960, the CAP mechanisms were adopted by the six founding Member States and two
years later… in 1962 the CAP came into force.
The objectives of the CAP
The objectives of the Common Agricultural Policy (CAP), as set out in Art. 39 of TFEU, are:
a) To increase agricultural productivity by promoting technical progress and by
ensuring the rational development of agricultural production and the optimum
utilisation of the factors of production, in particular labour;
b) Thus to ensure a fair standard of living for the agricultural community, in
particular by increasing the individual earnings of persons engaged in agriculture;
c) to stabilise markets;
d) to ensure the availability of supplies;
e) to ensure that supplies reach consumers at reasonable prices.

The original framework

• In 1957 the six countries of the EU had their own national agricultural policies based on
different tools: prices charged by farmers, controlling quantities produced and
supporting the income without interfering with the market equilibrium.
• A compromise had to be found among the different needs, in order to reach a
unanimous agreement and proceed with the integration process.
• The CAP was shaped according to the following principles:
• A unified market: this denotes the free movement of agricultural products
within the area of the Member States;
• Community preference: EU agricultural products are given preference
and a price advantage over imported products;
• Financial solidarity: all expenses and spending which result from the
application of the CAP are borne by the Community budget.

The original tool: price support mechanism

A price floor was set and implemented with tariffs (CETs) to ensure that imports never pushed
EU prices below the price floor. As world prices were changing, tariffs were adjusted to
guarantee price stability in the EU.

Analysis of graph above:

 • Loss in consumers’ surplus: A+ C1 + B + C2
• Area A is captured by producers, who benefit from the price support
• Area B is tariff revenues going to the EU budget
• Areas C1 and C2 constitute a net welfare loss
• As the world price changes, only tariffs change (and thus the level of protectionism). EU
consumption and imports are stable.

Early results and subsequent problems

• Initially, the CAP was well received in the EU:
- Higher and stable prices to farmers, higher farmers’ income.
- Growing receipts of tariff revenues (via the CET) for the EU budget.
- Pros and cons for consumers: higher prices with respect to RoW, but also more
food and lower dependence on food imports; empathy with farmers; high food
prices more than compensated by rising incomes.
• Post-war period saw productivity gains:
- High guaranteed prices encouraged investment.
- Agrochemical industry sprang up (pesticides, herbicides, fertilizers)
- Since CAP rewarded output, output rose much faster than consumption.
- No price fall: price still set above the world price.

The excess of supply problem

• Essentially, the CAP price support meant that producers could produce any quantity… and
they would always get their sales at the (high) price floor guaranteed…!!!
• EU farmers were producing more than the market could bear, creating excess supply, that
had to be dealt with through the EU budget:
§ Instead of earning money by imposing tariffs on imports..
§ … EU money was spent on “Direct Purchases” at the floor price and stocking (the
famous “wheat, beef and butter mountains”... mostly wasted).
e.g. In 1985 the EU had 18.5 million tonnes of cereals stored, about 70 kg for
each of its citizens
§ Later, to reduce the disposal problems, the EU also started buying at price floor
and selling cheap abroad. This form of dumping was called “Export Subsidies”.
• All these market interventions started to raise the cost of the CAP for the EU Budget...

The supply problem

In order to reduce the budget expenditure and

disposal problems, the EU started to export
at the World price what was buying at the Price
floor (dumping)

Price support mechanism: the need for a reform

 • EU producers did not respond anymore to market signals (price as the key
information). Farmers got closer to the EU governments than to EU consumers.
• Producers from the RoW were damaged by EU market closure and the negative effect
on international prices caused by the EU subsidies (dumping) => EU is not a small
country !!
Under WTO rules dumping is not permitted, especially when driven by
government subsidies. However, before 1994 Uruguay Round agreement,
the WTO placed no restriction on the dumping of agricultural goods.
• Consumers were facing high prices, with regressive effects (poorer consumers spend a
larger part of their income on food products than richer consumers do).
• Environmental problems and declining quality, as producers just had an incentive to
produce as much as possible, no matter what!

Price support mechanism: the need for a reform

Uneven distribution of benefits: price floors help all farmers but in proportion to their
production (hence the more you produce, the more benefits you receive), large farmers were
benefiting the most while small farmers were often barely surviving, with many leaving the
countryside (contrary to the objectives of the CAP).
80.5% of the farmers got just 15.5% of all the payments.
Thus the remaining 84.5% of the money goes to 19.5% of them

Drivers of reform in 1992

Endogenous driver:
• Decreasing internal support (environmental concerns, human health).
• Enlargements in the Eighties (Greece in 1981, Portugal and Spain in 1986) increased the
number of people engaged in agriculture and entitled to receive support.
Exogenous driver:
• In 1986, a new round of multilateral trade negotiations, known as the Uruguay Round,
had opened under the GATT agreement: for the first time, countries were supposed to
discuss also the issue of liberalising international trade in agricultural products.
Bottom Line: the price support mechanism of the CAP was no longer reasonable internally, nor
it was sustainable from an international perspective, and had to be replaced (elimination of any
support was not politically feasible).

The reform process:

1) MacSharry Reform (1992)
Main feature: from price support to income support
2) Before the “big enlargement” (1999, 2003)
Main features: decoupled income payments, cross-compliance, degression and rural
development
3) Today’s agricultural policy (2014-2020 and 2021-2027 MFF)
Main features: strengthened decoupling, cross-compliance, degression, rural development, and
climate change action
The 1992 MacSharry reform starts to lower price support (i.e. the CET) and to compensate
farmers for their income loss.
The attractiveness of “Direct Income Support” is threefold:
a) It does not entail market distortions, since the price is not set by the EU
authorities but by market players.
b) It is fairer than price support from a distributive standpoint (citizens do not pay
as consumers but as taxpayers progressively via the EU budget).
c) It opens the EU market to extra-EU imports (as the CET decreases, more foreign
products can be bought by EU consumers).
But notice: according to the 1992 reform, the amount of income support available to farmers
was directly proportional to the actual production.

Drivers of reform in 1999

Endogenous driver:
• The method of remuneration of farmers based on actual production still led some
producers to trying maximizing their production output in order to get as many
subsidies as possible, with the risk of over-exploitation of the land or the cattle, at the
expense of the environment or food safety (e.g. the “mad cow” desease).
Semi-Exogenous driver:
• Granting the same level of income support to the 12 “agriculturally-biased” acceding
countries would have put a great strain on the EU taxpayers (the Central and Eastern
European Countries were and still are net beneficiaries from the EU budget).
Moreover, the income support for the 12 Central and Eastern European farmers would had
been the compensation for the elimination of a price support which they never enjoyed.
=> A number of changes are implemented in the reforms of 1999 and 2003

A “decoupled” income support

• The 1999-2003 reforms introduce several new elements.
• The first is decoupling
• Decoupling means progressively linking aid to the potential fair income of the farmer,
and not to the actual production (e.g. considering the dimension of his or her land and
the number of cattle, among other things => see infra the concept of cross-compliance).
• A “fair” income should be that resulting from a correct exploitation of the land/cattle
available to the farmer, taking into account the need to preserve the environment and
the guarantee of food quality and safety (multifunctional role of agriculture).

Cross compliance, degression and rural development

• Cross-compliance links direct payments (income support) to compliance by
farmers with basic standards concerning the environment, food safety, animal
and plant health and animal welfare, as well as the requirement of maintaining
land in good agricultural and environmental conditions => remuneration of the
public goods produced by farmers.
 • Degression reduces direct payments for bigger farms, while new measures are
also introduced to favor young farmers.
• Rural development (is commonly referred to as the 2nd pillar of the CAP whereas
product and producer support is referred to as 1st pillar) is co-financed by
member States and grants funds to promote quality, animal welfare,
diversification, rural economy and to help farmers to meet EU production
standards.

CAP in the MFF 2014-2020

• Main objectives: viable food production, sustainable management of natural resources,
climate action and balanced territorial development.
• Further decrease of resources as compared to previous MFF, but still 37.8% of EU
Budget.
• Three types of expenditure:
1. Market support: mostly in terms of safety net for possible crises
2. New direct payments: greener and better targeted to those who are actively
engaged in farming (vs. rentiers)
3. Rural development
• Increased emphasis on environmental performance
• Measures for encouraging young farmers

Today’s CAP: MFF 2021-2027

• No changes with respect to previous MFF until 2022
• New CAP Strategic Plans to be implemented in 2023
• Some hints: 40% of CAP expenditure will be dedicated to climate action; environmental
objectives key within the “farm to fork strategy”
• Further decrease of resources as compared to previous MFF, but still 33.2% of EU
Budget (+ more coming from Next Generation EU)
• Two main funds for two pillars:
1. European agricultural guarantee fund (EAGF) – First pillar: finances income
support schemes (and residual market support, e.g., in case of extreme events to
limit fluctuations)
2. European agricultural fund for rural development (EAFRD) – Second pillar:
finances rural development and other green initiatives (with support from Next
Generation EU in 2021-2022

Protected Designation of Origin (PDO) gives status to a food product which is produced
entirely within a defined geographical area using recognised skills and ingredients from the
region and which is linked to its geographical origin. This includes many cheeses (Queso
manchego, Feta, Gorgonzola, Parmigiano Reggiano, Camembert de Normandie), meat products
(Prosciutto di San Daniele), olive oil and wines.
Protected Geographical Indication (PGI) denotes a food linked by its quality and reputation to a
region in which at least one stage of production, processing or preparation took place.
This includes Aceto Balsamico di Modena, beers (Münchener Bier, Ceskobudejovické Pivo),
meat (Scotch beef, many types of French poultry), fish (Scottish farmed salmon) and bakery
(Turrón de Alicante).

Economic and Monetary Union

Part I
Openness in financial markets
• Let’s study the decision of British people by assuming that there are only two one-year
bonds available: the UK one and the US one
• If you decide to hold UK bonds, you get a nominal interest rate equal to i t , i.e. for every
pound invested you get £ 1 ¿) next year
• If you decide to hold US bonds, you must first buy dollars, i.e. for every pound you get
Et dollars (notice: the nominal exchange rate tells you how many dollars correspond to
one pound)
¿
• When you invest $ Et in US bonds, you get $ Et ¿ next year, where i t is the nominal
exchange rate paid by US bonds
• But you will then have to convert these dollars back into pounds, at the expected
e
nominal interest rate prevailing next year E t +1
• So, overall, the expected return from holding US bonds is:

£ Et ¿

^^^Questo è spiegato in questa foto sotto^^^

A basic principle: interest rate parity
In equilibrium, if both domestic and foreign bonds are to be held, they must have the same
expected returns, so the following has to hold:
( 1+i t ) =¿
• That is, financial markets are in equilibrium when:

 Interest rate parity condition: holds if capital is fully mobile across countries

The impossible trinity

• Impossible trinity principle: only two of the three following features are compatible
with each other: (you need to give up one)
- full capital mobility
- fixed exchange rates
- autonomous monetary policy

Openness in goods markets

The real exchange rate is defined as the price of domestic goods relative to foreign goods. In
order to compute it, you first need to express both prices in the same currency.

• In reality countries produce more than 1 good, so we need to construct real exchange
rates that reflect the relative prices of all goods produced…
• So we use the GDP deflator, i.e. an index for the prices of all final goods and services
produced in an economy.
• Denoting P the domestic price deflator, and P* the price deflator in the foreign country,
we have the following expression for the real exchange rate ε :

EP Nominal exchange rate

ε=
P¿

• So, the intuition is exactly the same as for a one good comparison. However P and P¿
are indexes, so we are not interested in their level (1 or 100 in the whatever base year),
but just in their changes over time!

• A real appreciation is an increase in the real exchange rate (ε ↑), i.e. an increase in the
relative price of domestic goods in terms of foreign goods  loss of competitiveness
• A real depreciation is a decrease in the real exchange rate (ε ↓), i.e. a decrease in the
relative price of domestic goods in terms of foreign goods  gain in competitiveness

The need for macroeconomic coordination in the Single Market

• Single Market = four fundamental freedoms
• Imagine a monetary expansion in A within the Single Market (non coordinated monetary
policies), and the effect on another country B
• Interest rates in A decrease => depreciation of currency A vs. B => higher exports of
country A => higher output
• In B however the currency appreciation translates into a loss of competitiveness, lower
exports, and thus lower output
 • B suffers from the behaviour of the 'bad' neighbour A, the more so the more markets
(goods and capital) are integrated (less protection)

• Costs from lack of macroeconomic coordination

Monetary systems:
Gold standard:
Important property: the gold standard automatically restored a country’s external balance
through Hume’s price–specie mechanism, which applies to the internal working of a monetary
union:
- A country whose prices are too high is uncompetitive and runs a trade deficit 
importers spend more gold money than exporters receive from abroad  stock of
money declines  long-run monetary neutrality implies that prices will decline and the
process will automatically go on until competitiveness is restored. That is, imbalances
are self correcting.

Then we move from the gold standard => to gold exchange standard

• Thus, gold standard was inherently stable: fixed exchange rates, full capital mobility, no
monetary policy autonomy since the stock of gold money is determined by BoP.
• By the late 19th century, paper money started to exist: gold exchange standard where
paper money could circulate internationally, but each banknote was representing some
amount of gold.
• The continuing automaticity of the gold exchange standard relied on adherence to three
principles, known as the ‘rules of the game’:
1. full gold convertibility at fixed price of banknotes (i.e., fixed exchange rate);
2. full backing where central bank holds at least as much gold as it has issued
banknotes (i.e., no monetary policy autonomy);
3. freedom in trade and capital movements (i.e., full capital mobility).

The WW1 and WW2

• Gold exchange standard was suspended in 1914.
• Because of war expenditures, governments issued debt and printed money. During the
war, prices were kept artificially stable through rationing schemes; when war was ended
and prices were freed, the accumulated inflationary pressure burst in hyperinflation:
Germany, Hungary and Greece faced monthly inflation rates of 1000% or more in the
early 1920s.
• Post-war policymakers committed to return to gold exchange standard as soon as
practical: at which exchange rate? European countries adopted different strategies,
which ended up tearing them apart, economically and politically.
• The gold exchange standard collapsed again in 1933.(anarchy)
 • When gold exchange standard collapsed, exchange rates were left to float. Each country
(except Germany) sought relief by letting its exchange rate depreciate to boost exports:
tit-for-tat depreciations, which led to protectionist measures.
• The impossible trinity principle was violated as countries started to use monetary policy
unilaterally
• The result was political instability, leading to WWII.
• Among the many lessons learned, two are relevant for the monetary integration
process:
- freely floating exchange rates result in misalignments that breed trade barriers and
eventually undermine prosperity;
- management of exchange rate parities cannot be left to each country’s discretion: need
of a ‘system’.

Bretton Woods
• The Bretton Woods conference established an international monetary system based on
paper currencies:
- gold as ultimate source of value, but the dollar as the anchor of the system (with US
government guaranteeing its value in terms of gold);
- all other currencies defined in terms of the dollar;
- exchange rates ‘fixed but adjustable’ (in a coordinated way)
- IMF supervising compliance and providing emergency assistance;
- most countries made abundant use of capital controls, consistent with impossible
trinity, as countries maintained monetary policy autonomy.
• System unraveled with lifting of capital controls in the 1960s: exchange rates had to be
freed or authorities had to give up monetary policy autonomy. Most governments
refused to make such a choice. The dollar gradually became overvalued and:
- USA ‘suspended’ the dollar’s convertibility into gold in 1971;
‘fixed but adjustable’ principle was officially abandoned in 1973.

Europe’s snake (in the tunnel)

• First European response to the collapse of Bretton Woods: ‘European Snake’ = regional
version of the Bretton Woods system to limit intra-European bilateral exchange rate
fluctuations (± 2.25 per cent, stricter than allowed by Bretton Woods post 1971: ± 9%) .
• It was a very loose arrangement and when inflation rose due to the first oil shock of
1973–74, divergent monetary policies (e.g. restrictive in Germany, less so in UK and
Italy) led several countries to leave the Snake.
• In spite of its failure, the Snake brought about two innovations:
• determination to keep intra-European rates fixed, irrespective of what
happened elsewhere in the world;
• European currencies needed to be defined vis-à-vis each other (no role for
dollar). The Snake was meant to be ‘an island of stability in an ocean of
instability’.
• The next move was the European Monetary System (EMS).
 The European Monetary System

• Established in 1979, when it was clear that large exchange rate fluctuations were a
threat to the well functioning of the Single Market (recall the need for macro-economic
coordination)
• Heart of EMS is the Exchange Rate Mechanism (ERM): grid of agreed bilateral exchange
rates
- All ERM currencies were fixed to each other, with a band of fluctuation of ± 2.25
per cent around the central parity (Italy, Spain, Portugal and UK were allowed a
margin of fluctuation of ± 6 per cent)
- Fully symmetric system, as parities were defined with respect to the European
Currency Unit (ECU), i.e. a basket of EMS currencies
- Defense of bilateral parities through cooperation of central banks
- Realignments possible upon consensus of all participating countries, implying some
loss of autonomy

Realignment

When the EMS is not able to structurally maintain the exchange rates within the agreed central
parities, e.g. due to diverging inflation rates, it is possible to realign the parities towards a new
value. However, this can be done only with a unanimous decision. Any delay, entails a cost for
the concerned country

When the exchange rate hits the upper (or lower) bound of the bands of fluctuation, the
Central Banks intervene: e.g. B. of Italy sells DM, and buys Liras.
This reduces the supply of Liras on the market and increases the supply of DM: the “price” of
DM w.r. to liras decreases => the DM depreciates against the Lira. An alternative channel of
intervention is an increase of the interest rates on Liras.

Pb.: In order to sell DM, Bank of Italy has to use its foreign reserves, or obtain overnight loans of
DM from the German counterpart (for which DM is the “domestic” currency), through a specific
mechanism known as Very Short Term Financing Facility (VSTFF). Clearly, this implies a certain
degree of cooperation between Central Banks.

• As capital controls were lifted, realignments became increasingly destabilizing and

costly. Thus, high-inflation and depreciation-prone countries tried to reduce inflation to
converge to the lowest rate: Germany became the standard to emulate (i.e., German
monetary policy became the ERM standard and other countries de facto surrendered
monetary policy independence) and inflation rates started to converge.
• No realignment between 1987 to September 1992; a system designed to be symmetric
became perfectly asymmetric, especially as capital controls within the EU were formally
banned in July 1990
• Other countries resented the Bundesbank leadership, and wanted a shared monetary
policy…
• … Germany was unwilling to give up leadership but accepted a political deal in 1991:
monetary union in exchange for reunification with the former East Germany 
Maastricht Treaty (Dec 1991)

• German reunification was costly and became inflationary, which led to contractionary
German monetary policy. When other countries did not follow and referendum in
Denmark rejected the Maastricht Treaty, speculative attacks targeted countries that
were less competitive due to over-evaluation:
- Bank of Italy and Bank of England intervened to support their currencies;
- attacks became so massive that Bundesbank stopped its support  the lira and
the pound withdrew from the ERM;
- speculation shifted to the currencies of Ireland, Portugal and Spain (devalued
twice); contagion then spread to Belgium, Denmark and France;
- monetary authorities adopted new ultra-large (±15 per cent) bands of
fluctuation:  tight ERM was dead.

• Post-crisis ERM agreed in 1993 differed little from a floating exchange rate regime (i.e.,
bilateral parities could move by 30%).
• One condition in Maastricht Treaty for joining the monetary union: at least two years of
ERM membership  ERM is still in use as a temporary gateway but it has been re-
engineered:
- parities defined vis-à-vis the euro;
 - margin of fluctuation less precisely defined;
- interventions automatic and unlimited, but ECB may stop them.

Lesson learnt
• The EMS has been a key step in European monetary integration. For the first time,
European currencies defined their interrelationship without reference to an external
store of value, like gold or the US dollar. It involved deep and comprehensive
agreements among sovereign states that remain unmatched elsewhere in the world.
• And yet, the impossible trinity is binding!
• As long as the weaker-currency countries imposed restrictions on capital movements,
speculative attacks often accompanied exchange rate realignments, but they were
manageable. Once full capital mobility was achieved, central banks soon realized that
even large stocks of foreign exchange reserves are too small to repel speculative attacks,
and that unlimited interventions are practically impossible. In other words, the
conclusion was that monetary integration with separate currencies is a very risky
endeavor, possibly a hopeless quest. Monetary union was the response

The rationale for a single currency

• A Single Market works better with a single currency (One Market, One Money, 1990):
– No exchange rate risk; price transparency & reduced transaction costs
– Lower exposure to international fluctuations as lion’s share of trade becomes
internal to EMU, i.e. reduced degree of openness
• After the EMS crisis of 1992, due to the impossible trinity, it was clear that
independence of monetary policy had to be eliminated to achieve stability of exchange
rates (the alternative would have been re-introducing capital controls, i.e. giving up the
integration project)
• In the Globalization context, each single EU country was losing economic sovereignty
anyway in managing monetary and exchange rate policy
• Two-fold mutually reinforcing effects of a single currency
Micro: one currency => higher competition (price transparency) => stimulate industry
consolidation and investment in the EU => growth
• Macro: one (independent) central bank => low inflation in a context of low interest rates
=> stability

The Maastricht Treaty

• Building on the report of the Delors’ Committee (1989) and the EC document (One
Market, One Money), the Maastricht Treaty (December 1991) established the
foundations of the European Monetary Union:
- it described in great detail how the system would work, including the statute of
the European Central Bank;
- it set the conditions under which the monetary union would start;
- it specified entry conditions (mostly at German request);
 - fulfillment of these criteria was formally evaluated in May 1998. In the end, all
the countries that wanted to adopt the euro qualified, with the exception of
Greece, which had to wait for another two years.
- UK and Denmark negotiated an opt-out clause. All the other EU countries have a
formal obligation to join.
• On 4 January 1999, the exchange rates of 11 countries were ‘irrevocably’ frozen and the
power to conduct monetary policy was transferred to the European System of Central
Banks (ESCB), under the aegis of the European Central Bank (ECB). Euro banknotes and
coins were introduced in January 2002.
• Since then, eight more countries have adopted the euro, for a total of 19, the last being
Lithuania (1st January 2015)

The set-up of the EMU

The European Monetary Union has a number of specific characteristics:
• Once the exchange rates of the national currencies are irrevocably fixed, these are
progressively replaced by a new physical currency, the euro
• The monetary policy is run by a new single institution, the ESCB, where all the
countries share their monetary sovereignty
• While the monetary policy is centralized, fiscal policy remains decentralized (i.e. in the
hands of national governments) but is increasingly coordinated
In order to optimize the working of the EMU, both monetary and fiscal policies within the euro
area have been subject to a number of rules. These rules are firmly grounded in economic
theory (Nobel-awarded pieces of economic research have been legally 'incorporated' in the
Maastricht Treaty)
In what follows we cover those rules, and the relevant theories behind them, for both
monetary and fiscal policy.

EMU Monetary Policy

• According to the TFEU, Art. 127, the monetary policy is managed by the European
System of Central Banks (ESCB), whose tasks are:
– to define and implement the monetary policy of the Union;
– to conduct foreign-exchange operations (following the instructions eventually
given by the Council);
– to hold and manage the official foreign reserves of the Member States;
– to promote the smooth operation of payment systems;
– prudential supervision of credit institutions (details later in the course)
In particular:
• Executive Board of European Central Bank: ECB President, vice-president, 4 Executive
Members appointed by European Council. Responsible for implementation of monetary
policy.
• Governing Council of ESCB: 6 members of ECB Executive Board, plus all the 19
Governors of national central banks of EMU. Responsible for the definition of monetary
policy (and guidelines for operational implementation)
 • General Council of ESCB: ECB President and vice-president, plus all the 27 Governors of
national central banks of member States. Responsible for harmonization of rules and
consulting function

Economic Theory and EMU: the monetary side

• It is widely recognized that price stability is important for investment and growth.
• If central banks mainly care about unemployment, e.g. because they are not totally
independent from the government, they may deviate from the announced inflation
target after wages have been fixed: time-inconsistency problem of monetary policy
(Kydland and Prescott, Nobel prize takers in 2004).
W
e
P
• This inconsistency ultimately results in the same rate of unemployment but higher
inflation, as economic agents anticipate such behavior of the bank
• Thus, no incentive has to exist for central banks to deviate, so they have to care mainly
about inflation and be completely independent from the national government and the
political cycle.

EMU Monetary Policy: ESCB objective

 Clear commitment to price stability, in line with the most credible and stable
continental monetary institute which preceded it: the Bundesbank.
 Monetary policy shall also support the general economic policies of the Union, but
always without prejudice to the objective of price stability.

EMU Monetary Policy: ESCB independence

The ESCB is very much independent from any member states politics
EMU Monetary Policy: “No bail out clause”

The ECB are not there to finance to any members of the EU. They also don’t buy debt
instruments such as bonds. (they don’t purchase directly from member countries). What they
can do is by these bonds indirectly, aka secondary markets, and this is in line with the no bail-
out clause.

The no bail-out clause is aimed at further reducing the incentives for moral hazard by member
States. It is strict for the ECB (art. 123), somewhat milder for Member States (art. 125) => used
during the crisis

EMU Monetary Policy: ECB strategy

• At the beginning, the ECB announced a “double pillar strategy”:
1. Direct inflation targeting: between zero and 2 per cent
2. Monetary targeting: annual growth of the M3 monetary aggregate at 4.5 per
cent
3. However, the ECB did not achieve these objectives in the first years. In particular,
M3 growth always above 4.5 per cent.
• Criticism emerged that ECB was announcing and trying to run an overly restrictive
monetary policy w.r. to the economic conditions.
• In May 2003, ECB revised the strategy:
1. Governing Council has clarified that “The ECB aims at inflation rates of below,
but close to, 2% over the medium term”. This is to “provide a safety margin
against the risk of deflation”
 2. Formal reference to monitoring of M3 is dropped (although M3 developments
still taken into account in medium run due to monetary neutrality)

• There are 3 main problems related to a too low inflation target:

Nominal int. rate: i=r + π e
If the CB works well and is credible: i=r n
1. it may imply ineffective monetary policy, due to the zero lower bound for
nominal interest rates (if inflation too low => in equilibrium nominal interest
rates are too low => no room for decreasing them enough to stimulate the
economy in case of recessions); [in this case you would need non-conventional
monetary policies, e.g. Quantitative Easing]
2. due to measurement errors, a low measured inflation may actually capture a
slight deflation;
3. some inflation may actually “grease” the mechanism of relative price
adjustments in response to shocks, as there are nominal downward rigidities to
lowering prices/wages.

Example: it is easier for a country to regain competitiveness in a context of moderate inflation

rather than in a context of stable prices, as the latter would imply nominal decreases in
prices/wages. Hot issue in the aftermath of the crisis!

EMU Monetary Policy: definition of rates

The Governing Council of the ECB sets the key interest rates for the euro area:
 marginal lending rate: ECB overnight credit to banks from the euro
system. AKA the interest rate banks pay when they borrow from the ECB
overnight.
 deposit rate: The rate on the deposit which the euro system banks may
use to make overnight deposits
 MRO: The interest rate banks pay when they borrow from the ECB for
one week
 inter-banking interest rates/EONIA: This is the market rate at which
banks lend to each other overnight. This is influence from the above rate
but not determined by it.

Notice: the ultimate goal of the central bank is to influence the market rate, which in turn
affects the rate at which households and companies can borrow: transmission mechanism of
monetary policy
Commercial Banks vs. Central Banks

A commercial bank deposits part of its

excess of reserves on its account with the
CB at the deposit rate (transaction A).
It also lends another part to a commercial
bank at the market rate (transaction B)
against a guarantee (e.g. bonds)

A commercial bank pledges a guarantee

and receives a refinancing of (newly
printed) money by the CB at the policy rate
via a MRO, or a loan by the CB through the
marginal lending rate (transaction C in both
cases).
It also receives a loan from a commercial
bank at the market rate (transaction D)

Economic Theory and EMU: the fiscal side

• In general, monetary and fiscal policies should ensure the stabilization of the business
cycle over time so as to foster consumption smoothing (stable consumption over time)
• The latter implies the ability to generate deficits in ‘bad’ times to compensate for the
negative phase of the cycle => national budgets have a cyclical component (vs. EU
budget, in equilibrium each year)
• But in any case there is an inter-temporal budget constraint: in the long-run the
discounted sum of government revenues = discounted sum of government
expenditures. Any tax cut / higher public expenditure today has to be compensated by
higher budget surpluses tomorrow
• The latter also creates a link between monetary and fiscal policy: printing money may be
a way of increasing government revenues, generating inflation which reduces the real
burden of debt.
• Hence, in an economy which experiences high budget deficits, and where the central
bank is not fully independent, inflation expectations rise and inflation rates tend to be
higher…
• So, if an inflation target has to be achieved, public finances need to be balanced in the
medium-run
• This is even more beneficial in general as high public deficits tend to crowd-out private
investments in the economy (and hence reduce long term growth)
 • In EMU, the need for balanced public finances is reinforced by 2 factors:
1. Individual fiscal policies by Member State: a country can increase public spending => rise
in the interest rates; but part of this increase spreads out to other countries of the union
even if they have not changed their fiscal position, i.e. negative spillover (via crowding-
out of private investment)
2. As financial markets become integrated, the common central bank might have an
incentive not to let any country go bankrupt (by setting lower interest rates or buying
government bonds). This may loosen the incentives for budget discipline in each
country, i.e. moral hazard
• Overall… There is a clear need for stringent rules on budget discipline in a monetary
union
• And yet you may wonder: why would any country accumulate unsustainable debt?
Several answers have been provided: fiscal illusion, political business cycle, coalition
governments…

The political business cycle (Alesina & Perotti, 1995) or the same form of Government,
parliamentary vs. presidential (Persson & Tabellini, 2003) can lead a Government to generate
permanent and excessive deficits, even in positive phases of the cycle, and hence a build up of
debt. This is what happened in Europe since 1960.

!!! Vertical axis: if the country is generating a surplus (negative part) or generating debt
(positive part)
!!! Horizontal axis: If positive it means that the country is growing more than their potential
growth rate. If negative it means that the country is growing less than their potential growth
rate.
EMU Fiscal Policy
• Two key objectives:
1. achieve solid budgetary discipline and maintain it over time;
2. achieve a strong coordination of macroeconomic policies.
• The Maastricht Treaty states that “member States shall avoid excessive government
deficits” (Art. 126).
• Two specific fiscal provisions: deficit/GDP below 3%, and debt/GDP below (or
converging to) 60% (as in convergence criteria).
• The Treaty contains also an excessive deficit procedure to enforce these provisions (see
infra)
• The Maastricht fiscal criteria should ensure the consistency between a centralised
monetary policy and de-centralised national fiscal policies: aim is to avoid the
generation of excessive inflationary expectations and prevent the emergence of
negative spillovers / moral hazard problems.
• But is it enough? If we fix a 3% maximum deficit threshold and countries stay around
that threshold in the medium term (i.e. at zero output gap), this implies that in case of
slow-down of the economy the 3% threshold will be overcome, with a very limited
scope for the use of automatic stabilizers !
• Hence, in 1997, the idea to design a refined set of rules, on top of those contained in
the Maastricht Treaty, that ‘obliges’ countries to achieve a medium-term budget target
of close to balance, or in surplus

=> Stability and Growth Pact

Stability and Growth Pact (SGP): the rationale

So why 3% and 60% ?
• The previous analysis by Buti and Sapir (1998) across European nations in the period
1961-1990 has shown that the functioning of automatic stabilizers would have never
taken the deficit above 3% of GDP, starting from a situation of balanced structural
budget (i.e. no deficit at potential output level with no inflationary pressure)
• However, this does not apply to large recessions… Hence the exception for
“extraordinary circumstances” (i.e. a contraction of GDP by more than 2%, or even
between 0.75 and 2% discretionally)
• 3% of GDP is also in line with public gross capital expenditure in Europe, thus implying
that capital investment can be financed also by future generations through public debt
• 60% of debt/GDP is the stable level of debt that can be sustained with a 3% deficit
when having nominal growth (including inflation) of 5% per year (that is, 2% inflation
target + 3% GDP growth), which is in line with the potential output of the European
economy at the start of EMU

Stability and Growth Pact (SGP): the ‘preventive’ arm

• The underwriters of the Pact commit themselves to a medium-term objective (MTO) of
a public budget ‘close to balance or in surplus’, a stricter goal than the 3% deficit rule.
• The MTO is achieved over time through the set up of “stability programmes” (updated
each year) that detail the adjustment path of budget deficits toward the MTO. These
programmes normally range over five years.
• The medium-term objective (MTO) of budgetary positions “close to balance or in
surplus” is differentiated by member State (from -1% to surplus) and defined in
structural terms, which means that the MTO should take into consideration business
cycle swings and filter out the effects of one-off and other temporary measures.
• For the definition of the MTO and of the adjustment path, transitory elements besides
cyclical components have to be taken into account. In particular, the assessment has to
consider the role of structural reforms such as labor market reforms, policies to foster
R&D and innovation, pension reforms. Furthermore, the Council has also stated that
‘due consideration has to be given to any other factors which, in the opinion of the
concerned member state, are relevant in order to comprehensively assess in qualitative
terms the excess over the reference value’.

=> room for political compromise with danger of ambiguous interpretations

Stability and Growth Pact (SGP): the ‘corrective’ arm

• The deficit/GDP value of 3% remains as a maximum threshold, not to be trespassed.
Automatic exceptions are foreseen if the growth rate of a country falls by at least 2%;
for reduction in growth rates comprised between 0.75 and 2% a temporary waiver can
be granted.
 • Non-automatic waivers can also be granted for (temporary) excessive deficits resulting
from a period of negative growth rate, or from the accumulated loss of output during a
protracted period of very low growth relative to potential growth.
• Public debt is also considered excessive under the Treaty if it exceeds 60% of GDP
without diminishing at an adequate rate.
• If the country does not comply, an excessive deficit procedure proposed by the
Commission can be voted by the ECOFIN Council: the country is then obliged to take all
the necessary measures to comply with the SGP (i.e. reduce the deficit) within the time
horizon defined in the procedure (TFEU art. 126).
• If the country is still not complying, a fine is imposed: 0.2 % of GDP, if it fails to abide by
either the preventive or the corrective rules, or 0.5 % of GDP, if it repeatedly fails to
abide by the corrective rules.
• These rules of the SGP have been further strengthened during the crisis (see next slide
set)

EMU Fiscal Policy: Member States compliance

 After the introduction of the SGP in 1997, the Commission requested to the EcoFin
Council the activation of several excessive deficit procedures since 2002.
 But these requests were not always effective, as governments in the Council “colluded
in a repeated game”, e.g. sanctions against France and Germany were not approved by
the Council in 2003, which abstained from voting the Commission recommendation.
 The Commission then appealed to EU Court of Justice, which ruled against the Council…
asking for an explicit vote on the Commission request.
 The European Council then intervened, and ‘encouraged’ the Commission (recall who is
the boss in the EU?) to propose a reform of the SGP able to encompass the new
situation giving more flexibility to the Council with the introduction of a number of
discretional waivers / exceptions.
 Nowadays this remains a critical open issue…

Economic Theory and EMU: the cost side

• Since the seminal work of Mundell (1961), we know that a region can be considered as
an Optimal Currency Area (OCA) if 4 conditions are met:
1. The business cycles are perfectly synchronized, in order to ensure an optimal
conduct of the centralized monetary policy;
2. Fiscal policies are able to cope with asymmetric shocks eventually hitting the
area;
3. Prices and wages are perfectly flexible across the area;
4. Product and labor markets are integrated
• These factors have influenced the set-up of EMU and hence Mundell got the Nobel prize
in Economics in 1999
Maastricht Convergence Criteria
The Maastricht Treaty contains 3 nominal convergence criteria to be fulfilled by Member States
willing to adopt the euro:

1. inflation rates no more than 1.5 per cent above the average of the three EU countries
with the lowest inflation rates (one year before joining)
2. Long-term interest rates should be no more than 2 per cent above the average of the
three EU countries with the lowest rates
3. National currencies must not have been devalued and must have remained within the
normal (15 per cent) bands of the EMS for the previous two years

Rationale: These nominal convergence criteria aim to ensure the elimination of costs
associated with the synchronization of business cycles (“one monetary policy fits all?”);

N.B. recall that in the Maastricht Treaty there are two fiscal provisions related to the evolution
of public debt and deficit. Hence sometimes people refer to ‘five convergence criteria’ in the
Treaty, although the latter two are clearly different in nature.

These convergence phenomena can be see below:

ECB management of inflation before and after the financial crisis:

• ECB established a strong reputation of commitment to price stability.

• Inflation dynamics are a success: in 42 out of 110 months inflation below 2%, and
anyway upper deviations have not been substantial, especially if we look at “core
inflation” excluding unprocessed food and energy (more volatile at global level).
• Expectations remain just slightly above 2% even after 2005, as standard inflation was
rising due to food and energy price shocks.
• Volatility has also been reduced: from 0.6% in 80s to 0.3% in the 90s to 0.2% after 1999.

EMU Monetary Policy: results 1999-2008

• 2.1% avg. GDP growth for 1999-2008, same as 1989-1999 (2.2%), less than 2.6% of US.
• Heterogeneous picture across member States, e.g. small countries have grown more.
• 2 big economies have slowed down: Germany (from 2.5% to 1.5%) and Italy (around
1.5%).
• GDP growth can be decomposed in employment growth and labor productivity growth.
• Employment growth has been high: 1.3% against 0.6% in previous decade (and 1% in
US). Unemployment has decreased from 9.3% to 8.3%. This is attributed to labor market
reforms, shift to labor intensive services and wage moderation due to higher
competition (Single Market and Globalization at work).

If you’re below the 45° line: you grew not as fast as if you
did not join the EU. Conversely if you’re above the 45° line
 • Labor productivity growth has been very low: 0.8% against 1.6% in previous decade
(and 1.6% in US). WHY?
• Problem is low R&D, low productivity in services, low ICT adoption, outdated managerial
practices inconsistent with IT revolution: not enough competitive pressures / market
integration (i.e. without the euro it would have been worse)

EMU Fiscal Policy: results 1999-2008

• Average deficit/GDP in 1999-2008 has been 1.7%, below 4.3% of 1989-1999, and below
the critical 3%. So it seems that the SGP has been effective, although the upturn in cycle
has helped.
• Notice also the improvement from 1992 to 1998, thanks to convergence criteria.
• Average debt/GDP is 68.6% in both decades, increasing above 60% in France, Germany
and Portugal, although decreasing in high-debt countries
EMU and the crisis
(2007-2010)

----Origins: the globalization shock----

• From the second half of the nineties,
globalization allows US and EU firms
to import lower price inputs and
goods on a large scale from Asia and
particularly from China, which
benefits from huge scale economies
further lowering down unit costs.
• This creates a positive supply shock in
industrialized countries:
• Downward pressure on inflation…
• The Economist has referred to these
dynamics as “weapons of mass
disinflation”
----2004/05: Central Banks start increasing interest rates----

----2006/07: first signals of a mortgage crisis-----

The chain of events leading to the crisis
Ø Collateralized Debt Obligations (CDO) are created and sold => “originate to distribute”
model of risk (from mortgage to investors) =>
Ø higher US interest rates and falling housing prices =>
Ø crisis of sub-prime mortgages (then extended to normal mortgages, why paying a
mortgage for 200k $ if your house is now worth 150k?, you’d better sell your house) =>
Ø tensions on the inter-banking market =>
Ø fall in asset values => liquidity crisis
Ø deleveraging of banks’ balance sheets =>
Ø possible (e.g. Lehman Brothers) solvency crisis and overall contagion via Credit Default
Swaps (CDS) =>
Ø credit crunch =>
Ø recession, international trade collapse, i.e. “from Wall Street to Main Street”…

The role of banks in financial crisis:

• The balance sheet of a bank:

• Assets: government bonds, other securities, mortgages, loans to firms, reserves.
• Liabilities: deposit accounts, short-term and long-term debts as a result of borrowing
from financial investors or other banks.
• Capital: difference between total assets and total liabilities, you can think of it as being
funds initially invested by the owners of the bank.
• If there is a loss on assets, this will be absorbed by capital. If, due to losses, assets
become lower than liabilities, then the bank goes bankrupt… that’s why a safe amount
of capital has to be maintained, as a share of assets.

• Capital ratio=capital/assets
• It is equal to 20% for bank A, and only 5% for bank B.
• Leverage ratio=assets/capital
• That is equal to 5 for bank A, and 20 for bank B.
• The position of bank B is very risky… As soon as the value of assets decreases below €95
there is bankruptcy!

• And yet, a higher leverage ratio increases expected profits per unit of capital. For
example, assuming assets pay 5% and 4% is paid on liabilities, the following expected
returns on capital are obtained:
• Bank A: (€100*5% - €80*4%)/€20 = 9%
• Bank B: (€100*5% - €95*4%)/€5 = 24%
• Many banks were in the position of bank B in 2007, too little capital over assets… When
the value of assets went down, these banks went bankrupt!
From the US banks to the EU ones: spill over effect
Ø EU Banking system is the largest in the world: cannot be exempt from purchasing
available assets yielding good returns (CDOs…)
Ø Bank financing is more important for EU firms (around 70% of total) than for US firms
(around 25% of total)
Ø Not by chance, the first ‘signals’ of the crisis erupted in Europe (suspension of two CDOs
funds by BNP Paribas in July 2007)

2007/2008: the ‘heart attack’ scenario

• The credit crisis explodes in August 2007, as BNP Paribas defaults on two CDOs funds.
• In November 2007 the liquidity crisis turns into a solvency crisis for some institutions:
Bear Sterns (5th largest global investment bank) goes bankrupt and is rescued by JP
Morgan with the help of FED lending 80 bn USD in exchange for toxic assets owned by
Bear Sterns.
• On September 15th 2008, Lehman Brothers (4th largest global investment bank) goes
bankrupt and is not bailed-out.
• Merril Lynch (the 3rd largest) in distress is acquired by Bank of America, a commercial
bank (decision taken in the same meeting organized to rescue Lehman…)

• After Lehman and Merrill, the 2 remaining IBs (Goldman Sachs and Morgan Stanley)
change their statute to commercial banks and accept FED supervision. Then crisis hits
AIG (the greatest global mortgages broker), plus Fannie Mae & Freddie Mac (two
federal mortgages institutions).
• In the meantime, in the EU, several Banks had to be rescued: Northern Rock & RBS
(UK), Landesbank Sachsen (Germany), Fortis (Belgium), Bradford & Bingley (UK), Dexia
(France-Belgium), ABN-AmRO (the Netherlands)...
• On October 10th 2008 the global inter-banking market got stuck: banks do not trust
each other anymore… there is no liquidity exchanged…
• The whole economic system was about to collapse!

From finance to real economy

• The negative effects of the credit crisis quickly went from the financial to the real side of
the economy:
• Credit crunch: large increase in interest rates at which firms and families could borrow,
or simply drain of available loans (because of problems in banks’ balance sheets) =>
lower investment
• Loss of wealth: the value of financial assets and houses drops => lower consumption
• Decrease in confidence: with financial markets stuck and assets’ value spiralling down,
both companies and firms were afraid the situation would become worse and worse =>
negative effect from expectations
• Trade collapse: with less money available to pay in advance invoices, and with demand
falling everywhere in the world, also trade flows collapsed => lower net exports
 • Overall there was a large decrease in spending, synchronised across countries… [A big
shift of the AD curve to the left!]
• Risk of Great Depression #2 ….

The risk of Great Depression #2

• To avoid the free fall of the world economy, countries had to organize an extraordinary
and coordinated (at the G-20 level) set of responses, which refer to both monetary
policy and fiscal policy

Policy response: (conventional) monetary policy

• Conventional monetary policy: interest rates were cut down to (almost) zero over time
so as to stimulate consumption and investment

Policy response: ECB ‘quasi-conventional’ answer

 • As a response, not only the ECB cut the interest rate (traditional tool), but it also
modified the implementation of its monetary policy through the following:
• turned the minimum bid rate for the main refinancing operations (auction
system) into a fixed rate with full allotment of requested liquidity (‘cash
dispenser’ system)
• restricted the spread on marginal lending and deposit rate => lower cost for
standing facilities => ‘forced’ compression of EURIBOR rates from the top.
• Later on in 2011, the ECB also increased the maturity of some of the main
refinancing operations: from the standard 1 week to several months.

Policy response: (unconventional) monetary policy

100
Price of a coorporate bond=
1+r
Therefore, if r decreases => price of bonds increase

• As interest rates hit the zero lower bound, a number of unconventional monetary
policy measures have been undertaken globally…
• In particular, USA, UK and Japan engaged in Quantitative Easing (QE): using newly
created central bank money for large purchases of an array of financial assets, i.e. not
only short-term government bonds, but also long-term ones, as well as mortgage-
backed securities, corporate bonds etc. QE is essentially a far-reaching monetary
expansion, aiming to boost aggregate demand for given interest rates.
• Intuition: even when CB refinancing rates (official policy rates) are set equal to zero,
firms, governments and households may pay much higher interest rates if commercial
banks do not transmit properly the monetary policy set by the CB (recall inter-banking
markets not properly working)
• QE aims at reducing such rates: buying sovereign bonds or other assets, the price of
these assets goes up, the interest they pay goes down. The owners of these assets also
become richer. Thus, richer people and easier financing conditions => spending in the
economy (C+G+I) grows for given official interest rate.

Policy response: fiscal policy to bank rescues

• Between 2008 and 2009, national public budgets throughout the world have been used
for several banks’ bail-out operations, with provision of special loans, guarantees, new
capital and the like.
• All these measures in Europe have required public funds amounting to about 13% of EU
GDP (2008-2011).
• As a result of these operations, out of the 76 top EU banking groups, 19 currently have a
major or even a 100 percent government stake (=> temporary exception to the State aid
rules for banking).
• In the US, among other things, the Congress pledged around 700Bln$ (TARP - Troubled
Asset Relief Program) to purchase illiquid, difficult-to-value assets from banks and other
financial institutions
Policy response: fiscal policy to sustain output
In addition to public money spent for banks, both in EU, US and the RoW, public spending was
also used to stimulate the economy (mix of lower taxes and higher expenditures)

Rescue of banks + Fiscal Stimulus => increase in public debt

Due to the combined effects of fiscal stimulus and the cost of rescuing banks, together with the
fall in GDP, public debt/GDP ratios increased across countries.
Markets started to have doubts on debt sustainability in some euro area economies, with
negative implications for growth => negative feedback loop

The bank-sovereign negative feedback loop in EU

(banking risks and financial stability, Sovereign debt crisis, economic growth)

1. Rescuing banks (and fiscal stimulus) increases deficits, worsening the sustainability of
debt.
2. Since banks already have sovereign assets in their portfolio, the latter generates a
further bank deleveraging leading to less credit to the economy and lower growth
3. Lower growth worsens the sustainability of debt, hence the gov becomes even more of
a risky borrower

The EU thus moves from a credit crisis (2007/08) to a debt crisis (2010/11)

EMU Crisis Management

• The bank-sovereign negative feedback loop, if not stopped, endangers the entire
monetary union via the potential insolvency of some Member States.
• Still, the Maastricht Treaty did not foresee any specific mechanism to manage such a
broad financial crisis within the EMU: we had to engineer the solutions starting from
the existing juridical base (no bail out clauses / ECB independence / decentralized fiscal
policy).
• Two kinds of responses:
 1. Fiscal tools: allow countries to provide mutual financial guarantees (art. 125) to
support sustainability of public debt and minimize solvency risks
2. Monetary tools via ECB: allow the Central Bank to buy from the market sovereign
debt bonds (thus indirectly, recall art. 123 and the no 'direct' bail out of sovereign
debt), thus reducing borrowing costs of Member States and improving banks'
balance sheets (higher value of sovereign bonds)

The early Crisis Management tools: EFSF & SMP

Fiscal tool: the European Financial Stability Facility – EFSF (organised as an investment fund)
issues a AAA bond on the market (paying a yield of x%), guaranteed by one EU country. The
money so collected is used to finance a country in difficulty (e.g. Greece) at privileged rates (x%
+ premium), lower than the rates the country would have to pay on financial markets.
In exchange, the country receiving the loan runs a program of reforms aimed at restructuring its
public finances. Loans are disbursed in tranches: one tranche = one reform. The country then
repays the loan, and the money is used to repay the original bond emitted on the market. The
‘premium’ covers the operational costs of the EFSF.

Monetary tool: under the Securities Market Program (SMP) the ECB is authorized to buy on
the secondary market a sovereign bond of a distressed country, with newly printed money. In
doing so, the ECB supports the price of sovereign bonds of distressed countries, therefore
appeasing the potential losses (and perceived risk) of banks holding those bonds. The latter
eases the access of these banks to the inter-banking market. The ECB then reverts the
operation (‘sterilizes’ it) once market conditions have normalized.

The Crisis Management tools after 2011

The Long Term Refinancing Operation organized by the ECB between December 2011 and
February 2012 lends 490+530 Bln to banks at 1% for 3 years. This appeases the acute phase of
the crisis as it provides liquidity to those banks not having access to the inter-banking market,
easing the credit crunch and lowering the rates on public debt (the banks use the liquidity to
repurchase public debt)

But the crisis gets worse over 2012…

During 2012 the EU Governments and the ECB negotiate a new ‘fiscal compact’ i.e.
amendments to the EU Treaties/SGP legislation aimed at further strengthening fiscal
coordination and discipline across the euro area with a number of features. Most importantly:
- European Semester: National budget laws as well as national programs of reforms are
drafted in April in each year under the guidance of the EU Commission, approved by the
EU institutions in June, and only then implemented by Member States.
This paves the way to the two main crisis management tools:
- The European Stability Mechanism, a new EU Institution (fiscal tool)
- The Outright Monetary Transaction program of the ECB (monetary tool)

The European Stability Mechanism

(there is this stigma that by getting money from the ESM, you have hit rock bottom, and there is
this fear that you will lose part of you sovereignty)

The Treaty to create a European Stability Mechanism (ESM) was signed on February 2012 and
the ESM became operational in September 2012. The ESM is a Luxembourg-based international
financial institution, which supports euro area countries where indispensable to safeguard
financial stability.
All eurozone countries become members of the ESM jointly investing in its capital (contrary to
the old EFSF where guarantees were provided individually by each Member State, see infra).
Non-eurozone member states may also participate in stability support operations.
The ESM has a range of tools available. It can grant loans to countries, provide precautionary
financial assistance, purchase bonds of beneficiary member states on primary and secondary
markets and provide loans for recapitalisation of financial institutions.
Financial assistance is linked to appropriate conditionality specified in an agreement concluded
by European Commission, ECB, IMF (the so-called troika) and beneficiary Member State.
Decisions to grant stability support are taken by mutual agreement (unanimity with possibility
of abstention). However, in crisis situations in which the economic or financial sustainability of
the eurozone is at risk, decisions may be taken by a qualified majority (85% of votes).
Transitional arrangements between the EFSF and the ESM are established. The ESM’s lending
capacity is €500 billion, and the combined lending ceiling of the EFSF/ESM is set at €700 billion.
The ESM treaty goes in parallel with the new Treaty on Stability, Coordination and Governance
in the Economic and Monetary Union (TSCG), the so-called ‘fiscal compact’.

The ESM Key is the % contribution of

each Member State to the fund,
proportional to its GDP. A similar 'capital-
key' rule applies also to shareholding of
the ECB

The total capital pledged by Member States

to the ESM is 700Bln Eur, of which 80Bln
have been paid cash to guarantee the
operability of the fund

With this capital as a guarantee, the fund

then issues ESM-denominated bonds on
financial markets, currently rated AAA

As these bonds are ultimately guaranteed

by a capital jointly pledged by Member
States, they can be technically considered
as 'Eurobonds'
The European Stability Mechanism vs EFSF
Legal structure, ESM duration, EFSF duration, ESM Capital structure, EFSF capital structure

The ECB Outright Monetary Transactions

Through OMT, the ECB can purchase bonds on the secondary markets (as with the SMP) to
safeguard an appropriate monetary policy transmission. Contrary to the SMP, the OMT
program has well-defined characteristics:
 Conditionality: a necessary condition for the ECB purchase is strict and effective
conditionality attached to an appropriate EFSF/ESM programme requested by the
concerned Member State, in the form of a full macroeconomic adjustment program
(Enhanced Conditions Credit Line – ECCL as in IR, PT and EL), provided that these
programmes include the possibility of EFSF/ESM primary market purchases of
sovereign debt. The involvement of the IMF shall also be sought for the design of the
country-specific conditionality and the monitoring of such a programme.
The Governing Council will consider OMTs (to the extent that they are warranted from a
monetary policy perspective) as long as program conditionality is fully respected, and
terminate them once their objectives are achieved or when there is non-compliance with the
programme. The Governing Council will decide on the start, continuation and suspension of
OMTs in full discretion and acting in accordance with its monetary policy mandate.
 Coverage: OMTs will be considered for future cases of EFSF/ESM programmes or for
Member States currently under a macroeconomic adjustment program when they will
be regaining bond market access. Transactions will be focused on the shorter part of the
yield curve, and in particular on sovereign bonds with a maturity of between one and
three years. No ex ante quantitative limits are set on the size of OMTs.
  Creditor treatment: The Eurosystem accepts the same (pari passu) treatment as
private or other creditors with respect to bonds issued by euro area countries and
purchased by the Eurosystem through OMTs, in accordance with the terms of such
bonds => no penalization of private investors on existing traded securities
 Sterilisation: The liquidity created through OMTs will be fully sterilised (as for the SMP)
(monetary stock doesn’t grow)
 Transparency: Aggregate OMT holdings and their market values will be published on a
weekly basis. Publication of the average duration of Outright Monetary Transaction
holdings and the breakdown by country will take place on a monthly basis.

EMU Crisis Resolution: the EU ‘Four Arrows’

• To revamp the economy and stop deflation dynamics, the EU needs a coordinated set of
monetary, fiscal and banking policies, in a context of stability of inflation and public
finances.

Coherent startegy

• Monetary => revamp inflation

dynamics (Quantitative Easing by
ECB)
• Banking Union and credit easening
(Targeted LTRO + negative deposit
rate)
• Fiscal => trade-off flexibility with
reforms / common EU Investment
Plan (Juncker plan)
• Supply-side => structural reforms to
revamp productivity especially in
labor markets

The ECB Quantitative Easing

• In early 2015 the ECB announced an expanded asset purchase program, aimed at
fighting deflationary dynamics.
• This program crucially adds the purchase (on the secondary market…) of government
bonds and other public bonds (e.g. issued by EU institutions), to the already existing
private sector assets purchase program (asset-backed securities and covered bonds,
already active since Fall 2014).
 • Combined monthly purchases were around €60 billion (€80 billion between March 2016
to March 2017), to be carried until inflation goes back close to the 2% target.
• The program has been gradually phased out with lower purchases per month during
2018, and has ended in December 2018.
• The ECB was however committed in a reinvestment policy i.e. it maintained a constant
size of its balance sheet, by repurchasing the assets that progressively expire.
• Purchases are allocated across countries according to ECB capital key; cannot account
for more than 25% of a single national bond issue, and for more than 33% of total
national issued debt.

The long-term way out: solving the EMU trilemma

In a monetary union characterized by competitiveness differentials, only two of the three

following features are compatible with a stable institutional setup:
1) there is no monetary financing by the ECB (art. 123); 2) there are no fiscal transfers across
States (art. 125); 3) banks are dependent on their sovereign States.
The EMU has to decide which corner of the triangle it wants to cut in order to survive in the
long run. Cutting all corners = United States of Europe

Fiscal vs. Banking Union Lender of last resort:

The EU does not have it cause
the ECB will not start printing
money to buy government
bonds.
However the CB has been
borrowing on the secondary
market and hence has started
to behave as a lender of last
resort
The banking union aims at breaking the link between sovereigns and banks, minimizing
taxpayer losses in case of banks resolution, i.e. losses are to be absorbed by banks’
shareholdersand creditors (The tax payers money is the last one to be used to save the banks).
There are three key pillars: Single Supervisory Mechanism (a Single Rulebook, i.e. a common set
of rules on bank activities across the Eurozone with the ECB acting as the single supervisor);
Single Resolution Mechanism (same principle of bank resolution across Member States);
European Deposit Insurance Scheme (TBD: a joint guarantee for depositors across countries)

--- Location effects, economic geography and cohesion policy ---

The Treaty on the Functioning of the EU – art. 174

• In order to promote its overall harmonious development, the Union shall develop and
pursue its actions leading to the strengthening of its economic, social and territorial
cohesion.
• In particular, the Union shall aim at reducing disparities between the levels of
development of the various regions and the backwardness of the least favoured regions.
• Among the regions concerned, particular attention shall be paid to rural areas, areas
affected by industrial transition, and regions which suffer from severe and permanent
natural or demographic handicaps such as the northernmost regions with very low
population density and island, cross-border and mountain regions.

Gini coefficient:
Lorenz curve
Economic Integration and Cohesion: theory – I
Is the process of European Integration responsible for the uneven distribution of economic
activities across countries/regions?
=> A number of theoretical approaches/theories deal with the spatial distribution effects of a
processes of economic integration (i.e. lowering tariffs)

1. Neo-classical theories of International Trade

Basic message: as you integrate countries (and regions), they will specialize in different sectors
of activities according to their comparative advantage.

Heckscher-Ohlin-Samuelson model: specialization based on factor endowments (see next slide)

Ricardo: even when endowments are equal, specialization based on technological advantages

Bottom line: economic integration affects the allocation of economic activities across countries
(and regions), potentially leading to disparities, e.g., if some sectors grow more than others

Comparative Advantage

• Comparative advantage suggests that nations specialize in sectors in which they have a
relative advantage based on relative factor endowments and/or technology.
• Trade allows nations to “do what they do best and import the rest” since trade allows
nations to concentrate their resources in sectors where they have an adantage over
other nations.
 Example with factor endowments:
- Two products: pharmaceuticals (more skill intensive) and clothes (less skill intensive)
- Germany is relatively abundant in high skilled labour, Portugal is relatively abundant in
low skilled labour
- Without trade: you consume what you produce. Germany and Portugal have to produce
both pharmaceuticals and clothes (everyone needs them). Expensive clothes in
Germany, expensive drugs in Portugal
- With trade: Germany specializes in pharmaceuticals and trades them for clothes from
Portugal and the industrial structures of both Portugal and Germany would become
more specialized

Krugman specialization index: fraction of manufacturing that has to change sector to

make a nation’s sector-shares line up with the EU average sector-shares.

Index almost
always growing:
most EU nations
have become
more specialized
over time

• Imagine there are 3 sectors of activity in the economy: textiles, automotive, and
machinery.
• Country A has: 30% of output in textiles; 40% in automotive; 30% in machinery.
• The EU average is: 40% in textiles, 50% in automotive; 10% in machinery.
• You compute the Krugman Index as follows:
• Krugman Index=¿ ]/2
• Krugman Index= [ 10+10+ 20 ] /2 = 20
• Bottom line: 20% of output in country A should be re-allocated to a different sector in
order to replicate the EU average in country A.
• In particular, machinery should have 20% less; 10% moving to textiles, 10% moving to
automotive.
 • Intuition: the more countries specialize in different sectors, the higher the index will be.
• This is what we have observed in the EU.

Economic Integration and Cohesion: theory – II

Is the process of European Integration responsible for the uneven distribution of economic
activities across space/regions?
=> A number of theoretical approaches/theories deal with the regional distribution effects of a
processes of economic integration (i.e. lowering tariffs)

2. Neo-classical growth theory (Solow)

• Decreasing marginal productivity of K and exogenous technological progress
• Differences in initial endowments of K
=> In the Single Market, capital would flow relatively more towards less-endowed areas, thus
leading to s-convergence and b-convergence

The Solow diagram:

How addition of capital effects

the output per worker
depending on what point of
the GDP/L line you are

Two types of convergence

• σ-convergence (sigma) occurs when there is a reduction in the dispersion of GDP per
capita across a group of economic entities (there is a decrease in disparity between
regions)
• β-convergence (beta) occurs when the initially poorer economic entities within a group
grow faster than the richer ones. (the poorer region grows more than a richer region)
Notice: β-convergence is a necessary condition for σ-convergence, though not a sufficient one.
 Example: in year t, region A has GDP per capita equal to 100, region B to 200.
In year t+1, region A has grown and now it has a GDP per capita equal to 200, while region B
had negative growth and it now has GDP per capita equal to 100.
Overall, between t and t+1, there was β-convergence but NOT σ-convergence

Cohesion in the EU: income dispersion

s-convergence: clear for countries, less clear for regions

Coefficient of variation (the ratio of the standard deviation to the mean) of GDP per capita in
PPPs

Cohesion in the EU: convergence across countries

Until the crisis, per-capita GDP of poorer (Eastern) countries has been growing faster than
richer countries, in line with Solow model (b-convergence)
P per capita in PPPs
ge from 2000 to 2007)

GDP per capita in PPPs (2000)

Cohesion in the EU: income dispersion across regions
Since the crisis: many poorer regions have not been growing faster than richer ones (thus
contrary to Solow model)
However, regional income inequality within the majority of EU countries has been rising.

Coefficient of variation of GDP per capita in PPPs (2000 = 100)

• EU countries (by and large, and discounting for crisis) are following a process of
convergence within the EU, in line with standard neo-classical growth models (Solow)
• However, EU regions are not following a clear process of convergence

Economic Integration and Cohesion: theory - III

• So why EU regions are not following a solid process of convergence, while EU
countries (by and large, and discounting for crisis) are?
• New economic geography suggests that integration might tend to concentrate
economic activity spatially, i.e. EU integration may be partly responsible for EU regional
inequality.
• New Economic Geography is based on two pillars:
- on the one hand, agglomeration forces encourage spatial concentration:
• demand linkages: big markets;
• cost linkages: availability of suppliers
• on the other hand, dispersion forces favor the geographic dispersion of
economic activity (e.g., higher rent and land prices, high cost of services,
pollution and congestion costs, competition with other firms)

KEY ISSUE: the balance between agglomeration and dispersion forces tend to be different at
different territorial levels (countries vs. regions)
New economic geography
• Demand-linked circular causality: South market is larger, hence more consumers can be
served at lower costs if a firm locates there

• Cost-linked circular causality: South market is larger, hence provides more intermediates
that can be exploited at lower costs if a firm locates there

Note that if demand / cost-linked circular causalities are started, this leads to pure ‘core-
periphery’ patterns in the location of economic activities across space
Theory part II: new economic geography

Bottom line:
The balance between agglomeration forces and dispersion forces will determine the observed
allocation of economic activities across regions and countries
Any shock to the relevant forces (technological, institutional, infrastructure, transport costs)
may change this allocation…
Here we focus on the locational effects for economic activity due to the process of EU
integration

The locational effects of European integration

• European integration affects agglomeration and dispersion forces and thus the core-
periphery pattern in complex ways. Essentially, it reduces trade costs both within and
across countries.
• How does this change agglomeration and dispersion forces and thus the locational
outcome? In general:
• Agglomeration force: firms would, all else equal, prefer to locate in the big
market in order to save on trade costs of servicing that market, benefit from the
presence of suppliers and knowledge spillovers => lowering trade costs
decrease agglomeration incentives (you can obtain the same benefits of
proximity even if at higher distance);
• Dispersion force: firms would, all else equal, prefer to be in the market where
there are few local competitors => with lower trade costs, locating in the
periphery becomes relatively less attractive (you get higher competition even
at the periphery).
Bottom line: lower trade costs due to economic integration decrease both agglomeration and
dispersion forces. Which change will prevail (and thus whether higher or lower agglomeration
is observed) remains an empirical issue. Plus, the result can be different when we consider
countries vs. regions.

The locational effects of European integration

Empirical evidence for the EU:
at the regional level, dispersion forces have lost relatively more importance, so higher
agglomeration has been observed.
As a result, across regions inequality has increased.

The origin of cohesion policy

• Given the previous theoretical setting, it is clear that a policy aimed at creating a Single
Market could foster agglomeration of economic activities in the larger / richer markets
at the detriment of the periphery.
• Hence, a sizeable structural policy was needed to compensate for the potential losses
from economic integration the poorer countries and regions.
Cohesion Policy 2021 to 2027, funding:
Policy delivered through 3 main funds:
1. Regional Development Fund
2. Cohesion Fund
3. EU Social Fund+

Regional Development Fund

Regional development funds go to three categories of eligible regions:

- 1) Less developed regions (GDP < 75% of EU average)
- 2) Transition regions (GDP 75% to 100% of EU average)
- 3) More developed regions (GDP > 100% of EU average)

Cohesion Fund:
The Cohesion Fund goes to eligible Member States whose GDP
per capita is <90% of EU average

EU Social Fund+
Main areas of actions:
• Training of workers
• Combating youth unemployment
• Reducing school drop-outs
• Fostering social inclusion and gender equality
• Encouraging social innovation
Resources allocated to this fund can be spent in every country/region of the EU.
Summary:

Cohesion Policy 2021-2027

• Five key policy objectives:
1. Smarter Europe: innovation, digital development
2. Greener, carbon-free Europe: investing in energy transition
3. More connected Europe: transport and digital networks
4. More social Europe: supporting social inclusion
5. Europe closer to citizens: supporting locally-led development strategies

The Fiscal Compact

The Fiscal Compact contains the following rules:
General government budgets shall be balanced or in surplus.
The annual structural deficit must not exceed 0.5 percent of GDP.
Countries with government debt levels significantly below 60 percent and where risks in terms
of long-term sustainability of public finances are low, can reach a structural deficit of at most 1
percent of GDP. Such a rule will also be introduced in Member States' national legal systems
“through binding, permanent and preferably constitutional provisions”.
Member States shall converge towards their specific reference level, according to a calendar
proposed by the European Commission.
Member States whose government debt exceeds the 60% reference level shall reduce it at an
average rate of one twentieth (5%) per year as a benchmark

These proposals are binding unless a qualified majority of Member States rejects them.
----------- Guest lecture--------------
Macroeconomics of a pandemic
COVID-19 starts as a negative supply shock:
• The outbreak in China disrupts global supply chains
• Squeeze in labour supply (some workers are ill/die)
• Quarantine and social distancing decrease the number of hours worked globally
Different from ‘classic’ supply crisis cases:
• In wars / natural disasters, the origin of the supply shock is in the destruction of
infrastructure or a large-scale permanent loss in labour.
• Need to physically rebuild creates an obvious case for massive deployment of fixed
investment.

Negative demand effects materialize, driven by high uncertainty:

• Uncertainty about the evolution of the disease
• Uncertainty about the length of the shock
• Uncertainty about governments’ response
• Households ↓ consumption, ↑precautionary savings
• Firms ↓investments (also due to lack of liquidity)
• Negative demand effect
• Some workers will lose jobs and income (particularly in the most
affected industries and in those with the weakest contractual employment positions)
Testing the limits of an incomplete federation
¡ ECB’s activism shifts the boundary between monetary and economic policy, increasing
the risk of legal challenges.
¡ 5th May 2020: German Constitutional Court issued a landmark judgement on ECB’ Public
Sector Purchase Programme (PSPP), disagreeing with a prior ECJ case, and implying that
the Bundesbank may be ordered to halt its participation in PSPP.
 ¡ The judgement raises two major concerns:
- Can we rely on monetary policy, if the federal judiciary can be ‘hijacked’ by local
courts?
- Can we count on PEPP? ECJ’s view on PSPP legality relies heavily on the self-
imposed limits the ECB ditched in PEPP.

National fiscal stimulus

¡ In April 2020, the IMF expected global growth to dip to -3% in 2020 (compared to -0.1%
in the GFC)
¡ Budgetary impact of discretionary fiscal measures is unprecedented.
¡ On average, EZ countries implemented a discretionary stimulus of 4% of GDP, vs 1.5%
during Global Financial Crisis.

Legacy constraints
¡ The COVID-related national fiscal stimulus has been uneven across the EZ, due to
macroeconomic ‘pre-existing conditions’.
¡ Countries with a better fiscal position (positive budget balance, lower debt level) have
been able to provide more and faster stimulus.
¡ The debt legacy from the EZ crisis acted as a constraint on the fiscal response at the
national level.

Spending today Or tomorrow?

¡ Loan guarantees were used widely to address liquidity shortages.
¡ At the EZ level, the amount of announced guarantees accounted for over 16% of GDP.
¡ There is significant variation in the reliance on this tool: the country using it most
extensively is Italy, which is also the most constrained.

single market no more?

¡ Germany accounted for 53% of all EU State Aid cases approved by DG Comp as of June
2020 and the largest share of equity injections.
¡ Absent a central solvency tool, geography matters for probability to fail: unviable firms
may be kept alive in fiscally unconstrained countries, viable firms may fail in fiscally
constrained countries.
¡ Significant risk to Single Market.

Policy response:

Tale of 2 crises:
The Eurozone Crisis was:
¡ Asymmetric
¡ Origin endogenous to local economic policy
Ø Came from divergence, yielded convergence
The COVID-19 Crisis is:
¡ Symmetric
¡ Origin exogenous to local economic policy
Ø Risked unravelling convergence achieved

ESM Pandemic Crisis support

ESM A new tool Conditionality Surveillance

ESM lending stigma:

¡ Today, the appeal of borrowing from the ESM Pandemic support credit line is reduced
by the extremely low market borrowing rates.
¡ Italy is possibly the only country for which the market financing rate at 10 years still
exceeds the rate on the ESM Pandemic Support tool.
¡ Assuming Italy had borrowed the full 36 bn available under the tool, it would have saved
~200mn in interest costs annually.
¡ Why not? Stigma.

Next-Gen EU
To mitigate risk of asymmetric recoveries after a symmetric shock EU leaders approved a EUR
750 bn fiscal package.
It is revolutionary because:
1) Funded entirely with debt issued by the EU (10x previous issuance)
2) Half of it is in grants, which do not increase recipients’ public debt
3) By construction, it entails the 1st ever fiscal transfer across EZ countries.
Risks ahead
Inequality (of Impact)
Those who can easily work from home are employed in jobs that already pay more.
In Italy, the jobs that are the hardest to do remotely account for ~30% of GVA and ~45% of
employment but pay the lowest average wage.

Inequality (of Outcome)

We talked about precautionary saving, but WHO saves?
The rich consume less and can increase saving. The poor need to dis-save to be able to pay for
subsistence consumption.
Inequality is reinforced.

Inequality (of Opportunity)

At least 1.5bn learners have been affected by school and university closures. Half oh them do
not have a household PC. 43% have no internet at home (in advanced economies).
Additional disparities arise when considering access to educated adults or stressful home
environments. Closures will affect the most children from poor and low-income families.
Students in grades 1-12 affected by the closures might expect some 3% lower income over their
entire lifetimes.

So, How much is enough fiscal stimulus?

Asymmetry of fiscal stimulus approaches:

WHO PAYS…?
Fiscal dynamics are at risk of being markedly asymmetric from 2022 onward.
Assuming a return to trend of public finance indicators by 2023, the EZ as a whole is expected
to over-comply – mostly driven by Germany – but large economies like France and Italy would
have difficulties to keep the pace of consolidation currently required by EU fiscal rules.
The risk is once again that of inducing divergence, by forcing consolidation after the biggest
shock since the Great Depression, and of splitting the area into 'frontrunners' and 'left behind'.

…and how much?

Legal challenges are not the only problem for ECB’s action of stabilizing funding costs.
As 'frugal' countries return to pre-pandemic spending trends, ECB will find it more difficult to
rollover expiring public debt on its balance sheet without crowding out almost completely the
market for some government bonds.

A needed change of perspective

Next Generation is set up to be a temporary one-off. Cuts from original proposal have
concetrated on programmes that would have financed genuinely EU-level 'common goods’.
Some of these remain funded within MFF but funding through common issuance would have
sent a strong signal and helped transitioning towards more permanent federal spending.
Success of NRPP is key: growth as a political imperative, not just an economic necessity.