The Economics of European Integration: System Competition versus Harmonization

Table of Content

1. Introduction

2. Approaches to Economic Integration.
2.1. Competition-based integration
2.2. System competition
2.3. Harmonization

3. The process of the European Integration.
3.1. The Treaty establishing the European Community
3.2. The basic rights as a driving force towards System Competition
3.3. Acts of Centralisation and Constitutional Displacement

4. The Concept of Differentiated Integration..

5. Conclusion.

Glossary

1. Introduction

The process of European Integration, especially the economic perspective of these fascinating developments is the main issue of this seminar paper. The decisive questions leading through the analysis are the following: which approaches to economic integration exist, which one of them has been, is and will be dominant in the respective European Integration process and whether the current framework is appropriate for the future, always in mind the further enlargement towards a European Union of 25 or even 27 member states. I structure my analysis into mainly three parts, namely the underling theory, an empirical analysis and an outlook for the future. The emphasis is clearly on the first two parts, which are based on an economical perspective of integration processes. I present the underlying theory of economic integration, namely the two approaches to it, System Competition and Harmonization at first. Afterwards, an overview of the process of European Integration is provided, always in mind the perspective of economic integration and therefore the ongoing battle of the two approaches to gain more importance in the process. While doing so, I analyse phases or stages in which one of these approaches has been increasingly dominant in the integration process and try to analyse why this special pattern has occurred. At the end of my paper, I combine the economic perspective to integration with a more general, but interesting concept to integration processes, which could help to overcome the increasing stagnation tendencies in European Integration that is one of the main findings of my earlier analysis. Although this Concept, named Differentiated Integration provides one with extensive measures to reform the integration process, I limit the perspective to mostly the changes and proposals with importance to economic integration as this is the core issue of this paper. Thus, the final presentation of reform proposals is less focused on how the European Union as a final Political Union could look like in the far future, but more on how to overcome stagnation tendencies and gain dynamic impulses again with more technically orientated middle-term actions.

2. Approaches to Economic Integration

Integration is never an end in itself¹. Integration processes are mostly designed to lead to economic and/or political stability². The main underlying assumptions and factors of these aims are the peace-argument and the joint-market-argument concerning integration³. The peace argument assumes that ongoing integration of nation states reduces the risk of violent action between them in the future, whereas the joint-market- argument is based on expected efficiency and growth gains resulting from economic integration. Thus, integration is an instrument to reach political or economic goals. The peace argument is in the middle of the discussion about European integration. But as political integration faces something like a stagnation in Europe, the economic form of integration has developed itself to a driver of the European integration process. Therefore, I concentrate my analysis on the economic part of integration, whether or not it is primarily intended to lead to an even closer political partnership at European level besides the main economic goals. As I point out in the next section, the core question is, whether the establishment and existence of a common market in an integrated region requires ex-ante harmonization of national policy instruments and of national institutional arrangements or whether harmonization can be delegated to a competitive process between the institutional arrangements of the member states?⁴

2.1. Competition-based integration

Competition-based integration strategies follow the idea of applying free-market principles to trans-frontier transactions⁵. They are about reducing or abolishing obstacles of any kind that hinder cross-national transactions in the integrated region. Thus, the existence of a common market is in the centre of competition-based strategies. Thereby, market integration focuses only on the economic parts of integration, whereas System Competition goes further with its ambitions. In this section, I present the main patterns of market integration, because they are necessary preconditions for System Competition, which I will analyse afterwards.

As mentioned above, the establishment and functioning of a common market is in the centre of this concept of market integration. Main arguments in favour of this common market or single market are higher trade activities, efficiency gains, more product and process innovations, decreasing consumer prices as well as general growth impulses. Free market systems are designed territorially open to a more or less higher degree with the aim of enabling a free flow of capital and labour. Following the idea of market integration, this principle has to be applied to a higher, supranational level to guarantee the main patterns of market systems to function and therefore to reach the gains presented above. It is necessary as a precondition to establish a setting of non- discriminatory rules for the integration zone as a whole to guarantee the same rights and rules for every citizen in the integrated region. Following the concept of market integration, the nation states have to give up some of their discretionary power that could hinder the free factor movement and transfer it to a supranational level. The competencies at supranational level should however be strictly limited to the functional task of guaranteeing the existence of the common market. Thus, the concept of market integration concentrates only on the economic parts of competition-based integration. Applying the free-market principle to the supranational level, it enables economic advantages of free-market systems like the exploration and control function to work on a higher, supranational level.

2.2. System Competition

System Competition is the institutional dimension of competition-based integration⁶. Institutional Competition, Regulatory Competition or integration by framework activities are synonymous expressions with the same meaning. I will use the term of System Competition, meaning the alteration of national regulation in response to the actual or potential impact of cross-border mobility of goods, services or factors on national economic activity⁷. Having implemented the economic basis in form of market integration with its common market and free factor movement, it is therefore possible to apply the competition-based approach in further policy fields. Initiating competition of regulatory frameworks and institutional design puts regions or nations offering these frameworks under free market pressure. Similar to market integration, the core driver here is the cross-border factor movement. As factors are fully mobile in a common market the citizens of an integrated region can decide whether or not they are satisfied with their current regional or national institutional framework. If not, they simply move elsewhere, therefore creating an event of “institutional arbitrage”⁸. Thus, national regulation has to pass a litmus test of private agents voting with their purses and their feet⁹. As nation states and/or regions depend on the mobile factors and the generated tax revenues, they will adjust their regulatory frameworks to meet the citizens needs. System Competition can even be initiated by cross-border trade in goods and services. If the principle of mutual recognition concerning product standards have been implemented, goods and services can flow freely in the whole common market although being produced in different countries with different national standards. This also leads to a competition process between regions and member states, this time initiated indirectly by the citizens with their decisions as consumers.¹⁰

Two underlying assumptions are especially important for System Competition. The first one is that System Competition serves as a discovery or exploration procedure, therefore enables the market participants to find out on their own what serves their interest best¹¹. The second one is the assumption that System Competition has also got an internal control mechanism. While enabling actual or even only potential institutional arbitrage of the citizens, it disciplines the regions and nations offering institutional frameworks¹². Because market integration is one of the preconditions of System Competition, other consequences and preconditions like the transfer of competencies to a supranational level and the functional limitation of these competencies apply in the same way as mentioned above in the case of market integration.

In a certain perspective, the issue of Harmonization versus System Competition relates in fact to a time dimension. Namely in the form of the decision whether to harmonize national policy instruments and institutional arrangements ex ante the actual integration process or whether to enable market pressure to force the national policies and institutional arrangements to converge to at least some degree¹³ within the process. The latter approach would be an ex-post harmonization, although some authors argue that this is a non-sense expression, as there cannot be any harmonisation ex-ante from an economic perspective¹⁴. Nonetheless, I analyse the second main approach to economic integration, the so-called Harmonization, in the following section.

2.3. Harmonization

Harmonization is the standardization of national jurisdictions leading to a common institutional framework in certain areas or policy fields that applies to the whole integration zone¹⁵. Similar to System Competition, Harmonization is never an aim in itself, but serves common objectives¹⁶. In the case of economic integration, the aim is mainly the establishment and functioning of a common market. It standardizes jurisdictions in areas in which different national legislations or standards could severely hinder the cross-national factor mobility.

Thus, Harmonization is an ex-ante harmonization process, establishing a common regulatory framework for all citizens or market participants. The harmonization approach seems more ambitious in the way that it attempts to set purposes to parts of the economic system¹⁷. Its aim is therefore to expand the economic possibilities of each citizen, reduce or abolish obstacles that hinder the free movement of goods, services and factors and therefore guaranteeing necessary preconditions of the common market. One of the main characteristics and probably the main weakness of the Harmonization is that is presumes relatively simple and stable patterns of causation in economic transition processes¹⁸. To sum up, System Competition and Harmonisation can serve common objectives in many ways, they will even both be needed in a serious integration effort as Harmonization guarantees some fundamental preconditions that enable System Competition to work.

2.3. Assignment of the two different approaches

If used in a serious way concerning economic integration, both approaches serve the same goal, namely the establishment and existence of a common market, they are therefore both about reducing and abolishing obstacles to free cross-national factor movement. Whereas System Competition has got an internal endogenous limitation in serving this aim, Harmonization can easily be misused by applying it to a variety of policy fields that are not crucial to the common market. This part of the analysis is mainly concerned with this never ending battle of responsibilities of the main approaches to economic integration.

In the case of ex-ante Harmonization, the institutional arrangements of the member states have to be adjusted by a bargaining process, whereas in the case of a competitive process, Harmonization will occur over time, and the solution will not have to be found right away. Moreover, the extent of Harmonization will be determined in a decentralised process of private decisions and national public choices¹⁹. From a legislative perspective , the two approaches differ markedly when dealing with the integration of economic systems: System Competition means that the economic and political actors accept that universal or abstract rules are effective in coping with the endemic lack of knowledge on the one hand and that the competition of legal systems within the integration zone can help to improve the institutional framework in an unpredictable way. Harmonization contrarily implies an interpretation of law as a conditional planning program²⁰. As mentioned above, this assumes stable and predictable patterns of causation which simply do not exist. Although these two approaches seem to be fully substitutable contraries and according to Ehlermann, “System Competition is nothing else than the reverse of harmonisation”²¹, these supposition is not always correct. It is moreover the right mix of both approaches in an integration process that determines the success of the process according to its aims. Thus, the core issue is concerned with identifying, which approach of economic integration is the most suitable at a certain stage in a respective policy field. Regarding the integration process from an economic perspective, most authors (preferably the ordo-liberal economists) agree that both approaches are substantial for the whole integration process, but the competition-based strategy, namely System Competition should be the basis of it. This status is gained by the superior efficiency and welfare effects of System Competition, mainly caused by the two assumptions of the internal discovery and control mechanism of competition-based systems. Additionally, it might be questionable to apply the harmonisation approach in areas in which System Competition has not led to sufficient results. It is not expectable at all that a bargaining process of politicians provided with less than perfect information will lead to better solutions. That is why some authors label this way of acting a “Nirvana-approach”²²

There also exists the argument that human beings not only differ in their valuing of private goods and services, but also in their preferences of public goods and services. While supporting decentralised systems, System Competition therefore respects these preferences and regional differences and initiates a competition between these regions concerning the best institutional frameworks. Analysing the history of the medieval Europe, North comes to the finding, that is was especially the dynamic consequences of the competition between fragmented political bodies with a common belief structure that resulted in an especially creative environment²³. A similar conclusion can be found in the analysis of Prosi, who says that existing differences are a necessary precondition of progress. Thus, political decisions have to be decentralised, not only to allow individuality but even to support it²⁴. It is furthermore questionable, whether a possible harmonised solution leads to a superior outcome. Obviously, people, regions or nations apply better or the best solutions willingly after a short time period, whereas worse solutions have to be applied with constraint²⁵, which supports the view that market-based decisions automatically lead to more efficient results. But there are also arguments against System Competition as the main approach to economic integration. An important one is the argument that System Competition in the form of regions or nations competing with their institutional frameworks for the immobile factors is leading to a “race to the bottom” or even a “race below the bottom” in a certain sense²⁶ The dependency of them concerning mobile factors will initiate regions and nations to offer such institutional frameworks with extremely low tax-rates. In the case that revenues of these tax rates are not sufficient to guarantee the current level of public goods, regions and nations fight a competition to bankruptcy, whereas mobile factors will just move on to regions where these offers still exist. The contradictory argument in this case is that net payers do not orient themselves on the taxes that they pay but on the public goods that are placed at their disposal²⁷. Thus, there are rising opportunity costs that function as an endogenous brake in the downward process of decreasing tax rates²⁸.

As mentioned above, it does not make sense to apply one of these approaches solely to an integration process as a whole. Assuming that System Competition forms the basis of the integration process, this status is gained by the superior quality of the free-market- principle. But free-market systems need certain preconditions in order to function efficiently, mainly concerned with guaranteeing framework rules. Similar to national free- market systems, their focus is on internalising externalities, providing an institutional framework of competition policy and dealing with distribution issues²⁹. Theories of authors such as Horst Siebert, Claus-Dieter Ehlermann or Gerhard Prosi vary in the quantitative numbers of their arguments, but follow this pattern quite strict. My further analysis is based on the framework of Pelkmans, who analyses the economics of subsidiarity. The core of the subsidiarity principle as stated here in the Treaty of Amsterdam is the following:

“In areas which do not fall within its exclusive competence, the Community shall take action, in accordance with the principle of subsidiarity, only if and insofar as the objectives of the proposed action cannot be sufficiently achieved by the Member States and can therefore, by reason of the scale or effects of the proposed action, be better achieved by the Community. Any action by the Community shall not go beyond what is necessary to achieve the objectives of this Treaty”. (Amsterdam Treaty, Art. 5 (formerly 3b)).

Although the discussion of subsidiarity is currently more concerned with the reduction of the transfer of power and competencies from national to supranational level, it certainly also deals with the issue of System Competition versus Harmonization, simply from another perspective. Thus, one can say that subsidiarity is the political and jurisdictional definition of System Competition³⁰. To determine the actions, which are better done at supranational level using the harmonization approach of integration, one has to apply the analysis of market failure to the respective integration zone. Similar to other free market principles at national level, the state, respectively the supranational authority has a need to act if the outcome of a free market without distortions or other hindering factors is insufficient. There are four main types of a market failure: market power, externalities, internalities and public goods. Additional to one of these market failures, three criteria have to be fulfilled to justify regulation at supranational level using Harmonization. The market failure has to be overcome after regulation, it has to be opted for the least-cost form of regulation and the net benefit has to be positive³¹. These last criteria take the doubts of the “Nirvana-Approach”-critics into account. Namely, that Harmonization as an automatic reaction to a market failure in a competition-based approach must not necessarily lead to superior outcomes. The theory concerning the economics of the subsidiarity principle provides us with an excellent analysis to decide when there is a need to apply the harmonisation approach in an integration effort that is based on System Competition.

Thus, I pointed out the main advantages and disadvantages of the two approaches of economic integration. Both of them will be needed in a serious integration effort to at least some extent, whereas System Competition should form the basis of the process. Harmonization should therefore be reduced on a necessary minimum³²,whereas certain policies should only be dealt with Harmonization efforts after an intensive subsidiarity test as described above. According to the test principles, Harmonization and supranational regulation is only justified, if market failures, that form the necessary precondition to think about Harmonization, are overcome, the least-cost-form of regulation is opted for and the net benefit is positive. After presenting the basic theory of economic integration above, I turn to a practical example of these efforts, namely the example of European Integration. In this context, I analyse the economics of the European Integration efforts beginning with the Treaty of Rome until the current situation as it occurs today.

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¹ Mussler, W. and Streit, M. E. (1996), p. 265

² Mussler, W. and Streit, M. E. (1996), p. 265

³ Moeschel, W. (1994), p. 125

⁴ Siebert, H. (1990), p. 53

⁵ Mussler, W. and Streit, M. E. (1996), p. 269

⁶ Mussler, W. and Streit, M. E. (1996), p. 271

⁷ Pelkmans, J. (1996), p. 61

⁸ Mussler, W. and Streit, M. E. (1996), p. 271

⁹ Siebert, H. (1990), p. 57

¹⁰ Mussler, W. and Streit, M. E. (1996), p. 272

¹¹ Mussler, W. and Streit, M. E. (1994), p. 329

¹² Mussler, W. and Streit, M. E. (1996), p. 272

¹³ Siebert, H. (1990), p. 53

¹⁴ Prosi, G. (1991), p. 126

¹⁵ Mussler, W. and Streit, M. E. (1996), p. 274

¹⁶ Mussler, W. and Streit, M. E. (1994), p. 328

¹⁷ Mussler, W. and Streit, M. E. (1994), p. 329

¹⁸ Mussler, W. and Streit, M. E. (1994), p. 330

¹⁹ Siebert, H. (1990), p. 53

²⁰ Mussler, W. and Streit, M. E. (1994), p. 329

²¹ Ehlermann, C.-D. (1995), p.11

²² Mussler, W. (1999), p. 75

²³ North, D. (1994), p. 32

²⁴ Prosi, G. (1991), p. 128

²⁵ Prosi, G. (1991), p. 126

²⁶ Sinn, H.-W. (2001), p. 16

²⁷ Sinn, H.-W. (2001), p. 15

²⁸ Siebert, H. (1990), p. 66

²⁹ Hauser, H. (1993), p. 470

³⁰ Ehlermann, C.-D. (1995), p. 11

³¹ Pelkmans, J. (1997), p. 55

³² Prosi, G. (1991), p. 132