Economic Integration Principles and EU Framework

Posted on Apr 20, 2025 in Business Administration and Management (BAM)

Economic Integration: Concept and Objectives

Economic integration is the combination of several entities into a larger territorial unit. This implies the elimination of economic borders between countries. An economic border is any obstacle which limits the mobility of goods, services, and production factors between countries. Integration processes are articulated through agreements between different countries that normally include selective trade liberalization formulas.

Economic integration includes:

  • Positive integration: Transfer of powers to common institutions and adoption of common policies and standards.
  • Negative integration: Elimination of barriers to trade and the free flow of factors of production.

Economic integration is also a tool to achieve economic and political goals:

  1. Improve economic well-being: The prosperity of all participating countries is reinforced by overcoming inefficiencies.
  2. Peace and security: When countries become dependent on each other, the possibility of armed conflicts is reduced.
  3. Democracy: If participation is contingent on democratic governance, attempts to overthrow this system in a member country are less likely to succeed.
  4. Human rights: These can be guaranteed if set as a precondition for participation in an economic integration scheme.

Obstacles to Economic Integration

  1. Problems linked to the transfer of sovereignty: Since integration restricts the possibilities of action by national policies, it forces countries to transfer part of their sovereignty to supranational bodies, guided by the common interest.
  2. Increased competition: Although it benefits the economy as a whole, some sectors or companies will win and others will lose. In this regard, regional disparities and socio-economic imbalances may increase.

Effects of Economic Integration

Short-Term Static Effects

  • Trade creation (+): Process whereby inefficient national producers are replaced by more efficient producers within the integration zone.
  • Trade diversion (-): Occurs when international producers outside the integration zone are substituted as suppliers by less efficient but intra-group producers. When a country applies the same tariff to all nations, it will always import from the most efficient producer.
  • Expansion of trade (+): Mechanism by which greater income resulting from the reduction in the price of traded goods increases the level reached by international trade.

Conditions influencing static effects:

  • The more complementary the productive structures are and the greater the specialization, the more likely it is that trade has already been created before the constitution of the customs union.
  • The greater the size of the regional block resulting from the integration, the lower the risk of a trade diversion effect.
  • The lower the level of the tariff applied to the Rest of the World (RW), the lower the risk of trade diversion.

Long and Medium-Term Dynamic Effects

These effects, often of greater intensity, have been quantified at between 5% and 10% of the Community’s Gross Domestic Product (GDP). The main dynamic effect of integration is increasing competition, which stimulates productive and allocative efficiency and reduces excessive business margins. The larger market derived from economic integration enables the emergence of economies of scale. The confluence of greater competition and market size tends to stimulate investment to face increased competition and technical progress to succeed in the new environment.

Key EU Institutions

  • Council of the EU: Approves legislation and defends the interests of their own countries.
  • Court of Justice: Interprets EU laws and ensures their equal application across all EU member states.
  • EU Commission: Proposes legislation and the budget.
  • EU Parliament: Approves legislation proposed by the Commission and represents EU citizens.
  • European Council: Sets the general priorities of the EU.

EU Policy Areas by Responsibility

  • Centralized: Trade policy, competition policy, monetary policy, single market, common agricultural policy.
  • Shared Responsibility (EU & Members): Environment, protection of consumers, energy, transport.
  • Decentralized (Member States): Fiscal policy, taxation, social security system, health, education.

The 1992 EMS Crisis Explained

In the 1970s, there was exchange rate volatility due to the abandonment of the fixed exchange rate system based on the gold standard. In 1979, the European Economic Community created the ‘currency snake,’ a system of fixed exchange rates in which currencies could only fluctuate within a band of 2.25%. The main goal was to bring financial and monetary stability as well as reducing the risks associated with devaluations. These measures were intended to promote trade and investment between EU members. This institution was transformed into the European Monetary System (EMS).

However, the system failed once the freedom of capital flows had been established. Together with the instability derived from the economic policies applied in some countries, the Central Banks (CBs) were unable to maintain the exchange rates within the set limits. This resulted in great financial turbulence arising from speculative flows of capital in the financial markets, which led to the exit of some currencies (e.g., the Spanish Peseta). All these problems made the project of a single currency popular.

Costs vs. Benefits of Monetary Union

Devaluation is a more effective instrument in countries with a low level of trade openness because it has a more limited impact on inflation. Consequently, joining a monetary union implies a much higher cost for these countries. On the other hand, the advantages of a monetary union increase with the degree of trade openness, as the savings in transaction costs are larger. With this information, we can conceptualize the relationship between the costs and benefits of monetary union depending on the level of trade openness. A specific trade openness level, let’s call it ‘A’, represents the point from which the benefits outweigh the costs. The further ‘A’ moves to the right (higher trade openness), the greater the net positive effect of monetary union. Conversely, the further ‘A’ moves to the left (lower trade openness), the larger the net cost and the lower the benefit, potentially creating a negative overall effect.