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The Single European Market (SEM) programme was established with the 'aim of eliminating all barriers to the movement of goods, people and capital within the European Community' (Baldwin, 1992) thereby fostering European integration. Integration affects growth via its effect on physical capital, human capital and knowledge capital. This essay seeks to examine the effects of the single market programme on some of the European Union's (EU) poorer members since their accession to the EU. This is done in light of Robert Solow's growth model. The essay examines the growth rates of these economies since their accession.
Growth Effect can be divided into two: Medium-term effect and Long-term effect. The medium term effect is better known as induced capital formation according to Solow's analysis. Harold Badinger in his 2005 paper suggests that a closer European integration results in substantial medium-term growth effect. The extent to which this is true in relation to countries such as Spain, Portugal, Greece and Ireland is the business of this essay.
Analysis of Solow's Growth Model
The Solow Growth model assumes that the size of the workforce is fixed and people save a proportion of their income. The savings is then invested. Our objective using this model is to see if integration by the SEM programme induced firms to increase the level of capital per worker employed. The model is illustrated below. The size of capital stock per worker is on the horizontal axis and the level of national income per worker is measured on the vertical axis.
Now we examine what happens when the capital/labour ratio in the economy is increased. As the capital/labour stock increases output also increases but at a diminishing rate.
The green curve shows the output per worker which is upward sloping and concave. The black line shows depreciation per worker. It is assumed in the model that a constant fraction of the capital stock depreciates at a given rate δ. Baldwin and Wyplosz (2006) suggest that δ is around 12% in Europe. The red curve shows the inflow of capital curve. Increased output will mean increased saving and hence increased investment. Depreciation is outflow of capital per worker while investment is inflow of capital per worker. Equilibrium is where depreciation equals investment that is, point A and point B is the steady-state level of national income.
Solow pointed out in his diagram that accumulation of capital is not a source of long-run growth. Capital stock will increase up to point K/L* and then stop unless something else changes. He goes on to show that the explanation for the continuous growth we see in the modern world is technological progress. Technological progress has the effect of increasing the output from a given amount of investment.
Medium-term growth bonus
Medium term growth on the other hand can be explained with the Solow diagram and we can use the diagram to show how integration in Europe led to medium growth for European countries. Integration has two stages. In stage one; integration improves the efficiency of the European economy by encouraging a more efficient allocation of European resources when for example firms merge and there is greater competition. The single market programme was expected to reduce unit costs by 2% and consequently raise output by 2% (Baldwin 1992). This efficiency gain of integration has the side-effect of making Europe more attractive to investment. Thus there will be more investment beyond what it otherwise would have been.
According to Solow's Model, we know this increased investment causes output/worker to rise faster than it would have done otherwise. While this 'above-normal capital formation' is occurring, these economies are experiencing medium-term growth. It is medium-term because the higher growth will soon disappear once a new equilibrium is attained. The diagram below describes the medium-term growth bonus in detail.
The diagram shows that as integration leads to fewer and more efficient firms, at a national level this implies that more output can be produced using the same amount of capital and labour. Integration therefore leads to an upward shift in the output curve to GDP/L' (the green curve). Since there is a constant savings rate this would lead to an upward shift in the inflow of capital curve to s(GDP/L)'. The allocation effect is the increase in output that would occur without any change in capital-labour ratio. Movement from point C to E is the rise in output per worker. This growth is faster than normal growth until the economy reaches point E. As the capital-labour ratio rises towards the new steady-state level, there would be a knock-on increase in GDP per capita (Balwin 1994). This knock-on effect is the induced capital formation that is the medium-term growth. This is the difference between Y/L' and Y/L c. It can be implied that medium-term growth reflects that improved efficiency stimulates investment. Thus integration which leads to improved efficiency should result in medium-term growth.
Now we study the impact that EU membership had on the four relatively poor entrants that joined the EU between 1960 and 1995 in terms of economic growth. These countries are Spain, Portugal, Ireland and Greece. The results we expect to see since their accession to the EU and the start of the single market programme would relate to the following 'footprints' (Baldwin 2006):
Stock market prices should increase
The aggregate investment to GDP ratio should rise
The net foreign direct investment should improve
The current account should deteriorate as more capital flows in.
We expect these results because their existence buttresses the point made above that these countries should then have experienced medium-term growth.
Portugal and Spain
Both countries applied to join the EU in 1977. They both joined in 1986. Following the application, growth in Portugal picked up rapidly and stayed high during the negotiations and after the accession. Between 1977 and 1992, Portuguese economy expanded by 13% more than the French economy. Most of this rapid growth was as a result of a higher rate of capital formation. Baldwin and Seghezza (1998) data panel showed that Portugal's investment rate responded strongly and quickly to its EU membership. The panel on investment-GDP ratio for Portugal also shows that the investment ratio was still high after 1992 when the single market programme started. This rapid growth in Portugal may have been a result of reduced uncertainty concerning the nation's stability and the prospects of improved market access.
Stock market price indices also showed signs of improvements. From the panel we can see that Portugal's stock market index was above average and higher than that of France from 1993 to 1996. If the increased foreign direct investment inflows to Portugal are to be attributed to the single market then we can see the SEM had a strong positive impact on the Portuguese economy. The attractiveness of both Spain and Portugal was boosted by the SEM as industrial locations and as the 1996 report of the Economic and Social research Institute (ESRI) shows the SEM would have increased the GDP of Portugal by 11.5% by 2010 and that of Spain by 9%.
Spain also has similar results to that of Portugal though growth did not occur until after accession. Spanish investment rate pattern does follow the predictions of integration-induced capital formation growth. Since the establishment of the single market in 1992 till 1996 Spain's investment-GDP ratio improved greatly. Spain and Portugal actually witnessed growth as predicted by the Solow model until the recent 2008 recession. The capital account panel also supports the view that most of Spain and Portugal's high investment rates were financed by foreign capital inflows.
Figure 1: The panel data for the medium-term growth effect in Portugal and Spain.
Ireland joined the EU in 1973 and was thus the first poor country to join the union. The case of Ireland is a fairly clear one of integration-induced investment growth. The single market has had a positive impact on Ireland at least before 2008. The Irish GDP as at 1996 was 9% over what it would otherwise have been. Baldwin and Seghezza's work in 1998 showed that Ireland's investment to GDP ratio picked up after 1977 and was higher than that of France.
Monti (1996) showed that the Single market programme effect on Irish GDP was about 3.5% by 2000. The development of the SEM led to increased investment of the US in the EU of which Ireland benefitted immensely. While foreign direct investment (FDI) flows relative to GDP into Ireland were below those for EU in the 1980s, the inflows increased greatly in 1992 due to the completion of the SEM (GÓ§rg et al, 1999). The SEM was expected to adversely affect certain Irish sectors such as Clothing but the positive effect on manufacturing productivity and competitiveness led to an overall net benefit for the Irish economy. The Irish stock market was dominated by the traditional industries (clothing and footwear) and so in the short-run suffered a decline but was higher than that of France (the control nation) afterwards.
The figure below shows data on the four indicators of induced investment-led growth in Ireland.
Figure 2: Panel data for medium-term growth effect in Ireland.
Greece joined the EU in 1981 after a period of undemocratic governments. But the Greek government continued its insidious state controls. These state controls prevented the Greek economy from reacting flexibly to any shock. The SEM is meant to encourage productivity and reduce costs but the Greek economy was unstable and so didn't respond favourably to the SEM programme. Despite the fact that the SEM programmed stimulated foreign investment in the EU the Greek economy did not enjoy increased investment because the poor macroeconomic management of the economy further harmed the investment climate.
The ESRI (1996) report estimated that the SEM would have insignificant effects on the Greek economy by year 2010. The reason is that many of Greek indigenous industries are deemed as uncompetitive by the European Commission and also the flow of foreign direct investment into Greece remains low. These two reasons buttress the point of the poor economic and political climate in Greece. For example, Greek inflation rate is high and unstable. It has fluctuated between 25% and 20% between 1981 and 1991.
The following figure 3 suggests that EU membership and the SEM hardly had any impact on any of the four indicators for Greece.
Figure 3: Panel data for medium-term growth effect in Greece.
So far we have examined the impact of the Single market on EU's peripheral countries using Solow's growth model. As suggested by the model we would expect integration and its initiative such as SEM to result in medium term growth for the countries involved. But the results have varied greatly for EU countries. It is observed that a programme like the single market is only favourable given positive macroeconomic policy and stable governments in the respective countries. An example of this is the case of Greece in which despite the SEM there has been no real impact on the economy. Greeks are slow to adopt new technologies, and shortcomings in the education system mean that this is unlikely to change soon. It shows that while integration may improve the investment climate in a nation, this can be offset by other factors.
In addition, it might not be exactly true that most of the growth experienced by countries such as Ireland is due only to the SEM. Other factors such as social partnership agreements may have contributed to the Irish success. Also the fact that Ireland is an English speaking country may have contributed to the high level of investments by multinational companies from the US because this would have reduced the transaction costs for these companies. This gave Ireland an advantage over the other periphery countries. The above observation suggests that economic integration and the single market programme are a necessary but not certainly a sufficient condition for induced capital formation in a periphery country of the EU.