Sequencing Regionalism: Theory, European Practice, and Lessons for Asia

Baldwin, Richard E. Working Paper Sequencing Regionalism: Theory, European Practice, and Lessons for Asia ADB Working Paper Series on Regional Economic Integration, No. 80 Provided in Cooperation with: Asian Development Bank (ADB), Manila Suggested Citation: Baldwin, Richard E. (2011) : Sequencing Regionalism: Theory, European Practice, and Lessons for Asia, ADB Working Paper Series on Regional Economic Integration, No. 80, Asian Development Bank (ADB), Manila, https://hdl.handle.net/11540/2025 This Version is available at: https://hdl.handle.net/10419/109595 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/3.0/igo Sequencing Regionalism: Theory, European Practice, and Lessons for Asia Richard Baldwin No. 80 | May 2011 ADB Working Paper Series on Regional Economic Integration Richard Baldwin+ Sequencing Regionalism: Theory, European Practice, and Lessons for Asia ADB Working Paper Series on Regional Economic Integration No. 80 May 2011 This is a background paper prepared for the ADB fl agship study, “Institutions for Regionalism: Enhancing Cooperation and Integration in Asia and the Pacifi c,” under Technical Assistance Project No. 7284. +Professor, International Economics, The Graduate Institute of International and Development Studies, Room 501, 5th Floor, Richard Wagner 1, 1202 Geneval. Tel: +41 22 908 59 33. richard.baldwin@ graduateinstitute.ch The ADB Working Paper Series on Regional Economic Integration focuses on topics relating to regional cooperation and integration in the areas of infrastructure and software, trade and investment, money and finance, and regional public goods. The Series is a quick-disseminating, informal publication that seeks to provide information, generate discussion, and elicit comments. Working papers published under this Series may subsequently be published elsewhere. Disclaimer: The views expressed in this publication are those of the author and do not necessarily reflect the views and policies of the Asian Development Bank (ADB) or its Board of Governors or the governments they represent. ADB does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. By making any designation of or reference to a particular territory or geographic area, or by using the term “country” in this document, ADB does not intend to make any judgments as to the legal or other status of any territory or area. Unless otherwise noted, $ refers to US dollars. © 2011 by Asian Development Bank May 2011 Publication Stock No. WPS113542 Contents Abstract vi 1. Introduction 1 1.1 Existing Literature 1 2. Theory: Sequencing and Feedback Mechanisms 3 2.1 Feedback Mechanism Analytics 4 2.1.1 The Juggernaut Feedback Mechanism 5 2.1.2 Juggernaut Theory as a Sequencing Problem 6 2.2 Several Notable Feedback Mechanisms 8 2.2.1 Juggernaut Mechanism 9 2.2.2 Domino Feedback 11 2.2.3 Trade/Exchange Rate-Stabilization Feedback 13 2.2.4 Institution/Institution Feedback 15 2.2.5 Trilemma/Exchange Rate-Stabilization Feedback Mechanism 16 2.2.6 The Race-to-the-Bottom Unilateralism Feedback Mechanism 16 2.3 Spontaneous Cooperation 18 3. Historical Sequences: Europe and East Asia 19 3.1 Europe’s Twin Integration Sequences 19 3.1.1 The Two Sequences 20 3.1.2 Initial Conditions 20 3.1.3 The First Phase: European Payments Union and Experimentation 22 3.1.4 European Integration Takes Off 24 3.1.5 Domino Feedback: The Intergovernmentalist React 26 3.1.6 Deeper Economic and Monetary Integration 28 3.1.7 Institutions Begin to Matter: Reigniting European Economic Integration 32 3.1.8 Domino Feedback Effects: EFTAns ‘Forced’ into Supranationality 34 3.1.9 Single Currency and Bretton Woods II 38 3.2 Feedback Mechanisms and Sequencing in Asia 40 3.2.1 The Development of “Factory Asia” 40 3.2.2 The Muted Role of Institutionalized Cooperation 45 iv 4. Lessons: Europe and East Asia 48 4.1 Lessons from Europe’s Twin Sequences 48 4.1.1 Europe’s Sequences in a Nutshell 48 4.1.2 The Lessons 50 4.2 Lessons from East Asia’s Muddle through Approach 54 4.2.1 East Asia’s Sequences in a Nutshell 54 4.2.2 The Lessons 55 4.2.3 Caveats 56 4.2.4 Lessons 57 5. What to Do? The Feedback Sequencing Perspective 58 5.1 The Way Forward 59 5.2 Ideas on Where to Start: Institutionalize Asia’s “Spontaneous Cooperation” 60 6. Concluding Remarks 61 References 62 ADB Working Paper Series on Regional Economic Integration 66 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Figures 1. Tariff Cooperation 3 2. The Juggernaut Theory’s Feedback Mechanism 5 3. Supply and Demand for Protection, Unilateral Case 7 4. The Generalized Juggernaut Feedback Mechanism 9 5. Trade Diversion in the European Union and the European Free Trade Association, 1962–2004 27 6. Investment Diversion and the Single Market 34 7. Placement of Japanese Plants in East Asia, 1985–2007 42 8. Highly Stylised European Integration and Institutions Sequences, 1944–1969 48 9. The Gain-Sovereignty ‘Budget Line’ 51 10. Incomes in European Economic Community versus European Free Trade Association, 1960–1972 and 1973–2005 53 11. Feedback Sequencing: Trade versus Money 60 Tables 1. Non-Oil Export Composition 42 2. Association of South East Asian Nations Parts and Components Imports and Exports by Sector, 2003–04 44 3. Development of Factory Asia: Role of Parts and Components 44 4. Actual and Projected “Exclusion Indexes,” 2003 47 vi Abstract Feedback mechanisms are the key to sequencing when it comes to regional integration; can mean that today’s policy or institution alters the political-economy landscape in a way that makes it politically optimal for future governments to take further steps toward integration—even when these steps are not politically optimal from today’s perspective. After outlining the theory, the paper uses feedback mechanisms to organize Europe’s postwar integration narrative, and then draws lessons for today’s integration of East Asia. The paper suggests that the spontaneous cooperation that created “Factory Asia” has not been codified. One starting point for Asian regional institutions would be to institutionalize the spontaneous cooperation that already exists on trade, services, and investment. New, creative thinking is needed on the sort of soft-law commitments and new modes of cooperation that would make this work with limited sovereignty pooling. Keywords: sequencing regionalism, lessons of European integration, East Asian integration, regionalism JEL Classification: F02 , F13 , F15 Sequencing Regionalism | 7 2 Protection demand Protection Supply euros 22 T n To no FE, free entry schedule To crystallize the logic, we need to fill in some details. Government choices are determined by the maximization of a “politically realistic objective function.” As Baldwin and Robert-Nicoud (2006) show, this means that tariffs are chosen to balance the supply and demand for protection in the political market much as a price balances supply and demand in a competitive market (left panel in Figure 3). Figure 3: Supply and Demand for Protection, Unilateral Case The supply of protection is the marginal cost to the government of imposing a tariff, where the cost is in terms of damage to the economy as measured by simple utilitarian indicators. The demand for protection comes from producer surplus generated by the tariff (or the lobbying expenditures associated with it). The supply of protection intersects the horizontal axis in the positive tariff range as the “optimal tariff” in this sort of model is not zero. It rises since the welfare damage done by a marginal increase in the tariff rises with the level of T. The demand for protection intersects the vertical axis because a marginal tariff increase will generate higher producer surplus even at a zero tariff; it is rising since the marginal benefit to import-competing firms of a marginal increase in the tariff rises with the level of protection (the margin benefit of protection to producers rises when there is more to protect). The politically optimal tariff is defined at the intersection of the supply and demand curves. The number of firms is endogenous and related to the tariff as shown for importcompeting firms in the right panel of Figure 3; a similar curve determines the number of firms in the export sector, but the relevant tariff would be the partner’s tariff and the relationship would be negatively sloped as a lower foreign tariff would encourage domestic entry into the export sector. We now turn to defining more precisely the meaning of a feasible sequence. The sequencing that we have in mind takes place over decades. In recognition of this, and the inherent myopia of governments, we assume the government makes its policy choices considering only “current” effects where “current” could mean a 5 or 10 year 8 | Working Paper Series on Regional Economic Integration No. 80 period. Formally, the initial tariff in both nations is T0, and the question is whether the nations will accept a tariff cut to T1, that is, whether ];,[];,[ 000101 TnTGTnTG ≥ (2) where n0 is the vector of the initial number of firms; we show the partner’s tariff behind the semicolon in the government’s function, G, to denote the fact that the partner’s tariff is beyond the direct control of each government, but can affect the government’s view of the proposed tariff cut. A necessary condition for a sequence to be feasible is that T1 is such that this inequality holds. The second condition for a sequence to be feasible is that the second take-it-or-leave-it offer will also be acceptable. The condition formally is [] [ ] 0101111212 ][;;,;, nTTfnTnTGTnTG − = ≥ (3) In words this says that both governments have to be willing to cut to T2 given that the number of firms has been altered by the stage 1 tariff cut. The feedback of the Period 1 tariff cut on the Period 2 decision of the governments is formally captured by the law of motion. In this setting, a very large number sequences will be feasible. The optimal sequence would be the largest politically acceptable tariff cut in stage one, followed by the largest politically acceptable tariff cut in stage 2 (conditional on the altered economic landscape brought about by the stage 1 tariff cut). Lessons This simple example shows a way of thinking about the sequencing of regional integration. The central element is that government decisions depend upon a state variable that moves slowly in response to previous policy decisions; as always with laws of motion, initial conditions matter. The feedback mechanism is thus the combination of the state variable’s law of motion (especially how prior policy choices enter) and the state variable’s role in the government’s objective function. Before moving on, we should note that in many cases, the liberalization of barriers needs no international coordination (as in the first example). Mutual liberalization would look like “spontaneous cooperation” even though there was no cooperation per se. 2.2 Several Notable Feedback Mechanisms We now turn to a discussion of several feedback mechanisms that played important role in the European sequences and in Asia. Sequencing Regionalism | 9 Government decision rule Tighter economic integration: Goods trade (border and BBBs), Service trade (especially trade-related infrastructure services), IPRs (especially related to trade in goods and infrastructure services), Investment guarantees (especially related to trade and trade-linked investments), Rights of establishment, Capital movements (especially related to trade and trade-linked investment). Political strength of protrade & antitrade special interest groups Higher intensity of international commerce 2.2.1 Juggernaut Mechanism The basics of the juggernaut mechanism, as introduced by Baldwin (1994), are described above. Here we note it has implications that reach beyond tariff liberalization, highlighting the more general nature of international commerce. As Figure 4 shows, the logic can affect all manner of barriers to international commerce. It is worth highlighting such mechanism in three “corollary” feedback mechanisms, all of which were important in the European case. As noted, in some cases, the liberalization of barriers needs no international coordination. For example, as trade flows rise and their directions diversify, domestic exporters may push their government to open the market to foreign providers of trade credit financing as a means of maintain competitiveness against other nations which have access to superior trade-credit services. Thus the juggernaut will have liberalized trade in such “infrastructure” services—services that facilitate exporting and importing— without any international cooperation; as the same juggernaut will be operating in many nations, we may see “spontaneous cooperation” without any formal or informal agreement among governments. Figure 4: The Generalized Juggernaut Feedback Mechanism BBB = behind-the-border barriers, IPR = intellectual property rights. Trade/Behind-the-Border Feedback Reciprocal tariff and quota liberalizations are almost always the first forms of regional cooperation because they are easy—easy in the sense of being easy to negotiate and easy to sell domestically. More precisely, nations find it easy to formulate a “balanced” package, that is, one that can attract a winning coalition of special interest groups in both nations. Exporters and import-competitors have a good idea of what is on the table. After all tariffs and quotas are specifically designed to hinder foreigners’ market access, so the implication of their removal is easy for all parties to calculate. Once tariffs are gone, however, exporters will still face other trade barriers, so called behind-the-border barriers (BBBs), such as idiosyncratic product standards, government-controlled or cartelized distribution networks, among others. Removing these is harder as it can be much more difficult to negotiate a balanced, politically 10 | Working Paper Series on Regional Economic Integration No. 80 feasible package. The key problem is that these BBBs are not, for the most part, explicitly designed to protect domestic firms against foreign competition. Governments typically introduce micro-regulations—health, safety, and environmental product standards—with good-governance motives. They want to protect citizens and the environment, etc. However, these good intentions are typically subverted by ubiquitous political-economic pressures to favor domestic over foreign actors. Indeed, these rules are often so technical that only domestic firms have the know-how to write them. The regulated write their own regulations, or at least have an important input into their final shape. Such firms will naturally push for regulation that tilt the competitive edge their way against foreign rivals. In short, the protectionist content of BBBs is typically incidental to their announced purpose, but far from accidental. Exactly because the BBBs are not explicitly designed to protect, and because they can be so technical, it can be extremely difficult for all parties to agree on the economic impact of removing specific BBBs. This in turn makes it difficult to craft a politically feasible package of reciprocal BBB liberalization. All this goes to explain why governments worldwide turned first to tariff liberalization and only later to BBB liberalization. The GATT, for example, spend its first 20 years on tariffs, turning to BBB issues (or a specific variety called “technical barriers to trade” [TBTs]) only in the Tokyo Round. As far as sequencing is concerned, the point is that tariff liberalization does not make BBB liberalization any easier from a practical perspective. The juggernaut effect, however, increases the size/power of the special interest groups that want their governments to find a way to liberalize BBBs while simultaneously reducing the size/power of the groups resisting BBB liberalization. Trade/Finance Feedback Mechanism This is a minor feedback mechanism, but one that was critical in Europe during the 1950s. Intra-European trade was in a logjam created by hundreds of bilateral deals that essentially reduced bilateral trade to barter (due to the inconvertibility of European currencies). No one could expand their exports without the foreign exchange necessary to buy the raw materials and capital goods necessary to ramp up production. But the foreign exchange could not be earned with exports hindered by bilateral barriers. The scarce inflow of convertible currencies (US dollars and Swiss francs) and gold were marshaled to pay for essentials, like food and fuel (Eichengreen 2007, p. 60). The stage 1 policy was a clearing mechanism that multilateralized the bilateral deals. This allowed all sorts of Pareto improving trades, which in turned allowed production to rise along with export earnings. The new hard currency export earnings in turn relaxed the balance of payments constraints that lead to the foreign exchange restrictions and quantitative restrictions on imports. In essence the Period 1 policy (a clearinghouse) changed economic realities in a way that allowed governments to remove quantitative restrictions in stage 2. Sequencing Regionalism | 11 Trade/Capital-Control Feedback Barriers to trade and barriers to capital flows are separate. They are not, however, unrelated. As cross-border trade and investment flows draw economies closer, the distinction between payments for trade and payments for investment became blurred. Just to simplify business practices, corporations set up bank accounts in their foreign markets. As depositing money in a foreign bank account is a capital account transaction, it is easy to see how the two forms of convertibility can blend together against the background of international business.4 Moreover tight trade integration often takes the form of intra-firm trade. That is, the home-based firm sells its products to a foreign-based affiliate, which in turn makes the foreign sale. These foreign affiliates naturally have access to foreign banking, financial services, and markets. This access can be manipulated by the parent company, so the firewall between capital and trade transaction can melt away.5 What this tells us is that deeper trade and investment ties reduce the effectiveness of capital controls. But there is also a pull factor. As the pace of trade and investment integration picks up, and the range and sophistication of financial products expands, the administrative burden imposed by capital controls becomes more tiresome and costly. At the same time, cost-competition becomes more intense. In this situation, exporters and importers begin to press their governments to liberalize some capital controls—basically as pro-business deregulation. The feedback mechanism here is absolutely clear. Heighten trade and investment flows—themselves triggered by trade liberalization—change the political realities governments face when choosing capital market restrictions. The direction of change is systematically pro-liberalization. One could suppose that the causality was two-way (that is, loosening capital restrictions fosters cross-border trade and investment flows), but a one-way causality is all that the feedback mechanism requires; and it is the one clearly shaping the world. Even authoritarian regimes like the People’s Republic of China (PRC) have trouble enforcing capital controls. 2.2.2 Domino Feedback The feedback mechanisms discussed thus far concern the impact of policies chosen by the cooperating partners. There can, however, be policy spillovers. The domino mechanism describes the political-economy logic of one such spillover, namely trade 4 To take a current example of how trade and financial transactions are blurred, consider what happens when one buys a book from Amazon.co.uk with a Swiss credit card. The book purchase and shipping are clearly trade, but the credit card usage means a short-term loan is extended in Swiss francs and then converted into pounds sterling. So in effect the buyer is borrowing pounds sterling short term to buy the book. Indeed, if the order is cancelled and the money refunded, the buyer will have ended up speculating on the franc-pound sterling exchange rate. All this goes to say that it can be quite difficult to clearly distinguish between capital account and current account motives for buying foreign exchange; and the problem gets more severe as the flow and sophistication of transactions increase. 5 A classic example is when trading companies speculate on a devaluation by leading and lagging payments for imports and exports; or it can get money out of the country by having the foreign subsidiary bill the parent company for intangible headquarter services. 12 | Working Paper Series on Regional Economic Integration No. 80 diversion.6 In this feedback mechanism, it is the choices of other countries in Period 1 that alter third-nation situations in Period 2 so that the third nations find it politically optimal to adopt integration policies that they had eschewed previously (in Period 1). The domino theory starts with a positive model of participation in regional integration, with the easiest example being membership in a customs union. It proceeds in two stages—the immediate impact of an idiosyncratic deepening of integration among two or more nations, and the knock-on impact implied by this deepening. To start with the positive model, a nation’s decision to join the customs union is determined by its domestic political equilibrium that balances pro-membership and anti-membership forces. The theory associates the pro-joiners with the nation’s exporters, who gain from preferential access if the nation joins and suffer from discrimination if the nation stays out. The anti-membership political economy forces are associated with the importcompeting industries that would lose from liberalization as well as non-economic objections to membership that are invisible to the econometrician. Consumers and taxpayers are taken as interest groups of second-order importance for the usual “Olsen’s asymmetry” reasons.7 Given an initial political equilibrium, an idiosyncratic shock that deepens or enlarges the customs union generates new political-economy forces in nonmembers. Nonmember exporters now have a greater stake in membership—they face more discrimination if their nation stays out and greater market access if it joins. Anti-membership forces are also strengthened in nonmember nations as the liberalization implied by membership is heightened. If the industrial output of exporters is systematically larger than the output of import-competing sectors (which is normal as exporters usually produce for both domestic and foreign consumers) and both sides’ political power is linked to size, the shock raises the pro-membership forces more than the anti-membership side. For outsiders previously indifferent to membership (politically), these changes shift the domestic political-economy equilibrium to the pro-membership camp. The second stage starts if one nonmember actually does join the customs union. The enlargement implies that discrimination facing the remaining nonmembers expands— again heightening the pro-membership political-economy forces in outsiders—potentially producing a membership application from an outsider that previously found it politically optimal to stay out. The cycle repeats itself until a new political equilibrium in the customs union membership develops. If the world had perfect information and synchronized periodicity in political decisionmaking, membership bids would be perfectly coordinated and bloc enlargement would occur in a step-like fashion. Uncertainty, imperfect information and mismatches of decision timing suggest that the new political-economy equilibrium is reached only 6 See Baldwin (1993, 1995) on the original formulation of the domino theory, Baldwin (2006) for an early application to Asian regionalism, and Egger and Larch (2008) for empirical evidence. 7 Olsen’s asymmetry notes that the winners from protection (import competing firms) are asymmetrically easy to organized politically compared to the losers of protection (consumers); this is way governments typically listen more to the winners of protection. Sequencing Regionalism | 13 gradually, that is, during the transition it may look like regionalism is spreading like wildfire. Asymmetric Lobbying The political-economy forces driving the domino effect are strengthened by the peculiar tendency of special interest groups to fight harder to avoid losses than to secure gains. Joining allows excluded firms to avoid damages as well as win new commercial opportunities, so trade diversion may play a particularly important role in generating new, pro-membership political-economy activity. Many explanations for this “loser’s paradox” are possible, but one simple economic interpretation that is relevant to the domino theory is based on unrecoverable investments (sunk costs). Entry into most industries and markets involves large unrecoverable investments in product development, training, brand name advertisement, and production capacity. When this occurs, established firms can profit without attracting new firms, but only in so far as these profits constitute a fair return on the entry investments, that is, sunk costs create quasi-rents. Given that firms in an industry will have already incurred sunk costs, the deepening of an existing bloc, or formation of a new one, will generate de novo forces pushing the government to redress the new discrimination. The most direct path would be to join the bloc, but other modalities are possible. Governments of excluded nations may seek to restore profits by calling for a multilateral trade round, or forming their new trade bloc.8 See Baldwin and Jaimovich (2010) for a formal model that relies on this effect to extend the domino logic to free trade agreements (FTAs); Baldwin (1994) focused on the customs union case. 2.2.3 Trade/Exchange Rate-Stabilization Feedback The trade/exchange rate mechanism shows how deeper trade relations alter a government’s stance on exchange rate stability. This logic has been discussed by Freiden et al. (2005) and in earlier work dating back to the early 1990s. It has also been documented empirically by Devereux and Lane (2003), and Broda and Romalis (2009). While Freiden (1996) is quite explicit about posing the mechanism as influencing the sequencing of regional integration, he is not very specific about the exact channels through which the mechanism works, so it is worth spending a few words fleshing this out. Which economic actors both care about the exchange rate and are politically organized to make their views heard by the monetary authorities? Exporters are the most obvious special interest group. They are in the business of transforming domestic labor, capital and technology—all of which are priced in domestic currency—into goods that they sell abroad for foreign currency. Depreciation lowers the price of their inputs relative to the price of their outputs and thus raises profitability of foreign sales. In short, exporters like depreciations, and this preference intensifies as the exported share of production rises.9 8 See Baldwin and Robert-Nicoud (2002, 2005) for a formal treatment of the ideas and Baldwin (1993) for an early formal model. 9 This assumes that, as is typical, nominal depreciation is not immediately offset by a rise in the domestic currency price of inputs. Offsetting price changes have happened when workers figure out that depreciation is a roundabout way of lowering wages relative to those of foreigners, and thus demanded higher wages. Wage indexing does this automatically, but often with a lag. 14 | Working Paper Series on Regional Economic Integration No. 80 The second group consists of firms that sell domestically and produce with the help of imported inputs (ranging from fuel and other raw materials to parts and components). Appreciation lowers the cost of their inputs relative to the price of output, so a stronger currency boosts their bottom line. In short, domestic firms like currency appreciation— increasing as their imported-input shares rise. A third group are the import competitors, where depreciation “subsidizes” foreign competitors. Consider the dilemma facing monetary authorities. If they let the currency drop in value, exporters will cheer them, but the domestic firms will scream. A rise in the currency’s value elicits the opposition reactions. Stable exchange rates avoid this dilemma. The key to the feedback mechanism is that the magnitude of both anti-depreciation and anti-appreciation political voices gets stronger as a nation opens its doors to trade. In short, trade liberalization alters the environment in which a government chooses exchange rate policy, systematically increasing its interest in maintaining stability. The more open the economy, the greater the political-economic pressure to stabilize exchange rates. Two corollaries of this logic are both important and obvious. First, nations tend to stabilize bilateral exchange rates with major trade partners because they tend to elicit the largest special-interest group reactions. Plainly then, preferential liberalization that shifts a nation’s trade toward its regional partners tends to make governments more interested in the stability of bilateral exchange rates between regional partners. Second, as smaller nations tend to be more open, their monetary authorities are more likely to face pressures to keep their exchange rates stable. As small countries, at least in Europe, often have very lopsided trade dependence on a few (often one) nearby, large partners, these nations frequently fix their exchange rates to those of their large neighbors. In extreme cases, like Ireland, Lichtenstein, Luxembourg, Morocco, Andorra, among others, exchange rate stability was in the polar form of a currency union even before the World War II. In a nutshell, the trade/exchange rate-stabilization feedback mechanism describes the way an increase in bilateral trade changes the political-economy parameters affecting policymakers’ choices on further integration—in this case, exchange rate stabilization policies ranging for unilateral pegging to a currency union. Importantly, this feedback mechanism works both ways—trade makes policymakers want stable exchange rates; and stable exchange rates stimulate trade—but the two ways are very asymmetric in terms of magnitude. The trade-to-exchange rate stability direction is strong (Devereux and Lane 2003). The exchange rate stability-to-trade link is weak, as recent research has shown, revising the early, flawed research by Rose (2000) that showed large effects; see Baldwin et al. (2008) for a review of the evidence. Thus, liberalising bilateral trade can foster the adoption of policies that stabilize bilateral exchange rates (up to and including a currency union), but stabilizing bilateral exchange rates does not, per se, foster bilateral trade liberalization. Sequencing Regionalism | 15 2.2.4 Institution/Institution Feedback Institutions, once set up, rarely die; they adapt. In particular, if the institutions prove useful to participating nations, operational problems that arise can result in solutions involving more institutionalization. Section 3 provides several examples. National governments often agree on things subsequent governments come to regret. When it comes to intergovernmental cooperation, these situations almost always end in one party reneging on its commitments. Knowing this might happen, the European Economic Community (EEC)—but not the EFTA—established supranational institutions that could induce them to stick to the original deal. This is a feedback mechanism as the Period 1 establishment of supranational institution can alter the political realities facing governments in Period 2 in a way that the governments find it politically optimal to adopt integration policies that they otherwise would have rejected. The classic example concerns BBBs. Even as tariff barriers were being phased out, Europeans began to erect new trade barriers, detailed technical regulations and standards that fragmented European markets. While the extensiveness of such barriers was new, the idea was not. Their trade-inhibiting effects were recognized in the 1957 Treaty of Rome; Article 100 requires “approximation” (Euro-speak for harmonization) of national regulations for the “proper functioning of the common market.” In the late 1960s, the European Commission tried to cajole the EEC610 into liberalizing BBBs, but to no avail. Its members did not find BBB liberalization to be politically optimal. The deep problem was that the common-standard approach required unanimity in the Council of Ministers under the Treaty of Rome rules; in essence BBB liberalization was subject to an intergovernmental process of cooperation, not a federalist process, and the EEC proponents simply did not want to cooperate. (Neither did the EFTA, supporters by the way). The supranational institutions set up in 1957 could not accept this failure as the Court and the Commission were duty-bound to enforce the Treaty. EU law and EU Court decisions are supreme and its decisions have direct effect. Because the Treaty of Rome was made part of each member’s legal system, each member’s respect of its own national legal system implied acceptance of the Court’s power. In the key cases (Dassonville 1974 and Cassis de Dijon 1979), the Court ruled that BBBs were equivalent to quantitative restrictions and thus prohibited by the Treaty. More specifically, the EU Court created the presumption that Member States’ national standards were equivalent in terms of their ability to satisfy the legitimate goals of regulation. Thus, a member state could not prohibit the sale of a good that was lawfully made and marketed in another member state—even if the good was produced according to technical or quality requirements that differ from those imposed on domestic products. This supranational decision radically altered the political-economy reality of standardsrelated behind-the-border protection. If any member’s standards were automatically acceptable in all member markets, domestic firms had no reason to lobby for costly, 10 Belgium, France, Italy, Luxembourg, the Netherlands, and (the then) West Germany. 16 | Working Paper Series on Regional Economic Integration No. 80 idiosyncratic standards. Indeed, as lax standards implied a cost advantage, domestic firms had an incentive to lobby for the cheapest standards. Or to put it more directly, the Court’s imposition of the mutual recognition principle created the specter of a race-to-the bottom that undermined members’ de facto sovereignty over product standards. Thus switching to majority voting on such standards (in the Single European Act) allowed EC members to regain control over the production regulation process. This is a feedback mechanism. The supranational Court, which was created in Period 1, made a ruling that changed the political-economy forces affecting nations’ choices in Period 2, and in this case it made members accept policies in Period 2 that they had rejected in Period 1. 2.2.5 Trilemma/Exchange Rate-Stabilization Feedback Mechanism The final feedback mechanism is more involved, explaining how the removal of capital controls can affect nations’ choice of exchange rate regimes. The mechanism is founded on the famous trilemma. This states that a nation cannot attain the following trinity of policy freedoms: freedom to set exchange rates, freedom to set monetary policy, and freedom to set capital controls. Now suppose the trade/capital-controls feedback has induced governments to liberalize capital flows, thus making the “holy trinity” holier (more unattainable for mortals). The trilemma then forces governments to choose between, on one hand, fixing exchange rates by slaving monetary policy to defense of parity, and, on the other, choosing monetary policy for domestic stabilization, but then allowing the exchange rate to fluctuate with market whims. Now suppose also that the trade/exchange ratestabilization mechanism has induced governments to stabilize bilateral exchange rates with their major trade partners. This combination of effects thus induces governments to choose the most unexpected to the three angles in the impossible triangle; they sacrifice de facto sovereignty over monetary policy. This is a feedback mechanism as the Period 1 choice of capital market liberalization alters the economic realities that affect government choices on exchange rate regimes in Period 2. Backing this up one step, it is easy to see an aesthetically pleasing sequence whereby trade liberalization triggers capital market liberalization, which in turn triggers exchange rate cooperation of some form—possible all the way to currency union. An extreme example of this mechanism can be seen in Ecuador’s unilateral dollarization and Argentina’s strict currency board, although of course both of these were unilateral moves, not cooperative ones. 2.2.6 The Race-to-the-Bottom Unilateralism Feedback Mechanism The main vehicle for tariff liberalization among the world’s rich nations was reciprocal trade agreements—both multilateral and regional—in the 1950s, ‘60s, ‘70s, and ‘80s. Developing nations did not participate in the GATT tariff-cutting exercise as the GATT’s principle of “special and differential” treatment allowed their exporters to free-ride, gaining better access to rich nations’ markets without having to face down their own import-competing industries. This is why the juggernaut never worked in Asia, outside of Sequencing Regionalism | 23 In the first of a long series of repetitions, European reactions diverged. All federalist nations who were both democracies and free from Soviet influence joined this sectoral integration effort (France, Germany, Italy, and the Benelux nations—“The Six”). Intergovernmentalists shared the Beneluxers support for Franco-Germany rapprochement, but the idea that they themselves would pool sovereignty with the Six was beyond serious consideration. Failed Moves to Military and Political Integration: European Defense Community and European Political Community While not very successful in economic terms, the ECSC was a turning point. For diverse nationalistic motives, the Six came to view European integration as best solution to the “German problem.”12 By the time the ECSC was up and running in 1952, Europe was a very different place than it was in 1945. The highly favorable experience with European integration (mostly with the EPU which had been operating since 1950, but also the Six’s experience of negotiating and establishing the ECSC), combined with the Cold-War linked necessity of German rearmament, led the Six to embrace the European Defense Community (EDC). Although ultimately rejected by the French Parliament in 1954, the EDC was the highwater mark of proposed European supranationalism. Supported by the US (which was hoping to shift more of the defense burden to Europeans), the Six signed the Treaty establishing the EDC in May 1952. It called for 40 divisions sharing the same uniform and operating under a supranational command. Political guidance was to come from a Commissariat of nine members, a Council of Ministers, and a parliament-like EDC Assembly. Establishing a European Army without clear political control was a non-starter, so parallel talks on a European Political Community (EPC) were launched. The Constitution for the EPC (drafted by the unelected and highly idealist ECSC Assembly) strikes today’s reader as idealistic to the extreme (and indeed it was never signed by governments, much less ratified). Many of its more moderate elements, however, were carried over into the EEC’s 1957 Treaty of Rome. Due to Dutch efforts, the EPC also delved deep into economic integration. The so-called Beyen Plan (December 1952) called for a Common Market involving the free movement of goods, services, capital, and labor across all sectors of the economy. The ECSC Assembly adopted the EPC by a near-unanimous vote in March 1953.13 The French Parliament rejected the EDC Treaty in 1954. This left the “German question”—how to embed a rearmed Germany—unanswered. An alternative solution was rapidly adopted when France lifted its veto on German membership in the Western European Union 12 The French viewed it as a counterbalance to US-UK influence, and a way of assuring Germany’s recovery did not threaten modernization of France’s archaic manufacturing sector. The US supported it as an anti-communist bulwark. Germany saw it as the surest way to regaining sovereignty. Italy embraced it as a counterbalance to Communism at home, and a way to seal off its fascist past. Beneluxers were overjoyed with anything that lessened the prospects of a new Franco-German war. 13 The governments of the Six, which had yet to sign or ratify the Assembly’s draft of the EPC Treaty, found much to complain about in the draft. This was the first but not last time that a European parliamentary body proved to be radically more federalist than its Member State governments. The EPC sank along with EDC. 24 | Working Paper Series on Regional Economic Integration No. 80 (WEU) (October 1954), and finally agreed to West German sovereignty in 1955; in the same year, Germany joined the North Atlantic Treaty Organization (NATO), established a new army, and rearmed in earnest with US assistance. 3.1.4 European Integration Takes Off Compare Europe 1955 to Europe 1945. In 1945 the plan was to return Europe to its prewar structure of independent nation-states. The hobbling of Germany was the keystone of this new architecture—essential to avoiding WWIII. In 1955, the first part of the new architecture was in place, but without a keystone. Germany was on track to dominate European industry (this time eclipsing even Great Britain) and it was assembling the most powerful West European army ever. With the cataclysm of WWII still fresh, many Europeans, including many Germans, wondered whether Germany’s NATO membership, the ECSC, and the presence of the common Soviet enemy would be sufficient to prevent history from repeating itself. By 1955, coal and steel were no longer the “commanding heights” in economic or military terms. Having failed in their “frontal assault” of directly setting up a European Army, European Defence Community, and European Political Community, attention turned to backdoor economic integration—the Bayen Plan elements in the EPC. The push factor (solving the German question) was operating at the same time as a pull factor. Europe’s trade, industry, and incomes were booming in the mid-1950s, growing at rates that would be the envy of many East Asian economies today. As explained in the theory section, trade begets trade liberalization and vice versa, so this economic miracle fostered a political environment that favored further trade liberalization. Specifically, this juggernaut feedback mechanism was triggered by intergovernmental integration— primarily the EPU and to a lesser extent the GATT tariff cutting Round in 1947, 1949, and 1951. Messina and the Treaties of Rome The month Germany joined NATO, Benelux countries sent a memo to France and Germany suggesting that the economic elements of the rejected EPC be reconsidered as the core of a European Economic Community. The memo also mentioned two projects favored by France, ECSC-like sectoral integration in the transport and atomic energy sectors. With the push and pull factors in mind, foreign ministers of the Six met in Messina in June 1955 to start a process that soon led to two treaties, signed 25 March 1957. The first created the European Atomic Energy Community (Euratom)—something like a modern version of the ECSC but one that never function as expected.14 The second created the European Economic Community (EEC). The Treaties of Rome were 14 France, which pushed hardest for Euratom (making it a condition for its acceptance of the EEC), expected atomic energy to play as important a role in postwar industry as coal did in the prewar period. As France was developing atomic power, and Germany was banned from doing so, Euratom was to be a means of channeling and maintaining French influence in this new “commanding heights” sector. This never happened; its institutions, along with those of the ECSC, were absorbed into those of the EEC in 1965. Today Euratom’s major project is to coordinate the EU’s participation in the international fusion reactor. Sequencing Regionalism | 25 quickly ratified by the six national parliaments and the EEC came into existence in January 1958. European Economic Community Institutions The Treaty of Rome committed the Six to extraordinarily deep economic integration. It set up supranational institutions such as the European Commission, the European Parliamentary Assembly (which became the European Parliament), and the European Court of Justice.15 In addition to forming a customs union (removing all tariffs and quotas on intra-EEC trade, adopting a common external tariff, and delegating to the European Commission responsibility for external tariff policy for the EEC), it committed the members to free trade in services, free mobility of workers, capital market integration, and a range of common policies (for example, a common competition policy and a common production subsidies policy) some of which were to be implemented by executive decisions of the supranational European Commission. There were, however, deeper elements sprinkled across the Treaty whose import only became apparent with time. To start with, the preamble announced that the first goal of the EEC was “to establish the foundations of an ever closer union among the European peoples …”. This mattered when the Court of Justice interpreted the Treaty. It also mattered when the European Commission—the guardians of the Treaty—decided what sort of legislation to introduce. Another example is the Treaty Article that requires members to approximate their laws to the extent necessary for the smooth functioning of the Common Market. After a series of landmark Court decisions in the 1970s, this eventually triggered the radical deepening of EEC integration As embodied in the 1986 Single European Act (more on this below). The depth of the Treaty of Rome was not really a surprise at the time. Given the logic that emerged from the failed Fanco-Italian Customs Union Treaty, and the logic that led to the inclusion of the Beyen plan in the failed EPC, and the logic that produced supranational institutions in the ECSC, the EEC was clearly expected to go deep. This was driven by a combination of practical mercantilism and European idealism—the relative importance of which is impossible to decide definitively. As far as mercantilist motives are concerned, the basic point was that the governments of the Six believed that removing tariffs alone could lead to cheating. They required assurances that each others’ tricky behind-the-border-barriers (taxes, subsidies, exclusive producer or distribution cartels, dual pricing of rail transport, etc.) could not be used to nullify the market access created by the removal of tariffs and quotas. The fact that this embedded a rearmed Germany into a supranational European framework rendered even more attractive the depth explicitly agreed to and the open-ended nature of the commitment to an ever closer union. The actions of the Six forced the hand of the other OEEC nations; once again, the same political-economy factors were to produce very different choices among the federalist and the intergovernmentalists. 15 See Baldwin and Wyplosz (2009) Chapter 2 and 3 for details on EU institutions. 26 | Working Paper Series on Regional Economic Integration No. 80 3.1.5 Domino Feedback: The Intergovernmentalist React Britain was invited to participate in Messina and the European economic integration process, but sent no representative to Messina and formally withdrew from the process leading to a Common Market in November 1955. Yet the reality of the EEC destroyed the OEEC status quo and triggered a domino effect. Britain first renewed efforts to get a shallow but OEEC-wide trade agreement, but this was steadfastly refused by the Six. The EEC introduced a powerful new political-economy force into the European integration dynamic—discrimination. Before the EEC, trade liberalization (orchestrated by the OEEC) did not discriminate against OEEC members.16 The EEC promised to remove all trade barriers on a discriminatory basis and impose a common tariff against nonmembers. This pending discrimination from a huge and fast growing market left the other OEEC members—most of them small—on the sidelines. Fearing the discrimination and marginalization that might occur if they faced the EEC bilaterally, seven of these “outsiders” reacted by forming their own bloc in 1960, the European Free Trade Association (EFTA). This coordinated response was greatly facilitated by UK leadership. Domino Effects: 1961–1973 The 1960s saw the trade liberalization promised by the Treaty of Rome and the Stockholm Convention (EFTA's founding document) come to fruition. This had an immediate and dramatic impact on trade patterns. During the customs union (CU) formation, the EEC’s share in its own trade rose from about 30% to almost 50%. At the same time, the share of EEC imports coming from six other major European nations remained almost unchanged, falling from 8% to 7%. The domino-mechanism’s “gravitational force” can be estimated statistically by looking at the negative impact that non-membership had on sales between EFTA and the EEC. In Figure 5, the relevant numbers (EU01) show that discrimination peaked in the early 1960s, and again in the mid-1970s, in synch with EFTA moves to draw closer to the EEC market. The discrimination factor facing EU firms into the EFTA market is also shown, but is generally not statistically significant. The early surge comes from the rapid implementation of the EEC customs union; it comes down as the multilateral tariff-cutting of the GATT’s Kennedy Round begins to dampen the margins of preference by lowering the EEC’s common external tariff. This trade diversion generated de novo political-economy forces for lowering betweengroup barriers via the domino feedback mechanism. Of course, the same happened to EEC firms in EFTA, but given that the EEC’s market was about twice the size of the EFTA market, pressures on EFTA members to adjust were much greater than those on EEC nations. Britain was the first to react. In 1961, Great Britain overcame its long standard opposition to federalist integration and applied for EC membership. (See O’Rouke [2009] for more detail on the British thinking between 1957 and 1961.) 16 The ECSC was a members-only club, but it was essentially joint management of declining sectors that other Europeans offset with national policies. Sequencing Regionalism | 27 EU01 EU EFTA -60% -40% -20% 0% 20% 40% 60% 80% 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Figure 5: Trade Diversion in the European Union and the European Free Trade Association, 1962–2004 EFTA = European Free Trade Association, EU = European Union. Notes: Heavy lines show the point estimates for the year-by-year estimates; the lighter lines for the standard errors. EU01 is the trade diversion effect facing EFTA members. EU EFTA is the effect facing EU nations. Source: Baldwin and Rieder (2007). This move requires some explaining, as Britain had decided to withdraw from Common Market discussions just five years earlier. Note that while Britain’s move was unilateral, it triggered a second domino effect that induced Ireland, Denmark, and Norway to follow Britain’s lead, likewise overcoming opposition to supranationalism. (The other EFTA members still found the EEC’s depth of integration too high a price to pay for redressing the economic discrimination.) French President Charles De Gaulle unilaterally vetoed the UK’s application in 1963 and again in 1967 after the same four EFTA members reapplied. After De Gaulle resigned as French President, EEC membership for the four was agreed in 1973. Norway's population (which is even more intergovernmental than its government) refused EEC membership in a referendum. This triggered a third domino effect. The impending departure of four EFTA members to the EEC was anticipated well in advance and would have resulted in new barriers being constructed between the new EEC members and the remaining EFTAs as the EEC is a customs union. Moreover, it would have heighted the discrimination by widening the range of EFTA competitors that enjoyed EEC preference. EFTA industries pushed their governments to redress this situation. The result was a set of bilateral free trade 28 | Working Paper Series on Regional Economic Integration No. 80 agreements (FTAs) between each remaining EFTA member and the EEC, designed to take effect when the UK and company acceded to the EEC. By the mid-1970s trade arrangements in West Europe had evolved from two nonoverlapping circles to two concentric circles. The outer circle, which encompassed both EFTA and EEC nations, was a virtual free trade area for industrial products—the concatenation of three types of agreements. The inner circle was the EEC’s Common Market. 3.1.6 Deeper Economic and Monetary Integration The first decade after European integration took-off was a characterized by remarkable growth in income and trade, especially intra-Europe trade. In addition to triggering the domino effect just discussed, booming trade and investment triggered two sequencing feedback mechanisms: the juggernaut effect and a trade/exchange rate mechanism. Behind-the-Border Barriers EEC leaders had committed themselves to liberalizing behind-the-border-barriers (BBBs) in the 1957 Treaty of Rome and, critically, charged the independent European Commission and European Court of Justice with making sure that actions followed words. Just after completing the customs union, the European Commission—which is institutionally obliged to ensure that Treaty commitments are honored—embarked on BBB liberalization. It adopted a plan in May 1969, called the General Programme.17 The focus on BBBs reflected more than legalistic impulses. When the Treaty of Rome was signed, tariffs and quotas were very important barriers to trade and product regulation was primitive by today’s standards. As European incomes rose in the take-off stage, the range of BBBs—especially product standards and regulation—widened. European governments started to introduce more micro regulations—health, safety, and environmental product standards designed to protect citizens. Given the ubiquitous political economic pressure to favor domestic actors, many of these new rules and standards favored domestic firms. The protectionist content of the new BBBs was incidental to their purpose, but far from accidental.18 The impact of these on trade flows can be seen in Figure 5 as EFTA-to-EU trade diversion rises again in the 1970s. 17 The General Programme comprised four Council resolutions and a framework decision adopted on 28 May 1969. The resolutions concerned a detailed timetable for a large number of directives on industrial products, the same for foodstuffs, the expression of the Council’s intention to institute mutual recognition of conformity assessments, and a procedure for adapting directives to technological advances. The framework decision prescribed a standstill of Member State measures concerning products covered by the General Programme, and a requirement that Member States inform the Commission of new provisions for products not covered. This launched what came to be called the “traditional” or “old” approach to TBT liberalization. The adopted approach relied on detailed technical regulations for single products or groups of products implemented by unanimously agreed directives. See Lauwaars (1992) or Pelkmans (1980) for details. 18 For more on this logic see Baldwin (2000) and Baldwin, Evenett, and Low (2009). Sequencing Regionalism | 29 The same changes affected EFTA governments quite differently. Addressing technical barriers to trade—such as health standards for food—requires discussion of policies traditionally considered the exclusive purview of nation-states. Although EFTA governments were facing the same juggernaut pressures as the EEC governments, they were unwilling to engage in the sort of federalist process that would be required to effectively address BBBs. They did, however, react in a multilateral setting, trying to promote the internationalization of product standards, thereby reducing their protectionist content. The International Standards Organisation, which had been set up in 1947, had languished up to the late 1960s, but one of EFTA’s big industrialized exporters, Sweden, pushed for its reinvigoration with the appointment of Olle Sturen with support from the Swedish Standards Institute in September 1968. As the ISO’s first Annual Review in 1972 wrote, “it was in the sixties that international standardization really began to break through. Whereas about 100 Recommendations were published in the fifties, about 1400 documents were approved in the sixties.” The ISO was not by any means a good solution to the BBB problem, but it was about the best that could be done by staunch intergovernmentalists in the 1960s. Exchange Rate Stabilization: Economic and Monetary Union I The trade/ER feedback mechanism steadily ratcheted up pressure for exchange rate stability since the start of European trade liberalization in 1950 with the EPU. For much of this period, however, exchange rate stabilization was overseen by the IMF’s Bretton Woods system. From a European perspective, Bretton Woods was lacking. It stabilized rates against the US dollar within a fluctuation band. Even when EEC nations maintained their central rate against the dollar, the band meant that the bilateral rate could deviate against each other by twice the band width. Changes in the Bretton Woods central rates were also decided by a body dominated by the US, not by the EEC Six. Both of these features made Bretton Woods an imperfect policy response to the rising pressures for exchange rate stabilization within the EEC. EEC leaders responded in 1969 by proposing a sweeping deepening of European integration on this score. Leaders of the Six, meeting in December 1969—for the first time without the antifederalist Charles De Gaulle (he was replaced by the new, pro-European French President Georges Pompidou)—called for a plan on the staged introduction of a monetary union by 1980. The result was the 1970 Warner Plan. This was a huge leap in ambition as monetary cooperation was only meekly mentioned in the Treaty of Rome. In the late 1950s, Bretton Woods was working well and most considered as unrealistic the notion that the Six could establish a monetary system independent of dominant currencies—the dollar and the pound sterling. However, the Hague declaration did not come out of thin air. As part of a review of progress in the second stage of the custom union’s implementation, a Committee of the Six central bank governors was establish along with 30 | Working Paper Series on Regional Economic Integration No. 80 a call for prior consultation on exchange rate changes.19 The spark for the EEC’s big step, however, was the exchange rate turmoil of 1969—when the French franc was devalued 12.5% against the dollar (August) and German mark was revalued by 9.3% (October). All this took place in an atmosphere where chronic US trade deficits undermined the dollar's credibility as “paper gold.” This chipped away at the solidity of Bretton Woods fixed exchange rate system because the dollar—and the US’ ability and willingness to transform dollars into gold—was the heart of the system. Shock and Reaction Extremely poor macroeconomic performance in the early 1970s forced the EEC to shelve the Warner Plan, but discussion surrounding the plan revealed the difficulties of a monetary union in Europe. Most notably, the EEC leaders assumed that monetary union would be part of an important deepening of the Common Market—what they called “economic union.” The Hague Council introduced the phrase “Economic and Monetary Union” or EMU (often misstated as European Monetary Union), which was brought back in the 1992 Maastricht Treaty (Issing 1973). This was not a matter of beautiful words inspired by an idealistic desire to deepen European integration. It reflected hard economic and political-economic realities. Discussions quickly revealed that forming a monetary union would only be politically acceptable to EEC members if it was accompanied by important flanking policies, most notably liberalizing capital flows and tight coordination of national debt and deficit policies. As discussion of a customs union between France and Italy in the 1940s revealed the ineffectiveness of removing tariffs and quotes without disciplining BBBs, the 1969 discussion revealed an intrinsic lumpiness in the integration process—slipping gradually into monetary union would not be possible. While EMU was off the agenda, the trade/ER feedback mechanism was still functioning, forcing EEC leaders to react to the shock of global monetary instability triggered by irresponsible US policy and greatly amplified by the breakdown of Bretton Woods and the first oil shock. In March 1972, the EEC set up a plurilateral exchange rate stabilization system called the “snake,” its purpose being to reduce fluctuation of EEC currencies against each other. However the Six’s macroeconomic responses to the 1973–75 recession were uncoordinated and quite different; inflation reached double digits in most European nations—apart from Germany and the group of nations that unilaterally pegged to the deutschmark (the so-called DM bloc). As the crises settled down and the recession passed, EEC leaders decided to strengthen exchange rate stabilization by setting up a European Monetary System (EMS) in 1979. This was akin to the Bretton Woods system with a European Currency Unit (a weighted basket of all EEC 19 The institutional aspect of this reveals much about how EEC leaders’ views of supranationalism had changed since the 1950s. The Committee of Governors of the Central Banks of the Member States of the European Economic Community was not an official EEC body subject to supranational control by the Commission and the Court. It was intergovernmental cooperation; indeed, its meetings were held at the Bank of International Settlements (BIS) in Basel right up till the creation of the European Monetary Institute in 1994. Indeed the BIS handled operations for the European Monetary Cooperation Fund until 1994, just as it had handled transactions for the Marshall Fund’s EPU. Sequencing Regionalism | 31 currencies) as the anchor instead of the dollar. By stabilizing against the ECU, the whole grid of EEC bilateral exchange rates was stabilized. In addition to sowing the seeds of the euro, the 1970s disparate monetary reactions to a common external shock illustrated how difficult full monetary cooperation would be when national central banks were beholden to national politicians. The emergence of stagflation also illustrated the limits of discretionary macro policy. European nations that tried to stimulate demand via expansionary monetary policies ended up with recessions and double-digit inflation, while those that were more restrained experienced recession with much more modest inflation. These two facts acted in a scissor-like manner to cut support for keeping central banks under the direct political control of national governments—an outcome that reappears in the story in the 1990s. Intergovernmentalist Reactions to the Bretton Woods Shock The break of Bretton Woods was a global shock that destroyed the status quo; all European nations had to react. As monetary policy is one of the most sensitive national policies, the thought of formally pooling sovereignty on monetary and exchange rate affairs was abhorrent to the staunch intergovernmentalists left in EFTA. The trade/ER feedback mechanism, however, forced these governments to do something about the instability. The reaction was “spontaneous cooperation,” or what might be labeled “fortuitously coordinated unilateralism.” Because the EFTAs had roughly similar trade patterns—they all traded a great deal with the EEC9—their individual stabilization efforts mimicked the effects of the more institutionalized and federalist EEC schemes. Indeed some of the EFTAs (Austria and Switzerland) were core members of the deutschmark bloc and thus were unilaterally shadowing Germany monetary policy and thus stabilizing their bilateral exchange rates—at least as effectively as some formal EEC monetary arrangements (such as France and Italy). The schism took a new turn when it came to monetary cooperation in the 1970s. EEC membership for the UK, Ireland, and Denmark meant that some intergovernmentalists were among their EEC ranks. Britain decided not to join the new monetary integration schemes, so the federalist-intergovernmentalist schism started operating within the EEC as well as between the EEC and EFTA. Institution/Institution Feedback The first years of the EEC revealed problems with the functioning of European institutions. The most obvious was duplication and overlap among the separate but parallel institutions of the EEC, the ECSC, and Euratom. In 1965, the Six adopted the Merger Treaty, merging the ECSC and Euratom institutions into EEC institutions. To reflect this, the name European Communities (EC) was adopted. This is a clear example of institution/institution feedback. The integration accomplished by supranational institutions created a situation where the smooth functioning of these institutions became an important matter to the member nations. Problems that were swept under the rug in the interest of political expediency in 1957 could no longer be ignored. 32 | Working Paper Series on Regional Economic Integration No. 80 A second example came with the creation of the “European Council.” Member States in the Treaty of Rome were to be represented on a Council of Ministers. However, the power of initiative—the agenda was formally assigned to the European Commission. National leaders of the member states felt they needed to get back in charge of the European agenda. The Council of Ministers was not an appropriate institution as it met at the Ministerial level, not the Head of State level, and its agenda was largely shaped by the Commission, not its members. In reaction, national leaders of the Six would sporadically meet to hash out high-level political compromises and set political directions to guide the work of the Commission and Council of Ministers. In 1974, French President Giscard d’Estaing called for the formalization of these meetings into a “European Council.” This body—entirely outside the EU’s formal structure until the 1990s—worked on a purely intergovernmental basis, although of course the fact that the fallback may involve initiatives from the Commission and majority voting in the Council of Ministers put a limit on veto power. A third example came with the 1970s Budget Treaties. Before, budget obligations were being met by annual, ad hoc contributions from members—an exercise that always created tension, especially as the EEC’s agricultural policy—the Common Agricultural Policy—became increasing expense. A fourth example was the creation of the Committee of Governors of the Central Banks of the Member States of the European Economic Community—where institutional cooperation generated pressures to deepen further institutional cooperation. 3.1.7 Institutions Begin to Matter: Reigniting European Economic Integration While the terrible economic environment of the 1970s fostered exchange rate cooperation (both explicit and spontaneous) among EU and EFTA nations alike, it ruined EU efforts to advance trade integration beyond tariffs; the General Programme was a complete failure. The deep problem was that harmonizing standards required unanimity in the Council of Ministers under Treaty of Rome rules—in essence BBB was subject to an intergovernmental process of cooperation, not a federalist process—and the EEC members just did not want to cooperate. While EU members were happy to ignore their Treaty of Rome commitments, the supranational institutions set up in 1957 could not accept the General Programme’s failure. The Court and the Commission were duty-bound to enforce the Treaty. Here judicial activism by the supranational European Court of Justice was the critical factor. As a result of a series of landmark decisions—directly effecting all member’s legal systems and which could not be appealed in nation courts—the EU Court created the presumption of “mutual recognition;” that Member States’ national standards were Sequencing Regionalism | 39 The big change discussed concerned • Decision-making procedures (extending the range of topics where new laws could be made by supranational decision in the Council of Ministers);22 and • Creation of the two new intergovernmental pillars for cooperation on home and justice matters and foreign and defense matters was less significant than most believe. In essence, the pillars gathered under the EC’s wings a series of co-operations that had been going on outside the Community’s formal remit—such as the environment, health, energy, research and technology, and consumer protection. The big European nations had cooperated on defense and security matters since the creation of the WEU. The Maastricht Treaty’s pillars, however, allow this intergovernmental cooperation to be more easily coordinated with other EU policies and some hoped that it would trigger an institution/institution feedback effect that would induce member states to transfer real sovereignty to the EU. So far, though, it is hard to see outcomes on the CFSP side that would not have come about as the result of ad hoc cooperation among the big EU members. On the home and justice side, the juggernaut mechanism continues to blur the distinction between domestic and international policy, leading members’ special interest groups to push for ever greater integration, much of which is now taking place inside the EU. One should note, however, that the most successful of these, the Schengen Accord, was set up outside the EU initially. Several non-EU members have joined while some EU members have not, so this is not clearly an example of EU integration spawning forces that produced more EU integration. In January 1999, a subset of EU members adopted the electronic euro, taking the step to cash euros in January 2001. While Eurozone membership has grown, some EU members seem firmly resistant to join. Apart from small nations, there does not seem to be a domino-like feedback mechanism whereby a currency union draws in an every widening circle of members. There is, however, a feedback mechanism linking the common currency to deeper financial market integration, especially on technical issues like payment clearing mechanisms. Intergovernmentalist Reaction: Bretton Woods II Intergovernmentalists have found that a managed float against the euro is almost as good a solution economically as euro membership—without the formal loss of monetary sovereignty. Indeed the available econometric evidence shows that being outside the Eurozone does not harm exports to the Eurozone—there was not trade diversion of the type observed with discriminatory tariffs or BBB liberalization (Baldwin 2006c). All West European nations have found it optimal to establish central bank independence as a buffer against opportunistic monetary policy by politicians only interested in shortterm political goals. The removal of capital controls all but made necessary in Europe, 22 These issues were not settled and were addressed by a long series of IGCs and Treaties up to and including the Lisbon Treaty which came into force in 2010. 40 | Working Paper Series on Regional Economic Integration No. 80 but the globalization and sophistication of capital markets is also an important driving force. Indeed a very large number of governments around the world have decided they cannot trust themselves and have handed monetary policy sovereignty to independent, unelected officials. In many of these nations, especially in Europe, these central banks have adopted inflation-targeting strategies. Outside of Europe, especially in East Asia, many have chosen a peg to the US dollars (or a basket with a large dollar weight) as their external anchor. Regardless of which it is, the effect has been something like Bretton Woods II because the US Fed has pursued something like an inflation-targeting strategy (as least until it scrambled to pump-prime—and quantitative easing—to avoid a more serious recession in 2009 and 2010). This uncoordinated set of policies—spontaneous cooperation—has gone a long way to allowing individual nations to replicate the currency and exchange rate stability effects of more formal monetary cooperation (for example, the EMS or Eurozone). 3.2 Feedback Mechanisms and Sequencing in Asia As noted in the introduction, Asia experienced remarkably little formal integration among the major economies until the beginning of this century. Nevertheless, economic integration has proceeded in the region at a rapid pace since the mid-1980s. As Dee (2007) puts it: “From the 1980s, East Asia developed high levels of intraregional trade in response to market forces, not preferential trade agreements (PTAs). … The ASEAN Free Trade Agreement (AFTA) came into force in 1992, but this did not create much preferential trade. …. With successive rounds of unilateral liberalization, the margins of preference on the remaining lines were small. … less than 5% of intra-regional trade takes place at the preferential rate.” This section considers the sequencing of regional integration initiatives in Asia and considers the feedback mechanisms driving its. The focus is on East Asia as that is where the largest and most successful initiatives are found. As we shall see, the feedback mechanism that produced 20 years of East Asian tariff cutting is quite different to those that induced tariff cutting in Europe. In Europe reciprocity was the key (generalized juggernaut effect); in Asian reciprocity played almost no role. Before turning to the political-economy feedback mechanism, it is therefore necessary to describe the key difference between East Asian regionalism and European regionalism. 3.2.1 The Development of “Factory Asia” Regional trade in East Asian before 1985 was held down by three factors: • The very unequal size distribution (Japan was the only large economy); • The great development-level disparities (Japan was the only advanced economy); and • The “dual track” development strategies that actively discouraged imports of most manufactured goods, but especially those produced by East Asian economies—all East Asians wanted to produce and export the same thing, namely mechanical and electrical machinery (especially electronics). Sequencing Regionalism | 41 These three elements resulted in a pattern of protection against “neighbors” exports and correspondingly exaggerated reliance on extra-regional export markets, especially the US and EU. Information and Communication Technologies Revolution and the Second Unbundling East Asia was set on a new course by the ICT revolutions that began in the mid-1980s (Baldwin 2008).23 Then, the US and Japan began to geographically unbundle their manufacturing processes, moving offshore some stages to developing nations. For the US, Mexico was the main destination for these new factories. For Japan, developing East Asia was the natural destination. Technology opened the door for offshore development and competition pushed firms over the threshold—especially large Japanese firms. In essence, the production bays that used to be contained in a single factory in, say, Nagoya, became their own factories and were dispersed to locations that had factor prices and other characteristics better suited to the particular needs of the production stage. Factory Asia was born. Japanese firms’ off-shoring strategies fit in nicely with the export-track of the dual-track development strategies and the RTB unilateralism feedback mechanism began to operate. To attract such investment, ASEAN members unilaterally reduced their tariffs on triangle trade in what may be viewed as a “race-to-the-bottom.” Often this came in the form of “duty drawbacks” and duty-free treatment for plants located in export processing zones. An illustration of this can be found in the placement of auto and electronics plants by Japanese firms in East Asia from 1975 to 2004 (Figure 7). Toward the end of the 1990s, when the PRC decided to join the world economy, unbundling accelerated— attracted by the very low, productivity-adjusted cost of labor in the PRC. Rapid industrialization The development of Factory Asia was accompanied by a spectacular re-orientation of developing Asians’ export composition. The region where only Japan and the “four tigers” were able to export manufactured goods became a region where manufactured exports became pervasive. As Table 1 shows, the larger ASEAN members relied primarily on commodity exports in the mid-1970s. There was a marked change toward manufactures in the subsequent decade, but by the mid-1980s, more than half these nations’ exports consisted of primary products. The radical reorientation came between the mid-1980s and today. As the last column shows, manufactured goods account for the lion’s share of all five nations’ exports. 23 Some authors ascribe the change to the 1985 Plaza Accord that fostered yen appreciation; others focus on the 1997 crisis. Neither of these accounts explain why production unbundling and unilateral liberalization started in North American and Latin America at the same time it started in East Asia. 42 | Working Paper Series on Regional Economic Integration No. 80 ASEAN = Association of Southeast Asian Nations. Source: Organisation for Economic Co-operation and Development online data. 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 China ASEANs ex Singapore 4 Tigers China, People’s Republic of Figure 7: Placement of Japanese Plants in East Asia, 1985–2007 Table 1: Non-Oil Export Composition (% of Total Non-Oil Exports) 1976 – 77 1983 – 84 2003 – 04 Indonesia Primary Products 98 75 33 Manufactures 2 25 67 Malaysia Primary Products 91 63 12 Manufactures 9 37 88 Philippines Primary Products 90 51 10 Manufactures 10 49 90 Thailand Primary Products 85 66 20 Manufactures 15 34 80 Viet Nam Primary Products 75 87 25 Manufactures 25 13 75 Source: Athukorala, Prema-chandra (2006). Sequencing Regionalism | 43 The image of Factory Asia is intended to invoke the way in which trade in this remarkable region differs from that in Europe or North America. To a large extent, the manufactures trade within East Asia is trade in parts and components. More specifically, one can think of East Asia as falling into two groups: headquarter economies (Japan; the Republic of Korea; Taipei,China; Hong Kong, China; and Singapore) and factory economies (the PRC and the rest of ASEAN). Although the pattern is evolving, firms in the headquarter economies tend to develop and market final goods in advanced nations, especially Japan, the EU, and the US. Factory economies tend to specialize in producing various segments of value-added chains. One way to see this is to look at the sector composition of the parts and components that major ASEAN members import and export. In the image of Asia Factory, these nations import parts in, say, electrical equipment add some value and then re-export the parts (Table 2). This is especially true for the Philippines, where 73% of its imports of parts and components are in electrical machines (includes electronics) and 83% of its export of parts and components is in the same product categories. The People’s Republic of China Contrasts with Major Association of South East Asian Nation Economies Once the PRC joined the world economy—with, for example, WTO application and eventual accession—the nature of Factory Asia became more differentiated. The “headquarter” economies—Hong Kong, China; Japan; the Republic of Korea; Taipei,China; and Singapore—engaged in parts and components processing in the larger ASEAN economies (Indonesia, Malaysia, the Philippines, Thailand, and more recently Viet Nam) for assembly in the PRC (Table 3). The first salient point is that East Asian markets for final machinery have not become more important for East Asian exporters. For Japan, the Newly Industrialized Economies of Hong Kong, China; the Republic of Korea; and Singapore), and ASEAN4 (Indonesia, Malaysia, the Philippines, and Thailand), the share has remained steady at under 10% of total exports. The exception is the PRC, which has almost doubled the share of its total exports from the sale of final machinery to East Asia. The second salient point is the rapid increase in the importance of parts and components trade within East Asia. In all cases—again with the exception of the PRC— the role of P&C exports to East Asia almost tripled from 1990 to 2005. The PRC has seen its share of P&C exports to the region stagnate at 5%. The region’s preponderant and growing reliance on machinery exports is clear from the last line in the table. While the figure fell from 76% to 70% for Japan over the 15 years, it increased sharply for the other regional players. In a nutshell, Factory Asia involves mostly trade in parts and components among East Asian nations with the exception of the PRC, which has become an important exporter of final machinery to the region. 44 | Working Paper Series on Regional Economic Integration No. 80 Table 2: Association of South East Asian Nations Parts and Components Imports and Exports by Sector, 2003–04 (% of Total Parts and Component Trade) Source: Athukorala, Prema-chandra (2006) Table 3: Development of Factory Asia: Role of Parts and Components (%) Ja p an NIE3 A SEAN4 PRC 1990 2005 1990 2005 1990 2005 1990 2005 P&C machinery to East Asia 7 16 9 25 7 17 5 5 P&C machinery to rest of world 19 18 8 12 7 11 2 16 Final machinery to East Asia 8 8 7 8 3 7 9 16 Final machinery to rest of world 41 29 17 17 5 12 3 14 Sum machinery in total exports 76 70 42 62 22 47 19 50 Malaysia Philippines Thailand V iet Nam Indonesia Exports Imports Exports Imports Exports Imports Exports Imports Exports Imports Power generating machines 0 3 0 1 3 6 3 16 5 17 Special industrial machinery 1 2 0 2 1 2 4 10 3 11 Metalworking machinery 0 0 0 0 0 1 1 3 0 1 General industrial machines 1 3 1 1 6 7 9 12 5 21 Office machines 21 13 11 17 21 14 3 8 10 1 Telecomm and sound equipments 8 5 4 4 15 4 6 9 21 3 Electrical machines 68 73 83 73 49 54 69 28 47 16 Road vehicles 1 2 2 2 6 12 5 13 10 28 Other transport Equipment 0 1 0 1 0 2 0 2 0 2 Part and components trade 100 100 100 100 100 100 100 100 100 100 ASEAN = Association of South East Asian Nations; ASEAN4 = Indonesia, Malaysia, the Philippines, and Thailand; EA = East Asia; NIES = Newly Industrialized Economies; NIES3 = the Republic of Korea; Singapore; and Hong Kong, China; P&C = parts and components, PRC = the People’s Republic of China; ROW = rest of the world. Notes: "Intra-East Asia" here includes the PRC, ASEAN4, and NIES3. Due to lack of data available from UN COMTRADE, Taipei,China is not included in East Asia. Machinery includes both mechanical machinery such as transport equipment and electrical machinery, which includes electronics. Source: Calculations based on Ando and Kimura (2009) appendix tables. Sequencing Regionalism | 45 3.2.2 The Muted Role of Institutionalized Cooperation Formal regional trade agreements have only recently begun to matter in East Asia. Here we present a highly stylized historical sequence based on Baldwin (2008). It is useful to distinguish three phases of East Asian regionalism: Phase I—Rampant Unilateralism. From the mid-1980s to 1990, tariffs on intra-regional trade were reduced. But this was due to unilateral tariff cuts in the region driven by competition for investments and jobs related to Factory Asia. This phase is marked by an almost total lack of formal regionalism. Phase II—Regionalism Delayed, Unilateralism Accelerated. From roughly 1990 to 2000, East Asia witnessed an acceleration of unilateral tariff cuts as the PRC’s emergence heightened competition among East Asians for jobs and investment linked to an ever-expanding Factory Asia. Formal regionalism was kick-started by former Malaysian Prime Minister Mahathir Mohamad with his East Asian Economic Community (EAEC), which led to the ASEAN Free Trade Agreement (AFTA) in 1992. Mahathir’s vision, however, was much broader yet geographically exclusive. The US feared that an Asian-only economic bloc might bring in or even be dominated by the communist PRC, a nation whose economic resurgence was already causing concern (the US was still quite uncertain about PRC motives in the early 1990s). In 1993, the US countered Mahathir’s vision by backing the 1989 Australian proposal of creating the Asia-Pacific Economic Cooperation (APEC)—a new twist on the old strategy of undermining one preferential trade arrangement by proposing a larger one (as the UK did in the 1940s and 1950s). This diversionary tactic worked and the “exclusively Asian” aspects of Mahathir’s vision were sidestepped and replaced by the oxymoron “Open Regionalism.” Phase III—Rampant Regionalism. In November 2000, PRC Premier Zhu Rongji triggered a domino effect by suggesting that his country might be interested in an FTA with ASEAN. This idiosyncratic initiative strengthened pro-FTA political forces in excluded nations—especially Japan and the Republic of Korea. The result was a domino effect still being felt today. Domino Effects in Asia The November 2000 PRC initiative was something of a surprise to ASEAN. But it remained in line with 1990s PRC attitudes. One key element of the PRC economic development strategy during the 1980s and 1990s was the desire to avoid antagonizing others in the process. Because the PRC’s success in attracting industrial jobs and investment was increasing viewed as a threat by some ASEAN members, Zhu Rongji chose a big-hearted gesture to assuage ASEAN concern over competition from the PRC. Although the idea came as something of a surprise, it was generally welcomed surprise by ASEAN. It was immediately clear to most ASEAN leaders that preferential access to the large and fast growing PRC market would enormously boost their own attractiveness for creating new Factory Asia employment—although they naturally had reservations 46 | Working Paper Series on Regional Economic Integration No. 80 about liberalizing so-called “sensitive sectors.” A study group on a possible PRC-ASEAN FTA was the concrete result of the surprise. The formal proposal for a “[People’s Republic of] China-ASEAN Free Trade Area” (CAFTA) came from Rongji in November 2001. ASEAN leaders accepted it in principle, agreeing to set up groups to study detailed issues. This led to a Framework Agreement on Comprehensive Economic Cooperation in 2002, which foresaw an “ASEAN-[People’s Republic of] China Free Trade Area” (ACFTA) by the year 2010 along with some “Early Harvest” liberalization of agricultural goods. A whole series of agreements have been subsequently signed, most notably a trade in goods agreement concluded in late 2004.24 The surprise PRC proposal to ASEAN set off alarm bells all across Asia, but especially in the advanced economies of Japan and the Republic of Korea. Export dependence figures make the reason absolutely clear (Table 4). For Japan and the Republic of Korea, the AFTA discrimination in the ASEAN markets is relatively unimportant since Japan send only 17% of its exports to the region (and most of those face low MFN tariffs as we saw); the figure for the Republic of Korea is 13%. The ACFTA, however, changes the picture dramatically. ACFTA would imply that Japan-based and Republic of Koreabased firms would face tariff discrimination in markets covering 36% and 43% of these nations’ exporters in 2003. Moreover, just as in Europe in the 1950s, the ‘insiders’ are growing much faster than the outsiders, so the importance of getting in at an early stage is even more important than current export dependency ratios would suggest. It is also important to note that both the PRC and the ASEANs have relatively high MFN tariffs on many industrial goods, especially the sort finished products at which Japan and the Republic of Korea excel—consumer electronics, autos and the like. The importance of this is that it opens the door to the possibility that ACFTA would be highly discriminatory, i.e. have very high margins of preference. Worse still, the MFN tariffs of the PRC and most ASEANs are either not bound or bound at rates that substantially exceed the applied rate. In other words, the ASEANs and the PRC could—without formal repercussions in the WTO—raise their applied rates against exports from Japan and the Republic of Korea. Table 4 shows it should be no surprise that the PRC demarche to ASEAN triggered flashing red lights throughout the region—especially in Japan and the Republic of Korea. If the PRC and ASEAN were really to trade freely with each other preferentially, Japan plainly needed a plan for redressing any discrimination that might arise. Moreover, Japan worried about “missing the train.” In the 1960s, the UK was forced— commercially at least—to join an organization whose foundations were set without its participation. The lessons from Europe were: get involved early and stay involved no matter what, and propose an alternative that is more suitable to your interests. 24 CAFTA and ACFTA acronyms have been used interchangeably, but all refer to the same November 2004 Agreement. Sequencing Regionalism | 47 Table 4: Actual and Projected “Exclusion Indexes,” 2003 (%) Japan KOR PRC Malaysia Thailand Indonesia Philippines Singapore Viet Nam A SEAN 17 13 8 29 22 11 19 31 15 A SEAN+PRC 36 43 8 43 36 22 34 45 23 Japan 10 14 10 15 25 14 6 15 KOR 8 4 4 2 8 4 4 2 Moreover, Japan worried about “missing the train.” In the 1960s, the UK was forced— commercially at least—to join an organization whose foundations were set without its Japan chose the first option by approaching each ASEAN member to create an FTA while simultaneously launching slower talks with ASEAN as a group. It also revived discussions of a possible Japan-[Republic of] Korea FTA. The Republic of Korea is a significant destination for Japanese exports (see Table 4). More to the point, the PRC would be only half as interested in ASEAN as it would be in the combined Japan- [Republic of] Korea market. The threat of tariff discrimination against ASEAN and ACFTA exports arising from a Japan-[Republic of] Korea FTA would substantially counterbalance the possibility of ACFTA discrimination—not from an economic point of view, but rather from a diplomatic and domestic political perspective. In fact, Japan and the Republic of Korea launched FTA talks in 2003, which stalled in 2005. Japan also pursued the second option—forming an alternative arrangement. Japan also sought an FTA with ASEAN as a whole as well as with individual FTAs with the most economically important ASEANs (Singapore, Malaysia, Thailand, Indonesia, the Philippines and Viet Nam). In January 2002, Japan proposed an FTA with ASEAN and a Joint Declaration was signed in November. Commitment on both sides grew throughout 2003 with a complicated diplomatic dance of declarations, joint study groups, and framework agreements; the ASEAN-Japan (AJ) FTA talks actually began in 2005. In parallel with, but slightly preceding the AJ FTA moves, Japan initiated FTA talks with Malaysia, the Philippines, and Thailand (they started in 2004). The Republic of Korea had problems very similar to those of Japan. However, the lower export dependence of the PRC and ASEAN on its market left the Republic of Korea a narrow range of options. Although more hesitant in its reaction to the possibility of discrimination from ACFTA at first, the Republic of Korea signed a Framework Agreement with ASEAN at the same meeting as Japan (October 2003) and opened talks with ASEAN in 2005. The dominos continue to fall in East Asia as other trade partners—the US, the EU, India, Australia, and New Zealand, sought FTAs with ASEAN, and in most cases, the PRC. ASEAN = Association of South East Asian Nations, KOR = the Republic of Korea, PRC = the People’s Republic of China. Source: Trade data from Comtrade. 48 | Working Paper Series on Regional Economic Integration No. 80 Depth of Economic Integration Requires supranationa l decision-making CU/FTA Single Marke t Economic and Monetary. Union (EMU) Supranational institutions (Court) Unification price Domino effect (EEC is bigger & faste r growing) Domino effect ( EC is bigger & Single Marke t is deeper) No domino effect ( no trade diversion) 4. Lessons: Europe and East Asia Using the feedback mechanism approach to regional sequencing, several clear lessons emerge from Europe and Asia sequences. We start with European sequences. 4.1 Lessons from Europe’s Twin Sequences The historical narrative offers critical details that help explain the evolution of EU and EFTA integration sequences—and how they became intertwined via domino effects. To draw abstract lessons for Asia’s future integration, it is better to suppress detail and focus on the main points (Figure 8): Figure 8: Highly Stylized European Integration and Institutions Sequences, 1944–1969 CU = customs union, EC = European Communities, EEC = European Economic Community, EMU = Economic and Monetary Union, FTA = Free Trade Agreement. Source: Based on Baldwin (1994). 4.1.1 Europe’s Sequences in a Nutshell There was a highly stylized rendition of the 1957–2002 path toward Europe’s twin integration sequences. • European integration had highly unusual initial conditions; Europeans were reluctant to engage in serious regional integration until forced by a combination of outside pressures (intensification of the Cold War and direct pressure from the US). • By the end of the 1960s, both blocs had removed tariffs and quotas on trade in goods. Further integration of the goods market (such as tackling behind the border barriers) stopped until the mid-1980s. This halt was de jure for EFTAns (they had not committed to deeper integration) and de facto for the Sequencing Regionalism | 55 The possibility of new discrimination also induced Japan and the Republic of Korea to react by embracing a sequence of regional FTAs. The US and the EU have followed suit. East Asia has also made some government-led progress on financial integration via the Chiang Mai Initiative Multilateralization (CMIM) and the Asian Bond Markets Initiative. These, however, involve minimal loss of sovereignty—and in fact, the CMIM has never been used. 4.2.2 The Lessons The lessons from East Asia’s short experience with regionalism are much less clear than in Europe. The first one, however, seems very solid. Lesson #1: Supranationalism is out of the question In Asia, powerful, supranational institutions are out of the question. European nations agreed to historic shifts in power in a highly unusual setting—a time when large segments of European voters distrusted those governments that had so badly handled the tumultuous 1914–1945 era and its ensuing repercussions. Most governments in Asia find themselves in an almost diametrically opposed situation. They helped guide the “East Asian Miracle.” Most East Asians today enjoy living standards many times higher than their parents and prospects for their children look even brighter. The notion that most East Asian voters would support radical change in the way governments manage national sovereignty is farfetched. Lesson #2: East Asia is unlikely to have a clear leader Regional integration schemes in Europe, and indeed around the world, are almost always an initiative spawned by a regional hegemon, or cooperation between two regional hegemons. In East Asia, however, no leader has yet emerged. Decade-long debates over establishing a regional architecture makes it fairly clear that no one nation will take the lead. The default in East Asia has been ASEAN. While economically small, it still matters in trade and it has the enormous advantage of operating and without threatening East Asia’s dominant economies. Lesson #3: Spontaneous cooperation on exchange rates As in Europe, the trade/ER-stabilization feedback mechanism induced East Asia to unilaterally stabilize their exchange rates against baskets of currencies. Given the similarity of trade patterns, the composition of these baskets remains similar. In particular, given the dominance of the US market for the export of final goods, the US dollar tends to dominate. This “spontaneous cooperation” provides East Asia with de facto monetary integration—in the sense that integration effectively coordinates East Asian monetary policies much as the EMS coordinated monetary policies in Europe in the 1980s. In Europe, integration involved rules and institutional agreements de jure, but de facto operated as a deutschemark bloc. Although East Asia has no de jure scheme, it is de facto operating as a dollar bloc—helping stabilize the grid of bilateral exchange rates in the region. 56 | Working Paper Series on Regional Economic Integration No. 80 4.2.3 Caveats There are three important caveats. The first one concerns when to start. Initial Conditions Initial conditions matter. Conditions in Asia today and conditions in postwar Europe are about as diametrically opposed as one can imagine. Europe began from a tangle of bilateral trade restrictions crippling intra-European trade. So any gains from cooperation were great. Economic integration was desperately needed, yet the initial conditions and forms of the barriers meant that it could not happen unilaterally. Western Europe also faced pervasive external pressures encouraging, indeed requiring, Europe to set up institutional arrangements and economic integration schemes. The US with its Marshal Fund was willing to spend a great deal in facilitating the process—mostly driven by concerns over spreading communism and Soviet aspirations in Eastern and Central Europe—concerns shared widely among Western Europeans at the time. Both elements are missing in today’s Asia. Asia, at least East Asia, is marked by very low trade barriers, at least on high trade-volume items. Outside economic powers may not be opposed to institutionalizing Asian regionalism, but they are most certainly unwilling to subsidize it. Moreover, Europe started with a political atmosphere where citizens across many nations wanted radical change. As a reaction to the dismal wartime performance of status quo governance, one large fraction (and pressure groups) wanted to embrace communism, while another large fraction was willing to contemplate a pooling of sovereignty. The “Soviet menace,” as it was known at the time, ensured the latter group’s aims prevailed. Asian governments, by contrast, have supported the “economic miracle” for several decades. No large fraction of citizens or pressure groups wants radical changes in the allocation of sovereignty between the nation-state and regional institutions. In short, Europe started its twin integration sequences when demand for regional institutions had never been higher and resistance to them never lower. Asia starts when demand for regional institutions remains modest and resistance is high. Sequencing Institutions versus Sequencing Integration In Europe, the sequencing of institutions and integration were thoroughly intertwined because they began in tandem. The OEEC launched the integration of the 1950s, and the EEC and EFTA launched the integration of the 1960s and 1970s. The massive deepening of European integration in the 1980s and 1990s where launched by massive institutional changes (the Single European Act and EEA in the first instance and the Maastricht Treaty in the second). Asia, by contrast, has followed an integration sequence since the mid-1980s, achieving a high level of trade integration and a good level of exchange rate stability. All this economic integration has occurred with remarkably few regional institutions. Sequencing Regionalism | 57 In trade, the trigger was technological advance that allowed the “second unbundling” and development of Factory Asia (Baldwin 2006a, 2008).25 These changes created a political-economy environment where “race-to-the-bottom unilateralism” was politically optimal, at least for parts and components (Baldwin 2006b, 2008). Preferential trade liberalization in the region took off as the PRC-ASEAN FTA triggered a domino effect (Baldwin 2008). For both reasons, but especially the “spontaneous cooperation” built into race-to-the-bottom unilateralism, intra-Asian trade shares rose rapidly, bringing their export patterns even closer into line than originally. Returning to the caveat, the problem facing Asia today is how to sequence regional institutions given that trade integration has proceeded such a long way on the basis of “spontaneous cooperation.” One must be very careful in drawing simple analogies with EEC and EFTA integration. 4.2.4 Lessons The European experience very clearly shows that nations will only accept losses of policy autonomy in line with the political-economy gains of doing so. Turning around the old exercise dictum, the lessons of Europe tells us: “No gain, no Pain.” Applied to today’s Asia, we have to observe that economic integration is, de facto already quite advanced in East Asia, so gains from standard regional integration—the elimination of tariffs on intra-regional trade—would be modest. These modest political-economy gains tell us that any institutions must also expect at best modest sovereignty loss. Or, to rephrase the reversed adage, when it comes to institutionalizing Asian regionalism: “modest gains, modest pains.” The second point is that deeper trade integration—the removal of commercially important behind-the-border barriers such as idiosyncratic product standards—might well provide large economic benefits. But the European experience shows that it also requires supranational institutions.26 For example, harmonizing product standards in the automobile sectors of Japan, the Republic of Korea, and the PRC would yield substantial gains from economies of scale. It would, however, almost surely involve a relocation of final auto sales—which would preclude any form of intergovernmental cooperation on the matter. Progress would require, as in Europe, majority voting, and this is not a realistic option for Asia in the foreseeable future. Strong regional institutions—strong in the European sense of sovereignty transfers—in Asia seem unrealistic in the foreseeable future. Moreover, given the variety of monetary preferences and economic divergence in Asia, such an arrangement would very likely soon start operating asymmetrically—just as the supposedly symmetric EMS ended up operating as a deutschmark zone. However, this would not really provide large political economy gains. To take a hypothetical example, if everyone pegs to the renminbi and 25 The second unbundling is also known as trade in tasks, fragmentation, vertical specialization, slicing up the value-added chain, international supply sourcing, offshoring, among others. 26 See Baldwin (2000) for a detailed study of ways in which technical barriers to trade have been eliminated in various regions of the world. 58 | Working Paper Series on Regional Economic Integration No. 80 the renminbi largely tracks the dollar, how much economic gain would there be compared with the current situation where most of Asia track the US dollar? Here an important and often overlooked distinction must be made. When it comes to the trade/ER-stabilization feedback effect, one should net out parts and components trade. If country A sells only parts to country B, and B turns the parts into final goods and sells them to country C, then A and B are, in fact, just selling to country C; Freiden’s political economy pressures in both A and B will be to stabilize their exchange rates with respect to country C. The bilateral A-B rate will also be stabilized, but this is a side effect of the underlying political-economy forces—efforts to cajole A and B to stabilize their bilateral exchange rate as a priority will be working against the feedback mechanism, not with it. A fourth lesson is how to sequence trade and monetary integration. Europe’s experience (and there is abundant econometric evidence) shows that there is a two-way relationship between higher trade flows and more stable exchange rates. But the relationship is not symmetric. An increase in bilateral trade has an important, first-order effect on bilateral exchange rate stability (due to domestic political-economy forces). Exchange rate stability, on the other hand, has only a modest pro-trade effect, even if stabilization leads all the way to currency union. In short, stabilizing exchange rates may trigger a feedback mechanism that favors future trade integration (stability promotes trade that—a la juggernaut—alters government views of further trade liberalization), but it is very weak. Trade integration, by contrast, has a strong effect on incentives for further trade integration and monetary integration (at least of the “spontaneous cooperation” type). 5. What to Do? The Feedback Sequencing Perspective When thinking about the way forward on Asian institutions, three points are a logical starting point. The European experience very clearly shows that nations will only accept losses of policy autonomy that are in line with the economic and political-economy gains. Turning around the old exercise dictum, the lessons of Europe tells us: “No gain, no Pain.” Applying to today’s situation in Asia, we have to observe that economic integration is, de facto, already quite advanced in East Asia, so the gains from standard regional integration—the elimination of tariffs on intra-regional trade—would be modest. These modest political economy gains tell us that any institutions must be modest in terms of sovereignty loss. Or, to rephrase the reversed adage, when it comes to institutionalizing Asian regionalism: “modest gains, modest pains”. The second point is that moving goods market integration significantly beyond its current state—for example creating an “Asian Single Market” along the lines of the EU’s Single Market, or the European Economic Area agreements—would require Asia to pursue one of two paths: (i) adopt supranational institutions fostering policy harmonization and approximating national laws, standards, norms, and regulations—as noted, this is impossible given today’s Asia; and (ii) pursue hegemonic harmonization of product and regulatory standards. All East Asians could, for example, agree to adopt the standards of Japan, the Republic of Korea, or the PRC. This path is quixotic to say the least. This Sequencing Regionalism | 59 leads us to the conclusion that deep economic integration in Asia—namely the systematic removal and behind the border measures—is not yet in the cards. Such harmonization and standardization may, nevertheless, go forward in certain sectors, driven by market-led forces—witness the standardization of electronic components. Great standardization of auto parts, for example, would also seem possible. The final point is that the rapid unilateral liberalization of East Asian trade has created a gap between policies nations want to pursue against policies committed to in formal, international agreements. For example, much of the impressive autonomous liberalization of applied MFN tariffs has not been bound in the WTO or in any other agreement. 5.1 The Way Forward How should Asian regionalism be institutionalized? The perspective stressed in this paper is that some forms of integration and some forms of institutions trigger feedback mechanisms that transform the political economy realities in participating nations in a way that makes deeper integration more politically acceptable in the future. This is the real meaning of sequencing. When it comes to Asia, we can start from the proposition that all acceptable institutions will have to be strictly intergovernmental. Even something as ambitious as an Asian EFTA has limits given the wide divergence of preferences, levels of economic development, and the fact that a very high level of integration has already been attained by “spontaneous cooperation.” With this as a given, we are left with the choice of intergovernmental institutions concerning trade and investment flows, or institutions involving monetary coordination and integration. How does the feedback-sequencing perspective teach us to think about this choice? First consider which of the two unleashes the greater feedback effects. The juggernaut effects operate from more intensive international commerce to more intensive liberalization of barriers to commerce. It also unleashes the Freidenesque trade/ER- stabilization feedback mechanism that induces nations to embrace “spontaneous cooperation” on monetary policy (or, if the setting is right, more formal exchange rate stabilization schemes ranging limited debate all the way to currency union). The monetary integration route, however, has only weak effects on trade and investment (according to European experience and empirical evidence from around the world). Trade integration, in short, unleashes more powerful feedback effects. Next consider which of these is easier. As argued in Section 2, trade cooperation is intrinsically easier because the political-economy impact of removing barriers is much easier to gauge, making it much easier to piece together a package politically acceptable to all parties. Monetary cooperation is much harder, as the European experience in the 1970s and 1980s demonstrated. 60 | Working Paper Series on Regional Economic Integration No. 80 Trade in goods and services and related investment Real-sector integration policies Monetary coordination/cooperation policies Feedback sequencing: Trade integration is easier and triggers more feedback mechanisms With the trade route easier and more likely to trigger positive feedback mechanisms fostering deeper integration initiatives, trade seems to be the obvious choice for Asia. Figure 11: Feedback Sequencing—Trade versus Money 5.2 Ideas on Where to Start: Institutionalize Asia’s “Spontaneous Cooperation” One of the lessons of Europe’s experience is that institutions produce feedback effects that favor deeper institutions, even if these forces are not strong enough to induce the members to accept higher levels of supranationality. This suggests that there may be gains to getting the institutional ball rolling, even if the initial push is very small and the incline is not very steep. Following this get-it-started logic, one obvious starting point would be to institutionalize, on a strictly intergovernmental basis, the existing “spontaneous cooperation” we have already seen on trade liberation and, perhaps, exchange rate stabilization as well. The trade institution would not, in its first manifestation, be a free trade area (although that might follow). It would be a way of managing Factory Asia—the Asia-wide network of supply chains—by, for example, managing the massive unilateral and unbound tariff cutting since the mid-1980s.27 The institution could document and provide some very weak lock-in (something short of WTO binding, but stronger than pure, uncoordinated unilateralism) of the autonomous tariff cuts to date. It could also, following ASEAN’s lead, make progress on technical issues such as harmonizing tariff classifications beyond the HS 6 digit level. Finally, it could provide non-binding arbitration for regional trade disputes, either state to state or firm to state. 27 This can be thought of as an extension of the ideas presented in my 2006 “Managing the Noodle Bowl” paper; Baldwin (2008). Sequencing Regionalism | 61 The old Haasian notion of functionalism—where institutional cooperation fosters greater institution cooperation by altering the attitudes of the regional policy elites—is probably far too weak to explain Europe’s integration sequences. But it does seem to have had some effect. For example, the ECSC institutions, especially the Assembly, provided a venue where federalists could freely discuss their ambitions without the UK immediately pouring cold water on every idea. The astounding thing about Asia is that there are so few forums for such discussions. A modest institution with modest initial goals, might foster discussion of deeper economic integration by bringing Asian technocrats more frequently into contract with each other in the discussion of common problems that arise in the functioning of Factory Asia. In Baldwin (2008), I called this the “management committee” for Factory Asia, but here I would go further and add to it a formal role in disciplining Asia’s massive autonomous liberalization. In time one can hope that this would help nations see the merit of the even firmer discipline that would come with WTO bindings. 6. Concluding Remarks Europe’s founding fathers (and they were all men back then) did not start with grand designs. No one in the 1940s, for example, would have thought that starting with coal and steel was the obvious way forward. 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Washington, DC: Institute for International Economics. | 71 77. “Early Warning Systems in the Republic of Korea: Experiences, Lessons, and Future Steps” by Hyungmin Jung and Hoe Yun Jeong 78. “Trade and Investment in the Greater Mekong Subregion: Remaining Challenges and the Unfinished Policy Agenda” by Jayant Menon and Anna Cassandra Melendez 79. “Financial Integration in Emerging Asia: Challenges and Prospects” by Cyn- Young Park and Jong-Wha Lee *These papers can be downloaded from (ARIC) http://aric.adb.org/reipapers/ or (ADB) http://adb.org/Economics/publications.asp?fs=fm_9:999 Sequencing Regionalism: Theory, European Practice, and Lessons for Asia Feedback mechanisms explain how today’s institutions alter the political-economy landscape in a way that makes future integration steps possible—even when these steps are not politically optimal from today’s perspective. This paper uses feedback mechanisms to organize Europe’s postwar integration narrative, and draws lessons for East Asian integration. The paper suggests that one starting point for Asian regional institutions would be to institutionalize the spontaneous cooperation that already exists on trade, services, and investment. About the Asian Development Bank ADB’s vision is an Asia and Pacifi c region free of poverty. Its mission is to help its developing member countries reduce poverty and improve the quality of life of their people. Despite the region’s many successes, it remains home to two-thirds of the world’s poor: 1.8 billion people who live on less than $2 a day, with 903 million struggling on less than $1.25 a day. ADB is committed to reducing poverty through inclusive economic growth, environmentally sustainable growth, and regional integration. Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance. Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines www.adb.org/poverty Publication Stock No. WPS113542 Printed in the Philippines