Speech

Keynote Dinner Address at the Conference on Labor and Capital Flows in Europe Following Enlargement, by Anne O. Krueger, First Deputy Managing Director, IMF

January 30, 2006

Good evening. Thank you for that kind introduction. I am very pleased to be here and to have been able to join you for part of the conference.

I want first to say a word about the terrible weekend tragedy in Katowice. I want, on behalf of the Fund's Executive Board, Management and staff, to express our sincere condolences. Our hearts go out to all those involved, and especially those injured and the families of those who died.

This is a timely gathering, as I'm sure has been evident from the liveliness of the discussions. It is—amazingly—nearly two years since the last enlargement of the European Union. Extending membership of the EU to ten new members, most of them formerly centrally-planned economies seemed, at one time, a distant, and quite possibly unattainable goal both for the EU and for the new member states. Now, nearly two years after that enlargement exercise was completed—remarkably smoothly, I might add—the process of integration is well under way.

Next year will mark the half century since the founding of what eventually became the European Union under the auspices of the Treaty of Rome. The whole continent of Europe has been transformed since then in ways that nobody could have imagined in the 1950s. This conference has been focusing particularly on issues relating to migration and capital mobility: both vital elements in the vision of the founders of the European project in the 1950s. Labor and capital mobility have already played an important, and beneficial, role in the process of European integration over the years, and will continue to do so.

Tonight my aim is to put the conference discussions in a broader context. I'd like to share with you some personal reflections on what has been achieved in Europe, and specifically the European Union, in the postwar era and to look at the principal reasons for those achievements. And I want to look at the opportunities, as well as the challenges, that lie ahead. I want, in particular, to spell out what I strongly believe are the positive lessons of the vision of the founders of the Union. The most enduring lesson has been the dual commitment to trade liberalization: both in the context of intra-European trade and in the context of multilateral trade liberalization, with Europe lowering its trade barriers with the rest of the world. This has served the EU in good stead over many years—and can continue to bring benefits to "old" and "new" Europe given the necessary diligence and political will.

Key to the success of the European Union over this long period has been the global context in which it took shape and which substantially influenced the Union's subsequent development: the multilateral economic framework envisaged by the participants of the Bretton Woods conference in 1944 and established at the end of the Second World War. That the EU was so successful from its inception reflects the commitment to multilateral trade liberalization that its members have consistently demonstrated and which involved the rapid lowering of Europe's trade barriers with the rest of the world. The Union thrived because the global economy thrived: and the remarkable global expansion of the postwar period was, in large part, driven by even more rapid expansion of world trade that multilateral liberalization made possible.

The IMF has always been, and remains, a strong supporter of the multilateral framework: indeed, it is our raison d'etre. And we have actively encouraged the development of the EU in the context of this open multilateral system. Our principal mandate is the maintenance of international financial stability, but our Articles of Agreement make clear that this responsibility is to be seen in the context of the promotion of open multilateral trade and economic growth. We have thus sought to buttress the work of, first, the GATT, and now the World Trade Organization (WTO) as it seeks to supports the open multilateral trading system; and we have continued to be supportive of the WTO during the current Doha round negotiations.

As I shall argue shortly, the newly-enlarged EU now has the opportunity, in the context of the Doha round, to inject fresh impetus into the process of multilateral trade liberalization. This would enable the newest members of the Union to reap the full benefits of their membership and of the economic reforms they introduced as part of the transition from centrally-planned economies to members of the European Union.

Customs unions

It was always clear the original architects of what was at first called the European Economic Community had the ambitious aim of economic integration in their sights. But they recognized that this aim could only be realized gradually, over a long period; and they started out with a more pragmatic and more immediately attainable objective, a customs union.

So let me begin by taking you back to Jacob Viner, whose work in this area in the early postwar period was both original and far-sighted and which, I believe, still has something to teach us. Viner's analysis of the risks that he believed customs unions posed for global economic welfare predated the Treaty of Rome, of course, but coincided with postwar discussions about the economic future of Europe.

Viner argued that customs unions could be trade creating or trade diverting. Trade-creating customs unions stimulate trade by enabling one member, call it B, with lower production costs in an industry, to export to another, call it A, where costs in that industry are higher and where tariffs or other barriers previously protected production in high cost country A. Such trade is additional and benefits consumers within A now importing lower cost goods; the increase in trade also benefits exporters in the lower-cost producer, B; and it benefits the customs union as a whole. Now there may be a third country, C, with even lower production costs that does not have access to the markets of the customs union. But since that country did not export to the countries now in the customs union before it was formed, the formation of the union represents no loss of trade opportunities for C, while the more rapid growth of countries in the customs union is beneficial for the world as a whole. Thus Viner argued that under this scenario the customs union was trade-creating.

According to Viner, however, customs unions could also be trade-diverting. This would be the case when the formation of the union resulted in low-cost imports from C, outside the union, being replaced by higher-cost goods from B, a member of the customs union. So, for example, country A might have very high production costs for, say, radios and have previously imported these from the lowest cost producer, C. With the formation of the customs union, such imports would now come from country B, a member of the customs union able to produce at a lower cost than country A but not as low as C. If the cost differential between B and C is less than the tariff now imposed on C, this thus diverts trade and raises the costs to consumers and thus represents a loss of welfare both inside and outside the customs union.

Viner quotes with approval Lionel Robbins assertion that "the only completely innocuous tariff union would be directed against the inaccessible produce of the moon." Viner himself did not dismiss all customs unions: his view was that each ought to be assessed on its merits but judged against some general principles. He did, however, set the bar very high.

Since Viner, of course, this has become a particularly rich area of research and much work has been done to develop Viner's analysis. Lipsey, Johnson, and Kemp and Wan, among many others, have examined Viner's propositions and sought to explore further the link between customs unions and multilateral trade liberalization. The notions of trade creation and trade diversion have been extended to other areas, such as preferential trade arrangements. My own close friend, Richard Snape, did much of the groundbreaking work on PTAs, noting that these could either support or conflict with further multilateral trade opening; and he elaborated on the hazards that rules of origin could pose in this context. It is striking how well Viner's basic analysis has held up over the decades.

The origins of the EEC

The EEC was and the European Union is a customs union. But the context in which it was established and the principles that guided it arguably make it a customs union with a difference. Again let me take you back to the early postwar period, this time to the Committee on European Economic Cooperation, set up to prepare for American aid under the Marshall Plan. In its report of September 1947, the committee made two important commitments on behalf of its members. The first was to abolish as soon as possible the abnormal restrictions that hampered trade between them. The second was to aim for an open multilateral trading system based on that part of the Havana Charter that ultimately became the General Agreement on Tariffs of Trade signed in 1947.

The GATT committed its members to raise standards of living and ensure full employment by "entering into reciprocal and mutually advantageous arrangements directed to the substantial reduction of tariffs and other barriers to trade and to the elimination of discriminatory treatment in international commerce". The reductions in trade barriers that took place under the auspices of the GATT rapidly became a powerful force for the multilateral trade liberalization that underpinned the growth of world trade and global GDP in the postwar period.

The Treaty of Rome enshrined the commitment to freer trade among the members the EEC; but Article 29 specifically referred to the need to promote trade between the EEC and third countries. So the stage was set for the dual process, towards intra-European free trade and multilateral trade liberalization.

It was a winning combination. European growth rates in the 1950s and 1960s took most observers by surprise—the average annual growth rate of the 6 original member countries exceeded 6 percent in the 1950s and more than 5 per cent in the 1960s—far above earlier historical rates of growth and above expectations. The value of EEC -exports to the rest of the world grew more than eightfold in the two decades to 1973.

The liberalization of trade among the member states took place against a background of the complete removal of quantitative restrictions, required by the GATT, and rapidly falling external tariffs in the context of GATT negotiations on trade liberalization. Intra-EEC tariffs rapidly fell to zero from 40 percent and more. But for manufactured goods, the EU's external tariff was also reduced sharply, from the same 40 percent plus levels to what is, today, a weighted average of just over 3 percent now (excluding estimated ad valorem equivalents of specific tariffs).

In other words, the EU, as it now is, greatly liberalized its trade with the rest of the world as part of the GATT multilateral process—and went somewhat further at the regional level. The economic success of the Union over a long period was therefore the result both of the removal of internal trade barriers and the growth of intra-European trade; and of trade liberalization with the rest of the world, undertaken with its GATT partners. And the EU's framework, by locking in the principle of tariff reduction, acted as a disincentive to protectionist lobbying.

The progress of the Union

Viner, writing in 1950 when discussions about a Western European customs union were already under way, took the view that once a customs union had been formed, closer economic integration would inevitably follow, and the range of economic policies involved would gradually be extended. It is clear that founders of the EEC intended that it would develop rapidly into something far more than a customs union. At the same time as it was growing into a more sophisticated and complex economic entity, it also grew in size. In 1973, after more than a decade of wrangling, the UK joined, along with Ireland and Denmark. Then came Greece, in 1981; Spain and Portugal in 1986; and Austria, Finland and Sweden in 1995. So the enlargement of 2004, while much the biggest, was actually the fifth such exercise that the EU has undertaken. And the success of some of those earlier exercises offers important lessons for the success of the current one.

Go back to 1973, for example, when Ireland (along with the UK and Denmark) joined the Community. Ireland was a small, relatively underdeveloped economy, heavily dependent on its economic links with the UK. The initial adjustment process was slow. During the 1980s, Ireland's real GDP growth averaged less than 3 percent a year on average—close to 1 percentage point lower than the 1970s. But in the 1990s, as economic reforms were finally implemented, the Irish economy became one of the success stories of Europe. Growth averaged more than 7 percent a year throughout the 1990s, more than double the growth rate of the 1980s. And between 2001 and 2005, real GDP growth has averaged more than 5 percent.

According to the European Commission, Irish GDP per capita at the time of Ireland's accession in 1973 was little more than 60 percent of the average of the fifteen countries that had become members of the Union by 1995. That made it the poorest country, marginally below Portugal. Yet by 2005, using the same fifteen countries as a benchmark, Ireland's per capita GDP was one of the highest, exceeded only by Luxembourg. The Irish economy has diversified rapidly, and has become highly integrated into the EU.

The prospect of achieving EU living standards was also enticing for Greece, Spain and Portugal: and for their part existing members were keen to buttress the democratic process and integrate these countries into the European project.

But following accession in 1981, Greece was at first slow to implement economic reforms-with the result that real GDP grew by less than 1 percent a year during the first five years of membership. But better late than never: reforms were eventually introduced, growth accelerated and Greece is, of course, now a member of the euro area, having met the Maastricht criteria.

By contrast, Spain rapidly undertook wide-ranging reforms immediately following accession. These enabled the Spanish economy to undergo a remarkable transformation. Since it joined in 1986, Spain has become—and remains—one of the most dynamic economies in Europe. At the time of accession, Spain accounted for just under 6 and a half percent of the total GDP of the fifteen countries that were in the EU by 1995. Last year, its share of GDP of those same countries was getting on for 8 percent.

Per capita incomes in Spain have risen sharply, relative to its European neighbors. In 1986, real per capita GDP in Spain was just over three quarters that of the average of the fifteen countries that I've been using as a benchmark—those in the EU prior to the most recent enlargement. By last year, Spanish per capita GDP was more than 90 percent of the European average. And while Portugal remains one of the EU's poorer countries, it too has experienced a rise in per capita incomes, relative to its neighbors: up from less than 60 percent of the EU 15 average in 1986 to almost 70 percent last year.

Market-driven structural reforms that put in place the appropriate incentive structure are what ultimately determine a country's long-term growth potential. Labor market deregulation, the creation of a business-friendly environment that encourages enterprise, the development of a wide and deep financial sector well-equipped to manage risks and returns: these can all contribute to accelerated economic growth. Reforms of this kind enabled the founding members to grow rapidly in the 1950s and 1960s—look at the sweeping reforms implemented by Ludwig Erhardt long before the EEC was formed. And more recently, similar reforms have made it possible for Ireland and Spain in particular to grow rapidly over a long period. Reforms also create the conditions needed to attract foreign capital.

Resource transfers helped the poorer accession countries—Ireland, Greece, Spain and Portugal—in the adjustment process. But most estimates put these at no more than 4 percent of GDP for some of the years following the accession of these countries to the EU. And such transfers are not a substitute for reforms—witness the example of Ireland, where growth only accelerated significantly in the 1990s, long after Ireland's accession and only after wide-ranging reforms had been introduced. Indeed, it has even been argued that the resource transfers associated with Irish membership of the European Monetary System enabled successive governments to delay reforms more than was desirable.

Structural economic reforms make possible the sustained rapid growth and the rise in living standards that are essential to the integration process. It is also easy to overlook the important role that expectations can play in this process, as economic actors adjust to the prospect of structural and institutional change that EU membership involves, along with access to new markets and greater economic security. Changing expectations can themselves create a new incentive structure that encourages enterprise and investment.

That the earlier enlargement exercises were so successful ultimately owes much to the political determination of those involved. This helped all participants to overcome the daunting complexity of the negotiations. Problems were dealt with, compromises reached: and the outcome was of unequivocal benefit—to the existing members of the EU, to the newcomers, and to the rest of the world. Indeed, it is striking that many of the most dynamic economies of the late 1990s and the beginning of the 21^st century have been the newer members of the EU—and especially those where the reform process has been embraced enthusiastically.

The most recent enlargement was, of course, the most ambitious. But it followed a pattern. The ten new members were eager to join because of the opportunities that membership offered—the chance to benefit from trade growth, to share in the benefits that integration has brought the existing members of the Union and to benefit from resource transfers aimed at speeding the catch-up process. The EU is a large market, and it has a strong institutional framework and a well-developed infrastructure. Even the prospect of membership is enough to shape the ambitions and behavior of economic actors as they seek to position themselves to reap the benefits of increased economic interaction as rapidly as possible.

Yet again, the enlargement process has been relatively smooth. This is all the more remarkable when we think that even in the 1980s, anyone suggesting that the countries of Central and Eastern Europe would have been candidates for EU membership—let alone members—would have been ridiculed.

We are here tonight in the capital of the largest new entrant to the EU. This conference is focusing on capital and labor flows in a European Union stretching from West to East. Twenty years ago such a conference, here in Poland, would have been impossible, it would have been unthinkable, and it would have been irrelevant. Yet now the benefits that capital and labor flows can bring for all EU members, old and newer, is a topic of considerable interest: to economists and policymakers, of course, but also to firms and workers in the enlarged EU. Harnessing those benefits will be one of the important challenges going forward.

That the most recent enlargement took place so smoothly is a tribute to all concerned. Adjustments had to be made to the EU's system of governance, to ensure that it continued to function well with a membership of twenty five countries. But those adjustments pale in comparison with the adjustments that the accession countries had to undertake to be ready to join. It is a tribute to the governments of the new entrants that in little more than a decade so many formerly centrally planned economies were judged ready to join the EU.

So smooth has the process been that the scale and speed of the reforms tend to be overlooked. Making the transition from central planning to market economy was an undertaking without historical precedent. It is a sign of quite how much progress has been made that we nowadays tend to forget that. And the reforms needed went far beyond those strictly related to economic policy—they had to include governance, institutions, legal structures. Enormous institutional reforms have been undertaken in many of the new members in order to fulfill the eligibility criteria for membership.

Economic reforms had already started to bear fruit before accession in 2004. Look at the remarkably high growth rates of most new member states over the past few years. These countries largely shrugged off the cyclical downturn in the world economy in 2001-2002. And they have experienced more rapid growth than their Western European neighbors in recent years.

The prospect of EU membership provided a strong incentive for policymakers in the applicant countries—just as it is in the countries that still hope to join the EU in the future. The adjustment process may sometimes appear daunting, but the experience of earlier entrants has provided conclusive evidence that the economic reforms that EU membership requires are beneficial in and of themselves. EU accession and the trade and other opportunities that it brings is an additional benefit from economic reforms that would anyway make possible more rapid and sustained growth.

Looking ahead

We have now reached a critical juncture, however, when the EU—new members and older ones—needs to seize the opportunity afforded by the Doha round negotiations to ensure that the Union continues to be a dynamic force in the global economy.

The postwar multilateral framework has served Europe well. The benefits of European trade liberalization—both within the EU and externally, in the context of the GATT and WTO negotiations—have been enormous. Successive enlargements have succeeded in large part because new members have in most cases embraced economic reforms that both enabled them to maximize the gains of EU membership and at the same time positioned them to take advantage of the benefits of globalization.

Much of the long term success of the EU results from the underlying commitment to multilateral trade liberalization to which the founders attached so much importance.

The older members of the European Union prospered in very large part because of the rapid expansion of global trade which multilateral trade liberalization facilitated. It is important that the newer members have the chance to prosper in a similar fashion. They joined the EU at a time of unusually rapid global growth. An ambitious Doha round agreement that gives new impetus to the process of multilateral trade liberalization is vital to sustain the growth of world trade that will underpin future global growth. An agreement that is insufficiently ambitious will lead to slower world trade growth than we all want—and need—since it is trade growth that helps drive world GDP growth. More rapid global growth in turn makes further liberalization easier. What we need is the virtuous circle—growing world trade driving GDP growth that in turn drives trade liberalization—that a successful Doha outcome would produce.

The EU now comprises 25 countries and is thus better placed than ever to play a leading role in ensuring a successful outcome to the Doha round. All 25 members have a strong interest in a successful outcome—one that leads to further multilateral trade liberalization and which will thus act as a spur to growth both for the EU and the world as a whole. And by making a strong commitment to further liberalization in the context of the open multilateral trading system, the EU could exert considerable influence on developing country governments who have yet to appreciate the benefits of trade liberalization. Experience has shown that multilateral trade liberalization is a win-win situation—everybody has the chance to gain.

Conclusion

Let me conclude.

The ten new member countries—not quite so new as they approach the second anniversary of their accession—have joined a remarkably durable and successful Union. Over its almost fifty years, the EU has experienced rapid growth in real GDP and in trade both between its members and with the rest of the world.

This success owes much to the foundations on which it was built—above all the continuing commitment to union-wide and multilateral trade liberalization. Over its lifetime the Union has more than quadrupled the number of its members. Successive new entrants have, in general, been able to integrate rapidly and to reap the benefits of membership.

They have done so by embracing economic reforms that make possible sustained rapid growth and that foster enterprise and trade growth.

The ten countries that have joined most recently were well advanced in the reform process before they were admitted—indeed, it was a condition of membership. These countries all judged that the gains to be had from joining the EU far outweighed the costs of adjustment. They were right to make that judgment.

It is important to remember, though, that the economic reforms on which all ten countries had embarked offered significant gains even aside from EU membership. It is also important to remember that accession marked the beginning of the reform process, rather than its conclusion. In order to maximize the gains from EU membership, economic adjustment in an evolving world economy has to be a continuing process. Abandoning reforms prematurely, or letting the reform process stagnate will undermine the potential gains both from the reform process itself and from EU membership.

Thank you.