a sequential approach to regional integration: the european union and central and eastern europe

European Journal of

POLITICAL European Journal of Political Economy ECONOMY

Vol. 12 (1996) 581-598 ELSEVIER

A sequential approach to regional integration: The European Union and Central and Eastern

Europe

Philippe Martin *

Graduate Institute of lnternational Studies, 11 aoenue de la Paix, CH-1202 Geneva, Switzerland CEPII, Paris, France CEPR, London, UK

Received 15 October 1994; revised 15 May 1995; accepted 15 January 1996

Abstract

This paper develops a theory of optimal sequencing of regional integration and applies it to the specific question of Central and Eastern European countries (CEECs) and the EU. We show that the timing of transition and integration has implications for the long-term trade structure of Europe. In this model the interest to integrate the CEECs comes from harmonization of policies to attract industries. Without integration, European countries will try to inefficiently protect their industries. Because of the transfers implied by the CAP and the Structural Policies, the EU delays enlargement until the CEECs have sufficiently converged. CEECs might at this point prefer to stay outside the EU and attract industries by offering them more generous protection than the EU. Such timing may be inefficient ex ante for all countries because it may prevent full European integration in the long run, inducing firms to relocate outside of the EU and governments in the EU and the CEECs to inefficiently protect industry. During the transition, all countries benefit from regional integration among the CEECs.

JEL classification: F15; F14; F13

Keywords: Sequential integration; Central and Eastern Europe; Convergence

* E-mail: [email protected].

0176-2680/96/$15.00 Copyright © 1996 Elsevier Science B.V. All rights reserved. PH S0176-2680(96)00017- 1

582 P. Martin/European Journal of Political Economy 12 (1996) 581-598

I. Introduction

Recent moves towards regional integration in Europe have been characterized by their sequential nature: time has become a crucial dimension of regional integration. This is the case with multi-speed monetary unification, and the integration of Central and Eastern European Countries (the CEECs) to the EU: a core group of relatively rich countries decides to create an integrated area and denies immediate entry to the club to relatively poorer candidates because of the large costs implied. The poorer candidates are eager to enter very rapidly. In both cases, a common asymmetry characterizes the sequential approach to integration: the rich countries decide when to invite the poor countries to join the club and the poor countries can then only accept or refuse to enter.

In this paper, we extend previous work on optimal sequencing in the context of two-speed monetary unification in Europe (Martin, 1995). We develop a theory of sequential regional integration and apply it to the specific question of the CEECs integration to the EU to ask how the timing of integration, as described above, may affect the final outcome.

The main foreign policy objective of the governments in the CEECs has been to secure integration to the EU as early as possible. The largest countries, Poland, the Czech Republic and Hungary want to be full members by 2000 with negotiations starting by 1996. The question of integration of the former socialist countries in the EU will dominate the European trade and political agenda for the years to come. The reason is that the economic integration of Europe is viewed both by Western and Eastern Europeans not only in purely economic terms but also as an instrument for achieving political aims such as stability and peace. The question is not whether the CEECs will be invited to join but when.

The meeting of Copenhagen in June 1993 described the conditions for the enlargement (see Baldwin, 1994): "Membership requires that the candidate country has achieved .. . the existence of a functioning market economy as well as the capacity to cope with competitive pressure and market forces within the Union. . . The Union's capacity to absorb new members, while maintaining the momentum of European Integration, is also an important consideration. . ." . The last sentence refers implicitly to the main difficulty that is created by an Eastern EU enlargement and which will constitute the brake to such enlargement: that is, the budgetary effects. Baldwin argues that mainly because of the budgetary cost, " i t would be at least two decades before the leading CEECs can be full members without threatening incumbents' special interests".

The question we ask is whether the CEECs will have time to wait for so long, especially in the case where the main benefits for these countries from integration to the EU come during the long transition phase. In the model, the CEECs want to enter quickly because of the transfers implied by integration. These transfers decrease as the CEECs converge towards the economic and political structure of the EU members. We could as well have modelled the gains of integration for the

P. Martin/European Journal of Political Economy 12 (1996) 581-598 583

CEECs as 'political stability' ones or as gains coming from the faster economic transition from planned to market economies if the CEECs are integrated to the EU. The important point is that the gains of integration are the highest for the CEECs during the convergence or transition phase.

In this model, the long-run interest to integrate the CEECs comes from harmonization of policies to attract industries. Without integration, European countries, both EU ones and the CEECs, will try to inefficiently protect industries. This is because we assume that firms base their location decision on a comparison of protection and subsidies offered to them. Without integration, European countries end up in a suboptimal Nash equilibrium characterized by excessive subsidies and protection. Because of the transfer cost, a long waiting phase, during which the CEECs are not integrated to the EU, may appear as a first best strategy for the EU countries. However, if the EU delays entry until CEECs have sufficiently converged, CEECs might at this point prefer to stay outside and 'free-ride' on the liberal policies of the EU and attract industries by offering them more generous protection. Such timing may be ex-ante inefficient for all countries because it may prevent full European integration in the long run inducing firms to relocate outside of the EU and governments in the EU and the CEECs to inefficiently protect industry. It also implies that the CEECs have missed the gains of early integration.

Section 2 presents the economic model. Section 3 derives the Nash policies in the three possible institutional equilibria: (1) no integration between the EU and the CEECs; (2) regional integration among the CEECs; (3) enlargement of the EU to the CEECs. Section 4 analyzes the determinants of the political choice of regime for both sets of countries. Section 5 describes the case in which weak enforcement of industrial of policies by the CEECs inside the EU is the main reason to deny entry to the outsiders. Section 6 determines the optimal timing of integration and the tradeoff that exists between the necessity for convergence before integration and the danger of a free-rider problem if the waiting phase is too long.

2. The economic model

The model consists of three countries. There are two identical 'small ' CEECs (denoted CE 1 and CE 2) and the European Union (denoted EU) which we will treat as one large country. The size of each of the identical CEECs is 1 /2 and the size of the EU is a , so that the size of Europe is normalized to 1 + a. We will assume that a is more than 1 so that the EU is larger than the CEECs taken together.

We assume that a specific country can import output from the rest of Europe if it offers more generous subsidies and protection. Domestic and foreign firms, have an incentive to ask for import protection or /and subsidies as a condition to choose a particular location. Hence, the policy instrument will be trade barriers or subsidies. Governments will then compete by offering more generous protection to


potential investors. The subsidies can also take the form of lower taxes on profits and capital to attract foreign firms. Tax exemptions or tax holidays for newly installed firms are very common both in Eastern Europe and in the EU. They are especially important in regions facing high unemployment.

Hoekman and Mavroidis (1994) argue that even though competition laws of these countries tend to resemble the EU laws, "they leave great scope for discretion on the part of the enforcement authorities to interpret the relevant statutes". Hence, governments "may be willing to provide 'guaranteed' markets to inward investors, and do so in a way that conflicts with competition policy". Flassig (1993) notes: "Foreign companies participating in mergers often demand conditions for the establishment of joint venture that they would never dare to expect in their home countries". An example of such policy given by Hoekman and Mavroidis was the guarantee by the Czech government to Volkswagen (which acquired a large stake in Skoda) that import tariffs on cars would remain at 19 percent for at least four years.

An alternative interpretation of the model is that investors, domestic and foreign, have an incentive to ask for loose regulations regarding minimum wages, safety rules, unemployment insurance, social security, pollution standards, e tc . . . Imagine a multinational firm that has plants in the three countries and has to decide where to increase or decrease its labour demand and its production. This multinational will choose to increase labour demand and production relatively more in the country that has a lower level of regulations and lower level of labour cost i (for a given level of productivity). Hence, under this interpretation 'social dumping', which can take many forms, will be used to attract industries.

The important point behind these two interpretations is that an externality exists that induces governments to compete by overbidding (protection and subsidies) or underbidding (social regulations) each other. Integration, by standardizing these policy instruments removes such competition or output shifting policies by elimi- nating the possibility for governments to carry different policies. The supply functions, in per-capita terms, of the EU and of the two CEECs CE 1 and C E 2 a r e

characterized by the following equations which formalize the arguments described above:

1 1 ytZU = ptEU _ _pCE, _

2 ' 2

_pC ( l a )

i Hungary's labour costs (both wage and non-wage costs) which are significantly higher than in the rest of Central Europe, are still less than half those in Portugal, which has the cheapest in the EU. Non-wage costs, which may better reflect the component of the labor costs not determined by productivity levels but rather by policy choices, are also much lower in the CEECs than in the EU countries (see Business Central Europe, 1993).


(1 ) 1 yCE, = 2 + u pCE,_ ~ptCE2_ up?U, ( l b )

1 yCE2 = + U pCE2_ __pCE, _ 2 t uPt EU, ( l c )

where yj is the change in potential per-capita output and P/ is the level of protection in country i. Note first that we have chosen coefficients on the supply function such that protection does not have any impact on output for European countries as a group: 2 the policies used by the government are only shifting output. A more general setting, with a positively or negatively sloped curve at the European level, could have been assumed without changing the main results of this paper. The important idea behind the setting is that the potential tradeoff between output and industry protection is less favourable at the European level than perceived at the national level. This would be the case in any model where firms base their choice of location of production on international comparisons of industry protection.

The coefficient in front of the policy instruments reflect the size of the territory to which they apply: in Eq. (la), the size factor in front of pEtJ is 1 because the impact of an increase in pEU is tO attract firms from the CEECs which combined size is 1. In the same manner, in Eq. (lb), the size of the territory from which CE 1 can attract firms is: 1 /2 + a , that is the size of CE 2 and the EU combined.

The political loss function for the EU and the CEECs' policy makers are respectively:

= ~ f0 e-P'[(PtEU) + / 3 ( y E U - d ) Z l d t ' LEU fo e-" ' LEUdt = ~ 2 (2)

LcE= fo~e-PtLfEdt= foe-Pt[(ptCE)Z+ fl(yCE--dCtE)2]dt (3)

where p is the rate of time preference of the government, /3 is the relative weight that the government places on its two targets. The first target is an industrial protection target P. We assume that the government preferred level of industrial protection is zero because protection induces inefficiencies: protection creates non competitive market structures, inefficient resource allocation, and also induces rent seeking. Subsidies (through tax cuts or tax holidays) thus have economic and political costs. They may also induce an increase of the budget deficit or an increase of taxation of other economic activities or agents.

The second target is a target for actual per-capita output. We assume that it

2 One can check that the change in potential per-capita output at the European level is: ayffV+ ( yt ce~ + yCEz)/2 and equal to zero.


depends on the level of distortions which are higher in the CEECs than in the EU but converge to the EU level. Distortions could be due to missing or malfunction- ing markets and a structure of the economy that does not represent yet the preferences and factor endowments of the economy. Obviously, what matters for political support is not potential output per se but actual output, i.e. potential output minus the level of distortions. Moreover, I assume that dt cE, the level of distortions in the CEECs converges to d, the level of distortions in the EU and is not influenced by government policies:

dtcE = d + d~ E = d + d0CEe - ut (4)

where /x is the speed of convergence of economic distortions in the CEECs. Remember that the target for output is also a target for industrial location as

national output can be increased by attracting firms. Industrial relocation may have important redistributive consequences so that the political costs for policy makers may be much more important than the purely economic cost of relocation. For example, the increase in the unemployment problem has made trade unions and policy makers particularly sensitive to 'social dumping'. In a widely reported case, the United Kingdom was accused of 'social dumping' when Hoover decided to replace its Dijon plant of vacuum cleaners with a new plant in Glasgow in January 1993. This example shows that even though the economic cost to France and the economic benefit to the United Kingdom may not have been very important, the political implications of this particular relocation were significant. In general, the political implications of industrial relocations can be thought of as much larger than their purely economic consequences. Hence, we can think of /3 as measuring the relative importance of the political costs of relocation of firms outside the country.

3. Endogenous policy choice

There are two games in the model. The first one concerns policies over the level of protection. This game depends only on the institutional structure of Europe (known at the beginning of each period t). The second game concerns the institutional structure itself and involves the decision of whether and when to invite CEECs to join the EU and for CEECs whether to accept this invitation. Also, CEECs are faced with the possibility to create their own economic union. This section describes the Nash equilibria of the first game for each institutional structure.

3.1. The equilibrium without integration

It is assumed that each government perfectly controls the level of protection Pt. The game is identical in each period and the optimal policies in period t only

P. Martin~European Journal of Political Economy 12 (1996) 581-598 587

depend on the institutional structure at the beginning of period t. We assume that trigger strategies are not possible.

The problem of the government of country i is to minimize its instantaneous loss function with respect to P/ taking as given the level of regulations P/ of countries j v~ i.

Solving for the reaction functions, the optimal levels of regulations are:

p Eu NI t = / 3

p C I E = /3

l + / 3 ( a + l / 2 ) ( l + a ) / 3 2 ( a + 1 / 2 ) d + d~ E ,

1 + / 3 + a / 3 ( a + 1 /2) 1 +/3 + a/3(o~+ 1 /2)

( a + l / 2 ) ( l + / 3 + a / 3 ) / 3 ( 1 + / 3 ) ( a + 1 / 2 ) ;CE

1 + / 3 + c~/3(a+ 1 /2) dt '

d + 1 + / 3 + a / 3 ( a + 1/2)

(5)

where NI stands for No Integration. From Eq. (5), it can be seen that the level of protection in the CEECs will be more than in the EU. This is for two reasons. The first is that the level of distortions is higher in the CEECs than in the EU. Hence, the virtual political gain of increasing protection will be higher in the CEECs than in the EU. Another way to say this is that the optimal tradeoff between output and inefficiencies induced by protection is different in the EU and the CEECs. Second, because CEECs are small relative to the EU the potential per capita output gain of increasing the level of protection is higher in the CEECs than in the EU.

The per-capita output-change in the EU, which is also the transfer of output from the EU to the CEECs in per capita terms is equal to

EU __ p EU _ _ p CE y N L - - NI t N i t

oz - 1 /2 /3( a + 1 /2) d - d~t E

l + /3 + a/3( a + l / 2 ) l + /3 + a/3( a + l / 2 )

1 CE

- - - - - - Y N I , " ( 6 ) O~

3.2. Regional integration among the CEECs

The second institutional equilibrium that we want to study is one where the two CEECs create their own integrated economic area. In this case, the level of protection is identical in the two CEECs but need not be the same than in the EU. In this case, the supply functions become:

yEU = pEU CE. CE = ot[pCE _ peU'~ RI t - - PRI,, YRI, I, RI, RI, 1, (7)

588 P. Martin~European Journal of Political Economy 12 (1996) 581-598

where RI stands for Regional Integration. Deriving the reaction functions of the three countries and solving for equilibrium, we get the following optimal policies:

1 + + pSU =/S d +

1 + / 3 + ~/3 1+/3 pCE =Ct f l d + a f l ce2 d~E__

RI, 1 + f l + o¢2fl l + f l +

(8)

We derive the respective per-capita output levels which are also equal to the per-capita transfers of output:

fl(1 - c~) or/3 a2fl d~E 1 CE yEIU = pEU -- pCE = -- --YRI," (9) RI, Rb 1 + f l + a 2 f l d 1 + / 3 + ol

Hence, the output change is positive in the CEECs and negative in the EU because of the output transfer from the EU to the CEECs. From the above equations it can be seen that the optimal level of protection decreases both in Eastern and Western Europe with the regional integration among the CEECs. This is because with economic integration among the CEECs, these countries cooperate on their industrial and trade policies and do not compete any more against each other to try to import industries trough overbidding the level of protection in the neighbour country. This implies that part of the externality is internalized through the process of integration among the CEECs. Because the CEECs optimally lower their protection level, this triggers a similar move by the EU. However, it can be shown that the difference in protection levels between the CEECs and the EU countries decreases with regional integration among the CEECs. This is why output increases in the EU and decreases in the CEECs.

3.3. The CEECs integrated to the EU

In this case, the industrial and trade policies have to be identical in the whole integrated area. The supply function is affected and does not depend any more on the chosen level of regulations. With full integration lowering regulations cannot any more be used to compete over industries. If we had assumed that at the European level, the supply function was not vertical but that there is a tradeoff between regulations and output, then another dimension of the problem would be added because it would create inside the EU a conflict between the original EU members and the new members. The optimal tradeoff would be different between the Western countries and CEECs because of the high level of distortions existing in the CEECs. In our specification, full integration then implies that the optimal level of regulations is decreased to zero which is the efficient level.

However, this is not the end of the story because integration also entails


important transfers from the Western countries to the CEECs. These transfers are linked to the regional policies of the EU. We assume that the transfers are directly proportional to the difference in the level of distortions between the CEECs and the EU and converge to zero as the CEECs converge to the EU economic structure. Also, the amount of transfers is proportional to the size of the CEECs. The total per-capita transfer from the EU to the CEECs taken together is

r, : vd " (10)

where 3' is a positive number. 3 We assume that the transfer comes as additional output to the CEECs and is

subtracted from output in Western Europe. Hence, taking into account the relative size of countries, the changes in potential per-capita output become

= - - - - d t ; Y l , = y d , . ylEtU Y ~E CE ,"CE ( 1 1) O/

Certainly, regional transfers are not the only gains of the CEECs from integration to the EU. Other gains, such as liberalization, efficiency, political gains . . . (see Baldwin, 1994) will exist. However, the important point is that with convergence, these gains may decrease, relatively to the free-rider incentive. This would be the case for political gains that are often cited as the main reason why the CEECs want an early integration. These countries see integration to the EU as a way to insure political stability, continuation of reforms and help the convergence process. By nature, these gains will be the highest the earlier the integration to the EU.

4. The political choice of the institutional regime

The structure of the game played between the EU and the CEECs over the choice of the institutional arrangement is asymmetric. The EU countries decide if and when to admit the CEECs, but they cannot force them to enter. The CEECs only choice is between accepting and refusing the invitation to enter once it is made. However, once they are in, the CEECs cannot leave the EU. This is the way we characterize the integration process in Europe.

3 Note that y has a natural upper bound, y will be assumed to be less than 1, since 3' = 1 would imply that all the output effect of the distortions specific to the CEECs are compensated by the transfers.


We now examine the costs and benefits for all countries of the three possible equilibria. Without integration the policy makers' loss levels are:

[1 + f l ( c ~ + l / 2 ) ( 1 + c e ) ] d + / 3 ( a + 1 / 2 ) , ~ E 2 L~t~, = [3(1 + 13 ) 1 +/3 + a f l ( a ~ 1 / - 2 i '

ECE,=/3[1 +/3(c~+ 1/2) 2] (1 +/3+o~/3)d+(11 + f l + a / 3 ( t ~ + + / 3 ) d ~ E ] 2 ' 1 / / 2 )

(12)

With regional integration among the CEECs, they become:

(1 + a/3 + c~2/3)d + oLfldqL't E ]2, LEIU,=fl(1+/3) l + f l + a z f l

1 (13)

ECRE, = fl ( l + a Zfl ) [ ( l + fl + a fl ) d + ( l + /3 ) d~t E ] 2 fl + c~ zfl

We first want to show that the equilibrium with regional integration dominates the equilibrium without. This is true both for the EU and the CEECs.

The EU gains from the CEECs integration are twofold. First, the level of protection in the EU is decreased. Second, output increases because the net transfer of output to the CEECs is lowered: there is relocation of firms from the CEECs to the initial EU countries as the differential in terms of protection decreases. This can be checked by comparing the level of output in Eqs. (8) and (12). Hence, for the EU policy makers, regional integration among the CEECs is unambiguously improving their political support.

For the CEECs, this is not so obvious because of the decrease in the level of output that is implied by the move. However, it is easy to show that the loss for the CEECs is larger in Eq. (12) than in Eq. (13). This is because the loss in output is, in terms of political support, more than compensated by the decrease in protection. Without regional integration, the two CEECs were attempting to import output from each other. In equilibrium however, this was useless because the two countries being identical no actual transfer could occur. Protection was too high given the optimal tradeoff between output and protection. Integration in the CEECs removes inefficient and useless competition between CEECs. This inefficient competition between CEECs had a negative side effect on the EU because the low level of regulations implied some transfers of output to the CEECs. This side effect of competition among CEECs is removed with integration in the East. Hence, a normative implication of this analysis is that the EU should encourage integration among CEECs. It plays the role of an imperfect substitute to full cooperation with these countries on regulations setting, without the transfers

P. Martin~European Journal of Political Economy 12 (1996) 581-598 591

implied by integration in the EU. Hence, this constitutes a compromise for all countries and a viable institutional setting during the waiting period until integration in the EU. 4

As regional integration among the CEECs is beneficial for all, policymakers should be interested in encouraging it. There is an important element (not modelled here) that could make this scenario difficult in practice: competition among the CEECs to enter first. Nothing obliges the EU to integrate the CEECs as a group. In fact, it would seem rational for the EU to integrate first countries which converge faster because they would impose a lower cost. Also, if integration of poorer countries is costly because of the transfers implied, then reducing their number also reduces the cost of enlargement. However, if the CEECs form an integrated area with institutions of their own, it will be much more difficult to integrate them separately. Anticipating this scenario, some CEECs may refuse to join a Central and Eastern European integrated area, in the hope of integrating the EU first. Uncertainty on the form and timing of integration to the EU may therefore make cooperation among the CEECs more difficult. If this cooperation is important to the EU countries, and the model suggests the reasons why it will be, then the EU should commit to a credible calendar and define the groups of countries that would be integrated together. Otherwise, it may foster competition among the CEECs which is detrimental to all countries if it makes integration among the CEECs impossible during the transition phase.

In the rest of the paper we will abstract from this important problem and since both sets of countries have interest to push for the CEECs to cooperate, we will focus on the comparison of the equilibrium with the CEECs integration and the equilibrium where the CEECs are integrated to the EU.

When the CEECs join the EU, the loss levels in terms political support are equal to

L ,u ( -- dVEI 2 [d (1 2 I, = /3 d + ce , ] , ~, = /3 + - (14)

Comparing the levels given in Eqs. (13) and (14), we can analyze the determinants of the institutional choice in the model. The EU will refuse entry to the CEECs if y is large enough implying that the level of transfer is important. 5 Given this, a large level of initial distortion will increase the cost of early entry because the transfer is proportional to the difference in distortions between the two

4 See Baldwin (1992) who advocates the integration of the CEECs into EFTA. 5 For the Common Agricultural Policy (CAP), Anderson and Tyers (1993) estimate that allowing the

Visegrad-4 (Hungary, the Czech Republic, Slovakia and Poland) access to CAP would more than double present CAP spending. Begg (in Baldwin et al., 1992) and Baldwin (1994) estimates of the budgetary costs are respectively 8 and 11 billion ECUs.


sets of countries. Finally, early entry of the CEECs will be refused if d is sufficiently small because this determines the extent of firm relocation due to higher protection in the CEECs when they are not integrated in the EU. For the EU to refuse entry to the CEECs, a necessary condition must then be that the transfers implied by integration are greater than the loss of output implied by firm relocation in the no integration equilibrium. Hence, the way we characterize these transfers is very simple and does not allow for any bargaining. Certainly, on purely game theoretical grounds, 3/ should not be exogenous but should be bargained over during the negotiation on integration. However, as argued by Baldwin et al. (1992) in, the transfers, mainly the structural funds and the CAP, are largely determined by the level of per capita incomes and the importance of the agricultural sector. One could theoretically argue for early entry of the CEECs without any transfer or with a much lower levels of transfer than those implied by the current practice. Baldwin et al. (1992) argue however that such a possibility would be vetoed by the current main beneficiaries of the policy, that is, Portugal, Ireland, Greece and Spain. Entry without transfers for the CEECs would under- mine the case of these countries to receive their current transfers as they are richer than the CEECs (with the possible exception of Slovenia).

If 3' is large enough, then a large difference in distortion levels between the two sets of countries will make early entry very attractive to the CEECs because of the implied transfers. However, if 3' is not large enough then CEECs may prefer to stay outside because they can, with low levels of regulations, import output to compensate for these distortions. 6 If not integrated in the EU, and given the level of their distortions, the CEECs will not try to mimic trade and industrial policies of the EU.

In the long term, when d~ E and therefore the transfer approaches zero, it can easily be shown that EU policy makers will prefer with the CEECs inside rather than outside. This is because, when transfers approach 0, integration implies for the EU a higher level of output (no relocation is possible as the level of regulations is equal in all European countries) and a lower level of protection.

In the long term, when the CEECs have converged, that is when d~ E is equal to zero and transfers are themselves approaching zero, the CEECs may be tempted to stay outside of the EU if they can import output from the EU with a policy of generous protection. This will be the case in particular if a is large enough. A necessary condition is that /3 is smaller than 1. This last condition says that the inefficiency created at the European level by protection must not be too high for this free-rider problem to arise. The importance of output relative to inefficiencies

6 If the supply function was not vertical at the European level, an additional conflict would emerge in the EU between the CEECs and the rest of the union. Given the high level of distortions remaining in the CEECs, these countries would want a lower level of regulations. Depending on their political weight in decision making, the CEECs would not obtain their optimal level of regulations.


created by protection, as measured by /3, determines how much countries will attempt to overbid each other to attract employment and therefore determines the extent of the inefficiency created by such politically motivated non-cooperative behaviour.

5. The case of weak enforcement

Until here we have considered that once in the EU, the CEECs would change their legislation to have the same protection level than the EU. We have also assumed that the legislation would be enforced. However, experience in the existing EU shows that enactment and enforcement are two different things and that some European countries, in particular the ones which are believed to have the highest levels of economic distortions, have weak enforcement of EU legislation. This might come from a weak administration or /and from a deliberate policy. It is a well known fact that certain trade barriers can be erected without resorting to any legal framework. In the context of our model, weak enforcement, if possible (that is in particular if a central European authority does not punish the country that deviates), would come naturally as a deliberate policy. What would weak enforcement imply in our context? Even though countries could freely choose the level of protection in this case, the equilibrium would still be different from the one without integration because of the presence of transfers which change the tradeoff between high protection and output. These, in turn, would modify the optimal enforcement policy. Deriving the optimal 'actual' policies in this case, we get:

pEU 1 + °*/3 + °12/3 /3( y + ce2/3 ) d"CE It = J~ -1-~--~'--~-Og-~ d--~ o~(1 + / 3 + ~ - ~ 3 ) - ' '

pCE = C~/3 1 + /3+ a/3 1_+~-- Y d~CE (15)

where Pt now stands for the actual level of protection, that is the level of protection actually enforced.

Hence, in this case the level of protection, actually enforced, increases in the EU after the CEECs integration. This is because the transfers to the CEECs modifies the tradeoff between high protection and output and the EU is trying to compensate the transfer loss by higher protection. The CEECs will in this case decrease the actual level of their protection (even though nothing obliges them to) because the transfers change the optimal tradeoff for them too but in the opposite direction than for the Western European countries.

If this is partly what the EU anticipates will happen, then the reason why it refuses early entry to the CEECs is obvious as in this case, the EU has higher


protection and looses output. It can be shown that the loss due the transfer is larger than the gain, in terms of industry relocation, due to the diminution in the difference of protection between the EU and the CEECs. For the CEECs, this is all gain both in terms of output and protection. The way we characterize the weak enforcement possibility is certainly too extreme. Indeed, in this case, the EU would never have any interest to integrate the CEECs as there would be no efficiency gain from it. The reality is certainly less dark. If enforcement improves with time in the CEECs, then this problem can also explain why early entry is refused. However, as concern over weak enforcement may partly explain the EU position, we think it is helpful to keep this problem in mind. In the rest of the paper we will return to the case where policies announced are actually enforced.

6. Convergence and the timing of integration

The EU will favour a high degree of convergence because this allows them to integrate the CEECs with a minimum short-term cost. However, a high degree of convergence at the time when the CEECs are invited to join the EU may induce one or more of these countries to free-ride on the EU.

To examine a realistic situation we assume that convergence today is not sufficient for the EU countries to accept immediately the CEECs. Also, we assume that today the CEECs are willing to enter the EU. From Section 4, we know that these two assumptions imply that the transfers are important, that is, that the level of distortions in the CEECs today, d~0 E, is high, and that the transfer policy as measured by 3' is generous. The integration of the CEECs is so costly for the EU that the advantages of full integration (the absence of industrial relocation to the CEECs) is outweighed by its costs (the transfer cost to the CEECs). Beginning at time 0, the optimal institutional equilibrium for the EU countries is to exclude the CEECs. The policy makers of the EU are left with a question of timing: when should they invite the CEECs? Their first best strategy is to minimize their political loss function over an infinite horizon and choose T, the time at which they will invite the CEECs, accordingly. From 0 to T, the EU excludes the CEECs. After T, the EU includes all European countries. Hence, their problem is:

Min fore °'LE~,dt + f:e-°'L~dt (16)

with respect to T and T > 0.

This problem is the same as choosing T such that, at T, the political loss levels with and without integration of the CEECs are equal:

L~I v, = L~ o at t = T. (17)

P. Martin i/European Journal of Political Economy 12 (1996) 581-598 595

This equation in T has two solutions. However, since we have assumed that at time 0, the EU refuses entry to the CEECs and since we know that in the long term the EU countries are better off with the CEECs inside rather than outside, this implies that only one optimal positive T exists. It can be shown that T depends on the same factors as those explained in Section 4. T will be high if d~0 E, the initial level of distortion is high, if % the measure of the generosity of the transfer policy is high and if d, the level of distortion in the EU to which the CEECs converge is low. The intuition is the same as in Section 4. In addition, T will be larger the lower the convergence speed /z of the CEECs is, as it determines the speed at which the transfers decrease.

The EU countries must also take into account the optimal strategy of the CEECs. These countries only choice is whether to join or not the EU once the offer to enter has been made. When deciding over their best strategy, the CEECs take into account that if they accept to enter the EU, this constitutes an irrevocable choice. On the contrary, if they do not accept the invitation to enter at a certain period, they can always accept it latter. We define T* as the date at which the CEECs are indifferent between joining the EU and staying outside. Hence, T* solves the following equality:

f;;e-P'LC~dt = f;;e-P'LC~dt. (18)

Again, this equation has two solutions in T*. We have assumed that the CEECs are willing to enter at t = 0. Hence, if in the long term, that is when the CEECs have fully converged, the CEECs have an incentive to free-ride to take advantage of their relative small size to overbid the EU protection policy and attract industries, we know that there is a unique positive T ~ after which the CEECs are not willing any more to accept an invitation to enter. It can be shown that T * depends negatively on d~0 E, T, and /~. Again, the intuition is derived from Section 4. If on the contrary, the CEECs do not have an interest to free-ride in the long term, then there may be two positive T * that solve this equation. In this case, this would mean that an interim period exists during which the CEECs will refuse to enter if invited.

Even though the EU sets the calendar, this shows that it must take into account the optimal strategy of the CEECs when choosing the optimal time of entry of the CEECs. If the CEECs do not have any interest to free-ride in the long term, then the EU policy makers may attain their first best, that is integrate the CEECs after a long waiting period. However, if an interim period exists during which the CEECs refuse to enter, and if T happens to be during this period, the EU may want to advance the invitation date so as not to wait until the second date.

More important and interesting would be the situation if the CEECs have a long-run advantage to free-ride on the EU.

If T * > T, then the EU countries can achieve their first best. They will invite the CEECs when it is the most suitable for them.


If T * < T, then the free-rider problem has to be taken into account by the EU countries. 7 Otherwise, all European countries might, in the long term, be in a situation of incomplete integration, which, ex-ante, is not optimal for any of the countries. The only way for the EU countries to solve the free-rider problem is to accept to integrate the CEECs at a lower level of convergence, that is at a higher cost for them, just before the period T* when the CEECs have an incentive to free-ride. Hence, solving the long-run free-rider problem obliges them to soften their requirement for convergence. They will do so if solving the free-rider problem gives them a higher level of political support than having a partially integrated Europe forever, that is if

If this condition is satisfied, the free-rider incentive dictates the optimal timing of enlargement. It can be shown that this condition will be satisfied in particular for low discount rates.

These results imply that it would be dangerous to consider the timing of the CEECs integration to the EU as a way for Western European countries to achieve their first best. Waiting until the CEECs have sufficiently converged so that their entry imposes minimum costs may be a risky strategy. The timing of enlargement to the CEECs should not be based only on a narrow calculation of static costs and benefits for EU countries only. It should also take into account the incentives of the CEECs. Otherwise this could produce an inefficient equilibrium for both the EU countries and the CEECs, because a fully integrated Europe would never emerge. In this case, Europe would be characterized by suboptimally high levels of protection, both in the CEECs and in the EU countries. The CEECs having even higher levels of protection than the EU, industry relocation to the CEECs would take place, which would harm the EU countries. It also implies that the CEECs would miss the gains of early integration. The timing of transition and integration of the CEECs is not only a matter of when these countries join the EU but has implications for the long-term institutional, political and trade structure of Europe.

This also suggests that if policymakers in the EU countries are uncertain of the CEECs incentives (for example because the speed of convergence of the economy, the distortions levels are themselves uncertain), then they should err towards requiring less rather than more convergence. Under uncertainty, miscalculations neglecting the free-rider problem might endanger the whole process of trade integration in Europe.

7 This situation, the most interesting, arises in the following numerical example: d o = I0, d= 0.1; p = 0.01, /3 = 0.05; /z = 1 ; o~ = 3; y = 0.9. For these parameters, T = 4.53 and T * = 3.44.


7. Conclusion

Sequential regional integration is a characteristic of recent moves to further integration in Europe, in the monetary domain with multi-speed monetary integration, and in the trade domain with the enlargement to the CEECs. This paper has shown that sequential regional integration carries a danger. Members of the Union have an incentive to delay enlargement to new members until these countries have sufficiently converged so that they do not impose a too heavy cost. However, during the convergence phase some of the gains from integration may decrease and a free-rider gain may emerge, so that when the invitation comes it is refused. This is so even though ex-ante all countries gain from regional integration. Hence, sequential integration should not be considered as a way for the 'insiders' to achieve their first best by excluding the 'outsiders' until there is a gain to admit them. This is also an example in which the way transition is conducted has crucial consequences for the long-term institutional shape of the trade regime in Europe. Delaying entry because the CEECs have not sufficiently converged may lead to an equilibrium where convergence in terms of industrial, fiscal or social policies can never occur. 8 Softening some criteria for enlargement may have important short-term costs but may preserve from a situation where Europe would never be fully integrated.

Finally, another important result of the paper is that during the transition phase, both the EU countries and the CEECs benefit from regional integration among the CEECs. It can be thought of as an imperfect substitute to immediate enlargement. This is because it removes inefficient competition on policies to attract firms between the CEECs. As this competition has a side negative effect on the EU, removing it is beneficiary to all countries. Hence, cooperation between the CEECs should be encouraged during the transition. However, the present uncertainty on the timetable of integration gives the impression that the CEECs can and should compete against each other to enter first. Our model suggests that this may hurt both the CEECs and the EU.

Acknowledgements

I thank two anonymous referees and Heinrich Ursprung for helpful comments.

8 Martin and Ottaviano (1995) show that multi-speed integration may also induce geographical divergence in terms of industrial patterns if agglomeration forces are strong.


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a sequential approach to regional integration: the european union and central and eastern europe

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