The economic relations between the European Union and the United States (ARI)

The economic relations between the European Union and the United States (ARI)

Theme: The EU and the US are the world’s two most important economic blocs. This ARI examines their economic relations.[1]

Summary: This ARI examines the economic ties between the EU and the US in light of the weight that each holds in the world economy. It focuses on the process of establishing a transatlantic economic partnership, the future of the World Trade Organisation’s Doha Round, macroeconomic and exchange-rate prospects and the reform of the system of global economic governance.

Analysis: Although the rise of the emerging economies and the new energy nationalism of some hydrocarbon exporters is slowly changing international economic relations, the EU and the US are still the two main players in the world economy. In 2007 their combined production totalled more than €23 trillion (the EU-27 surpassed the US by €2 trillion), an amount which accounts for more than 60% of world GDP (slightly more than 40% if measured in terms of purchasing power parity rather than market exchange rates). Furthermore, the two regions are responsible for 60% of world trade, account for 75% of the world’s direct foreign investment, have a majority of votes in international financial institutions such as the International Monetary Fund and the World Bank, possess the world’s only two international reserve currencies (the US dollar and the euro), have almost absolute decision-making power in the G-8 and a very significant weight within the World Trade Organisation.

All in all, even though growth in certain developing countries is forcing the EU and the US to yield some power in the world economy, both continue to wield incomparable influence. They have been the driving force behind globalisation and continue to set the rules for it, their economies are on the cutting edge of technological and financial innovation and the economic interdependence between the two blocs is the closest in the world.

For all of these reasons, the future of the global economy depends to a large extent on how these two large blocs behave, both in their bilateral relationship and in their roles as players in international organisations. Therefore, in this paper we analyse these elements, focusing on the process of establishing a transatlantic economic partnership, the future of the World Trade Organisation’s Doha Round, macroeconomic and exchange-rate prospects and the reform of the system of global economic governance.

Trade and Investment: The Transatlantic Economic Partnership Process and the Future of the Doha Round
Economic ties between the EU and the US are the most intense of any on earth. Although this tight link was forged during the Cold War, the current era of globalisation which began in the 1980s has intensified both commercial exchanges and capital flows, even integrating markets that until a few decades ago were closed to the outside world. Thus trade between the two regions is practically deregulated in manufactured goods (tariffs have been below 4% for decades) and the degree of integration in markets for high value-added services (banking and financial services, insurance, consulting, telecommunications, etc.), although incomplete, is the highest in the world between two economic blocs. Underlying this tremendous intensity of trade (with a value of around US$400 billion a year) are high levels of cross-investments: 75% of the EU’s direct foreign investment goes to the US, which in turn sends 60% of its direct foreign investment to the EU. The transatlantic economy totals €2.9 trillion and covers practically all markets for goods and services (although important protectionist measures remain in place for agricultural products in the form of tariffs and subsidies, agriculture accounts for less than 10% of GDP in both blocs).

In general, the transatlantic economic relationship is free of conflict, even when governments on either side of the ocean clash for non-economic reasons, and there is no reason to expect this is going to change in the future. Besides specific disputes over steel, civil aviation (Boeing vs. Airbus) or certain foodstuffs such as genetically-modified meat or bananas, economic ties are smooth, conflicts are not usually aired publicly and very rarely are they taken before the WTO. This is because both blocs have open and liberalised economies and commercial interests that coincide (or are at least compatible), which is not the case with the developing economies.

However, the degree of transatlantic economic integration is far from complete. In other words, there is no single market with free movement of goods, services and production factors. Non-tariff barriers remain in place because each bloc maintains its capacity to regulate areas such as intellectual property, tax policy, immigration, laws governing the workplace, accounting and finances, or policies on competition, energy and the environment. This lack of harmonisation in economy-related legislation and in institutions in both blocs stems from the fact that the European and US economic models are different due to differing values and preferences among their citizens. The laws and institutions in each bloc reflect domestic electoral demands and how each has evolved historically, and sometimes they hinder economic integration.

Until a few years ago, the existence of these barriers –which raise transaction costs and reduce economic efficiency but serve to preserve institutional sovereignty and the most deeply-rooted social values– had not been called into question. It was taken for granted that economic integration would not be complete, because in this way a significant social toll could be averted. Therefore, no effort was made to ease these barriers, which for some constituted an unjustifiable ‘economic nationalism’ and for others a legitimate way to preserve national identity and sovereignty.

But the fast pace of global economic integration, the rise of emerging economies such as China and India, the difficulties in concluding the Doha Round of world trade talks and the perceived loss of competitiveness and market share in sectors that were traditionally dominated by advanced countries have led to a resurrection of the idea of a transatlantic economic partnership –one that would enhance bi-regional economic integration in order to boost the two blocs’ growth potential and strengthen their companies–. The project drew much media attention because it was endorsed by the German Chancellor Angela Merkel when her country held the EU’s rotating presidency and that of the G8 in 2007 (after Merkel visited the US President George W. Bush in January, the US Senate agreed to consider the proposal).

Although there are several versions of this partnership project, the main goal is to establish a free-trade area and a single market, and move forward in harmonising national regulatory frameworks in order to reduce transaction costs and uncertainty, strengthen legal security and enhance the efficiency and competitiveness of exports. In order to achieve this, the idea is to eliminate all tariffs (including agricultural tariffs), liberalise capital markets completely and tackle non-tariff trade barriers by establishing common institutions and regulations. This harmonisation would affect overall regulation as well as rules in specific areas (one proposal is to start with the financial sector, telecommunications, pharmaceuticals, aviation and automobile manufacturing). This would require drawing up common rules on technical and public health-related barriers to trade, intellectual property, competition policy (government aid, subsidies, behaviour that hinders competition, etc.), mutual recognition of professional services and accounting practices and the regulation of financial markets as well as the creation of joint incentives to boost investment in innovation, with special attention to the energy sectors and nanotechnology (immigration policy would be the next step, but naturally it has not yet been mentioned).

The most optimistic estimates are that total integration could increase joint GDP by 2%-3%, both through increased trade flows and, above all, greater efficiency and lower capital costs as a result of financial integration.

However, it is not very realistic to believe this project is going to get off the ground. Although the political confrontation over the war in Iraq has been left behind, neither of the two blocs is prepared to adjust its standards to those of the other, and mutual recognition is too problematic (even in the EU, after 50 years of integration, many of these markets remain fragmented). Furthermore, there is no social consensus for advancing with an agenda that would mainly benefit certain lobby groups (which are the forces behind the initiative) and over the short term would entail a productive restructuring and job losses that would be difficult to digest politically. Therefore, although it would be important to make progress in the least controversial areas, especially with regard to lowering tariff duties, the integration of financial markets, liberalisation and increasing competition, the harmonisation aspects will be difficult to address for now.

What is more –and this is the most problematic issue when it comes to developing countries and the WTO– even though the transatlantic trade area does not seek to be a closed bloc, it does foresee establishing minimum standards on labour, environmental, health and technical issues that goods and services produced outside the transatlantic bloc would have to meet. This would be easy for other rich countries but hard for poor ones. Given the enormous weight of the US and the EU, it would amount to forcing developing countries to harmonise their standards with those of rich countries. The developing nations have opposed this systematically at the WTO because it would sap their autonomy to decide their own industrial policy, eat away at their sovereignty and be very costly to implement. All in all, creating such a bloc could have an adverse effect on the WTO: the emerging countries would feel that the world’s two main economies are turning their backs on the only multilateral forum in which they have a greater negotiating clout.

This leads us to consider the prospects for the Doha Round, which has an agenda that is less ambitious than that of transatlantic integration but is more realistic and relevant from a political point of view for the sustainability and legitimacy of globalisation.

Right now the round is deadlocked. In July 2007, President Bush lost the so-called fast-track authority that allowed him to negotiate trade accords that US lawmakers would have to vote on without introducing amendments. The talks failed to seal a deal because once again, the European and American offers of liberalisation in agriculture did not satisfy the developing countries, which, at the same time refused to lower their tariffs on manufactured goods from rich countries.

Although this setback poses a problem for the consolidation of a multilateral regime of trade based on transparent, predictable rules, it is important not to overdramatise the crisis. The collapse of the negotiations will not raise the level of protectionism over the short term because many of the tariffs that countries apply are below the ceilings permitted by the WTO (another issue altogether is the fact that farm subsidies and high tariff duties for ‘sensitive products’ in wealthy nations will not come down for the time being). What is more, all WTO rules remain in force, its conflict-resolution system works effectively and growth in world trade continues to outpace GDP growth, especially in services.

In the end, the danger lies in the possibility of the breakdown in talks leading to a series of bilateral and regional accords that are discriminatory and undermine the system of governance of world trade. Indeed, it is the US and the EU which must resist the temptation to move forward with this kind of accord and go back to supporting multilateralism, besides liberalising their markets unilaterally whenever it is politically feasible. The agreement the US signed with South Korea a few months ago, the transatlantic partnership project discussed earlier in this article and the many sets of bilateral talks held with countries of Latin America and Asia weaken the effectiveness and credibility of the WTO as far as the emerging countries are concerned, and block progress in the Doha Round.

In any case, it is unlikely we will see progress in the Round in 2008. President Bush is lacking leadership and has little interest in trade issues, and the US Congress, in which Democrats have regained control, is becoming more and more protectionist, especially because of the problem with the growing bilateral trade deficit with China. The Round might resume in 2008 if the next President obtains fresh fast-track authority from Congress. If this occurs, if the EU becomes more willing to lower tariffs on farm goods and an economic slowdown is averted in the OECD countries (which, were it to occur, would heighten neo-protectionist feelings), the Round might get back on track and conclude around 2010 with an agreement in which the wealthy countries yielded on agriculture and the emerging ones on services and tariffs on manufactured goods. Seen from a historical perspective, concluding the Doha Round in nine years should not be considered a failure: the Uruguay Round took eight years and it was negotiated by 120 countries, 30 fewer than the current members of the WTO.

Macroeconomic and Exchange-rate Issues, and Global Financial Governance
Beyond the high degree of volatility of the global financial markets and the macroeconomic turbulence stemming from the US sub-prime mortgage crisis that began in the summer of 2007, a global economic recession is unlikely. Although it is difficult to predict the impact of this mini financial panic, a deceleration is expected in the US, with GDP growth of under 2% for the first time since 2001 and with inflationary pressures as well. Meanwhile, the euro-zone economy, which the mortgage crisis should not affect in such a direct way, should see growth of up to 3% (somewhat higher for the EU as a whole) with inflation below 2%. Furthermore, world economic growth is forecast to remain above 4% thanks to the strength of the emerging economies, as long as there are no new surprises in the energy and financial markets.

Therefore, barring unexpected events, in 2007 the European economy will have grown faster than the American economy, something that has not happened for years. At the same time, and although it is impossible to make predictions about exchange rates over the short term, the US dollar should continue to depreciate with respect to the euro over the medium and long term for several structural reasons: the US continues to accumulate an enormous current account deficit (close to 6% of GDP, more than US$800 billion), interest rates in the euro zone are following an upward trend while they could fall in the US, the budget deficit is still higher in the US than in the euro zone, and the emerging Asian economies will continue to refuse to let their currencies appreciate with respect to the US dollar, so the euro will bear most of the global exchange rate adjustment.

As long as this depreciation is gradual and helps ease the twin US deficits, it should contribute to correcting a fundamental element of dangerous global macroeconomic imbalances (it does not appear that Asian currencies are going to appreciate). With a lower current account deficit the US economy can reduce its need for external financing (today it needs to attract nearly US$2.2 billion a day), which will ease the risk of a crisis involving the US dollar.

Europe should view the rise of the euro as an opportunity: although it will harm exports, it will also help control inflation and boost the use of the euro as an international reserve currency, a practice which provides the EU with significant geopolitical advantages (flexibility in designing macroeconomic policy, cheaper external financing, greater revenue from seigniorage and greater political influence).

Looking beyond these macroeconomic issues, it is necessary to progress in reforming global economic governance, especially in its financial aspects (the commercial aspects are relatively well managed through the WTO). This must be done both at institutional forums (IMF and World Bank) and informal ones (the G8 or the World Economic Forum in Davos, Switzerland). The US and the EU, which control these institutions, should understand that the emerging powers must gain political power in them in order for globalisation to be more legitimate and thus more sustainable. However, the US and the EU do not yet seem to be prepared to do this. They continue to resist reforming an international economic order that is increasingly becoming an anachronism, as shown by the recent crises at the IMF and the World Bank.

Since the creation of the two institutions in 1944, there is a tacit agreement under which the Chairman of the World Bank is always an American and the head of the IMF is European. This unwritten rule was to some extent justified 60 years ago. But today it is a constant source of conflict between rich and emerging countries and undermines the credibility of both institutions in the eyes of the developing world. In 2007, the US and the EU missed a good opportunity to take a step in the right direction, naming France’s Dominique Strauss-Kahn and the American Robert Zoellick to run the IMF and the World Bank, respectively. Unless there are early departures like those of Paul Wolfowitz and Rodrigo Rato, we will have to wait five more years for candidates from the emerging countries to push for one of these jobs. Furthermore, the process of reforming the quota system –another way of assigning weight to the developing countries– is moving very slowly, and the developed countries have reduced their official aid for the first time since the 1990s. While progress is made on these issues, it would be a good idea for the G8 to accept China, India and Brazil as permanent members instead of just inviting them to attend the meetings as observers, as has been the case in recent years. If this is not done, all of these institutions will gradually lose importance and will not be able to play their central role: to ‘govern’ the process of globalisation and mitigate its adverse effects.

Conclusion: Despite the political uncertainty stemming from the US elections in 2008 the transatlantic economic relationship will remain healthy, although it will be difficult to move forward towards bi-regional integration because the two blocs are reluctant to harmonise their regulatory systems. At the same time the recent rise in protectionism (mainly in the US) and European resistance to liberalising its farm sector will make it difficult to conclude the Doha Round of world trade talks, at least until after a new US President is elected.

In the macroeconomic arena, the prospects indicate a deceleration of growth in the US and an acceleration in Europe, as well as a depreciation of the US dollar against the euro. This should serve to reduce the US current account deficit and global macroeconomic imbalances. Meanwhile, neither the US nor the EU seems willing to grant greater formal weight to the emerging economies in the international financial system. This poses a serious risk over the long term when it comes to increasing support for and enhancing the legitimacy of the globalisation process.

Finally, it is important for both economic superpowers to take measures to halt the growing rejection of globalisation among their own middle classes. This is happening because most voters are not benefiting enough from international economic integration, and see how their societies are increasingly unequal and insecure from an economic standpoint, leading them to demand more protectionism from their governments. The situation demands the recognition of the fact that globalisation creates winners and losers, and the establishment of mechanisms to compensate the losers in such a way as to stop the rising wave of economic nationalism (especially in the US) that might ultimately reverse the process of economic integration that has been so beneficial in aggregate terms. The EU’s Globalisation Adjustment Fund and the Trade Adjustment Assistance programme in the US –both of which provide aid to sectors that lose out in trade liberalisation–, although insufficient, are steps in the right direction.

Federico Steinberg
Lecturer at Madrid’s Universidad Autónoma and Analyst at the Elcano Royal Institute

[1] This paper was originally published in Economía Exterior, nr 42, autumn 2007.

Federico Steinberg, Senior Analyst at the Elcano Royal Institute and Lecturer in Political Economy at the Autonomus University of Madrid

Written by Federico Steinberg

Federico Steinberg is Senior Analyst at the Elcano Royal Institute, Lecturer in Political Economy at Madrid’s Universidad Autónoma and Special Adviser to the High Representative for Foreign and Security Policy and Vice-President of the European Commission Josep Borrell. He has been a consultant for the World Bank in Washington DC, Ghana and Bolivia, and has worked […]