Free Trade Area, Customs and Economic Union

Conditions for Economic Integration and Profitable Foreign Trade

An Article in the Compendium of Market-Based Social-Ecological Economics

Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium
Click here for the German-language version: Freihandelszone, Zoll- und Wirtschaftsunion

Table of Contents

  1. Abstract
  2. Preliminary Remarks
  3. The Free Trade Area
    3.1 The Latest Developments
  4. The Customs Union
  5. The Economic Union
  6. Thought Experiment on the Integration of Inhomogeneous Markets
  7. Prospects

1. Abstract

Experience with traditional models of regional trade liberalization is disappointing, especially in terms of the expected social and environmental welfare. Instead of contributing to the safeguarding of the future, the models have proved to be the nucleus and catalyst of neoliberal market deregulation and capitalist excesses. The devastations caused so far demand the development and introduction of future-oriented models – also and above all for the European Union.

2. Preliminary Remarks

The misconception and the unswerving endeavour to sustainably increase prosperity through foreign trade by renouncing agreed exchange rates, tariffs and trade quotas is unbroken. Because of that, the integration of differently developed national monetary and economic areas is still regarded as the jewel in the crown in safeguarding the future. Even recent experience in the European Union, especially in the eurozone, with recession, unemployment and over-indebtedness of Greece and other European countries as consequences of renouncing economic regulation has left no doubt in the political mainstream about the alleged benefits of unconditional integration and »liberalized« trade. The consequences are further aggravated by deregulation in the worldwide dollar zone. The global financial market and general economic crisis that emerged in 2007/2008, and was caused mainly by »liberalization« effects originating from the financial sector, even further intensified the economic and social impact of trading in euros and dollars.

By the way, the »market liberalization« started already as early as in the 1970s after the failure of the post-war order, the Bretton Woods System. With the US dollar as a quasi-reserve currency, the financial and goods markets were deregulated first on a step by step basis, until the World Trade Organization (WTO), founded in 1995, accelerated the process and extended it to the service markets. With the introduction of the euro at the turn of the millennium, »liberalization« was taken to hazardous extremes for the eurozone countries.

In the wake of the turmoil in the eurozone, the fundamental question arises as to the conditions under which large supranational economic areas can guarantee the prosperity and welfare of their citizens in a sustainable and comprehensive manner, and in particular whether, and if so how, extreme national differences in cultural tradition and economic productivity can be adapted or integrated at all. As a compliment see the article Sustainable Social Welfare.

In order to answer this fundamental question, I will use the three known models of regional trade liberalization to address the necessary conditions for sustainable, profitable trade relations:

3. The Free Trade Area

FreihandelszoneJPG01In the free trade area, participating economies commit themselves to dismantle all tariffs and trade quotas, while at the same time each economy retains its trade sovereignty vis-à-vis third (external) countries. Products imported from third countries must therefore be accompanied by certificates of origin and compensatory internal tariffs so that they do not distort competition within the free trade area. With regard to the agreement of internal exchange rates, there are no binding guidelines for free trade areas. It needs to be clarified what risks arise in this environment and how to counteract them:

If different national price and productivity levels within a free trade area are not neutralized by precisely calculated bilateral exchange rates, intra-zone competition will be distorted even without external influences. Distortions initially result in crowding-out and job losses, followed by a process of concentration of economic power and capital, territorial specialization, incentives for dumping and more job losses. All this leads to a desertification of the economic structures of the member states, irrespective of their level of productivity. That is, relatively productive as well as relatively unproductive countries are affected in a similar way. The possible growth of national products in the more productive countries will be offset by social and ecological welfare losses, mainly because the growth reaches only a fraction of the population and is achieved at the expense of society and the environment. In the absence of economic policy regulation and control, the free trade zone mutates into a breeding ground for radical »market liberalization«.

The distortions of competition caused by internal differences in productivity level and their consequences are all the greater in the free trade area,

  1. the less accurately the price and thus productivity differences of the member states are neutralized by bilateral exchange rates,
  2. the more inconsiderately tariffs and trade quotas are reduced, and
  3. the more negligently intra-zone capital movements and intra-zone labour migration are regulated.

Conversely, this means that distortions of competition caused by internal productivity differences and their consequences can only be avoided if the member states reach agreement,

  1. to derive bilateral exchange rates from the average price differences of trading products in order to neutralize price differences,
  2. to allow each member state to impose tariffs on individual imports, in addition to the average neutralization by exchange rates, that adjust import prices to the domestic price level in order to integrate foreign competition constructively into domestic competition and to place it at the service of progress,
  3. to agree on trade quotas in order to avert the risk of crowding-out of productions and thus the risk of a decline in regional diversity,
  4. to control cross-border mobility of labour and capital in order to prevent territorial imbalances, concentration of capital and mutual threats on social and environmental standards,
  5. to identify comparative advantages (relative prices) of their trading products based on the above-mentioned determination of exchange rates and to consistently align the trade flows with the relative prices in order to realize sustainable trade profits (as a compliment see the articles Comparative Advantage – Upgraded and Future-Proof Foreign Trade,
  6. to further ensure the sustainability of their trading profits by taking into account not only the relative price advantages but also the absolute quality advantages of products and production conditions, as well as
  7. counteract territorial concentration and specialization by means of tax measures in order to create or maintain a wide variety of subsidiary economic structures, that are subsidiarized according to production requirements, and that guarantee economic participation (employment) and a performance-related share (income) of the economic outturn to all citizens.

The conditions mentioned above as the inverse conclusion make it clear that unconditional free trade is certainly not a prerequisite for profitable trade and that the traditional understanding of free trade is a deterrent model that leads to widespread de-industrialization, inequality, unemployment and poverty.

By the way, each member state of a free trade area is well advised to create the conditions for profitable trade even when trading beyond the zone’s borders.

An example of a free trade area is the European Free Trade Association (EFTA), founded in 1960 as an alternative to the European Economic Community (EEC). The tendency towards uncontrolled territorial specialization within EFTA is avoided, at least in part, by a pronounced competition regime and derogations for various sectors of the economy.

3.1 The Latest Developments

In May 2010, the EU and the South American Free Trade Area/Customs Union Mercosur decided to resume negotiations on a common free trade area, which had been stalled for six years. Negotiations were blocked since 2004 because several EU member states feared that their agriculture sector would be adversely affected. However, Argentinean President and Mercosur Chairwoman, Christina Kirchner, once again left no doubt that EU subsidies and tax breaks must be put to the test. The EU reacted mildly and announced that it would compensate for European sectors which are likely to suffer from the disadvantages of free trade with Mercosur.

The loudest protest, however, came from Latin American small farmers, who were seriously harmed by free trade with US mass produced crops, and now feared that the US and the EU could engage in a competitive struggle on Latin American territory with even more devastating consequences.

Negotiations between the EU and Mercosur are exemplary of the neoliberal ruthlessness of giving priority to short-sighted profits from large-scale industrial mass production over the sustainable gains of mature local and medium-sized economic structures.

In November 2013 negotiations on a free trade agreement between the EU and the US have begun. The special features of this envisaged agreement and the dangers associated with it are discussed in detail in the German-language article Freihandelsabkommen EU – USA. A translation of this article will follow soon.

4. The Customs Union

ZollunionJPG02 Member states of a customs union commit themselves not only to reduce intra-zone tariffs and trade quotas, but as well to align tariffs and trade quotas vis-à-vis third (external) countries. A customs union can thus the regarded as a preliminary stage for an economic union (see below). An example of a customs union is the European Economic Community (EEC), which served as a supranational body for the preparation of the European Union (EU).

The economic, social and environmental risks to which the member states of a customs union are exposed correspond to those of a »liberal« free trade area. However, the obligation to standardize tariff and non-tariff trade measures vis-à-vis third countries deprive member states of the flexibility to independently shape their individual cross-border trade with external countries.

For endogenously and exogenously induced distortions of competition in the Customs Union, the causes listed above for the free trade area apply, as well as the above mentioned measures to avoid distortions and their consequences, both for the member states among each other and between member states and external countries.

5. The Economic Union

In an economic union, the economies involved merge into a single internal market and harmonize their entire internal economic and forein trade policies as well as their monetary, social and environmental policies. In the course of the harmonization process, member states introduce a common currency and open (deregulate) also, in addition to their goods and services markets, their factor markets (labour, raw materials and capital markets). For the member states the economic union is therefore linked to a very broad assignment of economic powers and sovereignty to the supranational union level. An example of an economic union (undergoing undetermined development) is the European Union (EU), and even more so the euro zone within the EU. From an economic union it is only a small step to a single, centrally managed and governed federal state.

The economic, social and environmental dangers to which the member states of an economic union expose themselves correspond to those of a »liberal« customs union. If there are only minor traditional and productive differences, the dangers in an economic union can be mitigated by a common social and environmental policy.

The introduction of a common currency in an economic union constitutes a very special feature. Initially, the effect is equivalent to that of price neutralizing exchange rates between the member states of a free trade area or customs union, provided that the national currencies of an economic union are converted at the time of the introduction of the common currency in line with price (and thus productivity) terms. If this is the case, identical products are labelled with identical prices in the common currency regardless of the place of manufacture and its productivity level. Although this initially eliminates the incentives for smuggling and simplifies travel, it does not change the productivity-related disparities in wages and purchasing power, nor does it eliminate the differences in economic structures and, most importantly, does not change the different speeds of productivity growth between member states. In fact, the economic indicators mentioned start to diverge from the beginning, because the more competitive member states are tempted to use their larger productive margins to initiate export initiatives across the economic union to the disadvantage of the producers of the less productive countries.

This of course is also true of the euro-zone, where productivity levels between countries are increasingly diverging, and hence wages and purchasing power, because the competition in euro prices prevents adjustments of the irreversible national characteristics and their economic manifestations by means of exchange rates, tariffs and trade quotas.

Open borders, a single currency and large wage and purchasing power gaps create immediate incentives for workers from low-wage countries to migrate to countries that offer higher productivity and higher wages, with the intent to increase their purchasing power. Once migrated, they compete on wages with resident workers, forcing them to lower their claims – with the effect that wages, social benefits and purchasing power are caught in a downward spiral throughout the economic union, upsetting the sensitive balance of productivity, wages and purchasing power. The further productivity and wages diverge, the deeper the purchasing power drops and the faster the flow of money and goods is drying up outside the large urban agglomerations into which concentrated, capital-intensive industries and their employees retreat.

At the same time, incentives arise for companies from high-wage countries to relocate production facilities (physical and monetary capital) to countries with lower wages, with a view to increase their return on investment. In the countries of origin, jobs are lost immediately, while the target countries usually only acquire isolated value added, which is not integrated into their existing economic structures and cycles and can be withdrawn at any time. In addition, these one-sided transfers of capital will reinforce the already existing trend towards territorial specialization and concentration, resulting in job losses, environmental costs and intensified intra-union cost and price competition with devastating consequencs for historically grown local and regional cycles. All in all this means, that a comprehensive de-industrialization takes place all over the economic union due to uncontrolled labour migration and capital movements.

The long-term convergence of large-scale industrial productivity, at least between highly productive member states, could be cited as an advantage, but in the light of the high social and environmental costs, it turns out to be a dangerous convergence of apparentproductivities.

The intended harmonization of social and environmental policy in an inhomogeneous economic union cannot be achieved either, because, as mentioned, of established local and regional cycles being destructed. All in all, the conditions described above for profitable internal and external trade of the free trade area also apply to the common good in the economic union, including the retention of national currencies and correspondingly price-neutralizing exchange rates as well as tariffs and trade quotas. In particular, however, the imperative is to maintain or establish diverse decentralized (subsidiary) economic structures to bring about full employment and direct responsibility for environmental protection.

However, even if countries that share the same level of productivity join together to form an economic union, citizens will only support the harmonization of all areas of life if they view it as socially and ecologically fair. In the case of a successful harmonization, especially concerning the creation of locally and regionally independent subsidiary structures, there is no obstacle to the introduction of a common currency in the long term.

If the EU had complied with these rules, particularly when the eurozone was introduced, the drifting apart of balances of payments, public and private over-indebtedness and the economic decline of the countries in crisis would have been spared. In addition, see also the articles EU: Federal Superstate or Confederation and Full Employment.

6. Thought Experiment on the Integration of Inhomogeneous Markets

The devastating effects of the unconditional opening of national markets and the associated renunciation of cross-border trade rules can be illustrated, for both developed and underdeveloped economies, by means of a simple but very realistic experiment:

Two differently developed countries decide to merge to form a free trade area, because they expect to achieve mutual prosperity gains in free trade. Until then, both countries have been economically self-sufficient and both show full employment. The country »Industria« is highly industrialized and runs a highly mechanized agriculture; the country »Agraria« is an exclusively agrarian country, whose agricultural productivity is only one third of that of Industria. However, Agraria produces a number of exotic agricultural products.

With the entry into force of the free trade area, the »four freedoms« being characteristic of neoliberalism are established. In other words, the financial, goods, services and labour markets are opened (deregulated) between the two countries without any restriction and, at the same time, a free floating exchange rate and unrestricted currency convertibility are introduced. The development of the two countries undergoes four phases:

Phase 1: Agraria’s farmers export their exotic products to Industria with the intent to invest the revenues in agricultural machines from Industria for higher productivity. The exotic products are sold in Industria at prices that are slightly lower than those of their comparable own products, so that an initial exchange rate arises, that roughly corresponds to the ratio of the differing agricultural productivities: The purchasing power of one hour’s pay in Agraria is now around one third compared with Industria. Exports of exotic products are on the increase and are replacing Industria’s own agricultural products. Subsequentially, unemployment in Industria’s agriculture is rising steadily, while internal supply shortages arise in Agraria due to the increasing export share of exotic products.

Phase 2: The imported machines increase the agricultural productivity in Agraria, thus creating incentives to export all agricultural products to Industria at competitive prices. The export prospects are leading to rising imports of machinery, generating a trade deficit for Agraria, followed by a devaluation of its currency and falling prices for its agricultural products in Industria. In view of growing sales volumes and profits, farmers in Agraria intensify the cultivation of all agricultial products in accordance with the rising demand in Industria and, at the same time, neglecting the demand and needs of their own people. Following Agraria’s aggressive export initiative, Industria has to abandon its own agricultural production for good, while, at the same time, the demand for agricultural machinery raises in Agraria so that Industria can raise its production and exports of machinery accordingly. A base of long-term rural unemployment emerges in both countries, in Agraria as a result of automation, in Industria because of its abandonment of production. The hopes in Industria of transferring unemployed farm workers to the exporting machinery industry are disappointed because of the inadequate level of training of farm workers and the rationalization measures being introduced.

Phase 3: Entrepreneurs in Industria take advantage of the low wage level and unemployment in Agraria to outsource labour-intensive productions to Agraria. Agraria exploits this opportunity in lowering its taxes and obligations for foreign enterprises to further reduce its unemployment. But the already existing surplus of job-seekers brings about a decline in Agraria’s wage level. More and more companies from Industria take advantage of this and outsource productions to Agraria, leading to industrial unemployment in Industria in addition to its rural unemployment. The labour market imbalance in Industria is further reinforced by the migration of unemployed agricultural workers from Agraria.

Phase 4: Under the pressure of unemployment, the two countries are caught up in a competition for industrial settlements, which triggers a downward spiral of all social and ecological standards. At the same time, given the competitive pressure to rationalize working processes, remove jobs and circumvent environmental constraints, they find themselves in merciless rationalization and cost competition. Industrial and agricultural (apparent) productivity is being irresponsibly increased in both countries at the expense of society and the environment. Industria finally ends up with insurmountable quantitative and structural unemployment through excessive dependence on agricultural imports, outsourcing of industrial production and socially and ecologically incompatible increases in productivity. Agraria has amassed an insurmountable trade deficit, thus accepting a devaluation of its currency and a dependence on agricultural exports as well as on low-skilled jobs in industrial settlements operated by Industria – thereby obstructing the path to independent industrialization.

Bottom Line: Ultimately, the original economic and social structures are damaged in both countries, the environment is overburdened, and instead of general prosperity gains and the prospect of social welfare, inequality, unemployment and poverty have spread.

The thought experiment illustrates that social and environmental devastations can simply be caused by bilateral trading when the economies involved renounce price and quality adjustments and quantitative restrictions in the exchange of capital, goods, services and workers. Such devastations do not at all require a worldwide pattern of free trade.

7. Prospects

The recommended rules for the free trade area, customs union and economic union are aimed at optimizing trade profits, employment and environmental protection, including performance-oriented equal distribution of income, assets and productive capital. Quite in contrast to the neoliberal understanding, which is limited to the euphemism of »market liberalization« and to the highest possible returns on capital, thus creating capitalist excesses and ultimately economic anarchy and chaos. Conditions which finally affect all market participants and citizens.

The »liberalization« of the economy, i. e. the renunciation of economic policy regulations for the unconditional opening of markets, is, as the term might suggest, not a value in itself. The association of the term »liberalization« with the concept of civil liberty, as intended by the neoliberal protagonists, is misleading. If it is the purpose of economic activity to ensure a better life, then this activity requires democratically legitimized regulation and control – both internally and in foreign relations – to sustainably optimize the profits for society and the environment.

Note on the COVID-19 Pandemic

The pandemic has noticeably revealed the significant weaknesses of the neoliberal economic system for everyone, above all the shortage of medical, but also other products, caused by disruptions in the absurdly networked value and supply chains across the globe.

The analyses of the neoliberal system as well as the principles and practical procedures based on them for building a sustainable system, which are presented in this compendium, thereby obtain an unexpected topicality. Now is the time to seize the opportunity and build up economic policy pressure to enforce the development of an economic order that is sustainably oriented towards social and ecological welfare.

The following article refers to the targeted arguments contained in the Compendium: COVID-19 and Globalization


Click here for the German-language version: Freihandelszone, Zoll- und Wirtschaftsunion

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