Undoing European Integration: the potential threat to productivity

Having the same trade barriers between members of the European Union (EU) as with the rest of the world would result in a more than 3% permanent loss in EU productivity. That is one of the findings of research by Dr Giordano Mion and colleagues, published in the June 2012 issue of the Economic Journal.

Their study examines a neglected source of the gains from freer trade between countries: the ‘selection’ of the most productive firms that is driven by increased cross-border competition.

Simulating an economic model of EU trade that emphasises this mechanism, the researchers find substantial productivity gains. They also find that reducing trade costs between European countries has a greater effect on productivity than reducing trade costs within a large European country.

One of the experiments reported in the study consists of ‘undoing European integration’ – that is, reinstating the same trade barriers between EU members as there are with the rest of the world. The researchers find that:

· The average EU country would experience a roughly 7% permanent productivity loss, with a 3% aggregate loss for the EU-15.

· The productivity gains from EU integration translate into substantially lower prices, lower markups and richer product variety. Decreases in prices and markups are of the same magnitude as productivity increases. Profits, in turn, decrease by an average of nearly 7%.

· The gains from freer trade are unevenly distributed between and within countries, according to size and geography. Small and peripheral countries are those that benefit the most.

· For example, Ireland would experience a 12.6% productivity loss from undoing European integration, whereas larger and more central countries, such as the UK and Germany, would experience 0.55% and 1.4% productivity losses respectively.

· Trade partners of the EU would gain from undoing European integration, as higher prices would allow a greater number of non-European firms to serve EU markets.

In another experiment, the researchers examine the relative importance of within-country trade costs compared with international trade costs. They find that:

· Reducing trade costs between EU countries has a greater effect on productivity than reducing trade costs within a large European country, such as France.

· For example, a 5% reduction in the cost of international trade leads to an aggregate 4.2% productivity gain for France, while a 5% reduction in the cost of trading within France leads to an aggregate gain of 1.4%.

· Again, these gains are far from being evenly distributed. Perhaps unsurprisingly, border regions benefit more from international trade cost reductions, while central regions of a country benefit more from intra-national trade cost reduction.

· As with countries, the gains vary substantially: 4.8% for the central region of France compared with 17.3% for Alsace (which borders Germany and Switzerland).

Since the 1988 Cecchini report, there have been many attempts at quantifying the benefits of EU integration. Mounting protectionist pressures in the aftermath of the financial crisis have reasserted the need for careful assessments of these gains from trade.

But traditional evaluation tools neglect an important channel: the selection of more productive firms caused by greater cross-border competition. Yet recent economic research has shown the mechanism to be extremely important to understand the benefits of integration.

This study finds that the selection mechanism is responsible for large gains. Overall, the results suggest that traditional trade policy evaluations tools may have overlooked a quantitatively important channel for the gains from trade.

‘Productivity and Firm Selection: Quantifying the ‘New’ Gains from Trade’ by Gregory Corcos, Massimo Del Gatto, Giordano Mion and Gianmarco Ottaviano is published in the June 2012 issue of the Economic Journal.