“The European Community: Friend or Foe of the Market Economy” by Milton Friedman Paper for Mont Pèlerin Society Meeting, West Berlin September 9, 1982 © Mont Pèlerin Society

I spent the fall of 1950 in Paris as a consultant to the U.S. agency that was overseeing the implementation of the Marshall Plan.1 My assignment was to analyze the plan proposed by French foreign minister Robert Schuman for the establishment of a common market for coal and steel, as a first step toward a more extensive common market. When I agreed to write a paper for this Mont Pèlerin session, my intention was to exhume a long — and long-interred — memorandum that contained my final analysis and compare its predictions and recommendations with what has actually occurred in the nearly a third of a century since. Unfortunately, I have been unable to find the memorandum in question among my papers, and it did not occur to me soon enough to see if the successor government agency in Washington could locate it in its files. I remember well two main conclusions: first, that an effective common market in goods and services would break down in the political circumstances of Europe unless it was accompanied by a system of flexible exchange rates among the member countries; second, that the United States should not support the establishment of a common market but instead should press for a reduction of trade barriers on a multilateral basis — that is, greater free trade worldwide, rather than within the European Community alone. Flexible Exchange Rates I can document the first conclusion because my article “The Case for Flexible Exchange Rates”2 had its origin in the memorandum in question. The published article did not refer specifically to the European Community but developed the general idea that fixed exchange rates were incompatible with free trade in a world in which countries pursued independent national monetary policies. Its intellectual precursor is John Maynard Keynes’s analysis of this issue in his Tract on Monetary Reform. In Keynes’ words, “If the external price level is unstable, we cannot keep both our own price level and our exchanges stable. And we are compelled to choose.”3 Writing in the early 1920s, Keynes did not consider exchange and trade controls as a way to render stable exchanges compatible with a stable internal price level. Since the invention, perfection, or what have you of extensive exchange control by Hjalmar Schacht in the 1930s, writers on the subject have considered a triad of which it is generally said any country can have any two, but not all three: (1) fixed exchange rates, (2) control over internal monetary policy (i.e., over the internal price level), (3) freedom of trade from exchange and similar controls. These writers have recognized that even this proposition has to be qualified, since only a limited

divergence between the fixed exchange rates and the unobserved market rates can be contained by exchange controls, even though they are fairly draconian. Moreover, in practice a clear choice is seldom made: countries adopt “dirty” fixed rates or “dirty” floating rates; let their independence in monetary policy be compromised by their concern about exchange rates and trade; and resort to open or concealed exchange and trade controls to widen their leeway in monetary and exchange rate policy. Yet the basic theoretical proposition remains and has important implications for policy: it is not possible in a world of sovereign nations for each of them to achieve three goals that are generally considered desirable: fixed exchange rates, a stable price level, and freedom of trade. The conclusion that fixed exchange rates among the Common Market countries would not be compatible with freedom of trade among them has certainly been confirmed by experience. One attempt after another to contain exchange rates, from the initial European Payment Union through an increasingly flexible series of “snakes,” to the present European Monetary System has not prevented changes in exchange rates and has broken down and had to be replaced. In terms of the major theme of this session — whether the Common Market has been a friend or foe of the market economy — experience with exchange rates has mixed implications. The repeated attempts to interfere with market determination of exchange rates represent clear interferences with the market economy. However, such attempts have occurred throughout the world and would have occurred had the Common Market never been established. The International Monetary Fund has no purpose except to prevent the market determination of exchange rates. The existence of the Common Market no doubt affected the form of attempted controls on exchange rates, especially the countries involved in such attempts, but even here its influence was limited, as is attested by the inclusion of countries outside the Common Market in many of the exchange rate control schemes. More important, the attempts to promote freer trade within the Common Market reduced the ability of individual countries to affect their own exchange rates by exchange and trade controls. As a consequence, it made it more difficult to maintain exchange rates differing from market rates, leading to a breakdown of the successive schemes at an earlier date than otherwise. In this limited sense, the Common Market on net has probably been a friend of the market economy with respect to the determination of exchange rates. One major qualification to this conclusion is that the Common Market may have increased the resources available for government manipulation of exchange rates by increasing the willingness of Germany to suffer exchange losses in the vain attempt to peg the exchange rates of some of its Common Market partners. However, that qualification depends on a political judgment I have no competence to make. A Common European Money Needless to say, a common European money was a goal of the initial proponents of European unification. They envisaged a United States of Europe, with a single central monetary authority.

That dream — whether desirable or not — was doomed by the form that the Common Market took — a confederation of independent states rather than a federal state with a separation of powers and a direct line between the central government and the individual citizens. The reason was well-explained by Alexander Hamilton almost two centuries ago in the Federalist Papers, in the course of examining the defects of the Articles of Confederation, which preceded the Constitution as the form of association among the original thirteen states. As it happens, the political structure of the European Economic Community is almost identical with that of the initial U.S. Confederation, which is why Hamilton’s remarks are so apposite: “The great and radical vice in the construction of the existing Confederation is in the principle of LEGISLATION for STATES or GOVERNMENTS, in their CORPORATE or COLLECTIVE CAPACITIES, and as contra-distinguished from the INDIVIDUALS of which they consist.… Though in theory [the Confederation’s] resolutions … are laws constitutionally binding on the members of the Union, yet in practice they are mere recommendations which the States observe or disregard at their option. “There is in the nature of sovereign power an impatience of control that disposes those who are invested with the exercise of it to look with an evil eye upon all external attempts to restrain or direct its operations. From this spirit it happens that in every political association … of lesser sovereignties, there will be found a kind of eccentric tendency in the subordinate or inferior orbs by the operation of which there will be a perpetual effort in each to fly off from the common center. This tendency is not difficult to be accounted for. It has its origin in the love of power. Power controlled or abridged is almost always the rival and enemy of that power by which it is controlled or abridged. “If we still will adhere to the design of a national government … we must resolve to incorporate into our plan those ingredients which may be considered as forming the characteristic difference between a league and a government; we must extend the authority of the Union to the person of the citizens — the only proper objects of government.…”4 Despite the establishment by the Common Market of a European Parliament, in the attempt to move toward political unification, I suspect that there will be little disagreement that Hamilton’s skeptical view is fully supported by the experience of the Common Market to date. A similar judgment of historical experience was expressed by Jacob Viner in his classic work on customs unions: “The common belief that economic union brings as a natural product political union has little historical evidence to support it.”5 Trade in Goods and Services With respect to my second and major conclusion — that free trade on a multilateral basis was preferable to the establishment of a European common market — I have only my memory to draw on in view of my inability to find my memorandum. And that is a most unreliable recourse. We may remember the major peaks, but we are unlikely to remember the minor peaks, let alone the detailed paths by which we reached them or the evidence cited in support of them. Moreover, there is no avoiding the rosy glow that hind-sight imparts to the recollection of foresight.

My own analysis was undoubtedly greatly influenced by Jacob Viner’s book on customs unions, published just before I undertook my assignment. Viner distinguished between two very different effects of customs unions on trade: trade diversion and trade creation. Trade diversion occurs if the common tariff around a customs union and the absence of tariffs within the union lead one of the member countries to purchase products from another member rather than from a “cheaper” producer in the outside world.6 An obvious example: Britain on entering the Common Market substituted more expensive Danish butter for cheaper New Zealand butter. Danish farmers gain; British consumers and New Zealand producers lose. The combined loss is greater than the gain, so that the international division of labor is rendered less efficient, and the market economy is distorted. Trade creation occurs if the abolition of tariffs between members of the customs union leads a member country to purchase products from another member country rather than producing it at higher cost itself. To use the same example as before, Germany purchases butter from Denmark instead of from German dairy farmers. Or, in the industrial area, Belgium purchases coal from Germany or France and closes down its own high-cost coal mines. Viner noted that, contrary to the general presumption of most writers on customs unions, the greater the similarity of the production mixes of the member countries — i.e., the more competitive they are — the greater the scope for trade creation relative to trade diversion. On the other hand, the more different the production mixes — i.e., the more complementary the countries are — the greater the scope for trade diversion. He noted also, as first among seven considerations determining whether a customs union is likely to operate in a pro- or anti-free trade direction, that “the larger the economic area of the customs union and therefore the greater the potential scope for internal division of labor,” the more likely is a customs union to operate in the free trade direction.7 Unfortunately, however, “potential” is not “actual” — one need only cite the Common Agriculture Policy of the Common Market which has been directed at preventing effective division of labor, not only between agriculture and other industries, but also within agriculture as between the several Common Market countries. One may note also the retention of high-cost steel production in essentially all of the member countries, as well as the various administrative and similar measures that have led to the predominance of French-origin cars in France, of German-origin cars in Germany, and of Italian-origin cars in Italy. Here again, Hamilton’s remarks are relevant. It is doubtful if the U.S. would have enjoyed free trade among the separate states if the Articles of Confederation had not been replaced by the Constitution which explicitly denied to the several states the power to “lay any imposts or duties on imports or exports” and, more important, established a central government with power to enforce that provision. The second of Viner’s seven points was that a custom union is more likely to operate in a free trade direction “the lower the ‘average’ tariff level on imports from outside the customs union area as compared to what that level would be in the absence of customs union.” He put “average” in quotes because of the difficulty of giving that slippery concept an unambiguous meaning.8

I am sure that there have been extensive studies of this issue with respect to the Common Market, but I must confess I do not know them and hence do not know if there is a consensus among experts on how the level of the common tariff compares with the possible alternative. One thing is clear, however. The common tariff is not negligible, and its adverse effect on the world division of labor is much enhanced by the extensiveness of the economic area around which it erects a formidable barrier. Viner recognized that countries forming a customs union would in fact not be likely to permit the extensive relocation and reorganization of industry required to realize the potential benefits from the division of labor. This is one of the considerations that led him to regard customs unions as “unlikely to prove a practicable and suitable remedy for today’s economic ills” but rather “a psychological barrier to the realization of the more desirable but less desired objectives of … the balanced multilateral reduction of trade barriers on a nondiscriminatory basis.” Experience during the past three decades clearly does not reject Viner’s doubts — to put it mildly. Trade has expanded rapidly within the Common Market and between the Common Market and other countries — consistent with both trade creation and trade diversion. However, the rise in trade between the Common Market and the rest of the world does not seem out of line with developments in other countries. And some countries outside the Common Market — notably the rapidly growing countries in the Far East (Japan, Taiwan, Korea, Singapore) — have experienced even more rapid growth, even leaving aside the OPEC countries as a special case. There presumably exist detailed statistical studies of the relative growth of trade among countries within the European Community, between the Community as a whole and the rest of the world, and between various other groupings of countries; as well as attempts to isolate the effects of the Common Market on trade creation versus trade diversion. Unfortunately, I am not familiar with that literature. I trust that the other participants in this session will remedy that defect. My casual judgment is that Viner’s fears have on the whole been realized, that trade diversion has swamped trade creation. Indeed, that outcome has been a main attraction to countries seeking to enter the Community. Their desire to enter has been sparked far less by pressure to promote free trade than by protectionist sentiments of enterprises that seek both shelter behind a common tariff and nontariff wall and entry into a rich market on privileged terms. Britain is almost surely an exception, both because of the importance of political rather than economic considerations in its entry into the Community and because it was in effect moving from one multilateral grouping — the Commonwealth — to another. One outcome of the European Community that was anticipated only imperfectly if at all has been the growth of an economics bureaucracy in Brussels. As in every such bureaucratic structure, the voice of the consumer is at most a whisper; of organized producers, a shout. And because of the structure of the Community — I revert once again to Hamilton’s analysis — pressure from consumers and for free trade is even more muted than in a government more directly responsible to the public. The result has been further extensive interference with free trade both within the Community and between it and the outside world.

Conclusion World trade has certainly grown greatly in the past three decades; the member countries of the European Community have, for the most part, prospered in that period and shared in the growth of world trade. The key issue is whether these developments have occurred partly because of, or wholly in spite of, the establishment of the European Community. As I view the broad developments, I believe they cannot be attributed to the establishment of the European Community. The countries that have experienced the most rapid economic growth and the most rapid growth in international trade are not members of the Community but are in the Far East. They have encountered opposition from the European Community, have been the victims of trade diversion to a far greater extent than they have been the indirect beneficiaries of trade creation. In the immediate postwar period, the mere removal of wartime exchange controls, the sweeping away of many prewar restraints, especially in the defeated countries, the emergence of the U.S. as the dominant economy in the world and its willingness to make unilateral transfers – all these were bound to lead to a loosening of trade barriers and a growth in trade. The initial “dollar shortage” dulled protectionist pressures in the United States, and the subsequent desire by many countries to accumulate dollar reserves, which gradually led to an overvaluation of the dollar, kept the resulting expansion in U.S. imports from enforcing restrictive domestic policies within the U.S. After the Bretton Woods system had to be abandoned in the early 1970s, the situation changed. The U.S. could no longer export the inflationary effects of the excessive monetary growth that resulted from full employment policies and the explosion in government spending. Enterprises in other countries no longer could depend so readily on the U.S. to absorb exports and their governments were no longer so willing to add to their holdings of dollars. The OPEC crises added greatly to the pressure. As a result, the growth of world trade, excluding oil, has slowed down, and protectionist pressures have risen throughout the world. It is hard to find any important role for the European Community in this process. Insofar as it had any role, it was as a more effective bargaining agency for Common Market producers, especially vis-à-vis the United States and Japan. No doubt the general loosening of barriers to trade around the world contributed to the rapid economic growth of many of the Common Market countries, but it benefited the countries outside the Common Market just as much. Britain lagged both outside the Market and inside it. Germany and France would, I believe, have grown rapidly during the 1960s and most of the 1970s if the Common Market had never been established — as Sweden, Norway, and Spain did during the same period. And the Common Market has not enabled Germany and France to escape the problems that have recently beset countries outside it. In the absence of the Common Market, less of the growth in economic output would have been dissipated in supporting the uneconomic division of labor. Again, the most dramatic case is clearly agriculture. It is dubious that without the income transfers under the Common Agricultural Policy, the separate countries could have coddled their agricultural producers as much as they have.

All in all, I see no reason to reject the conclusion I reached in 1950 that a common market in Europe was more likely to be a foe than a friend of free markets. Notes 1

Office of Special Representative for Europe, Economic Cooperation Administration. I was attached to the Finance and Trade Division. 2 Essays in Positive Economics (University of Chicago Press, 1953), pp. 157-203. 3 A Tract on Monetary Reform (London: Macmillan, 1923), p. 126, in Collected Writings of John Maynard Keynes, vol. 4, Royal Economic Society ed. (London: Macmillan for the Royal Economic Society, 1971). 4 See my column, “Alexander Hamilton on the Common Market,” Newsweek, June 4, 1973. 5 The Customs Union Issue (New York: Carnegie Endowment for International Peace, and London: Stevens & Sons Ltd., 1950), p. 103. 6 ”Cheaper” is not a self-evident term. It must be interpreted in terms of comparative cost not absolute cost. For simplicity of exposition I shall take this qualification as assumed throughout. Needless to say, Viner is careful in his use of the term. 7 The Customs Union Issue, p. 51. 8 Ibid., p. 51, pp. 66-68. 10/1/12