The view that European integration matters because people think it matters has traditionally been dismissed by economists, since self-fulfilling expectations have no place in many standard economic models. Although it has long been recognized that small changes in the economic `fundamentals' can lead to large changes in outcomes if there are multiple equilibria, this possibility is usually assumed away since it is difficult to decide which equilibrium will result a priori. Recent theoretical work on self-fulfilling expectations makes a virtue of this indeterminacy, and it shows that the actual equilibrium achieved may be determined by agents' expectations.

In Discussion Paper No. 471, Research Fellow Richard Baldwin and Richard Lyons apply these new tools to test formally the assertion that optimistic expectations about European economic and monetary integration may prove to be self-fulfilling. They start from Krugman's two-sector model of a small open economy: manufacturing displays external scale economies but non- manufacturing displays constant returns, labour is the only factor of production and the labour markets of both sectors are perfectly competitive. External economies in manufacturing imply that if the business community expects this sector to expand, it will build factories, develop technologies and products and hire workers. If the external economies are large enough, this expansion will be profitable, so the initial optimism will prove to be an accurate forecast. The marginal product of labour in manufacturing will increase with the numbers employed, while labour productivity and wages in non-manufacturing will be unaffected, since returns are constant. The two stable equilibria in the model occur when all labour is employed in the sector with the higher wage.

Baldwin and Lyons argue that any dynamic analysis must take account of the cost of changing sectors and future wage differentials. Workers' employment decisions depend on expectations of the future state of the economy, so expectations about the future wage gap may lead workers to move to the sector currently offering the lower wage rate in anticipation of positive wage differentials in the future.

Baldwin and Lyons find that self-fulfilling expectations may encourage a substantial expansion of EC industry, and that this may lead not to a contraction of non-manufacturing, but rather to a reduction in EC unemployment. A shift from `Euro-pessimism' to `Euro-euphoria' may therefore in and of itself help to ameliorate the European unemployment problem. These results suggest that reducing the costs of resource reallocation increases the likelihood that Euro-optimism will prove self-fulfilling. They do not imply, however, that Europe should push manufacturing at all costs, since the clear negative correlation between manufacturing employment and unemployment during the 1970s and 1980s does not imply causation, and recent evidence of external economies in manufacturing does not imply that they do not exist in non- manufacturing.

External Economies and European Integration: The Potential for Self-Fulfilling Expectations
Richard Baldwin and Richard Lyons

Discussion Paper No. 471, October 1990 (IT)