European Internal Market
Subsidies more costly than ever?

The European Community has set itself the target of `completing the internal market' by 1992. But the benefits of freer European markets may not be realized, L Alan Winters told a lunchtime meeting on 22 January. Member governments could be tempted to replace the current system of border restrictions with subsidies and barriers to competition, and the increased mobility of labour and capital which could result from the completed market would actually increase the damage done by such subsidies. Completion of the internal market must be accompanied by provisions to guard against the introduction of subsidies or anti-competitive practices by Community members, he warned.
L Alan Winters is Professor of Economics at the University College of North Wales and Co-Director of CEPR's International Trade programme. His talk, financed through a grant from the Ford Foundation, was based on Discussion Paper No. 222.
Completing the internal market entails removing all hindrances to the free circulation of goods, services and factors of production among member countries. The removal of frontier posts on internal borders is one sign of progress towards this goal. Their removal will make two existing barriers to internal trade impossible to operate: Article 115 of the Treaty of Rome and Monetary Compensatory Amounts.
Article 115 prevents `trade deflection', whereby imports excluded from one member country enter the Community via another and then flow to the first country under the provisions for free internal circulation. The Article allows national governments to restrict imports from third countries, so that identical goods may be sold at very different prices in different member states. For the EC as a whole, abolishing such measures would be beneficial, although if abolition involved increasing restrictions on imports into some countries, those countries could lose from the process. The effects of national import restrictions on domestic prices are difficult to estimate, but Winters provided illustrative calculations which suggested that had France, Germany and the UK pooled their quotas of jeans imported from Hong Kong in the first half of 1982, prices would have changed in the three countries by +3%, +12% and -19% respectively. These price changes would have reduced consumer welfare by ECU 7 million in Germany and raised welfare by ECU 11 million in the UK.
Monetary Compensatory Amounts (MCAs) are border taxes and subsidies on agricultural trade. Since MCAs vary among members, they cause prices to vary across countries and cause economic losses by distorting the allocation of resources. Winters argued that the abolition of MCAs would be generally beneficial provided it were accompanied by no rise in average EC agricultural prices. For countries with low agricultural prices, however, and in particular for Britain, there was some danger that the allocative benefits of uniform agricultural prices throughout the EC would be offset by raising domestic prices to the average EC level. But this was really an argument for abolishing MCAs and reducing the level of farm support in the EC, he noted, and not for maintaining MCAs.
Winters next considered the consequences of abolishing border controls on trade but failing to control the national subsidies that may replace them. Subsidies are still widespread, although data presented by Winters indicated that their level had fallen in the past five years. The Commission's attitude to such subsidies in the completed market is yet to be determined, but trade theory suggests that, for a small country, a higher degree of factor mobility increases the damage caused by subsidizing a particular sector of the economy. Subsidies are costly because domestic factors of production are diverted into the subsidized industry (where they can be profitably used only with the help of subsidies) and out of other industries (where they were previously employed productively). Higher factor mobility means that additional supplies of some factors can flow into the subsidized sector from abroad, so that even more local resources will be captured by the subsidized sector for relatively unproductive purposes.
Recent developments in international trade theory have suggested the possibility that subsidies might be beneficial if applied at an EC level. Such arguments suggest that a country may be able to `snatch' a larger share of monopoly rents on the world market by promoting the sales of its own companies over those of companies located elsewhere. But Winters doubted whether such opportunities existed or could be easily identified in practice, and his analysis suggested that such a policy was fraught with danger. Following earlier literature, Winters illustrated the dangers from rent-snatching in the market for scientists. In the completed internal market, there will be a single European market for scientists. If one member seeks to increase its share of world rent by promoting its own hi-tech firms, the subsidies will attract scientists from firms elsewhere in the EC, reducing their competitiveness. It would be likely that other members would retaliate by subsidizing their own industry and a costly subsidy war will result, almost inevitably leading to over-subsidization on an EC scale.
Winters concluded that the European internal market must be supported by the firmest of provisions against national subsidies and anti-competitive practices. Only then would the potential benefits of improved allocation and efficiency from a completed market be realized.