The process of European economic integration is at the centre of the current policy debate. The Centre for Economic Policy Research has contributed to this debate with analysis that is rigorous, yet presented in a readable and non-technical manner accessible to policy-makers, their advisers and the informed public. The Centre is now extending this work with a new series of Annual Reports on Monitoring European Integration, each to be written by a panel of CEPR Research Fellows meeting periodically to select relevant issues, analyse them in detail and highlight the policy implications of their analysis. Each year's report will typically be devoted to a particular theme or issue. The 1990 Report, `The Impact of Eastern Europe', examines the effects of recent developments in Eastern Europe on the process of integration among the West European economies.

The 1990 Report received generous financial support from the German Marshall Fund of the United States. CEPR is also grateful to the Alfred P Sloan and Ford Foundations and the Commission of the European Communities, who have provided support for much of the Centre's research in international macroeconomics and international trade, which informs the analysis in the Report. The opinions expressed are those of the authors alone, however, and not of these institutions nor of CEPR, which takes no institutional policy positions. The 1990 panel comprises David Begg (Birkbeck College, London), Jean-Pierre Danthine (Université de Lausanne), Francesco Giavazzi (Università degli Studi di Bologna), Carl Hamilton (Institute for International Economic Studies, Stockholm), Damien Neven (INSEAD, Fontainebleau), André Sapir (Université Libre de Bruxelles), Alasdair Smith (University of Sussex), L Alan Winters (University of Birmingham) and Charles Wyplosz (INSEAD and DELTA).

The 1990 Report will be launched at two CEPR lunchtime meetings: in Geneva on 6 November, to be addressed by Victor Norman and Jean-Pierre Danthine, held in conjunction with the European Free Trade Association; and in Brussels on 7 November, to be addressed by André Sapir and CEPR Director Richard Portes. It will also form the subject of a meeting of the IMF Visitors' Forum chaired by Jacob A Frenkel, Economic Counsellor and Director of Research at the International Monetary Fund, in Washington DC on 15 November, to be addressed by L Alan Winters and Francesco Giavazzi. The Brookings Institution will also host a discussion meeting on the Report.

The authors assess the medium- and long-term implications for Western Europe of the current economic transformation of Eastern Europe, assuming throughout that this difficult process will ultimately be successful. In the first chapter, on `Trade Patterns and Trade Policies', they focus on microeconomic implications by considering the effects of reform in Eastern Europe on the world energy market, the Common Agricultural Policy of the European Community, and the possible need for adjustment of trade and production in Western Europe. They conclude that the consequences of 1989 should not slow down the process of economic integration in Western Europe, but rather reinforce it.
Eastern Europe (including the Soviet Union) is likely to generate significant net exports of energy and of agricultural goods. Conservative calculations suggest that a decline of Soviet and East European energy intensities to some 500 tons per million dollars of GDP, even allowing for an increase in income of 50%, would make available energy exports of some 500 million tons of oil equivalent roughly 6% of world energy consumption or nearly half of OPEC's production. A resurgence of agriculture in Eastern Europe should lead to overall increases in its grain output of about 30%, or about 5% of the world output of grains. Unless there is a substantial reform of the CAP for example as part of the Uruguay Round then it will come under considerable pressure from the liberalization of trade in Eastern Europe; and the inclusion of the East European countries within the CAP would all but destroy it.

The fears of Southern European producers of manufactured goods such as clothing and footwear that they will be particularly hard hit by competition from Eastern Europe are probably misplaced, says the Report, since much of the long-run expansion in East European production and exports is to be expected in more skill- intensive goods. If the reforming economies succeed in attracting investment by multinational corporations seeking to take advantage of their endowments of skilled labour, there may be some striking expansions in `sensitive' industries such as consumer electronics and food processing, accompanied by a slowdown of multinationals' investment in Western Europe.

Far from East European reform providing an argument for slowing down West European integration, a good case can be made for the complementarity of the two processes. A closer association with the Community and eventual full membership may provide the essential institutional framework to make the reform process credible and to guard it from protectionist pressures in the West.

In the second chapter, `The East, the Deutschmark and EMU', the authors argue that the opening of Eastern Europe will have important effects on interest rates and investment patterns within the OECD and on the process of monetary integration within the European Community. Here, developments in the East may strengthen the case for an acceleration of integration in the West.

They proceed from the bench-mark hypothesis that growth in the countries of Eastern Europe (excluding the Soviet Union) could enable them to double their in ten years the growth rate achieved by West Germany in the 1950s and by South Korea since the mid-1960s. This implies that total imports of capital goods from the West over the next ten years could range from $1,350 to $2,910 billion, equivalent to about 15-30% of the total investment of the European Community or 5-10% of the corresponding total for the OECD.

They maintain, however, that the improved investment opportunities in the East will not elicit a significant increase in OECD savings, so that most of the adjustment in the West will be felt in the increase in interest rates, not in capital goods prices. Hence there will not be an increase in world investment, but rather a diversion of investment towards Eastern Europe. The increase in East European demand for capital goods will be skewed heavily towards Western Germany, which is also best equipped to supply such goods. Italy and Switzerland may also be able to exploit their comparative advantage in both location and specialization in capital goods, but this does not apply to the France, the UK or the US, which will therefore undergo both higher interest rates and lower prices of their capital goods.

In the absence of other changes, this additional demand for exports of capital goods will lead to an overheating of the German economy. German imports of consumer goods will increase as Western Germans seek to maintain their desired levels of consumption and the domestic production of such goods is crowded out by the boom in the capital goods sector. This will need to be accommodated by a substantial appreciation of the real exchange rate, to be achieved either through domestic inflation or a through nominal appreciation. Assuming that the latter is to be preferred, an appreciation of the Deutschmark against its EMS partners would increase the share of East European imports satisfied by (non-German) exports from Western Europe rather than the US or Japan.

In the long run, the transitional costs of German economic and monetary unification will cause German foreign assets, the permanent income to which they give rise and hence consumption to fall. The resulting deterioration of the current account will lead eventually to a fall in the real value of the Deutschmark. On the extreme assumptions of no trend growth, with consumption constant over time and based on permanent income alone, and immediate equalization of Eastern and Western German living standards, the annual per capita income in the united Germany will be some DM 2,740 less than in the former West Germany if investment in Eastern Germany yields returns at the prevailing world rate. If there are excess returns to intra-German investment during the transition, corresponding to the faster output catch-up for a given investment flow, then the corresponding reduction will lie in the range of DM 1,820-2,020.

In the short run, if consumption is smoothed over time, allowance is made for the dilution of West German exports in a larger population and also for the increase in German exports to the rest of Eastern Europe, then annual per capita imports must rise by a figure in the range DM 1,485-3,820 to keep aggregate demand in line with aggregate supply. The German current account must therefore deteriorate rapidly by roughly DM 200-300 billion, as against the West German surplus of about DM 100 billion in 1989. Even additional export orders to the rest of Eastern Europe will fall a long way short of the additional imports required to finance immediate consumption catch-up in Eastern Germany and to make good the temporary diversion of domestic capacity to the provision of net investment for Eastern Germany.

Since it is both implausible and undesirable for such an adjustment to be achieved through domestic inflation, the case for an immediate realignment of the Deutschmark is overwhelming. Since such a revaluation of the Deutschmark would signal the return of the `old' EMS, i.e. that realignments are once again the normal response to idiosyncratic shocks, this would certainly derail the Delors Plan for EMU and even threaten the break-up of the EMS in the new environment of free capital flows. The authors therefore suggest as an alternative the only realignment that would not signal such a return to the `old' EMS: one accompanied by a monetary reform and the adoption of a single currency. The resulting redefinition of units would allow for the pressures originating from Eastern Europe and thus provide a final opportunity to use the exchange rate to ease the cost of absorbing an external shock. They conclude that if European governments are prepared to trade the costs of surrendering the exchange rate as a policy instrument for the benefits of a common currency, then the time to accelerate is now.

Monitoring European Integration: The Impact of Eastern Europe,
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