Jean Monnet, one of the founding fathers of the European project, predicted that Europe would be forged in crises. The euro area crisis and the institutional reforms it engendered support the prediction. The present pandemic and concomitant economic-financial crisis may also prove him right. A plethora of rescue measures has been announced (and some implemented), including the ESM’s Pandemic Crisis Support (EUR 540 bn), the EIB’s guarantee fund (EUR 25 bn, supporting EUR 200 bn in financing), the EU’s SURE temporary, loan-based financial assistance (EUR 100 bn) and a Franco-German-proposed and European Commission-supported rescue fund (EUR 750 bn), not to mention the ECB’s Pandemic Emergency Purchase Programme (EUR 750 bn).
Some of the pandemic-related financial measures are characterised by a significant re-distributional element and are set to be financed by the issuance of EU (common) liabilities (esp. Franco-German fund). Commentators who have hailed the Franco-German agreement as a significant step towards fiscal integration overstate their case. Most of the measures consist of investments and/ or loans and virtually all measures are one-off and time-limited. The grant element of the Franco-German rescue fund is supposed to be EUR 500 bn. But this amounts to around 3% of EU-27 GDP, will disbursed over several years, and not all of represent a net resource transfer from one member-state to another. By comparison, US federal government spending exceeds 20% of GDP.
Neo-functionalism provides a conceptual framework that can help make sense of the economic dynamics and political forces underpinning European economic integration and ‘ever closer union’ (Haas 1958), including the recent pandemic-related measures involving joint liabilities. Spill-over effects are a core element of the theory. So-called spill-over effects occur when interaction between states in one economic area creates incentives for integration in another area in order to fully capture benefits of economic cooperation. Intensifying interaction between states therefore tends to lead to greater cooperation and integration. This in turn will require supra-national rules that supersede national rules, regulation and governance.
More specifically, neo-functionalism posits the following: (a) Increasing interaction leads to regional integration and the transfer of competencies and authority to the regional level; (b) interest groups begin to shift their lobbying activities to regional institutions and governance mechanisms; (c) regional institutions become autonomous actors and pursue their own institutional interests. In other words, increasing economic interaction creates economic interests and unleashes political forces with a keen interest in further integration.
As an explanation of regional integration, neo-functionalism is often contrasted with inter-governmentalism. The analytic focus of inter-governmentalism is on the nation-state and state interests rather than pluralistic interest groups. It is national government that decided whether or not to proceed with economic integration and what form integration should take (Moravcsik 1999). Unlike neo-functionalism, states are seen as remaining very influential in inter- and supra-national governance structures. The two theories do not necessarily generate different predictions, but they attribute economic integration to different causes/ actors.
Neo-functionalism offers a plausible - if not necessarily always an empirically valid - account of the economic logic and related political interests driving economic integration (Jaeger 2012). The logic goes something like this. As countries move to free trade in goods, a free-trade area turns limits potential efficiency gains due to administratively cumbersome rules-of-origin provisions. A move towards a custom union becomes economically desirable. In order to facilitate trade in goods, the liberalisation of trade in services represents the next step. This requires dealing with non-tariff barriers, involves regulatory ‘integration’ and can take various forms (equivalence, mutual recognition and uniform rules). Increased cross-border trade makes it more difficult to enforce capital controls and the liberalisation of capital flows offers further economic gains. Increased trade volumes makes it desirable to adopt stable/ fixed exchange rates.
The combination of fixed exchange rates and an open capital account limits national monetary policy autonomy, except for the anchor currency country, in addition to making fixed exchange rates vulnerable to sharp reversals in capital flows. This creates incentives to create a common currency given that all countries other than the anchor currency country effectively forfeit an independent monetary policy given the so-called impossible trinity (or trilemma). The anchor country has an incentive to agree to a common currency and share control over monetary policy in the face of recurring currency revaluation – provided monetary unions reflects its monetary and macroeconomic preferences. Monetary union removes exchange rate instability and its potentially adverse effects on trade flows.
Monetary union effectively removes monetary and exchange rate policy from members’ macroeconomic tool kit, forcing them to rely exclusively on fiscal policy to manage/ stabilise their economies. The reliance on only one macroeconomic policy instruments makes countries more vulnerable to economic shocks and government debt crises (at least if monetary financing of national government deficits is prohibited.) In theory, the greater potential macro instability risk can be addressed through the preservation of sufficient fiscal space and a high degree of microeconomic flexibility (OCA theory). In practice, it is bound to lead to greater ‘fiscal’/ government-financial integration in the form of conditional lending, insurance schemes, debt mutualization and/ or banking union. A common banking sector and/ or fiscal backstop, however designed, is desirable, even necessary. A fiscal or banking sector backstop requires the pooling of financial resources or at the very least increased risk sharing. If sustaining close economic integration requires an increased degree of financial transfers, political unification in the sense of transferring more political power from member-states to European institutions is bound to become necessary. This is a highly stylised account, but the underlying logic looks plausible.
The political dynamics and forces underpinning economic integration can also be readily rationalised in neo-functionalist terms. (Neo-functionalist theory has less to say about the political forces and interests opposing integration and this certainly opens theory to criticism.) At each integration step, some domestic-societal interests will favour further integration in order reap the benefit from closer cooperation through, economically speaking, the lowering of transaction costs and increasing economies of scale. Again, there will also be domestic-societal interests opposed to further integration for fear of losing out economically Export interests will support trade integration; import-competing interests will oppose it. Export interests will also favour stable (if competitive) exchange rates, while domestically oriented sector may oppose fixed exchange rates to the extent it constrains national monetary policy (Frieden 2015). Savers in countries with low interest rates and companies in countries with high interest rates will favour capital account liberalisation, and so on. A more complete account would require an explanation why pro-integration interest groups prevail. Perhaps they prevail because initial liberalisation benefits them these interests economically and they are then able of translating their greater economic wealth into political power?
From the perspective of inter-governmentalism, national-strategic interests account economic integration (e.g. Mazzucelli 1999) - and sometimes the lack thereof. By generating economic efficiency, economic integration can help states generate faster growth and grater aggregate wealth, whether through free trade or the free flow capital. Confronted with the risk of economic crises, instability and, worse, dis-integration, states will tend to move forward with integration in order to preserve economic gains and avoid potentially significant welfare losses. At least, this is what states are bound to do if they act rationally. Exit costs are typically high, as the UK is about to find out, and they are higher, the more economically integrated a country is (Eichengreen 2007).
In this sense, neo-functionalism and inter-governmentalism make the same (or very similar predictions) as far as economic integration is concerned. In the fact of the present pandemic-related economic crisis, EU member-states appear intent on preserving economic integration (Jaeger 2020). So do influential national interest groups (Financial Times, May 11, 2020). Moreover, the European Commission, in line with neo-functionalism, is strongly supportive of further integration, as are other European institutions (Financial Times, May 27, 2020). Neo-functionalism does not have much to say about the precise manner in which integration proceeds, just that integration begets further integration. It may correctly predict that a common market will emerge; but it does not have much to about how exactly monetary union or fiscal integration and/ or banking union will look like. Implicitly, it does seem to explain Monnet’s insight that Europe will be forged in crises. Crises do seem to lead to more economic integration in the European context, not less and neo-functionalism can readily explain why it does so.
As an aside, making use of concepts like critical juncture, increasing returns and path dependency, a historical institutionalist account of crises and integration has the potential to offer very interesting insights not only with regard to why integration and institutional change occur, but also what form institutional change is likely to take and why (Pierson 2004). More on this, another time, maybe.