4. Costs and Benefits of EC Association

The benefits of association with the EC (which also apply to similar arrangements with EFTA) can be compared to those that have arisen in different forms of market integration (free trade areas, customs unions or common markets). They can be further extended by several additional measures.

As a result of the formerly closed character of the Eastern and Central European economies, both structurally and institutionally, large potential "static" gains (latent comparative advantages) can be anticipated. Although Hungary has so far implemented some one-sided import liberalization measures, the opening will become mutual through free trade association. A free trade association may enable the countries of Eastern and Central Europe to exploit such advantages on a large scale, making it possible for producers and consumers to use the cheapest import sources for both production inputs and final consumption. This could lead to "trade creation" in both directions (replacement of inefficient and expensive domestic production by cheaper imports). These "static" advantages and efficiency gains could be substantial. In the areas where Hungary has a comparative advantage, export possibilities can be opened, and a conscious exploitation of them (by proper marketing strategies, flexible adjustment to market changes) could ensure over time a satisfactory external balance for the country. Parallel free trade arrangements with other partners (the other associating countries, EFTA, and even the USA) would assure that the diversion of trade would be minimal.

By opening the formerly closed domestic markets, their structures can be broken up, and really competitive market conditions can be created. Such a development would be extremely important. Thus far the reforms oriented toward marketization have often failed to produce the anticipated benefits precisely because monopolistic market positions have not been eliminated and so profits have remained a function of market position rather than expressive of increasing efficiency. Market competition could lead to the cutting of monopolistic prices and costs, to eliminating shortages, to improving the quality of goods and increasing efficiency in general.

Market competition and direct company contacts with Western partners would promote technological progress and the transfer of modern technologies as well as structural change. The bureaucratic central planning and the monopolistic position of state-owned enterprises were accompanied by an unreasonably slow rate of technological development, a lack of interest in innovation, and the general structural rigidity of the economy. Revolutions in technology have made drastic cost reductions possible (for example, by computerized systems of organization, new management structures, organization of cooperating partners outside the company). They have also led to a radical transformation of services and infrastructure (new information techniques and communication systems). The Central and Eastern European countries have missed much of this development, and thus the gap between them and the Western countries has increased. The competitiveness of Central and Eastern Europe has further deteriorated, and the region has missed many market opportunities (which have been seized by the NICs, especially in Asia). This was accompanied by serious distortion of their development. These countries had become severely indebted by the 1980s. There is no doubt that renewed emphasis on technology is of utmost importance; technological and structural modernization could help to realize enormous benefits once the market is adjusted.

The so-called dynamic effects of market integration can be exploited through association, too. Large open markets can give scope for utilizing the economies of scale and reducing costs in different fields of production. Technological progress, productive cooperation, and specialization in supplying components and in certain services lead to dynamic comparative advantages. Extensive participation in transnational company relations can increase microeconomic efficiency and ensure better access to global markets. These advantages can be extended by eliminating all the barriers to trade and cooperation (as within the EC owing to the internal market).

The larger markets can attract joint ventures and private capital investments. In the framework of market integration, capital resources can be mobilized and allocated in a more efficient way (particularly in common markets). The trade and the flow of technology, and the related capital movements, are interconnected. With larger markets, national economies are better placed to overcome structural and institutional bottlenecks in capital supplies. In this respect, Hungary's association and participation in the 1992 measures would improve the opportunities and the competitiveness of Hungarian enterprises. "Above all, the combination of market access in the EC, import liberalization and the improved and more predictable legislative framework should further stimulate the inflow of foreign investment, on which the three countries must rely for new technology and management. They hope that the association agreements will enable them to take full advantage of their two main advantages: a cheap and well-educated workforce; and proximity to the heart of an EC market about to become the largest in the world." (Financial Times, December 2, 1991) Companies from EC countries as well as the USA or Japan could take advantage of the skilled labor force and the low wage rates in Central and Eastern Europe to build factories there and ship products to the West.

An association may also improve the macroeconomic performance of the countries concerned in many respects. It is generally assumed that the dynamic effects of market integration increase the growth rates. The process of economic growth can be stabilized beyond the market impulses by proper economic policies, and in some fields by the coordination of policies. The structural change can help the nation better utilize its labor resources (thus reducing unemployment). Monetary cooperation (some sort of connection to the EMU) is, as the experience of some members and outsiders clearly proves, indispensable for stabilizing exchange rates and paving the way for the convertibility of national currency. It is, of course, necessary from the beginning to control tendencies toward accelerating domestic inflation. The association can improve the chances (through trade preferences and other support mechanisms) of avoiding serious external imbalances which would likely result from integration into the world economy.

It must be stressed that the Central and Eastern European countries (including Hungary) are not yet at all prepared for integration into Western Europe. The above advantages, therefore, are highly hypothetical and they may be realized only after a long and conscious preparation that must include tough adjustments. It should be clearly understood, as well, that association also involves several dangers. We need to be fully aware of them. These dangers could generate substantial costs, sometimes arising out of a confusingly close relationship to benefits.

(1) Structural changes based on and induced by market integration could lead to uncontrollable and undesirable economic and social consequences and tensions. The rapid elimination of inefficient enterprises and subsequent bankruptcies could result in relatively high unemployment, which could be aggravated by institutional and infrastructural rigidities (such as immobility of labor because of housing shortages, etc.). The process can be moderated by the asymmetric and gradual liberalization measures of association, and also by proper and comprehensive domestic employment and social policies.

(2) Structural changes based on market integration may be subordinated to an undesirable extent to the short-term commercial interests of foreign companies, which may even reproduce the structural distortions on a new scale. The growing foreign company involvement may concentrate simply on the region's cheaper labor, while the high-tech capacities are not introduced. Foreign concerns might mostly invest in fields vulnerable to the business cycle, leaving the country in trouble during a recession. These investments may also be limited only to certain sectors, leading to growing structural dependence of the country on the world markets. Or they could strengthen existing monopolistic structures instead of creating competitive alternative patterns.

Association, therefore, must be accompanied by comprehensive national structural policies based on carefully constructed preferences and incentives that consider the interests of both the foreign companies and the country. Recent experiences prove that these types of structural policies are absolutely necessary in order to strike a balance between host country interests and those of the foreign companies. Structural policies are also needed to avoid regional distortions arising out of market integration.

(3) Servicing the accumulating debt would require a surplus on the balance of trade and payments over a long period of time. Experience over the past few decades suggests, however, that market integration often leads to deterioration of the balance of trade and payments, particularly in the case of a less developed country. In spite of broad liberalization measures since 1988, this danger so far has not been demonstrated to occur in every instance. On the contrary, owing to rapid export expansion, Hungary managed to bring down its debt service ratio (percentage of debt service in export earnings) from 75 to 29 percent between 1986 and 1991. Once association is implemented, however, the balance of payments problems may emerge in the future because of structural weaknesses and inherited rigidities of the economy.

(4) Market integration can also cause deterioration in the macroeconomic performance of the affected country (depending on the economic policy). This particularly refers to the macrobalances, and not only the external balance. The country may suffer serious terms of trade losses through liberalization, and the continuous external imbalances may force a progressive devaluation of the national currency, which could result in uncontrollable inflation. Inflation and unemployment may induce economic policy-makers to set a course that is counterproductive from the point of view of consolidation and structural change.

On the other hand, of course, the country may be compensated for these losses. The need for monetary cooperation beyond simple free trade association must also be stressed in this context. One of the main shortcomings of the association agreements signed with the three Central European countries is that the EC has failed to address their financial difficulties in any respect.

To sum up, the association arrangement is accompanied by dangers and social costs which are neither totally unavoidable nor unmanageable. Some costs must be simply accepted, but they may be counterbalanced by the overall benefits of association. Others (e.g. unemployment) can be treated by appropriate economic policy measures, and the negative consequences can be reduced to a tolerable level. It is, however, very important to stress that an association is not automatically beneficial, and comprehensive integration strategies and measures must be developed both at the EC and domestic policy levels.