de Ménil concludes increasing the integration of these markets – which is one of the fundamental objectives of EMU – will have major economic and political consequences. The greatest challenges are political. If and when markets become more integrated, national regulatory and tax authorities will find themselves increasingly in competition with each other. The resulting pressure for deregulation can have a substantial liberalizing effect

de Ménil begins by addressing the question of how integrated long term capital markets have become on the eve of EMU? He notes that if the long-term capital markets of the European Union were fully integrated, there would be a tendency for the real, risk adjusted, rates of return of companies in different countries to converge.

The study uses, for the first time, the annual published returns of listed corporations from 1988 through 1995 to test for this convergence. The criterion of integration is not – as it is in tests of the mobility of short-term capital – a simple covered interest parity equation. Corporate investment programmes do not produce a sure return the way bonds do (assuming no risk of default). They are a bet on future earnings. The most that can be expected of a fully integrated, perfect market for risky investments is the convergence of risk adjusted rates of return. This new study carefully constructs such a test, and finds that, after controlling for the sector, the year, and the co-variance of each company’s return with the average of all of them, large, significant differences in real return remain.

Table 1 reports the estimated risk-adjusted, real country premia.

Table 1

For the sake of comparison, an identical study was performed with the annual reports of U.S. and Canadian firms. This study concluded real rates of return adjusted for risk are the same in those two countries. In other words, their two capital markets are fully integrated. This contrast indicates clearly how far capital market integration still has to go in Europe.

However, a parallel study of aggregate foreign direct investment flows demonstrates that, though still segmented now, European capital markets are more integrated than they were after the creation of the EMS.

This aggregate analysis compares foreign direct investment stocks and flows in the European Union and in the rest of the OECD, from 1982 through 1994. A ‘gravity’ equation is used to show that the equilibrium level of stocks of foreign direct investment owned by one EU country in another were four times greater, relative to GDP, in 1994 than in 1982.

This part of the study also indicates that exchange rate stability was not a factor in increasing long-term capital market integration. Exchange rate stability has tended to reduce foreign direct investment: a ten percent reduction in the standard deviation of the rate of change of real exchange rates is estimated to have led to a 16% reduction in the equilibrium level of FDI stocks.

Estimates also indicate that EU countries lost out due to the lack of a common language. The study shows that during the period examined, OECD countries with English as a common language had FDI stocks three times larger than those countries that did not.

EMU is widely expected to lead to a step increase in the integration of real capital markets in Europe. Increased capital market integration will have major economic and political implications. A more rational and efficient use of capital is an obvious economic benefit. This is a process in which some nations lose (those that lose capital, relatively), and some gain (those that gain capital).

But the most important potential consequences are political. Special interest regulations of an exclusively national nature will not survive. They will either fall before a wave of internationalist liberalization, or become embedded in ‘harmonized’ regulations at the federal level. If the result is a movement to liberalize excessive regulatory burdens, notably in the labour market, the productivity gains across the board could be very substantial. In such a process of liberalization, all countries gain.

This paper was first presented to the 26^th Economic Policy Panel meeting held in London on 17 April 1998. Economic Policy will be published on 20 October 1998.

George de Ménil is Professor of Economics at DELTA and a Senior Editor of Economic Policy.

We are very grateful to the Österreichische National Bank for hosting this event.

Economic Policy is published in association with the European Economic Association for the Centre for Economic Policy Research, the Center for Economic Studies of the University of Munich and the Département et Laboratoire d’Economie Théorique et Appliquée (DELTA), in collaboration with the Maison des Sciences de l’Homme.