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INTEGRATION Report Summary

Project ID: 336659
Funded under: FP7-IDEAS-ERC
Country: Israel

Periodic Report Summary 2 - INTEGRATION (International Integration and Social Identity: Theory and Evidence)

This project seeks to introduce social identity into international economics.
The determinants and consequences of international integration have been central concerns for economists for a long time. The economic benefits of integration are fairly well understood and have been studied since the time of Adam Smith. The costs often stem from having to satisfy divergent needs with a ‘one size fits all’ policy. Integration should therefore take place when fundamental differences between the candidate countries are small relative to the economic benefits.
But integration is often shaped by additional forces. Consider European integration. From the beginning, it has been clear that economic considerations were not the main driving force (Schuman, 1950). Economists writing in the 1990s about the looming European Monetary Union also recognized that the decision would not depend on the economic advantages and disadvantages. The prospects of developing a European identity that might transcend the bitter national identities of the past, as well as notions of national pride and status, appeared no less central than pure economic considerations.Indeed, the composition of the Eurozone is hard to understand using the framework of optimal currency areas alone. Countries such as Sweden and Denmark did not join, although they appeared like natural candidates based upon trade and co-movement in output and prices relative to the core Euro countries. On the other hand, countries more likely to require different monetary policy, like Greece Portugal and Spain, did join.
Recent European experience is also puzzling. Why did the UK vote to leave the EU despite a near-unanimous view among economists that Brexit would have negative consequences? And why did southern European countries join—and remain—in the Eurozone despite significant fundamental economic differences from the core northern countries, which require different monetary policy? “Identity politics” has been widely discussed as a prominent cause underlying such decisions. But we still lack a conceptual framework to help think through the implications of identity and what might reasonably be expected to happen in equilibrium, given that identities not only shape but also respond to changing economic circumstances. This project helps fill this gap.
We study economic and political unions when potential members may care not just about their own country but also about the union as a whole. We refer to such altruistic motivations as social identities. Basically, an individual is said to identify with a particular group if her utility is increasing with the material payoffs of members of that group and decreasing with her perceived distance from that group. In other words, her preferences are, to some extent, aligned with that group. Importantly, identities are not necessarily fixed. A German citizen, for example, may identify as a German but may, to some extent, also identify as a European.
We embed this framework in a simple bargaining model between two countries: the Core and the Periphery. Thus, France and Germany may be thought of as Core, politically dominant countries within the European Union, while Denmark, Spain, the UK and Greece are Periphery countries that may consider whether to join or remain in the union. The Core sets a common policy for the union (e.g. monetary policy, debt policy, regulation, immigration policy). The Periphery then chooses whether to join the union or leave and set its own policy. Replicating classic results, unions in this model are less likely to be sustained in equilibrium the larger the differences in fundamental economic and political conditions between potential members. The question is then: what policies does the union adopt and at what point does the union disintegrate? We say that a union is more accommodating if its adopted policies better suit the needs of the politically weaker Periphery (at some cost to the Core). We say that a union is more robust if it is sustained under larger fundamental differences between members.

Members of each country may identify nationally (i.e. with their country) or they may identify with Europe as a whole. Consider first what happens under a given, fixed, profile of social identities. A predominant view is that the European Union would be more robust if everyone in Europe identified more as European. Our analysis suggests a more nuanced view. First, consistent with common views as well as survey data, a union is more accommodating when citizens of the Core identify with Europe. This is because the Core then takes into account the interests of the Periphery, and hence makes policy concessions even when it would not make any concessions if it was only interested in its own material payoffs. However, a union is less accommodating when the Periphery identifies with Europe, essentially because in this case the Core can preserve the union with smaller concessions. Importantly, a union is most robust when individuals from the Core identify with their country (and not with Europe), while individuals from the Periphery identify with the union as a whole. This identity profile yields a more robust union than the profile in which everyone identifies nationally. Moreover this profile also yields a more robust union than when everyone identifies with Europe.
This analysis, however, takes social identities as given. During the past three decades it has become clear across the social sciences that ethnic, national or other social identities are changeable – and respond to the social environment in systematic ways. Implicit in such a perspective is the idea that individuals choose (consciously or unconsciously) to identify in a meaningful way with some of the social categories they belong to, but not with others – and that economic and political processes and institutions can affect the incentives individuals face when forming social identity attachments. Indeed, the founders of the European Union were quite aware of this possibility, and believed that economic integration would promote European solidarity. Thus, while in principle we can analyze the equilibrium policies under any specific profile of social identities, it is unclear whether such an identity profile would in fact be sustained given the economic and political conditions that result from these policies.
To address this problem, we incorporate insights from social identity research to endogenize the decision whether to identify with one's country or with the union as a whole. Beyond the fact that people tend to identify more with groups they are more similar to, an extensive literature in social psychology consistently finds that people tend to identify more with high-status groups than with low-status groups. But the status of both the union and of the potential member states is itself endogenous to the economic policy, which in turn depends on the identity profile. We therefore employ an equilibrium concept—Social Identity Equilibrium (SIE)—in which both identities and policies are jointly determined.
Consider first the simplest baseline case, in which similarity to the group does not affect identification decisions and the countries are ex-ante symmetric in status. One example is when status is determined by economic conditions alone. We show that in this case, in almost any equilibrium in which the union is sustained, the Core identifies nationally. From this perspective, the expectation that unification by itself would lead to the emergence of a common identity across the union seems misplaced: the very success of a union tends to enhance national identification in the union's dominant Core countries. This last conclusion extends to the more general case where ex-ante statuses vary and perceived similarity is important. National identification is of course shaped by many forces, but it is a mistake to expect unification per-se to act as an automatic antidote.
The general result is that when the Periphery has lower status than the Core, unification can be sustained despite relatively high fundamental differences between the countries. The basic reason is that if agents are allowed to choose their identity, members of a low-status Periphery will tend to identify with Europe, which in turn permits the union to be sustained under larger differences. This happens despite—and to some degree because of—the unaccommodating policies of the union vis-a-vis the Periphery, which accentuate the Core's status advantage. Furthermore, we find that when the Periphery has equal or higher status than the Core, disintegration can occur at relatively low levels of fundamental differences. Such equilibria are always characterized by national identification in the Periphery (but not necessarily in the Core). Beyond helping to explain the Brexit puzzle, one implication is that British national identification is unlikely to subside if and when Brexit takes place.
Finally, we consider policies that alter the salience of inter-country differences. When people care less about such differences, the union can be sustained at higher levels of fundamental differences. Moreover, this increases the set of circumstances in which both unification and an all-European identity profile can be sustained in equilibrium.
To derive empirical predictions, we compile data from various sources to gauge the main theoretical variables in the model for European countries today. This allows us to evaluate, in light of the model, the stability and challenges to the current composition of the EU and the Eurozone. With respect to the EU, the UK and Sweden appear to be at the highest risk of breakup. Portugal is at a lower risk of breakup than Spain, Ireland and Greece. The union with Austria, Belgium, the Czech Republic, Slovenia, Slovakia, and Hungary appears quite solid, despite expressed Euroscepticism in some of these countries. In terms of entry, Iceland currently seems to be the most likely candidate to join the EU. Switzerland and Norway are unlikely to join, despite low fundamental economic and political differences from the core European countries. Turkey is unlikely to become a member, in large part due to high political differences. This section also helps shed light on the composition of the Eurozone and the risks it faces.

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