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Lecture in Politiea's "EMU and.." series, Carlton House Terrace, London SW1, 25 May 1999.



Deepak Lal

James S. Coleman Professor of International Development Studies,

University of California, Los Angeles

Address (till end Sept.):
2 Erskine Hill,
London NW11 6HB
Tel/fax: 0181-458 3713
email: dlal@ucla.edu
May 1999


by Deepak Lal


If a Rip van Winkle had gone to sleep at the end of about 1870 and woken up in the last few years, he would find that little has changed in the world economy. He would note the various technological advances in transportation and communications (airlines, telephones and the computer) which have further reduced the costs of international trade and commerce and led to the progressive integration of the world economy which was well under way- after the first Great Age of Reform- when he went to sleep.

The terrible events of this century- two world wars, a Great Depression and the battles against two illiberal creeds- Fascism and Communism- which led to the breakdown of the first liberal international economic order(LIEO) - created under British leadership after the Repeal of the Corn Laws- would form no part of his memory. Nor would the various and varying fads in economic policy-both national and international - during this century make any sense, eg. exchange controls, the use of quotas rather than tariffs as instruments of protection, centralized planning and associated controls on production and distribution, and restrictions on the free flow of capital.

Having read his De Tocqueville he would also not be surprised that the US and Russia had become Great Powers in the latter part of this century- though the latter's greatness was to prove ephemeral. Nor, that it took the US nearly a century to become the predominant power, just as it took Britain nearly a century from the mid 18th century conflict with France till the end of the Napoleonic Wars to achieve its predominance. His reading of De Tocqueville would also allow him to see a natural progression from the rise of Great Britain -which was in a sense the victory of an aristocratic oligarchy over the divine right of kings- to that of the US, which is a victory of Demos over aristocracy. Whether this is an unmixed blessing is open to question.

He would be surprised by two features of the current world economy. For unlike the 19th century when there was free movement of goods, money and people, today there are relatively free flows of goods and money but no free movement of labor. This is related to the second surprising feature he would observe: the welfare states to be found in most advanced countries, which as he would soon recognize, have created property rights in citizenship. This, necessarily leads to restrictions on immigration. For immigration creates new citizens with an automatic right of access to the purses of existing citizens through the transfer state. Having gone to sleep in 1870 before the great scramble for Empire by the nations of Europe, and the universal spread of the Romantic movement's ideal of nationalism, he would also not be surprised by two other features of the contemporary world. First, that the territorial imperative which had motivated competition between nation states since the end of the wars of religion was replaced by the commercial competition of trading states following the example of Great Britain in the first great Age of Reform. Second, that as more and more developing countries, particularly India and China with their vast pools of relatively cheap labor, are brought into an integrated world economy, a new international division of labor is emerging, with developed countries mainly providing services and developing ones manufactures. With this spatial division between 'the head' and 'the body' of economic activity, trade is becoming essential for the well-being of all countries, thus reducing the attractions of nationalism and war. He would also not be surprised to see the world on a dollar standard as it is the currency of the dominant world power.

He would be surprised by the attempt to create an alternative world money in the Euro, particularly as it is the single currency of what still remains a politically disunited union. He would recognize that the Euro represents an unprecedented attempt to use economic means to achieve a political end- to recreate a new Holy Roman Empire. He would remember the failed attempt to create one under French arms during his lifetime, and would have read of the two failed attempts by the Germans to do the same while he was asleep. He would wonder if Germany had now found a cunning method- through EMU- of achieving this end, and if it would be anymore successful than past attempts. He would also wonder if, as during the period he was asleep, this new attempt at creating a united Europe under German hegemony might once again lead to the destruction of the newly emergent liberal international economic order (LIEO). It is these two questions arising from these latter of Rip's musings that I will explore in this lecture: first, what are likely to be the effects of EMU on globalization? and, secondly, whether EMU will promote or retard the process of globalization within Euroland?


The first question has two parts: the effects of EMU on the international monetary system, and secondly on the world trading system. On the latter I can be brief. On trade matters, the EU has already been acting as a bloc with one voice- for good or ill- for a considerable period, including the various trade rounds that have markedly liberalised world trade under GATT and now WTO auspices. EMU does not alter this position. It might, however, for reasons I will come to in examining the effects of EMU on Europe, effect its stance in future trade negotiations. But, the continuing mercantilist frictions- for instance in the recent banana and GM foods disputes with the US - show that it retains its protectionist instincts.

What of EMU's effects on the international monetary standard? As Rip noted, the world has in effect been on a dollar standard. A successful Euro could challenge this dominance. For the share of Euroland in global trade and production matches that of the US, and this could make it attractive as an international store of value and a vehicle currency for international transactions in goods and services, as well as for the dealings of the burgeoning international underground economy.

But would this rivalry with the hitherto dominant dollar be in the global interest? A number of economic historians have maintained that part of the cause for the break up of the 19th century LIEO was that the decline of Pax Britannica was not smoothly followed by the rise of Pax Americana. The economically and politically dominant power did not accept this new responsibility till the end of the 2nd World War. It is this US hegemony that Europe seeks to challenge. But, apart from the question of its likelihood of success, there is the danger that this attempt might create the type of frictions which led to the breakdown of the 19th century LIEO.

However, if the Euro can successfully challenge the dollar as an international store of value, a larger share of the world's money supply (including reserves) will be held in Euros rather than in dollars. This will provide implicit revenue in the form of seignorage to the European Central Bank. But, there would also be two other global consequences. If there was a large enough shift out of existing US assets and of further flows from the world's savers into the Euro, the current imbalance between savings and investment in the US would become untenable and its current account deficit unsustainable. A depreciating dollar, rising interest rates and a collapse of asset prices- not least in the bubble on Wall Street- would follow. But, nearly six months after the Euro took its bow, this has not come to pass.

Nor has the other implication that, with the inflows of capital induced by a desire of world investors to diversify their portfolios, ceteris paribus, the Euro would soar. This too has not happened so far. Why? The reason, I conjecture, is that the Euro is not as yet perceived as being credibly as good as the dollar. This is because while there is no question in any one's mind that, the dollar, in which the US treasury's long term (30yr) bonds are denominated, will still be around when they are redeemed, no one can be as certain of the Euro's survival when 30 year Euro bonds are issued by the ECB and come up for redemption.

This lack of credibility about its survival is intimately linked to the way the Euro was set up: by putting the cart of monetary union before the horse of political union. The currency of a genuine political state is credible because the currency's demise would be co- terminus with that of the state issuing it- which is unlikely. If not underpinned by a political union, a currency union is only credible if it fulfills the criterion of what economists call an "optimum currency area" - within which exchange rates should be fixed. Europe does not fulfill these conditions. Hence, the bulk of respectable mainstream economists see the Euro as a dangerous gamble with a high chance of failure.


Creating a monetary union without political union poses a number of political dangers which could undermine the process of globalisation within Euroland.

For a monetary union to work it is important either that, there is wage and price flexibility to deal with the unemployment that asymmetric shocks to different regions in the currency area could cause, or else there should be easy migration possible - as in the US- between regions with deficient and excess demand for labour. Neither attribute exists in Europe. Its labour markets are notoriously inflexible, and the major differences in customs and above all language make labour -except at the very top- largely immobile. When coupled with the 'stability' pact, countries in Euroland which suffer unemployment will be unable to deal with unemployment either via the exchange rate or expansionary fiscal policy. Nor, as in the genuine federal polity - the US- are federal fiscal transfers on a requisite scale likely to be forthcoming to offset regional unemployment. Here is the first serious source of political tensions, which have already emerged. An independent ECB, committed to a EU wide inflation target, cannot loosen monetary policy to deal with the regional unemployment problems that will arise. Something has to give in this impasse, and it is becoming increasingly clear from the statements of the German and French governments- which have been legitimised by the fiddles so many aspirants to join Euroland made to meet the Maastricht criteria- that it is the 'stability' pact that will go.

This points to the second danger. If the ECB maintains a tight monetary policy, while various regional governments loosen fiscal policy- a policy combination last seen in Regan's USA- the result will be a soaring Euro. This will adversely effect the competitive position of Euroland industry in world markets- worsening its already serious unemployment problems of Euroland. If instead, the ECB heeds the interests of the regions suffering a deficiency of demand by loosening the common monetary policy, that would lead to inflation in the other regions, which is exactly the latent fear of so many Germans in their dislike of the Euro having replaced their beloved Deutschmark.

Euroland is, therefore, likely to be riven by inter- regional political tensions, because of the monetary union. These could inflame those very nationalist passions which the creation of Euroland was aimed to suppress. Some like Martin Feldstein of Harvard have even predicted a resurgence of the old European wars as a result of these tensions engendered by the advent of the Euro. Rather than leading to political union, monetary union could perpetuate the current political disunion and further lead to the breakup of the Common market as economic nationalism is fed by these troubles.

The drive for European political unity is not helped by the fact that it is a political project which has tried to suppress normal politics in the member countries in getting though its various stages. It is a project borne out of the respective weaknesses of the participants and not their strengths. The French, despite their bravado and pride, are a defeated nation. They see the Anglo-Saxons, not least in their language and culture, triumphing world wide. The French elite- most of whom seem to be associated in one way or another with ENA (and can be properly called ENArques)- has, therefore seen the EU as its only hope of global influence in a Europe in which they would jointly exercise hegemony with the Germans- on their model of the French rider riding a German horse- in a new Holy Roman Empire. Germany, because of its World War trauma has gone along with this illusion, and used the clever ploy of promoting an economic union leading to political union to tie down German nationalism as the best way to tame the passions which have led to two savage European wars. Italy has gone along because it wishes to unload the unending burden of subsidising the Mezzogiorno to a larger body of European taxpayers, while the rest of the Mediterranean countries and Ireland have looked upon the subsidies, through the CAP and other regional schemes, they have obtained from Europe, as a drunk given free access to a liquor store.

And Britain? In search of a post Imperial role and identity, a part of its elite particularly in the Foreign Office has come to the defeatist conclusion that the only role left for Britain is as a part of "Europe" - where the parentheses emphasize the artificiality of this project- where its worldly experience would allow it to join France and Germany in running Europe. To another part of the establishment and the general public the European project was sold as merely a common market which would provide the usual gains from trade in a larger unified economic space. The explicitly political aim of the European partners was said to be just window-dressing. As this lie has been gradually exposed, Europe has become the great dividing line in British politics with- unsurprisingly- the Euro at its center.

Linking most of these elites there is also a not too hidden distaste for the United States and a desire to build a Europe which will be a bulwark against the crass and uncaring attitudes seen to be dominant across the Atlantic. Moreover, for the ENArques- whose connections are Europe wide- despite the lip service paid to 'subsidiarity' it will also be a Europe run by technocrats and not Demos, or a free market. This is why we see the divide between big and small business in their support for "Europe": with big business -which is more easily able to co-opt regulators to its benefit- being in favour of the regulatory state favored by the technocrats, and small business- more interested in the more level playing field a true free market economy provides- being against.

There is a third and equally serious danger. With the setting up of the ECB, it has pooled the reserves of its constituent 'national' central banks. In a fractional reserve banking system, as we have known since Bagehot, one essential task for a central bank in the face of a financial panic is to act as a lender of last resort. The Maastricht treaty is silent on who will provide this function in Euroland. Even if the 'national' central banks are willing to stem a regional financial panic, they may not be able as they have handed most of their reserves and the power to print national money to the ECB. By contrast the ECB maybe able but not willing to act in a regional panic because this could be taken as a bail out -at the wider EU taxpayers expense- of regional bankrupts. In a nation state with both political and monetary union this would not matter because of the sharing of a common national identity. But Germans in the EU are unlikely to take kindly to the promised successor to the Bundesbank bailing out some feckless Italian financial institution. Another source of political conflict. Once again it seems the cart of monetary union has wrongly been placed before the horse of political union. What is worse, this paralysis in acting as a lender of last resort could in the face of financial shocks lead to a European slump on the scale of the US Great Depression.

There is a fourth danger. If the Euro appreciates, there is likely to be a capital inflow whose obverse side is a trade deficit with the rest of the world. This will in the short run make it easier to finance budget deficits in Euroland, which are mainly caused by bloated and overgenerous welfare states. These have served the political purpose of keeping the lid on popular discontent arising from the unemployment caused by unreformed labour markets. The seeming easy financing of these deficits by capital inflows would delay those badly needed reforms without which Euroland has no hope of competing in the global economy. By reducing the productivity of investment, this sclerotic labour market also damages growth. As has happened in so many Latin American countries, foreign investors are then likely to take fright, and the drastic measures which may then be required to deal with deficits that have become unsustainable could tear apart the social compact of the European "social market economy." The resulting wrath of the hitherto ignored and docile Demos in Euroland could be terrifying.

The final danger is that egged on by the rising trade

deficits the Eurocrats may try to create a Fortress Europe. This would also fit in with their 'nation-building' aims. As Hecksher emphasised in his magisterial work on Mercantilism for the post Renaissance creation of European nation states, and Myint and I found for the post war Third World, this nationalist objective naturally leads to dirigisme. But, as worldwide experience has shown, this way lies the route to the poverty of the Second if not the Third World. It is also not viable in the long run.

Which of these various routes will undo the European project it is impossible to tell, but it is these political fears about the effects of the Euro on Europe which I suspect will also make it difficult for it to replace the dollar as a world currency in the near future.

There is also a geo-political point to be made. The dollars pre-eminence is based not merely on the US's economic strength but its geo-strategic hegemony. As the recent events in Yugoslavia show, a Europe which is unable to muster the requisite men and materiel to deal with a local tyrant within its domain, but must instead rely on those supplied by an increasingly reluctant America, can hardly be expected to challenge its supremacy as the world hegemon in the near future.


Euroland's embrace of globalisation is also being hindered by the contradictory expectations of the supporters of the Euro. The first, are the "Dinosaurs", the second the "Modernisers". The Dinosaurs look upon the Euro and the whole European project as protecting that whole economic and cultural complex which is called by that oxymoron a "social market economy" from- what are labelled- the neo-liberal effects of globalization and the spread of Anglo Saxon culture. The Modernisers by contrast look upon the Euro and the stability pact accompanying it as the means to establish a flexible, dynamic and truly globalised economy as achieved in Thacherite Britain.

I think the modernisers have logic on their side but the dinosaurs can harness passions in domestic politics concerning what has been called 'the social question' to stem the process of globalisation as their predecessors did at the end of the last century. For, the most important change in the global economy since the 19th century is an emerging new international division of labour. In the 19th century, the North mainly produced manufactures and the South, primary commodities. This led many to claim that without forced industrialisation the South would remain hewers of wood and drawers of water. Now, as a result of globalization, and after reversing their foolish import substituting industrialisation and protective trade policies, the countries of the South find that, under the impetus of the revolution in communications and differential labour costs, much of the North's manufacturing industry is shifting to them.

What of the North? It is coming to own what I call 'virtual factories.' This was the name given to his enterprise by a young and very rich entrepreneur I met in California. He is in the business of producing various consumer goods. His virtual factory consists of a few smart people with computers sitting in San Francisco, who have contacts with the major stores and designers in the US, as well as production facilities strung out all over the Asian Pacific Rim. Given the volatile and highly differentiated tastes of consumers for different products, the stores take orders for highly individualized products, which are then produced 'just in time' by the cheapest facilities the 'virtual factory' can find in Asia. The virtual factory provides the 'head' for the parts of the 'body' scattered all over the South.

This new division of labour can be compared with that which underlay the 19th century LIEO when the Industrial Revolution pioneered in Britain spread to other parts of Europe and North America. This is best seen by the nature of the first Industrial Revolution. The late Sir John Hicks used to emphasize that the major characteristic of the Industrial Revolution was that it led to the substitution of fixed capital for working capital in manufacturing. The simplest example is the substitution of the 'putting out ' system of producing textiles with handlooms by the 'factory system' of textile mills. Later, as a result of Henry Ford's innovation of the production line, mass consumer goods could be produced by even semi-skilled workers. This factory system required both capital and technology- both by and large lacking in the South. But, now, enter the multinational or transnational corporation. It can provide both to the South. Relative labour costs then become the main determinant of where particular manufactured goods and increasingly their components are produced- and this is increasingly in the South.

So what is their left for Northern workers to do? As my virtual factory example suggests, their future is increasingly in skill intensive activities, which are more in the nature of services than manufacturing. This new Industrial Revolution based on the microchip, therefore, involves substituting human for fixed physical capital in the North, whose traditional ways of making a living are moving to the South. In this way, as economists since Ricardo have known and preached, free trade leads to mutual benefits, with wages and incomes rising in both regions as they specialise in goods and services in which they have a comparative advantage.

But to obtain these gains, the processes of adjustment have to be allowed to work. In a market economy they are facilitated by wage signals, as can be seen in America- with the stagnation of the wages of the unskilled and a rising wage premium for each and every level of education. Though the income distribution has worsened, employment and per capita income have grown substantially. But this is not so in Euroland, where the views of the Dinosaurs still command widespread acceptance, and so the necessary wage signals have been muted and the unskilled are instead left unemployed but mollycoddled by generous welfare systems in these 'social market economies'.

It was precisely this, so called, "social question" which in part led to the unravelling of the 19th century LIEO, as the redistributive and egalitarian politics arising from the rise of Demos undermined that belief in classical liberalism which underlay the intellectual underpinnings of the LIEO. With globalisation picking up where it left off before this 'socialist' impulse- as we may call it- undermined the LIEO, the implicit philosophy underlying the so called 'Washington consensus' on economic policy is underpinned by classical liberalism. In this sense, globalisation has put an end to what might be called the Age of Keynes.

One of the consequences of the breakdown of the 19th century LIEO was that convertibility of currencies and free mobility of capital was greatly attenuated and in many countries snuffed out by exchange controls- I need not remind you that in the UK these were only abolished when the first Thatcher government came to power. The bottling up of capital was essential for the Keynesian system to work. This was explicitly recognised in its international expression- the so-called gold exchange standard established at Bretton Woods- which required controls on what were deemed to be short term capital flows to allow the adjustable peg exchange rate system to work- free from the speculative attacks which plague such systems.

The domestic consequence of this bottling up of mobile capital was that Keynesian remedies requiring the taxation of capital to subsidise labour, would not work if capital was free to move and escape these arbitrary and exorbitant imposts. This is not the place to relate the story of how the world moved to free mobility of capital, but once it did, dirigiste states find it increasingly difficult to claim that they are able to promote national prosperity and welfare through fiscal policies to maintain "full employment" and increases in redistributive taxation. Globalised capital markets, by allowing the prey to exit, have diminished the power of the predatory state to maintain- let alone- increase its take. Even those imbued by the 'socialist impulse' now recognise that their political prospects rely on the two Clintonian slogans :"It is the economy stupid", and "Its the bond market stupid"! Moreover, as Mohammed Mahathir of Malaysia is soon about to discover, opting out of this emerging global market economy can only damage the prospects of that popular opulence which is now a world wide demand and which this globalised economy can deliver to all its participants in an unprecedented manner.

There is also less danger today that the 'social question' posed by the current phase of globalisation will undermine the new LIEO as it did its 19th century predecessor. This is because of the different nature of the 'losers' in the North in the two cases and the mitigating actions they can take to preserve their prosperity. The rise of the factory system in the 19th century and its spread to the North meant that the economic integration of the Atlantic economy by the LIEO, led to relative declines or stagnation in the real incomes of the factors of production in each region which were relatively scarce, and a rise in the incomes of the more abundant factors. This meant that in the US which was labour scarce and natural resource cum land abundant, the distribution of income moved against labour. This led to the growth of populist politics and creeping protectionism on grounds first propounded by Alexander Hamilton. In Europe, which was labour abundant and land scarce, this 19th century globalisation led to landowners losing out relatively. This then led to political coalitions such as the famous one between 'rye and steel' in Germany and growing protectionism justified by the 'infant industry' arguments of Friedreich List. The UK alone stood by its Free Trade creed, largely because having fought off the 'landed interest' at the time of the repeal of the Corn Laws and being the first Industrial nation, the prosperity of both its industrial capitalist and workers was enhanced by the cheap grain flowing across the Atlantic as a result of the LIEO.

While political action by threatened interest groups seemed inevitable to deal with the distributive consequences of globalisation at the end of the 19th century, the situation is much more benign in the current phase of globalisation. For whereas in the earlier phase the losers- the industrial workers in the US or the landowners in Germany for instance- could not acquire the means to prevent their relative decline, this is not so in the current situation in the North. The main losers are the unskilled, and unlike the industrial factory workers of the 19th century who could not acquire the physical or financial capital to stem their relative decline in incomes, today's unskilled can acquire the necessary human capital to share in the immense gains from globalisation to their skilled compatriots in the North. Secondly, and equally important, with most Northern economies becoming primarily service economies, many more workers will be working in areas where the products produced are 'non-traded', i.e. sheltered from foreign competition. A hairdresser in Surbiton is not going to see his or her rates cut by competition from barbers in Bangkok. But, many of these personal services require not just skills but also personal attributes like tidiness, punctuality, politeness and trustworthiness. Mothers are hardly likely to employ a member of the so-called 'underclass' as a baby sitter or housekeeper even if they were willing to accept the wages of a maid in India. The undermining of the Victorian personal virtues in the underclass created by Western welfare states provides yet another reason why their reform is so important for helping the potential 'losers' from the current processes of globalisation.

But within Euroland the Dinosaurs still cling to the dirigiste vision, with the preservation of their bloated welfare states being its major objective and look upon the Euro as their saviour. The future prosperity of Europe therefore depends upon which of these two rival views wins in the near future. If the modernisers win, Europe could challenge the US in efficiency and growth. But it should be emphasised the Euro is certainly not necessary to further this process of globalization within Europe. Unilateral removal of tariff barriers, and eliminating capital controls are sufficient to integrate with the world economy.

Nor, as the successful city states of the Far East have shown, does size matter for prosperity in a globalised economy. Except for politicians, whose sense of self-importance maybe fed by the size of country they claim to represent, the welfare of ordinary citizens is dependent less on where and what particular goods and services are produced domestically than on the highest return they can get for their labour, capital and enterprise and the cheapest price they can obtain for the goods they consume. The provision of local public goods and amenities is the only government mediated action which would effect their welfare- apart from the usual provision of the classical public goods of law and order (including national defense).


For the Euro to successfully challenge the dollar, not only would all these processes of globalization need to be accepted in Euroland, but in addition, as I have argued, there will be a need to create a genuine nation state with a true European identity. For only then will it be viable in an economic area where the conditions for an optimum currency area not met. It is doubtful if, despite the spin doctors, there is any emerging European identity- as witness the recent World Cup, where all the ancient tribal rivalries were often on bloody display.

As regards the conflict between the dinosaurs and the modernisers, which will determine whether Euroland globalises, perhaps the optimists will be proved right. The Euro though not in itself essential for globalisation could act as a spur. EU politicians will bite the bullet and undertake the structural reforms necessary for Euroland to integrate fully with the global economy. I, however, remain a skeptic, partly, because this is like asking "whether pigs have wings". But, primarily because, as I have argued, for globalising Euroland, the Euro is as much the problem as the solution.




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