Towards an Optimal Governing Area
Mini Teaser: Today, individuals are no longer mere citizens--they are mobile consumers in a competitive governance market. Caveat emptor.
The world is getting smaller. The Internet, cheaptransportation, the spread of free and open markets, and surgingeducation of the masses are steadily eroding the last vestiges ofeconomic autarchy. This increased integration presents afundamental practical challenge to the sovereignty of nations.Policies that are possible in an isolated island state can beimpossible in our new and mostly democratic world of nomadiccapitalists.
This metamorphosis has created heightened demand forinternational cooperation, a demand that has been the midwife tothe birth of organizations that are rapidly becoming a haphazardworld government. At the birth of the United States, AlexanderHamilton wondered whether men "are forever destined to depend fortheir political constitutions on accident and force." Today, it isnot reason, but accident and force that are carving the contours ofthe global political environment.
The feckless and corrupt actions of the United Nations in recentyears provide a case study in how harmful attempts at worldgovernment can be when they go wrong. It is necessary that citizensand leaders of the United States develop a theory of internationalcooperation that can provide a guide to future global associations.This theory must address several specific questions. What areas ofhuman endeavor are likely to require international cooperation inorder to enable efficient outcomes? What types of internationalorganizations should the United States join? When should the UnitedStates be willing to partially cede its sovereignty to suchbodies?
Two strands of economic research provide a natural startingpoint for this discussion. First, the public choice literature hasexamined extensively which services should be offered by localgovernments and which should be offered by national ones. Theextension to world governments is straightforward. Second,specialists in industrial organization have developed a quite broadunderstanding of the functioning of cartels. Coalitions ofcountries often face the same challenges that coalitions of firmsdo. A synthesis of these two literatures provides a valuable guideto the problem of world government.
How Big Should a Country Be?
In one of the great intellectual accomplishments of the 20thcentury, economists Kenneth Arrow and Gerard Debreu set out theconditions under which a free market could be expected to produceoptimal outcomes for individual consumers. Adam Smith's "invisiblehand" of the marketplace was shown--under some conditions--to be afirm and steady force that allocates resources optimally. Theydemonstrated that no reallocation of resources exists that makeseveryone better off than does the allocation that arises as anatural equilibrium of a competitive market.
In these Arrow-Debreu efficient markets, there is a very smallrole for government, which keeps the peace, enforces propertyrights and does little else. If all markets were Arrow-Debreuperfect markets, governments could be very small indeed. We mighthave a federal authority that enforced patents across states,established a minimal set of rules, and allowed state governmentsto provide most government services.
Perhaps the largest contribution of this work, however, was itsillumination of the situations under which larger governments andinternational unions might be necessary. If we identify theassumptions under which markets are perfectly efficient, then wealso have learned when they are not and when they can benefit fromgovernment action.
Markets can fail when citizens require goods that are public innature, or when the production of the private goods they desireproduces significant externalities. A public good is a good that isconsumed by all, without possible exclusion. A textbook example ispublic safety. There is no reason to believe that individuals, ontheir own, would voluntarily contribute enough money to a commonpool to build an army capable of providing real security. Eachindividual would be tempted to free ride, that is, to assume thatothers would provide enough security. Collectively, free-riding canlead to suboptimal provision of public goods. An externality is aslightly different beast. If a steel factory produces pollutionthat harms agricultural output, then that pollution is anexternality. The steel producer, on his own, might ignore thesocial harm from the pollution and produce far more than issocially optimal, and regulation of pollution by government mayimprove social welfare.
There are countless examples of public goods that we require andexternalities that we must monitor. These provide a rationale for alarger and more aggregate government than would otherwise emerge ina free society.
The specific individual characteristics of our desired publicgoods have a significant impact on the optimal level of geographicaggregation. There is little question, to take an early example,that the desire to create a federal force large enough to fight theBritish provided a strong impetus for the unification of the statesat the Founding. The public good of "safety" required coordinationbetween the individual states at the broadest possible level. Totake a more recent example, allowing the social safety net to varyacross states might set off a destructive race to the bottom.States that offer relatively more generous welfare benefits mightfind themselves inundated with migrant paupers. If society viewsthe provision of a safety net as important, policy coordinationbetween the states may be necessary.
In order to provide for services that require a centralgovernment, nations have established federal authorities withpowers of taxation and enforcement. These powers can lead, overtime, to a significant evolution in the focus of the governmentaway from its original design. Elected officials may be tempted topursue actions, such as subsidizing farm production, that do notnecessarily focus on public goods or externalities.
As government's reach evolves, the problem of federalism becomesa tradeoff for those who might choose to join. On the one hand,allowing oneself to be absorbed into a larger whole can increasesecurity and provide access to valuable public goods that smallerentities might not be able to produce. On the other hand, joiningthe union forces one to harmonize undesirable policies withcitizens who may have significantly different tastes for governmentintrusion. This conflict between coordination and harmonization, asHarvard economist Alberto Alesina has recently demonstrated inseveral important studies, is the essence of the economic problemof modern government.
The problem was recognized long before Alesina, however. Indeed,a series of works by my colleagues Christopher DeMuth and MichaelGreve have documented the debate over these issues that occurred atthe birth of our nation. They have argued that our forefathers'preferred design of a federal system allowed for ample competitionbetween the individual states, and free movement of citizensbetween the states, for a good reason. Should a state pursuepolicies that are harmful to overall welfare, its citizens couldpick up and move to a neighbor.
The federal system set up a competition between states thatacted as a natural governor of the growth of harmful government.This political insight was later incorporated into the economiclexicon by economist Charles Tiebout, who demonstrated that "votingwith your feet" often leads to efficient provision ofgovernment.
As the United States turns its gaze outward to the worldcommunity, therefore, it must entertain the possibility thatmembership in an aggregated global governing body may be necessaryin order to ensure that global public goods are adequatelyprovided. But it must weigh the benefit of improved coordination inthe provision of these public goods with the potential costs ofharmonizing policies with nations that have far different socialpreferences. And the citizens of the United States should be waryof entering into compacts that limit the beneficial competitionthat preserves liberty and constrains the growth of inefficient andintrusive government. It is essential, then, that we identify whencompetition between states leads to better outcomes, and when itdoes the reverse.
Government or Cartel?
In the classic Arrow-Debreu world, products are produced bycountless identical and competitive firms. From the point of viewof consumers, the competition is beneficial, since it drives theprice of any product down to its cost. From the point of view ofthe firms, however, the competition is an annoyance, since itlimits profits. Accordingly, firms may recognize that anassociation between all of them might lead to much higher prices.This association is a "cartel", of which OPEC is the leadingpractical example. From the point of view of the firm, a cartel isa wonderful, profit-enhancing device. From the point of view of theconsumer, it is a terrible, price-raising conspiracy.
Economists have learned that cartels can be very unstableentities. If all OPEC countries, for example, agree to reduce theiroutput sharply and drive the price of oil up to $80 per barrel,then the enterprising country that cheats and produces more thanits quota can reap tremendous financial benefits. Accordingly,mechanisms for enforcing cartel discipline are important forensuring cartel survival.
In the early days of cartels, discipline was often imposed byagglomeration. The German chemical firm I.G. Farben was formed in1925 when the eight members of a chemical cartel decided it waseasier to merge. When agglomeration is impossible, as happenedafter anti-cartel legislation was passed in most Western nations, aprecondition for success has often been the existence of a clearlydominant member. For example, many observers believe OPEC hasremained successful because Saudi Arabia has such a large share ofproven world oil reserves that it can alter the world price of oilwith its own behavior when it so chooses.
For governments, international bodies serve the same role as thecartel. They allow countries to establish rules that harmonizegovernment actions and eliminate competition. From the point ofview of the citizens of these nations, however, a key questionarises: When governments form a cartel, should a citizen think ofhimself as a member of that cartel or as a consumer of the productproduced by it?
The answer depends on whether the competition between states inthe instance cited can be expected to lead to a better or worseoutcome for the individual. In terms of the provision of publicgoods and coordination of externalities--the key economicrationales for government--the question clearly depends on thescale of the public good or externality in question. Nations cancompete over the provision of public goods that are efficientlyproduced at the national level. If a particular country'sgovernment establishes a wonderful environment filled withefficient public infrastructure, then activity will migrate to thatcountry to the detriment of those with wasteful governments.
If, on the other hand, nations compete over goods that are moreefficiently produced at the global level, then competition can beharmful. For example, if states do not agree universally to foregothe use of ozone-destroying chlorofluorocarbons, then the reductionin demand by the "virtuous" states may drive the price of CFCsdown, increasing demand in states that ignore the ban. Progress atthe global level may well require global cooperation.
There is another factor that must be considered. Provision ofgovernment at the local level requires taxation. In an isolatednation, with no factor mobility, it is easy for the government totax labor, capital or both. When these factors can move freelybetween countries, then the power to tax is undermined andsometimes eliminated. Today, capital is highly mobile betweencountries, and this has set off a raging tax competition. Thebiggest mover in this contest has been Ireland, which beganlowering its corporate tax rate from 50 percent in the late 1980sto the current rate of 12.5 percent and has experienced remarkableand persistent economic growth, as tax-dodging capital from aroundthe world flowed across its borders. Subsequently, many othernations (most recently Greece) have sought to copy the Irishexample. Clearly, as my colleague Eric Engen and I noted in arecent article in Tax Notes, the world may be headed for anequilibrium with a zero capital tax.
However, tax competition need not erase the ability to taxaltogether. First, countries can always tax immobile factors suchas land. Second, mobile individuals might voluntarily exposethemselves to taxation if valuable government services are bundledwith it. Indeed, individuals are likely more sensitive to thequality of public goods (parks, schools, clean air) than iscapital. Accordingly, taxes on labor will not necessarily beeliminated by global tax competition, even as the homogenization ofcultures, language and low cost of travel makes migration morecommon. If a country offers a good mix of public goods and taxes,laborers will choose to work there, just as many Americansvoluntarily move to high-tax suburbs. If it does not, they willmove to a country that does.
The one big exception to this rule is clearly redistributive taxpolicy. While wealthy individuals may have a higher demand forgenerous public services (witness the quality of public schools inrich suburban communities), they may often be unwilling toacquiesce to redistributive taxes that are high relative to theother benefits offered by government. Even the most social-justiceloving of millionaires will be tempted to move when the personaltax costs of existing government policies are higher than theperceived benefits.
Oppressive regulation may also lead countries to seek theprotection of a cartel, but the philosophical attachment of leadersto inefficient regulatory schemes could well be weaker than theirattachment to redistribution. The one exception to this may beregulations that in effect redistribute wealth, such as extravagantlabor laws or agricultural subsidies. If one bundles these into thecategory of redistribution, then it seems safe to say that cartelsformed by the world's governments to prevent competition willlikely do so to protect redistribution.
Germany and France, for example, have social welfare states thatput a heavy burden on all of their revenue raising devices. Taxcompetition from countries like Ireland reduces their ability torely on capital taxes, making their spending plans difficult tofinance. The problem is not that paupers move to these countries.Rather, it is that those with the financial wherewithal to financethe democratic socialists' objectives are moving away, literallyand figuratively. Similarly, heavy labor-market regulation has madeunemployment high throughout most of Europe and has led to higheremigration. This impact of policy on mobility is becoming visiblein the data, a sign that competition may be heating up in manyareas. And multinationals are not the only mobile players in thegame. If one plots net migration patterns in OECD countries againstthe Heritage Foundation's index of economic freedom, for example,one can see a clear and statistically significant tendency forindividuals to move toward countries with more freedom.
In response to these and other factors, Germany and France haveattempted to force fellow members in the EU to harmonize tax andregulatory policy in their direction. So far they have failed ontaxes. The benefits to deviating from the harmonized policy, asIreland has demonstrated, are too rich to ignore. But manyregulations have successfully been harmonized by the EU, and passedon to new members as well, despite the fact that the rigiditiesassociated with EU regulations are likely harmful to economicgrowth. Central European countries such as Poland clearlydetermined that harmonization across the broad range of governmentpolicies required by the EU was a cost worth paying, given the manybenefits of membership. And the ability to force some harmonizationhas clearly removed some of the pressure for change in Germany andFrance.
This pattern of bundling positive benefits of internationalcooperation with cartel-driven barriers to internationalcompetition is the most troublesome development in worldgovernance. Indeed, one recent study co-written by Alesina was ableto "confirm that the extent and the intensity of policymaking bythe EU have increased sharply over the last 30 years . . . . Inrecent years the areas that have expanded most are quite remotefrom the EEC's original mission . . . ." But it is likely that muchof the morass that is EU regulation would have a difficult timewithstanding the competition between nations if the EU were unableto tether its regulations to other attractions of membership, suchas free trade, that have large pecuniary benefits associated withthem.
Sovereignty & World Government
There are two main motivations for government cartels. The firstis the desire to achieve some global public good, such asprotecting the ozone layer from CFCs, and the second is toeliminate competition that especially undermines incomeredistribution. From the perspective of the United States, thechallenge of global government is to focus on the provision ofnecessary public goods, but not to create powerful agencies thatcan, like the EU, turn into effective international cartels thatundermine beneficial competition between nations. Until the UnitedStates decides that necessary social welfare objectives are beingthreatened by competition between states, it should only be willingto form very narrow policy cartels with very little real authorityover members.
When an issue emerges that requires action at a global level,our nation should not seek to address that issue with an existingagency. To the extent that the global action is valuable, foldingit into the purview of, say, the United Nations will only increasethe leverage that the agency will have in the future to imposeharmful policy coordination. Rather, the United States should takeadvantage of the fact that since it is such a large country, it caneffectively create new cartels with just a few partners. The UnitedStates should adopt the rule that any new international objectiveto require policy coordination between nations should necessitatethe creation of a new agency with a charter that limits itsactivities to that specific issue.
An opponent of this policy might argue that such limitedorganizations may be unable to discipline their members withouthaving available "clubs" such as trade sanctions. But just as aclean park can improve a community, global public goods significantenough to motivate coordination should be desirable enough on theirown that they encourage nations to participate in their provision.Should rogue states misbehave, individual nations can always decideto punish defectors. Existing international bodies have, to say theleast, a spotty record of success in this area, and thecompetition-defeating risks associated with granting these bodiessovereignty over the actions of civilized nations seem far higherthan any benefits that might emerge from their strict discipline ofrogue nations.
What issues might require increased world government? There aremany public goods and externalities that cannot adequately bemanaged at the national level. Global warming is clearly onepossibility (if the science becomes decisive), as is the use ofCFCs, the protection of patents, halting the spread of communicablediseases and perhaps the elimination of terrorism. Each of thesemay require more international cooperation, but if so, it will bebecause the global objective in that area is worthy in and ofitself, and a stand-alone body that does not empower harmfulgovernment cartels would be adequate for the task.
An international body with a wide agenda and authority willinevitably be a tempting takeover target for countries with welfareand regulatory states that are so large that they could not prosperunder global competition. The best defense against such an outcomeis to spread the global authority as thinly as possible. Absentrational design in our global government, we may stumble into aworld that poorly provides valuable international public goodsbecause the global agencies pursue both worthy and questionableobjectives. As the world becomes smaller, the promise ofcompetition rises, as does the threat of government cartels.
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