Federalism Is the Solution to the Structural Problems of the EU

by Emmanuel Martin

From the start, the postwar European project was caught in an ambiguity that still plagues it today. Some of its intellectual fathers, such as Jean Monnet (1888-1979), saw the project with their planners’ eyes as a “top-down” political enterprise. A new Europe had to be constructed with the ultimate goal of making it a federation, a sovereign, centralized state. Mr. Monnet’s European Coal and Steel Community plan, supported by Robert Schuman (1886-1963), was just a practical start toward a supranational entity. Other co-authors of the design, including most probably Mr. Schuman, instead felt that a European entity (and identity) would only gradually emerge in a “bottom-up” fashion from the liberalization of economic relations between nation states and only after a long confederation phase.

This conflict of visions has shaped the history of Europe’s integration process and led to a double compromise on both options. European politicians have been so fearful of the competitive process of markets opening that mechanisms of compensation, redistribution, harmonization, etc., have been put in place, increasing the ambiguity of the system, which is stranded between a common free market and common “policies.” The European Union today represents a hybrid contraption that is neither a federal state nor a confederation but features elements of both. In such a design, mechanisms of accountability are hard to find. Small wonder that more and more Europeans are growing weary of the project – which does not mean that they are necessarily anti-European.

Today, some want to double down on centralized policies to combat so-called “harmful” tax competition or social dumping with complex regulations and redistribution schemes such as, for example, a European minimum wage, as well as a common budget (at least for the eurozone). Since Brexit, the French have pushed more openly in this direction. French President Emmanuel Macron recently said that he was not “for complete federalism” but “for a lot more united Europe.” This would still mean “partial sovereignty” for the center – a vague concept in itself. In the eyes of many, such a European project would increasingly look like a big France and strip it of federalist advantages.

Federalist Virtues

One virtue of a genuine federalist system with a limited central government and decentralized states or regional governments (a la Switzerland) is that it enables institutional diversity, and, through a competitive selection process, sorts out better institutional solutions.

Moreover, such a system helps mitigate the central government’s “majority tyranny,” hence has strong democratic credentials. Also, it leads to more prudent public spending. Constitutional constraints, such as deficit bans or “golden rules,” can play such a role as well, but these are often not respected, as recent European history demonstrates. Fiscal competition through a federalist system is a proven instrument for rationalizing public spending.

Indeed, centralized states can act as a monopolist on the market: extract as much money as possible from its clients in exchange for the least possible service – here, less so-called public goods. At the same time, as public choice theory has taught us, electoral races can incentivize politicians to promise more spending and more protections while hiding the actual cost of these policies through mechanisms of fiscal illusion (numerous, small taxes; public debt; inflation, etc.).

Simultaneously, vested interests can lobby politicians and bureaucrats to extract rents (subsidies, protections) that generate substantial benefits for these small, well-organized groups. Voters, who are numerous, unorganized and misinformed, have no power to counter the trend – especially as each rent cost is almost painlessly spread over millions of individual taxpayers. The incentives of the two groups are different.

All in all, absent constitutional constraints, “political markets” in such a monopoly context usually lead to dysfunctional management of public money and regulation. Brussels’ increasing centralization of spending decisions and its centralization and harmonization of regulation is a case in point.

Two Competitions

A federal system can, in some sense, mimic market competition at the political level, and reduce monopolist incentives. In a genuine federal system with states in competition, citizens have an exit option and can thus vote with their feet. Like on the market, they can compare the costs (taxes) and benefits of the services provided by producers, i.e. local states. Competition among states helps reveal citizens’ preferences and local governments’ best practices to reduce public spending and minimize present and future taxation.

Besides, the smaller size of jurisdictions not only makes it easier for citizen-taxpayers to use their exit option; their “voice” option (their vote) is more effective, which increases accountability and democracy. And the more numerous decentralized governments – the more fragmented the system is – the better for competition, as this reduces citizens’ potential exit costs, increases exit opportunities for them and makes it more costly for politicians from various regions to collude to reduce competitive pressure on themselves.

One Condition

However, there is one critical condition for a system of decentralized states to work its wonders on public spending: fiscally autonomous regional states. This means, firstly, that the subsidiarity principle should apply: most issues should be dealt with at the lowest possible governance level, and only when this cannot be the case should the central government be involved (issues such as national security, etc.). This also entails that the fiscal autonomy of decentralized entities should exist, with the freedom to tax and spend – a crucial element when trying to assess the prospects of federalism in Europe.

In so-called federal countries such as Argentina, or “decentralized” countries without genuine local autonomy or subsidiarity, such as France, the federalist logic is distorted by systems of fiscal equalization between regional governments and/or redistribution through grants from the central government. This undermines the virtuous mechanism of genuine federalism. The outcome is less accountability, as well as weaker checks on governance and public spending, as local politicians are encouraged to spend as much as possible with taxpayer money. The subtle link between taxes paid and public services received at the local level can be severed.

In this type of hybrid federalism, some feel they pay too much; others that they don’t get enough. Moreover, a “shield effect” is gradually taking place: local politicians blame the central authorities for things that go wrong. Responsibility and accountability are weakened. Tensions and mistrust are created between local populations and the remote authority, and local populations among themselves. Recent votes in Europe tend to show people are wary of these outcomes.

In this kind of hybrid system, the competition – supposedly bringing fiscal discipline and institutional diversity – between decentralized governance entities is broken. So is the sound division of power between the top (central government) and the bottom (decentralized states). While the federalist mechanism is supposed to limit the powers of both levels of governance, in a hybrid system, the top naturally gets the upper hand. It sets the conditions for its growth: the EU Commission has been expanding its unaccountable power while the democratic semblance of the EU Parliament is joining in the push for more centralization and harmonization.

One Nation

The EU’s system is increasingly hard to sell to populations. Another problem is that federalism implies the idea of a nation at the federal level, as sovereignty is transferred to it (unlike in confederation projects). Even though there is an undeniable feeling of Europeanness in our part of the world, it is still hard to see any “European nation” today. Despite European flags and Erasmus programs, each European nation essentially teaches its national history, celebrates its national holidays and commemorations. Only after this, the European narrative is added as if it were an appendix.

Look at the historic example of Germany. It gradually emerged as a nation: firstly, in reaction to the imperial designs of Napoleon I in the 1800s and 1810s; then to the French-Prussian War masterly provoked in 1870 by Otto von Bismarck (chancellor of the German Empire from 1871 to 1890); and, finally, to the lopsided Treaty of Versailles of 1919. The threat from a common enemy was instrumentalized to reinforce the nationalist sentiment of the German people. The Swiss federation also evolved from a confederation based on treaties of mutual protection against common external threats. (The Swiss example also reminds us that a common language or religion is not a precondition for a nation.)

In 21st-century Europe, no serious common external threat is pushing toward unification (which is, of course, a good thing). The fear stems from Europe’s past of frequent and bloody wars – the reason why federalists are pushing for a federal Europe. However, without a shared sense of belonging to a European nation (however artificial that may be), it seems hard for Europe’s nation-states to relinquish sovereignty. Worse still, even attempts at the partial delegation of sovereignty to the supranational entity can be perceived as illegitimate and undemocratic when solutions are imposed on populations against the results of referenda (like the Maastricht or Lisbon treaties in France’s case).

Unaccountable Schemes

The feeling of Europeanness has been further weakened by the EU’s collectivist, unaccountable, centralized mechanisms of redistribution. The Common Agricultural Policy, for example, has created tensions among Europeans because the very design of such mechanisms provides skewed incentives to living off other people’s money. This breeds acrimony and mistrust rather than “solidarity” and is hardly a way to nurture a shared national sentiment. No wonder former British Prime Minister Margaret Thatcher (1979-1990), an “anti-federalist Europhile,” could once say “I want my money back”, or that Chancellor Angela Merkel’s Germany has resisted all attempts at socialization of debts and risks since the euro crisis. The creation of the EU Parliament could have given a sense of more accountability, but many see it as weak in comparison to the EU Commission.

The single currency project itself was another path toward forced federalization. Politicized from the beginning (the French did not want a superpowerful deutsch mark after the German reunification), the euro was built on a compromise with the very theory that was supposed to underly it. Economist Robert Mundell’s “optimal currency region” (OCR) theory lists conditions for a successful currency that have not been met: factor mobility, especially work, was hindered by linguistic barriers; market flexibility in some countries (e.g., Greece) was quite problematic; and, thirdly, a central transfer system to mitigate asymmetric regional exogenous shocks was nonexistent.

Leaders came to a compromise on the transfer system: that fiscal discipline should do the job. However, the Germans and the French were the first ones to flout this compromise. The Greek and then European tragedies that followed were practically inevitable, given the single currency users’ lack of respect for its essential rules. Here again, the instrument of forced federalism turned poisonous. (Today, federalists want to remedy the problem of the transfers with a common budget.)

Which Way?

The future can take different paths. One is a return to a more modest-scope project, based on the Single Act, for example. Countries in the eastern rim of the union, such as Poland or the Czech Republic, and the New Hanseatic League in the North, do not want a France-like Europe that would stifle their economic dynamism. But the pressure to go in that direction would be intense in Brussels and Paris.

Another path is more exits from the EU. The trend in the last EU elections indicates such ideas may receive some popular support. This could not mean the end of everything for the integration project. After all, some nations within the continent but outside the EU trade freely and peacefully through the European Free Trade Association. However, Brexit has proven disruptive and complex, the process purposefully made harder by the EU (to discourage future desertions).

Finally, despite the recent shift in the Parliament with euroskeptics’ success, a continuation of business-as-usual seems most probable in the short term. The potential for fiscal crises, however, in Italy for example, should not be underestimated, especially with the recent slowdown in regional and global growth. We might see another stress test of the European project’s sturdiness.

Dr. Emmanuel Martin is the general manager of the French MOOC project “École de la liberté.” He holds a PhD in economics from the University of Aix-en-Provence in France.


The views expressed on austriancenter.com are not necessarily those of the Austrian Economics Center.

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