The Centralization-Decentralization Issue

Allocation of Competences

The focus so far has been on fiscal policy but the EU carries out some important functions. It has power – exclusive competence – in some very important economic areas: monetary policy (Eurozone only), competition, commercial policy and the conservation of maritime resources. It has also shared competences in a number of areas, including the internal market, consumer protection, transport and energy and, in a lesser way, R&D. In this respect, the EU has important federal attributes.

Policy Area and Fiscal Federalism

How do these common policies square with the principles of fiscal federalism? Table 3 presents a simple evaluation. For each EU exclusive or shared competence, the table attempts to identify which principle(s) justify transfer of competence and which one(s) argue in the opposite direction. Policy failure describes either of two cases. First, when local conditions or capture by private interests argue in favor of centralization on the sometimes dubious assumption that the failure will not occur at the EU level. Second, when the failure occurs at the EU level, so that a transfer of competence is ill-justified. Two stars indicate that the case is strong, no star when it is weak. The table is no doubt highly debatable as it involves personal judgment.

Table 3 Allocation of competences and fiscal federalism principles.

	Pro centralization	Against centralization
Exclusive EU competence
Monetary policy	Externality**	Local preferences*
Competition	Externality, effectiveness, policy failure
Commercial policy	Externality, policy failure	Local preferences*
Conservation of maritime resources	Policy failure	Local preferences*
Internal market	Externality, effectiveness	Asymmetric information, local preferences
Shared EU competences
Social policies	Externality	Asymmetric information, local preferences
Cohesion	Externality	Asymmetric information, local preferences, policy failure
Agriculture & fisheries	Externality, policy failure*	Asymmetric information, local preferences, policy failure*
Environment	Externality, effectiveness, policy failure	Local preferences*, policy failure
Consumer protection	Policy failure*	Asymmetric information, local preferences, policy failure*
Transport	Externality, effectiveness*	Asymmetric information, local preferences, policy failure
Energy	Externality*	Asymmetric information, local preferences**, policy failure
Freedom, security and justice	Policy failure	Asymmetric information, local preferences, policy failure
R & D	Effectiveness, policy failure*	Local preferences
Outer space industry	Effectiveness**	Local preferences*
Development & cooperation	Effectiveness, policy failure*	Local preferences**,
Humanitarian aid	Effectiveness, policy failure*	Local preferences**,

According to the table, exclusive competences are mostly well justified where it has been achieved. The case for the common conservation of maritime resources is the least convincing. The situation regarding shared competences is less clear-cut. The list includes some difficult areas, such as transports, where strong pros coexist with strong cons; the solution involves multi-tiered arrangements, separating local and pan-European connections, as should be. Value-related areas (social policies, cohesion, humanitarian aid and freedom, security and justice) are hardest to justify, especially when local preferences are naturally bound to vary from one country to the other. The subsidiarity principle suggests that there is little scope for further centralization.

Structural Reforms

Structural reforms are intended to improve the functioning of the economy, delivering better productivity and higher standards of living as well as lower structural unemployment. They are the mother's milk of macroeconomics: if well designed, they can do no harm and possibly much good.

Reforms, however, invariably hurt special interests. Indeed, they aim at removing market and policy failures, most of which are the result of past successful lobbying. Quite often, a market failure – e.g., natural monopolies or domination of monopsonist employers over employees, non-marketable public goods – are replaced by a policy failure that provide few people with a rent paid by a great many. Reforms involve pitting highly determined rentiers against a silent and generally unaware majority. Reforms may be Pareto-improving, but they amount to income redistribution and Pareto side payments are rarely on offer. As such, structural reforms are inherently political and require elected officials to organize these income transfers.

Unsurprisingly, governments are reluctant to carry out divisive reforms, whose political costs are immediate and highly visible while the returns accrue over long horizons and are often hard to detect. Incentives may be required. It is quite natural, therefore, to envisage external pressure to untie domestic knots. The EU has moved in that direction.

It started with soft cooperation. The SGP reform has moved to harder incentives since lack of progress on bringing public debts down can be compensated by structural reforms. The results from soft cooperation have been disappointing, in spite of the formalized procedure that has been set up. Fiscal federalism principles suggest that there are good reasons for that to be the case. It is surprising, therefore, that Juncker et al. (2015) propose a whole new range of procedures and instruments to promote structural reforms in the Eurozone. At no point, however, the five presidents provide any justification for this centralization step. Observing, as they correctly do, that structural reforms are needed to promote prosperity, is a far cry from justifying further centralization. It is worrying to note that they seem unaware of the principles of fiscal federalism.

The idea of using external incentives to encourage difficult domestic action is quite natural. Using external pressure as a scapegoat is a time honored practice, but it can have a drawback. The external agent is resented if it seen as infringing into domestic affairs. This is most visible with IMF conditionality. However IMF conditions are imposed during a temporary period. Thereafter, the threat of an IMF return can further be used to support useful but unpopular reforms and policies. Within the EU, the situation is radically different. The EU is not meant to "leave the country". Resentment towards EU imposed policies can turn into against EU membership. Politicians can use this to campaigns aiming at leaving the EU instead. This is not a fanciful prospect anymore.

If, then, the external agent of change argument is of doubtful value, we should revert back to traditional fiscal federalism arguments. Are there solid enough externalities or returns to scale to over-ride the powerful information asymmetries and heterogeneities that characterize structural policies? This question requires examining more precisely the externality issue.

A negative externality occurs when one country's policy produces adverse effects in other countries. In that case, there is always too much of it (it produces a Nash equilibrium) and cooperation will help out. When one country enacts productivity reforms, it gains a comparative advantage over its trade partners. When the exchange rate is fixed, the effect is not mitigated. The unreformed countries will face a slump and, eventually, their prices and production costs will have to decline relatively to those in the reforming country. Should we conclude that reforms should be discouraged in a monetary union?

The answer cannot be positive, of course. The EU answer is to encourage non-reforming countries to follow suite. It is important, however, to note that the incentives operate in the right direction, based on competition and market pressure. The more some countries reform their economies, the stronger are the incentives to conduct reforms in the other countries. The spirit is one of experimentation and the adoption of best practice. In a way, this is what the Lisbon strategy was about. Going further, as with the new SGP, reflects disappointments with the strategy. However, this disappointment does not justify further centralization because it involves the center into deeply political sub-central issues, for which information asymmetries and local preferences are very important.

This conclusion carries even further. From an economic viewpoint, the EU is a commitment to integrate markets, and the monetary union is a commitment to not use exchange rates strategically and to support financial integration. This should lead to higher economic growth, ceteris paribus. But there can be no presumption that the result will be a convergence of growth rates or of unemployment rates. At best, one can hope for a convergence of standards of livings as catch-up forces are less hindered. There is no presumption either that all countries will pursue common structural policies. After all, a country should be free to undergo an economic decline is that is what its citizens collectively wish, including by not undertaking necessary reforms, as long as they respect the four freedoms.