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Centrifugal and Centripetal Forces on Economic Areas

The flurry of secessionist around the world today raises important questions about optimal political and economic arrangements. But if there is any clear takeaway, it is that "optimal" is a moving target: good governance entails adaptability to constantly changing circumstances and accommodation of diversity.

STANFORD – Several years ago, I predicted that there would be a tectonic shift toward devolution, secession, and independence around the world, owing to the failure of political institutions to manage economic, cultural, ethnic, and religious differences.

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Supranational economic and political institutions were clearly generating a backlash, as they concentrated more power in central governments. Citizens in many countries started to feel as though their sovereignty had been eroded. And they worried that the costs of increasing immigration were too high, given the slow recovery from the Great Recession, weak productivity growth, and labor’s declining share of income.

Since then, the United Kingdom has decided to withdraw from the European Union. “Divorce” discussions are now underway to determine how much the British will pay the EU, and what future trade relations will look like. The process has not been easy, because EU negotiators are worried that if the exit terms are too generous, other member states might follow the UK out of the bloc.

Meanwhile, the United States, under President Donald Trump, has withdrawn from the Trans-Pacific Partnership and abandoned the Transatlantic Trade and Investment Partnership with the EU. Now it is threatening to withdraw from the North American Free Trade Agreement unless Mexico and Canada make concessions.

In Spain, on October 1, the government of the semi-autonomous region of Catalonia held a referendum in which an estimated 43% of Catalans took part, voting overwhelmingly for independence. After the Catalan parliament declared independence, the Spanish national government invoked a constitutional provision to take administrative control of the region, escalating the crisis.

Not to be outdone, more than 90% of those who participated in recent referenda in Lombardy and Veneto, Italy’s two richest regions, voted for more control over local education spending and taxes. Italy’s massive public debt and subsidies to poorer regions were certainly on these voters’ minds. But Giuseppe Garibaldi, the general who united Italy’s city-states in the nineteenth century, must be turning over in his grave.

Elsewhere, Iraq’s Kurdistan Regional Government, having held an independence referendum in late September, is now trying to negotiate with the central government in Baghdad, which has sent troops to reclaim the region’s oil fields. And Chinese President Xi Jinping used this month’s 19th National Congress of the Communist Party of China to consolidate his position further, by shifting more power from the provinces to the central government in Beijing.

Even in countries long known for stability, there is a clear tension between centralized and decentralized political authority. For example, a group called Calexit is trying to introduce a California ballot proposition to secede from the US. According to early polls, one-third of Californians would support such an initiative. And early this month, California Governor Jerry Brown signed a bill declaring California a “sanctuary state” – a mostly symbolic gesture indicating that the state will not fully cooperate with the Trump administration’s efforts to enforce federal immigration law.

At the national level, congressional Republicans’ ill-fated attempt to repeal and replace the 2010 Affordable Care Act (Obamacare) sought to shift more responsibility to the states through federal block grants. And yet, the Republican tax-reform proposal that is now being discussed would eliminate a federal tax deduction for state and local taxes that other states consider a subsidy for high-tax states like California and New York. (Netting all the fiscal interactions and transfers, the reverse is closer to the truth.)

In Europe, the EU has continued to kick the can down the road, rather than deal with its crises in sovereign debt, banking, growth, and unemployment. EU leaders are hoping that a modest cyclical upturn will buy them time. But, at the end of the day, they will still have to confront a core problem: Germany, which has benefited the most from a monetary union in which its trading partners have no currency to depreciate, doesn’t want to foot the bill for bailing out profligate member states.

It may come as no surprise that a recent Pew Research Center poll found that 70% of Europeans, Canadians, and Americans favor more direct democracy, “in which citizens, rather than elected officials, vote on major issues.” This would horrify America’s founders, who regarded direct democracy as a precursor to mob rule, and established a system of checks and balances precisely to prevent such an outcome.

Each of the aforementioned examples of centralization and devolution is unique. But it is worth asking if there are also commonalities among them.

When the Nobel laureate economist Robert Mundell, the intellectual “father of the euro,” set out to determine an optimal currency area, he put a premium on natural trade and macroeconomic ties. As a Canadian, he was struck by the “horizontal” nature of the Canadian and American currency areas. To his mind, “vertical” areas comprising the Canadian and American west might make more economic sense.

Mundell’s insight can be applied much more broadly. Economic areas are continually forming, combining, and dissolving as a result of competing centrifugal and centripetal forces. Constant shifts in comparative advantages, economies of scale, and transaction costs affect the benefits of accommodating more homogeneous localized preferences.

Likewise, “optimal” political areas change over time, owing to changes in technology and demography, and their interaction with evolving cultural, ethnic, religious, and other factors. These processes of coming together and falling apart can be beneficial or harmful. The EU has certainly been a great success as a trade area, but less so as an integrated labor market and currency union; and it has altogether failed as a banking and fiscal area.

Or consider the Indian subcontinent, where distrustful neighbors armed with nuclear warheads pose a danger to themselves and the world. Given that India still has almost as many Muslims as Pakistan, it is possible that religious tensions could have been mitigated within the confines of a single country. By my estimate, Pakistan and India’s current volume of trade should be 25 times higher than it is. That would greatly benefit both countries, not least because they would each have a greater stake in the other’s success.

Governing well in a context of economic, political, ethnic, and religious diversity is not easy. But failure to do so can mean substantially less growth – and substantially more political risk.

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