Sunday, June 26, 2016

The Optimality of Brexit: The Federalist Model Is Doomed and the Democratic Deficit Is Growing

What is the fundamental cause of the Brexit? What did prompt British voters to unambiguously choose, again on June 23, the high seas over a continued participation in the continental state building venture?

The short answer: Moore’s Law – the doubling of microchips’ capacity every eighteen months or so – that kept going on and on since the beginning of the information revolution in the early 80s without showing any sign of slowing down.

Let me elaborate a little bit. Many commentators have emphasized the importance of the Schengen-enhanced immigration problem, implying that the British are xenophobes, which is clearly false given the number of immigrants from a large sample of countries already living there. London is a much more cosmopolitan city than most others on the continent. Some pretend that British voters have been longing for a return to a now defunct empire and its protected markets. But it would be hard to find a basically protectionist demand in the public opinion. On the contrary the UK economy is more and more integrated in worldwide, out of Europe, trading and production. It exchanges less with the EU and more with the rest of the world than in the past.

Few economists I suppose would object to have a look at the benefits and costs of the British involvement in the European Union. The ratio here has changed quite a lot since the 80s. Especially since 1986 when the “Single Act” promoted by Jacques Delors and other French socialists transformed the Common Market, essentially a device for opening formerly closed national markets after WWII, into an integrated single market that, they claimed, should be complemented by a single currency and a single regulatory apparatus to strengthen competition and become fully efficient. This Single Act changed the nature of the European enterprise from a competitive economic device into a politically motivated state building project detrimental to competition.

There is no evidence whatsoever in economic theory that a single currency is necessary for free trade, or that competition should be enhanced by regulatory unification. On the contrary a single currency consists in suppressing markets, currency markets that is, and the price mechanism there, the free variation of exchange rates between national currencies. Hence competition is reduced, not augmented, by monetary unification. British politicians understood that perfectly and rapidly decided to get out of the SME in September 1992, while declining to participate in the creation of the euro, in spite of the pressure exerted by the City in favor of entering the Eurozone.

On the other hand regulatory centralization is a handsome gift granted to big business since instead of negotiating 27 or so accesses to 27 markets, a large company can focus its efforts on only one regulatory authority in Brussels, for a similar overall budget that accordingly becomes huge for each negotiation (roughly multiplied by 27 at the level of Brussels, relative to the lobbying budget available for each national regulatory process before regulatory centralization at the European level). The regulatory authority in Brussels also sees its bargaining power and potential benefits multiplied by 27, creating an incentive for “cozy” relations with business lobbies.

All of that change favors the firms that can best collude with each other and with the single regulatory authority, and penalizes consumers and competition. It follows that big business in Britain as elsewhere were strongly in favor of participating in the European Union centralization.

The drawback however was that since monetary and regulatory centralization was put in place without the creation of a single super state, the democratic control of political decisions was considerably reduced. The eurocrats ruled and could create benefits and costs without adequate representation of citizens. Instead of national voters controlling 100 per cent of laws and regulations applicable to them, these were now decided by coalitions of foreign representatives. The best example is the recent decision of Ms. Merkel to allow immigrants in Germany that could later migrate to whatever member of the EU that they chose.  It follows that for citizens of member states there is now legislation without adequate representation.

A solution to that problem that is inherent in the process of European unification would be to create a government directly elected by the whole of voters in the Union, and/or a President also democratically elected. A super state in other words.

But this won’t happen. And it is the result of Moore’s Law. Indeed following Coase’s analysis of the raison d’ĂȘtre of hierarchical structures, i.e. firms, that type of organization of production of goods and services develops when high transactions costs preclude the use of a decentralized organization of production, that is, production through markets exchanges between smaller and more numerous hierarchies. And since transactions costs are basically information costs, it follows that when information becomes abundant and extraordinarily cheap, as is the case since the beginning of the information revolution of the 80s, the use of decentralized markets becomes cheaper than the use of hierarchically integrated firms. Smaller firms become more efficient than larger ones.

This is also the case of the largest firm in our economies, the State. The state is just like other firms, a team organized for the production of various services (police, justice, transfers) and some industrial and private goods. Its optimal size shrinks with the new abundance of information.

There has been accordingly a complete trend reversal from the period of the “first twentieth century” (let’s say 1900-1975) when production was increasing much more rapidly than information, a period of general centralization of commercial production and political production, and the period of the “second twentieth century” (since 1974) characterized by a general downsizing of optimal hierarchical structures due to the vertical fall of the cost of information and communication.

These hierarchical structures that exist and were optimal in the past, however, tend to resist that trend for obvious reasons (basically the interests of managers and employees). It is particularly true in societies where democracy is imperfect because consumers and voters interests are not well respected and producers (firms and managers) rule. It follows also that European firms are too large, and European states have in the main continued to grow whereas their optimal theoretical size was shrinking. This is the cause of the underperformance of European economies, especially since the 2008 crisis, which is a crisis of structural transformation, of suppression of markets (currency markets) and of over-regulation of markets, weighting mostly on small firms and giving a competitive hedge to over-large ones. Thus stifling the productivity and dynamism of the economy.

This second twentieth century downsizing trend, continuing in the twenty first (because Moore’s Law continues unabated), explains why the European super state that elites everywhere on the continent want to believe to be the key to future growth, but which would be the problem and not the solution, won’t happen.

After declining to be a part of the single currency venture and exiting the EMS on September 1992, British voters, in a perfectly consistent if belated decision, have chosen to exit the regulatory an fiscal apparatus that Europeans try to build, but much too late. The era of large states and empires is closing fast.

The model of centralization of production and politics that was adapted to the conditions of information scarcity and production abundance of the late XIXth century and the first three quarters of the XXth, what I call the American-German model of empire building by war and political integration (the Civil war in the US and monetary centralization by the building of the Fed in 1913; and the German centralization under Bismarck, waged by war with many other European nations in the 1860s and achieved by the French defeat of 1871), is now obsolete since the 1980s. In spite of three “European civil wars” (1870, 1914, 1939) the building of a German-European empire imitating the American one proved impossible to achieve. But our politicians did not realize that until now, and still believe that the way to obtain more power and a faster growth is still to imitate Lincoln and Bismarck. Their hubris alas is our burden.

The British who have a much stronger tradition of commerce and of democracy than the other Europeans have understood that this is not the case anymore.

Just as they did after 1992, they will be vindicated by the coming years. Other Europeans forecast dire consequences of the EMS exit of 1992: inflation, unemployment, and no growth. The contrary happened, and Britain did profit from its political “clairvoyance”.

The same will happen in the following months and years. The European state building project is dead, and the Euro will follow. In the meanwhile the “organizational sclerosis” will continue to hamper growth and dynamism on the continent.

There is hope however in the current crisis: as noted by Rudiger Dornbusch, a great German economist of American culture, crises are often long in the making, but when they happen they tend to proceed at a very fast pace.

PS: Readers interested in the topic could have a look at my January 2013 post, mentioning my hypothesis of an “organizational eurosclerosis”, as well as my presentation at the Bruges Group meeting of 2012 available on my homepage in the section “Some recent work: A. Policy: Euro and Europe”, The single market and European organisational sclerosis. Bruges Group, London. November 10, 2012

Here is the 2013 post:

 My Analysis of the Single Market and European Organizational Sclerosis

On November 10, last year, I was invited by the Bruges Group in London to deliver a speech on the “Single Market”, to which the organizers of the conference wanted Great Britain to “say no”.

I used to be quite in favor of a single market that I saw as the continuation and deepening of the “common market”, thus leading to increasingly competitive markets in the EU. 

But in the process of thinking the topic over I came to realize that the Single Market, a notion invented in1986 by Jacques Delors and the eurocrats in Brussels, was quite different from the Common Market created by the Treaty of Rome in 1957. Apparently, thirty years had not been enough to open the national markets in the European Community, in spite of the suppression of tariff and non-tariff barriers to trade, and more action was needed.

What Delors wanted actually was a suppression of political and regulatory competition within the EU. This, I realized when writing “Euro Exit”, amounted to a big boost for European wide cartels, intended to replace defunct national cartels that had been stripped of their market power by the opening of the national economies, both within Europe and by globalization. Indeed, when regulations are centralized, business firms have a strong incentive to collude in order to negotiate from a common position with the regulatory authority. And the distance is short from collusion to cartelization.
Thus it appeared to me that the suppression of regulatory competition, the political centralization and the cartelization of the European industries were just one and the same transformation.

The result, as I see it, is a growing sclerosis of the organizational structure of state and firms in the EU as large and centralized units are reinforced while the underlying trend of the information society is towards fragmentation of large hierarchical organizations and general decentralization. 

This is what I call the “European organizational sclerosis”. While the official diagnosis and current conventional wisdom is that labor market rigidities constitute the main obstacle to growth, I now think that excessively large public and private organizations – and thus taxes and rents - are the real barrier to growth in Europe. At the same time as I explained elsewhere, the devastating effect of high taxes on growth is not so much that of taxes on capital, but of taxes on labor, the various forms of payroll taxes that have been growing massively during the last three or four decades. 

A policy to stimulate growth should thus focus first on the overall organizational structure of European countries and on realistic plans to reduce the labor tax.

Meanwhile the process of continuously expanding centralized regulation should be halted and a return to diversity would favor economic and political competition within the EU. 

The text of my London speech is now available on my homepage here.