Federalism and the New Economy:
Sovereignty as a moving target

A lecture at the Aix-en-Provence Summer University 2000 on the theme of Subsidiarity
by Brian Lee Crowley, Ph.D.,
President, Atlantic Institute for Market Studies

Ladies and Gentlemen,

It is a pleasure to be back with you for my second and final lecture at the Summer University.

In the short time that is available to me, I am going to divide my remarks on Federalism and the New Economy into three parts.

Part One: Federalism and the New Economy

Federalism, as it is practised in North America, is a system of government that very clearly shows its roots in the old economy.

remember that federalism is a system for dividing sovereignty — it is not administrative decentralisation, where central government lends some of its powers to local or regional governments. Rather, each level of government is granted sovereignty in its respective spheres of authority by a constitution that is superior to all governments and from which they derive their legitimacy.

When I say that our types of federalism are stamped with the features of the old economy, what do I mean? That federalism was based on a 19th century model of economic production that looked roughly like this:

Mass production, chiefly of good
Markets were primarily national and geographical circumscribed
Transport and mobility costs were high
Returns to capital were maximised by economies of scale
Manufacturing techniques were inflexible, resulting in production of large quantities of uniform goods
Capital was chiefly physical, fixed and easily taxed
Capital was scarce, labour plentiful
National economies sought to exclude goods from other nations to achieve internal economies of scale
National governments, aside from providing national defence and the like, had primarily the roles of 1) excluding foreign products, thus ensuring a captive market for local goods and 2) preventing local governments from pursuing policies that divided national markets into purely local ones that would not support efficient levels of capital investment and mass production. These tendencies toward centralisation of economic policy were reinforced by the inevitable centralisation that wars entail, as well as by the centralisation of monetary policy and the rent-seeking capacities created by national governments’ access to rich national tax bases.

But I would draw your attention to the fact that the economic model on which this whole approach to central government within the nation-state is based is falling down all around us.

Contrary to what we saw of the old economy, the new economy has the following features:

Production is hugely diversified and customised
Production is chiefly services, not goods
Transport and mobility costs are low
Capital is chiefly intellectual and mobile and hard to tax
Labour is scarce while capital is abundant
Economies benefit from openness and mutual access to world markets
Production cannot be contained within national borders of even largest states
The effect of these differences is that the old divisions of power between governments under federalism are just as outdated as the economy to which they were tailored.

Sovereignty is thus being pushed in several directions, and away from central governments. Most notably:

National and local sovereignty is more and more constrained by market-opening rules (trade agreements) as we move toward an expanded international rule of law
National and local taxation power is being reduced by footloose economic activities
Costs of national isolationism and protectionism are growing
The ability of national and local governments to restrict inward and outward access is rapidly declining
Thus sovereignty is moving, in part, to individuals and voluntary groups. Under a regime of robust property rights and intellectual freedom in a wired world, communities are more and more constituting themselves on a non-geographic basis, as people are better able to connect cheaply and quickly with those with whom they share interests, rather than those with whom they happen to share a given piece of territory.

Part Two: What should government look like in a world like this?

My second set of comments has to do with the kind of government that is appropriate in a world in which economic sovereignty is being transferred down to individuals and corporations and other voluntary organisations (‘civil society’). By the way, the struggle over Internet taxation is one such struggle between governments on the one hand and civil society on the other.

The most successful governments, the ones that make the greatest contribution to the well-being of their citizens, will be those who )1 make the greatest transfers of sovereignty to their citizens and to civil society; and 2) who facilitate the emergence of the rule of law at the international level, thus helping to create an economic world in which transactions across international borders are as easy and inexpensive as possible, including movements of capital and workers.

It is these forces that have driven governments, often in spite of themselves, towards greater privatisation and greater efforts in the field of regional and global reduction of barriers to trade.

But there is a great danger that governments will simply use globalisation and the new economy to push, not for the evolution of the rule of law, but for something else. After all, the rule of law is not very sexy politically; it merely provides a framework for the members of civil society to pursue their objectives.

Instead, governments can and will use the emergence of globalisation and the rule of law as an excuse to augment their power, on the following grounds:

they need to “harmonise” standards, practices and goods, including currencies, to allow greater economic exchanges and co-operation across political boundaries; and
they need to restrain some governments from engaging in “unfair practices”, such as “tax competition” and “social dumping”.
Do not be fooled.

The new economy, given its characteristics that I have already outlined, has no need of government imposed harmonisation, which is the very opposite of the dynamic energies that are driving growth and progress. Harmonisation is the death of diversity, experimentation and innovation.

Moreover, competition between governments — competition for enterprises, for workers, for investment — is precisely what reveals to us the jurisdictions that are pursuing sensible policies. Remember what I said about competition being a discovery procedure. This is just as true in government as in the private sector. If a government offers better value for lower taxes, if it draws fewer people into welfare and dependence, and more into education and work, then this is a comparative advantage that must be known and put to work.

I don’t say this because I want to see the populations of uncompetitive jurisdictions harmed. On the contrary, I want them to be able to learn where they have gone wrong, by being able to compare the costs of the policies their governments pursue, in comparison with the costs and benefits of policies pursued by others. I want their rulers to be accountable for their policies and their effects, and I want their populations to be able to point to other countries and demand that their governments put in place policies that will help them to succeed as well. Competition between countries doesn’t drag them down to the lowest common denominator — it lifts them up towards the highest common denominator, because the costs of bad policies are fully revealed.

Part Three: Canadian federalism: a rent-seeker’s paradise

My third series of remarks is drawn directly from Canada’s experience with federalism: namely that governments are the best organised, most powerful and most successful rent-seekers of all, especially when they can exploit some powerful social division, such as ethnicity or economic disparity.

After all, federalism by definition confers constitutional power and legitimacy on a democratic government speaking for a particular segment of the national population. Since the Civil War, this problem has not really troubled US federalism, because the US population is relatively homogeneous. US politics and federalism would be radically different, however, if, say, there was one state which contained 25% of the population, and that population had a huge majority distinctly different from the national majority — say a black or a Hispanic majority.

In my country, the French-speaking province of Québec occupies just such a position, and has exploited it brilliantly in order to capture huge economic and political rents for itself, quite disproportionate to its economic or political weight in the federation.

In fact, the result has been a kind of destructive competition between governments, in which the federal and Québec governments have engaged in a kind of bidding war for the political loyalty of the Québécois, with most of the booty taking the form of social benefits. And of course once Ottawa decided that it needed to buy the loyalty of the Québécois with a spending programme, logic and politics required its extension to the country as a whole, whether it was wanted or not. Ethnic conflict within our state has been a huge motor for the growth of the welfare state.

Let’s take a moment to look at a slightly different example, that of the region where I live, Atlantic Canada.

This region is the poorest in Canada, and has used its relative underdevelopment as a ground for claiming huge benefits from the rest of the country, chiefly in the form of transfers to persons and provincial governments. Provincial governments have in fact been the chief spokesmen claiming greater transfers for the region, a strategy that has proven wildly successful for them: federal transfers represent, on average, 40% of the budget of each of the four provincial governments in my region.

This strategy has also been seemingly wildly successful in another sense: Atlantic Canada has been the most subsidies region in the Western world — more heavily subsidies than the west of Ireland, than the south of Italy or the east of Germany.

Let me give you a sense of the scale of these transfers. They have reached a height of 40% of GDP, which meant that at one point all-government spending was the equivalent of two-thirds of GDP.

Net transfers (federal spending in the region less taxes paid by the region to the federal government), had they been invested in US 90-day T-bills over the last 30 years or so, would now amount to the colossal sum of $1-trillion CAD, enough to pay off the entire national debt of Canada and have over $400-billion left over. Put another way, the 2.3 million people of my region could each have about $400,000 in their retirement account today.

What has this money bought us? Well, economic theory and empirical evidence both suggest that lagging economies should normally grow faster than leading edge ones — this is know as the phenomenon of convergence. With just normal policies, one can expect such convergence to operate at the rate of around 2-3% annually. That’s if you do nothing special by way of “economic development” measures.

We sought to close the economic gap by government spending. The effect? My region is closing the gap at less than half the rate convergence theory and the empirical evidence of its effects would predict, for reasons fully explored in a book by my Institute called Retreat from Growth. Our unemployment rate diverged from the national rate and has remained stubbornly higher. Private investment has declined. Dependence on government has grown.

Let me close with this remark. There are many of you here from Eastern Europe where people are seeking early membership in the European Union. This “urge to merge” is driven in part by a desire to capture huge transfers from wealthy regions through the Common Agricultural Policy, the structural funds and so forth.

My message to you, based on our experience in Atlantic Canada: be very careful what you wish for. You just might get it.

Thank you.