Government and Institutions

Lessons from Political Economy for the EU referendum

The debate about the UK’s membership of the EU is dominated by economic arguments – would we be better off in or out? It is hard to see any convincing arguments either way. Probabilities derived from econometric models do not really inform the voter. The model builders are not able to factor in the role of governments (and international organisations like the EU) in the determination of economic progress. They regard political machinery as a static variable. But, as students of political economy (as opposed to some econometricians) know, institutions matter. The perspective of political economy allows us to widen the debate from the abstract realms of economic models, statistics and probabilities to a more concrete consideration of the effects of political institutions on economic progress. The pros and cons of membership of the EU can only be fully evaluated from the perspective of political economy.

A first order question in political economy is ‘can government really determine the way in which an economy works?’ The earliest explorers of this branch of economics, and those wrestling with the question today, share one common premise. Institutions and political choices do matter. Get them wrong and an economy will fail to thrive. Get them right and there is at least a chance that enterprise and innovation will flourish. A second order question concerns the policy direction taken by governments. Does getting it right mean removing barriers to enterprise or central planning, control and harmonization of regulations? Removing barriers to enterprise and trade has a better track record than does the command economy. Above all, a command economy requires a strong centralised government to enforce its decisions.

The European Union provides a fascinating case study in political economy. I have recently published In or Out: An Impartial Guide to the EU, which covers the EU’s legal status, institutions, methods of decision making and primary policy directions and choices.  Close reading of the EU’s ‘constitution’, that is, the Treaties governing its operations, makes it clear that it is merely an intergovernmental organisation with certain powers conferred on it by its members. It has not been given any of the primary characteristics of a state or the tools necessary to at least have a stab at trying to stimulate or control economic activity. It does not have the essential backing either of force (to ensure that its rules are adhered to) or of the power to directly tax citizens. It has neither government nor opposition. It is primarily a customs union with internal free trade, operating like other international organisations and, like the World Trade Organisation, has had some success in stimulating trade through tariff abolition and standardisation.

The EU’s greatest achievement is the establishment of a single internal market for goods.  It has not so far managed to match that achievement with a single internal market for services largely because it is composed of 28 states with very different cultures, practices, administrative capacity and economic structures. It has achieved free movement of workers but cannot compare with the degree of labour mobility found in the USA. Although there is technically free movement of capital, the financial markets of the EU remain highly fragmented even within the Eurozone. Students of political economy have pointed out that a regional free trade area (at least for goods) is relatively easily achieved. Integration is relatively easy where heterogeneity costs are relatively low. After all, a fridge is a fridge so it does not matter a great deal where it has been manufactured. The trade-offs between integration and heterogeneity, however, are less advantageous when it comes to services and capital where national practices and cultural preferences are as highly varied as they are in the 28 member states of the EU.

By the first decade of the 21st century the EU, having achieved substantial progress on the easier bits, turned to the more difficult tasks. These are proving divisive rather than integrative. As I show in the book, new devices have had to be invented to allow member states to opt out, opt in, achieve derogations and in some cases go off on their own in smaller groups wishing to adopt common policies.  The 21st century EU is a kaleidoscope – displaying variegated patterns of different states and forms of togetherness that wax and wane.

The inability of the EU to match the capacity of a state has not stopped it from putting forward long term ‘strategic plans’ for the development of what it calls ‘The European Economy’, as though there was one such thing. Half way through the current planning period (Europe 2020) it concludes that the 2008 financial crisis blew it off course. But eurocrats seem unwilling to confront the fundamental fact that an international organisation simply does not have either the powers or the machinery to do much more than remove barriers to trade.

For those members of the EU that do not use the Euro the future in a kaleidoscopic multi-speed Europe is no doubt an attractive proposition.  It is better than ineffective central dominance. For those member states in the Eurozone, however, it may not be enough. The Euro was established without the necessary machinery of a state to provide support and stability. All the heavy lifting has fallen on the ECB and monetary policy. There is no ‘fiscal stance’ for the Eurozone because there cannot be in such a diverse group of states. The ‘Five Presidents’ Report’ sets out the need for stronger machinery but shies away from the essential question. Even what the Presidents call ‘political union’ is merely a plea for greater involvement by the national parliaments in the processes of supervision and control by the centre. The Five Presidents cannot confront the need for a new Euro state, not least because neither France nor Germany would be able to sign up to it faced by the need to consult their citizens and their representatives.  In any case, these two key member states have very different approaches to the role of the state in the management of the economy. France wants a host of new institutions (which it can then ignore) while Germany demands stronger rules. France is the home of central planning, Germany of the social market. Any decisions on the future institutions of the Eurozone are put off until after the French and German elections in 2017. Whoever wins, the result is not likely to be new strong machinery for the management of the Eurozone’s economies. The EU will remain a toothless tiger.

Bringing the role of political institutions into the debate on the UK’s referendum enlarges the set of probabilities that voters will have to weigh up. Just looking at economic forecasts assumes a static set of political institutions. That is entirely unrealistic. There is ample evidence that the political structures of the EU are changing. Voters have to decide, on the basis of evidence, whether the EU has a future as a variegated international organisation or whether it will eventually become a single state: Europa.

If the European economies are to escape from their current stagnant situation the institutions and the policies of the EU will have to be reformed. As I conclude in my book, close reading of the current Treaties shows that there is plenty of scope for constructing a leaner and more effective Union should the voters in the UK decide to remain. Prospects for a new European state seem distant. Armed with information about the political entity that is the EU, voters can make up their own minds as to whether to stay or leave.

Above all the European Union is not a state backed by the ultimate sanction of force. It simply cannot force its members to obey the rules they agree to. So far there has been a reasonable expectation, especially in law abiding member states like the UK, that any rules agreed to will be obeyed. The EU is held together by consent only.  So long as it is apparently delivering on its promises that consent will not be withheld. But the trust in the EU not only among the population at large but by some politicians is beginning to evaporate as the gap between rhetoric and reality widens. The long list of infringement proceedings brought against almost all member states on a wide range of different policy areas is evidence of the unwillingness of member states to do as they are bidden by EU rules.

For the EU as a whole the solution is simple.  Full recognition that the EU is merely a regional customs union and no more will satisfy the majority. For those member states using the Euro, however, there is a real dilemma. To run a single currency in a sub optimal currency area without any common fiscal policy is almost an impossibility. This was understood from the time of the McDougall report.  Sir Donald MacDougall fully understood the way in which currency unions are held together – federal states like the USA and Canada have sufficient central fiscal capacity to counteract the effects of economic change on less advantaged regions. The EU does not. Even if the Eurozone obtained a form of fiscal union to support the currency it might still not have sufficiently strong machinery for making sound economic policy but at least it would have two legs rather than the one (monetary policy) which is all that is keeping it standing up today.

2 thoughts on “Lessons from Political Economy for the EU referendum”

  1. Posted 17/05/2016 at 14:00 | Permalink

    I seem to remember that Sir Donald MacDougall’s report predicted that if the EU was unable or unwilling to change the way the eurozone was projected to work, then it would simply turn into a ‘low growth, high unemployment club’. How right he was! It is all very well Ann Robinson saying there is ‘plenty of scope’ for a more effective European Union if voters in the UK should decide to remain, but is there really any evidence at all that the EU will do anything to reform its current complacent and inflexible attitude? Of course I agree that political economy is important, but I didn’t notice much reference in Ann Robinson’s discussion to the need for ‘democracy’ in bringing about the ‘fundamental and far-reaching reform’ to the EU that David Cameron called for in his Bloomberg speech..

  2. Posted 23/05/2016 at 03:24 | Permalink

    The article is interesting in the aspect of how it comments on government involvement. “A command economy requires a strong centralized government to enforce its decisions.” This is interesting because the the article continues on with talking about free trade, but can there really be free trade with government intervention? Other things about this article is the fact that the article discusses about EU anting to have a single currency in a place where many currency exist, I agree with the article when they state that this is impossible because the EU does not have sufficient central fiscal capacity, the EU taxes aren’t as high as USA and Canada so even if they do created a separate currency its will be hard for EU economy to support the currency change.

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