Sunday, February 15, 2015

15/2/15: European Federalism: Principles for Designing New Federal Institutions

This week, I was honoured to have been invited to participate in a discussion panel of the Future of Europe at the Trinity Economic Forum 2015.

Here are my extended speaking notes on the subject of European Federalism and the challenges of building future European institutions.

The Global Financial Crisis, the Great Recession and the Euro Area Debt Crisis exposed structural weaknesses in the political, economic and social institutional designs of the European Union. As the result of these weaknesses, today, we are increasingly faced with a Union of the few (the ever-shrinking in numbers European ‘core’), with the membership of the many (the growing ‘periphery’ excluded from the decision-making within the EU, and the stand-alone Eastern Europe, largely left to its own devices and pursuing own objectives that increasingly represent a confluence of geopolitical aspirations and the interests relating to achieving capital and economic convergence with the core).

As the result of continued build up in the relating economic and social imbalances, the deepening twin challenges of restoring both the viability and the cohesion within the Union present an existential threat to the EU. But beyond the fear of political and social disruption, the same challenges represent an opportunity to renew institutions of participatory democracy and cooperative governance that can harnesses the power of social, political, economic and cultural  heterogeneity of the Member States to deliver a renewed EU.

Currently, the European nations and their voters are being presented with two alternatives for addressing structural weaknesses of the EU, exposed by the crises. On the one hand, European Intergationism offers an ever accelerating and deepening concentration of decision making within the EU in the hands of technocratic institutions of the European Commission, the European Council, the Eurogroup and the ECB. On the other hand, Euroscepticism calls for a radical devolution of power and greater autonomy in favour of the member states, opposing any idea of federalisation of the EU or within the EU.

This is a false dichotomy, based on the ossified political ideologies no longer sufficient in the modern world of rapid change, amplified risks and social and economic disruptions. In my view, gradualism, coupled with institutional design from below, from the level of European demos, are the twin approaches that can deliver effective evolutionary process for building future European institutions.

A combination of internal and external challenges and on-going changes that acts to force a disruption to the status quo ideologies, politics and institutions of Europe is substantial. These include:
On-going technological revolution that started with rapid computerisation and automatisation of economies in the 1980s and to-date has witnessed the EU member states falling far behind the productivity growth curve that has propelled North American and Middle Income economies growth during the 1990s and 2000s. The same technological revolution drives both, radical changes in the traditional models of enterprise development and the labour-capital relations which the European economies and European institutions are not equipped to address.
Global economy shift away from traditional North-South globalisation axis of development toward much greater and growing regionalisation of trade, investment, savings and human capital flows, and, thus, greater regionalisation of growth drivers. These changes increase marginalisation of the ‘platform’ or ‘gateway’ models for trade and investment, as well as for human capital on-shoring on which many European economies rely today.
Amplification and acceleration of shocks and traditional business cycles, including the ever-rising complexity of risk propagation and contagion channels across financial markets, real economy and public finances.
Demographic challenges represented by ageing populations, declining labour force and rising unfunded liabilities. These challenges not only threaten the traditional social democratic model of income and services provision to the older populations, but also the supply of investment (in physical and human capital) and other drivers of future growth in the aggregate demand. They also weaken European economies and societies to innovate and adopt innovation.
Decline and fracturing of the traditional body of politics and ideologies in the post-crisis environment – a challenge compounded by the changing nature of public discourse (social and alternative media), as well as by the rising power of direct democracy. One, immediate, manifestation of this is the decline of the traditional European Centre in politics and the rise of the more extremist parties and groups. But beyond that, there is also a far more threatening trend of reducing political participation and undermining democratic mandates of the Governments increasingly elected on the basis of shrinking and more concentrated segments of the demos.

To survive and succeed in this new and constantly changing environment, the EU needs to develop institutional structures that combine the benefits of both, traditional systems of governance (based on technocratic capabilities), and direct and open democracy structures (based on public discourse, sourcing of ideas and participation), while minimise their respective costs and risks.

Consider the economic and monetary policy institutions as a laboratory for testing this process of institutional transformation.

Eight years into the crises, it is now an accepted wisdom that the European leaders have failed to see even the basic risks arising from the rules-based compulsory monetary integration. The crises have highlighted deep divisions within the European Monetary Union (EMU) on matters as diverse as inflationary preferences, demographics-anchored economic expectations, legal systems regulating the financial markets, and fiscal transfers.

These differences underlie the reality that common currency cannot be successfully deployed across a vastly heterogeneous base of economies, demographics and institutions without, ex ante, federalising the political and fiscal systems. Nor can the lack of supportive political and institutional systems be remedied by the purely managerialist solutions.

In fact, it remains an open question whether federalisation itself is a sufficient or even feasible condition for addressing these challenges. The crises exposed the fallacy of European integrationism – a doctrine that closer and closer harmonisation of institutions between the member states should be the desired objective of the Union. Shocks impacting the euro area since 2008 have been asymmetric in nature, geographic distribution and magnitude, as well as heterogeneous across the economic sub-systems. This is true today, eight years into the crises, and it was true at the points of the individual crises impact. While German economy runs extremely low levels of unemployment, Italian unemployment is hitting historical highs and the French and Spanish unemployment figures remain stubbornly close to their crisis peak. Meanwhile, all four economies see government bonds yields at or near historical lows. While all four economies differ in terms of their external balances, all four share in terms of stagnant domestic demand and the resulting risks of deflation. Meanwhile, stagnation in the real economies is now contrasted by an asset bubble in the public debt markets, just as Europe’s capacity to use fiscal policy to stimulate short term growth is being exhausted by already high public debt levels. And it is being reinforced by another asset bubble emerging in risk-based equity markets, just as Europe’s real investment remains stagnant.

In this environment, no singular monetary policy can even in theory match the economic objectives of the EMU members. The integrationist’s solution to this problem is to enhance fiscal coordination and use debt federalisation and fiscal spending to compensate for the side-effects of monetary failures. Alas, that too is an impossible balancing act. Based on the IMF estimates, Euro Area’s General government gross debt stood at almost 97 percent of GDP at the end of 2014. With Euro Area Government revenues amounting to nearly 48 percent of GDP, and public spending running at close to 51 percent of GDP, there is simply no room for a ‘federalised’ Europe to pump more debt into the Member States’ economies.

Worse, looking at the net Government debt across the Euro Area, one quickly arrives at the conclusion that harmonising fiscal policies cannot be and should not be an objective even within a fully federalised EU. In 2014, net Government debt in the Euro Area ranged from -47.6 percent of GDP in the case of Finland to +168.8 percent of GDP in the case of Greece. And in terms of external balances, Euro Area remains fragmented across three dimensions, the fragmentation that persisted from the 1980s on through today. While ‘core’ Euro Area economies (Austria, Belgium, Finland, Germany, Luxembourg and the Netherlands) average current account surplus for 1980-2014 runs at 3.25 percent of GDP, delivering a cumulated average surplus of 91.3 percent of GDP over the period, the ‘peripheral’ Euro Area states (Cyprus, France, Greece, Ireland, Italy, Malta, Portugal and Spain) experienced average current account deficits of 3.2 percent of GDP and have cumulative average current account deficit of 102.2 percent of GDP over the same period. The third dimension to this fragmentation is the presence of the deficit-generating Eastern European Accession States (Estonia, Latvia, Slovak Republic and Slovenia). In simple terms, net borrowers remain net borrowers, net lenders remain net lenders and this situation remains ‘sticky’ over the last 35 years.

Federalised Europe may be a necessary condition for addressing these imbalances, but it is hardly sufficient, as increasing degree of policies and institutions harmonisation has not delivered any real convergence to-date. Clear example of this failure is the creation of the Euro itself. Since the formation of the common currency, none of the Euro Area ‘peripheral’ states have managed to shift from the regime of running perpetual current account deficits to a regime of generating surpluses.

European leaders’ diagnosis of the problems compounds them. Instead of treating the actual malaise (the attempt to view harmonised policies across the heterogenous economic, political and social systems as efficient solutions to the problems of combining under singular institutional umbrellas vastly heterogeneous and even divergent national systems), the EU is attempting to treat its symptoms (the lack of credit transmission from one economy to another, or the mismatch in debt financing costs across the economies, or deflationary pressures, or fiscal divergences and imbalances, and so on).

Having confused causes and effects, the EU is naturally confusing poison for cure.

Continued enhanced harmonisation of the European institutions, absent ex ante deep reforms of these institutions, risks weakening Europe’s ability to respond to the future crises by increasing systems’ rigidity in the face of the future shocks, and, thus, systems’ fragility. The Banking Union, the Genuine Monetary Union, fiscal harmonisation (the Fiscal Compact) and the Political Union – all are replicating the very same error of centralising command, control and supervision over diverse national systems in the hands of technocrats. This implies further weakening of democratic buy-in for future crisis-related policies, amplified memory of the lack of such buy-in from previous crises policies and, subsequently, reduction in the political spectrum that remains un-tainted by the previous participation in shaping unpopular policies. But beyond these already powerful forces, the increased harmonisation approach to dealing with institutional weaknesses fails at an even more basic or fundamental level: all top-driven harmonisation and consolidation efforts at reforming our institutions either de facto or de jure (and in majority of the cases – both) assume perfect foresight of the future crises and perfect wisdom of the one-solution-fits-all answers to such crises.

The main lesson of the Euro area crises should be that artificially centralised systems, such as the EMU, create own risks that compound external shocks, while adding complexity to the shocks- and risks-transmission mechanisms. When such systems are imposed onto structurally heterogeneous political and economic institutions, even smaller shocks (e.g. to the euro ‘periphery’) become systemic.

Instead of rigid umbrella institutions that standardise responses to shocks, Europe needs to develop more agile, adaptable and de-centralised institutions that encourage policy experimentation and learning, while setting robust downside controls and collective insurance. In financial markets, these twin approaches are known as diversification principle for portfolio allocation and stop-loss rule, respectively.

To achieve this, the EU needs to evolve a federalist superstructure that simultaneously draws on a direct democracy mandate, maximises cooperative policy formation and deployment, and is based on bottom-up approach to policy innovation.

By definition, such a structure cannot supersede the Member States’ except in the core competencies that reflect cross-shared values of all members of the Union. These competencies have been well-defined in the European polity and electorates as securing free trade, free mobility of capital and labour, and common markets. These, then, should once again become the sole competencies of the Federal EU.

The Federal system should be bi-cameral, with directly elected Parliament and nationally-elected, member states’ representative, upper chamber. Its executive should be headed by the directly elected President, and funded by a designated federal tax. The best basis for such a tax can be each member state GDP per capita, with the common tax rate controlled by the upper chamber of the legislature.

The model for balancing the referenda-based direct democracy, the national and Federal legislative and executive mechanisms across the EU can be Switzerland.

On the EMU side, Europe needs to create a functional and well-defined mechanism for member states to exit the EMU without jeopardising their membership in the EU itself. The EU will also need to abandon the requirement for its members states to progress toward membership of the EMU. This does not mean that Europe will move to pre-EMU fragmentation of its currencies. Instead, in many EU states, Euro can coexist – in circulation and deposits – with domestic tender. But it does mean that some of the states will be free to pursue their own monetary and exchange rate policies. These states should be facilitated in transitioning to a new currency set up. Such transition should allow parallel circulation of the Euro and domestic currencies for a period of time, with strict control from the ECB in terms of monetising Euro denominated liabilities.

There are many other reforms that will be required, beyond the main principles outlined above. But the core principles remains:
1. European federalism can only evolve on the basis of drawing strength from the diversity and pluralism that define Europe, not by undermining or displacing it.
2. European federalism cannot be imposed from above nor can be spread via technocratic reforms across an ever-widening space of competencies. Instead, it must build on the foundations of participatory democracy and pluralist approach to policy debate and formation.
3. Gradualism, beginning with a handful of core competencies areas of common agreements, should take precedence in building up federal European systems and institutions.

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