disintegration 2.0

8/12/2019 Disintegration 2.0

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Vladimir Gligorov

Why Do Unions Fall Apart? (Draft 1.5)

(W)hile the politicianand the economist when

he is advising on concrete measures must take

the state of opinion for granted in deciding what

changes can be contemplated here and now, these

limitations are not necessary when we are asking

what is the best for the human race in general.

Hayek, Monetary Nationalism and International

Stability

Introduction

Why is it important for a monetary union to be anchored in a fiscal union? And how

important is that? Has the experience of failed monetary unions something to tell us about the

challenges faced by the European Monetary Union (EMU)? One way to address these

questions is to look at the limits of integrations from an economic point of view. These two

questions why unions disintegrate and why states do not integrate into unions? - are

basically the same. However, unions need to exist in order to disintegrate, which suggests that

states, or nation states, may not be much more stable than more confederate political systems.

These two types of instabilities, of unions and states, characterise the key economic and

political challenges that Europe in particular faces.

In this essay, I look at some stylized facts of economic, mainly fiscal and monetary,

disintegrations, which are based on a limited number of cases of some relatively recent

disintegrations in Europe, and some existing theories mainly developed in the last two or so

decades, and offer an alternative explanation, which might be useful for the understanding of

the dilemmas faced by the European Union (EU).

In addition, I want to rely on Hayeks criticism of nationalism (Hayek 1937, 1948,

1976, 1990), much of which was informed by the pre-World War II disintegration of Europe,

in understanding the challenges that its resurgence in Europe presents.1In that I look into his

idea of a political and economic union and compare it with the constitution of the European

1The criticism is more generally Austrian, but I rely only on Hayek in this paper, and in fact only on the few

books and articles that I explicitly reference; and in that, only on a rather restricted set of issues dealing mostly

with his disagreement with Friedman's monetary and exchange rate policies. Still, the underlying argumentsagainst nationalism are more general and could easily be applied to a much wider set of constitutional and policy

issues. See Judt (2010) on how historical experience of the nationalist, authoritarian, and disintegrating Europe

influenced Hayeks thinking.


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Union; for that I also refer to the work of Buchanan (1990, 1995) and Mundell (1971).

Finally, I discuss his disagreements with Friedmans monetary and exchange rate policies

which I find useful to understanding the problems that the European Monetary Union has

been facing from its inception, but have become acute in the current crisis.

The main point I make is about the difficulty to maintain a political and economic

union without fiscal integration. By contrast, a system of nation states tends to be unstable

without some inter-state integration, or union, mainly for financial and monetary reasons.

That may account for cycles of integration and disintegration that are characteristic for Europe

in any case. Throughout I rely on as simple, i.e. general, ideas and models as possible in order

to isolate what I consider is the main thread of arguments that have been developed in this

area of research. My aim is not so much to describe, but to explain the processes of

disintegration and integration.

Though I look at economic issues primarily, the underlying problems are obviously

political. I do not consider directly distributional conflicts over territories and other security

risks, but those are of course implied in the conflicts over the fiscal authority, which is

fundamental for most economic theories of disintegration. I discuss those in detail in Gligorov

1994 and comment on them shortly close to the end of this paper.

Some Stylized Facts

Political and economic unions have often disintegrated through wars or other types of

severe conflicts or after a prolonged crisis. This was the case with the Austro-Hungarian

Empire (for economic assessments see e.g. Dornbusch 1992, Garber and Spencer 1994), the

Soviet Union (for the dissolution of the rouble zone see e.g. Dabrowski 1995, Conway 1995,

Boughton 2012), and Yugoslavia (Gligorov 1994; for a recent economic explanation see

Desmet, Le Breton, Ortuno-Ortin and Weber, 2011, though there are some factual

inaccuracies in this paper, but it is a rare attempt to apply what is now a standard theory of

instability of diverse or heterogeneous states or unions to the Yugoslav case), to take these

three examples. In addition, disintegrations of empires are also quite violent, which has

contributed to the theory that states are born and die in wars.2

However, if the definition of an economic or political union is widened to various

types and levels of integrations, peaceful disintegrations can be also added to the list. Thus,

2

On the role of war in state-making see Tilly 1985, 1992. The debate on whether states come about throughcoercion or grow out of society or are based on social compact is as old as political philosophy or science (see

e.g. Mills survey of competing theories in Considerations on Representative Government). These theories

basically answer different questions and are not competing explanations for the most part.


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the collapse of the gold standard, of the Bretton Woods international monetary system, of

currency boards, or fixed exchange rate regimes of various types, as well as fiscal devolutions

and territorial separations and secessions could be looked at in order to come up with stylized

characteristics of economic and political disintegrations. In recent times, there have been a

number of peaceful disintegrations or devolutions, in Europe in any case; e.g. earlier Norway

and Sweden, more recently Czech and Slovak Republics, much of Soviet Union, then

Belgiums continuous decentralization, Spains and Britains devolutions, and the secession

of Montenegro, to name some. Of course, the literature, theoretical and empirical, on all these

episodes is enormous.

Generally, it can be argued that violent disintegrations suggest that political, basically

territorial, reasons lead to economic disintegrations, while peaceful ones suggest the opposite,

that economic reasons drive political disintegrations.3

As a rule, disintegrations of complex political and economic unions are characterised

by both. Even more generally, following Rodrik 2012, it can be argued that global community

and economy disintegrate to nation states, or fail to integrate, due to the impossibility to

coordinate political and economic institutions in a cosmopolis, so disintegration is a type of a

second-best solution, which is all that is politically feasible anyway, at least according to

Rodrik. Indeed, the emergence of nation states in Europe can be seen as such a process of

disintegration or of political preference for nationalism over the cosmopolitanism of the

Enlightenment.

Some stylized facts summarize the majority of disintegrations, at least in their

economic dimensions.

One almost invariable characteristic is that the lack of a fiscal union, or more

precisely of taxing powers by the union, is associated with the disintegration of a monetary

union though not necessarily of other types of monetary integrations. In some cases, fiscal

devolution preceded the monetary one, while in other cases monetary union or integration did

not lead to fiscal discipline or unification (Gligorov 1994 and 2012).

The other is that in the run up to monetary disintegration there is often a surge in

inflationand not infrequently an episode of hyperinflation (Dornbusch 1992). This tends to

be difficult to disentangle from post-war or post-crisis attempts to rely on inflation to wipe out

the accumulated public debts. But, more generally, currency crisis have often been preceded

by a speed up in inflation.

3I am not going to deal with political and in particular with security issues, though they are central to the

issue of political integrations and disintegrations. My primary interest is in the political economy of

disintegrations. I deal with the wider issue in Gligorov 1994.


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Finally, unions especially prone to disintegration have been those with asymmetric

political or economic constitutions. Even with symmetric institutions, as e.g. in a federal

system, real asymmetries in political or economic influences, the inequality in political and

economic say (e.g. permanent minorities or lack of economic convergence), are often

associated with disintegrations. Sometimes these institutional asymmetries are captured by

some measure of economic, social or cultural heterogeneity (e.g. as in Alesina and Spolaore

1997, which is referred to approvingly by Rodrik 2012),4but that kind of diversity is usually

not among the causes of actual disintegrations though it can be the way to justify them either

ex anteor more often ex post.

One element invariably present in disintegrations is a distributional conflict, not

necessarily violent. Though it can be argued that disintegrations are efficient, i.e. Pareto-

improving (better for all; Buchanan 1971, Rodrik 2012), historically they have been an

outcome of a distributional conflict with almost invariably Pareto-inferior (worse for

everybody) or Pareto-incomparable (some do better and some worse) outcomes, at least in the

short to medium run.

That is why disintegrations proceed from fiscal devolution or resistance to fiscal

centralisation, to monetary disintegration, and in the end to a renationalization of financial and

other markets.

Some Informal Theory

Analytically speaking, there is a state where there is the right to collect taxes (in the

context of this paper Schumpeter 1918 is an important reference; in the context of integration

and disintegration of states Friedman 1977 is an early and influential representative of the

fiscal theory of states). That right is of course based on might, as taxes are not voluntary

contributions but are extracted by coercion. Indeed, state is a coercive institution,5 and

collecting taxes is the prototype of coercion. In any case, once a tax collecting authority

exists, it can issue money, which is a liability of the state, and back it by taxes. In a closed

economy, money is just another instrument of fiscal policy; it is a way to finance the public

debt and thus defer the collection of taxes or distribute their burden within and between

generations (for an influential statement see Barro 1979).

4The pervasive assumption in practically all theories of integration and disintegration is that the larger the

population or territory or both, the higher the diversity (also in Hayek 1990). Hardly ever there is a suggestion onhow to represent, e.g. measure, the diversity.

5Even if it is based on a social contract or is constitutional; it still consists in the right and might to coerce

or use force to compel or tax.


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Thus, in a closed economy, monetary union is just another facet of the fiscal union.

Money may be used as an instrument to finance the state budget as long as the fiscal union

holds, i.e. as long as there is the right and the ability to collect taxes (including the inflation

tax, i.e. seignorage).

In an open economy, money is also an instrument of foreign trade and finance (and has

been seen as primarily such since early monetary theory, e.g. Hume 1741-1742). As a

consequence, it is partly international, i.e. divorced from the respective fiscal unions. In that

sense, the fiscal authority cannot use its own money unconditionally; there is a monetary

constraint due to the inevitable split between the fiscal and monetary unions and authorities.

Traditionally, one distinguishes between the outside or fiat money and the inside money, e.g.

foreign reserves (or reserves of commodity money). The former, but not the latter, is anchored

in fiscal authority.6

This can be generalized, as it usually is. Even in a closed economy, there is inside

money, in fact quite a number of various money-like instruments that compete with the

outside or fiat money; at high levels of rates of inflation, or lack of credibility due to the

history of high inflation, inside money may drive out the fiat one (Hayek makes that point

repeatedly). In addition, even a closed economy is open to future generations. Because of that,

there is a limit to states power over future generations and thus inter-temporally, there is only

so much of a fiscal union. So, monetary and fiscal powers overlap only partially due to the

geographical, economic and temporal limitations of the fiscal monopoly.

Thus, fiscal union is neither a necessary nor a sufficient condition for the existence of

the monetary union. Even if all currencies are national, money is still international; and even

if there is a fiscal union, there may not be a monetary union.

These asymmetries between fiscal and monetary unions have consequences for the

financial system, especially for the banking system. On the one hand, stability of the banks

depends on the support by the central bank, but also on the implicit or explicit guaranties by

the fiscal authority (Diamond and Dybvig 1983). On the other hand, cross-border financial

activities are conducted as if in a system of free banking with scant or uncertain central

banking and fiscal support (with some constraints imposed and support provided by the Bank

6There are different ways to distinguish between inside and outside money. Gurley and Shaw (1960) treat

gold and commodity money together with fiat money as coming from the outside of the private sector balance

sheet and bank money as arising from inside. Lagos (2008) defines outside money as central bank liabilities that

are not backed by assets or at least not by assets that are not in zero net supply by the private sector, i.e. as fiat

money. It is hard to see that gold or other commodity money can be treated in the same way in the central banksbalance sheet. In general, this distinction between inside and outside money is difficult to apply to an open

economy.


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of International Settlements and the International Monetary Fund, but with no international

fiscal backing). This dualism is present in political and economic unions that have common

monetary, but not fiscal system too.

Thus, there is an endogenous banking instability which may support the disintegration

of the common central bank if there is no fiscal union or the distributional problems are such

that the fiscal union is not sustainable.

In monetary theory, there are two approaches as identified e.g. by Goodhart (1998)

that neatly illustrate this dual character of money. As a medium of exchange, domestic or

international, money is a device that minimizes transaction costs (Menger 1892), while as a

source of liquidity money depends on the state monopoly power, i.e. on the power to coerce,

as in the power to tax (Hayek 1937, 1990). These two monetary facets in fact coexist because

the power or at least the right to coerce does not extend across state borders while money is

useful in settling cross-border trade and other transactions. Similarly, the central bank has

liabilities beyond its own monetary jurisdiction as its money may be used by the international

banking system.

Thus, fiat money is preferred if it is more liquid and bears lower transaction costs and

is inferior to the competing money otherwise (through currency substitution, bank liabilities,

or commodities, e.g gold).

This dualism also impinges on the policy mixes available to the authorities. Even in

the case of a closed economy, it may not be possible to sustain price stability without making

monetary policy independent in some sense. In an open economy, it may prove impossible for

these two policies not to get into each others way. In general, in targeting the internal

balance, i.e. level of employment, fiscal policy tends to dominate (whether it is active or

passive in the sense of Leeper, 1991; see also McCullam and Nelson, 2006) while in securing

the external balance, the sustainability of the balance of payments, monetary policy tends to

dominate.7 But, the two may prove not to complement each other, due to changing public

preferences over the different macroeconomic goals, thus inciting various types of instability

(for a recent survey of monetary and fiscal policy interactions see Canzoneri, Cumby, and

Diba 2011).

Thus, in general, there is no definite reconciliation between fiscal and monetary

policies, except in a closed economy setting with constant population which lives forever or

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Mundell believes that the policy assignment depends on whether the exchange rate regime is fixed orflexible; but as long as the economy is an open one, fiscal policy will be constrained by monetary policy

considerations even if there is a flexible exchange rate regime in place; for more on the assignment issue see

Gordon and Leeper 2006, Kirsanova, Leith, and Wren-Lewis 2009.


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where the overlapping generations are strongly connected by one or the other characteristic

attributed to them by various types of nationalists. However, distributional effects of changes

in policy mixes, e.g. of monetary and banking renationalization may be sufficient to support

the disintegration of the monetary union. In case there is no fiscal union, financial

disintegration may prove to be even more attractive.

Appendix I: Simple Idea of Fiscal and Monetary Policy Interaction

Probably the simplest way to illustrate the connection between the fiscal and monetary

policies is with the inter-temporal government budget constraint:

B/P = E (T-G) (1)

where B is public debt, P is price level, E is expectations operator, T is taxes and G is public

spending (expected future real fiscal surpluses).

To the extent that monetary policy can set P, whether by controlling the quantity of

money or by setting the interest rate on short term government liabilities, it will also set the

needed real fiscal surpluses given the level of public debt. If, however, fiscal surpluses are

falling short of what is required to cover the public debt, or fiscal deficits are too large, prices

need to increase in the equilibrium. In the first case, there is monetary dominance (monetary

policy aiming at price stability determines the needed fiscal surplus), while in the second there

is fiscal dominance (the desired fiscal surplus or deficit determines the price level). However,

to the extent that either interest rate or quantity of money is in part or completely

endogenously determined, e.g. monetary policy is constrained via the balance of payments,

there is monetary dominance externally even if there is fiscal dominance internally. The

international interest rate, however, is set endogenously, basically in the financial markets.

The Dynamics of Disintegration

In a typical case, there is a growing interest in fiscal devolution due either to

asymmetries in the political or economic constitution of the union, i.e. biased fiscal system or

because of the discretionary use of monetary policies. The former may be because it is

believed that there is taxation without representation, or without adequate representation,

while the latter, that can be also interpreted as the case of representation without taxation, is

more often the case if either there are diverging interests when it comes to the setting of the

inflation target by the central bank or because of the dissatisfaction by some with the

exchange rate regime or policy.


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In a number of cases, e.g. the dissolution of the Austro-Hungarian monetary union or

the two Yugoslav monetary unions (Socialist Yugoslavia and the one consisting of Serbia and

Montenegro) and possibly of the rouble zone too, due in part to the distributional effects of

monetary policy, i.e. disagreements over the inflation targets and problems with the choice of

the exchange rate regime, the creation of a fiscal union was resisted or there was a persistent

push for fiscal devolution. In these as well as in other cases of monetary renationalization, the

lack or the weakness of the fiscal union or its devolution preceded the disintegration of the

monetary union.

Once there is no fiscal union, an attempt by the central bank to inflate the economy to

support growth or to ease the fiscal burden tends to create incentives for renationalization of

monetary policy. Whatever fiscal aim inflation can achieve in the union as a whole, it can

achieve it even better if monetary policy is renationalized; while the damage that common

monetary policy might do can also be avoided by getting out of the monetary union.8These

distributional effects are especially strong at higher rates of inflation, which is why they tend

to be associated with the disintegrations of monetary unions.

The distributional effects of monetary policy can arise either because the distribution

of debtors and creditors differs across the various regions of a union or because the spread of

inflation is staggered so that some parts of the union experience a speed up in inflation before

the others. The former may be a consequence of different balances in savings and investments

while the latter can be due to differences in the way labour markets work. Clearly, creditor

nations may not be happy with the acceleration of inflation while countries with rigid labour

markets may prefer higher inflation rates than the rest of the union.

Some point to the need for a dominant player in the monetary union that can ensure its

continued existence (Cohen 2000). However, in the examples mentioned here, the existence

of the dominant influence on the monetary policy was one of the reasons for the drive to

disintegrate. Once there is a distributional conflict, the asymmetry of power will lead to

secession being preferable to continued cooperation because of the expectations that the costs

will be distributed in reversed proportion to the distribution of power. So, the role of the

dominant player in economic and political unions is more ambiguous especially when it

comes to the use of monetary policy (on game-theoretic aspects of the balance of power with

the dominant player see Gligorov 1994).

Disintegration is speeded up if fiscal and monetary problems are accompanied by a

threat or an actual collapse of the banking system. More often than not, financial crisis, often

8On the ability of a central bank of a small open economy to control inflation see Woodford 2010.


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with international causes and consequences, precedes the fiscal and monetary crisis (Reinhart

and Rogoff 2010). Public resources are needed to stabilise or even bail out the banking system

and the existence of an explicit or implicit fiscal guarantee will lead to the renationalization of

the banking system or prevent the creation of a banking union. That process will be easier if

the fiscal system is renationalized, or if fiscal union never came into being and if there is a

national central bank that can provide or can be expected to provide the needed liquidity with

ease.

Thus, first fiscal union is either not put together or devolves, then speed up of inflation

destroys the monetary union, and finally bank resolution problems require the

renationalization of the banking system and the reintroduction of tariffs and capital controls.

And the union falls apart.

The Mechanics of Disintegration

The literature on political and economic disintegration identifies causes relying on a

number of assumptions about the optimality of states or unions. The key assumptions are

about the homogeneity of public preferences and economic activities (Mundell 1961, Alesina

and Spolaore 1997, Bolton and Roland 1997, McCallum 1999). In addition, flexibility of

prices of productive factors, especially of wages, plays an important role. The homogeneity of

public preferences are taken to be a consequence of one or the other attribute of national

identity, e.g. common culture, while labour mobility and homogeneous production

specialization may be due to geographical factors. Indeed, it is often assumed that with

geographical distance, heterogeneity, cultural and economic, increases, so that the benefits of

economic, fiscal, and monetary unions decline.

Mainstream theory assumes that heterogeneous political unions or states are unstable

and will be prone to disintegration (Alesina, Angeloni and Etro, 2005). In reality, unions fall

apart because of the inability to solve emerging distributional problems (for the near

irrelevance of heterogeneity for distributional problems Gligorov 1992-2012). Again, as

unions often disintegrate through wars or violent internal conflicts, it is hard to identify the

causes that drive the process of breakup (Gligorov 1994).

In a number of cases, the problems start with a financial crisis. The distribution of

losses proves to be hard in a union either because of the lack of a proper fiscal system of risk

sharing or because of the appeal of fiscal devolution as a means to minimize ones own costs

by shifting them to somebody else. In some cases monetary policy is used to support thefailing banking system, which tends to politicize the central bank. In most failed unions,


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central monetary authority was identified with the interests of a particular, often dominant,

state in the union. That may induce the other states to look for ways to renationalize various

aspects of the monetary authority, which arises naturally if there is no fiscal union. If there is,

fiscal devolution is the step that precedes the one of the establishment of monetary

sovereignty.

Thus, financial crisis tends to be the usual cause of the drive for fiscal devolution and

of the renationalization of the monetary system. Often, the attempts to inflate the crisis away

or to extend fiscal authority prove to be counterproductive because they increase the stakes of

the distributional conflict over the costs of the crisis.

Appendix II: A Generalized Idea of Crisis

Probably the best understood is the currency crisis. If the exchange rate is fixed or

managed, and if it gets misaligned, i.e. overvalued, a speculative attack will succeed as long

as foreign reserves are finite because it will be advantages to speculators to buy all the

reserves and then sell them back once the exchange rate has devalued. With M for money

growth, P for prices, i for the interest rate, e for exchange rate:

M| P, i, > M| efixed efixed < efloat (2)

If money grows faster than is required for maintaining a fixed or a managed exchange rate,

the exchange rate will collapse under a speculative attack.

In general, crisis will occur if relative prices are misaligned because there will be

money to be made as long as there is relative price rigidity. The key is the existence of the

relative price misalignment, it is not enough that the exchange rate is fixed, and it is not even

necessary as flexible exchange rates can also be misaligned. In the latter case, foreign reserves

at the central bank need not be as high as in the case of the former. However, the reserves

serve to fight back speculative attacks when the exchange rate is not misaligned. Once it is,

the reserves are what speculators are after.

Speculative attacks can take the form of what has become to be known as crisis of

sudden-stops. If foreign financial inflows stop, the country may face shortage of money which

may be larger than the existing foreign currency reserves may cover. Substituting home for

foreign money may not be possible even under flexible exchange rates in a country with large

currency substitution perhaps because crediting in domestic currency is limited or non-

existent (Calvo 1979).

Also, hiking the interest rate in order to stop the haemorrhaging of the foreign financesmay prove counterproductive because it may eventually lead to even steeper devaluation


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preferred policy mixes, which are closer to their public preferences than those that would

prevail in a large state or in a union with significant level of federalization.

The outcomes, by and large, do not support these expectations. In most cases, the

systemic outcomes do not accord with the justifications of disintegration.

The emerging sovereign states need not be more homogeneous (culturally, politically,

or in economic terms). In fact, due to the flexibility of gerrymandering, there may be no end

to cycles of disintegration all the way to the state of affairs in which every person is a

Robinson Crusoe and even in that case there is the issue of inter-temporal consistency and

sustainability (on all that see Gligorov 1994 and 1992-2012).

Even with a debt write-off, the tax burden of the macroeconomic and financial

stability, and the provision of the full set of public goods in the disintegrated states, tends to

increase. This is not only due to the diseconomies of scale. Even if possible increases in

expenditures on security (military, political, economic, or social) are disregarded, ex ante

public preferences may differ from the ex postones. In the Tiebout 1956 type of a setting,

borders are given and people move to regions that have policies, e.g. tax rates, which they

prefer, so there is no reason for these preference to change after regions are homogenised

precisely on the basis of preferred policies. In the case of people not moving but the borders

being redrawn, the policy preferences before secession are drawn over the different policy

space than the one that emerges with the redrawing of the borders. The preferred policy mix

before secession may not be the same as the one after the secession in part because the policy

goals and instruments may be different. It may be the case that more homogeneous societies

will tend to redistribute less than the more heterogeneous ones, but the usual motivation of

renationalization is in fact to redistribute more rather than less. So, more often than not, fiscal

burden tends to increase. Thus, tax levels often increase because of the lower mobility of the

tax base. That is especially the case if tariffs are hiked and capital controls introduced. So,

overall, the promises of renationalisation as the promises of nationalism in general prove to be

largely illusionary in the international context.

The scope for autonomous or active monetary policy is strictly limited. Monetary

sovereignty is often not attained, since nationalization of the central bank leads to a fiscal

dominance except to the extent that the interest rate and the rate of inflation depend on the

foreign financial flows. That does not mean that there is scope for active fiscal policies, but

rather there is a regime of monetary dominance, the one anchored in reserve management

with a limited role for exogenous money and thus for fiscal policy.


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In a number of cases, the new currencies proved inferior to foreign alternatives. For

instance, most currencies in the post-rouble zone as well as in the post-Yugoslav dinar zone

have failed to attract trust of either debtors or creditors and foreign currencies are used for

most monetary functions. In addition, fixed (or managed) exchange rate regimes are more

common than the floating ones. So, often common currency is substituted with a pegged

exchange rate and with a central bank that functions as a currency board. In those

circumstances, it is hard to argue that monetary sovereignty has been regained. The central

bank often lacks credibility and currency substitution is used as an insurance against surprise

devaluation and surge of inflation. This lack of credibility translates into real costs in the form

of a higher interest rate and higher need for sterilization. The improvement in the international

position through the exchange rate adjustment tends to be temporary if it is not followed by

changed propensity to save and with increased investments in tradable goods and services.

Banking renationalization proves to be rather costly due to the need to bail out the

banks. Also, the probability of national banks going bust does not decrease; in other words,

the probability of a systemic risk decreasing in national banking systems is rather low. In fact,

due to higher openness of smaller economies, dependence on international finances increases

and the allocational benefits of national banking systems decreases.

So, overall, the system of nation states does not necessarily lead to increased policy

autonomy or to improved policy performance.

The Case of the European Monetary Union

If the rule you followed brought you to this, of

what use was the rule? Anton Chigurh, No

Country for Old Men.

European Monetary Union is designed to be supported not by a fiscal union in the

sense of centralized taxing powers but by fiscal rules. The idea is that if the rules are right and

if there is the firm commitment that those will be adhered to, no delegation of taxing authority

is needed, i.e. fiscal powers need not be federalised. In addition, the European Central Bank is

also a rule-following institution, which is the foundation of its independence. Finally, the

banking sector is, to quote Mervyn King (or was it Charles Goodhart?), international in life,

and national in death, i.e. the risks of bank failures are borne by the national budgets.

The general idea of the construct does not differ fundamentally from what can be

found in Hayeks essay on inter-state federalism (Hayek 1948, originally 1939). It could beargued that Hayek, by implication, in that piece envisages a constitution for a union along the


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lines of Buchanan 1990. Also, in this piece, unlike in Hayek 1976 (1990), again by

implication, he supports a monetary union along similar lines of argument as Mundall 1971.

Finally, insisting on rules rather than discretion, the paper anticipates the main institutional

characteristic of the EU, which is that stability comes from adherence to rules and not from

discretionary policies (though Hayek does not deny the need for those).

The key difference between the EU and the EMU on one side and a state, however

federalised, on the other side is that the former relies on compliance rather than on

enforcement, which is characteristic of the latter. The system of compliance is supposed to be

based on rules that should substitute discretionary or other policies indeed, the idea is that

the EU, on all levels of decision making, will be based on rule-following and to the extent that

there is scope for policies, those would be limited by the adherence to the rules. That is why

there is the often noticed disproportionate reliance on regulation to the detriment of executive

power. That applies not only to the regulation of the common market, but also to fiscal policy,

and even to monetary policy.

Generally, the EU is a rule based political and economic union. That is supposed to

solve the problem of commitment and the pervasive problem of time-inconsistency. As long

as there is the possibility for the decision-makers to change their mind, there is the problem

that following through with the commitment may not be the optimal policy in changing

circumstances. In fact, sequential optimization may lead to the final outcome that is far

removed from the one that would have been arrived at if the initial commitment had been

adhered to. In addition, the latter may Pareto-dominate the former.

Because of that, EU is not just rule-based, but also the rules it relies on are those that

are assumed to be optimal in the long run. Those should signal a very strong commitment and

thus stabilize expectations. Those should in turn enable the pursuit of monetary policy that

stabilizes inflation and fiscal policy that stabilizes public debts at levels that are agreed on as

being most conducive to potential growth that also leads to convergence of initially large

regional differences. In fact, the only policy instrument left is that of increasing market

integration through liberalization. That in particular applies to financial markets and cross

border banking.

Thus, the end result is a customs union (free trade in goods, services, and labour), an

independent central bank targeting low inflation rate (close but below 2%), fiscal compact

(Stability and Growth Pact targeting public debt of 60% of GDP or less with balanced or in

surplus primary fiscal balance), and financial liberalization. EU is an economic and politicalunion without the right to tax and to borrow. It is supposed to provide the legal and the


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regulatory framework for free enterprise, free banking and free trade. This will be so if the

rules and regulations are incentive compatible and dynamically self-sustainable. Simply

stated, that means that they are not only Pareto-optimal but are also stable in the sense that

they adjust to shocks or crisis by reforms that sustain the basic institutional set up.

The main lacunas in the construction are those that are associated with the authority of

a state: lack of instruments for stabilisation policy and of institutions that deal with

distributional problems. There are some elements of policies of compensation and

development, but the main instruments of distribution and redistribution across borders of

member states are lacking. In terms of major social risks, there is no economic and political

union. The union has no taxing powers and does not provide for social security. So, it is not at

all clear how is it supposed to deal with distributional conflicts.

Thus, faced with financial crisis, the union faces strong incentives to disintegrate in

order to renationalise the banking and thus the monetary system relying on the never united

fiscal system. The key to this outcome emerging is the fact that fiscal systems are national.

That essentially means that the EU is organized as a collection of separate insurance systems

as fiscal systems are mainly about the risk sharing within and between generations. So,

increased risks tend to make international or across the EU risk sharing unattractive because it

requires redistribution from those facing lower risks to those with higher risks, those that are

distressed. It is in a way the mechanism of adverse selection, often mistaken for the attraction

of homogeneity, which is driving the process of disintegration.

Appendix 3: Fiscal Risk Sharing

Fiscal union is a way to insure risks, which for the reason of one or the other market

failure cannot be privately insured (Persson and Tabellini 1996a, 1996b). Security is the

primary example, but justice and welfare are the other two among those that are the most

important. Systemic risks, financial but also in other markets, most importantly in the labour

market, that can fall under a more general notion of security, also feature as reasons for fiscal

insurance.

Clearly, fiscal as any other insurance system pulls risks that, when realized, have

distributional effects. Those are the reason that there is a market failure to begin with and for

the coercive way in which contributions are collected. That of course introduces a moral

hazard as in part a cost for lower overall risk. In addition, for the same reason that individuals

do not pay taxes voluntarily, states do not integrate fiscally just because that leads to betterinsurance and lower risks. In addition, they have an interest to disintegrate once the risks


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materialize and those less affected need to foot the bill of those that are more affected, i.e.

there is the problem of adverse selection.

Internationally, states are like private insurance systems that are subjected to adverse

selection problem. So, those better off do not want to share risks with those worse off and the

latter may have an interest in protecting themselves from the former, by putting barriers to

trade and nationalizing their monetary and banking systems. However, when considering

optimal taxation and transfers, fiscal unions are superior on both moral hazard and adverse

selection grounds.

One way to see the insurance aspect of fiscal institutions is to think in terms of inter-

generational justice. Assume, as Rawls or Harsanyi or Arrow, that the fiscal union of, e.g.

Germany and Greece, or any number of states on different levels of development is

considered. If those deciding do not know whether they will be born or end up living in the

more developed rather than less developed region of the union, they may want to design an

insurance system to share that risk. This is a problem similar to the one where migration is

treated in the overlapping generations setting. At every point in time, better off cover the risks

of the worse off, however over generations the opposite may very well be true.

Appendix 4: Mechanism Design and Backward Induction (Rules and Commitment)

EU policy set-up has been strongly informed by the time-inconsistency argument and

not only in the case of problems with moral hazard issues. Therefore, it is rather inimical not

only to discretionary policies, but to the existence of political bodies with discretionary

powers altogether. The idea is that the constitution should be designed in such a way that it is

incentive compatible and that this can be ascertained by a backward induction argument that

leads to the Nash equilibrium in interests and commitments. By that reasoning, liberalisation

of markets and regulation that sustains it should rule out the need for stabilization policies

beyond those that are delegated to the central bank. The bank, however, is committed to price

stability, which is defined as the rate of inflation of less than but close to 2% over the medium

term. So, the scope for discretionary monetary policy is quite limited in terms of the inflation

target. It is also instrumentally limited as the European central bank is not a government bank,

as there is in fact no government for this monetary union.

The Great Idea (an allusion to Musil)

The key problem in political unions is the constitutional one (Gligorov 1994;Buchanan 1990). That seems like an easier problem in nation states, in part because policies


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need not be substituted by rules. Many unions have faced the problem of finding The Great

Idea to base the common institutions and policies on. This was the case with Austro-Hungary

and the Yugoslav state at least. It is the case with the EU too. Every political union searches

for a constitution that is implicitly cosmopolitan, i.e. is based on The Great Idea.

However, nation states face problems with justifying their borders and founding a

stable international order. Apart from economic reasons for the uneasy relationship between

trade, fiscal, and monetary policies, there is the political issue of stable distribution of power

or of balance of power. For instance, it appears that Rodrik argues for a system of nation

states assuming that the issue of stable power distribution has been solved. Most theories of

the number and size of nations rely on simplifying assumptions about the distribution of

preferences and decision making rules (so that they can make use of the median voter

theorem; Gligorov 2000 in 2012).

In general, though, a cosmopolis can be decentralised in many, possibly infinite

number of, ways. So, there is no reason to assume that a system of states (Wight 1971) will

ever prove stable as there is no stable and sustainable distribution of power. Even assuming

initial ethnic homogeneity, there is no reason to believe that it will be sustained against

migrations or even endogenous cultural differentiation. So, both great ideas cosmopolitan

one or the national onewill prove deficient either constitutionally or politically.

In economic terms, this is central to the debate between Friedmans nationalism and

Hayeks cosmopolitanism discussed shortly below.

Criticism of Nationalism: Hayek vs. Friedman

What is wrong with nationalism apart from international security concerns? In the

context of fiscal and monetary interaction issues, Hayeks criticism of Friedmans preference

for a particular monetary policy rule and for flexible exchange rates may be of some

intellectual interest. These diverging conceptions were forged at the time of collapsing system

of nation states and of the rebuilding of the new international monetary and economic order,

so it is not just of intellectual interest.

It is perhaps less often emphasized that Hayek was a consistent critic of nationalism.

Perhaps his best argument for a federal constitution is to be found in the last chapter of Hayek

1948 (originally 1939). There he argues for comprehensive market liberalization and

integration of countries ready to commit to those. It does not apply to any particular region

and could include all countries committed to free trade and complementary economic policies.Clearly, in the end, that is a cosmopolitan vision.


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More concretely, he argued against monetary nationalism in his 1937 book and

especially in the controversial Denationalisation of Money book (third edition 1973). The key

point is that he saw monetary nationalism not only as a source of instability, but primarily as

an instrument to increase public revenues. Nationalism is a way to introduce an additional tax.

The instability comes through the reliance on the monetary rule (like the one Friedman

proposed) or through the reliance on flexible exchange rates that allow for national inflation

targets and lead to increased international instability (on autonomy of monetary policy with

flexible exchange rates see Clarida, Gali and Gertler 2001, Woodford 2008).

On both these issues, he criticised Friedman rather sharply. He argued that fixed rate

of money growth is destabilizing because it will invite speculation (similarly to the fixed

exchange rate, one might add). He quotes Bagehot to that effect and argues that the central

bank needs to have some operational discretion if it is to succeed in stabilizing inflation.

Similar argument can be applied to the policy of interest rate targeting. When it comes to

flexible exchange rates, he argued that it can be expected that those will be destabilizing

because the volatility will increase significantly. The reason is that all those fiscally dominant

national policies will be difficult to stabilize in the international money markets. He, indeed,

believed that in a free banking system with competing currencies, endogenous monetary

dominance will assert itself.

More fundamentally, monetary and fiscal nationalism is a way to limit the private

property rights and to limit individual rights and freedoms. It does not have only negative

effects on growth and employment, but also on security and justice. The alternative

arrangement of common market and financial liberalization as well as reliance on the rule of

law is certainly also at the basis of the European Union (though he did not think in his 1948

chapter, written originally before the Second World War, that the inter-state federalism should

be restricted to Europe). The key remaining problem is that of risk sharing and fiscal union.

The federal system of taxation with competition and fiscal federalism in the provision of

public goods is one possibility. Financial instability remains as a problem, but may not lead to

disintegration and to rising nationalism.

Conclusion

Basically, unions disintegrate for distributional reasons, though disintegrations are

often caused by financial crisis. The main attraction of nationalism is distributional, while the

main disadvantage of monetary unions is that monetary policy may redistribute via inflationin a manner that may lack legitimacy. However, except in closed economies, there is no easy


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cohabitation between monetary and fiscal policies. Indeed, the world economy is closed at

least intra-temporally which perhaps explains the drive to regional, like EU, and global

integration. There is the problem of inter-temporal distribution, which is properly the task for

global risk sharing. If there is no such system, there will be cycles of integration and

disintegration.

Appendix 5: Hayek on Friedman

In Denationalization of Money, Hayek criticises Friedmans monetary theory and

policy extensively. This quote contains almost the whole argument:

Where I differ from the majority of other monetarists and in particular from the

leading representative of the school, Professor Milton Friedman, is that I regard the simple

quantity theory of money, even for situations where in a given territory only one kind of

money is employed, as no more than a useful rough approximation to a really adequate

explanation, which, however, becomes wholly useless where several concurrent distinct kinds

of money are simultaneously in use in the same territory. Though this defect becomes serious

only with the multiplicity of concurrent currencies which we are considering here, the

phenomenon of substitution of things not counted as money by the theory for what is counted

as money by it always impairs the strict validity of its conclusions.

Its chief defect in any situation seems to me to be that by its stress on the effects of

changes in the quantity of money on the general level of prices it directs all too exclusive

attention to the harmful effects of inflation and deflation on the creditor debtor relationship,

but disregards the even more important and harmful effects of the injections and withdrawals

of amounts of money from circulation on the structure of relative prices and the consequent

misallocation of resources and particularly the misdirection of investments which it causes.

This is not an appropriate place for a full discussion of the fine points of theory on

which there exist considerable differences within the monetarist school, though they are of

great importance for the evaluation of the effects of the present proposals. My fundamental

objection to the adequacy of the pure quantity theory of money is that, even with a single

currency in circulation within a territory, there is, strictly speaking, no such thing as the

quantity of money, and that any attempt to delimit certain groups of the media of exchange

expressed in terms of a single unit as if they were homogeneous or perfect substitutes is

misleading even for the usual situation. This objection becomes of decisive importance, of

course, when we contemplate different concurrent currencies.


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A stable price level and a high and stable level of employment do not require or permit

the total quantity of money to be kept constant or to change at a constant rate. It demands

something similar yet still significantly different, namely that the quantity of money (or rather

the aggregate value of all the most liquid assets) be kept such that people will not reduce or

increase their outlay for the purpose of adapting their balances to their altered liquidity

preferences. Keeping the quantity of money constant does not assure that the money stream

will remain constant, and in order to make the volume of the money stream behave in a

desired manner the supply of money must possess considerable elasticity.

Monetary management cannot aim at a particular predetermined volume of circulation,

not even in the case of a territorial monopolist of issue, and still less in the case of competing

issues, but only at finding out what quantity will keep prices constant. No authority can

beforehand ascertain, and only the market can discover, the optimal quantity of money. It

can be provided only by selling and buying at a fixed price the collection of commodities the

aggregate price of which we wish to keep stable.

As regards Professor Friedman's proposal of a legal limit on the rate at which a

monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can

only say that I would not like to see what would happen if under such a provision it ever

became known that the amount of cash in circulation was approaching the upper limit and that

therefore a need for increased liquidity could not be met.9

Everybody knows of course that inflation does not affect all prices at the same time

but makes different prices rise in succession, and that it therefore changes the relation

between prices although the familiar statistics of averageprice movements tend to conceal

this movement in relative prices. The effect on relative incomes is only one, though to the

superficial observer the most conspicuous, effect of the distortion of the whole structure of

relative prices. What is in the long run even more damaging to the functioning of the economy

and eventually tends to make a free market system unworkable is the effect of this distorted

price structure in misdirecting the use of resources and drawing labour and other factors of

production (especially the investment of capital) into uses which remain profitable only so

long as inflation accelerates. It is this effect which produces the major waves of

unemployment, but which the economists using a macro-economic approach to the problem

usually neglect or underrate.

9To such a situation the classic account of Walter Bagehot would apply: In a sensitive state of the

English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin and would run like

magic.


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This crucial damage done by inflation would in no way be eliminated by indexation.

Indeed, government measures of this sort, which make it easier to live with inflation, must in

the long run make things worse. They would certainly not make it easier to fight inflation,

because people would be less aware that their suffering was due to inflation. There is no

justification for Professor Friedmans suggestion that

by removing distortions in relative prices produced by inflation, widespread escalator

clauses would make it easier for the public to recognise changes in the rate of

inflation, would thereby reduce the time-lag in adapting to such changes, and thus

make the nominal price level more sensitive and variable.

Such inflation, with some of its visible effect mitigated, would clearly be less resisted

and last correspondingly longer.

It is true that Professor Friedman explicitly disclaims any suggestion that indexation is

a substitute for stable money, but he attempts to make it more tolerable in the short run and I

regard any such endeavour as exceedingly dangerous. In spite of his denial it seems to me that

to some degree it would even speed up inflation. It would certainly strengthen the claims of

groups of workers whose real wages ought to fall (because their kind of work has become less

valuable) to have their real wages kept constant. But that means that all relative increases of

any wages relatively to any others would have to find expression in an increase of the nominal

wages of all except those workers whose wages were the lowest, and this itself would make

continuous inflation necessary.

It seems to me, in other words, like any other attempts to accept wage and price

rigidities as inevitable and to adjust monetary policy to them, the attitude from which

Keynesian economics took its origin, to be one of those steps apparently dictated by

practical necessity but bound in the long run to make the whole wage structure more and more

rigid and thereby lead to the destruction of the market economy. But the present political

necessity ought to be no concern of the economic scientist. His task ought to be, as I will not

cease repeating, to make politically possible what today may be politically impossible. To

decide what can be done at the moment is the task of the politician, not of the economist, who

must continue to point out that to persist in this direction will lead to disaster.

I am in complete agreement with Professor Friedman on the inevitability of inflation

under the existing political and financial institutions. But I believe that it will lead to the

destruction of our civilisation unless we change the political framework. In this sense I will

admit that my radical proposal concerning money will probably be practicable only as part ofa much more far-reaching change in our political institutions, but an essential part of such a


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reform which will be recognised as necessary before long. The two distinct reforms which I

am proposing in the economic and the political order are indeed complementary: the sort of

monetary system I propose may be possible only under a limited government such as we do

not have, and a limitation of government may require that it be deprived of the monopoly of

issuing money. Indeed the latter should necessarily follow from the former.

The historical evidence

Professor Friedman has since more fully explained his doubts about the efficacy of my

proposal and claimed that

we have ample empirical and historical evidence that suggests that [my] hopes would

not in fact be realised-that private currencies which offer purchasing power security

would not drive out governmental currencies.

I can find no such evidence that anything like a currency of which the public has learnt

to understand that the issuer can continue his business only if he maintains its currency

constant, for which all the usual banking facilities are provided and which is legally

recognised as an instrument for contracts, accounting and calculation has not been preferred

to a deteriorating official currency, simply because such a situation seems never to have

existed. It may well be that in many countries the issue of such a currency is not actually

prohibited, but the other conditions are rarely if ever satisfied. And everybody knows that if

such a private experiment promised to succeed, governments would at once step in to prevent

it.

If we want historical evidence of what people will do where they have free choice of

the currency they prefer to use, the displacement of sterling as the general unit of international

trade since it began continuously to depreciate seems to me strongly to confirm my

expectations. What we know about the behaviour of individuals having to cope with a bad

national money, and in the face of government using every means at its disposal to force them

to use it, all points to the probable success of any money which has the properties the public

wants if people are not artificially deterred from using it. Americans may be fortunate in

never having experienced a time when everybody in their country regarded some national

currency other than their own as safer. But on the European Continent there were many

occasions in which, if people had only been permitted, they would have used dollars rather

than their national currencies. They did in fact do so to a much larger extent than was legally

permitted, and the most severe penalties had to be threatened to prevent this habit from

spreading rapidly-witness the billions of unaccounted-for dollar notes undoubtedly held inprivate hands all over the world.


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I have never doubted that the public at large would be slow in recognising the

advantages of such a new currency and have even suggested that at first, if given the

opportunity, the masses would turn to gold rather than any form of other paper money. But as

always the success of the few who soon recognise the advantages of a really stable currency

would in the end induce the others to imitate them.

I must confess, however, that I am somewhat surprised that Professor Friedman of all

people should have so little faith that competition will make the better instrument prevail

when he seems to have no ground to believe that monopoly will ever provide a better one and

merely fears the indolence produced by old habits.

Hayek (1937) on the international standard:

Theoretical economists frequently argue as if the quantity of money in the country

were a perfectly homogeneous magnitude and entirely subject to deliberate control by the

central monetary authority. This assumption has been the source of much mutual

misunderstanding on both sides. And it has had the effect that the fundamental dilemma of all

central banking policy has hardly ever been really faced: the only effective means by which a

central bank can control an expansion of the generally used media of circulation is by making

it clear in advance that it will not provide the cash (in the narrower sense) which will be

required in consequence of such expansion, but at the same time it is recognised as the

paramount duty of a central bank to provide that cash once the expansion of bank deposits has

actually occurred and the public begins to demand that they should be converted into notes or

gold. (13)

As I have pointed out before, the "national reserve principle" is not insolubly bound

up with the centralization of the note issue. While we must probably take it for granted that

the issue of notes will remain reserved to one or a few privileged institutions, these

institutions need not necessarily be the keepers of the national reserve. There is no reason why

the Banks of Issue should not be entirely confined to the functions of the issue department of

the Bank of England, that is to the conversion of gold into notes and notes into gold, while the

duty of holding appropriate reserves is left to individual banks. There could still be in the

backgroundfor the case of a run on the banksthe power of a temporary "suspension" of

the limitations of the note issue and of the issue of a emergency currency at a penalizing rate

of interest.

The advantage of such a plan would be that one tier in the pyramid of credit would be

eliminated and the cumulative effects of changes in liquidity preference accordingly reduced.The disadvantage would be that the remaining competing institutions would inevitable have to


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act on the proportional reserve principle and that nobody would be in a position, by a

deliberate policy, to offset the tendency to cumulative changes. This might not be so serious if

there were numerous small banks whose spheres of operation freely overlapped over the

whole world. But it can hardly be recommended where we have to deal with the existing

banking systems which consist of a few large institutions covering the same field of a single

nation. It is probably one of the ideals which might be practical in a liberal world federation

but which is impracticable where national frontiers also mean boundaries to the normal

activities of banking institutions. The practical problem remains that of the appropriate policy

of national central banks. (92)

Here my aim has merely been to show that whatever our views about the desirable

behaviour of the total quantity of money, they can never legitimately be applied to the

situation of a single country which is part of an international economic system, and that any

attempt to do so is likely in the long run and for the world as a whole to be an additional

source of instability. This means of course that a really rational monetary policy could be

carried out only by an international monetary authority, or at any rate by the closest

cooperation of the national authorities and with the common aim of making the circulation of

each country behave as nearly as possible as if it were part of an intelligently regulated

international system. (93)

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