Need for Non-Market Institutions for Inter Country Transfers: Referendum Lesson

The European Union receives a bad press, especially in the UK, for its alleged inability to deal with crises. The British press is world class in its ability to misinform, but the way in which the Commission has handled the Greek debt crisis has not helped the cause of European unity. The EU negotiators representing creditors have alienated both the right and the left in politics. Now it appears that they have fallen out with their partners, the International Monetary Fund, on negotiating strategy. EU representatives have been handicapped by the terms of the Maastricht Treaty, thus making a molehill of a problem into a treacherous mountain to climb.  This particular problem has its origin prior to the euro. Those that drafted the Maastricht Treaty did not heed advice for the need for non-market mechanisms of inter-regional transfers which would be triggered automatically to deal with regional inequalities and shocks.

The EU has demonstrably failed to manage shocks impacting on an economy that counts for only 1.15 per cent of the EU GDP. Greece is a small economy. Put it another way, the potential loss of EU output following the economic turmoil of the Brexit vote could dwarf the magnitude of the entire current level of Greek GDP. If political stalemate continues in London, investment decisions are kept on hold and British entities enmeshed in EU-wide supply chains start winding down, the cumulative loss of potential UK output could reach levels comparable to the GDP of Greece. Failure to resolve the problem of Greek debt does not bode well for the present structure of decision making both within and outside the euro zone of the Union.

If they are not automatically triggered, even the smallest of transfers across national frontiers within a closely integrated economic community can lead to the political narrative of  ‘they are taking what is ours’.  As I shall discuss presently, this contributes to time consuming and output retarding disputes.

This type of political problem was anticipated in the Brussels-commissioned MacDougal report submitted in 1977. A former colleague of mine at Bangor University, R Ross MacKay, warned in his paper “Automatic stabilisers, European union and national unity” published in 1994 in the Cambridge Journal of Economics of the perils of if ignoring the need for non-market mechanisms for regional transfers to deal with shocks in the Maastricht Treaty.

These warnings remained unheeded presumably because of religious faith in the powers of unregulated markets to mitigate smoothly through capital and labour mobility problems of uneven development between regions in an integrated trading area.

The MacDougal Report anticipated a Community budget of 2.5% of the Community output in the short run, reaching a target of 5-7% of Community GDP in due course (Mackay 1994:578). There was no political will take up the challenge (Mackay (1994:572):

“Sixteen years later (and after the key date for the Single European Market — 1 January 1993) the Community Budget remains below 1% of Community GDP, provides no automatic response to regional decline, has no strong re-distributional role between richer and poorer parts of Europe, and is still dominated by agriculture. … The Maastricht Treaty provides no mention of fiscal co-ordination, the institutions which such co-ordination would require remain unformed. … Progress towards European integration may be checked by the absence of automatic stabilisers.”

To place the problem of Greece for the EU in context, the EU budget still hovers around 1% of the combined GDP of the 28 members; whereas government expenditure consumes almost half of the GDP in many of the member nations. Fiscal transfers of the type recommended by MacDougal in 1977 are not possible.

Substantial amount of debt write-off, the need for which is finally being acknowledged by the International Monetary Fund, could have occurred without impacting on growth and without souring the idea of the Union with the drumbeat of nationalism if recommendations of the MacDougal report had been heeded.  Instead, the narrative that developed in northern Europe, the narrative of German taxpayers subsidising Greek consumers, was not helpful. It was misleading. Taxpayers in many countries have been called upon to recapitalise banks holding Greek debt within and outside the euro area. The German exchequer has gained by having to pay lower interest on borrowing because the perception of problems in Greece has increased the attractiveness of German debt to international lenders. These calculations of gains and losses to individual countries are problematic especially when everybody loses by delaying solutions in pursuit of populist and nationalist agenda.

Availability of an institutional mechanism of automatic transfers in the background of credible and enforceable rules for fiscal integration reduces the chances of economic policy being held hostage to growth-retarding jingoism. For example, there are non-market institutional mechanisms to ameliorate without fanfare the impact of localised disruptions within regions of the UK. These transfers can be discussed calmly without becoming the fodder of tabloid newsprint.

The House of Commons Select Committee on the Treasury took evidence in 2005 without making newspaper headlines about some of the ways of examining regional divergence in productivity, public expenditure and tax transfer:

Calculation of which region gains more (less) through public expenditure is problematic due to the fact that public output, for example roads and workforce trained in publicly funded institutions, in one part of an economically integrated geographical entity is also used by those living elsewhere. Likewise, income taxes attributed to a region depends on whether commuters from outside are counted. Corporate taxes recorded for an area have to be apportioned at least by corporate output to be attributed to the region. There are conceptual difficulties in computation. Thus a precise figure is not possible to calculate but a range of plausible numbers can be computed. If these calculations become subject to political quarrel, transactions cost of political agreement can destroy the economic synergy of geographical integration.

According to written evidence submitted by the Greater London Assembly, “in 2001-02 London’s net contribution to the UK public purse was between £9 and £15 billion. This is equivalent to between 14 and 23% of all tax revenues generated in London.”

Government needs to heed Schumpeter’s dictum that “the will of the majority is the will of the majority” and this is not necessarily the “will of the people”. Otherwise rules for automatic transfers within the UK could come into sharp political focus, as the light falls on geographical cleavages of the referendum result, without prospect for resolution. This would be to further detriment to the economy.  In the ensuing negotiations with European partners, government has the unenvious task of articulating an encompassing interest from a referendum vote fractured by regions and demography.

About the author: Prof Shanti Chakravarty is an Emeritus Professor of Economics at Bangor University.