In a post-Brexit world, a look at the economics of secessions5 min read . Updated: 23 Jul 2016, 11:37 PM IST
Many governments are besotted to their political maps and reluctant to see the benefits from autonomy and economic integration
The UK has chosen to exit the European Union (EU). Not long ago, Scotland voted to remain with the UK. On the surface, it seems that these events are driven entirely by politics. However, economic considerations also play a role in the dynamics of political maps.
For a long time, economists considered the formation of borders as given, and not something that is driven by a host of factors including openness to trade, population size, the tax base and the ability to provide public goods (especially defence).
Charles Kindleberger, an ardent champion of European integration, wrote in his book Power and Money that, “the economist is interested only in specialized aspects of sovereignty. He is interested in jurisdiction, only insofar as different laws, regulations, or policies may affect economic factors in one country or another".
In the past two decades, economists have begun to assemble evidence on why maps are redrawn and new borders are created.
One of the clearest economic explanations for the break-up of nations can be found in a book titled The Size of Nations, by Alberto Alesina of Harvard University and Enrico Spolaore of Tufts University. Using events from a variety of contexts, Alesina and Spolaore calculate the costs and benefits associated with secession.
They build the case that globalization has been largely successful in eroding the main advantage that larger nations had—large markets. With steadily diminishing trade barriers, smaller countries have enjoyed greater economic growth.
Simultaneously, international economic integration has also meant that domestic markets become relatively less relevant. This also means that regions which seek greater autonomy—Catalonia in Spain, Quebec in Canada or Scotland in the UK—from their parent countries have greater incentive in this arrangement to secede.
How does exit work? One of the earliest explanations for the formation of new states can be found in a 1956 paper by Charles Tiebout. He argued that the solution to the problem of providing services to citizens and raising taxes lies in according greater autonomy to local governments. Local governments know the preferences of their citizens better than central authorities.
In the Tiebout universe, smaller states are more efficient. On similar lines, William Oates, in a 1972 paper, argues that smaller states are optimal when there are too many heterogeneous sub-groups.
Small states are bedevilled with their own share of problems. One, there are costs involved in setting up bureaucratic, legal and financial systems. Two, the burden of providing public goods falls on a smaller set of taxpaying citizens. Alesina and Romain Wacziarg of the University of California, Los Angeles, in a 1998 study showed that country size is negatively correlated to the size of government, which simply means that smaller countries spend greater share on providing public goods to their citizens.
In economic jargon, this is known as scale effect. Larger countries are more efficient in providing public goods as it is relatively easier for them to spread the tax burden across different regions.
As discussed before, free trade does water down the negative effects associated with size, and allows smaller nations to thrive and reap the fruits of globalization. The question that begs to be asked is the following: is there an optimal size for a nation state?
Alesina and Spolaore argue that the optimal or equilibrium size of a country is determined by the trade-off between the gains from size and the costs incurred due to ethnic (or caste-based) diversity. In a democratic setting, there will be a greater number of countries, as regions have the choice to secede through voting. In another world, which Alesina and Spolaore call “Leviathan’s equilibrium", the larger, more aggressive countries will subsume the smaller ones. The Russian occupation of Crimea in 2014 can be considered as an example of Leviathan equilibrium.
What can be done to avoid a costly internal exit or secession? Decentralization can be one possible answer to this question. Inter-regional transfer of resources may deter secession. However, the success of federalism, as shown by William Riker in his book Federalism: Origins, Operation, Significance, is contingent upon two factors—the strength of the national government and how autonomous local representatives are in decision-making. These are, in turn, dependent on the quality of political institutions.
This brings us to a related theme: whether India should have more states or there should be greater decentralization without any further changes in state boundaries.
In a response to the States Reorganisation Act of 1956 that led to the formation of linguistic states, B.R. Ambedkar wrote a note on probable new states, highlighting the importance of size in determining the number of states. Ambedkar pointed towards the populous north Indian states of Bihar, Madhya Pradesh and Uttar Pradesh and warned that large inter-state differences in population size may destabilize the country, and suggested that smaller states are more efficient.
There is some evidence that the creation of three new states in 2000 led to greater economic activity and a rise in school enrolment in the new states.
To sum up, determining the number and size of countries is an arduous task. Many governments across the world are besotted to their political maps and reluctant to see the benefits from autonomy and economic integration. Alesina and Spolaore call this the greatest risk.
They write: “National borders should not be viewed as permanent and eternal entities, but as human-made institutions, which can be changed in function of changing political and economic needs. And the forces of the past decades—democracy, international cooperation, economic integration—have paradoxically increased the incentives for autonomy and localism. This means that we should expect increasing demands for autonomy and independence from groups that do not feel represented by traditional central governments. The reaction should not be a stubborn defence of the status quo at all costs, but a pragmatic and creative use of democratic institutions."
This resonates with what Kindleberger wrote about two decades ago in his book Centralization Versus Pluralism. Kindleberger argued that greater integration within the EU requires “a heroic effort of political imagination". Using his analysis, economist Perry Mehrling of Bard College argued that in the post-Brexit world, while there is indeed a shift towards centralization within the UK, there might be greater push towards further economic integration within the EU.
As Kindleberger noted: “From a simple-minded (economic) viewpoint, the world is the optimum economic area, with its constituent countries committed to free trade, a single international currency, and harmonised standards, whereas the optimum social area is much smaller, and based on the criterion that a social unit should be small enough for an individual to know that he or she counted."
The balance between the two—centralization versus pluralism—continues to be a complex issue.
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