Federating Up Versus Devolving Down

Reformers tend to assume that progress requires higher levels of government that embrace more people and more nations. This assumption should be challenged. Some reforms may be achieved more quickly by moving in the opposite direction, by devolving down from the national level to newly created subnational jurisdictions.

Even as the EU commits to more federation, as it seems poised to do with the proposed banking union, we need to ask if devolving down to new reform zones might be an important complement to familiar national and multi-national strategies. These familiar strategies have allowed the twin problems of corruption and labor market distortions to fester in member states that are dangerously vulnerable.

If we look at examples from industry, it seems obvious that federating-up is both unlikely to spur reform and not the only option. In the United States, it would surely have been a mistake to try to reduce costs in the retailing sector by merging Montgomery Ward and Sears. The approach that worked was to let these established retailers face competition from such new entrants as Wal-Mart and Target.

The same approach has been used successfully to change important national policies. Just as Target began as an internal startup within an existing retailer, Shenzhen was an internal startup in China, one of four special zones that first allowed foreign firms to bring in foreign technology and hire Chinese workers. The export processing zone (EPZ) in Mauritius was a startup jurisdiction with new rules that supported free trade. It showed that a reform zone could be conceptual rather than geographic; firms could decide to join the zone merely by declaring that they wanted to follow its new rules. Just as Target eventually took over its parent, the reforms in Shenzhen eventually spread throughout China, and the reforms in the Mauritian EPZ spread to the rest of the economy.

In some reform efforts, federating-up is a natural and successful strategy. In monetary policy, the formation of the Euro area let countries with high and unstable inflation move quickly to low and stable inflation. It is obvious now that this was achieved at the cost of forcing a one-size-fits-all monetary policy on the heterogeneous Euro area, but the formation of the Euro zone nevertheless shows that it is possible to extend systems of governance from leading countries to those that lag behind. In bank regulation, federating-up may be the right strategy, especially if it involves the same clear and complete delegation of authority by member states.

The WTO is a natural multi-national solution to the problem of encouraging international trade. Like the WTO, the precursor to the European Union was designed to support freer trade. Over time, however, the mission of the European project expanded to include broader political and economic reforms. The conjecture was that in some states, the national reform process would take too long — perhaps forever. The fear was that a lack of progress for some could threaten all.

The hope was that federation would, among other things, reduce corruption and labor market distortions. The result, however, has been that federation allowed corruption and labor market distortions to persist or even worsen in countries that were already members of the union. If these trends are frightening in the small economy of Greece, they should be terrifying in the much larger economy of Italy.

If federating-up is not the path to reform in industry — and if new conceptual or geographic jurisdictions can sometimes change national policy — then any time a reform strategy based on federating-up is proposed, we should ask how the same reforms might be accomplished by devolving-down and letting a new system of rules enter and compete.

Might a new city modeled on Shenzhen allow new norms and laws about corruption to flourish at a site in southern Europe? Might a conceptual reform zone modeled on the Mauritian EPZ create a new labor market regime that firms and workers could jointly opt into?

The stakes are high. Persistence along familiar reform paths may not succeed. Instead of determination, what progress may require now is imagination.

This post originally appeared on the NYU Stern Urbanization Project’s blog. To read the original post, click here.