European federalism comes in degrees. The current architecture of the European Union resembles a confederacy with federalist features; a common currency, centrally administered trade policy, universal suffrage in a common parliament and a supreme court as arbiter of treaty disputes. As Jean-Claude Trichet, former president of the European Central Bank, argued at an OMFIF event in London, incremental moves towards federalism within the confederate union architecture entail large economic bounties. The European Parliamentary Research Service estimates the potential gains from increased integration at €2.8tn in additional gross domestic product per year.
There are three domains within the economics of European integration. Collective investment in European public goods is about shared spending on common priorities. Market integration efforts are about diminishing the barriers to trade that impede growth. Financial market infrastructure and architecture policy is about bolstering market efficiency and removing barriers to capital market financing. While the mechanics of integration differ in each, the conditions underlying judgements on the need for incremental federalist steps – the selective transfer of additional spending, regulatory and enforcement tools to the EU – are common.
Collective investment in EPGs
EPGs provide greater benefits for European citizens when supplied at the EU level as opposed to national, due to cross-border spillover effects or efficiency gains, and cannot be adequately provided without EU intervention. The case for such intervention depends on the existence of cross-border externalities, economies of scale associated with EU provision and the extent of homogeneity of preferences between member states.
Foregone investment in clear-cut EPGs entails foregone economic efficiency. However, tensions between the narrow economic interests of member states and broad economic interests of the union, particularly in cases of unevenly distributed costs and benefits, often result in the undersupply of EPGs.
In some cases, externalities are so large that even where direct benefits are unevenly distributed the union-level economic case is sufficiently strong to justify shared investment. Horizon Europe, a research funding programme that sees disbursements flow disproportionately to high-income countries with significant research and development programmes, is an example. However, in other cases, such as a unified European energy grid, concentrated costs and diffuse benefits endlessly retard progress. While increased integration at the union level could result in €40bn in annual cost savings and increased security and resilience of energy supply, the local political economy of the transition is constrained by cost-sharing disputes over infrastructure investment and caution at the national level from countries with low existing energy costs.
Under current EU governance structures, there is an obvious inefficiency here. Where unanimity at the European Council is required for provision, EPGs may be undersupplied where the costs of EPG provision exceed the national benefits for some member states.
Versions of this collective action problem paralyse European decision-making in a number of domains. In some, like transport, the distributional economic consequences are paramount. In others, like defence procurement, national preference heterogeneity dominates. While the legitimacy of the EU rests on its respecting the heterogeneous preferences of its members, the economics of collective investment are overwhelming in many domains.
A connected European energy grid would increase power-source reliability and lower costs for the average consumer, but not in every country. Although not all EPGs are equal, and the economics vary depending on the policy domain, the incrementalist federalist solution of increasing collective investment to finance more EPGs is undergirded by strong economic efficiency arguments.
Intra-union trade
Barriers to trade inhibit union-wide growth. Through reducing such barriers, the single market increased real per capita GDP by 12%-22% between 1993 and 2014. Completing the single market in goods and services, where intra-union trade barriers equate to tariff effects of 95% for services and 67% for goods, could further increase EU GDP by €507bn per year. However, progress is slow.
Policy hurdles to single market advancement are largely national in nature. The regulation of many kinds of professional qualifications, firm-level local licensing requirements for service provision, packaging, labelling and waste rules, and nationally administered subsidy and tax rules all hinder the advancement of the single market. Many such functions are rightfully national competencies best administered by local and state officials, with on-the-ground knowledge of local affairs. Others, like certain professional licensing requirements, the classic example being the three-year dual vocational ‘Ausbildung’ training programme for German bakers, inhibit labour mobility and market efficiency, and principally protect national interests at the expense of the union.
Although divergent member state practices are a principal barrier, the EU also bears responsibility for ailing single market integration. Weak enforcement of rules made under its existing competencies and lacklustre strategies and data collection hamper its role as standardiser. To its credit, the 28th Regime, allowing companies to operate across the EU under a single set of rules is a workable solution to a real problem. This programme is a striking example of incrementalist federalism in action, where EU policy will establish a union-wide legal track that bypasses national idiosyncrasies, while leaving the national regimes in place.
However, much transformational progress remains impeded by the constraints on EU power, and by fractious national interests that diverge at the crucial points where policy gives rise to diffuse benefits and concentrated costs. From the perspective of European economics, the optimal solution would involve the transfer of some further competencies to the union level. Similar to the conditions for the supply of EPGs, it is possible to distinguish between such competencies based on efficiencies gained by EU administration, the capacity for the correction of externalities at the union-level and the degree of homogeneity in national preferences.
Germans may reasonably prefer a vocational system that protects the quality of their comestibles. However, Europe has a comparative advantage in market regulation due to scale, and pan-union regulatory consistency entails inherent cross-externalities. While bread may need to be nationally regulated due to preference heterogeneity, where preferences are more homogeneous, such as in technical standards for construction products, the case for pan-European regulatory frameworks is even stronger. Incremental federalist steps can entail substantial economic gains in these policy domains.
Financial market infrastructure and architecture
The modern policy incarnation of the financial integration project is the Savings and Investments Union, which aims to create a homogenous European financial ecosystem, including a single market for capital, an integrated banking system and union-wide incentives for the investment of household savings. Parallel economic and monetary union projects such as the creation of a euro-denominated safe asset and the digital euro sit alongside the SIU as financial system architectural planks, inching the European economy towards cohesive financial markets.
Of the three economic domains for European integration, the conditions for policy intervention to engender positive effects at the union level are clearest in the context of financial markets. The economies of scale in financial regulation and the creation of a useable products and infrastructure ecosystem are obvious. The cross-border externalities are an inherent feature of the system; many of the relevant policy objectives can only be achieved at the union level. Preference divergence at the national level is the key constraint.
The reluctance of Germany to allow the takeover of Commerzbank by UniCredit is the archetypal example of national interest given precedence over diffuse union-wide benefits. Although Europe needs globally competitive financial institutions, and the economics of banking consolidation imply union-wide benefits in this case, national interests have thus far triumphed over European interests.
High-profile public battles like this are, however, the exception rather than the rule when it comes to barriers to financial market integration. The real issues are nuts-and-bolts national policy divergence on matters such as insolvency, bankruptcy and restructuring law, corporate and capital gains taxation, pension regulation and securities settlement rules. Union-wide integration on such topics inevitably entails trade-offs and unevenly distributed costs and benefits among member states that restrain action despite potentially enormous benefits.
While EU regulation and the consolidation of powers within the hands of the union is not a panacea here, the collective action problem is such that some form of centralisation of rulemaking is the only workable solution to many of these issues. An incrementalist federalist agenda, increasing European powers, has the potential to reap large benefits for the union.
Sovereignty lost today or tomorrow
To the extent that incremental European federalism entails encroachments on sovereignty, the minor losses of national sovereignty today pale in comparison to the losses of union-wide sovereignty that follow from Europe’s waning relevance in global economic affairs, should it continue to eschew integration. The geoeconomics of global power conflict are such that Europe’s inability or unwillingness to tackle the foundational problems in its markets is increasingly becoming a threat to its security and policy autonomy.
Decades-old collective action problems demand fresh solutions, and a more federalised EU appears to hold the key. Increased collective investment in EPGs, the diminishment of intra-union trade barriers and more integrated financial markets entail enormous economic welfare benefits for the union that will protect European sovereignty.
At a time when geopolitical fragmentation is dividing Europe, and foreign powers increasingly encroach on its sovereignty, the arguments in favour of collective action in a more federalised EU have never been stronger. Trichet described the present global geopolitical environment as a ‘Monnet moment’ for the continent. Where efficiency gains from EU action are large, cross-border externalities are clear and preference heterogeneity is minimal, the economic case to seize this moment and advance incrementalist federalism is clear.
Conor Perry is an Economist at OMFIF.
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