Regulation of finance and network industries

There are very interesting parallels between financial and network industries' regulation. Public interventions in network industries have historically addressed a number of concerns. Market power is perhaps the most prominent one, but there also concerns with externalities (positive and negative) and with asymmetric information. Equity concerns have also played a role, for example in universal service policies or secutirty of supply. Some of these policies have different time horizons: allocative efficiency concerns have typically a short run horizon but universal policy or security of supply have a longer run horizon. Some of the interventions operate ex ante (typically regulation), and others operate ex post (typically antitrust). Sometimes ex ante and ex post concerns are complementary and in other occasions theu are substitutes. These policies interact: for example, it is difficult to maintain universal service policy in the absence of new policy instruments when an industry is liberalized. In this sense, network industries are not very different from other industries, such as financial industries, where a number  of market failures and policy concerns interact, as the global financial crisis has made clear. A lender of last resort instrument (which has a clear distributive component) cannot exist without instruments of monetary policy, and the lender of last resort effectiveness depends on the effectiveness of policies of financial supervision (which have to do mainly with asymmetric information problems). And all these operates on an industry (banking) that is imperfectly competitive, and where the degree of competition, together with the degree of insurance guaranteed by the lender of last resort, affect the risks taken by agents (institutions and individuals). In the global financial crisis, market power concerns have clearly been trumped by the other concerns. Politicians are better at making decisions when the policy has far reaching redistributive implications so that compensation of losers is important; criteria of aggregate efficiency do not easily pin down the optimal policy; and if there are interactions across different policy domains so that policy packaging or evaluating controversial trade-offs is required to build consensus or achieve efficiency. The introduction of multi-dimensionality and distributive concerns in banking regulation and monetary policy after the global financial crisis has caused Central Bank independence becoming more vulnerable.
In the field of monetary policy and financial regulation, although banking supervision and monetary policy interact (as it is widely acknowledged after the global financial crisis), given the difficulty of measuring output on supervisory tasks, the systemic risk supervisor must necessarily be more accountable and less independent than central banks are on their monetary task. And since explicit incentives are not very useful, they must develop a strong culture and ethic, a sense of intrinsic preferences for doing their job well, because little credit is given if things go well, but a great deal of scrutiny and criticism are given if things go badly (specially for some interest groups). Although the literature argues that a single, large supervisory authority is better able to attract, develop and maintain professional staff expertise, this has not been found to be the case in other domains, where specialized agencies can offer a congenial environment to the experts in that field irrespective of size. Enlarging the focus of regulatory agencies has thus organizational and incentive costs. But as it was seen with the financial crisis (for example with the Northern Rock debacle in the UK), the central bank’s absence from supervision has also enormous costs.

Woodrow Wilson was wrong

The US President Woodrow Wilson, at the end of the first World War, to finish with the power of empires, proposed to implement the right of self-determination for all nations: a state for each nation. He became to our days a myth for several nationalist generations all over the world. With the benefit of hindsight, it is easy to see Wilson’s mistake in the origin of many later problems: the expansion of Germany prior to the second world war, Ukraine, Yugoslavia, the wars in Israel…

The great Italian writer Claudio Magris summarizes in his book Danubio, all the problems of implementing Woodrow’s receipt, at least in the European continent. It is impossible to cut the map of Europe in separated nations, because national groups are mixed in each and every one of the corners of Europe.

The economist William Easterly in his new book “The Tiranny of Experts” explains the contraditions between looking for freedom for peoples and pursuing freedom for individuals: for example, Wilson wanted peoples’ self-determination but defended racial segregation at home.

In the XXIst century nation-states are a bad unit of analysis and of action. We need more institutional diversity tan that. Terry O’Rourke remarked that “Wilson's legacy proved to be a hodge-podge of simplistic and emotion-laden concepts, which Hitler successfully used to manipulate and divide Western opinion.”

Margaret MacMillan says that “The Paris Peace Conference was only partly about making peace settlements and about making a better world; it was also the focus of the hopes and expectations of nations trying to reconstitute themselves, in the case of Poland, who wanted their independence from an empire, in the case of the Baltic states, or who were new nations such as Yugoslavia, Czechoslovakia, or Kurdistan. Paris was in the six months between January and June 1919 the centre of world power, perhaps even a sort of world government. The peacemakers rapidly discovered that they were dealing with an agenda which kept on growing.”

Independence is not what it used to be (a brief comment about McCrone's book)

The book by Gavin McCrone "Scottish Independence. Weighing Up the Economics" is a comprehensive account of the economic issues involved in the referendum about the independence of Scotland that will take place in September. There are chapters on welfare, on monetary policy, on financial regulation, on energy, on fiscal issues, and others. Two of the main ideas are i) that even in the case of "independence" the Scottish powers will be strongly constrained by the realities of economic links, and ii) that the intention of the Scottish nationalists to remain in a currency union with the UK after independence is contradictory with other objectives of secession. On the first issue, the constraints of an independent Scotland, it is quite clear that an "independent" nation-sate in the European Union in the XXI century is not the same as an independent nation-state say in 1922, when Ireland became independent (and as the author explains, started a long and painful road until becoming a rich nation), let alone when Scotland was independent until 1707. Many of the discontinuities between national borders in the past have today disappeared in Europe, and a national government is today constrained by flows of people, capital, and by the rules of the European Union. Relatedly, many policies that the Scottish nationalists claim that would be possible under independence are possible today and are not being implemented, or would be possible under enhanced devolution. On the second issue, the problems of a currency Union with the UK, McCrone stresses the difficulties of keeping a currency union and at the same time pretending to have fiscal sovereignty, something that was also pointed out by the Governor of the Bank of England, Mark Carney. This is an excellent and very balanced book by one of the persons that better knows the Scottish economy. He claims that an independent Scotland would be a perfectly "viable" state, and does not use any scaremongering arguments at all. But his conclusion is clear: the uncertainties and contradictions of the project for Scottish "independence" are such that the alternative of a better devolution scheme in the context of a rebalanced (federal?) United Kingdom is much stronger.

Two very promising books

I bought and started reading two very promising books, one on the economics of Scottish independence, and another one on the politics of banking crises. The first is the essay written by Gavin McCrone, "Scottish Independence. Weighing Up the Economics" according to many the most objective and neutral analysis of the economic aspects of the independence debate in Scotland. I couldn't resist the temptation of reading the conclusions: they are basically pro-federalist, that is, no to "independence," no to "devolution max," but yes to "devolution plus." More details when I finish reading the rest of the book (with chapters on fiscal issues, banking crises, energy and others). The other book I bought and started reading is the one on the history, economics and politics of banking regulation and banking crises, by Calomiris and Haber "Fragile by Design. The Political Origins of Banking Crises and Scarce Credit." The book is basically in the tradition of Douglas North and the New Institutional Economics, and it argues that banking institutions are the result of political forces and lobbying coalitions that manage to entrench arrangements that are not necessarily efficient or in the common good. A minority of countries (including Canada) have produced institutions that avoid banking crises, but most countries (including the United States) have not been able to do so. The book seems to tackle head on the tensions between democracy, populism and sound regulation. I am sure that I will not agree with everything, because at the end of the book they confess their admiration for two personalities: Alexander Hamilton (I have nothing against him) and Margaret Thatcher.

This is the debate we should have: what kind of federalism?

Peter Singer says in an article that "The European Union has brought 28 countries into a closer political and economic union. Paradoxically, it has also made it more feasible to contemplate the breakup of some of those countries. Independence for a small state outside of a political and economic group like the EU would be risky nowadays. Within the EU, however, the barriers between states – and thus the economic and political risks of independence – are lower." He explains much better than I did how the nationalist elites of these small old nations are free-riding on the idea of Europe: "if Scotland and Catalonia ever become independent countries, it will only be because the UK and Spain permit it. All states have an interest in stability, so it is hard to imagine that, in the absence of widespread, grave, and undeniable human rights violations, other states would recognize a region that, after being part of a state for many centuries, declared itself independent without the acquiescence of the country from which it secedes. The EU is also unlikely to accept Scotland or Catalonia as a member if the UK or Spain rejects their claims to independence. Indeed, European Commission President José Manuel Barroso has said that the EU may reject Scotland and Catalonia's applications, or at least delay them considerably, even if the UK and Spain do accept their independence. And, without EU membership, it is hard to imagine that a majority of people in Scotland or Catalonia would take the plunge into economic uncertainty that independence would bring. The role of a referendum in a region seeking to secede can therefore only be a form of persuasion aimed at the government of the existing state. A large turnout showing a clear majority for independence would be a way to say: See how strongly we feel about this issue. We are so dissatisfied with the status quo that most of us now favor secession. If you want us to stay, you need to address the grievances that have caused a majority of us to want to leave." I strongly agree with Singer's arguments. Given that secession cannot be justified in democratic countries where human and many other rights (including the right to self government) are widely respected, the debate we should be having is the debate that is typical in civilized societies like the USA or Canada: what kind of federalism should we have in Europe and its member states?

Andorra or Denmark? Secessionists free-riding on the idea of Europe

Secessionists in Catalonia and Scotland pay lip service to the European ideal: they want, so they claim, to be "independent" member-states in Europe. They want to be "like Denmark", small countries with a very high standard of living and high quality institutions. However, it is hard to see how they can build these institutions, which in the case of Denmark have their origins in an era where financial and trading transactions across borders were much lower than today. It is hard to see how they will build better institutions than those that they enjoy today, when they are in fact capturing their democratic institutions to promote the project of a part of their societies, instead of spending their time using the important bunch of the state they already control to improve the quality of life of all their citizens. It is hard to see how an independent Scotland will have better democratic institutions than British institutions. That is why even those in favour of the yes vote in the September referendum want to retain some key UK institutions, such as the Monarchy, the currency or the public television. By seceding from countries that have gone to great lengths to decentralize in the last decades, and that are integrated in the European Union and in a global economy, they run the risk of actually leaving the EU and becoming like Andorra (a small fiscal haven) rather than like Denmark. Europe is in the process of advancing towards a closer Union and creating new borders is clearly a step backwards in this process. Better institutions are build by efficiently using the current instruments of democratic government. Secessionists in Quebec also claimed for a long time (before the majority stopped listening) that Canada was a failed country. If Canada, one of the most civilized, democratic and decentralized countries in the world, is a failed country, what are all the others? In fact, when they are hard pressed, secessionists have no interest in the idea of a Union that leaves nation-states behind, and they reveal that their preferred option to solve Rodrik's trilemma is either to abandon democracy de facto (by retaining globalization and the nation-state) or to abandon globalization (they must know how).

What kind of Europe

Now that a new European Commission will be appointed, it may be the right time to ask what kind of Europe do we want to build from an institutional point of view. It is more and more clear to many people that a confederal Europe based on the sovereignty of the nation states is not feasible any more, although some (like the British or French sovereignist right) may not like it. To me, the kind of Europe that we need is one that solves Rodrik's trilemma by progressively reducing the importance of the nation state. National and jurisdictional fragmentation has been the biggest problem of Europe since the fall of the Roman Empire, a problem that culminated in the devastating wars of the XX century. The European Union is precisely an attempt to overcome such fragmentation and make war unthinkable in our continent. Thus we need a Europe that avoids market and infrastructure fragmentation, and that reaps the economies of a scale of an appropriately regulated large market. But it must also be a Europe that allows institutional diversity in a common framework. Markets have fuzzy borders, and jurisdictions should be fuzzier than the dominant nationalistic rhetoric allows. Some aspects of the idea of the Swiss economist Bruno Frey and his co-authors about Functional Overlapping and Competing Jurisdictions are worth paying attention to. Leagues of euro-cities, euro-regions, jurisdictions that transcend traditional borders to address specific problems and internalize externalities, are ideas that should be promoted by the new Commission to create a new European demos that helps build a democratic federalism.