Towards an optimal governing area

National Interest, The, Winter, 2004 by Kevin Hassett

THE WORLD is getting smaller. The Internet, cheap transportation, the spread of free and open markets, and surging education of the masses are steadily eroding the last vestiges of economic autarchy. This increased integration presents a fundamental practical challenge to the sovereignty of nations. Policies that are possible in an isolated island state can be impossible in our new and mostly democratic world of nomadic capitalists.

This metamorphosis has created heightened demand for international cooperation, a demand that has been the midwife to the birth of organizations that are rapidly becoming a haphazard world government. At the birth of the United States, Alexander Hamilton wondered whether men "are forever destined to depend for their political constitutions on accident and force." Today, it is not reason, but accident and force that are carving the contours of the global political environment.

The feckless and corrupt actions of the United Nations in recent years provide a case study in how harmful attempts at world government can be when they go wrong. It is necessary that citizens and leaders of the United States develop a theory of international cooperation that can provide a guide to future global associations. This theory must address several specific questions. What areas of human endeavor are likely to require international cooperation in order to enable efficient outcomes? What types of international organizations should the United States join? When should the United States be willing to partially cede its sovereignty to such bodies?

Two strands of economic research provide a natural starting point for this discussion. First, the public choice literature has examined extensively which services should be offered by local governments and which should be offered by national ones. The extension to world governments is straightforward. Second, specialists in industrial organization have developed a quite broad understanding of the functioning of cartels. Coalitions of countries often face the same challenges that coalitions of firms do. A synthesis of these two literatures provides a valuable guide to the problem of world government.

How Big Should a Country Be?

IN ONE OF the great intellectual accomplishments of the 20th century, economists Kenneth Arrow and Gerard Debreu set out the conditions under which a free market could be expected to produce optimal outcomes for individual consumers. Adam Smith's "invisible hand" of the marketplace was shown--under some conditions--to be a firm and steady force that allocates resources optimally. They demonstrated that no reallocation of resources exists that makes everyone better off than does the allocation that arises as a natural equilibrium of a competitive market.

In these Arrow-Debreu efficient markets, there is a very small role for government, which keeps the peace, enforces property rights and does little else. If all markets were Arrow-Debreu perfect markets, governments could be very small indeed. We might have a federal authority that enforced patents across states, established a minimal set of rules, and allowed state governments to provide most government services.

Perhaps the largest contribution of this work, however, was its illumination of the situations under which larger governments and international unions might be necessary. If we identify the assumptions under which markets are perfectly efficient, then we also have learned when they are not and when they can benefit from government action.

Markets can fail when citizens require goods that are public in nature, or when the production of the private goods they desire produces significant externalities. public good is a good that is consumed by all, without possible exclusion. A textbook example is public safety. There is no reason to believe that individuals, on their own, would voluntarily contribute enough money to a common pool to build an army capable of providing real security. Each individual would be tempted to free ride, that is, to assume that others would provide enough security. Collectively, free-riding can lead to suboptimal provision of public goods. An externality is a slightly different beast. If a steel factory produces pollution that harms agricultural output, then that pollution is an externality. The steel producer, on his own, might ignore the social harm from the pollution and produce far more than is socially optimal, and regulation of pollution by government may improve social welfare.

There are countless examples of public goods that we require and externalities that we must monitor. These provide a rationale for a larger and more aggregate government than would otherwise emerge in a free society.

The specific individual characteristics of our desired public goods have a significant impact on the optimal level of geographic aggregation. There is little question, to take an early example, that the desire to create a federal force large enough to fight the British provided a strong impetus for the unification of the states at the Founding. The public good of "safety" required coordination between the individual states at the broadest possible level. To take a more recent example, allowing the social safety net to vary across states might set off a destructive race to the bottom. States that offer relatively more generous welfare benefits might find themselves inundated with migrant paupers. If society views the provision of a safety net as important, policy coordination between the states may be necessary.