Economist Writing Every Day

One of my favorite economic journal articles is by Barry Weingast and has the short title “Market Preserving Federalism” (MPF). In this paper, Weingast lays out the conditions necessary for two tenuous equilibria: A) Federalism  & B) Federalism that preserves a market economy.  Given that we just celebrated Independence Day in the USA, it seems to me like a good opportunity to share some brief thoughts on this paper. I’ll speak in terms of the US for ease.

Weingast enumerates 5 features for MPF, starting with two that characterize a stable federalism:

F1) A hierarchy of governments, that is, at least “two levels of governments rule the same land and people,” each with a delineated scope of authority so that each level of government is autonomous in its own, well-defined sphere of political authority

F2) The autonomy of each government is institutionalized in a manner that makes federalism’s restrictions self-enforcing

The first feature is just the definition of federalism. So, NBD. The second feature identifies what makes it stable. It’s a lot bit hand-wavy, but the idea is to have a means for political and institutional competition such that states want to reign in the excesses of the national government and the national government wants to reign in the excesses of the states. In other words, federalism is a tenuous, dynamic equilibrium in which two sets of players keep each other in-check by a not-always-peaceful balance of power. Weingast is short on details here because there are a lot of ways that F2 can manifest.

In the 19^th century US, state legislatures appointed US senators such that the interests of states could be more cohesively represented in the national government (they are now elected popularly). This gave states much more power to coordinate state and national policy.

For example, slavery was practiced by southern states and those states worked hard to prevent the national government from enacting an excess of interfering policies. Similarly, northern states wanted more national infrastructure investment and they couldn’t get it until the western states developed and wanted improved access to national and international markets. The contentions between the states is what prevented the national government from acting. On the other side, the national government retains the authority of the supreme and district courts, the US military, and whatever legislation they can pass. There is a constant, usually peaceful fight between everyone.

The remaining features are what preserve a market economy within the federal system.

F3) Subnational governments have primary regulatory responsibility over the economy

F4) A common market is ensured, preventing the lower governments from using their regulatory authority to erect trade barriers against the goods and services from other political units

F5) The lower governments face a hard budget constraint, that is, they have neither the ability to print money nor access to unlimited credit

These last features are where the golden nuggets are. All of them are necessary and work together. No one or two of them will preserve a market economy. They are best understood in relation to one another.

States must have local authority over their economic policies (F3). This is the means by which they differentiate themselves, compete with one another, and respond to local changes. However, the ability to regulate doesn’t provide adequate incentive to regulate *well*. A common market (F4) ensure that states aren’t simply local authoritarians. Individuals and firms have the power to respond by moving to another state. Of course, such changes occur on the margins. If a state adopts a policy that rubs enough people the wrong way, then they get feedback in the form of fewer residents, workers, less economic activity, etc. Implicitly, we know that economic activity is higher in market economies.

If people move from a state, then SO WHAT? Is it just “good riddance” and “like it or leave it”? That brings us to F5. If economic activity falls in a state, then there is less tax and fee revenue for the state.  Less revenue means less command over resources and less actionable authority to do things like provide public goods and amenities. F5 is the reason that state governments care whether people stay or go. F5 gives states the incentive to regulate in a way that is both pleasing to residents and enriching to the state treasury.

Just as there is a constant back-and-forth between the states and the national government, there is also a constant back-and-forth between the states and residents. States enact economic policies, residents arrive/depart, states get objective feedback by looking at their budgets and costs, and then react with policy adjustments. It’s a never-ending sequential game.

If such a process seems implausible to you, then keep in mind that regulations affect people’s costs and benefits on the margin. For example, states that have no income tax don’t instantly vacuum away the residents from other states. There are plenty of good things about Colorado and Virginia even though they have income taxes.

But, even people with strong home-state allegiances are affected in the long-run. How big does the income gap between Kentucky and Tennessee have to be before people start crossing the border? In the very long run, even if you want to stay close to childhood family, will your children? Eventually, your children move elsewhere and you and your generation find your natural end.**

Something that I like about Weingast’s paper is that it gives us a framework for discussing things that are hard to discuss. Is the USA on the road to serfdom? Is it going to hell in a hand basket? How are we doing systemically? There has always been conflict among everyone. It’s built into our federal system. It’s constant, and our system can’t function well without it.

Do we retain a common market (F4)? Mostly yes. We lack one to the degree that labor regulations require state-specific barriers to entry. Do states have a hard budget constraint (F5)? Mostly, yes. I do worry about whether there is an implicit bail-out for California and Illinois and similar states. Also, the national government provides a bunch of grants to states and localities. That makes sense for national infrastructure. But such grants also insulate states from bearing the cost of their policies. Do states have sole authority of economic regulation (F3)? Yes and no. Obviously, there are national labor regulations and the like. But states still retain the authority to regulate further and those further margins are the margins of competition among states. The danger is that the national government observes no regulatory boundaries. But even then, F3 remains intact so long as states have *some* regulatory authority. Obviously it’s a matter of degree.

Personally, I worry the most about F2. We might have the market-preserving features satisfied. But those can’t operate without a competition for power between the national and state governments. I worry that states lack the tools to push back. This is not so much a worry about remaining a market economy. It’s a deeper worry that our national government has become less and less restrained and constrained over time, increasing the stakes of political competition. Sometimes, high stakes result in violence.

Thoughts?

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**Well that got dark.