1

Vladimir Gligorov

Why Do Unions Fall Apart? (Draft 1.5)

(W)hile the politician and the economist when
he is advising on concrete measures must take
the state of opinion for granted in deciding what
changes can be contemplated here and now, these
limitations are not necessary when we are asking
what is the best for the human race in general.
Hayek, Monetary Nationalism and International
Stability

Introduction
Why is it important for a monetary union to be anchored in a fiscal union? And how
important is that? Has the experience of failed monetary unions something to tell us about the
challenges faced by the European Monetary Union (EMU)? One way to address these
questions is to look at the limits of integrations from an economic point of view. These two
questions why unions disintegrate and why states do not integrate into unions? - are
basically the same. However, unions need to exist in order to disintegrate, which suggests that
states, or nation states, may not be much more stable than more confederate political systems.
These two types of instabilities, of unions and states, characterise the key economic and
political challenges that Europe in particular faces.
In this essay, I look at some stylized facts of economic, mainly fiscal and monetary,
disintegrations, which are based on a limited number of cases of some relatively recent
disintegrations in Europe, and some existing theories mainly developed in the last two or so
decades, and offer an alternative explanation, which might be useful for the understanding of
the dilemmas faced by the European Union (EU).
In addition, I want to rely on Hayeks criticism of nationalism (Hayek 1937, 1948,
1976, 1990), much of which was informed by the pre-World War II disintegration of Europe,
in understanding the challenges that its resurgence in Europe presents.
1
In that I look into his
idea of a political and economic union and compare it with the constitution of the European

1
The criticism is more generally Austrian, but I rely only on Hayek in this paper, and in fact only on the few
books and articles that I explicitly reference; and in that, only on a rather restricted set of issues dealing mostly
with his disagreement with Friedman's monetary and exchange rate policies. Still, the underlying arguments
against nationalism are more general and could easily be applied to a much wider set of constitutional and policy
issues. See Judt (2010) on how historical experience of the nationalist, authoritarian, and disintegrating Europe
influenced Hayeks thinking.
2

Union; for that I also refer to the work of Buchanan (1990, 1995) and Mundell (1971).
Finally, I discuss his disagreements with Friedmans monetary and exchange rate policies
which I find useful to understanding the problems that the European Monetary Union has
been facing from its inception, but have become acute in the current crisis.
The main point I make is about the difficulty to maintain a political and economic
union without fiscal integration. By contrast, a system of nation states tends to be unstable
without some inter-state integration, or union, mainly for financial and monetary reasons.
That may account for cycles of integration and disintegration that are characteristic for Europe
in any case. Throughout I rely on as simple, i.e. general, ideas and models as possible in order
to isolate what I consider is the main thread of arguments that have been developed in this
area of research. My aim is not so much to describe, but to explain the processes of
disintegration and integration.
Though I look at economic issues primarily, the underlying problems are obviously
political. I do not consider directly distributional conflicts over territories and other security
risks, but those are of course implied in the conflicts over the fiscal authority, which is
fundamental for most economic theories of disintegration. I discuss those in detail in Gligorov
1994 and comment on them shortly close to the end of this paper.

Some Stylized Facts
Political and economic unions have often disintegrated through wars or other types of
severe conflicts or after a prolonged crisis. This was the case with the Austro-Hungarian
Empire (for economic assessments see e.g. Dornbusch 1992, Garber and Spencer 1994), the
Soviet Union (for the dissolution of the rouble zone see e.g. Dabrowski 1995, Conway 1995,
Boughton 2012), and Yugoslavia (Gligorov 1994; for a recent economic explanation see
Desmet, Le Breton, Ortuno-Ortin and Weber, 2011, though there are some factual
inaccuracies in this paper, but it is a rare attempt to apply what is now a standard theory of
instability of diverse or heterogeneous states or unions to the Yugoslav case), to take these
three examples. In addition, disintegrations of empires are also quite violent, which has
contributed to the theory that states are born and die in wars.
2

However, if the definition of an economic or political union is widened to various
types and levels of integrations, peaceful disintegrations can be also added to the list. Thus,

2
On the role of war in state-making see Tilly 1985, 1992. The debate on whether states come about through
coercion or grow out of society or are based on social compact is as old as political philosophy or science (see
e.g. Mills survey of competing theories in Considerations on Representative Government). These theories
basically answer different questions and are not competing explanations for the most part.
3

the collapse of the gold standard, of the Bretton Woods international monetary system, of
currency boards, or fixed exchange rate regimes of various types, as well as fiscal devolutions
and territorial separations and secessions could be looked at in order to come up with stylized
characteristics of economic and political disintegrations. In recent times, there have been a
number of peaceful disintegrations or devolutions, in Europe in any case; e.g. earlier Norway
and Sweden, more recently Czech and Slovak Republics, much of Soviet Union, then
Belgiums continuous decentralization, Spains and Britains devolutions, and the secession
of Montenegro, to name some. Of course, the literature, theoretical and empirical, on all these
episodes is enormous.
Generally, it can be argued that violent disintegrations suggest that political, basically
territorial, reasons lead to economic disintegrations, while peaceful ones suggest the opposite,
that economic reasons drive political disintegrations.
3

As a rule, disintegrations of complex political and economic unions are characterised
by both. Even more generally, following Rodrik 2012, it can be argued that global community
and economy disintegrate to nation states, or fail to integrate, due to the impossibility to
coordinate political and economic institutions in a cosmopolis, so disintegration is a type of a
second-best solution, which is all that is politically feasible anyway, at least according to
Rodrik. Indeed, the emergence of nation states in Europe can be seen as such a process of
disintegration or of political preference for nationalism over the cosmopolitanism of the
Enlightenment.
Some stylized facts summarize the majority of disintegrations, at least in their
economic dimensions.
One almost invariable characteristic is that the lack of a fiscal union, or more
precisely of taxing powers by the union, is associated with the disintegration of a monetary
union though not necessarily of other types of monetary integrations. In some cases, fiscal
devolution preceded the monetary one, while in other cases monetary union or integration did
not lead to fiscal discipline or unification (Gligorov 1994 and 2012).
The other is that in the run up to monetary disintegration there is often a surge in
inflation and not infrequently an episode of hyperinflation (Dornbusch 1992). This tends to
be difficult to disentangle from post-war or post-crisis attempts to rely on inflation to wipe out
the accumulated public debts. But, more generally, currency crisis have often been preceded
by a speed up in inflation.

3
I am not going to deal with political and in particular with security issues, though they are central to the
issue of political integrations and disintegrations. My primary interest is in the political economy of
disintegrations. I deal with the wider issue in Gligorov 1994.
4

Finally, unions especially prone to disintegration have been those with asymmetric
political or economic constitutions. Even with symmetric institutions, as e.g. in a federal
system, real asymmetries in political or economic influences, the inequality in political and
economic say (e.g. permanent minorities or lack of economic convergence), are often
associated with disintegrations. Sometimes these institutional asymmetries are captured by
some measure of economic, social or cultural heterogeneity (e.g. as in Alesina and Spolaore
1997, which is referred to approvingly by Rodrik 2012),
4
but that kind of diversity is usually
not among the causes of actual disintegrations though it can be the way to justify them either
ex ante or more often ex post.
One element invariably present in disintegrations is a distributional conflict, not
necessarily violent. Though it can be argued that disintegrations are efficient, i.e. Pareto-
improving (better for all; Buchanan 1971, Rodrik 2012), historically they have been an
outcome of a distributional conflict with almost invariably Pareto-inferior (worse for
everybody) or Pareto-incomparable (some do better and some worse) outcomes, at least in the
short to medium run.
That is why disintegrations proceed from fiscal devolution or resistance to fiscal
centralisation, to monetary disintegration, and in the end to a renationalization of financial and
other markets.

Some Informal Theory
Analytically speaking, there is a state where there is the right to collect taxes (in the
context of this paper Schumpeter 1918 is an important reference; in the context of integration
and disintegration of states Friedman 1977 is an early and influential representative of the
fiscal theory of states). That right is of course based on might, as taxes are not voluntary
contributions but are extracted by coercion. Indeed, state is a coercive institution,
5
and
collecting taxes is the prototype of coercion. In any case, once a tax collecting authority
exists, it can issue money, which is a liability of the state, and back it by taxes. In a closed
economy, money is just another instrument of fiscal policy; it is a way to finance the public
debt and thus defer the collection of taxes or distribute their burden within and between
generations (for an influential statement see Barro 1979).

4
The pervasive assumption in practically all theories of integration and disintegration is that the larger the
population or territory or both, the higher the diversity (also in Hayek 1990). Hardly ever there is a suggestion on
how to represent, e.g. measure, the diversity.
5
Even if it is based on a social contract or is constitutional; it still consists in the right and might to coerce
or use force to compel or tax.
5

Thus, in a closed economy, monetary union is just another facet of the fiscal union.
Money may be used as an instrument to finance the state budget as long as the fiscal union
holds, i.e. as long as there is the right and the ability to collect taxes (including the inflation
tax, i.e. seignorage).
In an open economy, money is also an instrument of foreign trade and finance (and has
been seen as primarily such since early monetary theory, e.g. Hume 1741-1742). As a
consequence, it is partly international, i.e. divorced from the respective fiscal unions. In that
sense, the fiscal authority cannot use its own money unconditionally; there is a monetary
constraint due to the inevitable split between the fiscal and monetary unions and authorities.
Traditionally, one distinguishes between the outside or fiat money and the inside money, e.g.
foreign reserves (or reserves of commodity money). The former, but not the latter, is anchored
in fiscal authority.
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This can be generalized, as it usually is. Even in a closed economy, there is inside
money, in fact quite a number of various money-like instruments that compete with the
outside or fiat money; at high levels of rates of inflation, or lack of credibility due to the
history of high inflation, inside money may drive out the fiat one (Hayek makes that point
repeatedly). In addition, even a closed economy is open to future generations. Because of that,
there is a limit to states power over future generations and thus inter-temporally, there is only
so much of a fiscal union. So, monetary and fiscal powers overlap only partially due to the
geographical, economic and temporal limitations of the fiscal monopoly.
Thus, fiscal union is neither a necessary nor a sufficient condition for the existence of
the monetary union. Even if all currencies are national, money is still international; and even
if there is a fiscal union, there may not be a monetary union.
These asymmetries between fiscal and monetary unions have consequences for the
financial system, especially for the banking system. On the one hand, stability of the banks
depends on the support by the central bank, but also on the implicit or explicit guaranties by
the fiscal authority (Diamond and Dybvig 1983). On the other hand, cross-border financial
activities are conducted as if in a system of free banking with scant or uncertain central
banking and fiscal support (with some constraints imposed and support provided by the Bank

6
There are different ways to distinguish between inside and outside money. Gurley and Shaw (1960) treat
gold and commodity money together with fiat money as coming from the outside of the private sector balance
sheet and bank money as arising from inside. Lagos (2008) defines outside money as central bank liabilities that
are not backed by assets or at least not by assets that are not in zero net supply by the private sector, i.e. as fiat
money. It is hard to see that gold or other commodity money can be treated in the same way in the central banks
balance sheet. In general, this distinction between inside and outside money is difficult to apply to an open
economy.
6

of International Settlements and the International Monetary Fund, but with no international
fiscal backing). This dualism is present in political and economic unions that have common
monetary, but not fiscal system too.
Thus, there is an endogenous banking instability which may support the disintegration
of the common central bank if there is no fiscal union or the distributional problems are such
that the fiscal union is not sustainable.
In monetary theory, there are two approaches as identified e.g. by Goodhart (1998)
that neatly illustrate this dual character of money. As a medium of exchange, domestic or
international, money is a device that minimizes transaction costs (Menger 1892), while as a
source of liquidity money depends on the state monopoly power, i.e. on the power to coerce,
as in the power to tax (Hayek 1937, 1990). These two monetary facets in fact coexist because
the power or at least the right to coerce does not extend across state borders while money is
useful in settling cross-border trade and other transactions. Similarly, the central bank has
liabilities beyond its own monetary jurisdiction as its money may be used by the international
banking system.
Thus, fiat money is preferred if it is more liquid and bears lower transaction costs and
is inferior to the competing money otherwise (through currency substitution, bank liabilities,
or commodities, e.g gold).
This dualism also impinges on the policy mixes available to the authorities. Even in
the case of a closed economy, it may not be possible to sustain price stability without making
monetary policy independent in some sense. In an open economy, it may prove impossible for
these two policies not to get into each others way. In general, in targeting the internal
balance, i.e. level of employment, fiscal policy tends to dominate (whether it is active or
passive in the sense of Leeper, 1991; see also McCullam and Nelson, 2006) while in securing
the external balance, the sustainability of the balance of payments, monetary policy tends to
dominate.
7
But, the two may prove not to complement each other, due to changing public
preferences over the different macroeconomic goals, thus inciting various types of instability
(for a recent survey of monetary and fiscal policy interactions see Canzoneri, Cumby, and
Diba 2011).
Thus, in general, there is no definite reconciliation between fiscal and monetary
policies, except in a closed economy setting with constant population which lives forever or

7
Mundell believes that the policy assignment depends on whether the exchange rate regime is fixed or
flexible; but as long as the economy is an open one, fiscal policy will be constrained by monetary policy
considerations even if there is a flexible exchange rate regime in place; for more on the assignment issue see
Gordon and Leeper 2006, Kirsanova, Leith, and Wren-Lewis 2009.
7

where the overlapping generations are strongly connected by one or the other characteristic
attributed to them by various types of nationalists. However, distributional effects of changes
in policy mixes, e.g. of monetary and banking renationalization may be sufficient to support
the disintegration of the monetary union. In case there is no fiscal union, financial
disintegration may prove to be even more attractive.

Appendix I: Simple Idea of Fiscal and Monetary Policy Interaction
Probably the simplest way to illustrate the connection between the fiscal and monetary
policies is with the inter-temporal government budget constraint:
B/P = E (T-G) (1)
where B is public debt, P is price level, E is expectations operator, T is taxes and G is public
spending (expected future real fiscal surpluses).
To the extent that monetary policy can set P, whether by controlling the quantity of
money or by setting the interest rate on short term government liabilities, it will also set the
needed real fiscal surpluses given the level of public debt. If, however, fiscal surpluses are
falling short of what is required to cover the public debt, or fiscal deficits are too large, prices
need to increase in the equilibrium. In the first case, there is monetary dominance (monetary
policy aiming at price stability determines the needed fiscal surplus), while in the second there
is fiscal dominance (the desired fiscal surplus or deficit determines the price level). However,
to the extent that either interest rate or quantity of money is in part or completely
endogenously determined, e.g. monetary policy is constrained via the balance of payments,
there is monetary dominance externally even if there is fiscal dominance internally. The
international interest rate, however, is set endogenously, basically in the financial markets.

The Dynamics of Disintegration
In a typical case, there is a growing interest in fiscal devolution due either to
asymmetries in the political or economic constitution of the union, i.e. biased fiscal system or
because of the discretionary use of monetary policies. The former may be because it is
believed that there is taxation without representation, or without adequate representation,
while the latter, that can be also interpreted as the case of representation without taxation, is
more often the case if either there are diverging interests when it comes to the setting of the
inflation target by the central bank or because of the dissatisfaction by some with the
exchange rate regime or policy.
8

In a number of cases, e.g. the dissolution of the Austro-Hungarian monetary union or
the two Yugoslav monetary unions (Socialist Yugoslavia and the one consisting of Serbia and
Montenegro) and possibly of the rouble zone too, due in part to the distributional effects of
monetary policy, i.e. disagreements over the inflation targets and problems with the choice of
the exchange rate regime, the creation of a fiscal union was resisted or there was a persistent
push for fiscal devolution. In these as well as in other cases of monetary renationalization, the
lack or the weakness of the fiscal union or its devolution preceded the disintegration of the
monetary union.
Once there is no fiscal union, an attempt by the central bank to inflate the economy to
support growth or to ease the fiscal burden tends to create incentives for renationalization of
monetary policy. Whatever fiscal aim inflation can achieve in the union as a whole, it can
achieve it even better if monetary policy is renationalized; while the damage that common
monetary policy might do can also be avoided by getting out of the monetary union.
8
These
distributional effects are especially strong at higher rates of inflation, which is why they tend
to be associated with the disintegrations of monetary unions.
The distributional effects of monetary policy can arise either because the distribution
of debtors and creditors differs across the various regions of a union or because the spread of
inflation is staggered so that some parts of the union experience a speed up in inflation before
the others. The former may be a consequence of different balances in savings and investments
while the latter can be due to differences in the way labour markets work. Clearly, creditor
nations may not be happy with the acceleration of inflation while countries with rigid labour
markets may prefer higher inflation rates than the rest of the union.
Some point to the need for a dominant player in the monetary union that can ensure its
continued existence (Cohen 2000). However, in the examples mentioned here, the existence
of the dominant influence on the monetary policy was one of the reasons for the drive to
disintegrate. Once there is a distributional conflict, the asymmetry of power will lead to
secession being preferable to continued cooperation because of the expectations that the costs
will be distributed in reversed proportion to the distribution of power. So, the role of the
dominant player in economic and political unions is more ambiguous especially when it
comes to the use of monetary policy (on game-theoretic aspects of the balance of power with
the dominant player see Gligorov 1994).
Disintegration is speeded up if fiscal and monetary problems are accompanied by a
threat or an actual collapse of the banking system. More often than not, financial crisis, often

8
On the ability of a central bank of a small open economy to control inflation see Woodford 2010.
9

with international causes and consequences, precedes the fiscal and monetary crisis (Reinhart
and Rogoff 2010). Public resources are needed to stabilise or even bail out the banking system
and the existence of an explicit or implicit fiscal guarantee will lead to the renationalization of
the banking system or prevent the creation of a banking union. That process will be easier if
the fiscal system is renationalized, or if fiscal union never came into being and if there is a
national central bank that can provide or can be expected to provide the needed liquidity with
ease.
Thus, first fiscal union is either not put together or devolves, then speed up of inflation
destroys the monetary union, and finally bank resolution problems require the
renationalization of the banking system and the reintroduction of tariffs and capital controls.
And the union falls apart.

The Mechanics of Disintegration
The literature on political and economic disintegration identifies causes relying on a
number of assumptions about the optimality of states or unions. The key assumptions are
about the homogeneity of public preferences and economic activities (Mundell 1961, Alesina
and Spolaore 1997, Bolton and Roland 1997, McCallum 1999). In addition, flexibility of
prices of productive factors, especially of wages, plays an important role. The homogeneity of
public preferences are taken to be a consequence of one or the other attribute of national
identity, e.g. common culture, while labour mobility and homogeneous production
specialization may be due to geographical factors. Indeed, it is often assumed that with
geographical distance, heterogeneity, cultural and economic, increases, so that the benefits of
economic, fiscal, and monetary unions decline.
Mainstream theory assumes that heterogeneous political unions or states are unstable
and will be prone to disintegration (Alesina, Angeloni and Etro, 2005). In reality, unions fall
apart because of the inability to solve emerging distributional problems (for the near
irrelevance of heterogeneity for distributional problems Gligorov 1992-2012). Again, as
unions often disintegrate through wars or violent internal conflicts, it is hard to identify the
causes that drive the process of breakup (Gligorov 1994).
In a number of cases, the problems start with a financial crisis. The distribution of
losses proves to be hard in a union either because of the lack of a proper fiscal system of risk
sharing or because of the appeal of fiscal devolution as a means to minimize ones own costs
by shifting them to somebody else. In some cases monetary policy is used to support the
failing banking system, which tends to politicize the central bank. In most failed unions,
10

central monetary authority was identified with the interests of a particular, often dominant,
state in the union. That may induce the other states to look for ways to renationalize various
aspects of the monetary authority, which arises naturally if there is no fiscal union. If there is,
fiscal devolution is the step that precedes the one of the establishment of monetary
sovereignty.
Thus, financial crisis tends to be the usual cause of the drive for fiscal devolution and
of the renationalization of the monetary system. Often, the attempts to inflate the crisis away
or to extend fiscal authority prove to be counterproductive because they increase the stakes of
the distributional conflict over the costs of the crisis.

Appendix II: A Generalized Idea of Crisis
Probably the best understood is the currency crisis. If the exchange rate is fixed or
managed, and if it gets misaligned, i.e. overvalued, a speculative attack will succeed as long
as foreign reserves are finite because it will be advantages to speculators to buy all the
reserves and then sell them back once the exchange rate has devalued. With M for money
growth, P for prices, i for the interest rate, e for exchange rate:
M| P, i, > M| e
fixed
e
fixed
< e
float
(2)
If money grows faster than is required for maintaining a fixed or a managed exchange rate,
the exchange rate will collapse under a speculative attack.
In general, crisis will occur if relative prices are misaligned because there will be
money to be made as long as there is relative price rigidity. The key is the existence of the
relative price misalignment, it is not enough that the exchange rate is fixed, and it is not even
necessary as flexible exchange rates can also be misaligned. In the latter case, foreign reserves
at the central bank need not be as high as in the case of the former. However, the reserves
serve to fight back speculative attacks when the exchange rate is not misaligned. Once it is,
the reserves are what speculators are after.
Speculative attacks can take the form of what has become to be known as crisis of
sudden-stops. If foreign financial inflows stop, the country may face shortage of money which
may be larger than the existing foreign currency reserves may cover. Substituting home for
foreign money may not be possible even under flexible exchange rates in a country with large
currency substitution perhaps because crediting in domestic currency is limited or non-
existent (Calvo 1979).
Also, hiking the interest rate in order to stop the haemorrhaging of the foreign finances
may prove counterproductive because it may eventually lead to even steeper devaluation
11

because the spread between the foreign and domestic interest rates will increase. That
effectively saps monetary policy at least as long as exchange rate and interest rate
misalignments persist. This is a point made by Stiglitz during the Asian and South American
crisis in the 1990s. Start with uncovered interest rate parity (ih for home interest rate, if for
foreign interest rate and Ee for expected devaluation):
ih if = Ee (3)
then hiking the domestic interest rate will imply deeper devaluation. Conversely, as is the case
with the convertibility problem in the eurozone now, but was characteristic in many
disintegrations, the widening interest rate spread on various sovereign euro bonds indicate
speculation about the exchange rate of emerging currencies if the monetary union
disintegrates.
Given that it is the misalignment that is the cause, other relative price misalignments,
e.g of the interest rate, can lead to crisis too. So, interest rate misalignment, e.g. low interest
rate that leads to asset price bubbles will lead to banking crisis because it will lead to
increased leverage (if interest rate on debt is lower than the growth rate of the price of the
underlying asset, every leverage ratio is sustainable). Again, from a macroeconomic point of
view, if interest rate is lower than it is justified by the potential growth rate, booms and busts
will be justified speculatively. Equity requirements, leverage ratios, reserves requirements or
low fiscal deficit and public debt will prove irrelevant as long as there is relative price
misalignment. The same applies to wage and unit labour cost developments that is to inflation
differentials between different countries.

The Outcomes
The outcome of disintegration is an increase of number of states and an international
system of states with their policy autonomies. It is argued in much of the literature on the
number and size of nations that indeed this policy control that is in greater accordance with
the public preferences of the population is the motivation for disintegrations or lack of interest
for integrations. Especially favourable circumstances for nation- and state-building are an
international system of free trade and the spread of democratic decision making. The former
diminishes the economies of scale that large states offer in a protectionist world while the
latter diminishes the negative economies of scope that go with the greater diversity in the
large states (for a review see Spolaore 2011). The assumptions are that smaller states are more
homogenous in their policy spaces and that they can in fact design and implement their
12

preferred policy mixes, which are closer to their public preferences than those that would
prevail in a large state or in a union with significant level of federalization.
The outcomes, by and large, do not support these expectations. In most cases, the
systemic outcomes do not accord with the justifications of disintegration.
The emerging sovereign states need not be more homogeneous (culturally, politically,
or in economic terms). In fact, due to the flexibility of gerrymandering, there may be no end
to cycles of disintegration all the way to the state of affairs in which every person is a
Robinson Crusoe and even in that case there is the issue of inter-temporal consistency and
sustainability (on all that see Gligorov 1994 and 1992-2012).
Even with a debt write-off, the tax burden of the macroeconomic and financial
stability, and the provision of the full set of public goods in the disintegrated states, tends to
increase. This is not only due to the diseconomies of scale. Even if possible increases in
expenditures on security (military, political, economic, or social) are disregarded, ex ante
public preferences may differ from the ex post ones. In the Tiebout 1956 type of a setting,
borders are given and people move to regions that have policies, e.g. tax rates, which they
prefer, so there is no reason for these preference to change after regions are homogenised
precisely on the basis of preferred policies. In the case of people not moving but the borders
being redrawn, the policy preferences before secession are drawn over the different policy
space than the one that emerges with the redrawing of the borders. The preferred policy mix
before secession may not be the same as the one after the secession in part because the policy
goals and instruments may be different. It may be the case that more homogeneous societies
will tend to redistribute less than the more heterogeneous ones, but the usual motivation of
renationalization is in fact to redistribute more rather than less. So, more often than not, fiscal
burden tends to increase. Thus, tax levels often increase because of the lower mobility of the
tax base. That is especially the case if tariffs are hiked and capital controls introduced. So,
overall, the promises of renationalisation as the promises of nationalism in general prove to be
largely illusionary in the international context.
The scope for autonomous or active monetary policy is strictly limited. Monetary
sovereignty is often not attained, since nationalization of the central bank leads to a fiscal
dominance except to the extent that the interest rate and the rate of inflation depend on the
foreign financial flows. That does not mean that there is scope for active fiscal policies, but
rather there is a regime of monetary dominance, the one anchored in reserve management
with a limited role for exogenous money and thus for fiscal policy.
13

In a number of cases, the new currencies proved inferior to foreign alternatives. For
instance, most currencies in the post-rouble zone as well as in the post-Yugoslav dinar zone
have failed to attract trust of either debtors or creditors and foreign currencies are used for
most monetary functions. In addition, fixed (or managed) exchange rate regimes are more
common than the floating ones. So, often common currency is substituted with a pegged
exchange rate and with a central bank that functions as a currency board. In those
circumstances, it is hard to argue that monetary sovereignty has been regained. The central
bank often lacks credibility and currency substitution is used as an insurance against surprise
devaluation and surge of inflation. This lack of credibility translates into real costs in the form
of a higher interest rate and higher need for sterilization. The improvement in the international
position through the exchange rate adjustment tends to be temporary if it is not followed by
changed propensity to save and with increased investments in tradable goods and services.
Banking renationalization proves to be rather costly due to the need to bail out the
banks. Also, the probability of national banks going bust does not decrease; in other words,
the probability of a systemic risk decreasing in national banking systems is rather low. In fact,
due to higher openness of smaller economies, dependence on international finances increases
and the allocational benefits of national banking systems decreases.
So, overall, the system of nation states does not necessarily lead to increased policy
autonomy or to improved policy performance.

The Case of the European Monetary Union
If the rule you followed brought you to this, of
what use was the rule? Anton Chigurh, No
Country for Old Men.
European Monetary Union is designed to be supported not by a fiscal union in the
sense of centralized taxing powers but by fiscal rules. The idea is that if the rules are right and
if there is the firm commitment that those will be adhered to, no delegation of taxing authority
is needed, i.e. fiscal powers need not be federalised. In addition, the European Central Bank is
also a rule-following institution, which is the foundation of its independence. Finally, the
banking sector is, to quote Mervyn King (or was it Charles Goodhart?), international in life,
and national in death, i.e. the risks of bank failures are borne by the national budgets.
The general idea of the construct does not differ fundamentally from what can be
found in Hayeks essay on inter-state federalism (Hayek 1948, originally 1939). It could be
argued that Hayek, by implication, in that piece envisages a constitution for a union along the
14

lines of Buchanan 1990. Also, in this piece, unlike in Hayek 1976 (1990), again by
implication, he supports a monetary union along similar lines of argument as Mundall 1971.
Finally, insisting on rules rather than discretion, the paper anticipates the main institutional
characteristic of the EU, which is that stability comes from adherence to rules and not from
discretionary policies (though Hayek does not deny the need for those).
The key difference between the EU and the EMU on one side and a state, however
federalised, on the other side is that the former relies on compliance rather than on
enforcement, which is characteristic of the latter. The system of compliance is supposed to be
based on rules that should substitute discretionary or other policies indeed, the idea is that
the EU, on all levels of decision making, will be based on rule-following and to the extent that
there is scope for policies, those would be limited by the adherence to the rules. That is why
there is the often noticed disproportionate reliance on regulation to the detriment of executive
power. That applies not only to the regulation of the common market, but also to fiscal policy,
and even to monetary policy.
Generally, the EU is a rule based political and economic union. That is supposed to
solve the problem of commitment and the pervasive problem of time-inconsistency. As long
as there is the possibility for the decision-makers to change their mind, there is the problem
that following through with the commitment may not be the optimal policy in changing
circumstances. In fact, sequential optimization may lead to the final outcome that is far
removed from the one that would have been arrived at if the initial commitment had been
adhered to. In addition, the latter may Pareto-dominate the former.
Because of that, EU is not just rule-based, but also the rules it relies on are those that
are assumed to be optimal in the long run. Those should signal a very strong commitment and
thus stabilize expectations. Those should in turn enable the pursuit of monetary policy that
stabilizes inflation and fiscal policy that stabilizes public debts at levels that are agreed on as
being most conducive to potential growth that also leads to convergence of initially large
regional differences. In fact, the only policy instrument left is that of increasing market
integration through liberalization. That in particular applies to financial markets and cross
border banking.
Thus, the end result is a customs union (free trade in goods, services, and labour), an
independent central bank targeting low inflation rate (close but below 2%), fiscal compact
(Stability and Growth Pact targeting public debt of 60% of GDP or less with balanced or in
surplus primary fiscal balance), and financial liberalization. EU is an economic and political
union without the right to tax and to borrow. It is supposed to provide the legal and the
15

regulatory framework for free enterprise, free banking and free trade. This will be so if the
rules and regulations are incentive compatible and dynamically self-sustainable. Simply
stated, that means that they are not only Pareto-optimal but are also stable in the sense that
they adjust to shocks or crisis by reforms that sustain the basic institutional set up.
The main lacunas in the construction are those that are associated with the authority of
a state: lack of instruments for stabilisation policy and of institutions that deal with
distributional problems. There are some elements of policies of compensation and
development, but the main instruments of distribution and redistribution across borders of
member states are lacking. In terms of major social risks, there is no economic and political
union. The union has no taxing powers and does not provide for social security. So, it is not at
all clear how is it supposed to deal with distributional conflicts.
Thus, faced with financial crisis, the union faces strong incentives to disintegrate in
order to renationalise the banking and thus the monetary system relying on the never united
fiscal system. The key to this outcome emerging is the fact that fiscal systems are national.
That essentially means that the EU is organized as a collection of separate insurance systems
as fiscal systems are mainly about the risk sharing within and between generations. So,
increased risks tend to make international or across the EU risk sharing unattractive because it
requires redistribution from those facing lower risks to those with higher risks, those that are
distressed. It is in a way the mechanism of adverse selection, often mistaken for the attraction
of homogeneity, which is driving the process of disintegration.

Appendix 3: Fiscal Risk Sharing
Fiscal union is a way to insure risks, which for the reason of one or the other market
failure cannot be privately insured (Persson and Tabellini 1996a, 1996b). Security is the
primary example, but justice and welfare are the other two among those that are the most
important. Systemic risks, financial but also in other markets, most importantly in the labour
market, that can fall under a more general notion of security, also feature as reasons for fiscal
insurance.
Clearly, fiscal as any other insurance system pulls risks that, when realized, have
distributional effects. Those are the reason that there is a market failure to begin with and for
the coercive way in which contributions are collected. That of course introduces a moral
hazard as in part a cost for lower overall risk. In addition, for the same reason that individuals
do not pay taxes voluntarily, states do not integrate fiscally just because that leads to better
insurance and lower risks. In addition, they have an interest to disintegrate once the risks
16

materialize and those less affected need to foot the bill of those that are more affected, i.e.
there is the problem of adverse selection.
Internationally, states are like private insurance systems that are subjected to adverse
selection problem. So, those better off do not want to share risks with those worse off and the
latter may have an interest in protecting themselves from the former, by putting barriers to
trade and nationalizing their monetary and banking systems. However, when considering
optimal taxation and transfers, fiscal unions are superior on both moral hazard and adverse
selection grounds.
One way to see the insurance aspect of fiscal institutions is to think in terms of inter-
generational justice. Assume, as Rawls or Harsanyi or Arrow, that the fiscal union of, e.g.
Germany and Greece, or any number of states on different levels of development is
considered. If those deciding do not know whether they will be born or end up living in the
more developed rather than less developed region of the union, they may want to design an
insurance system to share that risk. This is a problem similar to the one where migration is
treated in the overlapping generations setting. At every point in time, better off cover the risks
of the worse off, however over generations the opposite may very well be true.

Appendix 4: Mechanism Design and Backward Induction (Rules and Commitment)
EU policy set-up has been strongly informed by the time-inconsistency argument and
not only in the case of problems with moral hazard issues. Therefore, it is rather inimical not
only to discretionary policies, but to the existence of political bodies with discretionary
powers altogether. The idea is that the constitution should be designed in such a way that it is
incentive compatible and that this can be ascertained by a backward induction argument that
leads to the Nash equilibrium in interests and commitments. By that reasoning, liberalisation
of markets and regulation that sustains it should rule out the need for stabilization policies
beyond those that are delegated to the central bank. The bank, however, is committed to price
stability, which is defined as the rate of inflation of less than but close to 2% over the medium
term. So, the scope for discretionary monetary policy is quite limited in terms of the inflation
target. It is also instrumentally limited as the European central bank is not a government bank,
as there is in fact no government for this monetary union.

The Great Idea (an allusion to Musil)
The key problem in political unions is the constitutional one (Gligorov 1994;
Buchanan 1990). That seems like an easier problem in nation states, in part because policies
17

need not be substituted by rules. Many unions have faced the problem of finding The Great
Idea to base the common institutions and policies on. This was the case with Austro-Hungary
and the Yugoslav state at least. It is the case with the EU too. Every political union searches
for a constitution that is implicitly cosmopolitan, i.e. is based on The Great Idea.
However, nation states face problems with justifying their borders and founding a
stable international order. Apart from economic reasons for the uneasy relationship between
trade, fiscal, and monetary policies, there is the political issue of stable distribution of power
or of balance of power. For instance, it appears that Rodrik argues for a system of nation
states assuming that the issue of stable power distribution has been solved. Most theories of
the number and size of nations rely on simplifying assumptions about the distribution of
preferences and decision making rules (so that they can make use of the median voter
theorem; Gligorov 2000 in 2012).
In general, though, a cosmopolis can be decentralised in many, possibly infinite
number of, ways. So, there is no reason to assume that a system of states (Wight 1971) will
ever prove stable as there is no stable and sustainable distribution of power. Even assuming
initial ethnic homogeneity, there is no reason to believe that it will be sustained against
migrations or even endogenous cultural differentiation. So, both great ideas cosmopolitan
one or the national one will prove deficient either constitutionally or politically.
In economic terms, this is central to the debate between Friedmans nationalism and
Hayeks cosmopolitanism discussed shortly below.

Criticism of Nationalism: Hayek vs. Friedman
What is wrong with nationalism apart from international security concerns? In the
context of fiscal and monetary interaction issues, Hayeks criticism of Friedmans preference
for a particular monetary policy rule and for flexible exchange rates may be of some
intellectual interest. These diverging conceptions were forged at the time of collapsing system
of nation states and of the rebuilding of the new international monetary and economic order,
so it is not just of intellectual interest.
It is perhaps less often emphasized that Hayek was a consistent critic of nationalism.
Perhaps his best argument for a federal constitution is to be found in the last chapter of Hayek
1948 (originally 1939). There he argues for comprehensive market liberalization and
integration of countries ready to commit to those. It does not apply to any particular region
and could include all countries committed to free trade and complementary economic policies.
Clearly, in the end, that is a cosmopolitan vision.
18

More concretely, he argued against monetary nationalism in his 1937 book and
especially in the controversial Denationalisation of Money book (third edition 1973). The key
point is that he saw monetary nationalism not only as a source of instability, but primarily as
an instrument to increase public revenues. Nationalism is a way to introduce an additional tax.
The instability comes through the reliance on the monetary rule (like the one Friedman
proposed) or through the reliance on flexible exchange rates that allow for national inflation
targets and lead to increased international instability (on autonomy of monetary policy with
flexible exchange rates see Clarida, Gali and Gertler 2001, Woodford 2008).
On both these issues, he criticised Friedman rather sharply. He argued that fixed rate
of money growth is destabilizing because it will invite speculation (similarly to the fixed
exchange rate, one might add). He quotes Bagehot to that effect and argues that the central
bank needs to have some operational discretion if it is to succeed in stabilizing inflation.
Similar argument can be applied to the policy of interest rate targeting. When it comes to
flexible exchange rates, he argued that it can be expected that those will be destabilizing
because the volatility will increase significantly. The reason is that all those fiscally dominant
national policies will be difficult to stabilize in the international money markets. He, indeed,
believed that in a free banking system with competing currencies, endogenous monetary
dominance will assert itself.
More fundamentally, monetary and fiscal nationalism is a way to limit the private
property rights and to limit individual rights and freedoms. It does not have only negative
effects on growth and employment, but also on security and justice. The alternative
arrangement of common market and financial liberalization as well as reliance on the rule of
law is certainly also at the basis of the European Union (though he did not think in his 1948
chapter, written originally before the Second World War, that the inter-state federalism should
be restricted to Europe). The key remaining problem is that of risk sharing and fiscal union.
The federal system of taxation with competition and fiscal federalism in the provision of
public goods is one possibility. Financial instability remains as a problem, but may not lead to
disintegration and to rising nationalism.

Conclusion
Basically, unions disintegrate for distributional reasons, though disintegrations are
often caused by financial crisis. The main attraction of nationalism is distributional, while the
main disadvantage of monetary unions is that monetary policy may redistribute via inflation
in a manner that may lack legitimacy. However, except in closed economies, there is no easy
19

cohabitation between monetary and fiscal policies. Indeed, the world economy is closed at
least intra-temporally which perhaps explains the drive to regional, like EU, and global
integration. There is the problem of inter-temporal distribution, which is properly the task for
global risk sharing. If there is no such system, there will be cycles of integration and
disintegration.

Appendix 5: Hayek on Friedman
In Denationalization of Money, Hayek criticises Friedmans monetary theory and
policy extensively. This quote contains almost the whole argument:
Where I differ from the majority of other monetarists and in particular from the
leading representative of the school, Professor Milton Friedman, is that I regard the simple
quantity theory of money, even for situations where in a given territory only one kind of
money is employed, as no more than a useful rough approximation to a really adequate
explanation, which, however, becomes wholly useless where several concurrent distinct kinds
of money are simultaneously in use in the same territory. Though this defect becomes serious
only with the multiplicity of concurrent currencies which we are considering here, the
phenomenon of substitution of things not counted as money by the theory for what is counted
as money by it always impairs the strict validity of its conclusions.
Its chief defect in any situation seems to me to be that by its stress on the effects of
changes in the quantity of money on the general level of prices it directs all too exclusive
attention to the harmful effects of inflation and deflation on the creditor debtor relationship,
but disregards the even more important and harmful effects of the injections and withdrawals
of amounts of money from circulation on the structure of relative prices and the consequent
misallocation of resources and particularly the misdirection of investments which it causes.
This is not an appropriate place for a full discussion of the fine points of theory on
which there exist considerable differences within the monetarist school, though they are of
great importance for the evaluation of the effects of the present proposals. My fundamental
objection to the adequacy of the pure quantity theory of money is that, even with a single
currency in circulation within a territory, there is, strictly speaking, no such thing as the
quantity of money, and that any attempt to delimit certain groups of the media of exchange
expressed in terms of a single unit as if they were homogeneous or perfect substitutes is
misleading even for the usual situation. This objection becomes of decisive importance, of
course, when we contemplate different concurrent currencies.
20

A stable price level and a high and stable level of employment do not require or permit
the total quantity of money to be kept constant or to change at a constant rate. It demands
something similar yet still significantly different, namely that the quantity of money (or rather
the aggregate value of all the most liquid assets) be kept such that people will not reduce or
increase their outlay for the purpose of adapting their balances to their altered liquidity
preferences. Keeping the quantity of money constant does not assure that the money stream
will remain constant, and in order to make the volume of the money stream behave in a
desired manner the supply of money must possess considerable elasticity.
Monetary management cannot aim at a particular predetermined volume of circulation,
not even in the case of a territorial monopolist of issue, and still less in the case of competing
issues, but only at finding out what quantity will keep prices constant. No authority can
beforehand ascertain, and only the market can discover, the optimal quantity of money. It
can be provided only by selling and buying at a fixed price the collection of commodities the
aggregate price of which we wish to keep stable.
As regards Professor Friedman's proposal of a legal limit on the rate at which a
monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can
only say that I would not like to see what would happen if under such a provision it ever
became known that the amount of cash in circulation was approaching the upper limit and that
therefore a need for increased liquidity could not be met.
9

Everybody knows of course that inflation does not affect all prices at the same time
but makes different prices rise in succession, and that it therefore changes the relation
between prices although the familiar statistics of average price movements tend to conceal
this movement in relative prices. The effect on relative incomes is only one, though to the
superficial observer the most conspicuous, effect of the distortion of the whole structure of
relative prices. What is in the long run even more damaging to the functioning of the economy
and eventually tends to make a free market system unworkable is the effect of this distorted
price structure in misdirecting the use of resources and drawing labour and other factors of
production (especially the investment of capital) into uses which remain profitable only so
long as inflation accelerates. It is this effect which produces the major waves of
unemployment, but which the economists using a macro-economic approach to the problem
usually neglect or underrate.

9
To such a situation the classic account of Walter Bagehot would apply: In a sensitive state of the
English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-
third were fixed by law, the moment the banks were close to one-third, alarm would begin and would run like
magic.

21

This crucial damage done by inflation would in no way be eliminated by indexation.
Indeed, government measures of this sort, which make it easier to live with inflation, must in
the long run make things worse. They would certainly not make it easier to fight inflation,
because people would be less aware that their suffering was due to inflation. There is no
justification for Professor Friedmans suggestion that
by removing distortions in relative prices produced by inflation, widespread escalator
clauses would make it easier for the public to recognise changes in the rate of
inflation, would thereby reduce the time-lag in adapting to such changes, and thus
make the nominal price level more sensitive and variable.
Such inflation, with some of its visible effect mitigated, would clearly be less resisted
and last correspondingly longer.
It is true that Professor Friedman explicitly disclaims any suggestion that indexation is
a substitute for stable money, but he attempts to make it more tolerable in the short run and I
regard any such endeavour as exceedingly dangerous. In spite of his denial it seems to me that
to some degree it would even speed up inflation. It would certainly strengthen the claims of
groups of workers whose real wages ought to fall (because their kind of work has become less
valuable) to have their real wages kept constant. But that means that all relative increases of
any wages relatively to any others would have to find expression in an increase of the nominal
wages of all except those workers whose wages were the lowest, and this itself would make
continuous inflation necessary.
It seems to me, in other words, like any other attempts to accept wage and price
rigidities as inevitable and to adjust monetary policy to them, the attitude from which
Keynesian economics took its origin, to be one of those steps apparently dictated by
practical necessity but bound in the long run to make the whole wage structure more and more
rigid and thereby lead to the destruction of the market economy. But the present political
necessity ought to be no concern of the economic scientist. His task ought to be, as I will not
cease repeating, to make politically possible what today may be politically impossible. To
decide what can be done at the moment is the task of the politician, not of the economist, who
must continue to point out that to persist in this direction will lead to disaster.
I am in complete agreement with Professor Friedman on the inevitability of inflation
under the existing political and financial institutions. But I believe that it will lead to the
destruction of our civilisation unless we change the political framework. In this sense I will
admit that my radical proposal concerning money will probably be practicable only as part of
a much more far-reaching change in our political institutions, but an essential part of such a
22

reform which will be recognised as necessary before long. The two distinct reforms which I
am proposing in the economic and the political order are indeed complementary: the sort of
monetary system I propose may be possible only under a limited government such as we do
not have, and a limitation of government may require that it be deprived of the monopoly of
issuing money. Indeed the latter should necessarily follow from the former.
The historical evidence
Professor Friedman has since more fully explained his doubts about the efficacy of my
proposal and claimed that
we have ample empirical and historical evidence that suggests that [my] hopes would
not in fact be realised-that private currencies which offer purchasing power security
would not drive out governmental currencies.
I can find no such evidence that anything like a currency of which the public has learnt
to understand that the issuer can continue his business only if he maintains its currency
constant, for which all the usual banking facilities are provided and which is legally
recognised as an instrument for contracts, accounting and calculation has not been preferred
to a deteriorating official currency, simply because such a situation seems never to have
existed. It may well be that in many countries the issue of such a currency is not actually
prohibited, but the other conditions are rarely if ever satisfied. And everybody knows that if
such a private experiment promised to succeed, governments would at once step in to prevent
it.
If we want historical evidence of what people will do where they have free choice of
the currency they prefer to use, the displacement of sterling as the general unit of international
trade since it began continuously to depreciate seems to me strongly to confirm my
expectations. What we know about the behaviour of individuals having to cope with a bad
national money, and in the face of government using every means at its disposal to force them
to use it, all points to the probable success of any money which has the properties the public
wants if people are not artificially deterred from using it. Americans may be fortunate in
never having experienced a time when everybody in their country regarded some national
currency other than their own as safer. But on the European Continent there were many
occasions in which, if people had only been permitted, they would have used dollars rather
than their national currencies. They did in fact do so to a much larger extent than was legally
permitted, and the most severe penalties had to be threatened to prevent this habit from
spreading rapidly-witness the billions of unaccounted-for dollar notes undoubtedly held in
private hands all over the world.
23

I have never doubted that the public at large would be slow in recognising the
advantages of such a new currency and have even suggested that at first, if given the
opportunity, the masses would turn to gold rather than any form of other paper money. But as
always the success of the few who soon recognise the advantages of a really stable currency
would in the end induce the others to imitate them.
I must confess, however, that I am somewhat surprised that Professor Friedman of all
people should have so little faith that competition will make the better instrument prevail
when he seems to have no ground to believe that monopoly will ever provide a better one and
merely fears the indolence produced by old habits.
Hayek (1937) on the international standard:
Theoretical economists frequently argue as if the quantity of money in the country
were a perfectly homogeneous magnitude and entirely subject to deliberate control by the
central monetary authority. This assumption has been the source of much mutual
misunderstanding on both sides. And it has had the effect that the fundamental dilemma of all
central banking policy has hardly ever been really faced: the only effective means by which a
central bank can control an expansion of the generally used media of circulation is by making
it clear in advance that it will not provide the cash (in the narrower sense) which will be
required in consequence of such expansion, but at the same time it is recognised as the
paramount duty of a central bank to provide that cash once the expansion of bank deposits has
actually occurred and the public begins to demand that they should be converted into notes or
gold. (13)
As I have pointed out before, the "national reserve principle" is not insolubly bound
up with the centralization of the note issue. While we must probably take it for granted that
the issue of notes will remain reserved to one or a few privileged institutions, these
institutions need not necessarily be the keepers of the national reserve. There is no reason why
the Banks of Issue should not be entirely confined to the functions of the issue department of
the Bank of England, that is to the conversion of gold into notes and notes into gold, while the
duty of holding appropriate reserves is left to individual banks. There could still be in the
backgroundfor the case of a run on the banksthe power of a temporary "suspension" of
the limitations of the note issue and of the issue of a emergency currency at a penalizing rate
of interest.
The advantage of such a plan would be that one tier in the pyramid of credit would be
eliminated and the cumulative effects of changes in liquidity preference accordingly reduced.
The disadvantage would be that the remaining competing institutions would inevitable have to
24

act on the proportional reserve principle and that nobody would be in a position, by a
deliberate policy, to offset the tendency to cumulative changes. This might not be so serious if
there were numerous small banks whose spheres of operation freely overlapped over the
whole world. But it can hardly be recommended where we have to deal with the existing
banking systems which consist of a few large institutions covering the same field of a single
nation. It is probably one of the ideals which might be practical in a liberal world federation
but which is impracticable where national frontiers also mean boundaries to the normal
activities of banking institutions. The practical problem remains that of the appropriate policy
of national central banks. (92)
Here my aim has merely been to show that whatever our views about the desirable
behaviour of the total quantity of money, they can never legitimately be applied to the
situation of a single country which is part of an international economic system, and that any
attempt to do so is likely in the long run and for the world as a whole to be an additional
source of instability. This means of course that a really rational monetary policy could be
carried out only by an international monetary authority, or at any rate by the closest
cooperation of the national authorities and with the common aim of making the circulation of
each country behave as nearly as possible as if it were part of an intelligently regulated
international system. (93)













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