Diego Zuluaga // 1 November 2017

The turmoil in Catalonia appears finally to be subsiding thanks to the central government’s intervention this weekend to restore constitutional order. The decision to sack the Catalan cabinet is an unaesthetic but necessary and entirely legal and legitimate action by Madrid. Only in that way can the rule of law, and respect for Spain’s devolved system of government, be restored.

But it is clear that Catalonia, and the rest of Spain, need a new constitutional settlement. The government and main opposition have already agreed to address this matter after regional elections take place in Catalonia at the end of December. Many hope that constitutional reform will deliver an even more decentralised federal system which addresses existing asymmetries in powers between regions, whilst ensuring that each is largely responsible for their own decisions.

There are many economic reasons why federal systems of government are preferable to more centralised ones. Because the governors are closer to the governed, decentralised systems tend to be more responsive to changing local needs. Moreover, the variety brought about by federalism makes it easier for people to choose the location which offers their preferred mix of taxes and public services.

Differentiation also creates competition for residents and their tax revenue, so federalism often leads to more efficient public services. In fact, some of the world’s most successful countries, such as Canada, Germany, Switzerland and the United States, operate decentralised systems of government.

Another reason to prefer federalism is motivated by the theory of portfolio allocation, which seeks to explain how to pick investment assets so as to obtain the greatest return for the lowest amount of risk. It teaches that a broadly diversified portfolio is preferable to a single asset because individual assets are imperfectly correlated with each other. This means that one can achieve the same mean return with much reduced portfolio volatility if one buys a broad selection of assets.

Modern portfolio theory is at the heart of passive investing: the idea that the best performance can be achieved, not by hiring ostensibly astute stock pickers, but by ‘buying the whole market.’

How is this relevant to the system of government that a country should have? Consider the following scenario. There are two countries: Federalia and Centralistan. Federalia has a highly decentralised system of public administration, with municipalities and regions in charge of all public services except for national defence and the court system. In Centralistan, by contrast, all public policy is decided in the capital.

Assume that the economic performance of a country or region is partly the result of economic policy, whose effects are persistent. Performance is also affected by random shocks, such as an oil price drop or a surge in foreign demand. Federalia and Centralistan are equally at risk of such shocks, have the same mean growth rate, and are identical in all respects except for their system of government.

Because Federalia is decentralised, economic policy across the municipalities tends to diverge, which means that the performance of the various localities is imperfectly correlated. Even if all of Federalia’s constituent parts are equally affected by economic shocks, the extent to which they are affected and the speed of recovery varies because of their different policy responses. By contrast, a shock has the same effect on all of Centralistan because the response is the same across the entire country.

So, we have a state that resembles a diversified portfolio, Federalia, and one which behaves like a single asset, Centralistan. But we haven’t yet explained why the superiority of the former to the latter in investment can be transposed to one’s choice of a system of government. For that we have to invoke the philosopher John Rawls, who proposed that the right framework to choose a just political system is behind a veil of ignorance, where individuals do not know where along the spectrum of possible economic, political and social positions they will find themselves.

Consider then an individual choosing behind the veil of ignorance. She likes consumption – preferring more of it to less of it – and dislikes volatility – periodic fluctuations in consumption. Of the two countries, Federalia and Centralistan, which one would she prefer to be born in? Under reasonable conditions, she will prefer to be born in Federalia.

What are those conditions? Federalia must have either or both of labour mobility and a system of income transfers between better- and worse-performing regions. Labour mobility enables the residents of bad performers to move to more successful jurisdictions. Since performance is persistent, individuals who move are, on average, better off. Income transfers cushion the blow to income in the bad performers, but they also reduce income in the better performers. Risk-averse individuals, however, are happy to sacrifice some consumption in the good times for a consumption increase of similar size in bad times.

By choosing Federalia over Centralistan, our representative agent is guaranteeing herself the same rate of consumption growth with lower volatility during her lifetime. Of course, households in Centralistan may save privately or institute a rainy day fund to smooth consumption. But under no circumstances can Centralistan achieve better outcomes under its system of government than Federalia does under its own.

The upshot is that, for many Catalans undecided between independence and remaining part of Spain, prudence would recommend the latter. As with their financial affairs, they should avoid putting all their eggs in one basket. “Diversify – stay part of Spain!” may not be the most eye-catching motto, but it is true.

The post first appeared on the IEA’s blog.