september/october 2009

 

Special issue: Federations and the Economic Crisis

 

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Overview: Constituent units risk lengthy dependency on federal aid

 
Passersby are reminded of gloomy news as they walk past a newsstand in central Melbourne.
REUTERS/Mick Tsikas
Passersby are reminded of gloomy news as they walk past a newsstand in central Melbourne.

by richard m. bird

To cope with the ‘raging’ economic crisis, federations have to increase spending at all levels of government. This generally means increasing federal handouts to regions and localities. In doing so, however, federal governments have to take care not to increase the acquired codependency of the subnational units, thus sapping their incentives to manage budgets sensibly.
This special issue of Federations magazine is devoted entirely to assessing the actions and performance of 13 federal countries, plus the European Union, to get a keener sense of how they are coping and what the most effective antidotes have been to this economic pandemic.

Two questions underlie the articles in this issue:
• How has the public sector managed the public policy response to the crisis?
• What difference does being a federation make in how the meltdown has hit the country?

The answers are as varied as the countries. This is no surprise. The federations included here are a sample of the world as a whole. All six continents are represented, rich countries and poor, large countries and small. Like other countries, federations are “in crisis” in varying ways and to varying degrees.

Running off in all directions
Some countries have done much more to manage the crisis than others. Responses to the first question posed above run the gamut from, as the Canadian humorist Stephen Leacock once put it, “running off madly in all directions” – as some might perhaps characterize the United States – to “not much” in the case of Ethiopia, the poorest and least connected to the world economy of the countries covered here.

Even in Ethiopia, however, the crisis has added to the stress of policymakers, as Tamrat Giorgis shows. As in every crisis, they are bound to get some things wrong. Different people, even in the same country, see the problem (or problems) differently and place different weights on alternative answers. Countries face different economic pressures as a result of the crisis and different political problems at home.

One difference between countries is the extent to which the crisis is seen as purely external – something foisted on the country by the outside world, more specifically by the United States – or as also reflecting internal weaknesses – for example, in financial regulation.

Another is the extent to which the crisis is viewed not just as a challenge that has to be dealt with but also as an opportunity to pursue goals beyond immediate relief, a view that is perhaps most clearly articulated by Armando Chacón with respect to Mexico.

For those who see it as an opportunity, a central question is whether there is any trade-off between achieving stimulus (by expanding demand) and achieving longer-range goals like energy efficiency, industrial restructuring and poverty alleviation.

The danger of worrying too much about getting expenditure right in terms of long-term policy is that it may unduly delay the desired short-term impact on demand and hence hinder recovery. The danger of overemphasizing the quick pushing out of money is that it may lead to waste and even corruption.

It is no surprise that countries in which the latter problems loom larger, like most developing countries, place less emphasis on demand stimulus than more developed countries. As Jayati Ghosh and Bernardo Kucinski show, fast-growing India and Brazil have, for example, behaved quite differently both from each other and from most developed countries in their reactions to crisis.
Countries more dependent on volatile oil revenues like Nigeria, as Dejo Olatoye discusses, have been more directly impacted. In a vivid illustration of the financial truism that with high rewards go high risks, these countries have learned that what goes up fast may also come down fast.

Dampening inflation pressures
One striking difference from country to country is the relative emphasis being placed on reacting to the immediate crisis – which usually means increasing public sector spending – compared to dealing with what might be called the “post-crisis crisis,” that is, how to restore budgets to balance and to dampen down inflationary pressures. Deficit-phobic Germany has been particularly wary of the latter crisis, as Karen Horn discusses.

Opel and General Motors logos are pictured at an Opel plant in Poland, south of Warsaw. Opel, formerly owned by GM, was the target of a bidding war between Canadian car parts dealer Magna and RJH International, a private eqity firm in Brussels.
REUTERS/Vasily Fedosenko
Opel and General Motors logos are pictured at an Opel plant in Poland, south of Warsaw. After a long bidding war, GM’s board recommended selling Opel to Canada’s Magna International and the Russian bank Sberbank in September 2009.

Developed countries like Germany generally have “automatic” budgetary programs that require no explicit political decision in order to sustain consumer demand. Developing countries like India and Nigeria, however, have few such programs. They have placed greater emphasis on sustaining infrastructure spending, which is also seen as building a more growth-facilitating economy.

As Malcolm Curtis discusses in Switzerland, even developed countries have emphasized discretionary infrastructure spending. Perhaps one reason is the desire of politicians to leave visible evidence of their efforts. Perhaps it is because they see this as the best way to achieve longer-term policy objectives such as ‘greening’ the economy.

Worthy as such objectives might be, it is not clear that this is the best way to maintain the needed level of economic activity. Unless countries have “on the shelf” well-designed and worthwhile public sector works as well as the capacity to execute them immediately, by the time the roads or waterworks get built the problem may be more inflationary budget deficits than lack of effective demand. Delayed responses may increase rather than alleviate problems.

Balancing policy goals
Countries are thus attempting to ‘have their cake and eat it too’ by spending quickly enough to maintain demand but doing so in a way that fits into their longer-term policy agenda with respect to the environment, energy, infrastructure development and the like.

Some may succeed. But it is difficult to reconcile either of these objectives – demand support or long-run development – with the single most striking uniformity found in many countries: subsidization of the auto sector. Canada, the United States, Germany, Brazil and Russia are all in different ways playing this game. One wonders how, or if, this marked concentration of effort fits in with longer-range energy and environmental concerns.

Another noticeable difference is seen between countries like the United States, where the principal emphasis at least initially was on the financial crisis, and most other countries where the main concern has been what might be called the real crisis: the drying up of world credit markets that has increasingly impacted on export trade and business finance more generally and resulted in rising unemployment.

It is no surprise that countries more integrated into the world economy were affected both most quickly and most deeply. It is also no surprise that countries in which financial markets are most important are those that have spent most time and effort thinking about how to revise financial regulation.
In view of the problems that have arisen in state-owned financial institutions in countries such as Germany and Spain, however, it is odd that many countries are contemplating yet more state intervention in private financial markets as a way of avoiding future problems.

Strikingly, although some elements of nationalism and protectionism are evident almost everywhere, the strongest anti-globalization reactions seem to have occurred in some countries that were less ‘globalized.’ Among the developing countries, Mexico stands out as one that appears to think that the best reaction to the global crisis is not to withdraw from interaction with the rest of the world but to strengthen its internal market institutions and to re-engage actively in reviving the world economy. Others, like India, appear to view this prospect with more foreboding.

Federations are of course different from other countries: they are federal. In principle, regional and perhaps even local governments may have more freedom to act independently than do their counterparts in unitary countries. In practice, how different federations have reacted to this financial crisis depends on just how their federal institutions function.
Governments delegate stimulus to regions, cities
For example, one possible test of federalism is the extent to which ‘stimulus’ spending by the federal government is carried out by regional and local governments. If this is the test, then most countries considered here have passed.

Federal governments often decide what general types of projects they fund for regions and cities. But this poses another test for federalism: whether the federal government seizes its expanded financing role to get its way in directing how, when, and where the funds are spent. By doing so during the crisis, a number of federal governments have failed the second test..
Most countries have reacted to the crisis mainly at the central level. Although regional and local governments often play a critical role in implementing central spending plans, in most countries they have been given little leeway on what to do or how to do it. What Alan Greenblatt calls “golden rule federalism” – whoever has the gold makes the rules – seems to prevail in most federations.

In a small way, then, one result may be, as in the much more serious Great Depression of the 1930s, increased centralization even in the most “federal” of federations. The question raised by the crisis may be not so much “whither federalism?” as “wither federalism?”

This question is perhaps particularly relevant with respect to the case of the European Union discussed by David Gow. Will the crisis move the EU towards or away from becoming more federal in character? Preliminary indications are that, if anything, the net effect may be to reinforce the key role played by the central governments of EU member states.

In most federations, however, the crisis seems unlikely to have much long-term effect. In most, the response has been ‘business as usual.’ In a few countries – as Mike Steketee illustrates for New South Wales in Australia and Rodrigo Amaral for Castile y León in Spain – this means that regional governments have attempted to play an activist role.

Canada stands out in this respect. Canadian provinces have both major spending roles and important taxing powers. They also have full and free access to capital markets and no formal constraints on their borrowing. Provinces are not only participating in federal stimulus programs but also doing some stimulating of their own. Most notably, hard-hit Ontario, home of most of Canada’s automobile industry, has added over $3 billion of its own funds to the federal government’s $10 billion or so to support the sector.
Even if one may question the wisdom of this decision, Canada’s central government and its provincial governments are on the whole working together to counteract the downturn. As Alain Dubuc shows, however, this really is ‘business as usual’ in Canada.

Desperate tax hikes
Elsewhere, regional and local governments have little direct access to large tax bases. Indeed, most are adding to the crisis-induced contraction of the real economy by reducing expenditures and even raising taxes in a desperate attempt to maintain budgetary balance.

While particularly noticeable in the United States, where most states are constitutionally required to have balanced budgets, similar actions are visible elsewhere as Ismail Bermúdez illustrates for Argentina and Alexander Deryugin for Russia.

Such adverse effects from region and local actions may be offset when central governments provide access to transfers and subsidized credit as many countries have done. It clearly makes sense to prevent regional and local expenditure reductions or tax increases, which would only serve to harm economies when they are at their most vulnerable. But there may be undesirable long-term consequences for federalism if central intervention goes too far. Forum of Federations logo

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Richard M. Bird

 

 

 

 

 

Our consulting editor for this special issue on the economic crisis in federal countries is prominent Canadian economist Richard M. Bird. After teaching at Harvard, the University of Toronto, and Georgia State University, he is now Professor Emeritus and Associate of the University of Toronto’s Rotman School of Management.

Over his lengthy career, he has served with the International Monetary Fund and taught in Australia, India, Japan, the Netherlands, and the United States. In this introduction, Professor Bird helps us understand the ways federal countries have responded to the economic crisis.