TCS Daily

Hail Sovereignty

By Pavel Kohout - February 10, 2005 12:00 AM

The word "sovereignty" is a twisted one, and so is the general understanding of it. It made its first appearance in medieval Latin in late 13th century as "supremitas". Its original form in classical Latin was "suprema potestas" -- supreme power. This power was exercised by the prince -- sovereign, or, as the medieval Latin would put it, the superanus.

With the arrival of democracy, supreme power passed into the hands of the people. However, for practical reasons, power must be delegated to a representative. This leads to a conflict. The interests of voters, owners of power, may not necessarily be identical with those of their representatives. It is the classical economic problem of the principal-agent relationship, which was first systematically described by the economist Stephen Ross in 1973.

The manager (agent) hired to run a firm usually has a different objective in mind than the firm's owner (principal). The manager's goal is to maximize sales, and thus boost his power, prestige and salary. Similarly, public servants -- the administrators of sovereignty -- are motivated to maximize the income of the government, hence also their own wages. This is not merely a problem of the so-called "democratic deficit". The principal-agent conflict occurs regardless of whether the agent is elected or appointed. There is a substantial difference between the sovereignty of citizens and that of the public servants.

It would be unfair to say that the EU is only advantageous for its officials. Its measures promoting the freedom of individual citizens are certainly good. Free movement of persons, goods, services and capital increases the power -- "sovereignty" -- of individuals. The same applies to the euro: the common currency facilitates business, investment and travel. But all the various support programs, action plans, commissions and regulations boost the power of bureaucrats at the expense of citizens. The European constitution, complex to the point of being unreadable, is another step in this direction. European public servants are exposed to an immense temptation to abuse the entrusted power for their own benefit. Their methods of persuasion sound like those of hucksters: "You don't have to read the Treaty; the legal language is too complex for you to understand, anyway; so just say yes, it's for your own good... Don't ask what happens if the Treaty would not be approved."

Are European integrators wrong in saying that the progress towards an ever closer union is necessary and good? Yes, they are. In The Size of Nations, the economists Alberto Alesina and Enrico Spolaore analyze the relation between size of a nation and its prosperity. The emphasis on large territory and population made sense at times when national economies were separated by customs and administrative barriers. Under those circumstances, economies of scale could actually emerge at the national level. Companies operating in a large nation could, for instance, benefit from a larger market. Colonial empires made sense as free trade zones.

In the situation of open economies, a large nation is no longer necessary. "Small countries may prosper in a world of free trade, whereas under trade restrictions the size does matter," say Alesina and Spolaore. The arguments of euro-federalists are based on the ideas of 19th century, with its high tariffs and other sorts of barriers. The imperial ambitions of the powers of that time had some economic justification. Today, they are no longer valid. Who needs a colonial empire now?

Another economic argument against European federalization lies in the following question: Why has the vision of total monopolization of industry and banking, which was popular in the late 19th century, never become reality? Vladimir Ilyich Lenin had a vision of a world where all banks would merge into one monopoly and all industrial corporations would merge into one giant conglomerate. Communist countries tried to create such monopolies artificially. They proved not to be viable. Not lack of democracy, but failure of the hyper-merger Communist frenzy caused the decline and fall of the Soviet bloc. Lenin hugely overestimated the benefits of post-merger synergies and underestimated the insurmountable obstacles associated with running the national economy as a single corporation.

A strong economy is composed of many independent entities. Europe has become powerful over the centuries because of competition of sovereign states. The experience of mergers in modern capitalist economies also teaches us that big is not always beautiful. Management structures in merged corporations tend to be duplicated, important information get lost in noise, powers and responsibilities are poorly divided. Salaries and bonuses are no longer directly linked to performance. Who can say this doesn't happen in the European Union? There are whole industries and regions that get paid for underperformance. This is called cohesion and many European public servants are handsomely paid for running cohesion programs.

Too many mergers eventually leads to financial losses, often ending up in a "divorce". A Business Week study covering the period from 1995 to 2001, concludes: "Fully 61% of buyers destroyed their own shareholders' wealth. A year after their deals, the losers' average return was 25 percentage points below their industry peers'. The gains of the winning minority couldn't make up for the buyers' losses: The average return for all buyers was 4.3% below their peers and 9.2% below the S&P 500. (...) Managers sometimes bought a pig in a poke - not fully understanding what they were getting. Often, they envisioned grand synergies that proved illusory or unworkable. They underestimated the costs and logistical nightmares of consolidating the operations of companies with very different cultures. They overestimated cost savings and failed to keep key employees aboard, sales forces selling, and customers happy."

In other words, these poor results are due to the megalomania of managers, which is comparable to the passion for grandeur of European politicians.

Why does Europe have almost 10,000 banks anyway? That's easy: only about a third of bank mergers or acquisitions are successful. "The more sizeable a bank, the less chance there is of achieving cost-saving," says G√ľnther Tichy, professor of finance from Vienna. For each bank (and state), there is an optimal size -- a threshold which is not worth exceeding. If European integration exceeds a critical point, Europeans will pay dearly. Excessive size brings complexity, high costs and inability to compete with smaller independent entities. This applies to any organization, including the European Union.

European federalism is an ideology of the 19th century, such as colonial ambitions of European powers or Lenin's hypothesis of inevitable monopolization and centralization. It has long been proved false in both theory and practice. It is a paradox that many Europeans still consider the ideology of centralism "modern" in its recent Eurofederalist disguise.

The author is an associate of the Center for Economics and Politics (CEP), Prague.



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