Brexit and Economic Competition

New British Prime Minister Theresa May and her Conservative Party cabinet will soon begin the difficult task of managing Brexit. The immediate financial market panic is behind us, and now that the dust has settled, policymakers in the United States and around the world should look ahead to the long-term implications of the United Kingdom’s separation from the European Union. The good news is that a carefully considered Brexit—one guided by the lessons of economic history—can be a significant positive both for the United Kingdom and Europe.

Trade and mobility of capital, labor, and ideas have increased dramatically over the past few decades, especially in Europe. But even more widely, the emergence of English as the primary language of trade; advances in the Internet, education, and health care; and myriad other developments have made Berlin, Hong Kong, and London closer substitutes for one another for today’s firms and workers than Boston, New York, and Philadelphia were a hundred years ago.

The flatter world has made necessary supranational organizations such as the EU, and economic theory has a lot to say about how they should function. Our view, as we first outlined in a 2012 paper that we coauthored with Matthew Jensen of the American Enterprise Institute, is that such bodies can play an enormously positive role in the evolution of the world economy. In practice, however, they haven’t achieved all of their promise, primarily because those bodies have yet to fully understand the role they need to play in the interconnected world. The key insight harkens back to a dusty economics seminar room in the early 1950s, when University of Michigan graduate student Charles Tiebout purportedly made a joke that ended up revolutionizing economics and economic policy.

The presentation that day was by Harvard economist Richard Musgrave, who was discussing the emerging body of research on how market economies work. If we take a typical private good, say, an apple, we don’t have to worry that society will not produce enough of them. If people love apples, they will pay dearly for them, and suppliers will be willing to produce more. The problem with governments, Musgrave remarked, was that they produce public goods such as, say, parks. But public goods come with a free rider problem. Citizens might not bother to invest their own funds in a nice park, hoping that everybody else will fund it instead. In this case, nothing guarantees that governments will produce the right amount of public goods.

At that moment, Tiebout, according to recollections, said that governments could be driven to efficient behavior if people can move. A big wasteful place to live that neighbors a utopian dream should lose citizens. In the end, a feckless government that can’t compete for citizens with other governments disappears, just as an inefficient firm is driven from markets by another that can offer better products at a lower price.

This observation, which Tiebout developed fully in a landmark paper published in 1956, led to an explosion of work by economists, much of it focusing on the impact of the competition among local governments in the United States. This body of research is large and contains a diversity of conclusions, but there are many bits of evidence that confirm the important beneficial effects that can emerge when governments compete. Perhaps the most notable episode was the twentieth-century wave of immigration from the southern United States to the north in response to horrifying discriminatory policies. School quality, the provision of public services such as security, and low taxes have also been shown to have an impact on location decisions.

A flatter world should make the competition among national governments increasingly like the competition among smaller communities. Such competition can provide the world’s citizens with an insurance policy against the out-of-control growth of massive and inefficient bureaucracies. In this world, supranational organizations such as the EU can play a vital role. Just as the United States is so much better off today because those being discriminated against in the south could move, Europeans confronted with undesirable economic or social policies can, because of the common labor market, simply move to a better country. In time, even the threat of such movement should provide a positive force constraining the growth of European leviathans; countries worried about losing citizens should reform.

That’s the theory. But, as Brexit indicates, the EU has not successfully focused solely on the potentially positive role it could play. Indeed, as often as not, one can view the actions of the EU government as being an attempt to form a cartel to harmonize policies across member states, and standing in the way of, rather than advancing, competition. The EU has a simple job to do: help Tiebout competition. Instead, it has flexed its regulatory muscles almost without bound, festooning states with large regulatory costs with sometimes questionable benefits. These stretch from the energy sector, to labor markets, to the absurd. The EU even recently passed regulations that sharply reduced the power of vacuum cleaners, setting off a run on the devices. Put it all together, and you get a Brexit.

Given the complex history of Europe’s nation states, it seems likely that an EU that acts as a competition-stifling cartel will grow increasingly unpopular, and more countries will leave it. The initial harsh—even threatening—reactions to Brexit by European Commission President Jean-Claude Juncker and German Chancellor Angela Merkel suggested an out-of-control centralized authority protecting its sweeping powers. Yet it should be relatively easy to manage free and open trade with the United Kingdom, just as EU members do with many other countries. So why the threats? Citizens of European democracies will increasingly (and, in this case, rightly) feel that they have lost their autonomy if they are held together by coercion. If the EU instead focuses on maximizing mobility and enhancing the competition among states, allowing the countries to compete on regulation, taxation, and in other policy areas, then the union will become a populist’s dream and the best economic friend of its citizens.

In the meantime, the United Kingdom can serve both its own objectives and foster the long-run health of the world economy if it aggressively competes with the EU. British policymakers can study EU policies, identify those that are most unfriendly to economic activity, and lure investors and workers with the promise of superior ones: reformed taxes, better infrastructure, and more sensible government regulations. Such polices will force the EU to roll back its own anti-competitive rules and become the positive force that it could be. When this policy tit-for-tat does happen, Tiebout, who died in 1968, will be somewhere smiling, as will investors everywhere.