Year LXVII, 2025, Single Issue, Page 39
FEDERALISM AND ECONOMIC DEVELOPMENT:
A THEORETICAL PERSPECTIVE
Introduction.
Federalism refers to an institutional system in which powers, fiscal resources and responsibilities are distributed in a stable and rational manner between the central level and lower levels of government. The term does not imply a single possible model, but rather allows for multiple interpretations of how, and the extent to which, public functions should be centralised. In this article, I analyse what I consider to be the key economic theories of federalism—those proposed by Musgrave, Oates and Tiebout—in order to show how, albeit with varying theoretical nuances, they all converge on the need for a form of federalism. I also discuss the potential economic benefits of a fully-fledged European federation.
The Economic Benefits of Federalism.
European federalism refers to an institutional system in which the European Union—endowed with autonomous fiscal powers, independent and centralised spending capacity, and tools for macroeconomic stabilisation—does not merely coordinate the activities of different states, but exercises actual functions of government at supranational level. Unlike simple intergovernmentalism, it frames Europe as a truly autonomous level of government, in accordance with the principle of subsidiarity.
The idea of a European federation is more than a mere ideological position; it is supported by rational economic arguments grounded in the potential benefits it offers.
The aim enshrined in the 1957 Treaty of Rome was to establish a single European market for goods, services, capital and people. Trade liberalisation between member states offers several advantages: access to better-quality—and potentially less expensive—goods, a more skilled workforce, and more efficient investment opportunities. Over time, the European Union has achieved significant progress in this area, even in the absence of a true federation.
In establishing a true single market, however, the issue of a single currency must necessarily be addressed. Any economic operator within a market naturally seeks to maximise gain while minimising potential risks. But it must be acknowledged that some degree of risk is inevitable: one might, for example, purchase goods that prove to be defective, or invest in a business that goes on to yield poor returns. Such risks are an inherent part of entrepreneurial activity, and cannot be eliminated. In the context of international trade, additional uncertainties arise, such as exchange rate risk. Purchasing or selling in a foreign currency involves conversion costs and exposure to potential fluctuations in exchange rates.
Prior to the introduction of the euro, this was a very real risk, with fluctuating exchange rates capable of undermining the value of contracts that had already been signed. If, for example, I signed a contract to buy German sweets at 2,000 Italian lire per unit in January, when the exchange rate was 2,000 lire=1 German mark, a sudden devaluation in February (1 mark=3000 lire) would increase by 50 per cent the actual cost of the goods I was importing.
The creation of the euro eliminated these risks for transactions within the eurozone, reducing costs associated with currency fluctuations and giving businesses and investors greater stability.
One of the main economic benefits of a federation is its ability to stabilise the economy. States have two fundamental tools at their disposal to counter temporary crises: monetary policy, carried out via open market operations and interest rate adjustments, and fiscal policy, implemented through transfers and targeted public spending measures. Accordingly, the eurozone member states, in delegating responsibility for monetary policy to the European Central Bank (ECB), surrendered an important short-term intervention tool. Moreover, although the ECB is able to respond effectively to common shocks, it struggles more when addressing crises affecting only specific areas of the Union. Indeed, although tools such as selective reinvestment of government bonds in asset purchase programmes can make monetary policy more targeted, they carry significant limitations. In the absence of a well-targeted monetary response, fiscal policy can help to fill the gap, providing temporary resources for areas affected by asymmetric shocks. However, the European Union possesses no true centralised fiscal capacity. Its budget is limited in size and still largely funded through national contributions, and it lacks complete fiscal autonomy. Furthermore, the EU also lacks stable borrowing capacity—one of the tools most commonly used by states to respond to economic shocks.
An exception to this lack of centralised borrowing capacity occurred during the COVID-19 pandemic, when the EU introduced its NextGenerationEU package (NGEU), funded by European debt. This exceptional mechanism, approved unanimously by the member states, highlighted the possibilities but also the limitations associated with borrowing in the absence of a solid and permanent fiscal foundation. According to a report by the think tank Bruegel, the markets treated the bonds issued under the NGEU in the same way as they do those issued by supranational entities such as the International Monetary Fund, rather than equating them with national government bonds.1 As a result, these bonds carried higher yields, reflecting a greater perceived risk. At this point, it is reasonable to assume that, all else being equal, debt issued by a European federation—likely to be perceived as safer—would be less expensive. After all, like a state facing bankruptcy, a European federation, to repay its debts, would have the ability to raise emergency taxes. The European Union, on the other hand, does not have this ability, and although any debt it issues is ultimately guaranteed by the member states, markets do not consider this guarantee sufficient to justify lower interest rates.
Another crucial aspect to consider is the ability of a federation to address issues that reach beyond national borders. Let us consider the case of two neighbouring countries separated by a river polluted by both of them. If one country unilaterally decided to bear the cost of the clean-up, this would naturally result in inefficiency, as the other would benefit without contributing. A federal government with authority over both countries would instead be able to manage this issue centrally, ensure equitable distribution of the costs, and eliminate the risk of opportunistic behaviour arising from positive externalities.
Environmental policies, such as those aimed at reducing CO2 emissions, illustrate this point in real-world terms. If, for example, Italy were the only country to adopt restrictive measures, the whole of Europe would benefit, while the costs would be borne solely by Italian taxpayers. In such cases, centralised management of environmental policy at European level would be not only fairer but also more effective.
Theories of Economic Federalism.
Reading the first part of this article, some might observe that a fundamental aspect appears to have been overlooked: the possibility of reducing territorial inequalities through transfers between more and less developed areas. This is a key point in many theories of economic federalism. The following is a summary of the ones I consider most significant, together with the key differences between them.
American economist Richard Musgrave identifies three basic functions of the public sector: allocation, redistribution and stabilisation.2 Allocation is concerned with the delivery of public goods and services such as healthcare, education, security and transport; redistribution aims to correct imbalances in the distribution of wealth, through subsidies or pensions, for example; and stabilisation—through interventions in the event of crises and recessions—aims to keep the economy steady. According to Musgrave, redistribution and stabilisation require the presence of a central level of government, as local governments lack the necessary tools, and risk losing sources of tax revenue if they aim to redistribute too much: a state applying high levels of taxation might, for example, find that its richest citizens prefer to emigrate to countries with lower taxes. Although Musgrave does not refer directly to “federalism”, his vision is clearly aligned with a federal model. Wallace Oates, another American economist, starts from Musgrave’s ideas to formulate his decentralisation theorem, according to which every public function should be assigned to the lowest level of government capable of carrying it out effectively.3
Decentralisation works in the presence of certain conditions. First of all, when the local community has heterogeneous preferences: some citizens, for example, might prefer lower taxes and less in the way of services, while others are willing to accept higher taxes for better services; second, when externalities are limited (consider the earlier case of the river between two states); third, when economies of scale are preserved, in such a way that smaller-scale expenditure does not lead to inefficiencies.
Like Musgrave, Oates thinks that redistribution and stabilisation require central coordination. Instead, a third US economist, Charles Tiebout, offers a different vision. In his federal model, competition between jurisdictions promotes efficiency because citizens, behaving like market consumers, choose where to live on the basis of the tax-services ratio offered.4 This mechanism, whereby people ‘vote with their feet’, incentivises local governments to be more responsible and more responsive to citizens’ needs. A simple hypothesis might clarify this: were Italy to embrace purely left-leaning policies, and France only more right-wing ones, citizens could freely choose to reside in the country that best caters to their inclinations.
Essentially, we can say that the first two federal frameworks favour a more solidaristic approach, and the third a more individualistic one, or that the first two allow more room for public intervention, whereas the third values competition and a laissez-faire philosophy. Naturally, both perspectives have their limitations. While overly structural redistribution risks creating moral hazard (discouraging less competitive states from modernising and adapting their development models), completely ignoring the issue of territorial inequalities means forgoing a tool for income redistribution.
That said, both interpretations rest on the existence of a solid federal institutional framework, and both are compatible with a project for a federal Europe. What divides them, if anything, is the further step (centralised redistribution) proposed by the first.
This is precisely why I consider it strategic, in both political and cultural debate, to focus on what unites us—not just us as federalists, but also us in the broader sense of the general public.
To concentrate on disagreements over issues that must be considered secondary to the question of the institutional framework—to the point of being prevented from seizing the opportunity to build a federal Europe—would amount to a failure for us all. Our focus, instead, must be the fundamental areas capable of driving further economic and social development, namely the single market, a full monetary union including all EU member states, and a strong economy able to withstand crises.
Our goal must be to build the broadest consensus possible—something that becomes far more difficult when focusing on deeply divisive positions. The good news for those more concerned with issues beyond the scope of the debate on Europe’s institutional framework is that, once the federation is established, there will be a parliament where these issues can be freely debated. Until then, we must concentrate on what unites us.
Conclusion.
Greater institutional integration may be seen as not just a political ideal, but also an economically rational and strategic choice. The theories of Musgrave, Oates and Tiebout offer different perspectives, but converge on the need for a functional division of competences between different levels of government. In a setting like Europe, characterised by economic interdependence, global challenges and asymmetric crises, the current intergovernmental system is looking increasingly inadequate.
A federal Europe, endowed with independent fiscal powers and a genuine macroeconomic stabilisation capacity, could strengthen the internal market, reduce systemic inefficiencies, tackle common challenges such as the green transition, and boost the EU’s overall resilience. It is not about standardising everything, rather about guaranteeing that functions requiring coordination are managed at federal level, while decisions that more directly impact citizens continue to be taken at local level.
In pursuing our federalist goals, we must take into account our own internal divisions within the context of the European political framework, as well as the divisions present in public opinion. We need to concentrate on the question of Europe’s institutional framework, as this is the area where it will be easier to overcome party-based divisions and build consensus.
Stefano Chiesa
1 Grégory Claeys, Conor McCaffrey and Lennard Welslau, The rising cost of European Union borrowing and what to do about it, Bruegel Policy Brief 12/23, Bruegel (May 2023), https://www.bruegel.org/policy-brief/rising-cost-european-union-borrowing-and-what-do-about-it.
2 Richard A. Musgrave, The Theory of Public Finance: A Study in Public Economy, New York, McGraw-Hill, 1959.
3 Wallace E. Oates, Fiscal Federalism. New York, Harcourt Brace Jovanovich, 1972.
4 Charles M. Tiebout, A Pure Theory of Local Expenditures, Journal of Political Economy, 64, n. 5 (1956).
