Market Mechanisms For Policy Decisions

MARKET MECHANISMS FOR POLICY DECISIONS. Tools for the European Union.

Alessandra Casella* Columbia University, GREQAM, NBER and CEPR

October 2000

Abstract The success of an enlarged European Union will require transparent and subtle mechanisms for policy coordination. A common policy is a public good, and economists have developed many schemes for the efficient provision of public goods.The European Union offers a promising soil for such schemes, but they must be simple and tailored to its specific needs. The paper discusses two possible examples: a system of tradable deficit permits implementing the fiscal constraints of the Maastricht treaty; and a rule allowing country representatives to shift their own votes intertemporally when deliberations are taken in periodic committeemeetings.

JEL Nos: F33,H41,P16 Keywords: European Union, policy coordination, Stability Pact, voting.

* Department of Economics, Columbia University, New York NY 10027, USA. Email: ac186@columbia.edu Tel: 1 212 8542459 Fax: 1 212 8548059

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The author thanks the NSF for financial support, through grant #SBR-9709237. INTRODUCTION

The European Union exists to coordinate the policiesof its member states. Devising a coherent, common policy for a number of independent and diverse countries is a difficult matter, and will become more difficult still when the Union proceeds with the planned enlargement of its membership. The question of how best to achieve this coordination will remain the underlying thread behind the more specific debates facing the European Union. The thesis ofthis paper is that inspiration for more innovative and efficient answers can come from market games, the mechanisms studied by economists to induce optimal provision of public goods. The observation is not very surprising. A common policy is a public good: as in the traditional example of national defense, an economic policy decision is identical for all regions and all individuals subject to it -think of the common interest rate and money supply in a monetary union, of common external tariffs in a custom union, of the common ceiling on fiscal deficits in the Pact for Stability and Growth. At the same time, not all regions and individuals are affected by the policy in the same manner or benefit from it equally. Thus in general a common policy is a public good shared by economic agentswith heterogenous preferences. How to choose and finance such a public good in the most efficient fashion is a classical problem in economics, and economists have developed a large number of plausible market mechanisms that aim at eliciting truthful preferences and implementing the correct public good supply. The challenge then is to identify among the existing proposals those that could be tailoredto the selection of macro policy in the European Union and realistically implemented.1 The first part of this paper describes briefly one such possible application: the efficient implementation of the fiscal limits established by the Pact for Stability and Growth through a system of

From the original Clarke and Groves schemes, a multitude of applications and variants have developed. Ofparticular simplicity (and interest in our context) are market mechanisms for public goods provision in environment of complete information (for example, Bagnoli and Lippman (1989), Moore and Repullo (1988), Moore (1992), Varian (1994)).

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2 tradable deficit permits. Inspired by the markets for environmental permits, the proposal suggests exploiting the incentives created by the possibility oftrade to achieve fiscal discipline at minimum cost. Given the basic idea, the exact design of the scheme must take into account the specific features of the problem on hand, but with enough care and imagination it seems possible to address the concerns that the system may raise. Market-based mechanisms have three main advantages over administrative rules: they rely on the creation of correct...