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What Makes Decisions Legitimate? It Matters for Policy, Markets
The lesson of Brexit and Narendra Modi’s GST victory is that who makes decisions matters just as much, if not more, than the outcome.
The Brexit vote was, in part, a result of growing dissatisfaction with perceived undemocratic and illegitimate decision making. Putting aside whether it was the right or best decision for the British people, a majority of them are clearly unhappy with the level at which decisions are being made on their behalf.
Insofar as people primarily identify as being British rather than European, they want key decisions made in Westminster, not Brussels. Insofar as the European project has been switching group identities away from individual nations to the larger collective, then the project includes an element of nation building. Different generational loyalties have resulted: The younger generation voted overwhelmingly in favor of remaining, and the older in favor of leaving.
The process of nation building has an attendant literature. Aside from the use of violence to create new boundaries, successful nation building has made strenuous efforts to create universal values. The two most common ways to do this have been via a common army and a common school system. Having the same currency and fiscal system may also be seen as essentials, without which grievances can build over imbalances and visible inequalities. For the historical perspective, if I were to choose one book of particular insight, it would be Philip Bobbitts The Shield of Achilles: War, Peace and the Course of History. Bobbitt takes the reader through different historical stages of sovereignty. He also highlights the modern conflict between, on the one hand, the concept of noninterference in another countrys internal affairs (established by the Peace of Westphalia in 1648, ending the horrors of the Thirty Years War) and, on the other hand, the right of a people or nation to self-determination. A nation of people is defined by cultural ties and shared values, tradition and history by collective identities. As identities multiply and become more complex, conflicts can also become more difficult to solve, as we are seeing.
This raises some key questions about the level at which decisions should be made. Some environmental, law enforcement and health issues have strong cross-border externalities. They are not contained by national boundaries, and for the purposes of efficacy and efficiency, they are best dealt with at a multinational or international level. Other matters, such as road maintenance, rubbish collection and school governance, can best be delegated to local governments.
However, to be most implementable and sustainable, decisions also need to be made at a level at which they are considered legitimate. These levels are often, but may not be, the most theoretically efficient.
This fact is well known, even exploited. Sometimes a central government will delegate responsibility over issues with strong cross-boundary externalities down to lower levels precisely to avoid effective implementation. Conversely, strong local governments can delegate responsibility for unpopular measures up to a central government. Though the latter is rarer, a historical example can be found with fiscal policy in Argentina. Politicians first loyalties there have often been at the provincial, not federal, level, and the result has been that provincial governments tend to spend the taxes (thereby creating and feeding political loyalties), the collection of which is delegated to the federal government. The result has been a long history of collective fiscal irresponsibility and sovereign default.
The issue of who should make decisions is becoming more topical. Many decisions are perceived as illegitimate in the West and ineffective in the emerging markets. It was two, seemingly unrelated, news items that prompted me to write on this topic. First was the internal International Monetary Fund report highly critical of the funds support for Greece, going back to the original decision to lend in 2010. The countrys economic program was not sustainable and did not qualify for support. Lending criteria were altered to ensure a loan could be made, and the process of approval was unusually opaque.
The current IMF managing director, Christine Lagarde, has defended the action which was taken under her predecessor, Dominique Strauss-Kahn as being necessary to enable Greece to remain a member of the euro zone. I would argue, and I am not alone, that Greeces remaining in the euro zone in 2010 was not an appropriate objective for the IMF. That was and remains a wider political objective of Greece and its European Union partners but lies outside the technical mandate of the Fund. It could be argued that Greeces staying in the euro zone helped international financial stability a clear IMF objective but not if the program was unsustainable and if lending billions merely put off the inevitable. More important, it is difficult to see how maintaining the status quo of an overvalued exchange rate, which kept Greece in a state of economic depression, was ever going to promote trade, employment, sustainable economic growth or the reduction of poverty. As a political decision of strong interest to other EU members, and not necessarily in the best economic interests of the people of Greece, it should have been made by politicians, not by the supposedly agnostic IMF. By supporting Greece as it has, the IMF has damaged its reputation, and possibly also its financial standing.
The other, hugely positive, news that got me thinking about legitimacy was the approval by Indias upper house, the Rajya Sabha, of the long-awaited constitutional reform allowing a national Goods and Services Tax. The GST allows the creation of a single market in India unhampered, as it is today, by interstate inspections and distortions caused by different state sales taxes. The measure, which the government of Prime Minister Narendra Modi intends to introduce in April 2017, could add 1 to 2 percentage points to GDP. In this vast country, which contains one sixth of the worlds population, the government in New Delhi has won an important victory in its long battle with the subcontinents regional identities.
The moral for the IMF and its political masters, as with the Brexit vote, is that Western elites stray from their mandate at their peril. The moral from India is Churchillian: Democracy may be messy, but it gets the right policy in the end. Who makes decisions matters, not just the outcome.
Jerome Booth is founder and chairman of New Sparta Asset Management, based in London, and the former head of research at Ashmore Investment Management.