The world is getting smaller. The Internet, cheap transportation, the spread of free and open markets, and surging education of the masses are steadily eroding the last vestiges of economic autarchy. This increased integration presents a fundamental practical challenge to the sovereignty of nations. Policies that are possible in an isolated island state can be impossible in our new and mostly democratic world of nomadic capitalists. This metamorphosis has created heightened demand for international cooperation, a demand that has been the midwife to the birth of organizations that are rapidly becoming a haphazard world government. At the birth of the United States, Alexander Hamilton wondered whether men "are forever destined to depend for their political constitutions on accident and force." Today, it is not reason, but accident and force that are carving the contours of the global political environment. The feckless and corrupt actions of the United Nations in recent years provide a case study in how harmful attempts at world government can be when they go wrong. It is necessary that citizens and leaders of the United States develop a theory of international cooperation that can provide a guide to future global associations. This theory must address several specific questions. What areas of human endeavor are likely to require international cooperation in order to enable efficient outcomes? What types of international organizations should the United States join? When should the United States be willing to partially cede its sovereignty to such bodies?

Two strands of economic research provide a natural starting point for this discussion. First, the public choice literature has examined extensively which services should be offered by local governments and which should be offered by national ones. The extension to world governments is straightforward. Second, specialists in industrial organization have developed a quite broad understanding of the functioning of cartels. Coalitions of countries often face the same challenges that coalitions of firms do. A synthesis of these two literatures provides a valuable guide to the problem of world government.

How Big Should a Country Be?

In one of the great intellectual accomplishments of the 20th century, economists Kenneth Arrow and Gerard Debreu set out the conditions under which a free market could be expected to produce optimal outcomes for individual consumers. Adam Smith's "invisible hand" of the marketplace was shown--under some conditions--to be a firm and steady force that allocates resources optimally. They demonstrated that no reallocation of resources exists that makes everyone better off than does the allocation that arises as a natural equilibrium of a competitive market.

In these Arrow-Debreu efficient markets, there is a very small role for government, which keeps the peace, enforces property rights and does little else. If all markets were Arrow-Debreu perfect markets, governments could be very small indeed. We might have a federal authority that enforced patents across states, established a minimal set of rules, and allowed state governments to provide most government services.

Perhaps the largest contribution of this work, however, was its illumination of the situations under which larger governments and international unions might be necessary. If we identify the assumptions under which markets are perfectly efficient, then we also have learned when they are not and when they can benefit from government action.

Markets can fail when citizens require goods that are public in nature, or when the production of the private goods they desire produces significant externalities. A public good is a good that is consumed by all, without possible exclusion. A textbook example is public safety. There is no reason to believe that individuals, on their own, would voluntarily contribute enough money to a common pool to build an army capable of providing real security. Each individual would be tempted to free ride, that is, to assume that others would provide enough security. Collectively, free-riding can lead to suboptimal provision of public goods. An externality is a slightly different beast. If a steel factory produces pollution that harms agricultural output, then that pollution is an externality. The steel producer, on his own, might ignore the social harm from the pollution and produce far more than is socially optimal, and regulation of pollution by government may improve social welfare.

There are countless examples of public goods that we require and externalities that we must monitor. These provide a rationale for a larger and more aggregate government than would otherwise emerge in a free society. The specific individual characteristics of our desired public goods have a significant impact on the optimal level of geographic aggregation. There is little question, to take an early example, that the desire to create a federal force large enough to fight the British provided a strong impetus for the unification of the states at the Founding. The public good of "safety" required coordination between the individual states at the broadest possible level. To take a more recent example, allowing the social safety net to vary across states might set off a destructive race to the bottom. States that offer relatively more generous welfare benefits might find themselves inundated with migrant paupers. If society views the provision of a safety net as important, policy coordination between the states may be necessary.

In order to provide for services that require a central government, nations have established federal authorities with powers of taxation and enforcement. These powers can lead, over time, to a significant evolution in the focus of the government away from its original design. Elected officials may be tempted to pursue actions, such as subsidizing farm production, that do not necessarily focus on public goods or externalities.

As government's reach evolves, the problem of federalism becomes a tradeoff for those who might choose to join. On the one hand, allowing oneself to be absorbed into a larger whole can increase security and provide access to valuable public goods that smaller entities might not be able to produce. On the other hand, joining the union forces one to harmonize undesirable policies with citizens who may have significantly different tastes for government intrusion. This conflict between coordination and harmonization, as Harvard economist Alberto Alesina has recently demonstrated in several important studies, is the essence of the economic problem of modern government.

The problem was recognized long before Alesina, however. Indeed, a series of works by my colleagues Christopher DeMuth and Michael Greve have documented the debate over these issues that occurred at the birth of our nation. They have argued that our forefathers' preferred design of a federal system allowed for ample competition between the individual states, and free movement of citizens between the states, for a good reason. Should a state pursue policies that are harmful to overall welfare, its citizens could pick up and move to a neighbor.

The federal system set up a competition between states that acted as a natural governor of the growth of harmful government. This political insight was later incorporated into the economic lexicon by economist Charles Tiebout, who demonstrated that "voting with your feet" often leads to efficient provision of government.

As the United States turns its gaze outward to the world community, therefore, it must entertain the possibility that membership in an aggregated global governing body may be necessary in order to ensure that global public goods are adequately provided. But it must weigh the benefit of improved coordination in the provision of these public goods with the potential costs of harmonizing policies with nations that have far different social preferences. And the citizens of the United States should be wary of entering into compacts that limit the beneficial competition that preserves liberty and constrains the growth of inefficient and intrusive government. It is essential, then, that we identify when competition between states leads to better outcomes, and when it does the reverse.

Government or Cartel?

In the classic Arrow-Debreu world, products are produced by countless identical and competitive firms. From the point of view of consumers, the competition is beneficial, since it drives the price of any product down to its cost. From the point of view of the firms, however, the competition is an annoyance, since it limits profits. Accordingly, firms may recognize that an association between all of them might lead to much higher prices. This association is a "cartel", of which OPEC is the leading practical example. From the point of view of the firm, a cartel is a wonderful, profit-enhancing device. From the point of view of the consumer, it is a terrible, price-raising conspiracy.

Economists have learned that cartels can be very unstable entities. If all OPEC countries, for example, agree to reduce their output sharply and drive the price of oil up to $80 per barrel, then the enterprising country that cheats and produces more than its quota can reap tremendous financial benefits. Accordingly, mechanisms for enforcing cartel discipline are important for ensuring cartel survival.

In the early days of cartels, discipline was often imposed by agglomeration. The German chemical firm I.G. Farben was formed in 1925 when the eight members of a chemical cartel decided it was easier to merge. When agglomeration is impossible, as happened after anti-cartel legislation was passed in most Western nations, a precondition for success has often been the existence of a clearly dominant member. For example, many observers believe OPEC has remained successful because Saudi Arabia has such a large share of proven world oil reserves that it can alter the world price of oil with its own behavior when it so chooses.

For governments, international bodies serve the same role as the cartel. They allow countries to establish rules that harmonize government actions and eliminate competition. From the point of view of the citizens of these nations, however, a key question arises: When governments form a cartel, should a citizen think of himself as a member of that cartel or as a consumer of the product produced by it?

The answer depends on whether the competition between states in the instance cited can be expected to lead to a better or worse outcome for the individual. In terms of the provision of public goods and coordination of externalities--the key economic rationales for government--the question clearly depends on the scale of the public good or externality in question. Nations can compete over the provision of public goods that are efficiently produced at the national level. If a particular country's government establishes a wonderful environment filled with efficient public infrastructure, then activity will migrate to that country to the detriment of those with wasteful governments.

If, on the other hand, nations compete over goods that are more efficiently produced at the global level, then competition can be harmful. For example, if states do not agree universally to forego the use of ozone-destroying chlorofluorocarbons, then the reduction in demand by the "virtuous" states may drive the price of CFCs down, increasing demand in states that ignore the ban. Progress at the global level may well require global cooperation.

There is another factor that must be considered. Provision of government at the local level requires taxation. In an isolated nation, with no factor mobility, it is easy for the government to tax labor, capital or both. When these factors can move freely between countries, then the power to tax is undermined and sometimes eliminated. Today, capital is highly mobile between countries, and this has set off a raging tax competition. The biggest mover in this contest has been Ireland, which began lowering its corporate tax rate from 50 percent in the late 1980s to the current rate of 12.5 percent and has experienced remarkable and persistent economic growth, as tax-dodging capital from around the world flowed across its borders. Subsequently, many other nations (most recently Greece) have sought to copy the Irish example. Clearly, as my colleague Eric Engen and I noted in a recent article in Tax Notes, the world may be headed for an equilibrium with a zero capital tax.

However, tax competition need not erase the ability to tax altogether. First, countries can always tax immobile factors such as land. Second, mobile individuals might voluntarily expose themselves to taxation if valuable government services are bundled with it. Indeed, individuals are likely more sensitive to the quality of public goods (parks, schools, clean air) than is capital. Accordingly, taxes on labor will not necessarily be eliminated by global tax competition, even as the homogenization of cultures, language and low cost of travel makes migration more common. If a country offers a good mix of public goods and taxes, laborers will choose to work there, just as many Americans voluntarily move to high-tax suburbs. If it does not, they will move to a country that does.

The one big exception to this rule is clearly redistributive tax policy. While wealthy individuals may have a higher demand for generous public services (witness the quality of public schools in rich suburban communities), they may often be unwilling to acquiesce to redistributive taxes that are high relative to the other benefits offered by government. Even the most social-justice loving of millionaires will be tempted to move when the personal tax costs of existing government policies are higher than the perceived benefits.

Oppressive regulation may also lead countries to seek the protection of a cartel, but the philosophical attachment of leaders to inefficient regulatory schemes could well be weaker than their attachment to redistribution. The one exception to this may be regulations that in effect redistribute wealth, such as extravagant labor laws or agricultural subsidies. If one bundles these into the category of redistribution, then it seems safe to say that cartels formed by the world's governments to prevent competition will likely do so to protect redistribution.

Germany and France, for example, have social welfare states that put a heavy burden on all of their revenue raising devices. Tax competition from countries like Ireland reduces their ability to rely on capital taxes, making their spending plans difficult to finance. The problem is not that paupers move to these countries. Rather, it is that those with the financial wherewithal to finance the democratic socialists' objectives are moving away, literally and figuratively. Similarly, heavy labor-market regulation has made unemployment high throughout most of Europe and has led to higher emigration. This impact of policy on mobility is becoming visible in the data, a sign that competition may be heating up in many areas. And multinationals are not the only mobile players in the game. If one plots net migration patterns in OECD countries against the Heritage Foundation's index of economic freedom, for example, one can see a clear and statistically significant tendency for individuals to move toward countries with more freedom.

In response to these and other factors, Germany and France have attempted to force fellow members in the EU to harmonize tax and regulatory policy in their direction. So far they have failed on taxes. The benefits to deviating from the harmonized policy, as Ireland has demonstrated, are too rich to ignore. But many regulations have successfully been harmonized by the EU, and passed on to new members as well, despite the fact that the rigidities associated with EU regulations are likely harmful to economic growth. Central European countries such as Poland clearly determined that harmonization across the broad range of government policies required by the EU was a cost worth paying, given the many benefits of membership. And the ability to force some harmonization has clearly removed some of the pressure for change in Germany and France.

This pattern of bundling positive benefits of international cooperation with cartel-driven barriers to international competition is the most troublesome development in world governance. Indeed, one recent study co-written by Alesina was able to "confirm that the extent and the intensity of policymaking by the EU have increased sharply over the last 30 years . . . . In recent years the areas that have expanded most are quite remote from the EEC's original mission . . . ." But it is likely that much of the morass that is EU regulation would have a difficult time withstanding the competition between nations if the EU were unable to tether its regulations to other attractions of membership, such as free trade, that have large pecuniary benefits associated with them.

Sovereignty and World Government

There are two main motivations for government cartels. The first is the desire to achieve some global public good, such as protecting the ozone layer from CFCs, and the second is to eliminate competition that especially undermines income redistribution. From the perspective of the United States, the challenge of global government is to focus on the provision of necessary public goods, but not to create powerful agencies that can, like the EU, turn into effective international cartels that undermine beneficial competition between nations. Until the United States decides that necessary social welfare objectives are being threatened by competition between states, it should only be willing to form very narrow policy cartels with very little real authority over members.

When an issue emerges that requires action at a global level, our nation should not seek to address that issue with an existing agency. To the extent that the global action is valuable, folding it into the purview of, say, the United Nations will only increase the leverage that the agency will have in the future to impose harmful policy coordination. Rather, the United States should take advantage of the fact that since it is such a large country, it can effectively create new cartels with just a few partners. The United States should adopt the rule that any new international objective to require policy coordination between nations should necessitate the creation of a new agency with a charter that limits its activities to that specific issue.

An opponent of this policy might argue that such limited organizations may be unable to discipline their members without having available "clubs" such as trade sanctions. But just as a clean park can improve a community, global public goods significant enough to motivate coordination should be desirable enough on their own that they encourage nations to participate in their provision. Should rogue states misbehave, individual nations can always decide to punish defectors. Existing international bodies have, to say the least, a spotty record of success in this area, and the competition-defeating risks associated with granting these bodies sovereignty over the actions of civilized nations seem far higher than any benefits that might emerge from their strict discipline of rogue nations.

What issues might require increased world government? There are many public goods and externalities that cannot adequately be managed at the national level. Global warming is clearly one possibility (if the science becomes decisive), as is the use of CFCs, the protection of patents, halting the spread of communicable diseases and perhaps the elimination of terrorism. Each of these may require more international cooperation, but if so, it will be because the global objective in that area is worthy in and of itself, and a stand-alone body that does not empower harmful government cartels would be adequate for the task.

An international body with a wide agenda and authority will inevitably be a tempting takeover target for countries with welfare and regulatory states that are so large that they could not prosper under global competition. The best defense against such an outcome is to spread the global authority as thinly as possible. Absent rational design in our global government, we may stumble into a world that poorly provides valuable international public goods because the global agencies pursue both worthy and questionable objectives. As the world becomes smaller, the promise of competition rises, as does the threat of government cartels.

Kevin A. Hassett is a a resident scholar and the director of economic policy studies at AEI.