Learning from the Swiss experience, this article argues that federalism and direct democracy are effective mechanisms for dealing with the diversity of interests, languages, cultures and religions in Europe. These institutions only partly harmonize economic, social and cultural politics. By far more important is that federalism and referenda foster competition between the various interests, but do so within a well-defined basic constitutional design so that competition produces beneficial effects. Federalism is not an alternative to referenda but rather a prerequisite for the effective working of a direct democracy. In small communities, the information cost of voters deciding on issues or judging representatives' performance are much lower than in a large jurisdiction. The more fiscal equivalence is guaranteed, the better the benefits of publicly supplied goods can be acknowledged and the corresponding costs be attributed to the relevant political programmes or actors. Thus, while federalism provides for cheaper information, referenda enable citizens to use this knowledge effectively in the political process. The interdependence of federalism and referenda also works the other way around: referenda improve the working of federalism. Besides the possibility of voting with their feet, citizens may also vote directly. This represents a double incentive for politicians to take their citizens' preferences into account; otherwise, they may lose their tax base to another jurisdiction or may be forced by referenda and initiatives to meet the demands of the voters.