Lessons for Europe’s fiscal union from US federalism

C Randall Henning, Martin Kessler

In the last few months, several Vox columns have drawn parallels between Europe today and an emerging – and even less stable – United States in the eighteenth century. This column stresses that Europe’s leaders in search of a fiscal union need not seek to replicate the US experience but they should at least learn from it.

The Eurozone crisis and debate over fiscal reform have led many observers to pray for salvation by a modern, European version of Alexander Hamilton. By this they generally mean someone capable of leading a movement for a robust fiscal union and implementing this vision. (See for example McKinnon 2011.) Europe has instead, they lament, a collection of leaders who are primarily responsive to divergent national electorates rather than engaged in building a pan-European political movement. Consequently, they despair, instead of transforming the fiscal architecture of the monetary union,1 European officials are now dithering over the details of a ‘fiscal compact’,2 which is little more than an uninspiring upgrade of the Stability and Growth Pact.

Balancing the budget

The fiscal compact’s rules on balanced budgets are not necessarily wrong; their appropriateness depends on how they are ultimately designed and implemented. However, the emphasis on the fiscal compact distracts European policymakers from more immediate demands of the Eurozone crisis and is woefully incomplete and badly sequenced with other elements of fiscal and financial integration. In a new paper (Henning and Kessler 2012), we argue that the history of US fiscal federalism from the founding of the republic to the present holds important lessons for the architects of Europe’s fiscal union. Europeans do not want to replicate US experience but learn from it.3

As part of his plan to establish the credibility of the US government as a borrower and build a ‘modern’ financial system, Hamilton famously ‘assumed’ the debt of the states. This federal bailout, which was repeated after the War of 1812, is anathema to present concepts of the fiscal ‘sovereignty’ of the states in the US. But the powers of the federal government grew largely from that decision. After establishing its authority, the federal government shifted to a no-bailout stance in the 1840s, letting several states default. Simultaneously, and subsequently during the nineteenth century, states adopted balanced-budget rules of varying strength on their own accord. Today, all states except Vermont have such a rule inscribed in their law or constitution and, although these rules can leak, state debt accumulation has been relatively limited.

Debt brakes

Balanced-budget rules among the states parallel the effort – adopted at the March 2011 European Council meeting and affirmed at the December 2011 summit4 – to introduce constitutional rules or framework laws, ‘debt brakes’, in the member states of the Eurozone. The fiscal compact agreed at the December 2011 summit specified that members’ annual structural deficits should not exceed 0.5% of nominal GDP, among other things.

Before drawing too heavily on the US experience in concluding that constitutional debt brakes are a key solution to Europe’s debt problems, however, Europeans should consider three essential aspects of the context in which the balanced-budget rules of the American states operate.

First, the US constitutional design is very different from what European leaders envisage for the Eurozone, ie debt brakes that are mandated by the union and enforced by the Commission and the European Court of Justice. The difference is likely to be consequential in two respects. We suspect that local ownership and enforcement make debt brakes more effective than under central mandates, particularly in the context of credible no-bailout norms, and that rules that are centrally mandated are likely to prove to be more brittle than those adopted in a decentralised fashion. When one state violates the rule, as the experience with the Stability and Growth Pact demonstrates, its applicability to other states is less credible. That is less likely to be the case with rules that have been adopted autonomously.

We acknowledge that some of the impetus for debt brakes comes from within Eurozone countries. The present crisis could be sufficiently traumatic and thus politically transformative to produce an autonomous reduction in debt tolerance within some of the most afflicted member states, just as the American states adopted balanced-budget rules autonomously from the federal government in the 19th century. Such an autonomous change in preferences would serve as an omen for the effectiveness of debt brakes. But the strength of the internal shift in debt tolerance is uncertain and is likely to vary significantly among member states.

Second, stabilising the banking system is primarily the responsibility of the federal government in the US. As a consequence, this function did not come into conflict with balanced-budget rules at the state level. In the Eurozone, by contrast, harmonisation of bank regulation is still young and the fiscal costs of bank rescues and recapitalisation remain primarily a national responsibility. The introduction of debt brakes threatens to collide with the need for member states to mount largescale rescues of their banking systems. As such provisions are put in place, therefore, it is all the more important that the Eurozone unifies banking regulation and creates a common pool of fiscal resources for rescuing and recapitalising banks (Posen and Véron 2009, Véron 2011).

Third, US federal debt has been supported by the full system of federal powers, including a sweeping power to tax and the federal budget has helped to stabilise the national economy in a countercyclical fashion since the 1930s. State and local budgets have behaved procyclically during recessions in the US. State-level restrictions would have been difficult or impossible to sustain in the absence of federal countercyclical policy. Although automatic stabilisers might play a greater role in some of the national economies in Europe than in the American states, creating stringent state-level debt brakes in Europe without a capacity for countercyclical stabilisation would be a serious mistake.

The route to fiscal union?

The rules of the fiscal union in the US evolved in a distinct sequence. The federal government first developed a robust fiscal capacity, with the assumption of state debt, issuance of federal debt, and access to its own tax revenue. Once that was established, the states could adopt balanced-budget provisions. By introducing strict balanced-budget rules prior to a robust fiscal union – assuming that some of them harbour ambitions for such a union – European policymakers are attempting to reverse this sequencing. Adopting such rules might reassure the ECB and smooth the path for further expansion of its operations, both of which are desirable, but it leaves the Eurozone short in terms of countercyclical tools. The need for a fiscal instrument for macroeconomic stabilisation is not a new observation, but we believe that it is an inescapable one, the implications of which have not yet been sufficiently incorporated in European deliberations over the fiscal architecture.

Advocates of the fiscal compact might note that the debt brakes are defined in structural terms, and therefore allow countercyclical action at the national level. While feasible in principle, this route to countercyclical capacity is strewn with problems of calculating the structural balance, external spillovers and coordination with the fiscal stance of other members. Creating a common capacity for countercyclical action – through a more robust central budget, issuance of euro bonds, backed by tax authority – is more reliable. But this route of course requires strong political cohesion and robust institutions for the monetary union that would match those through which Hamilton worked.

Some worry that the modern equivalent of Alexander Hamilton cannot emerge in Europe for lack of a political union similar to that of the US after 1789. But the absence of full political union in Europe is neither reason to despair nor an excuse for low expectations or half measures. Remember, as General Washington’s chief of staff, delegate to the Philadelphia Convention, and author of three fifths of the Federalist Papers, Hamilton himself helped to create the institutional prerequisites for the adoption of his plan, the Constitution, and the governing institutions of the young nation. He and the other founding fathers did so, moreover, under financial conditions considerably less favourable that European policymakers face today.

References

Bordo, Michael, Lars Jonung, and Agnieszka Markiewicz (2011), A fiscal union for the euro: Some lessons from history, VoxEU.org, 21 September

Chamley, Christope (2012), “Europe requires European bonds”, VoxEU.org, 10 January.

Eichengreen, Barry (2011), "Economic History and Economic Policy", Presidential address to the annual meeting of the Economic History Association, Boston, September.

Henning, C Randall and Martin Kessler (2012), “Fiscal federalism: US history for architects of Europe's fiscal union”, Bruegel Essays and Lectures Series and Peterson Institute Working Paper 12-1. Also available from the Peterson Institute here.

Marzinotto, Benedicta, André Sapir, and Guntram B Wolff (2011), “What kind of fiscal union?”, Bruegel Policy Brief 11/06, November.

McKinnon, Ronald (2011), “Oh for an Alexander Hamilton to save Europe!”, Financial Times, 18 December.

Pisani-Ferry, Jean (2012), “The euro crisis and the new impossible trinity”, Bruegel Policy Contribution 12/01, January.

Posen, Adam, and Nicolas Véron (2009), “A solution for Europe’s banking problem”, PIIE Policy Brief, 09/13, June.

Véron, Nicolas (2011), “Testimony on the European debt and financial crisis”, Policy Contribution, 2011/11, Bruegel.

1 Compare it to the blueprint for fiscal union of Marzinotto et al (2011) and Pisani-Ferry (2012).

2 The third draft of the compact is available at openeurope.org.uk here.

3 Eichengreen (2011) describes the role of historical analogy nicely as being “not to dictate action but to shape the consideration set – that is to say, to define the options”. For lessons drawn from the experience of other federal systems, see Bordo et al (2011) and Chamley (2012) on this site.