The European Debt Crisis in an American Fiscal Mirror

Fiscal federalism: US history for architects of Europe’s fiscal union

By C. Randall Henning (henning@piie.com) and Martin Kessler (mkessler@piie.com)

URL: http://d.repec.org/n?u=RePEc:bre:esslec:669&r=his

Abstract: European debates over reform of the fiscal governance of the euro area frequently reference fiscal federalism in the United States. The “fiscal compact” agreed by the European Council during 2011 provided for the introduction of, among other things, constitutional rules or framework laws known as “debt brakes” in the member states of the euro area. In light of the compact and proposals for deeper fiscal union, we review US fiscal federalism from Alexander Hamilton to the present. We note that within the US system the states are “sovereign”: The federal government does not mandate balanced budgets nor, since the 1840s, does it bail out states in fiscal trouble. States adopted balanced budget rules of varying strength during the nineteenth century and these rules limit debt accumulation. Before introducing debt brakes for euro area member states, however, Europeans should consider three important caveats. First, debt brakes are likely to be more durable and effective when “owned” locally rather than mandated centrally. Second, maintaining a capacity for countercyclical macroeconomic stabilization is essential. Balanced budget rules have been viable in the US states because the federal government has a broad set of fiscal powers, including countercyclical fiscal action. Finally, because debt brakes threaten to collide with bank rescues, the euro area should unify bank regulation and create a common fiscal pool for restructuring the banking system.

Review by: Manuel Bautista González

This paper was included in the NEP-HIS report issued on January 18th, 2012, through it C. Randall Henning and Martin Kessler contribute to the debate on fiscal solutions to the current European debt crisis. This by offering insights drawn from the past and present of U. S. fiscal federalism.

Henning and Kessler periodize their historical overview in five moments, namely, the financial reforms enacted after the adoption of the U. S. constitution, the state defaults of the 1840s, the financial troubles of state and local levels during the Reconstruction period, the fiscal instability during the Great Depression, and some recent experiences of state and local troubles from the 1970s to the current economic recession.

Later, in the analytical section of the paper, the authors study the probable adoption of balanced budget rules in the European Union with regards to their political enactment, their diversity across the Union and their effectiveness in preventing fiscal disarray. Henning and Kessler assess the need for (federal) countercyclical policies that complement the procyclical fiscal discipline at the state and local levels. They also review the literature on the relationship between state and local debt and capital and banking markets and offer preliminary conclusions relevant to both policymakers and scholars of monetary unions and fiscal federalism.

In light of the attention that the authors give to the formative years of the early American republic, it is necessary to remark the importance of the fiscal developments that preceded the monetary integration of the United States, as Robert E. Wright has recently argued.  Following Alexander Hamilton’s recommendations, the US Congress adopted the dollar as unit of account; however, this did not translate in an immediate monetary unification. Before the Civil War, the United States had a very diverse money supply. Bank notes, notes issued by both financial and non-financial entities, and counterfeit paper money circulated with metallic coins, in what historian Stephen Mihm has described in his book A Nation of Counterfeiters as “a multifarious monetary system”.

The monetary plurality was also palpable in the state-level heterogeneity prevailing in the banking system of antebellum America. The failed experiences of the first and second Bank of the United States meant in practice that banks operated under state regulations and thus the sector experienced no federal intervention. It was not until the Civil War that the federal government asserted its preeminence in monetary and financial matters with the establishment of the greenbacks as means of payment with legal tender and the reforms that gave birth to the national banking system.

To what degree was the United States a monetary union as well as a consolidated fiscal entity in the first two historical periods revised by Henning and Kessler? By answering this question, the authors could caution the reader regarding the virtues and limits of comparing US and European experiences of fiscal federalism.

An interesting aspect that might be explored in future research is the political economy of the enactment of fiscal discipline rules in the United States during the 19th century. The question is pertinent due to the level of public goods provided by the state and local authorities in the US as opposed to the present government expenditures of Euro countries, for one of the many worries of European Union policymakers is how to enact fiscal discipline top-down without undermining the support of constituencies largely unaccustomed to fiscal astringency. It is in the realms of political and social legitimacy where the convenience of local “ownership” (p. 19) of the budget rules implemented in Euro countries will meet its final test.

On the whole, Henning and Kessler provide a brief and compelling review of both the history and empirical studies of US fiscal federalism. Their charts offer valuable statistical information: interested readers might also find useful to consult The Economist’s interactive map of troubled Europe, the KPI Library’s Eurozone Debt Crisis Dashboard, the Wall Street Journal collection Charting the Eurozone Crisis and a very valuable infographic prepared by the BBC on Who Owes What to Whom in Europe.

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