Mutualisation and constitutionalisation

Harold James, Hans-Werner Sinn, 26 February 2013

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It is often claimed – especially but not only by US economists – that the travails of the euro show that it is impossible to have a monetary union in the absence of a political union. Thomas Sargent used the bully pulpit of the Nobel Prize acceptance speech to tell Europe to follow the US example in the aftermath of the War of Independence and assume the debts of the individual states (2011). Such an assumption of debts was, for Hamilton, “the powerful cement of our union”. Paul de Grauwe has recently stated the case quite simply: “The euro is a currency without a country. To make it sustainable a European country has to be created” (2012).

Following US precedent

The discussion of European integration – both in the past and in the future – has largely been driven by analyses of how precedents on the other side of the Atlantic have worked. At the highest political level, such reflection concerns the constitution, with the US precedent encouraging European leaders to contemplate (rather unproductively to date) the possibility of drafting a European constitution. The US constitution was not drawn up until 1787, and was really only completed in 1791 with the Bill of Rights.

Modern European attempts to follow the 18th-century US constitutional path were suspended after the proposed constitutional treaty was rejected in referenda in France and the Netherlands in the summer of 2005. That was not, however, the end of the discussion. In the wake of the financial crisis, some – including Chancellor Merkel – suggested that, in the long run, a new constitutional settlement is the only acceptable way of defining the claims and obligations of member states. This is a convincing argument. If monetary union is to be followed by the development of some measure of fiscal federalism, a constitutional solution that clearly lays out the extent and limits of European member states' commitments would be an essential condition.

The aftermath of the recent financial crisis has prompted another sort of European reflection on how a workable federal fiscal system arose in the US. Again, this system was not introduced until 1790, some 14 years after the Declaration of Independence. Fiscal federalism actually took much longer to work its nation-building magic. It was not until the middle of the 19th century that ‘the US is’ became the accepted grammatical form – rather than ‘the US are’.

Assuming debt

Alexander Hamilton’s eventually-successful proposal in 1790 for the assumption of War of Independence state debt was certainly a decisive initial step in the creation of a real union – and it accompanied the constitutionalisation of the American experiment. This assumption, however, did not produce a responsible system of state finance and during the half century that followed there were numerous state-level defaults and a debate about new debt assumptions and/or new ways of blocking state indebtedness. The irresponsibility of individual states also gravely damaged the reputation of the federal government and made external borrowing prohibitively expensive.

Hamilton argued – against James Madison and Thomas Jefferson – that the war debt accumulated by the states in the War of Independence should be assumed by the federation. There were two sides to his case, one practical, the other philosophical:

  • Initially the most appealing argument was that a federal takeover of war-related state debt was an exercise in providing greater security, and thus reducing interest rates from the 6% at which the states funded their debt to 4%;
  • As for the philosophical side, Hamilton also insisted on a stronger reason for following good principles than merely the pursuit of expediency;
    There existed, he stated, “an intimate connection between public virtue and public happiness.” That virtue consisted of honouring commitments.

The condition for success in the US case was that the Union raised its own revenue, initially mostly through new excises and federally administered customs houses. The logic of a need for specific revenue also applies in modern Europe, where the sources of funding for bank rescues or for a recapitalisation fund should be clearly spelled out. This consideration has produced an initiative to impose a small levy or tax on financial transactions.

In the longer term, and after the foundation of a common state with a common army, parliament and government, the analogy with Hamilton’s system would require a more extensively reformed fiscal system that might include a common administration of customs or of value-added tax (with the additional benefit in both cases of eliminating a great deal of cross-border fraud).

Lessons for Europe

Would an expansion of European federal fiscal capacity represent a massive transfer of power from member states to EU authorities? It is significant that the 1790 assumption of state debt occurred in the context of an understanding that federal powers should be few and limited. In Federalist Paper No. 46, James Madison had made it clear that central authority should be carefully circumscribed, and had concluded that: “The powers proposed to be lodged in the federal government are as little formidable to those reserved to the individual states, as they are indispensably necessary to accomplish the purposes of the Union”.

Not cement but dynamite

In fact, the fiscal union turned out to be dynamite – rather than cement – because the tariff dispute turned into a constitutional struggle by the 1830s in which southern states claimed that the Constitution was merely a treaty between states and that the southern states could ignore federal laws that they deemed to be unconstitutional. The fiscal mechanism designed to allow servicing of a common liability raises inherently explosive distributional issues.

The distributional consequences between states of a fiscal mechanism would also be a potentially divisive mechanism in contemporary Europe. The most popular suggestions currently under discussion are a general financial transactions tax, which would fall heavily on major financial centres (and for this reason is resolutely blocked by the UK); or a European payroll tax, which would raise problems of different implementation and coverage in the various European states.

The fiscal union was also dangerous because it allowed states to recommence their borrowing. As with the dispute over the tariff, this problem became very apparent in the 1830s. As international capital markets developed in the first decades of the nineteenth century, US states used their newfound reputation to borrow on a large scale, and ruined their creditor status fairly quickly as a result.

The practice of default spread in 1841-42, with Mississippi, Florida, Michigan, Pennsylvania, Maryland, Indiana, Illinois, Arkansas and Louisiana all announcing their unwillingness or inability to pay. At this time, a whole palette of responses was contemplated, ranging from the expulsion of defaulters from the Union to the repetition of the Hamiltonian assumption.

Inevitably, the Hamiltonian option of debt assumption became influential again. In 1843, a congressional committee recommended a new assumption, on the grounds that the debts incurred had been mostly to fund infrastructure, which was “calculated to strengthen the bonds of Union, multiply the avenues of commerce, and augment the defences from foreign aggression” But this proposal was rejected, primarily on moral hazard grounds: if states were freed of present debt, they would only be likely to get into debt very quickly again.

The eventual solution lay in the adoption of debt restraint or balanced budget laws. At the end of the 19th century, many states set a very low ceiling on permissible state debt, and other states limited indebtedness to a (small) share of total taxation. Only the northern states (New Hampshire, Vermont, Massachusetts, Connecticut and Delaware), which had never really experienced the debt problem, allowed their legislatures to contract unlimited debt. By the early 21st century, such legislation limits state indebtedness in all but one of the 50 states.

Conclusions

The choice of the fiscal mechanism to service a federalised debt potentially raises deeply divisive issues about the distributive effects of the tax or tariff on the constituent states. It requires a well-constitutionalised system of restraint on fiscal behaviour, both at the federal level and at that of individual states. In particular, a commitment not to renew the assumption of state debts is a condition for stable financial and political development of the union.

References

Sargent, Thomas (2011), “United States Then, Europe Now”, Nobel Prize speech.

De Grauwe, Paul (2012), “The Eurozone’s Design Failures: can they be corrected?”, 28 November, LSE Public Lecture.

Topics: Economic history, Politics and economics
Tags: banking union, Eurozone crisis, mutualisation, US

Professor of History and International Affairs and the Claude and Lore Kelly Professor of European Studies, Princeton University and CIGI Senior Fellow
Professor of Economics and Public Finance at the University of Munich, President of Ifo Institute for Economic Research and Director of CES.