(European) Debt Mutualisation: Lessons from the USA

This post considers events in the history of the United Stated (USA) that involved the bailing out of state governments by the (newly created) federal government. This considerations are made because of their value as a template for  a reform path that worked in dealing with relatively similar problems to the ones now faced by the EU.

I apologise in advance for any offence that might be incurred by sensitive American readers caused by my outsider perspective on the history of the United States. My point is neither to glorify nor to trash the USA, but rather to use it as a template for how political and economic integration may work, which could be of tremendous use in Europe. My hope is that by understanding those drivers of political integration that pushed the 13 newly independent states from a loose and highly decentralised confederation to a much more united federation, I may gain some understanding of the potential outcomes of the Euro-Zone sovereign debt crisis. Hopefully, if imitation is the most honest form of compliment, no offence will be incurred.

Background of USA Fiscal Federalism

Following the end of the the American war of independence (1775-1783), the loose confederate form of government that had been adopted was, according to some commentators, more akin to one regulated by international law between independent countries, rather than the familiar federal government instituted after the Constitutional Convention and reasserted during the Civil War.This institutional setup caused at least 2 problems:

  • On the one hand, it was difficult to enforce cooperation, so that when it came time to impose retaliatory trade practices across the confederation, given the absence of a credible higher authority, it was always possible to find at least one state that would defect from the agreement and at least tacitly facilitate the access of British trading ships to its ports, which undermined the security of all states.
  • Secondly, the newly independent confederate states were overwhelmed by debt and rampant inflation, particularly in the merchant North. This pushed some state governments towards austerity policies, rising taxes to meet debt needs.

The consequence of the latter was that the pressure put on farmers (at the time, the world economy was agrarian, possibly not too different from what was the case in Ancient Rome) who inevitably became unable to meet their debt and tax (debt) obligations. As the courts intervened and state officials attempted to collect what was legally due, the social pressure became too large and the populations revolted. As I understand it, these were the driving mechanisms behind the 1786 Shays’ Rebellions in Massachussets.

Federalist Papers and Hamilton’s argument for Debt mutualisation

Following considerations of territorial claims which are not relevant to this dicussion  Federal Paper 7 goes  on to make considerations about trade and debt. I rather like the following track, which I find is general enough to apply as a warning to all failed cooperative endeavours, and written in a language so elegant it would seem different from ours:

“The public debt of the Union would be a further cause of collision between the separate States or confederacies. The apportionment, in the first instance, and the progressive extinguishment afterward, would be alike productive of ill-humor and animosity. How would it be possible to agree upon a rule of apportionment satisfactory to all? There is scarcely any that can be proposed which is entirely free from real objections. These, as usual, would be exaggerated by the adverse interest of the parties. There are even dissimilar views among the States as to the general principle of discharging the public debt. Some of them, either less impressed with the importance of national credit, or because their citizens have little, if any, immediate interest in the question, feel an indifference, if not a repugnance, to the payment of the domestic debt at any rate. These would be inclined to magnify the difficulties of a distribution. Others of them, a numerous body of whose citizens are creditors to the public beyond proportion of the State in the total amount of the national debt, would be strenuous for some equitable and effective provision. The procrastinations of the former would excite the resentments of the latter. The settlement of a rule would, in the meantime, be postponed by real differences of opinion and affected delays. The citizens of the States interested would clamour; foreign powers would urge for the satisfaction of their just demands, and the peace of the States would be hazarded to the double contingency of external invasion and internal contention.”

While trade was among the first issues settled by Europeans, Publius’ (aka Alexander Hamilton) remarks about trade conflicts are still relevant for today’s Euro and its asymmetric shocks. The necessities of all states and their interdependence meant that a failure to integrate further into a rule based system that avoided easily distorted and captured discretion left them at risk, not only of internal bickering but also of foreign invasion or of some other manipulative exploitation.

“The opportunities which some States would have of rendering others tributary to them by commercial regulations would be impatiently submitted to by the tributary States. The relative situation of New York, Connecticut, and New Jersey would afford an example of this kind. New York, from the necessities of revenue, must lay duties on her importations. A great part of these duties must be paid by the inhabitants of the two other States in the capacity of consumers of what we import. New York would neither be willing nor able to forego this advantage. Her citizens would not consent that a duty paid by them should be remitted in favor of the citizens of her neighbors; nor would it be practicable, if there were not this impediment in the way, to distinguish the customers in our own markets. Would Connecticut and New Jersey long submit to be taxed by New York for her exclusive benefit? Should we be long permitted to remain in the quiet and undisturbed enjoyment of a metropolis, from the possession of which we derived an advantage so odious to our neighbors, and, in their opinion, so oppressive? Should we be able to preserve it against the incumbent weight of Connecticut on the one side, and the co-operating pressure of New Jersey on the other? These are questions that temerity alone will answer in the affirmative.”

The point that is made about the conflicts between New York and Connecticutcould easily be refrased in today’s European context. Indeed, replace New York, Connecticut and New Jersey by Germnay, Italy and Spain and we could correctly state that

Germany, from the necessities of inflation stability, must avoid high wages. A great part of the cost of low inflation must be paid by the inhabitants of the two other States in the capacity of less productive exporters in the same currency union. Germany would neither be willing nor able to forego this advantage. Her citizens would not consent that the fruits of  their competitiveness  should be remitted in favor of the citizens of her neighbors (…). Would Italy and Spain long submit to be taxed by Germany for her exclusive benefit? Should we be long permitted to remain in the quiet and undisturbed enjoyment of a common currency, from the possession of which we derived an advantage so odious to our neighbors, and, in their opinion, so oppressive? Should we be able to preserve it against the incumbent weight of Italy on the one side, and the co-operating pressure of Spain on the other? These are questions that temerity alone will answer in the affirmative.”

Although this article is the most important, the Federalist papers 12 and 15 may also offer a certain amount of interest for this issue, albeit only tangencially so.

First Report on the Public Debt

Following the ratification of the new constitution, Hamilton’s first congressional report on public debt finds him offering the executive conclusion that guided the views expressed in Federalist Paper 7:

The Secretary [of the Treasury], after mature reflection on this point, entertains a full conviction, that an assumption of the debts of the particular states by the union, and a like provision for them, as for those of the union, will be a measure of sound policy and substantial justice.

The (Dinner Table) Compromise of 1790

Not very surprisingly, and despite a reasonable consensus, the aforementioned elegant use of language was not enough to convince all members of the house of representatitves about the soundness of the debt mutualisation. A compromise had to be found between the emerging pro-centralisation Federalist faction of Hamilton, and Madison and Jefferson’s pro-decentralisation Republican faction. The funding act which facilitated the implementation of Hamilton’s debt mutualisation vision was achieved as a compromise. The  Jefferson’s counterpart , known as the residence act, demanded that the new capital be moved away from the financial/Federalism East Coast, to the more rural/Republican shores of the Potomac river, leading to the construction of Washington D.C.. Political brinkmanship is not a novelty of the 21st century…

Who Borrowed More? – Congress or The States

During the American war of independence (1775-1783), the 13 newly self-declared independent states together with their Confederate Congress contracted, by the 1789 counts of Alexander Hamilton, over US$54 million, upon which accrued an interest payment of more or less US$2.24 million plus another US$600 thousand for the service of 1789’s debt and interests. By 1790, the US Federal debt amounted to US$71m, according to the US Treasury’s website (Treasury Direct).

For our purposes, it important to determine the distribution of this debt burden. Finding state debts is rather difficult. One  source of such information is provided by the Massachussets Historical Society, but the predominance of £ denominated bonds and my inability to convert this into US$, makes me unable to explore them further. Eventually, after some research, I came across the particularly useful  The Finances of the United States from 1775 to 1789, by Bullock. According to this source (p.149),

“their total amount was estimated by Hamilton at US$25 million. The funding act of 1790, which provided for the assumption of these debt by the United States, stipulated that none of these obligations should be assumed that should appear to have been issued for any other purpose than the prosecution of war; and limited the amount of the assumptions to US$21.5 million. After the debts were finally adjusted on this basis, US$18.271787 million was assumed by the national government.”

Clearly therefore, at around 76% [(USD54m – USD21.5m)/USD54m], the United States in Congress, the legislative body of the United States between 1775 and 1789, was responsible for most of the debt issuance during this period. This is an important fact, considering that the the present state of affairs in Europe is the opposite, with EU states responsible for most of the debt issuance. Therefore, any attempt at a comparison faces at least the criticism that with the opposite distribution of debt issuance the United States had a path dependency advantage over today’s EU: It was less of a revolutionary move to have a national government issue debt than it would be for us now to have a European equivalent.

Sequencing, Institutional Insights & Applications in Europe

There are three underlying issues that supported the achievement of debt mutualisation in the USA:

  • First, there is an issue of political reform sequencing in that the USA had already empowered itself with the necessary constitutional authority to acquire and dispose of the necessary resources to tax, spend and borrow, which are very indirect and severely constrained in the EU. Even the relative significances were already adjusted in favour of debt mutualisation. Possessed of this levers, debt mutualisation was only a matter of engaging those levers.
  • Secondly, there was a enormous political effort in the underlying the economic issue of debt mutualisation in the early USA. It would appear, as stated above, that the debt mutualisation may have been contingent on the capital laying close to the wealthier Southern states in order to allow them to better monitor the activities of the federal government. The whole issue was also fuelled by the single mindedness of one individual, Alexander Hamilton, and his followers.
  • Finally, the reform was a lump sum, one time event. It created no moral hazard, which Eurobonds and Eurobills, by their continued burden sharing would unfortunately create, as Gros argues. Although I am fond of these tools as intermediary steps towards delegated, federalised borrowing to finance delegated, federalised expenditure, I am accutely aware that shared resources (debt) and exclusive benefits (expenditure) create the sort of moral hazard that inevitably turns into a collective action problem, which students of fiscal federalism call the fly paper effect. Because this can easily lead to rampant debt growth, it may be appropriate to reconsider the necessity of also making this mistake on the way to arrive at the right set of institutions.

If Europe is to eventually follow in the footsteps of the USA, a similar proposal, a similar individual and similar partisans must be found to fuel such a push. Where are they? – Shying away, while Germany refuses to spend and France refuses to delegate sovereignty.

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