The current sovereign debt crisis in Europe, now threatening the existence of the euro, has revealed major faults in the design of the fiscal framework of the Eurozone. It has inspired a heated debate reflected in a steady flow of proposals concerning the proper rules and institutions for fiscal policymaking in the EU. The debate shows no sign of an emerging consensus (see for instance Gual 2011 and Wyplosz 2011 on this site).
One reason for this lack of unanimity is that the Eurozone represents a new type of monetary union. It is the first monetary union where monetary policy is decided at the central (European) level while fiscal policy is carried out at the sub-central (member state) level. Thus, the economics profession lacks historical cases to use as guidance for theoretical, empirical, and policy-oriented work. The debate also reflects different country perspectives. Economists and policymakers in EU member states like Germany with strong fiscal positions and current-account surpluses tend to have other views than economists and policymakers in debtor countries like Greece and Italy with weak fiscal records.
In a recent working paper (Bordo et al 2011), we add to the current debate by turning to the history of fiscal federalism for an answer to the question: What are the lessons from the past for the fiscal arrangements in the Eurozone? In short, we ask, which fiscal arrangements in the federal states that we study would help to avoid the centripetal forces that threaten the stability of the Eurozone? This is done by exploring the record of five federal states: Argentina, Brazil, Canada, Germany, and the US.
The five federal states studied by us are monetary unions as well as fiscal unions based on fiscal federalism. They are monetary unions in the sense that they have all one common currency and one central bank managing monetary policy for the union. They are fiscal unions in the sense that one central authority is in charge of union-wide fiscal policy. However, these fiscal unions are organised as federations, where sub-central (regional or state) political entities enjoy significant independence to decide legislation, including taxes and government expenditures, at a level below the national (central) one. Within the fiscal union, there is a common market characterised by free trade and mobility of labour and capital.
The governance structure of the Eurozone has important similarities with that of a federal state. It is set up as a monetary union with the ECB as the central bank of the Eurozone. However, the central budget, the EU budget, is much smaller than the size of the budget of the central government of a typical federal country reflecting the fact that the political power of the centre (‘Brussels’ for short) is also much weaker in the Eurozone.
Lessons from the history of fiscal federalism
Our survey of the evolution of the five federal states in our sample leads to the following conclusions:
First, all the fiscal unions have evolved in close interaction with the political unions forming the ultimate basis for their fiscal cooperation. Federalism is not a static pattern, characterised by a precisely defined division of powers between governmental levels. It is a continuous process by which a number of separate political communities enter into arrangements for working out solutions and making joint decisions on common problems. Thus, each federation is an evolving entity shaped by economic and political events.
In particular, fiscal policy arrangements are driven by exceptional events, often by deep economic crises. The most prominent example is the Great Depression of the 1930s which affected in a fundamental way the institutions of the five federal states. During and after the Great Depression, the American, Canadian, Argentine, and Brazilian federations underwent a process of centralisation. This centralisation made it easier for the federal governments to either introduce (as in the Canadian case) or extend (as in the US example) measures aiming at equalisation of incomes across regions. Such measures were part of the stabilisation process, since the regions which were more harmed by the recession received larger financial transfers. Thus in case of a major negative shock the federal state learned to implement measures to improve the conditions of the most harmed regions.
History also suggests that the most appropriate way to finance interregional transfers in distressed times is by a national (union-wide) bond market. After the American War of Independence, Alexander Hamilton, the first Secretary of the Treasury, introduced a stabilisation plan to get the new Republic on its feet. The war had been largely financed by the issue of paper money and the resulting hyperinflation plus the default by the states on their debt left the new nation in a fiscal shambles. Hamilton consolidated the state and federal debt in a new national bond which was to be serviced by customs duties and excise taxes. The new bond issue was a success which allowed for the financing of future wars and secured tax revenue at the national level.
By contrast, Argentina when it gained its independence two decades later emulated Hamilton’s plan. However, shortly after creating its fiscal union, Argentina monetised its debt. It was not able to secure sufficient revenue sources to service its debt.
We also find a clear difference between well-functioning and poorly functioning federal states concerning inflation and debt accumulation. The US, Canada, and Germany are federal states that have maintained a relatively strict fiscal discipline among sub-national units during recent decades. They have fared better than Argentina and Brazil in our sample. As a rule, the former three countries have displayed lower rates of inflation; less inflation variability and less debt accumulation than the latter two.
Our account of the history of fiscal federalism demonstrates that fiscal discipline has been obtained through several techniques: explicit or implicit no-bailout clauses, constitutional restrictions, and discipline exercised by financial markets for government debt. Once overall budgetary discipline prevails through a no-bailout rule, considerable revenue and expenditure independence of sub-national governments can be maintained. This independence for regional fiscal units is thus due to a system of rules that ‘anchor’ their fiscal behaviour at a sustainable path.
The present system of budgetary discipline in successful fiscal federations is the result of a ‘learning-by-doing’ process. In the presence of moral hazard, the federal government must give a signal of commitment to the sub-national authorities. Otherwise, the latter will not learn. For example, the US government as early as 1841 gave the message that it would not provide bailouts to states in financial trouble, gaining credibility for a no-bailout policy. Today, virtually all of the US states have their own balanced budget rules and most importantly they respect them. Today, it is the federal government that displays high deficits.
Two out of the five federations were not able to learn from their negative fiscal experiences in the past. The Argentine and Brazilian federations during the 1980s and 1990s experienced several financial crises, which occurred because they followed an undisciplined fiscal policy. Moreover, for them, the lesson has not yet been learnt. In each of these crises, the central government has bailed-out the sub-national fiscal authorities. Indeed, there is still no credible mechanism in these federations to impose fiscal disciple.
Lessons for the Eurozone
The history of successful fiscal federalism points to the following policy lessons of relevance for the Eurozone today.
The first lesson from history suggests that a no-bailout clause helps to avoid pressures threatening the stability of the monetary union. This has worked in combination with a system of close monitoring of the fiscal policy and debt accumulation of the members of the monetary union, carried out by an institutionalised system as well as by financial markets. Without a strict and credible no-bailout clause, the financial market mechanism is likely to fail as an efficient disciplining device on fiscal policy.
A main problem of fiscal policymaking in the Eurozone, undermining budgetary discipline and the workings of the Stability and Growth Pact, is the lack of efficient fiscal governance in a number of member countries. The solution is to improve at the level of the member states weak domestic fiscal institutions through reforms, increasing their independence, accountability and transparency – much in the spirit behind central bank reforms in the past decades.
The second lesson for the Eurozone suggests that regional fiscal units (member states) can have considerable revenue and expenditure independence within a system of no-bailout by the centre (Brussels and the ECB).
The third lesson indicates that the creation of a union-wide bond market with a common bond may prove to be a successful way to finance temporary increases in public expenditure to prevent the malaise experienced today in Europe. Federal borrowing avoids the problems of liquidity and credibility faced by member states suffering from lack of fiscal discipline, thus giving rise to overall lower interest rates than otherwise.
A fourth lesson from history is that, in the face of a global crisis like the Great Depression, the fiscal capacity of the central government is strengthened and the system of transfers and equalisation payments across the members of the fiscal union is increased. This pattern suggests that the recent global crisis, which is the most severe one since the 1930s, may contribute to an increase in the central fiscal power of the EU, paving the way for larger transfers to the member states hardest hit by the crisis.
Indeed, the policy response of the EU since the start of the recent crisis strongly suggests that such a movement has begun concerning recent proposals for strengthening of EU surveillance and control of fiscal policies, the creation of a Eurozone Financial Stability Facility (EFSF) and the design of EU financial regulations.
The fifth lesson from the experience of successful fiscal unions is the importance of learning from – and adapting to – changing economic and political circumstances. Such a process has already started in the EU as witnessed by the reforms and changes in the institutional framework both at the EU-level and within several member states. The future will reveal if these changes will prove to be sufficient to make the Eurozone a sustainable monetary union.
The history of fiscal federations provides us with a number of conditions necessary for a fiscal union to function smoothly and successfully and thus also the monetary union on which the fiscal union is based. The first and probably the most important condition is a credible commitment to a no-bailout rule for the members of the fiscal union. The second one is a degree of revenue and expenditure independence of the members of the fiscal union reflecting their political preferences. The third condition is a well-developed transfer mechanism to be used in episodes of distress. This transfer mechanism can be facilitated by the establishment of a common bond. The fourth condition is a capacity to learn from past mistakes and adapt to new economic and political circumstances.
The Eurozone was created without an effective fiscal union. The institutions that were established to serve as the foundation for the fiscal union (the Maastricht Treaty and the Stability and Growth Pact) – to discipline domestic fiscal policies – did not function as planned as revealed by the crises and recession from 2007-2009 and onwards. The lessons from the historical experience of the five federal states surveyed by us could be helpful for the Eurozone to avoid disintegration.
Bordo, Michael, Agnieszka Markiewicz, Lars Jonung (2011), “A fiscal union for the euro: Some lessons from history”, NBER Working Paper No. 17380.
Gual, Jordi (2011), “The Eurozone debt crisis: Is this a banking problem?”, VoxEU.org, 13 September.
Wyplosz, Charles (2011), “Public debt in the Eurozone, Japan, and the US”, VoxEU.org, 16 September.
This post originally appeared at VOX and is reproduced with permission.