photo: Stephen Little
The current crisis in the European Monetary Union (EMU) has led to comparisons between the EMU and the United States as currency unions. There are similarities and differences, but one similarity is that they are both federations in the sense of a higher level government interacting with a lower level government. They both have common currencies among members, but as fiscal federations, they have distinct differences that have important implications for their currencies. In the case of Greece, a fiscal crisis has been allowed to grow into a monetary crisis that threatens the possibility of Greek exit from the Eurozone. In the US, institutional differences from the EMU have prevented fiscal crises of states and cities from spilling over into monetary crises that could lead to exit from the dollar.
Moral Hazard and Fiscal Discipline
A fundamental problem for fiscal federations is that higher level governments must find a way to avoid the moral hazard problem that results from accepting responsibility for debts of subordinate governments. This problem is painfully obvious in the case of EMU members who want to limit their exposure Greek debt. A cynic once described a fiscal federation as one in which “you pay my bills”. Fiscal discipline can be achieved either by the use of hierarchical rules or by the use of financial markets. Higher level governments can limit their obligations by using hierarchical rules that limit spending, taxation, and borrowing by lower level governments (hierarchy). Alternatively they can refrain from imposing intrusive rules on subordinate governments and promising to not bail out subordinates if they cannot pay their debts (markets). This alternative uses the discipline of financial markets to evaluate the creditworthiness of governments, and it requires a credible no bailout pledge by the higher level government (Rodden).It is common for higher level governments to pledge no bailouts in advance of a crisis, but given the history of bailouts, it is difficult to make a no bailout pledge credible to the public. Early EMU documents and statements by officials promised no bailouts, but repeated bailouts of Greece and other members have rendered these promises not credible. Much of the time, financial market participants have acted as if Greek bonds are subject to an implicit guarantee by other members.
In contrast to the EMU, the United States has developed a set of institutions that has made the no bailout pledge of the federal government credible (Arellano et al). The Constitution binds the states in important ways, and the Congress has refrained from bailing out states for over 200 years. This tradition of not bailing out lower level governments has led participants in financial markets to treat these governments as de facto sovereign states. State and local governments with debt problems are currently acting as if they do not expect to receive bailouts (Wall Street Journal). However,this tradition of no bail outs has been weakened by Federal bailouts of prominent private firms as well as by the rise of revenue sharing between Federal and state governments.
Fiscal Discipline in the United States
Prior to the adoption of the Constitution in 1789, the new United States was governed by the Articles of Confederation that were characterized by a weak federal government. The Articles allowed states to use their power to create their own currencies and pass laws that bailed out debtors (Arellano et al). The Constitution changed the relationship between creditors and debtors by preventing states from creating their own currencies, from abrogating private contracts, and from redenominating debts in a new currency. The EMU has restrictions against member states imposing capital controls, but they were not enforced against Greece. The lack of will and/ or the power to enforce the rules means that the EMU has a significantly different kind of fiscal federalism than the United States. The probability of Greece replacing the Euro with a new drachma was considered much higher than the probability of Illinois abandoning the dollar to deal with its debts.
In 1790, Secretary of Treasury, Alexander Hamilton, proposed that the new Federal government be responsible for the Revolutionary War debts of the states. Congress agreed, and passed the Funding Act of 1790. Since then, there have been numerous requests to bail out lower level governments, but all of them have been rejected by the Congress, so far. In the 1840s several states defaulted on their bonds, and in the 1930s other states defaulted. Recently the Detroit and several other cities settled their unpaid debts in bankruptcy court. Several states, including Illinois and California have current debt problems related to unfunded pension liabilities, and the territory of Puerto Rico has missed payments on bonds last August and this January. So far, the federal government has refrained from providing extraordinary financial assistance to any of these lower level governments. The United States today has its own public debt problems (Grennes and Strazds), but those problems are not the result of obligations to bail out state and local governments.
Credibility of No Bailout Pledges
Evidence from financial markets indicates that the no bailout promise by the US Federal government is credible. In the US, interest rates on state government bonds (also default swaps and credit ratings) have moved independently from interest rates on corporate bonds of firms located in those states (Arellano et al). For example, when the state of Illinois has been forced to pay a higher interest rate premium on its bonds or when its bond rating declined to the lowest level among the 50 states, corporations domiciled in Illinois have not been forced to also pay a higher interest rate on their private bonds. The opposite has been true for interest rates in Greece. When interest rates on Greek government bonds have increased, interest rates on bonds issued by Greek corporations have also increased. This implies that market participants expected the Greek government to pursue policies that interfere with repayment of debts by Greek corporations. Closing banks and restricting the use of bank accounts and ATMs are examples of Greek government policies that states, such as Illinois, are unable to use in the US. Fiscal and monetary institutions in the US are fundamentally different from those in the EMU.
Resistance to Hierarchical Rules
Influential countries, such as Germany, face a dilemma related to bailouts. When Chancellor Merkel says that if Greece fails, Europe fails, this implies that bailouts are essential for the EMU. However, while advocating bailouts for Greece, Germany, has also sought to limit its exposure to Greek debt by imposing strong conditions (debt brakes, collateral, etc) on loans. Some of the fiscal restrictions have been so austere that Greek real GDP has fallen in seven of the eight years since the crisis of 2007, and it is forecast by the IMF to fall again in 2016. Contrary to the intentions of the creditors, the Greek debt/GDP ratio continues to rise (Vegh).
German leaders have advocated greater use of hierarchical rules from Brussels at a time when there is increasing resistance by EU member states to imposing more common policies from Brussels. Examples of fiercely disputed rules are sanctions against Russia, quotas for accepting refugees, and national quotas on carbon emissions. Also the UK faces a referendum on continued EU membership, and Prime Minister Cameron has made his support for remaining in the EU conditional on loosening controls on the UK from Brussels. Specifically, the UK has requested the right to withhold local benefits to legal migrants for four years after they arrive. If the UK is granted such a waiver on common labor market policies, how can the authorities in Brussels impose tighter common policies on other members? A recent analogy by Robert Kaplan has described the EU as more like the weak and fragmented Holy Roman Empire than a unified nation state (Kaplan).
Synergy Between Markets and Hierarchical Rules?
Is there room for compromise between greater use of hierarchy and greater use of markets to restrain the borrowing of lower level governments? One proposal is for EMU members to explicitly guarantee repayment of some bonds issued by member states, but to limit the value of bonds that are guaranteed. The guaranteed or more senior bonds would be expected to offer a lower interest rate than the riskier non-guaranteed bonds (Chaterjee and Eyigungor). A simple rule could be that EMU members would collectively guarantee repayment on bonds up to 60% of GDP. However, this scheme would require imposition, and more importantly, enforcement of much stricter hierarchical rules on national governments than the than the 3% budget deficit to GDP and 60% public debt to GDP thresholds in the Maastricht Treaty that have now been violated by most Euro area countries. It also implies that the market, which failed to discipline national governments when they were breaching the 60% limit in the past, will now succeed in making them lower their debt ratios. In addition, as we pointed out when this proposal was first aired, a well-known theorem in corporate finance predicts that the total weighted average cost of borrowing for the respective national governments would not change much (Grennes and Strazds, 2012). The distinction between the two kinds of bonds would depend on the credibility of the no bailout pledge for the non-guaranteed bonds. If it were not credible, the interest rates on the two kinds of bonds would converge.
In the Summer of 2012, we stated that “the solution to the Eurozone debt crisis is likely to emerge from a combination of reducing current public expenditure, increasing public investment expenditure, privatization of state assets in the most heavily indebted countries, and using the proceeds to reduce indebtedness, carrying out product and labor market reforms, tax and education reforms, moving toward a banking union, the ECB using its Securities Market Program to provide countries with temporary relief from financial market pressure, or even further debt restructuring” (Ibid). Now in retrospective the ECB has gone much further than we were expecting in 2012. A banking union has been created, however, policy steps in other areas are lagging behind. If the other reforms are not carried out, the crisis will resurface with new force once the ECB starts removing its monetary stimulus.
The United States is a country whose constitution and fiscal institutions restrict fiscal actions by states in important ways. The Euro Area is not a nation state, and the EU central government in Brussels lacks strong control over the fiscal actions of member governments. However, what is even more important, The US has demonstrated a credible no bailout policy by the federal government since 1790. Conversely, the much younger EU government has demonstrated the opposite with respect to member bailouts. Attempts by Germany and others to bailout Greece, while limiting their own exposure to Greek debt, have led to greater use of hierarchical fiscal controls. Imposing more common rules of any kind from Brussels comes at a time when there is greater opposition to “one size fits all” rules for member countries. Moreover, both markets and governments still have fresh memories of how commonly agreed rules were breached in the not so distant past. A reputation for saying one thing and doing another, can only be changed by actions, not words.
It remains to be seen whether a monetary union can succeed without a tighter fiscal union, and current conditions are not favorable for members to accept stronger rules from Brussels. However, to implement a credible tighter fiscal union, the inherited lack of credibility will have to be resolved. A good way to start would be for the national governments to use the time bought by the ECB’s quantitative easing program to carry out a series of reforms in the other policy areas that are the domain of national governments.
Arellano, Cristina, Andrew Atkeson, and Mark Wright. 2015. “External and Public Debt Crises”. NBER Working Paper 21456.
Chatterjee, Satyajit, and Burcu Eyigungor. 2015. “A Seniority Arrangement for . Sovereign Debt”. American Economic Review, December.
Grennes, Thomas, and Andris Strazds. 2015. “United State Government Debt is in Uncharted Territory”. EconoMonitor, September 25.
Grennes, Thomas, and Andris Strazds. 2012. “Applying the Modigliani-Miller Theorem of Capital Structure to Governmentsz: Why Blue Bonds are Not the Silver Bullet to Kill the Eurozone Debt Crisis”. EconoMonitor, June 28.
Kaplan, Robert. 2016. “Europe’s New Medieval Map”, Wall Street Journal, January 16.
Rodden, Jonathann. 2013. “Can Market Discipline Survive in the U.S.? in Paul E. Peterson and Daniel Nader, Eds., The Global Debt Crisis: Haunting US and European Federalism. Washington: Brookings Institute Press.
Vegh, Carlos. 2015. “Fiscal Policy in Emerging Markets: Procyclicality and Graduation”. NBER Reporter, Number 4.
Wall Street Journal.2015. “States’ Pension Woes Split Democrats and Union Allies”. December 30.