It has become customary for European leaders and observers of eurozone’s debt crisis to invoke the name of Alexander Hamilton. As the first U.S. Treasury Secretary, Hamilton urged the federal government to ‘assume’ and honor the debt of U.S. states that emerged from the Revolutionary War as indebted as Greece or Portugal are today. “Europe is at an Alexander Hamilton moment,” former Fed Chairman Paul Volcker declared in January, “but there’s no Alexander Hamilton in sight.”
No wonder Hamilton is popular these days. For the proponents of ever-closer Europe, this is too good a crisis to waste."For a genuine economic and monetary union to be established, I think that we need a banking union, a fiscal union and further steps towards a political union," says Jose Manuel Barroso, the president of the European Commission. Similarly,François Hollande, alongside Italy's Prime Minister Mario Monti and Spain's Prime Minister Mariano Rajoy, are the most vocal proponents of a closer fiscal union, in which Europe would stand ready to honor the debt obligations of its individual members.
Those who use Alexander Hamilton as a pawn would benefit from a more nuanced reading of U.S. fiscal history. The federal government in the U.S. was not set up with the purpose of bailing out colonies in financial distress– it was created to provide public goods for the United States as a whole: provision of security, justice and defense, and foreign policy. Recall that the enemies of the young American nation included the King of England, who was running the world’s greatest military and naval power of the time.
The purpose of federal debt was not to reduce the borrowing costs of individual U.S. states but to fund spending that was better provided at the federal than at the state level. And while it is legitimate to have a discussion about what the European Union should and should not do, it is frankly tough to think about common goods and services that would justify the EU to issue its own debt. How much money does one not need to keep the common market running? And, after Lady Ashton, does anyone really want Europe to have a common foreign and security policy?
Under Hamilton, the federal government assumed the debt of U.S. states after the Revolutionary War – and then again after the War of 1812. For a while, this created the expectation, similar to contemporary Europe, that fiscal profligacy by states would go on unpunished. However, from the 1830s onwards, the government adhered to a strict no-bailout policy towards individual states, letting several of them go bust. As a result, states themselves adopted legal rules about debt and deficit. Today, all states except Vermont have fiscal rules inscribed in their constitutions.
Such rules are imperfect and, although the accumulation of state-level debt has historically been limited, the fiscal situation of states has worsened in recent years. This is because federal bailouts have become a real possibility, eroding fiscal discipline. During the latest crisis, the federal government has engaged in shadow bailouts of a number of states, most prominently of the unfortunate trio of California, Michigan and New York.
However, the American model of fiscal federalism has had a significant affect on the bond markets. Economists Rabah Arezki and Amadou Sy, from the IMF, and Bertrand Candelon, from Maastricht University, have shown that the U.S. state bond market displays negative spillovers. That is, worsening of borrowing conditions for one state means better borrowing conditions for other states – and vice versa. In other words, for investors, state bonds are substitutable.
That is at odds with the oft-cited scare of contagion on bond markets. Negative spillovers create natural incentives for virtuous competition – a ‘race towards the top’ in matters of fiscal governance. The necessary condition for such competition to exist – in Europe as in the United States – is the credibility of a no-bailout policy.-
In short, Europeans ought to uncouple the issue of fiscal governance from the European project. There is no reason why a default by Greece, Portugal or Spain should be the end of the common European market. Conversely, there is no reason why a political and fiscal union should be seen as a necessary component of the solution to the periphery’s debt problem.
Europe does not need a new Alexander Hamilton to collectivise its debt obligations. To avoid fiscal crises in the future, all it needs are leaders who will ensure that a policy of no bailouts is credible and that national governments face the full costs of their fiscal behavior.