Fiscal Union is Not the Answer: A Historical View of US and EU State Debt
Fiscal unity is not the answer to the Eurozone’s problems: credible future surpluses are. In his Nobel Lecture (only starts after 17:00), Thomas Sargent looks at two historical attitudes towards individual state debt in the US. His main message is that investors buying debt today have expectations on tomorrow’s future government surpluses.
USA: To bail-out or not to bail-out
After the War of Independence state bonds were trading at a significant discount. Many doubted whether the debt would be repaid in full. Hamilton and Washington decided to bail-out the state bonds in return for more centralized taxation. The main argument for the bail-out was that the debts were accrued for a federal cause (independence) and thus all states should share the cost. This was a clever political move as creditors would want a stronger central government to guarantee the repayment of the debts. This initially had strong positive economic effects as interest rates decreased with creditors expecting future federal surpluses.
The downside came in the early 1840′s. Cheap credit allowed many states to expand infrastructure and public services in their states. Eventually as recession hit investors noticed that the many projects did not have the anticipated returns and creditors doubted if they that they would be repaid as interest rates increased. Now the federal government decided not to bail the indebted states out as it was deemed unfair for a state that had spent its taxes on public works in its own state to be bailed out by other states taxes. The individuals in the more thrifty states had not had the benefit of the same expenditure on public works.
This came as a shock. Many investors had expected the federal government to bail-out the individual states. In addition many, especially foreign creditors, could not easily distinguish between different state debts, this led to some contagion and the federal bonds rate also increased.
The positive outcome was that states started to signal their own creditworthiness by including balanced budget amendments and signing other agreements. These agreements increased investors expectations of future surpluses and a decreased the rate of interest demanded on government debt.
Eurozone: Fiscal Union is a race to the bottom
The EU should not fall in the trap of a Fiscal Union. Fiscal Union increases moral hazard. The best strategy in a Fiscal Union is for every European country is to increase its debt and hope another country’s surpluses will cover it. This is a race to the bottom. We need a race to the top. Eurozone countries should compete in creditworthiness by signally future surpluses to investors.