Lessons for Europe’s Fiscal Union from US Federalism

Yves here. Even though both writers are affiliated with the Peterson Institute, this post talks about the need for countercyclical mechanisms in the eurozone, which makes it less austerian than the prevailing line of thinking in the officialdom. But some readers will not be so keen about the worship of Hamilton.

By C Randall Henning, Professor of International Economic Relations, American University and Martin Kessler, Research Analyst, Peterson Institute of International Economics. Cross posted from VoxEU

In the last few months, several Vox columns have drawn parallels between Europe today and an emerging – and even less stable – United States in the eighteenth century. This column stresses that Europe’s leaders in search of a fiscal union need not seek to replicate the US experience but they should at least learn from it.

The Eurozone crisis and debate over fiscal reform have led many observers to pray for salvation by a modern, European version of Alexander Hamilton. By this they generally mean someone capable of leading a movement for a robust fiscal union and implementing this vision. (See for example McKinnon 2011.) Europe has instead, they lament, a collection of leaders who are primarily responsive to divergent national electorates rather than engaged in building a pan-European political movement. Consequently, they despair, instead of transforming the fiscal architecture of the monetary union, European officials are now dithering over the details of a ‘fiscal compact’, which is little more than an uninspiring upgrade of the Stability and Growth Pact.

Balancing the budget

The fiscal compact’s rules on balanced budgets are not necessarily wrong; their appropriateness depends on how they are ultimately designed and implemented. However, the emphasis on the fiscal compact distracts European policymakers from more immediate demands of the Eurozone crisis and is woefully incomplete and badly sequenced with other elements of fiscal and financial integration. In a new paper (Henning and Kessler 2012), we argue that the history of US fiscal federalism from the founding of the republic to the present holds important lessons for the architects of Europe’s fiscal union. Europeans do not want to replicate US experience but learn from it.

As part of his plan to establish the credibility of the US government as a borrower and build a ‘modern’ financial system, Hamilton famously ‘assumed’ the debt of the states. This federal bailout, which was repeated after the War of 1812, is anathema to present concepts of the fiscal ‘sovereignty’ of the states in the US. But the powers of the federal government grew largely from that decision. After establishing its authority, the federal government shifted to a no-bailout stance in the 1840s, letting several states default. Simultaneously, and subsequently during the nineteenth century, states adopted balanced-budget rules of varying strength on their own accord. Today, all states except Vermont have such a rule inscribed in their law or constitution and, although these rules can leak, state debt accumulation has been relatively limited.

Debt brakes

Balanced-budget rules among the states parallel the effort – adopted at the March 2011 European Council meeting and affirmed at the December 2011 summit4 – to introduce constitutional rules or framework laws, ‘debt brakes’, in the member states of the Eurozone. The fiscal compact agreed at the December 2011 summit specified that members’ annual structural deficits should not exceed 0.5% of nominal GDP, among other things.

Before drawing too heavily on the US experience in concluding that constitutional debt brakes are a key solution to Europe’s debt problems, however, Europeans should consider three essential aspects of the context in which the balanced-budget rules of the American states operate.

First, the US constitutional design is very different from what European leaders envisage for the Eurozone, ie debt brakes that are mandated by the union and enforced by the Commission and the European Court of Justice. The difference is likely to be consequential in two respects. We suspect that local ownership and enforcement make debt brakes more effective than under central mandates, particularly in the context of credible no-bailout norms, and that rules that are centrally mandated are likely to prove to be more brittle than those adopted in a decentralised fashion. When one state violates the rule, as the experience with the Stability and Growth Pact demonstrates, its applicability to other states is less credible. That is less likely to be the case with rules that have been adopted autonomously.
We acknowledge that some of the impetus for debt brakes comes from within Eurozone countries. The present crisis could be sufficiently traumatic and thus politically transformative to produce an autonomous reduction in debt tolerance within some of the most afflicted member states, just as the American states adopted balanced-budget rules autonomously from the federal government in the 19th century. Such an autonomous change in preferences would serve as an omen for the effectiveness of debt brakes. But the strength of the internal shift in debt tolerance is uncertain and is likely to vary significantly among member states.

Second, stabilising the banking system is primarily the responsibility of the federal government in the US. As a consequence, this function did not come into conflict with balanced-budget rules at the state level. In the Eurozone, by contrast, harmonisation of bank regulation is still young and the fiscal costs of bank rescues and recapitalisation remain primarily a national responsibility. The introduction of debt brakes threatens to collide with the need for member states to mount largescale rescues of their banking systems. As such provisions are put in place, therefore, it is all the more important that the Eurozone unifies banking regulation and creates a common pool of fiscal resources for rescuing and recapitalising banks (Posen and Véron 2009, Véron 2011).

Third, US federal debt has been supported by the full system of federal powers, including a sweeping power to tax and the federal budget has helped to stabilise the national economy in a countercyclical fashion since the 1930s. State and local budgets have behaved procyclically during recessions in the US. State-level restrictions would have been difficult or impossible to sustain in the absence of federal countercyclical policy. Although automatic stabilisers might play a greater role in some of the national economies in Europe than in the American states, creating stringent state-level debt brakes in Europe without a capacity for countercyclical stabilisation would be a serious mistake.

The route to fiscal union?

The rules of the fiscal union in the US evolved in a distinct sequence. The federal government first developed a robust fiscal capacity, with the assumption of state debt, issuance of federal debt, and access to its own tax revenue. Once that was established, the states could adopt balanced-budget provisions. By introducing strict balanced-budget rules prior to a robust fiscal union – assuming that some of them harbour ambitions for such a union – European policymakers are attempting to reverse this sequencing. Adopting such rules might reassure the ECB and smooth the path for further expansion of its operations, both of which are desirable, but it leaves the Eurozone short in terms of countercyclical tools. The need for a fiscal instrument for macroeconomic stabilisation is not a new observation, but we believe that it is an inescapable one, the implications of which have not yet been sufficiently incorporated in European deliberations over the fiscal architecture.

Advocates of the fiscal compact might note that the debt brakes are defined in structural terms, and therefore allow countercyclical action at the national level. While feasible in principle, this route to countercyclical capacity is strewn with problems of calculating the structural balance, external spillovers and coordination with the fiscal stance of other members. Creating a common capacity for countercyclical action – through a more robust central budget, issuance of euro bonds, backed by tax authority – is more reliable. But this route of course requires strong political cohesion and robust institutions for the monetary union that would match those through which Hamilton worked.

Some worry that the modern equivalent of Alexander Hamilton cannot emerge in Europe for lack of a political union similar to that of the US after 1789. But the absence of full political union in Europe is neither reason to despair nor an excuse for low expectations or half measures. Remember, as General Washington’s chief of staff, delegate to the Philadelphia Convention, and author of three fifths of the Federalist Papers, Hamilton himself helped to create the institutional prerequisites for the adoption of his plan, the Constitution, and the governing institutions of the young nation. He and the other founding fathers did so, moreover, under financial conditions considerably less favourable that European policymakers face today.

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  1. F. Beard

    But some readers will not be so keen about the worship of Hamilton. Yves Smith

    That’s an understatement! Hamilton wanted a national debt to (paraphrase) “bind the interests of the rich to the success of the Nation” . Well, that need is long past gone. Now the National Debt is simply a wealth transfer mechanism from the poor to the rich and banks. It should be paid off as it comes due with new fiat and all future US Government deficits financed with pure money printing (US Notes).

    1. Historicaecon

      The problem with Hamilton was not his desire for debt. All of the states had debt after the Revolutionary War – something I think everyone can agree was worth spending money on. (His most important success was turning those state debts into a national debt, making the national government the locus for financial speculators and the like. He made many of his friends extremely wealthy in the process.) Instead, the problem with Hamilton is that he (and his successors down the present day) didn’t believe in democracy. Instead of trying to make democracy work, he used his considerable talents to subvert it, to make the U.S. a democracy in name only. Much of his work in that regard was reversed by Jefferson and his successors, but his followers still celebrate it. Centralized authority – in Europe or here in the U.S. – is their goal because of the “wealth” it creates for those well connected enough to take advantage of it.

  2. NotTimothyGeithner


    Hamilton emerged prior to 1789. He was rumored to be the illegitimate child of one General George Washington (he was sterile) as well as an officer in the Continental Army. Not only that, he and his fellow Washington aide, Madison, created the political union. They did not emerge in the Constitutional System.

    Hamilton, Madison, and Jay spoke to the new Zeitgeist from their Continental Days (I’m not sure about Jay), spoke as members of elite (Hamilton because he was close to Washington), and spoke as outsiders/new kids on the block because they had little to do with the Articles of Confederation.

    Hamiltion recognized the need for things like a national bank even before 1789 and that the Articles of Confederation would face a crisis which would leave member states seeking their own solutions and leaving. Hamilton, Madison, and Jay acted prior to the political crisis and created a political union before an economic union because they understood the political union had to come first, and they knew that if the non-foreign crisis came the states would split instead of coming together.

    1. anon48


      Perfect evaluation!

      The creators of the EU treaties(probably many of which were so-called brilliant economists) seemed to have completely missed this little detail. In the long run, they did their people no favor by forcing through an agreement without first satisfying this most basic premise. Because in the end, there will either be catastrophe or some loss of sovereignty (or combination thereof)forced upon many of the people of the EU(including Germany). The ultimate costs to present and future European generations could well exceed whatever benefits that have accrued thus far by forcing through an incomplete treaty.

      The possibility of a crisis arising with the potential of fracturing an imperfectly formed union somewhere down the road was absolutely knowable to the treaty proponents. A bunch of guys were able to anticipate this possibility more than 220 years ago (without having the benefit of 20/20 hindsight).

      Apparently, your little detail was also missed by the author of the above post (or he relegated to being only of secondary concern).

    2. Susan the other

      Before fiscal, political. Before global, regional. Somewhere in this timeline things got derailed. An intermediate step is missing. Instead of encouraging expanding regional trade pacts, the globalization movement did the opposite, it tried to eradicate nationalism and regionalism. Superimposed from above. Nobody is saying globalism isn’t working. I wonder why? It not only isn’t working, it has really screwed up what could have become a balanced system but is now in disarray. There is no equitable distribution system to fall back on. But lucky for all of us earthlings, money can substitute for politics and so it can be smeared across the globe like butter if need be, thereby buying time for actual policies to emerge. Before global, political. It is going to take years to fix this mess.

    3. Historicaecon

      Hamilton was an officer during the Revolution. He was a bastard, born in the West Indies. He came to New York to attend King’s College and dropped out to join the Revolution. Hamilton believed that a state could never be powerful without a class of individuals controlling concentrated capital. His system (implemented during George Washington’s first term when he was Secretary of the Treasury) was designed to create that class and bind it to the U.S. It worked. Whether it was a good thing or not is another question.

  3. Schofield

    Of course the corruption of the Federal Government primarily by Wall Street resulted in taxation without representation as a consequence of the house price bubble and this has resulted in a huge loss of tax revenue for states and local councils. Despite Obama repeatedly stating there is “no money left” the Federal Reserve has continued to conjure money from nowhere to give to Wall Street through its QE program despite Wall Street’s failure to use it productively to boost the economy. In a rational world bi-partisan Congress ear-marked tax credits to pay down mortgage debt which was illicitly imposed would now be the only way forward to help recovery of the states and local tax bases. A Steve Keen tax-reversal program if you like which can contain a guarantee against inflationary consequences by the threat of increased taxation on Wall Street fat cats and the 1% – 10% generally. Some pipe-dream for a corrupted nation in decline!

  4. Jim

    The colonies had a common culture and language. Would Greeks be comfortable with Germany as the national language? With the federal government based in Berlin?

    I’m surprised that so many “progressives” who would otherwise be against anti-democratic movements are so amenable to the Eurocrats in Brussels imposing a United States of Europe on people who don’t want one.

    How would US citizens have felt if the Chinese, one decade ago, would have insisted that US taxpayers bailout Argentina, thereby preserving the “fiscal union” between the US and that country?

  5. sherparick

    I grew up in a very anti-Hamilton pro-Jefferson household, but after reading some real good historians of the period, particularly Page Smith and Gordon Wood, I realized that in actual practice Hamilton was more democratic than Jefferson. He organized and electionered for popular parties in New York City and State, opposing Aaron Burr’s Tammany machine. I have the Library of America’s book on Hamilton’s writings, and he is brilliant, even when I think he is ultimately wrong on some issues. But on the public debt of the United States, he was completely right, and long as the Government can pay the interest on such debts from its taxes, it should take on as much debt as necessary to reduce unemployment to 6% and restart growth. Of course, if that growth is to be primarily in America, we have to adopt intelligent neo-Mercantilist policies versus on the neo-mercantilist rivals in China, Japan, and German dominated Europe.

    1. F. Beard


      The US Government, since it is monetarily sovereign, has no need to borrow money and shouldn’t since it is a pointless gift of a risk-free return to the banks and to the rich at the expense of everyone else.

      Furthermore since US Government debt is essentially a perfect money substitute anyway it is even more inflationary to issue that debt than to just spend fiat into existence since interest must be paid on that debt.

  6. Fiver

    The Peterson Institute is about as far up the Wall Street/Washington, US-based global multinational corporate elite backside as it’s possible to be without hitting (the departing before the the real second phase of this hits circa late 2014) Tim Geithner’s feet. You can be sure that whatever is recommended by these people will not be in the interests of ordinary people anywhere.

    Here’s a hoot by way of example:


    Globalization is Corporatism’s creation and it is a disaster. It turns everything it touches into production units administered on behalf of managers at Head Office, units that become increasingly incapable of functioning independently. It is very rapidly turning us into ants, which is apparently acceptable to a good many people. But what isn’t acceptable, at least not if a human and humane future is desired, is for all those ants to be effectively living in one hill, all being dependent on one enormously complex system we’ve built but have no idea how to safely operate. We are obliterating diversity,i.e., ethnically, culturally other ways of being human – we no longer tolerate it at all when it comes to political/sovereign/economic independence of nations, or any other forms of large-scale, geographically defined social groupings attempting to assert a different set of rules/values (the world’s Muslims, or indigenous peoples everywhere, for instance). Globalization, i.e. multinational corporatism, is not just intensely aggressive, often brute exploitation, it is orders of magnitude more prone to major disruptive events of all kinds.

    A forced fiscal union done only to satisfy somebody’s notion of the rightly SCALED solution is both ill-conceived and illegitimate, and ought not be pursued. These are different peoples with languages and histories gong back thousands of years – in no way comparable to the US. This solution to me has the look of someone UP the chain’s idea of the re-org for the European Division.

    This was the first kick at the can for a Europe no longer organized as a defensive front-line bulwark against imagined Soviet expansionism. And who knows how long it may have lasted were it not the second victim (US being first) of the fraudulent Wall Street notion that risk is dispersed (thus magically profitable) in a financial world where everything (and everyone) is hedged against everything else.

    Neither the world, nor the nations of Europe, need greater central corporate management, greater “integration” that now equals subservience to unelected writ. They would be best served for all its component countries to unwind massive foreign financial entanglements, and re-acquaint with the notion of more, not less, local flexibility, and the REAL security greater self-sufficiency conveys.

  7. Paul Tioxon

    There was no financial infrastructure and no institutional authority of the Revolutionary States so international financing could be obtained by a government, as there was no means to collect taxes to repay loans. Enter Robert Morris who to personally guarantee loans:







    Scroll down on the link until you get to Morris.

    Notice, all of this was done before there was a US Constitution, not ratified until 1788 and not operational until 1789. It was the political act of Union, the will to power, which preceded the constituent elements of the relationship of the people of the states to the nation of the USA. It was an ongoing act of political deliberation during the exigencies of war that started in 1776 and concluded 13 years later. This is not mergers and acquisition but a different type of decision making with consequences on a scale and of a quality different than that of the market in aggregate.

    Europe has to work out a more complex set of issues, not only fiscal, but military integration before you will see anything close to the USA. It can not replicate it because it really is about fully formed nation states with military as well as fiscal disparities. The colonies coming together as a nation is too different than nations coming together in some sort of federal unity, after accomplishing a similar feat to become a nation in the first place.

    1. Fiver

      Good comment. Considering the obliteration of rights and law of the past decade, makes me wonder if what we see today is a reversion to a pre-Constitutional mindset – some sort of bizarre overshoot.

  8. Sundog

    I’m very sorry to see this sort of disclaimer at NC: “even though both writers are affiliated with the Peterson Institute”.

    No doubt I’m naive when it comes to DC but the Peterson crew seems to consistently base their work on widely accepted data. As a Left-Libertarian that puts them in my camp though I may disagree on interpretations.

    On the EU I think it was some wit at The Economist who came up with the notion “Brussels reacts to democracy as Dracula reacts to garlic.”

    Europeans have a high but not unlimited tolerance for granting technocrats legitimacy but Monetary Union v1.0 gambled on legitimacy catching up to it. Turned out otherwise.

    Despite the burden of history, the Germans would do all a favor by reverting to the DM. After another 20 years, a Monetary Union v2.0 might actually work.

    Incremental iterations (v1.01, v1.103, v1.2140) solicit chaos.

    1. Foppe

      When it comes to economic analysis, “using widely accepted” data/insights is not necessarily a boon. “Great Moderation” and all that..

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