Tuesday, November 22, 2011

Lessons for the Eurozone from US Fiscal Federalism

If the euro disintegrates because of a failure to take short-term measures needed to support it, we won’t have to worry about long run governance issues.  Just in case the e-zone gets through the immediate crisis, however, here are a few thoughts based on US experience.

There are 50 US states (plus a few colonies), and each has its own budget.  By law, this budget must balance in 49 of them, and the holdout (Vermont) doesn’t operate differently in practice.  The logic behind this constraint has nothing to do with optimal fiscal policy—whether budget deficits are “good” or “bad” in any given context—but reflects the centralization of macroeconomic policy, monetary and fiscal, in Washington.  Suppose, for the sake of discussion, that a state, even a large one like California, decides to go its own way and runs a large fiscal deficit.  This would pose several challenges to federal-level policy:

It would add to the stock of dollar-denominated public debt, whether or not policy-makers, or the public, elsewhere in the country wanted it.  In other words, it would be undemocratic, imposing an outcome on a broader jurisdiction which that jurisdiction would be unable to decide on.

It would put pressure on Washington to guarantee, explicitly or implicitly, state-level debt.  As in today’s Eurozone debacle, it would be extremely costly to permit defaults by large members of the community; the effects would spill over to other state fiscal authorities.  But if the federal level guarantees state debts, there need to be limits on the borrowing choices of the states.  In this sense, there is some support for a German-style “hard” fiscal constraint on states.

It would also put pressure on the Federal Reserve.  Under normal circumstances, although not today’s liquidity trap, more public debt means higher interest rates, and this places a burden on all dollar-denominated public borrowers; it also has the potential to crowd out private credit creation.  The Fed is then forced to decide how much of this pressure it wishes to relieve through monetization, thereby assuming the risk of inflation.  Despite putative central bank independence, there is normally a loose coordination between monetary and fiscal policy, since the effects of each depend greatly on the other, but that would not be possible if it were state fiscal choices that were driving the aggregate public budget.  In fact, the thought experiment of active California (or other state) fiscal policy makes clear how important it is to coordinate monetary and fiscal spheres.

Up to this point, it looks like fiscal orthodoxy is the takehome message: if the Eurozone wants to centralize its finances, it needs to impose something like a balanced-budget rule on its member states.  If you are Wolfgang Schäuble, you can stop reading right now.

But it’s not so simple.  There are two big caveats that have to be taken into account.  The first is that the balanced budget rules at the state level apply only to operating expenses; these have to be financed out of current revenues (or surpluses set aside during balmier times).  States routinely issue bonds to finance capital projects, and these are just as surely fiscal deficits as any other form of debt-financed spending.  There is no statutory limitation on the capital budget in any state, although political resistance has usually kept bond issuance at moderate levels.  (In many states new bond issues have to be put to a public vote.)  One advantage of exempting capital projects from balanced budget rules is that, in theory, these project provide a stream of future benefits to offset future debt service.  If you think that dividing state budgets into operating and capital components and treating each differently makes sense, you would want to look for an alternative to a simple hardening of the Stability and Growth criteria.

The second caveat is the biggest: the federal government conducts fiscal policy.  It oversees the lion’s share of automatic stabilizers, such as tax receipts and transfer programs.  (Where it doesn’t, as in unemployment insurance, it tends to be more generous in backstopping the states—at least it was until the Republican Party decided it wanted to undo the New Deal.)  In other words, the federal government assumes the majority of taxing, spending and transferring activity in the US; even combined, the states are second-tier.  During 2010, for instance, and indulging in a bit of rounding, the federal government accounted for 70% of all government spending and 60% of all public revenues, with the rest going to all other levels of government.  (The difference between these two shares reflects the federal assumption of deficits.)  It would be presumptuous to claim that this is the right set of proportions, but it gives an idea of what the fiscal transformation of the Eurozone would entail.  Clearly such a shift of financial wherewithal from the members to the center cannot be undertaken without a corresponding political transformation—the creation of a consolidated, Eurozone-level democratic space.  (To his credit, by the way, Schäuble understands this.)

But it is not enough for the center to have fiscal capacity, it has to use it.  When the financial crisis of 2008 struck, it was essential for the federal government to use its borrowing capacity to make up for the credit collapse in the private sector; without the big budget deficits we’ve seen since then, we would be very deep in a depression.  In fact, as most reality-based economists recognize, the deficits should have been bigger; they should be bigger right now.  A different way to put it is that the fiscal restrictions on the states only make sense if there is no such restriction at the federal level, and policy is free to be as expansionary or contractionary as needed.  There must be no Stability and Growth criteria for center.

The link between these long-term considerations and the current negotiations over immediate measures is this: any pressure on governments to impose austerity in return for financial support should be balanced by fiscal expansion elsewhere in the system.  It should be at least euro-for-euro simply to retain the existing fiscal stance.  If you regard Eurozone-wide unemployment as too high or euro-denominated balance sheets too fragile, you would demand even more expansion than austerity.  This would anticipate the sort of viable consolidated fiscal mechanism of the future.  Imposing austerity without such a counterbalance anticipates a Eurozone whose consolidated fiscal account is simply the sum of member budgets, each subject to a deficit constraint—a US federal system without a US Treasury free to set policies as conditions require.  That’s a bad idea in good times and a death wish in the midst of a slump.

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