Washington refuses to rescue near-bankrupt statesby C Randall Henning / June 20, 2012 / Leave a comment
Europe should look to America, where California’s crisis does not threaten the union
The euro crisis has now entered a decisive stage, a moment of truth for the governments of the troubled currency bloc. Countries with sound public finances, led by Germany and its chancellor Angela Merkel, have been demanding progressively more intrusive control over the budgets of crisis-stricken members to guarantee that their financial support will not be abused. In this debate about how far Europe should move towards federalism, European officials often allude to the financial constraints that the 50 states accept under the federal system of the United States.
But the comparisons risk misunderstanding the nature of the financial discipline at the heart of the American model. The plight of California offers some hope to Europeans: it shows that a union of many members can survive when some are profligate, and without resorting to bailouts by the financially stronger members, or by a central federal government. In all the anguished debate in California, there is no serious prospect that the US federal government will bail out the state. Nor does anybody in the US really doubt that California will remain part of the US monetary union—the dollar. But the second lesson demands further action from Europeans: this overall robustness, and the ability to be tough towards profligate members of the union, is possible only when the costs of government and of protecting banks are shared to a far greater degree than the eurozone has yet accepted.
California has been in a budget crisis for years. It entered a new, acute phase in May when estimates of its budget deficit in 2013—the gap between its projected revenue and its spending for that year—were revised sharply upwards. The state’s politics are famously dysfunctional. Major tax increases require the support of two-thirds of both houses of the state legislature, which is frequently at odds with the governor regardless of who occupies that office. Critical fiscal decisions are often the subject of statewide referendums—a repeated test of whether voters will actually back cuts and personal discomfort in pursuit of more stable finances for the state overall. To close a $15bn budget gap, Governor Jerry Brown has placed a referendum before the electorate for a vote in November that proposes a combination of a 0.25 per cent rise in the sales tax and higher tax rates on incomes over $250,000.
Yet there are several reasons why California is better off than Greece, Portugal and Spain. For a start, its economic situation is not as desperate. Its debt (principal and interest) amounts to $168bn, which is only about 8.6 per cent of state GDP. Although California’s bonds compete with those of Illinois for the lowest rating of the 50 states, they are still considered “investment grade” by ratings agencies. By contrast, the ratio of general government debt to GDP is about 81 per cent for Spain, 114 per cent for Portugal, 123 per cent for Italy and 161 per cent for Greece—even after a restructuring of privately held Greek government bonds. These countries are also in either mild or severe recession. In 2011, California’s economy grew at 2 per cent. But the federal arrangements of the US also prevent California’s crisis affecting the whole country.
A central principle of US federalism is that states are formally “sovereign.” This does not mean that they are economically separate or do not receive federal money; states receive a good deal of federal spending. But the federal government cannot mandate state tax increases or spending cuts. Nor can states declare bankruptcy, while the federal government does not guarantee state debt.
The principle that Washington will not bail out states is not part of the Constitution; it was established when Congress rejected pleas by the states in the 1840s, and nine of them subsequently defaulted on payments due on their loans. As a result of that experience, states introduced balanced-budget rules of varying effectiveness into their own constitutions. The federal government has assumed the debts of no state since then.
Is the federal government’s “no bailout” stance still credible, given its rescue of US banks and automobile companies during 2008-2009? Yes, and the reasons are instructive for the eurozone. The federal government is responsible for roughly 60 per cent of all government spending in the US and issues the lion’s share of government debt in the form of US treasury securities. These bonds serve as safe assets in the banking system and are used by the Federal Reserve in monetary policy operations. Contrast this with the European Union: its debt obligations are small relative to those of its member states, and private banks and the European Central Bank hold large amounts of national sovereign debt. If EU states default on their debt, it threatens the financial system of the monetary union as a whole. Default on state debt in the US would harm the financial portfolios of rich investors, who hold most state bonds, but affect the US financial system less than such an event in Europe.
The “no bailout” stance draws further credibility from two other elements of US federalism. First, the US has a banking union, to use the phrase now much discussed in Europe. The costs of stabilising the banking system are borne by the federal government and so shared across the country. When a bank goes bankrupt in California, Nevada, North Carolina or New York, depositors are covered through the Federal Deposit Insurance Corporation (FDIC). During the subprime mortgage crisis, the federal government injected capital through the treasury’s Troubled Asset Relief Program (TARP). The costs of rescuing banks do not push individual states more deeply into debt, as they have for Ireland and Spain. The weakness of banks is still dragging European sovereigns into crisis, while the euro area as a whole could afford these rescues.
Second, the US federal government budget plays an important role in stabilising the overall economy. In 2008 and 2009, Washington provided a critical stimulus by spending money when the individual states were tightening budgets. If the default of a state—its inability to pay its debts—ever threatened to cause a recession, the federal government could protect the rest of the economy by providing a stimulus. If it did not have that counter-cyclical role, rules insisting that states balance their budgets would not be viable.
The lessons of the American model might be counterintuitive. But the US shows that federations or other unions can be equipped to deal more forcefully with irresponsible members if they “mutualise” or share the costs of government and of recapitalising failing banks. These features enable Washington to avoid being blackmailed into providing bailouts. The “no-bailout” stance in turn deters the excessive accumulation of debt by individual states. It is important to note that the US has not sought to shield the union from the economic spillover from dysfunctional states by “receivership” or any other form of direct intervention by the federal government in state decisions.
The EU should take inspiration from this feature of the American model. Governments should agree to insure bank deposits across the eurozone collectively and to create a way of acting together to recapitalise banks directly rather than channeling capital to banks indirectly through their member states. Sharing the cost of bank restructuring should be accompanied by bank regulation and supervision that limits the risks that banks can take and enforces rules about how much capital they must hold. Leaders should chart a path towards a future agreement on eurobonds, which could be issued for investment projects that benefit several countries and would strengthen the fiscal capacity of the monetary union.
European countries should take these steps towards a banking union and proto-fiscal union in order to spread risk beyond individual member states, calm markets, and restart growth in the highly indebted countries. But these measures should also appeal to the narrow self-interest of the fiscally sound member states that emphasise the need to prevent excessive risk taking in the southern periphery. By protecting the euro area from blowback of the markets as the US has done, this leap forward would prepare the union to refuse bailouts to undeserving states in the crises of the future.