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The Fiscal Union Delusion

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The Fiscal Union Delusion

Any day now, the leaders of the euro zone will present a grand plan to prevent future fiscal or financial crises from threatening the single currency. Or so we are told. This is likely to include some step toward the buzzphrase of the season: "fiscal union," supposedly in the American model.

Politicians in Paris, Berlin and Brussels argue that Europe needs such fiscal centralization to make its monetary union work. Unsurprisingly, partisans of an ever-expanding economic role for the state strongly favor this approach, along with greater "economic union." But creating a United States of Europe by aligning Irish tax rates to German ones, or by making Dutch citizens pay for French entitlements, would be the wrong solution to the wrong problem—and the wrong lesson for Europe to take from America.

Yes, the U.S. has both a monetary and fiscal union, but the economic situations of many of American states and local jurisdictions are not appreciably better than those in the troubled nations of Europe. The problems facing both Europe and the U.S. reflect less the shape of the table than what political leaders have been doing there. Both European and American policy makers adopted unsustainable economic policies, which markets are now betting against. Were Europe to further weaken market discipline and political accountability with a new system of fiscal transfers between national governments, it would simply be delaying the painful but inevitable adjustments that past mistakes necessitate.

The governments of Greece and Portugal spent too much and promised too-generous retirement and health benefits. The result was insolvency. Similar problems afflict many American states and cities, whose borrowing costs are now skyrocketing. America is both a monetary and fiscal union, but that has done little to fend off its fiscal problems. What has saved America from similar crises in the past is the American idea and practice of "competitive federalism."

While there exist certain federal-level regulations in the U.S., the specific rules governing the sale of goods and services differ not just between states but between local jurisdictions as well. Compare regulation-happy California and freewheeling Texas. California is losing jobs and tax revenue; Texas is gaining them. That is the competitive process at work, and California will need to find some competitive advantage over Texas—and 48 other states—to improve its fiscal and economic outlook.

Moreover, California politicians find it hard to look to Washington for help. National politicians in the U.S. haven't explicitly bailed out insolvent states or localities, unless you count the prospect that the Federal Reserve's so-called "easing" will help state and local governments inflate their way out of debt.

This arrangement has deep historical roots. After America's Revolutionary War, the nascent national government assumed the wartime debts of the pre-Constitutional national government and individual state governments. . When eight states defaulted in the 1840s, and when Arkansas did so in 1933, there were no bailouts. These public borrowers had to take drastic steps to regain competitiveness and eventually earn back creditors' trust. It is that discipline—not monetary and fiscal union—that gives U.S. states a strong incentive to keep their spending, borrowing and regulation under control.

America's fiscal system also allows states considerable discretion on fiscal matters. They incur their debts in a common currency, but that has not allowed erring political entities to escape responsibility for those debts. Recently, Jefferson County in Alabama, with a population bigger than Luxembourg's, entered a state of insolvency, but has managed to work with its creditors to reach an orderly restructuring of its debt. The spillover problems did prompt the state to provide assistance to the county, but the primary responsibility to solve the problem has been the county government's, not the state or national government's. The incentives to avoid a complete default were high, and both the county and its creditors shared the losses.

Europe's mistake was not that it did not indulge in fiscal union when it created a monetary union, but that it harmonized too deeply and quickly in the pursuit of a common market. The entire principle of the acquis communautaire—law that all EU member states must share—is the root of Europe's current problems. It has already led to such a buildup of pan-European rule-making that few economic issues or other problems can be addressed at the national level.

America, with its states as laboratories of democracy, does not yet have this problem. Yet the Obama administration is doing its best to Europeanize America. The regulatory onslaught in everything from environmental protection to health-insurance mandates and workplace standards threatens to overwhelm states and reduce the differences between them. At a time when Europe needs to learn from America's competitive model, it seems instead that America is repeating Europe's mistakes.

Recently, Bundesbank President Jens Weidmann told Der Spiegel that "lawmakers must decide between two models: a model with autonomous members, who are not liable for others and are disciplined by the market, and a model with deeper political integration. There is no stable middle ground." He is right. If European leaders seek American-style "union," they should strengthen market disciplines by weakening central economic control.

European attempts at discipline through transnational politics have failed repeatedly. If Europe is to learn anything from America, it is that competition—even at the state level—is the best tool yet devised for disciplining and sustaining wealth creation.