Europe’s Fiscal Crisis and U.S. States
Should Europe's struggles to solve Greece's financial mess sound familiar to Americans?
- The bottom line from U.S. economic history is encouraging — fights over money need not ruin a good federal union.
- These were long and painful crises. Such economic pain may have been expected in the United States of the 19th century, but governments cannot simply stand by in 21st century Europe as the economy moves through a deep crisis.
- Since the Depression, no state government in the United States has defaulted on its general obligation debt — but plenty of other state and municipal issuers have.
- These balanced budget provisions were not imposed on the states by the central government — but rather were a response by state lawmakers, who bowed to pressures from financial markets.
- Arkansas's 1933 default on its debt is the last time a U.S. state failed to pay its general obligation debt.
The lessons of the evolution of state and local government borrowing in the United States seem to be:
Welcome to the dilemmas of fiscal federalism. For all the discussion across the Atlantic on the ins and outs of bailing out Greece, the bottom line from U.S. economic history is encouraging — fights over money need not ruin a good federal union.
Though problems with money may rival problems with sex as reasons to end a marriage, more often than not, couples manage to find a way to patch things up — not only for the sake of the children, but for their own sake as well. Economic and political "marriages" among fiscal jurisdictions may not be so different.
Whether in the United States in the 19th and 20th centuries, or in Europe in the early 21st century, any real economic integration poses a recurrent dilemma. Three dimensions stand out:
1. Sovereign governments do make their own mistakes — and they are the ones who need to correct them.
2. At the same time, financial chaos in one part of an integrated economy can drag down the rest of it.
3. However, if the rest of the collective bails out the delinquent government, a moral hazard is created, undermining the delinquent's incentives to straighten out and fly on the right path in the future.
Does the following story extracted from the annals of American history ring a bell in the context of the contemporary upheaval in global financial markets?
The economy was already in bad shape when the depression hit. The state took over financial responsibility for existing debt issued by local authorities, because the locals had promised to spend far more than they could pay for. The predictable result was that state debt mushroomed. Soon enough, the state in question simply could not keep up with its bills. In 1933, the state government defaulted on its highway bonds, and essentially functioned on the basis of transfer payments from the central government for two years. The state government started to dig itself out only when it passed new taxes, but even then, Arkansas had to stop road building for 16 years.
Arkansas's 1933 default on its debt is the last time a U.S. state failed to pay its general obligation debt. But there are many earlier cases of default by state governments — and many subsequent examples of default by local governments and agencies of state and local government.
Over the course of the last 200 years, institutions and mechanisms have evolved in the United States that have helped build a firewall between obligations of state and local authorities and the central (federal) government.
These have significantly limited the power of state governments to undertake some kinds of policy, notably countercyclical fiscal policy. The system works pretty well, if measured by the volume and the liquidity of both federal and state and local debt markets.
Notably, the institutional changes that brought government debt markets from a situation of vague delimitation of debt service responsibilities to today's far more clearly defined system was the result almost entirely of market-driven reforms.
When the 13 colonies successfully won independence from Britain, the central government they created was exceedingly weak.
Alexander Hamilton, the visionary architect of early U.S. economic institutions, asserted the importance of the central government in 1790 by getting the United States to assume the debt accumulated up to that point of all the 13 colonial governments. This is the one and only time the U.S. federal government assumed state debt.
Heavy opposition arose to Hamilton’s assumption of state debts, especially in the American South, which had paid off most of its debt.
Southern states saw in Hamilton’s proposal a plan to alleviate the tax burden on northern states lagging in their debt payments, while southern states had already reduced their debt at great internal cost.
In the end, Hamilton pushed his proposals through the U.S. Congress, and the nation reaped the economic rewards — as 19th century European investors increasingly purchased U.S. government bonds and invested in the U.S. economy.
But borrowing by the individual states, which had begun in Massachusetts in 1751 — a quarter century before America's war of independence — did not end with the establishment of the United States. Indeed, state and local borrowing was a major source of finance for transportation infrastructure in the 1820s and 1830s.
An economic crisis that began with the panic of 1837 and lasted five years brought the first wave of defaults on state debt. Nine U.S. states (of the 26 that had joined the United States by this time) ended up defaulting on their debts. Four repudiated all or part of their debts — and three went through substantial renegotiations.
Two of the defaulting states — Maryland and Pennsylvania — were able to resume debt payments, with back interest, as soon as a property tax was enacted. The other defaulting states, however, already had high property taxes. Without access to new revenue sources, these states were forced to default, and then either renegotiate or repudiate their debts.
In the wake of this crisis, states began to enact laws that forced fiscal restraint on their governments, initially to limit state guarantees of private borrowing.
Laws to constrain state and local borrowing — which today are at the point that 49 of the 50 states (the exception is Vermont) have some clause in their constitutions that requires operating revenues to cover operating costs — gradually have been strengthened over time.
These balanced budget provisions were not imposed on the states by the central government — but rather were a response by state lawmakers, who bowed to pressures from financial markets.
Legal limits on state and local finance, however, did not prevent the emergence of other crises. In the wake of the Civil War, in the late 1860s and 1870s, another nine states defaulted. The Panic of 1873 increased the indebtedness of a number of states while limiting their borrowing opportunities.
This time, defaults were concentrated in the South, where unpopular Reconstruction-era state governments had chosen to borrow, rather than tax, to finance the rebuilding of infrastructure. Again, default stimulated institutional innovation, with the establishment of private-sector-based rating systems for state and local debt issues.
As the market for state and local debt deepened and expanded, it developed various kinds of instruments with different degrees of risk. "General Obligation" bonds, backed by "the full faith and credit" of state governments, were supplemented by revenue bonds that pledged future revenue streams (fees and tolls for delivery of services) from a large variety of quasi-governmental entities.
When the Great Depression hit in the 1930s, defaults on state and local debt once again rose. In 1933, 16% of state and municipal debt was in default. But only one state government failed to honor the "full faith and credit" it had pledged: Arkansas, as mentioned above.
Since the Depression, no state government in the United States has defaulted on its general obligation debt, but plenty of other state and municipal issuers have.
Among notorious defaulters have been the Washington (state) Public Power Supply System, which in 1982 defaulted on $2.25 billion in bonds issued to finance nuclear power plants that never were completed; New York City, which in 1975 delayed payment to its bond holders; and Orange County, California, which in 1994 similarly missed payments to its bond holders.
Most of these defaults have been resolved relatively quickly, not much affecting the value of the actual cash flow. However, some, especially for revenue-backed bonds, have led to significant losses among bond buyers.
The institutions that have evolved in the U.S. state and municipal bond market have kept it liquid and active. However, they have significantly limited the options of borrowers. State and local governments in the United States pursue chronically pro-cyclical budget policies, spending and cutting taxes in good times and reversing these measures in bad times.
If it were not for countercyclical policies by the central government — not the least of which is grants to state governments when the economy is in recession — state and local fiscal policies, constrained by limits to borrowing, would only aggravate the business cycle. Nevertheless, everybody knows that whatever mess a state may get into, it must solve it internally.
California voters cannot expect additional national revenues to be funneled their way when they reject increases in state tax rates. Nor is discussion of future central government debt problems (or the interest rate on Treasury debt) influenced by considerations of state and local fiscal dilemmas.
One might conclude, from our review of U.S. economic and financial history, that Europe could survive a Greek default. However, to draw this prescription from U.S. history is problematic in three ways: