America’s fiscal federalism is less superior than you might think
Europe’s federation has been surprisingly effective
Quick: would you rather face the worst economic crisis in history as a resident of America’s fiscal union, or Europe’s?
An easy choice, surely; a decade ago, the euro area’s skeletal economic institutions turned an American-made panic into a near-collapse of the European project. By 2013 euro-zone output was 3% below its peak in 2008, whereas America’s was nearly 5% higher.
Look again, though, and the answer is less obvious.
Both fiscal federations have flaws. But the covid-19 crisis shows that Europe may not be so badly outclassed by America’s fiscal union after all.
The division of the power to tax and spend across many layers of government—fiscal federalism—has many potential benefits. Decentralisation allows governments to satisfy a diverse population’s policy preferences and cope with regional needs.
Given free movement of labour and capital within a federation, competition between regional governments can lead to policy innovation and limit state overreach.
At the same time, membership of a federal entity brings scale economies: access to more resources and a bigger market; more effective risk-sharing. Economists reckon that the task of macroeconomic stabilisation is best left to the highest level of government.
It has a greater capacity to manage local shocks: as federal-tax receipts in one region fall, revenue is cushioned by those from elsewhere. For a federal authority, the spillover of fiscal easing across state borders is not a problem. A shared currency, too, should be complemented by fiscal powers.
A strong federal budget, though, creates the risk of moral hazard. The lower levels of government may borrow too much, counting on federal bail-outs when things go wrong.
Effective fiscal federalism thus requires a mechanism to constrain states’ borrowing. America confronted this problem in the 19th century. After fiscal integration led to reckless state borrowing and defaults, state governments adopted balanced-budget rules.
All except Vermont are bound by them, leaving countercyclical policy the prerogative of the federal government. In downturns, states depend on federal relief: in the form of reduced federal-tax payments, increased welfare spending, and occasional discretionary stimulus (like the $1,200 cheques posted to most Americans earlier this year).
No real-world federal system meets the ideal. The euro area, on the eve of the financial crisis in 2007-09, suffered from dangerous defects.
Monetary power rested with the supranational European Central Bank (ECB). But member states retained near-total control over crucial policy levers, like the power to tax and spend, and to regulate banks.
The crisis exposed these weaknesses. Unsure that the ECB would act as lender of last resort to troubled member states, investors shunned vulnerable governments, sending bond yields soaring and raising the spectre of chaotic exits from the eu.
The predicament contrasted starkly with events in America, where a fiscally powerful central government backed by a proactive central bank stood ready to help hard-hit states and troubled banks. Many economists urged the euro area to replicate two centuries’ worth of American-style fiscal integration.
Instead the zone did just enough to survive. A promise by the ECB to defend the single currency persuaded bond vigilantes to retreat.
Even as it limped out of crisis, Europe seemed to sow the seeds of future troubles. As its crisis abated, the euro area moved to minimise moral hazard. Limits on government borrowing agreed in the late 1990s were strengthened post-crisis: through the introduction of closer monitoring and punitive sanctions, for instance.
But these efforts were not matched by complementary, American-style mechanisms to provide collective stimulus. The oversight seemed designed to leave the European project vulnerable, once again, in the face of any new recession.
Yet for all its missteps, Europe’s fiscal performance compares surprisingly well with America’s. Government spending contributed positively to euro-area growth in every year except 2011, when its effect was neutral, and 2012, when governments’ budgets reduced growth by just 0.1 percentage points. Austerity did concentrate economic pain in parts of the periphery.
But that was also the case in American states, where balanced-budget rules led states to make deep spending cuts. Indeed, these were so large that the federal largesse intended to keep America’s overall fiscal position stimulative barely managed to offset the cuts.
Government spending at all levels contributed 0.7 percentage points to growth in 2009, but was neutral in 2010 and subtracted 0.7 percentage points from growth in 2011—even as the federal government provided roughly half a trillion dollars in aid to states that year.
Just you wait
The response to covid-19’s economic devastation looks similar. On the surface, the staggering stimulus package enacted in America in the spring, worth about 13% of GDP, looks a far more potent contribution than the EU’s fiscal package, agreed in July. That recovery fund, supported by collective borrowing, will spend nearly 5% of eu GDP over several years.
But America’s stimulus is largely exhausted, and its dysfunctional Congress has been unable so far to pass additional measures. Cuts to state and local governments are already weighing on the economy, subtracting 0.4 percentage points from the (annualised) growth rate in the second quarter.
The euro area, by contrast, agreed that fiscal rules should not apply during the pandemic, allowing members to provide economic support on a par with America’s federal response.
No one will mistake the euro area for an exemplar of federalism. Some member states, such as Italy, Spain and even France, will exit the crisis with huge public-debt burdens. The suspension of borrowing rules could deepen anxiety about moral hazard, and lingering hardships could yet trigger a crisis that threatens the entire European project.
But conventional wisdom could use some revision. American fiscal federalism, so often cited as a model for the euro area, looks ever less clearly the superior system.
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