One nation overdrawn

Lessons for Europe from America’s history

Dec 17th 2011 | from the print edition

IN THE frantic race to save the euro, many Europeans have sought inspiration from the United States, perhaps the most successful monetary union in history. Germany’s council of economic experts has proposed a debt “redemption pact” modelled on the American federal government’s assumption of state debts in 1790. To European federalists, America demonstrates that monetary union cannot survive without fiscal union. And proponents of a European lender of last resort to insulate sovereigns from liquidity crises note how America can still borrow at 2% thanks to a deep and liquid government bond market backstopped by the Federal Reserve.
Look more carefully, however, and the American example is more complicated. Fiscal and currency union did indeed kick-start America’s early economic development. But fiscal and monetary frameworks were so rudimentary that they contributed little to nation-building.

America began life as a fiscal basket-case. The federal and state governments were deeply in arrears on loans taken out to finance their war for independence from Britain; federal debt traded at 50 cents on the dollar, state debt for 20 cents or less. Alexander Hamilton, the first Treasury secretary, considered it vital to America’s economic health to re-establish faith in the national credit. He proposed in 1790 that the federal government assume the states’ war debts and then arrange a new schedule of payments and interest to refinance all of the republic’s unpaid bills. Holders of the restructured bonds would be encouraged to exchange them for capital in a new central bank that would issue a uniform currency to unify the states’ financial systems.
Foreshadowing the rifts within Europe today, Hamilton’s plan was deeply divisive. Virginia and other southern states that had paid off their debts resented being asked to pay taxes to bail out the others. Hamilton at one point feared for the future of the union if his plan did not pass: “Our credit will burst and vanish; and the States separate, to take care every one of itself.”
Virginia eventually withdrew its opposition in return for having the nation’s new capital located on its borders. But Hamilton’s success at forging a fiscal union did not mean America now also had a fiscal policy that would transfer resources from strong states to weak. For the first century of America’s existence, the federal government’s presence was minuscule. Its total expenditures were usually less than 2% of gross domestic product (compared with 25% now), not much different from the European Union’s expenditures today as a proportion of the EU’s GDP, and the overwhelming share went to national defence. America did not become a transfer union until the New Deal of the 1930s.
Nor did the federal assumption of state war debts in 1790 mean the entire country was thereafter liable for the debts of individual states, as European nations would be under proposals for Eurobonds. In the 1820s and 1830s many states borrowed overseas to fund canals and other internal improvements.
Jonathan Rodden of Stanford University says some investors in such bonds apparently thought the federal government stood behind them. But that expectation was shattered when, following the depression of the late 1830s, nine states defaulted. In subsequent decades, most adopted balanced-budget laws to limit the growth of their debts. Michael Bordo of Rutgers University says the lesson for Europe is to ban bail-outs and stick by the rule.
If at first, you don’t succeed
As for monetary union, America twice created central banks in its early years and then dismantled them because of populist dislike. Private, state-chartered banks issued their own currencies which often traded at a discount to those of other banks, depending on a bank’s perceived ability to redeem the currency in specie (gold and silver). Rapid growth in the western states led to perpetual shortages of money, high interest rates and, it appears, balance-of-payments deficits with eastern states. Those deficits were financed by eastern capital as specie moved into western banks. But western banks still habitually issued more bank notes than even that increased specie could back, leading to inflation.
Peter Rousseau of Vanderbilt University notes the Second Bank of the United States would sometimes accumulate the banknotes of weak banks and present them en masse for redemption. If the bank could not comply, it failed. This had the effect of forcing deflation on those regions with failing banks, and thus redressing the balance-of-payments imbalances that had developed. But it also fuelled resentment at the bank and in 1832 President Andrew Jackson vetoed the renewal of its charter.
America spent the next 80 years without a true central bank, and as a consequence suffered repeated banking panics and depressions. But the economic union, if anything, grew tighter (with the exception of the South, before and after the civil war). For all the shortcomings of America fiscal and monetary institutions, capital and labour did move freely from state to state. When one state suffered higher unemployment, its people left for better opportunities in another. By one estimate, the north-east and south-Atlantic regions’ share of the labour force declined from 93% in 1800 to 52% in 1860, while the Midwest’s share grew from less than 1% to 23%.
Today, Europeans remain far less mobile than Americans, despite the EU’s free market in labour. This is probably the result of linguistic and cultural barriers and of inflexible labour laws. The ultimate lesson of America, then, is that what holds an economic union together has less to do with fiscal and monetary institutions than the desire of its people for closer political cohesion. That is an example that Europe is struggling to emulate.

^Sources

^{How Alexander Hamilton negotiated the federal assumption of state debts and the creation of the first Bank of the United States are well described in Forrest McDonald's book "Alexander Hamilton: A Biography" and in Joseph Ellis' Founding Brothers: The Revolutionary Generation," Chapter Two, "The Dinner."
Michael Bordo draws comparisons between early America and Europe in a 2004 article for the Cato Journal, "The United States As A Monetary Union And The Euro: A Historical Perspective"  and in an article for VoxEU co-written with Lars Jonung and Agnieszka Markiewicz, "A fiscal union for the euro: Some lessons from history"
Robert Margo explored "Labor Market Integration Before the Civil War" in a 1998 paper}

^{Peter Rousseau, "Jacksonian Monetary Policy, Specie Flows, and the Panic of 1837"}
Howard Bodenhorn and Hugh Rockoff, "Regional Interest Rates in Antebellum America"
http://www.economist.com/node/21541836