barry eichengreen, is the George and Helen Pardee professor of economics and political science at the University of California (Berkeley).
Illustrated by joe ciardiello
Published October 23, 2020
The Broadway musical was not the inspiration – Covid-19 was the proximate cause. But, battered by the pandemic and on the heels of Brexit and the traumatically slow recovery from the 2009 financial crisis, Europe may finally be on the brink of a “Hamiltonian moment.” It could now move toward the deeper fiscal integration that the architects of the European Union long hoped to see.
The eye-catching event here was the deci-sion of EU member-states in July to issue €750 billion (roughly $850 billion) worth of bonds backed by the whole union. In effect, Europe is doing what Alexander Hamilton did in 1790 when he arranged for the federal government to assume the debts of the 13 U.S. states. Hamilton’s singular achievement es-tablished that the nascent republic would be more than a loose confederation of states with independent economic policies. And by creating a federal treasury with its own sources of revenue, Hamilton saw to it that the nation would have a common fiscal policy to complement its common currency.
Europe is now traveling (albeit tentatively) down this road. More than 20 years after creating the euro, it could be building the foundation of a fiscal union to accompany its monetary union. Put differently, the Eurozone is taking a first step beyond the neitherfish- nor-fowl position in which it has a common monetary authority, the European Central Bank, but 19 independent national treasuries that can (and do) go their own ways. The result, in 21st-century Europe just as in 18th-century America, would be a regional entity better able to hang together economically and politically.
That’s the idea, anyway – and why Google reports more than 600,000 hits when one searches for “Europe’s Hamiltonian Moment.” But that’s not the whole story.
Hamilton’s Original Rap
Americans will remember from high school history (or, more likely, a certain Broadway show) the gist of the debate over federalism in the United States. That early struggle pitted the federalist concept of a strong national government against Thomas Jefferson and James Madison’s view that governing was purely the job of states and localities. The Jeffersonians’ opposition to centralized governance derived from the fear that a powerful president and Congress would bring back the sort of authoritarian rule by the elite against which the founding fathers had rebelled. The Federalists, led by Hamilton, largely dismissed this danger in arguing that a strong central government was essential for jump-starting and sustaining the growth of the new nation.
Hamilton’s foot in the door was the quid pro quo, reached in 1790, in which the federal government would assume the debts incurred by the 13 colonies during the war of independence. Once independence was secured, the debt load (or lack thereof) became a source of jealousy and recrimination.
Everyone agreed that the expenditure had been worthy, that the cause was common and that the resulting fiscal burden was spread unevenly, all of which supported the argument for debt mutualization. As we will see, all three observations apply equally to Europe’s fiscal response to Covid-19.
To seal Hamilton’s debt deal, a side-payment had to be extended to Southern states, whose debts were light and whose residents inclined to the Jeffersonian approach. That side payment came not in the form of cash, but rather as an agreement to locate the new national capital on the banks of the Potomac River dividing Maryland from Virginia (rather than in one of the large port cities of the Northeast). This precedent suggests the logic of a side payment to placate the “Frugal Five” of the European Union – Austria, Denmark, Finland, the Netherlands and Sweden – whose sovereign debts are not as burdensome as those in much of the EU.
The other ingredient in Hamilton’s recipe for sustaining a strong central government was the assignment of a dedicated source of revenue to pay the interest on the newly federalized debt. To that end, on July 4, 1789 (notice the date), President Washington signed an act authorizing the federal government to collect duties on imports. Four weeks later, the Congress established the U.S. Customs Service to collect those duties, freeing the central government from dependence on state officials – and, as a bonus, shifting control of some very juicy patronage jobs to the president.
This arrangement ensured that the federal government would have revenues commensurate with the fiscal needs of a growing economy. And it ensured that Congress and the President wouldn’t be in the position of having to beg the states for funds to carry out their functions.
How the U.S. Fiscal Union Works
The U.S. fiscal federation evolved considerably over the subsequent two centuries. Federal revenue is now a much larger share of GDP. Moreover, the government draws funds not just from Hamilton’s customs and excise duties, but from individual and corporate income taxes, estate and gift taxes, and payroll taxes. Given that income taxes account for a significant fraction of revenues, it follows that high-income states such as Connecticut pay more per person into federal coffers than lower-income states such as West Virginia.
Washington spends some of these revenues directly (much of it on defense). But it also transfers a substantial portion to the states, supporting their spending on transportation, Medicaid and other social programs. How much states receive depends on their transportation needs, whether they have many or few Medicaid recipients and whether they are home to firms that receive government contracts. According to the Rockefeller Institute of Government, West Virginia got back two dollars for every dollar of federal taxes paid by its residents in 2017, whereas Connecticut received only about 75 cents on the dollar. The precise figures vary with current economic conditions, but the broad pattern doesn’t.
The intent here isn’t hard to fathom. First, the federal government takes responsibility for financing “public goods” – goods whose benefits accrue to the residents of every state, but that individual states would under-provide if left to their own devices. A classic case of this free-rider problem is the national defense, but there plenty of others.
For example, basic scientific research is a vital building block of a large, dynamic economy. But the private sector will underinvest in it since it lacks direct commercial potential, while state governments will undersupport it since much of the value can be expected to accrue to residents of other states. This, in a nutshell, is why we should (and do) fund the National Science Foundation through the federal government.
Second, the federal fiscal system has an insurance function. When energy prices rise, the oil patch booms and the automobile industry tanks. Texans pay more federal taxes and get back less in federally funded unemployment benefits. The opposite, meanwhile, is true in Michigan. The impact of higher energy prices on Michigan is partially offset by its residents’ lower federal tax payments and higher federal transfer receipts. Texans pay more and receive less, but at a time they can afford it. When energy prices go down, the mechanism runs in reverse. In effect, the two states are insuring against unsynchronized economic shocks.
Third, the federal system has a stabilization function. Imagine Michigan and Texas both fall into recession at the same time – not an unusual occurrence. Residents of both states, now earning less, pay less in federal taxes, as well as a smaller share of what they do earn because the income tax is progressive. Meanwhile, both states automatically receive additional transfers from the federal government. Their residents end up with more disposable income to help maintain their spending, which in turn helps to moderate the economic downturn.
Why don’t governments in both Michigan and Texas raise state spending and cut state taxes in response to the recession? To some extent, they do. But most states have legislative and constitutional limits on their ability to borrow. Many of these limits were self-imposed in the 19th century, following earlier state defaults, as a way to prevent another wave of overborrowing and to enable state governments to regain a modicum of creditworthiness. History, evidently, casts a long shadow.
Many of these limits were self-imposed in the 19th century, following earlier state defaults, as a way to prevent another wave of overborrowing and to enable state governments to regain a modicum of creditworthiness.
In any case, a state that runs budget deficits would have to levy higher taxes in the future to service and retire the bonds issued to cover the red ink. And, in any event, there are practical limits on the ability of one state to levy higher taxes than its neighbors without triggering an exodus of high-income individuals and footloose firms.
Fourth, fiscal federalism has an equalization function. The federal system transfers resources from wealthier to poor states on an ongoing basis, independent of the business cycle. Personal income per capita in West Virginia, before taxes and transfers, is 60 percent that of Connecticut. After taxes and transfers, the figure rises to 80 percent. A charitable interpretation of this pattern is that it reflects America’s commitment to national solidarity – the commitment of more fortunate Americans to help less fortunate ones. A less selfless interpretation is that equalization prevents states with few economic opportunities from flooding other states with migrants in need of disproportionately large social services.
Both motives were at work in Germany in the 1990s, when reunification brought together the low-income east with a high-income west. The Federal Republic (notice that name) responded with massive equalization transfers from west to east.
Europe, at this point, lacks similar arrangements. The national governments of the 28 EU member-states each have their own budgets, while the budget of the EU itself is barely 1 percent of Europe’s GDP. Memberstates make transfers to the EU following a formula based on each member’s income, with larger economies paying more. Basically, the members first decide the size of the EU budget, then determine the share of national income that each member must contribute.
Some 70 percent of this budget is spent on agricultural subsidies and on public investment in economically depressed regions. Both programs are legacies of the bloc’s history. There was a reluctance in the 1950s, when the European Economic Community was founded, to allow free trade in agricultural products. Memories of World War II food shortages were fresh, animating arguments for agricultural self-sufficiency. Moreover, farmers were a powerful lobby, and those in less fertile regions worried that they would be undercut by low-cost foreign competition.
But a common market that excluded agricultural products would have been unworkable. Therefore, the common market was coupled with price supports and income subsidies for farmers that – in updated form – still operate today.
The regional development fund (formally, the Structural and Cohesion Funds) was designed to limit mass regional out-migration by endowing Europe’s poorer regions with modern infrastructure and aiding their own efforts to catch up with more prosperous parts of the continent. If you’ve ever admired Spain’s largely unused toll roads, Portugal’s recently constructed roundabouts or Greece’s newly enhanced tourist sites, you will have noticed a blue and white sign reading, “This project is funded by the European Union.” Since the Structural and Cohesion Funds have operated for some years, the infrastructure is now there; the convergence of incomes, not so much.
The upshot is that after the cost of these inherited programs and the 6 percent of the EU budget that pays the salaries and pensions of the bureaucrats, rent on the buildings in which they work and a school system for their children, all that’s left for other programs is one-quarter of 1 percent of the EU’s GDP.
Truth and Consequences
This leaves the EU with scant funds to invest collectively in defense, border security, climate-change abatement and other public goods. Although national governments pursue some of these goals on their own, we know from both theory and the U.S. experience that individual states underinvest when the benefits spill over to their neighbors.
Moreover, there is no mechanism for coinsurance, as Europe discovered when Greece succumbed to recession and crisis in 2010. When a U.S. state experiences a recession, it automatically receives resources from the federal government that mostly don’t have to be paid back. In the absence of anything analogous to fall back on, Greece had to negotiate loans from its EU partners and the International Monetary Fund.
The lenders, who wanted some assurance they’d get their money back, attached strict conditions designed to generate national budget surpluses. Not surprisingly, those conditions did more to protect the interests of the creditors than to help Greece recover. Consider, too, that these conditions were seen as humiliating in Greece, causing resentment to boil over against the country’s French and German paymasters and against the IMF.
Following this toxic experience, the EU created the European Stability Mechanism, an agency charged with lending to countries with these kinds of economic and financial problems. The idea was to remove national politics from the process while allowing Europe to take back control of negotiations from the IMF.
The ESM will be able to draw on capital paid in by member-states and can further finance its operations by issuing bonds. But its total lending capacity is less than 3 percent of the EU’s GDP. And ESM loans come with strict conditions, seen as humiliating by the borrower. It is perhaps unsurprising, then, that there have been no ESM loans in the mechanism’s seven years of existence – not even in response to the economic crisis created by the pandemic.
A Changing Europe
These issues have been dogging Europe in one form or another since the Treaty of Rome created the EU in 1958. But the resulting dysfunction has been highlighted by the Eurozone crisis in 2009 --10, and now by the pandemic.
The Eurozone crisis was a classic example of the sort of asymmetric shock discussed earlier. It mostly affected member-states at the periphery of the EU – not just Greece, but also Spain, Portugal, Italy and Ireland, which had all experienced housing bubbles and were now suffering the fallout. They all faced deep recessions and formidable bank-recapitalization costs. Their governments attempted to finance budget deficits by issuing bonds. But they found themselves shut out of the international bond market, as institutional investors questioned their ability to repay.
The rich core of the EU was in much better shape. Germany, in particular, felt little, in large part because the economy enjoyed strong demand from China for its machinery exports.
Importantly, having adopted the euro, the crisis countries no longer had their own central banks able to purchase the bonds their governments issued and thereby support their borrowing. The European Central Bank, which might have served that function, was prohibited by statute from purchasing newly issued government bonds or otherwise financing budget deficits. German officials had insisted on these provisions, an insistence reflecting deeply ingrained German fears that such practices were inflationary.
As a new institution in its first decade of existence, the ECB’s board interpreted its authority narrowly so as not to come under political attack. Consequently, the crisis countries had nowhere to turn – nowhere, that is, except the IMF. This was an embarrassment to the governments of countries that thought of themselves as advanced.
The shock of the Covid-19 pandemic has been more symmetric. It hit all EU countries simultaneously, albeit with different degrees of severity. All member-states responded by ramping up public spending on health, income maintenance and business support. But the magnitude of the response differed. Some countries, like Italy, were constrained by heavy sovereign debts, whereas others, like Germany, were free to do more. The fact that Italy could borrow at all without seeing interest rates on its bonds skyrocket reflected the support it received from the now-less-timid ECB. Indeed, the ECB initiated a Pandemic Emergency Purchase Program under which it hoovered up more than €1 trillion of the members’ government bonds.
This shift in central bank practice reflected a changing of the guard – the ECB was now headed by former IMF head Christine Lagarde. It also reflected the bank’s intellectual and political maturation. The ECB now had the fortitude to plow through predictable objections from the EU Constitutional Court and the ever-inflation-wary German Parliament. The critics’ complaint this time around: the ECB was straying dangerously close to setting fiscal policy, which was properly the remit of national governments.
Of course, the reason the ECB chose to expand its task was the reality that not all of the aforementioned authorities had the capacity to respond – Italy again being a case in point. And there was no mechanism for transferring resources among member-states, a shortcoming that the European Commission, the EU’s executive branch, now set out to remedy.
Europe’s Bad Rap
So why did it take Europe so long – more than 60 years after the birth of the European Union (née the European Economic Community), and more than 20 years since the creation of the euro – to get its act in gear? The obvious answer is that Europeans differ sharply among themselves in their visions of what their union is and should be. Some see it simply as a glorified free trade area – that, evidently, is how a slim majority of English voters who voted for Brexit (but apparently expected free trade to endure) saw it in 2016.
Others view the EU as a seamlessly intergrated Hamiltonian economic zone. The United States had a common currency (the dollar) and a slew of federal laws supplementing Constitutional protections to limit commercial friction at internal borders. Europe, for its part, had equivalents: the euro and the Single Market Act of 1987.
For the champions of a politically federated Europe, shifting tax and spending decisions to the European Commission (the EU’s executive branch) and European Parliament (the closest the EU has to a Congress) is a key step.
Still others see “ever closer union,” the language enshrined in the Solemn Declaration on European Union signed by heads of state at their Stuttgart summit in 1983, as leading to political federation. For the champions of a politically federated Europe, shifting tax and spending decisions to the European Commission (the EU’s executive branch) and European Parliament (the closest the EU has to a Congress) is a key step. With the ability to collect taxes come the resources needed to mobilize a police force to keep the peace and an army to defend the EU’s external borders.
As noted above, though, this vision is less than universally shared. Opponents of a federal Europe reside in all parts of the continent – not just in the UK.
It’s not as if Europeans reject the logic behind public goods – the logic of collective support for a sturdy defense, for instance. But they have significant disagreements, rooted in their national histories, about just how sturdy. Germany, mindful of its National Socialist history, is reluctant to finance a large standing army, either nationally or at the EU level. By contrast, France, still conscious of its military defeat and occupation in 1940, insists on maintaining its own nuclear deterrent.
Similarly, European policymakers generally agree that Europe needs a common border policy. They understand that one country’s border controls will accomplish little if refugees and immigrants can enter through another country with more porous controls and move freely through the single market. But different member-states are of different minds on whether to accept refugees (and how many), again reflecting their differing histories.
Equalization is even more problematic. Americans have their differences, but at some level they still all view themselves as Americans, regardless of their state of residence. This creates an element of solidarity that muffles complaints from the residents of high-income states, who effectively gift billions of dollars, year after year, to their compatriots in lower-income states.
Residents of Connecticut understand that they pay more taxes into the federal coffers than residents of West Virginia, and that the federal government also favors West Virginia on the spending side because that state is home to more poor people. This is not enough to lead Connecticut residents to wish to secede from the union, however, or even to demand a radical change in the federal tax and transfer system.
In contrast, the majority of Europeans see themselves as citizens of their own countries first and citizens of Europe second. Consequently, residents of wealthy economies view the prospect of ongoing transfers to poorer economies, not as helping their less fortunate fellow countrymen but as giving away their hard-earned euros to undeserving foreigners.
Even Europeans who would aim for full integration worry about encouraging bad behavior – about creating what economists refer to as “moral hazard.” This issue was prominent in the debate over rescue packages for Greece and other countries affected by the Eurozone crisis.
Rightly so, at least in part, since the proximate cause of the financial crisis was imprudent policies at the national level. In some countries, lax supervision and weak regulation allowed banks to use borrowed funds to invest in risky mortgage-backed securities and related financial instruments, and to lend excessively to housing developers. In others, governments took advantage of access to cheap credit (built on private lenders’ assumption that, one way or another, the EU would always backstop the debtors) to run excessive deficits. Thus, the thinking goes, bailouts would only encourage more such excesses down the line.
This diagnosis was not universally accepted. But it constituted a powerful argument against an EU system of intergovernmental transfers.
Given these concerns, only a cosmic disturbance could overcome Europe’s resistance to the creation of an EU fiscal capacity. For better and worse, the pandemic proved to be exactly that.
A True Hamiltonian Moment, or Only the Broadway Version?
In May, the European Commission proposed a €750 billion fund for emergency spending, in the form of a mix of grants and loans, for member-states hit by the Covid-19 crisis. Funds would be disbursed from 2021 to 2025. Thus, the money would support not just the immediate response to the public health emergency, but also address its longerterm financial consequences.
In mid-July, EU leaders agreed to a slightly modified version of the controversial plan. Although details remained to be worked out, it was clear that the initiative would involve unprecedented levels of redistribution across member-states. Provisionally, those hit hardest by the health crisis, such as Italy, stood to receive some 5 percent of their national income in grants and guarantees. Poorer Eastern and Southern European countries stood to receive even more. And the Frugal Five were given rebates and related financial concessions to bring them on board. Not quite the equivalent of situating the U.S. capital on the banks of the Potomac, but of a form.
Why this change? It was clear that standard objections to transfers on moral-hazard grounds did not apply. The Covid-19 shock was not a matter of fiscal chickens coming home to roost, and it was not something that grants and guarantees would encourage governments to repeat.
The crisis was also an existential challenge for committed Europeanists. If the EU failed to respond, leaving member-states on their own, citizens could rightly ask what purpose the EU served other than facilitating free trade – if that. Europeanists at the Commission and in national capitals saw it as essential for the EU to rise to the task.
There was also the not-so-small matter of repaying the principal, of course. But those repayments could be spread over time.
The decision to issue EU debt was abetted by record-low interest rates. With rates on high-quality government debt running at just 0.5 percent, paying the interest on €750 billion in debt would cost less than €4 billion a year. There was also the not-so-small matter of repaying the principal, of course. But those repayments could be spread over time – a very long time, if some of the bonds ran 30 years to maturity, as proposed by the European Commission.
The question was where to find these additional funds. One option was to go hat in hand to the member-states and ask them to supplement their normal contributions to the EU budget. This would encourage the perception that the €750 billion of bonds were a one-off pandemic response. The idea that this was an exceptional fiscal initiative to contain an exceptional health and economic emergency would create no presumption that a true precedent had been set.
The alternative was for the EU to acquire dedicated revenue sources, like the U.S. government did in 1790. To this end, the European Commission proposed a new EU carbon border adjustment tax, an EU-level corporate tax on multinational corporations and a tax on large digital platform companies (think Google, Facebook, Amazon). The resulting revenues would be “own resources,” which would accrue directly to the EU. They would increase with the growth of the European economy, just as the customs receipts accruing to the American government in the 19th century increased with the expansion of U.S. trade.
But sovereign leaders were unable to agree on the Commission’s proposal; they tabled the key decision about own resources until 2022. Leaders ultimately agreed only on a “contribution” based on each country’s nonrecycled paper waste – a token measure that hardly came close to paying off a €750 billion bond issue.
• • •
Europe may just limp along, covering the costs of the initial commitment to offset the ravages of the pandemic without creating a true Hamiltonian moment. Once Covid-19 is finally beaten, determination to overcome enduring resistance to fiscal integration could ebb away. But the fact that European leaders did rise to the occasion may well make a difference in the long term as well. If the fiscal relief brought by the €750 billion goes smoothly, it may set in motion a virtuous cycle, bringing a greater sense of community and a greater willingness to yield sovereign prerogatives.
Or that’s the idea, anyway.