Date post: | 14-Apr-2018 |
Category: |
Documents |
Upload: | narcis-postelnicu |
View: | 217 times |
Download: | 0 times |
of 34
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
1/34
NBER WORKING PAPER SERIES
A FISCAL UNION FOR THE EURO:
SOME LESSONS FROM HISTORY
Michael D. Bordo
Agnieszka Markiewicz
Lars Jonung
Working Paper 17380
http://www.nber.org/papers/w17380
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
September 2011
We have received constructive comments from many. We would like to thank in particular Iain Begg,
Michael Bergman, Daniel Heymann, Sven Langedijk, Paul van den Noord, Jakob von Weizsckerand Guntram Wolff. Michael Bordo started this paper in 2006 when he was a visiting scholar at DGECFIN
in Brussels. The original research was funded by DGECFIN from a grant to him in 2006-2007. The
views expressed herein are those of the authors and do not necessarily reflect the views of the National
Bureau of Economic Research.
2011 by Michael D. Bordo, Agnieszka Markiewicz, and Lars Jonung. All rights reserved. Shortsections of text, not to exceed two paragraphs, may be quoted without explicit permission provided
that full credit, including notice, is given to the source.
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
2/34
A Fiscal Union for the Euro: Some Lessons from History
Michael D. Bordo, Agnieszka Markiewicz, and Lars Jonung
NBER Working Paper No. 17380
September 2011
JEL No. H10,H70,H73
ABSTRACT
The recent financial crisis 2007-2009 was the longest and the deepest recession since the Great Depression
of 1930. The crisis that originated in subprime mortgage markets was sp read and amplified through
globalised financial markets and resulted in severe debt crises in several European countries in 20 10and 2011. Events revealed that the European Union had insufficient means to halt the spiral of European
debt crisis. In particular, no pan-European fiscal mechanism to face a global crisis is available at present.
The aim of this study is to identify the characteristics of a robust common fiscal policy framework
that could have alleviated the consequences of the recen t crisis. This is done by using the politicaland fiscal history of five federal states; Argentina, Brazil, Canada, G ermany and the U nited States.
Michael D. Bordo
Department of Economics
Rutgers University
New Jersey Hall
75 Hamilton Street
New Brunswick, NJ 08901
and NBER
Agnieszka Markiewicz
Erasmus University, Rotterdam
Lars Jonung
Knut Wicksell Centre of Financial Studies
School of Economics and Management
Lund 8niversity
Box 7080
220 07 Lund
Sweden
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
3/34
2
Afiscalunionfortheeuro:Somelessonsfromhistory
Introduction
Theeuroarea isaunique formofamonetaryunionwithnohistoricalprecedence.Themember
statesof
the
euro
area
have
assigned
the
framing
of
monetary
policy
to
acommon
monetary
authority,theEuropeanCentralBank(ECB),setupasahighlyindependentcentralbanktoinsurethat
itwillbe able to carryout apolicyofprice stability. Fiscalpolicywithin theEuropeanUnion (EU)
remainsthetaskofthenationalgovernmentsunderasetofrulesgivenintheMaastrichtTreatyand
theStabilityandGrowthPact (SGP).These rules,pertaining to theEconomicandMonetaryUnion
(EMU),covereuroareamemberstatesaswellasmemberstates thathavenotadopted theeuro.
Theyaremonitoredcentrallyby theCommission inapolicydialoguewith thememberstates.This
system represents the existing fiscal policy framework of the euro area that complements the
monetaryunionanditssinglecurrency,theeuro.
Ever since the plans for a single European currency were launched about twenty years ago, the
institutional system for framing fiscal policies and for preserving the fiscal sustainability of the
monetary union has been the subject of a heated debate among economists as well as among
policymakers.
2
The
recent
global
financial
crisis
and
mainly
the
European
debt
crisis
have
added
new
impulsestothedebateabouttheproperfiscalpolicyarrangementswithintheEuropeanUnion.
Several viewsexist.According toone camp, themonetaryunion shouldbe supplementedwith an
extendedsupranationalorpanEuropean fiscalunion tobeviableandsustainable. Inshort, theEU
shouldhaveaccesstoalargerbudgetinordertodesignandcarryitsowncentralfiscalpolicies.Some
experts,likeDeGrauwe(2006)gofurtherandpromotetheideaofadeeperpoliticalunion,toensure
thesuccessoftheeuro.ThepresentdebtcrisiswithintheEMUhas inspiredanumberofproposals
forstrengtheningthefiscalpowerofEU.
Others argue that such an extension of the fiscal powers of "Brussels" would not be accepted
politicallybyEUcitizens,threateningthepoliticalsupport forthemonetaryunion insomemember
states, inparticular inGermany. Instead, it isarguedthatthepresent institutionalsetup isroughly
theproperone.Somecommentatorsproposethatthemonetaryunionisnotinneedofanycentral
fiscal coordination across the member states, or at least of less coordination than presently. Forthem, likeMckay (2005), the fiscalpolicy framework shouldbe solely thebusinessof themember
states.Anotherschoolrecommendsimprovements inthequalityofthefiscalpolicyprocessandthe
fiscalinstitutions acrosstheEUasapromisingwaytoimprovefiscalpolicygovernanceintheEU.3
Sofarthedebatehasshownnosignsofanemergingconsensus.4Rather, it isgettingmoreheated
duetothepresentcrisis.Onereasonforthelackofunanimityisthattheeuroarearepresentsanew
typeofmonetaryunion.Moreprecisely, theeuroarea isthefirstmonetaryunionwheremonetary
policy is set up at the central (European) level while fiscalpolicy is carried out at the subcentral
(national) levels. Thus, the economics profession lacks historical cases to use as guidance for
theoretical and empirical work. Instead, many contributions are based on either theoretical
considerations oreconometriccalibrationsand testsondata, insomecasesoriginatingpriorto the
launchoftheeuro.
Theaimofourstudyistocontributetothisdebatebyturningtothepoliticalandfiscalhistoryoffive
federalstatesforananswertothequestion:Wouldtheadoptionofafiscalunionsimilartothefiscal
2Forearlysurveysofthisdebate,seeforexampleButiandSapir(1998)andHalletetal(1999).Morerecently,ButiandFranco
(2005),Korkman(2005)andWierts(2006)amongothersdealwithfiscalpolicyissuesoftheEMU.SeealsoEuropeanEconomy
(2008)ontherecordofthefirst10yearsoftheEMU.3SeeforexampleWyplosz(2005)andJonungandLarch(2006).
4ThedebateabouttheStabilityandGrowthpactbeforeitsreformin2005isastrikingillustrationofthewidelydivergentviews
morethan100separatecontributions withintheeconomicsprofessionontheroleoffiscalpolicy intheeuroarea.Fora
surveyoftheseviewsontheproperdesignoftheSGP,seeJonungetal(2008).
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
4/34
3
arrangements currently in place in the federal countries thatwe study help to avoid some of the
centripetalfiscalforcesthatthreatenthestabilityoftheEuropeanmonetaryunion?Inshort,wetry
tobringoutthe lessonsfromthepastconcerningthefiscalarrangements intheeuroareaoftoday.
Asweareprimarilyconcernedwithmacroeconomicstability issues,we focuson fiscalpolicyasan
instrumentofstabilisation. Wearewellawarethatfiscalpolicymakingcoversmanypolicyareas, in
particular,distributional issuesareclosely related toquestionsofmacroeconomic stabilizationand
insurance.
Therecentcrisishashighlighteddeficienciesinboththefiscalframeworkandthefinancialregulatory
frameworkoftheeuroarea. Inthispaper,however,wedonotanalyzethe issuewhethertheeuro
areaneedsa common financialstabilityauthority.We focussolelyon fiscal issues relevant for the
stabilityoftheeuroarea.
We organise our study in the following way. In section 1, we give a brief overview of some key
concepts and central issues. Next, in section 2, we summarize past and current experience of
monetary and fiscal unions in five countries: the United States, Canada, Germany, Argentina, and
Brazil. In section 3, we condense lessons from our account of the evolution of fiscal federalism.
Section 4 contains a comparison between these lessons and the framework for fiscal policy
governanceintheEU.Section5concludes.
1.Fiscalfederalismandfiscalpolicyinmonetaryunions
1.1.Theconceptofmonetaryandfiscalunions
Amonetaryunioniscommonlydefinedasagroupofstatessharingasinglecurrency.Inthestrictest
senseoftheterm,amonetaryunionmeanscompleteabandonmentofregionalorseparatenational
currenciesandfullcentralisation ofmonetaryauthorityintoasinglejointinstitution. Thisisthecase
of the euro area, a subset of the Economic and Monetary Union (EMU), which covers all the 27
memberstatesoftheEU.5
Theconceptofafiscalunionentailsfiscalfederalismamongitsmembers,whichcouldbeeithersub
national (subcentral or regional) political units or nation states. Fiscal federalism is based on a
cooperative arrangement between the members of the fiscal union regarding the design and
distributionoftaxesandpublicexpenditures.
Thereisnosingledefinitionoffiscalfederalism.Sorens(2008)forexampledefinesthe"idealtype"of
fiscal federalismasconsistingof the following fourelements: (1)subcentralpoliticalentitiesenjoy
independence/autonomy todecide taxes andexpenditures, (2) thesegovernments face fairlyhard
budgetconstraints,thatisanobailoutruleisconsistentwiththeidealtypeoffiscalfederalism,(3)
there is a commonmarketbasedon free trade andmobilitywithin the fiscalunion, thus there is
scope for competition among subcentral governments, and (4) the system of fiscal federalism is
institutionalized inasetof rules.Wewould like toadda fifthelement to this list: (5) thecommon
marketisbasedonacommoncurrency,thatis,thesubcentralaswellasthecentralfiscalauthorities
aremembersofthesamemonetaryunion.
The governance structure of the EU is a challenge to put into the standard framework of fiscal
federalismas
there
is
no
similar
institutional
set
up
anywhere
else
in
the
world.
The
EU
is
different
as
stressedbyBegg(2009):"thefactthattheEUissetupasaunionofcitizensandofMemberStatesis
oneof itsmostdistinctivefeatures."Its"federal"budget,that istheEUbudget, isabout1%ofthe
national incomes of the Member States. This is a much smaller ratio than the size of the federal
budgetsinthetypicalfederalcountry.Asstressedinitially,thecentralizationofmonetarypolicyinthe
ECBandthedecentralization offiscalpolicytotheMemberStatesoftheeuroareaisanotherunique
featureoftheEU.Still, inouropinionthere ismuch inthehistoryoffiscalfederalismthatcanbear
5Presently theeuroarea includes the following17 countries: Austria,Belgium,Cyprus,Estonia, Finland, France,Germany,Greece,Ireland,Italy,Luxembourg,Malta,Netherlands, Portugal,Spain,SlovakiaandSlovenia.
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
5/34
4
uponthedesignofEUgovernanceinspiteofthefactthatEMUandtheeuroareuniqueinstitutions
withnohistoricalprecedence.
Musgrave(1959)providestheclassicalapproachconcerningthepolicytasksofthepublicsector.His
scheme identifies three basic policy functions: allocation/efficiency, distribution and stabilization.
Thesefunctionscanbeperformedbydifferentpoliticalentitieswithinafiscalunionaccordingtothe
adoptedfiscalsystem.
Thestudyoffiscalfederalism,asdefinedbyOates(1999),isthestudyofhowtheserolesareassigned
todifferentlevelsofgovernmentandthewaysinwhichtheyrelatetooneanotherthroughdifferent
policy instruments. The stabilization function, that is the implementation of monetary and fiscal
policies, is usually the task of the central government and the central bank. The stabilization of
economicactivityviafiscalpolicycanbeachievedthroughtwomainchannels.Thefirstonerefersto
theroleofautomaticstabilizers, smoothingeconomicactivityviatheautomaticresponseoftaxesand
transfer systems to the business cycle. The second channel consists of discretionary fiscal policy
measures.
Inthispaper,wewilloftenrefertosubnational,regional,localorsubcentralpoliticalentitieswithin
variousfederations. Wewillinterchangeablycallthemjurisdictionsandcommunities.Also,depending
on the federation in question, these regions take different names; states in the United States,
provincesin
Canada
and
Argentina,
Lnder
in
Germany,
and
municipalities
in
Brazil.
1.2Thenormativeargumentsforfiscalfederalism
AsstatedbyOates (1972),The traditional theoryof fiscal federalism laysoutageneralnormative
frameworkfortheassignmentoffunctionstodifferentlevelsofthegovernmentandtheappropriate
fiscalinstrumentsforcarryingoutthesefunctions.Thistheorycontendsthatthecentralgovernment
should have the basic responsibility for macroeconomic stabilization and income distribution. In
additiontothesefunctions,thecentralgovernmentshouldprovidenationalpublicorcollectivegoods
thatservicetheentirepopulationofthecountrysuchasdefence.
Decentralisedorlowerlevelsofgovernmenthavetheirraisondtreintheprovisionofpublicgoods
andserviceswhoseproductionandconsumption is limitedtotheirownjurisdictions.Theeconomic
argument for providing public goods at the subnational level was originally formulated in a
decentralization theoremthatthelevelofwelfarewillalwaysbeatleastashighifParetoefficientlevels of consumption are provided in each jurisdiction than if any single, uniform level of
consumptionismaintainedacrossalljurisdictions,seeOates(1972).
Thus,fiscalfederalismaddressesseveral issues.First, ithasastheobjectivetorespondtodifferent
politicalpreferencesacrossacountry.Second, itproducespositiveexternalitiesas itmaygenerate
benefitsfromintergovernmental competition,improvethefiscalresponsibilityofgovernment,foster
politicalparticipationandasenseofbeingmemberofademocraticcommunity,andhelptoprotect
basiclibertiesandfreedoms(InmanandRubinfeld1997).Finally,fiscalfederalismalsoprovidesaway
ofmaintainingthegovernmentshareofGDPatalowlevel(Sorens2008).
Anobviouscostoffederalismisthelossofautonomybythecentralgovernment.Infact,thebenefits
ofdecentralisation require that the central governments authority is limited (Rodden2006).As a
result,in
highly
decentralised
fiscal
federations,
central
governments
might
find
it
difficult
to
implementcoordinatedeconomicandother typeofpoliciesandprovide federationwidecollective
goods.
Theconclusionthatdecentralisedgovernmentswillprovidetheefficientlevelofpublicgoodsrestson
anumberofassumptions.Oneisthathouseholdsandfirmsarefreelymobilewithinthefederationto
generatecompetitionbetweenjurisdictions.Iffreemobilityisnotthecase,competitionamongsub
central governments may lead to suboptimal outcomes. Another assumption is the lack of
interdependencies between the policies of different jurisdictions. When this is not the case,
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
6/34
5
competitionamongsubnationalgovernmentsmaygeneratenegativespilloversorexternalities, and
thussuboptimaloutcomes.
If thereare strong fiscal interdependencies betweensubnationaljurisdictionspolicymakersmight
faceincentivestoincreasetheirexpenditurewhileexternalising thecosttotheothers.Rodden(2004,
2006) argues that this incentive is higher if the central government cannot fully commit to a no
bailoutrule.Furthermore,thecentralgovernmentscommitmentbecomeslesscredibleifsubcentral
governmentsare
heavily
dependent
on
transfers
from
the
central
authority.
Intergovernmental
transfers,asopposedto localtaxation,changebeliefsaboutthe levelsof localexpenditurethatcan
besustainedbycreatingtheperceptionthatthecentralgovernmentwillultimatelyprovidefinancial
help. Transfer dependent local governments usually face weaker incentives for responsible fiscal
behaviour. For this reason, Rodden (2004,2006) recommends a principle of subcentral sovereign
debtwithinfiscalfederationstomaintainoverallfiscaldiscipline.
1.3.Fiscalpolicyinthetheoryofoptimumcurrencyareas
The traditional theory of optimum currency areas (OCA), based on the work by Mundell (1961),
McKinnon(1963)andKenen (1969),also labelledbyMcKinnon (2004)asMundell I, isthestandard
approach used by economists to evaluate and study the optimality (and thus the desirability) of
monetaryunions,inparticularthatoftheeuroarea.Thisapproachweighsthebenefitsforacountry
ofadopting
acommon
currency
against
the
costs
of
abandoning
its
national
currency
and
thus
its
independentmonetarypolicy.
Thebenefitsarehigherifcountrieswillingtojointhemonetaryunionareopeneconomiesandtheir
trade ishighlyconcentratedwithother countrieswilling tojoin theunion.On theotherhand, the
costsarehigherwhenmacroeconomicshocksaremoreasymmetric(countryspecific)andwhenother
adjustmentmechanismsare lesseffective inoffsettingtheseshocks.Thesemechanisms includethe
flexibilityofwagesandpricesand themobilityof labourand capital. If thesemechanismsarenot
sufficiently developed, an appropriate fiscal policy could minimize the loss of the exchange rate
channelforadjustmenttoasymmetricshocks.
Thus, domestic fiscal policy turns into the sole tool of stabilization policy left for a member of a
monetaryunionwheremonetarypolicy iscarriedoutbyacommoncentralbank.Fiscalpolicymay
alsobeorganisedandcoordinatedatthecentrallevelofthemonetaryunion,implyingatransferof
bothmonetaryandfiscalpolicytocommoncentralauthorities.
WhiletraditionalOCAtheoryemphasisesthetradeandadjustmentcharacteristicsofregions/nation
states willing to form a currency union, recent developments of the OCA approach, also labelled
MundellII inspiredbyMundell(1973),focusesontheroleoffinancialintegrationasasourceofrisk
sharing(insurance)andconsumptionsmoothing.
The OCA approach according to Mundell II suggests that monetary unification triggers financial
market integration and the development of marketbased risksharing mechanisms. These
mechanismsmaysubstituteforfiscalpoliciesastheyattenuatetheeffectsofasymmetricshocks.As
Eichengreen (1991, p. 17) notes, Interregional transfers accomplished through federal taxes are
justifiableonly if insurancecannotbeprovidedbythemarket.TheMundellIIOCAtheory identifies
such a channelofprivate insurance. It isanempirical issue towhatextent this channelmay fully
replacefiscal
transfers
within
amonetary
union.
In case the private insurance channel is not sufficient, a monetary union requires a system of
interregional and intertemporal transferswhich canalleviate the consequencesofnegative shocks
such as occurred in the financial crisis of 20072009. Increased public spending, necessary during
economicrecessionscanbefinancedeitherbythefederalorsubnationalgovernmentswhichinturn
couldborrowdomesticallyor internationally. Thebenefitsfromsubnationalsaccesstothefinancial
market are numerous. Yet subnational borrowing, left unregulated, entails the risk of insolvency,
whichthreatenslocalservicedeliveryaswellasmacroeconomicandfinancialsystemstabilityofthe
entiremonetaryunion.According toWebb (2004),subnationaldebtmarketshave three important
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
7/34
6
agencyproblems:(i)subnationalborrowershaveanincentivenottorepaytheirlendersasprincipals
if they anticipate bailouts; (ii) subnational borrowers have an incentive not to reveal certain
characteristicsaboutthemselvestolendersasprincipals,resultinginadverseselection;(iii)banksare
implicit agents of the nation, entrusted to maintain the nations payment system and
creditworthiness, and they often abuse this trust by lending to not creditworthy subnational
governmentswiththeexpectationofbailoutsbythefederalgovernmentincaseoftrouble.
Theseagency
problems
related
to
subnational
borrowing
suggest
that
federal
debt
is
asuperior
solution. The empirical literature provides clear evidence that federal bonds are superior to state
bondsbecauseofalowerriskpremium(seee.g.AmihudandMendelson,1991;PoterbaandRueben,
1997;Lemmen,1999).Theriskpremiumonfederalbondsislowerbecausethefederalgovernment
in a monetary union controls money creation, has tax autonomy and has access to more liquid
marketsthandolowerlevelsofgovernment.
AmajorweaknesswiththeOCAapproach,oldaswellasnew,isthelackofattentionpaidtopolitical
and institutional factors.6 The preferences of the public across the member states of a monetary
unionarethemajordeterminantofthesustainability ofmonetaryunification.Thesepreferencesare
influencedbymany factors,politicalaswellaseconomicones.Here thedesignof the institutional
frameworkforfiscalpolicymakingatthenationalaswellasattheunionlevel comesatthecentre.
1.4.Fiscal
policy
in
the
euro
area
Anextensiveliteratureanalyzesthemacroeconomicconsequencesoftheinstitutional frameworkfor
monetaryandfiscalpolicymakingintheEMU.Inparticular,itinvestigatestheimpactoninflationand
debtaccumulationby theexistenceofmany independentnational fiscalauthoritiesandonesingle
centralbank.
The theoretical literature on the interaction of fiscal and monetary policies identifies various
mechanismswhichmay lead to spillovereffects (externalities) acrossmemberstates.Forexample,
DixitandLambertini (2001)showthat ifmonetaryand fiscalauthoritieshavedifferent idealoutput
andinflationtargets,Nashequilibriumoutputorinflationorbotharesuboptimal. Similarly,Chariand
Kehoe(2004)findthatifthecentralmonetaryauthoritydoesnotcommittoafuturepolicypath,the
freeriderproblemleadstoinefficientoutcomes,i.e.excessiveinflationinthewholemonetaryunion
andexcessivedebtissuedbyeachmember.Uhlig(2002)concludesthattheexistenceofindependent
fiscalauthoritiesandonecentralbankwithinasimplestochasticmodel leads, inanoncooperativeNash equilibrium, to higher deficits of the member countries than in the cooperative equilibrium
wheretheywouldbesettozero.
In linewiththepropositionbyRodden(2004,2006),thesestudiespointoutthatasetupofasingle
monetaryauthorityandnumerousfiscalauthoritiesrequiresbindingfiscalpolicyconstraintstoavoid
excessivedeficitsatthesubcentrallevel,thatisonthelevelofthememberstatesinthecaseofthe
euro area. Default by a subnational government can impose a negative externality upon other
subnationalgovernmentsorthefederalgovernmentbyincreasingthecostofborrowingforallfiscal
units.Animportantquestionthatarisesinthesecircumstancesistheimpactofeffectivedisciplineon
borrowingthatisimposedbythemarket.Thesemarketforcescanworkefficientlyonlyifsubnational
governmentshavenoperceivedchanceofabailoutbythecentralgovernment(orthecentralbank).
Lane (1993)argues thatexpectationsofabailoutare themost important reason for the failureof
marketdiscipline.
If
abailout
occurs,
it
might
disturb
or
even
destroy
completely
market
forces
that
preventfiscalunitsfromoverborrowing.
Tosummarizethisliterature,theinterplaybetweenseveralfiscalandonemonetaryauthoritywithin
a federation generates freeriding issues or common pool problems.7 This mechanism works as
6For theshortcomings of theOCAapproach,see i.a.Goodhart (1998)andMongelli (2005).ThetraditionalOCA theoryhas
givenanegativebiastotheviewsofUSeconomistsonthesinglecurrency,seeJonungandDrea(2010).7Thecommonpoolproblemarisesinsituations wherethecostsofanactivity,whichbenefitsasmallgroup,aresharedamong
awidergroupofindividuals,countriesorprovincesasinourcaseofamonetaryunion.
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
8/34
7
follows. Each of the individual fiscal authorities sees itself only as a small player who has a little
impactonthecommonmonetarypolicy.Asaresult,itsfiscalpolicychoiceswouldbepurelydrivenby
nationalinterests.Inequilibrium,eachcountryfreeridesandtheoutcomeisworsethantheonethat
couldbereachedinacooperativeequilibrium.
2.Theevolutionoffiscalfederalismwithinfivemonetaryunions
According to Eichengreen (1991), if a country is subject to asymmetric shocks, a systemof fiscal
federalism can, through regional insurance, attenuate these shocks. This proposition reflects the
positive impactof fiscal federalismhighlightedby theory.The argument is that amonetaryunion
accompaniedbyafiscalunionislikelytooperatemoresmoothlythanamonetaryunionwithoutit.A
fiscalunion,however,functionssmoothlyonlyifanumberofassumptions,advancedintheprevious
section,aresatisfied.Historyhasfrequentlyshownthatthenecessaryconditionsmaynotbeinplace.
In that case, fiscal centralisation can lead to damaging fiscal policies and result in large
macroeconomic imbalances reflected in high and variable inflation and unsustainable debt
developments.
Toisolatethecharacteristicsthatwerekeytothecreationofdurablefiscalunions,wefirstpresent
anaccountofthehistoricalexperiencesandthenoftherecentexperienceof fivefiscalunions.We
focusontwogroupsoffederations:firsttheUS,Canada,andGermany;secondArgentinaandBrazil.
Thefirst
group
largely
represents
cases
of
successful
fiscal
unions,
as
measured
by
inflation
and
debt
performance,asdemonstrated inTable1whichcoverstheperiod19802006.Thesecondgroupof
Argentina and Brazil consists of less successful examples of fiscal unions. These federations are
characterized by a much higher average rate of inflation than the US, Canada, and Germany as
illustratedinTable1.
Wedonotaimatdeliveringanexhaustivedescriptionofthehistoriesofthesefederations. Instead,
wefocusonepisodeswhichareparticularlyrelevantforthequestionunderscrutiny.Moreprecisely,
weanalyze(i)thecircumstancesinwhichthefederationswereborn;(ii)theevolutionofthefederal
subnational governments relationships, in particular, their transformation during the Great
Depression;(iii)thedebthistoryofthefivefederations includingthedevelopmentofbondmarkets
andbailouts.
2.1The
United
States
The United States is a constitutional republic. Its government is based on a congressional system
under a set of powers specified by its Constitution. The United States Congress is a bicameral
legislature. Thehistoryof fiscal federalism in theUnited Statesdatesback to the foundingof the
Union in1789.Priortotheestablishment ofthefederalgovernment,thestateshadexercisedtheir
powerstolevytaxesandprovidecertainpublicservices.ThetenthamendmenttotheUSconstitution
explicitlyreservestotheStatesortothepeopleallpowersnotdelegatedtotheUnitedStatesby
theConstitution,norprohibitedbyittotheStates.
2.1.1CreationoftheUSfederation
Duringtheprefederalperiod,theunionthatexistedundertheArticlesofConfederationconstituted
a
league
of
sovereign
states.
It
did
not
have
the
power
of
national
taxation,
or
the
power
to
control
trade,andithadacomparativelyweakexecutive.Itwasaleagueoffriendshipwhichwasopposed
toanytypeofnationalauthority.BoydandFauntroy(1997)arguethatthegreatestweaknessofthe
ArticlesofConfederationwasthattheyonlyestablishedstatesovereigntyandonlydelegatedafew
responsibilities tothecentralauthorities.Asaresult,themajorityofthepowerrestedwiththestates.
Moreprecisely,eachstatehadtheauthoritytocollect itsowntaxes, issuecurrency,andfinance its
ownarmy.Thefederalgovernmentsmainactivitywastocontrolforeignpolicyandconcludetreaties.
AsCongress,undertheArticles,didnothavethepowertocollecttaxes,thecentralgovernmentwas
unabletobalanceitsfinances.Itresultedinadebtof$42millionaftertheRevolutionaryWarwhich
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
9/34
8
weakenedconsiderablythegovernmentseconomiccredibility.Thisfinancialobligationwasnotpaid
offuntiltheearly1800s.
The United States Declaration of Independence, an act of the Second Continental Congress, was
adoptedonJuly4,1776.ItdeclaredthattheThirteenColonieswereindependentoftheKingdomof
GreatBritain.TheArticlesofConfederationservedasatransitionbetweentheRevolutionaryWar
and theConstitution. In1789, theUSconstitution wasratifiedand in1790 thefederalgovernment
assumedresponsibility
for
the
war
debt,
which
some
have
called
an
early
form
of
federal
aid.
The
TenthAmendment,addedtotheConstitutionin1791,protectedtherightsofthestatesanddeclared
thatallpowersnotexpresslydelegatedtothecentralgovernmentbytheConstitutionwerereserved
forthestates.Thislaidthefoundationfortheconceptsofstatesrights,limitednationalgovernment,
anddualspheresofauthoritybetweenstateandnationalgovernments(BoydandFauntroy(1997)).
2.1.2Evolutionofthefederal statesgovernmentrelationship
Theperiodfrom1789to1901hasbeentermedtheeraofdualfederalism.8Itwascharacterisedby
little collaboration between the national and state governments. During this period, in particular
between1820and1840,thestatesengagedinextensiveborrowingtofinancetheirinternalactivities
anddevelopmentwhich resulted inhighdebts. Insteadof introducingnew taxesoradjusting their
spending, numerous states demanded bailouts from the federal government. In fact, the states
assumedthat
their
debt
implicitly
carried
afederal
guarantee.
However,
the
Congress
refused
to
bailout indebted states and in 1840 several states defaulted on their debt and had to undertake
painfuladjustmentmeasures.Thus, thefederalgovernmentsentacostlybutclearsignalregarding
thelimitstoitscommitmenttofiscalsupporttothestates.
As a result, in the following decades, the US states developed the fiscal sovereignty that we still
observetoday.AsRodden(2006)puts it,statesmayoccasionallydancearoundthetopicofbailouts
buthopesforthemarenotsufficientlybrightthatstateswouldactuallyrefusetoadjustwhilewaiting
fordebtassumption.
Dualfederalismwasfollowedbyaperiodofcooperativefederalism,from1901to1960.9Thisperiod
wasmarkedbygreatercooperationandcollaborationbetweenthevariouslevelsofgovernment.
The period from 1960 to 1968 was called Creative Federalism by President Lyndon Johnson's
administration. President Johnson'sCreativeFederalism,asembodied inhisGreatSocietyprogram,was an important departure from the past. It further shifted the power relationship between
governmentallevelstowardthefederalgovernmentthroughanexpansionofthegrantinaidsystem
andtheincreasinguseoffederalregulations.
2.1.3AlexanderHamiltonandtherestructuringofUSdebt
UnitedStatesdebthistorybeganwiththeRevolutionaryWar,whichwasmostlyfinanced(85%)by
the issueoffiatmoneybytheCongressandthestates.TheCongresshadvirtuallynotaxingpower,
whilethatof thestateswas too limited topay formore thanasmallfractionof totalexpenditure.
Foreignbond finance deterioratedbyuncertaintyabout thewarsoutcome anddomesticbond
issueswerelimitedbyathinbondmarket.In1782,thefederalgovernment,unabletoraisetaxeson
itsownbothbeforeandafterthe1783ArticlesofConfederation, hadtodefaultonbothitsdomestic
debtand
debts
to
France.
The Constitution of 1789 gave the federal government expanded powers in monetary and fiscal
affairs including the ability to raise tax revenues and the sole right to issue currency. Alexander
Hamilton,theSecretaryoftheTreasurybetween1789and1795,puttogethertheplantorestructure
thepublicdebtand createdeep financialmarkets.BordoandVegh (2002)posit that thepackage
included four elements; (i) funding the national debt,(ii) creation of a Sinking Fund, (iii) securing
8ThetermdualfederalismwasintroducedbyCorwin(1950).
9ThetermCooperative FederalismwasextensivelyusedbyElzar(1966).
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
10/34
9
sufficienttaxrevenue,(iv)creationoftheBankoftheUnitedStates.Thecentralideaoftheplanwas
to convert outstanding federal and state debt obligations into longterm bonds and to create
mechanisms tobothserviceandamortize thisdebt.Thiswouldhelp increatinganeffectivecapital
marketandhencetofacilitategovernmentborrowinginwartime.
Consequently, Hamilton proposed a plan designed to fund the debt which involved converting
outstanding paper securities of the states and the federal government into specie denominated
securitiesat
the
official
par
of
exchange.
The
debts
of
various
maturities
plus
arrears
were
converted
intoadebtpackagethatgreatlyreducedtheeffectiveinterestratetowellbelowthe6percentrate
stipulatedonmostsecuritiesoutstanding in1789.The issuedbondsweresimilar toBritishconsols
withno specific retirement date.Shortlyafter successful conversion and fundingof thedebt,U.S.
government securitiesbecamequickly accepted both at home and abroad and yields fell to rates
comparabletobondsoftheleadingEuropeanpowers(Perkins,1994,p.218)
Following theBritishexampleof1717,Hamiltonproposedasinking fundasawayofensuring the
credibilityofhisfundingprogram.Theideawastosetasiderevenuesprovidedbyspecifictaxestobe
usedtopurchasepublicsecuritiesontheopenmarket.Theinterestearnedbythesinkingfundwould
beusedtoacquiremorepublicsecuritiesandeventuallypayoffthedebt.Akeyfeaturewasthatthe
revenuesaccumulatedby the fundcouldnotbedivertedby theCongressata laterdate forother
expenditures.ThesinkingfundwascreatedbytheactofMay8,1792.AnactofMarch3,1795made
explicitthe
revenues
to
be
devoted
to
the
fund,
including
part
of
import
duties,
excise
taxes,
and
the
saleofpubliclands.
Another element of Hamiltons debt package was to ensure the governments ability to collect
sufficienttaxrevenues tocontinuouslyservicethedebt.Debtservicewasanimportantingredientof
theprogramofcreatingawellfunctioning,credible longtermcapitalmarket.Hamiltonproposeda
nationaltariffsufficienttogeneraterevenuesequalto10percentof importvalues.Tariffrevenues
weretobesupplementedbyexcisetaxes,andthesaleofpublicland.
AlexanderHamiltonsdebtpackagehadalltheelementsofamodernstabilizationplan.It ledtothe
creation of a U.S. government bond market which in the future would be key to longterm
sustainability oftheU.S.fiscalunion.
2.1.4USfederalismandtheGreatDepressionThe Great Depression played a particularly important role in the reconstruction of the relations
betweenthecentralgovernmentandthestates.Theperiodfrom1929to1941wasthemostserious
economiccrisis inUShistory.RealGDPandprices fellbya thirdand theunemployment rate rose
above20%in19291933.Recoverytothe1929levelwasnotachieveduntilthestartofWorldWarII.
The stateswereunable to respondeffectivelyon theirown to theeconomic consequencesof the
Great Depression leading to a major change in fiscal federal arrangements. In 1933, as a major
componentofhisNewDeal,PresidentFranklinD.RooseveltandtheCongressgreatlyexpandedthe
federalgovernmentsroleinthedomesticeconomy.
TheNewDealerarepresentedaturningpoint inthehistoryofAmericanfederalism,particularly in
theareaof federalstateand local relations.Themain change ingovernment structureduring the
1930swastheshiftinexpendituresfromthelocaltothestateandfederallevels.Wallis(1984)argues
thatthe
emergence
of
"big"
government
in
this
period
was
aresult
of
achange
in
the
relative
importanceof federalandsubnationalgovernments rather thanan increase in thegrowth rateof
governmentexpendituresbyitself.Heshowsthatbetween1932and1940thesharesofgovernment
expendituresoriginatinginfederalandlocalgovernmentswerealmostexactlyreversed.Before1932
relativesharesforeachlevelwereroughly50%local,20%state,and30%federalgovernment.After
1940,30%of relative shareswere local,24% state,and46% federal.Amajorpartof increasing
government expenditures, 75 %, came in programs administered at the federal level but in
cooperationwithstateand localgovernments.Additionally,strongagriculturalpricesupportswere
introduced at the federal level and were not matched by any corresponding shift in subnational
expenses.
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
11/34
10
Themost importantmodificationof theUS federation frameworkcameasanewrolefor the fiscal
policy of the central government. Before the GreatDepression, the U.S. governmentborrowed in
timeofwar,andmostofthetimeransurplusestopayoffaccumulatedwardebt.Thepossibilityof
using thegovernmentdeficitasa toolofmacroeconomicmanagementwasnever considered.The
GreatDepressionmade it impossible topreserve thispattern.De Long (1996)notes thatboth the
Hoover and the first Roosevelt administrations wished to maintain the pattern of surpluses of
peacetime,but
both
found
the
austerity
necessary
to
achieve
surplus
in
the
time
of
the
Great
Depressiontobepoliticallyimpossible.Intheend,theUSgovernmentacceptedthatlargedeficitsin
timeofrecessionhelpedtoattenuatethebusinesscycle.
2.1.5ContemporaryfederalismintheUS
Contemporary federalism, theperiod from1970 to thepresent,hasbeencharacterisedbyshifts in
the intergovernmental grant system, the growth of unfunded federal mandates, concerns about
federalregulations,andcontinuingdisputesover thenatureof the federalsystem.Therehasbeen
somedevolutionofprogramsbacktothestates,reflecting,inpart,dissatisfaction withtheeconomic
effectsofseverallargefederalprograms.
Americanstates
are
largely
free
in
their
choice
of
tax
bases
and
rates,
subject
to
only
afew
limitations
imposed by the federal constitution. On the expenditure side, most major spending functions are
locatedatthestateorlocalgovernmentlevel,importantexceptionsbeingnationaldefence,pensions
andhealthinsurancefortheelderlyanddisabled.Totalexpendituresoflocalgovernmentsarealmost
aslargeasthoseofstategovernments,andthesumofthesetwo,ascanbeseenincolumn1ofTable
2,isroughlyequaltocentralgovernmentexpenditure,reflectingahighdegreeofdecentralisation in
theUS.
Subnational governments in the United States are, in principle, free to borrow without federal
involvement. In reality, however, nearly all States have some kind of constitutional or statutory
balancedbudgetrequirement. Indeed,according toTable2,column5, theborrowingautonomyof
the subcentral governments is rather limited. The precise nature of the requirements varies
considerablyacrossstates.TheU.S.federalgovernmenthasfollowedanobailoutpolicy(column6in
Table2).
IntheUS,there isneitheroverallfederalstatecoordinationoffiscalpolicynorarevenuesharing
systembetweenthefederalandstategovernments(Shah1995).Infact,atthefederallevel,thereare
notransfersspecifically intendedtodealwithsubnational imbalances. Themost importantfederal
transfersarethosethatfundhealth,educationandtransportprogramsadministratedbythestates.
Althoughthereisanattemptinmanyoftheseprogramstorelatetransferstosuchindicatorsofneed
as incomepercapita income, there isnogeneralsystemofequalisationsimilar for instance to the
Germanone.Thus,theUSstatesarenothighlydependentontransfers.Accordinglytobothmeasures
reported inTable2columns3and4, the transfersbased revenueaccounts foraround30%of the
totalrevenueofstates.
2.2Canada
Canadaisaconstitutional monarchyandaparliamentarydemocracywithafederalsystemandstrong
democratictraditions.Originallyaunionoffourprovinces,Canadaisnowcomposedoftenprovinces
andthreeterritories.Itbecameafederationin1867,whichmakesitthethirdoldestfederationinthe
worldtoday,aftertheUnitedStates.
Canada has a twotiered, highly decentralised system. It can be characterised as a model of dual
federalismwith a coordinating central authority.Whereas federal and provincial governments are
equalpartners in the federation, localgovernmentsdonotenjoy independentconstitutional status
andaresimplythehandmaidenoftheprovinces(Shah1995).Thedistinctfunctionsoftheprovincial
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
12/34
11
legislaturesandoftheParliamentofCanadawereestablishedintheBritishNorthAmericaAct,which
waslaterrenamedtheConstitutionAct,1867.
2.2.1CreationoftheCanadianfederation
The evolution of the federal system in Canada contrasts significantly with the evolution of the
Americanfederation.Boththeoriginsofthetwosystemsandtheirmajordevelopmentsdiffer.Watts
(1987)argues
that
the
Canadian
federation
was
born
in
pragmatism
rather
than
from
an
anti
imperial
revolutionsentiment.ThemajorincentivefortheunificationoftheCanadiancoloniesin1867wasthe
threatofpolitical,economicandmilitaryabsorptionbytheUnitedStates.
Twodistinctive featuresmarkedthefederationcreatedbytheBritishNorthAmericaAct.First,central
powerswerehighlyconcentrated.Second, theCanadianpoliticalsystemcombinedaparliamentary
formofgovernment(similartotheBritish)withfederalism.
2.2.2PublicdebtinCanada
CanadahadafairlywellestablishedfinancialstructureinplacebeforetheBankofCanadaopenedin
1935. Canadas legal system and strong ties to Britain during its early years supported the early
developmentofabondmarket(seeNowlan2001).
ThehistoryofGovernmentofCanadabondsinthedomesticmarketdatesbackto1868withtheissue
of6%10yearbonds.TheGovernment continued to issuebonds in thedomesticmarket to retire
foreigndebtwhichhadbeen issuedby theprovincesprior toConfederation in1867.At thesame
time,theGovernmentcontinuedtoissuebondsdenominatedinbothsterlingandU.S.dollars,inthe
LondonandNewYorkmarkets.
During theGreatDepression,Canadaborrowedabroadextensively. Inspite the fact that italready
hadconsiderableborrowingfromabroad,theriskpremiumonDominionbondssoldabroaddidnot
significantly increaseduring the1930s.Thissuggeststhat investorsdidnotviewCanadaas likelyto
default,andlendfurthercredencetotheviewthattherewasnoexternaldebtcrisis.Further,during
thefirstandthesecondworldwars,awelldevelopedbondmarketallowedtheCanadiangovernment
tocollect fundsdomestically ata lowcost.DuringWorldWar II,theGovernmentwasable toraise
about $13 billion, all domestically and most of it long term. By the early 1950s, Canada had a
frameworkinplaceforadomesticbondmarketandhadmanyyearsofexperiencefromborrowinginboth domestic and international markets. Although there was no real money market by the early
1950s, shortterm GovernmentofCanada bondswere held in large amountsoutside thebanking
systemandwereactivelytraded.
Duringtherecessionsofthe1980sand1990sseveralprovincesissuedexcessivelyhighlevelsofpublic
debtleadingtoanincreaseinriskpremiaandadowngradingoftheirbondratings,andpressureon
thefederalgovernmentforabailout.Theevolutionoftheshareofprovincialdebtsincethe1970sis
plottedinFigure1.
Since198384,provincialterritorialprogram spendinghasdeclinedasa shareofGDP.Asa result,
someprovincesissuedexcessivelyhighlevelsofpublicdebtleadingtoanincreaseinriskpremiaand
adowngradingoftheirbondratings,andpressureonthefederalgovernmentforabailout.Dueto
thedifficult
public
finance
situation
aconflict
between
the
federal
and
provincial
levels
of
the
government arose. Kneebone (1993) provides the province of Ontario as an example of such a
conflict.AsaconsequenceoftheoverlylaxfiscalpolicyofOntario,theBankofCanadahadtotighten
itsmonetarypolicy.Thisepisodedemonstrateshowthefiscalchoicesofoneprovinceinfluencedthe
decisionsof thecentralbankandhowall theprovinceswere indirectlyaffectedbythebehaviorof
thisprovince.
Intheearly1990s,Canadianprovincesandterritorieswerehithardbytherecession,whichcauseda
significantincreaseinspendingonsocialassistanceandsocialservices.Bythemid1990s,increasingly
largedeficitsanddebtburdens,especiallythoseofthefederalgovernment,ledtofiscalrestraintthat
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
13/34
12
culminatedinsignificantreductionsacrossawiderangeoffederalexpenditures,includingtransfersto
provincesandterritories.Hence,Canadianprovincesbecamethemainprovidersofsocialprograms
involvingpublicservices,while the federalgovernment is largely restricted to socialprograms that
involve transfers. The fact that such social programs include a significant proportion of program
spendingatbothlevelsofgovernmentemphasisestheimportanceofredistribution asanobjectiveof
governmentpolicy.
TheGreatDepressionandCanadianfederalismLiketheU.S.,Canadasufferedamajordepressionfrom1929to1939.Intermsofoutputloss,itwas
similarinbothtimingandmagnitudetotheGreatDepressionintheUnitedStates.Between1929and
1933,GNPdroppedby43%andexportsshrankby50%.Commodityprices felldramatically around
the world and therefore the regions and communities dependent on primary industries such as
farming,miningand loggingsuffered themost.Theeconomybegan torecover,slowly,after1933.
However,theDepressiondidnotenduntiltheoutbreakoftheSecondWorldWarin1939.
The Great Depression was a turning point for Canadian economic policies. Before 1930, the
government intervened as little as possible, believing the free market would take care of the
economy.DuringtheDepression,thegovernmentofCanadabecamemuchmoreinterventionist and
proposedlegislation
that
paralleled
Roosevelt's
New
Deal
agenda.
In
particular,
it
introduced
high
tariffs toprotectdomesticmanufacturing, a step thatonly createdweakerdemandandmade the
Depressionworse. Italso introducedminimumhourlywages,astandardworkweek,andprograms
suchasoldageassistanceandunemploymentinsurance.TheBankofCanadawascreatedin1934as
acentralbanktomanagethemoneysupplyandbringstabilitytothecountrysfinancialsystem.
In1937,thefederalgovernmentappointedtheRoyalCommissiononDominionProvincialRelations,
commonlyknownas theRowellSiroisCommission. Itsobjectivewas toexamine issuesof taxation,
governmentspending,thepublicdebt,federalgrantsandsubsidiesandtheconstitutional allocation
of revenue sources. Ruggeri (2006) argues that the most important recommendation of the
Commissionwas thepayment to theprovincesby the federalgovernmentofnationaladjustment
grants,asetofunconditionaltransfersaimedatequalising provincial fiscalcapacity. Inreturn, the
federal government acquired exclusivejurisdiction over personal and corporate income taxes and
successionduties.Thisnewdivisionof responsibilitiesbetweendifferent levelsof thegovernment
representedamajorshifttowardsfiscalcentralisation.
In 1938, following the Commission recommendations, the federal government for the first time
consciouslydecidedto increasespendingtocounteractadownturnineconomicactivity.Inaddition
tofiscalexpendituresthegovernmentalsoofferedloanstomunicipalitiesforlocalimprovementsand
passedaNationalHousingAct toencourage thebuildingofhomes.Consistentwith thisKeynesian
approach,thegovernmentalsoreducedtaxesandofferedtaxexemptionsforprivate investors.The
idea of a static and balanced budget was abandoned. In its place fiscal policy would stimulate
economicrecoveryviagovernmentdeficitsandeconomicmeasures.
Thebudgetof1938marksthebeginningofanewconceptoftheroleofgovernmentinCanada.Until
thenthefederalgovernmenthadconcentratedonprovidingpublicservices.Ithadnowundertakena
new and significantly different responsibility: that of smoothing economic activity. It was a most
radicalinnovation
inspired
by
the
Great
Depression.
2.2.3RecentdevelopmentsintheCanadianfederation
SincetheBritishNorthAmericanActof1867,theprovinceshavebeenassignedanincreasingnumber
oftaxes.AsstressedbyShah(1995),today,theyareresponsiblefortaxcollectioninallareasexcept
customs,unemployment insurancepremiums,andcontributionstotheCanadaPensionPlan.10
10SometimesCanadianprovincessharethetaxresponsibilitieswiththecentralgovernment.
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
14/34
13
Canadahasahighlydecentralisedfederalsystem.Subnationalexpendituresaccountedformorethan
50%of totalpublicexpendituresduring the1990s (column1and2 inTable2).AsnotedbyShah
(1995), in Canada, there are elaborate mechanisms for federalprovincial fiscal coordination. The
majorityofdirectprogramexpendituresareatthesubnational levelbutOttawa (i.e.theCanadian
federalgovernment)retainsflexibilityandachievesfiscalharmonisation throughconditionaltransfers
andtaxcollectionagreements.
In thepast severalyears,provincial concernhasemergedover theuseof federal spendingpower
simplyasameansof transferring revenues to theprovinces.Canada, likealmostall federations, is
characterisedbyaverticalfiscalgap:amismatchbetweentherevenuemeansandexpenditureneeds.
In particular, Canadian federal revenue exceeds what is required by direct and indirect spending
responsibilities of the central government. Regional governments have fewer revenues than their
expenditure responsibilities with the result that excess central revenue being transferred to the
provinces inone formoranother.Over time, the sizeof the verticalgaphasgraduallydecreased,
implyingthatprovinceshavegraduallybecomemoreandmoreselfsufficient.
Much of the discipline on public sector borrowing comes from the financial sector monitoring
deficitsanddebtatall levelsofgovernment.Moreoverfinancialmarkets,especiallybondandstock
markets and provincial electorates impose a strong fiscal discipline at the subnational level. The
borrowingautonomy
index
in
Canada
is
the
lowest
in
the
group
of
countries
under
study
(column
5in
Table 2). Furthermore, national policies explicitly forbid bailouts of provinces at risk of default
(column6inTable2).
2.3Germany
The Federal Republic of Germany consists of a federal (Bund) government, 16 Land (state)
governments,andnumerousmunicipal (or local)governments.There isa formal, indirectlyelected
headof state, thePresidentof the FederalRepublic.Allof the federaland Landgovernmentsare
organisedonthebasisof theparliamentary system.AllLnderhaveunicameral legislatures,whose
membersareelecteddirectlybypopularvote.
2.3.1FoundationoftheGermanfederation
Germanyisarelativelyrecentnationstate.Inthemidnineteenthcentury,Germanywasacollection
of smaller states that were linked together as a German confederation. This confederation was
dominatedbyAustria,whichasan imperialpowerwaspoliticallyandeconomicallysuperior to the
smallerGermanstates. In the1860's, thedominanceofAustriawaschallengedbyPrussiaand the
processofunificationandcodificationofGermanlawbegan.
Agradualprocessofeconomic interdependence from theearly stagesof the IndustrialRevolution
through to the mid19th century saw the German states move towards economic unification. For
example, thegrowthof the railwaynetwork inGermany led toeasieraccess todifferentresources
across the confederation. This helped to stimulate economic growth and meant that economic
prosperitywasincreasinglyreliantuponstronglinksbetweendifferentmemberstatesoftheGerman
confederation.
This led to the introduction of theZollverein customs union, an agreement amongst the German
statestohavepreferentialcustomspoliciesformemberstates.ThiseconomicunionexcludedAustria,
illustrating a growing German sense of identity and a lesser dependency upon the largest of the
Germanstates.
The final national unification of Germany was achieved in two steps: the creation of the North
GermanConfederation in186667andthenoftheGermanReich in1871. In1866awarbrokeout
betweenAustriaandPrussia, lastinga fewweeks.ThePrussianvictoryover theAustrians led toa
clearerdivisionbetweenAustrianandGerman interests.Thisnewsituationalso forced thesmaller
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
15/34
14
statestoalignthemselveswiththePrussians,withwhomtheysharedmoreeconomictiesduetothe
commonZollvereincustomsagreement.
Atthesametime,between1866and1870,relationsbetweenPrussiaandFranceworsened.In1870,
FrancedeclaredawarthatwaswonbyPrussia.FollowingvictoriesoverFrance, inJanuaryof1871,
PrussiapersuadedotherGermanconfederationmembersthatunificationwasdesirable.Asaresult,
Wilhelm,kingofPrussia,wasproclaimedEmperorofGermanyonJanuary18,1871inVersailles.The
SecondGerman
Reich
was
born.
2.3.2TheevolutionoftheGermanfederation
With unification, Prussia inherited a set of states with already highly institutionalised governance
structuresinplace:welldevelopedpubliceducationsystems,effectivesystemsofpublicfinance,and
stablepopulations, seeZiblatt(2004).Afterunification,theGermanReich increased itsspendingso
thattheshareoftotalgovernmentexpendituresoverGNProsefrom10%in1881to17.7%in1913
whilethecentralgovernmentsshareincreasedfrom2.9to6.2%,Hefeker(2001).
WorldWarIendedindefeatforGermany.Asthegovernmentfinanceditsburgeoning deficitsbythe
monetaryprintingpress,saddledwithenormouswardebtsandreparations,theeconomyslidintoa
hyperinflationin
1922
23.
The
hyperinflation
was
ended
by
astabilisation
package
based
on
fiscal
consolidation.
When,afterthewar,theWeimarRepublicwasfounded,adrivetowardsacentralizedstatestrongly
dominated separatist tendencies and thus limited the possibilities for development of a federal
system.TheWeimarRepublic isdescribedasa "decentralised unitary state, rather thana federal
state.
Inearly1928,Germanyseconomyslipped intorecession,thenstabilisedbeforeturningdownagain
inthethirdquarterof1929.ThedeclineinGermanindustrialproductionduringtheGreatDepression
was roughly equal to that in the United States. Lacking adequate sources of finance, the federal
governmentwasforcedtocoveritsbudgettoalargeextentbyissuingdebt,runningultimatelyintoa
seriousdebtcrisis.TheGermangovernmentdidnotuseactivistfiscalpolicytoattenuatetheeffects
ofthecrises.11
InJanuary1933,HitlerwasappointedReichChancellor.Intermsofeconomicpolicy,theHitlerregime
didnotrepresentaradicalbreakwithpastconservativepolicies,atleastnotuntil1936.Itincreased
spendingformilitarypurposes.TheNaziregimecreatedaunitarystatewithallpowersheldby the
centralgovernmentwhiletheStateswererelegatedtoadministrativedistricts.
AftertheSecondWorldWar,anewtypeoffederalismwas imposedonGermanybyFrance,United
Kingdomand theUnitedStates.Becauseof theNazi totalitarianexperience,aunitarystructure for
postwarGermanywasruledout.Insteadafederalsolutionwasadopted,foundedonthecreationof
newLnderthathadnotexistedbefore.Theywereconceivedasstateunits,clearlydistinctfromthe
federation.ThedistributionofpowersbetweenthecentralandLndergovernmentsaccordingtothe
GermanConstitution,theBasicLaw(Grundgesetz)of1949,stillreflectssomeaspectsoftheWeimar
Republic. However, sinceWorld War II, the federal government has been more limited in several
areas.The
creation
of
the
structure
of
federalism
continued
in
1990
when
six
new
Lnder
were
establishedwithGermanreunification.
ThesystemcreatedbytheBasicLawdidnotfacilitatecooperativefederalismoreventhesharingof
politicalresponsibility betweenfederationandstate.TherathercompetitivestructureoftheGerman
federationreducedthefinancialresponsibilityofthealreadylargelytransferdependentLnder.Asa
rule, the Lnderhave stronglydefended theirauthorityand financial resourcesagainst the central
11Cohn(1992)notesthatGermanyoptedforconservativefiscalpoliciesbecauseofitshugenationaldebt.
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
16/34
15
government.Althoughthecentralgovernmentofficiallyfollowsthenobailoutrule,thiscommitment
is not fully credible. There is an incentive for the Lnder to borrow excessively as their taxing
authority is rather limited. Indeed, the excessive debts of some of the Lnder and the financial
securityprovidedbythecentralgovernment,aftertheSecondWorldWar,demonstratethe lackof
credibilityandcommitmentoftheLander.
2.3.3German
debt
and
bailouts
AlthoughtheGermanfederalgovernmentandtheBundesbankarefamousforitsprudentmonetary
andfiscalpolicies,thefiscalperformanceofthesubnationalsectorisfarlessadmirable(Rodden
2005).
Intheimmediatepostwarperiod,thelevelofthepublicdebtwasratherlowandevenlydistributed
betweenthethreelevelsoftheGermanfederation.Inthe1970sand1980s,thedebtsofthecentral
governmentandespeciallyoftheLnderhaverisenatasharprate.SomeoftheLnder,whichwere
particularly indebtedandwhichwerealsoused to receivehighamountsof transfers,expected the
centralgovernment tobail themout. Inorder tostrengthen its credibility, thecentralgovernment
couldhaverefused,astheUSfederalgovernmentdid in1840. Instead, inearly1987theLnderof
BremenandSaarlandbegantoreceivespecialsupplementary transfersformthecentralgovernment
explicitlyaimed
at
coping
with
their
high
debts.
In1992 the FederalConstitutional Courthandeddown adecision stipulating that the constitution
requiredtheBundtomakeextratransferstoBremenandSaarland,amountingtoaround30billion
DM over the period from 19942000, see Rodden (2004) and HeppkeFalk and Wolff (2008).12
Furthermore,thesetransferstoBremenandSaarlandhaveneverhadtoberepaid.
The bailout provided by the German government was a signal of its lack of commitment,
demonstratingthedifficultiestocommitintheexistingconstitutional setting,andcreatedincentives
forfurtherirresponsible fiscalbehaviouronthepartoftheLnder.ThehugedebtsattheLnderlevel
werelargelyresponsibleforGermanysproblemoffollowingtheStabilityandGrowthPactin2002.13
Alsoinafederalconstitutional courtrulingof2006onBerlin,nofundamentalchangeoftheprinciple
of solidarity was undertaken and investors continue to price German Lnder essentially similarly
(SchulzandWolff(2009)).
Asecond,interestingfeatureofGermanfederalismisthatallLnderparticipateintheGermanfiscal
equalization system which guarantees a minimum level of annual tax revenues. In practice, the
minimumisveryclosetotheaverageandsomeLnderarepermanentnetrecipientswhileothersare
permanentnet contributors.This fiscalequalization also affects the markets perceptionof a sub
centralgovernments credit risk,as the centralgovernmentmay find ithard to refusebailouts to
stateswhicharepermanentnetrecipientofequalizationgrants.Schuknecht,vonHagenandWolswijk
(2009)findthat,Germanregions,and,inparticular,thosethatwereconsistentlynetrecipientsinthe
Germanequalization scheme,didnotpayriskpremiumsrelatedtotheirfiscalperformanceinexcess
oftheGermanfederalgovernment.
Rodden (2005) argues that the current fiscal federalism in Germany is characterized by structural
weaknesses intheGermanfederalsystemsthathavebeenpresentthroughoutthepostwarperiod.
Specifically,the
collaborative
intergovernmental
system
of
revenue
legislation,
collection,
and
distribution breaks the link between taxing and spending decisions that is critical for effective
governmentprovisionofgoodsandservices.Whilemostspendingandpolicyimplementationoccurs
at theLandorGemeinde level,mostrevenuedecisionsaremadeat theBund level.Rodden (2005)
12ArulingbytheFederalConstitutional Courtin1992introducedthenotionofextremeemergencyasthenecessarycondition
forsupportfromthefederalgovernment.13
SeeHeppkeFalkandWolff(2008)foradiscussion ofthemoralhazardproblemandtheissueofbailoutintheGermanfiscal
federation.
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
17/34
16
argues thatGermany's complex, interdependent, collaborative styleof federalism tends toweaken
fiscalaccountability andsoftenbudgetconstraints.
2.3.4RecentdevelopmentsinGermanfederalism
TheBasicLawdividesauthoritybetween the federalgovernmentand theLnder,with thegeneral
principlegoverning
relations
articulated
in
Article
30:
"The
exercise
of
governmental
powers
and
the
dischargeofgovernmentalfunctionsshallbeincumbentontheLnderinsofarasthisBasicLawdoes
nototherwiseprescribeorpermit."Thus,thefederalgovernmentcanexerciseauthorityonlyinthose
areasspecifiedintheBasicLaw.Thefederalgovernmentisassignedagreaterlegislativeroleandthe
Landgovernmentsagreateradministrative role.The fact thatLandgovernmentsemploymorecivil
servantsthanfederalandlocalgovernmentscombinedillustratesthecentraladministrative function
oftheLnder.
Originally, theBasic Lawdivided the federal government's legislative responsibilities intoexclusive
powers, concurrent powers, and framework powers. The exclusive legislative jurisdiction of the
federal government extended to defence, foreign affairs, immigration, transportation,
communications, andcurrencystandards.Theseareaswereadditionallyenlargedbyanamendment
totheBasicLaw in1969,whichcallsforjointaction inareasofbroadsocialconcernsuchashigher
education,regional
economic
development,
and
agricultural
reform.
After
the
reform
of
federalism
in
2006,thefederalandLandgovernmentsshareconcurrentpowersinseveralareas.
TheLnderretainnosignificantpowersoftaxation.Therevenueprovidedbythesetaxesisverylow,
relativetototalsubnationalrevenue.Indeed,asindicatedincolumn4ofTable2,taxrateautonomy
isequalto0.04,muchlessthanintheUSandCanada.
Akeyaspectof theGerman federalstate is thesolidaritybetween the individualLnder.However
economicallyweak individualLndermaybe,nosingleLandwillhave lessthan95%of theaverage
per capita budgetary resources. The Basic Law provides for the establishment of equal living
conditionsthroughoutthecountryandthemaintenanceof legalandeconomicunity inthenational
interest.This includes theconstitutionally mandated revenue sharingwith theLnder from federal
taxes.Virtuallyallofthemajorfederaltaxrevenuesourcesareshared inthisway.Theseconstitute
extensivenondiscretionary unconditional transferstotheLnder.
WattsandHobson(2000)notethatinadditiontherearesubstantialintergovernmental transfersboth
from the federalgovernment to the Lnder,andamong the Lnder,which,asa result,arehighly,
transferdependent.When themeasureof the latter includes revenuesharingmechanisms,Lnder
reachthetransferdependenceof70%(column3inTable2).
Ontheotherhand,Lnderareautonomousintheirborrowingactivities(column5inTable2).14
The
centralgovernmenthasnopowertoplacenumericrestrictionsontheborrowingactivitiesofLnder.
Nevertheless, Lnder have their own laws imposing adequate restrictions. Most often, these are
basedon thegoldenrule, i.e.the loan isdesignated for investmentpurposes.However,asRodden
(2006)notes, investment isaslipperyconceptandmanyofthefinancialneedscanbepresentedas
investments.
Inaddition,
the
investment
limits
have
often
been
breached
with
the
argument
that
exceptional
events have triggered expenditure needs. With the currently ongoing financial crisis leading to
massivelyincreasingdeficits,thepoliticalresponsehasbeentoimposefurtherstrictlimitsondeficits.
TheselimitsaresupposedtoapplytothefederalaswellastotheLnderlevel.
14TheLndergetindividual ratingsfromratingagencies.
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
18/34
17
2.4Argentina
Argentina isa federalrepublicwith24provinces. Ithasapresidential governmentandabicameral
legislatureconsistingoftheChamberofDeputies(257seats)andtheSenate(72seats).Sturzenegger
and Werneck (2006) note that while the Chamber of Deputies supposedly elects deputies in
proportion to their populations, the Argentine system overrepresents the participation of small
provincesthroughaminimumnumberoffivedeputiesperjurisdiction.15
TheSenateisrepresentedby
threesenators
from
each
province,
two
from
the
first
majority
and
athird
from
the
second
party.
2.4.1CreationoftheArgentineanFederation
TheArgentinestatewasbornoutoftheunionofcolonialregionswithdifferingeconomicandsocial
characteristics.Therevolutionof1810againstSpanishcontrolledtothedeclarationofindependence
of the United Provinces of the Rio de la Plata in 1816. Independence revealed strong regional
disparities which had been hidden by Spanish rule. As a result, the establishment of a national
governmentandaconstitution tookalmostfourdecadesaccompaniedbyviolentstruggle.Finally,in
1853 theConstitutionestablishedaconstitutional federalrepublic.Thechanges in theConstitution
introduced in 1860, gave the provinces priority over the central government. The provinces also
gained autonomy in the administration of their territories. Despite some later modifications, the
essential federalist structure of the 18531860 Constitution remains in force today (see Tommasi
(2002)).
Bythebeginningofthetwentiethcentury,Argentinawasoneofthemostdevelopedcountriesinthe
world.However,aftertheGreatDepression,itenteredapathofeconomicdeclinelargelyreflectinga
successionofpooreconomicpoliciesbasedonpopulism.
TheArgentineanFederationandtheGreatDepressionTheGreatDepressionbegan inArgentina inthe late1920s,evenbeforethedateofthestartofthe
Depression in the core countries of NorthAmerica and Western Europe following the Wall Street
crashof1929.Like inmanycountriesof theperiphery,Argentinawasexposedtocommodityprice
shocksand,duringthe1920s,itstermsoftradeworsenedconsiderably. Bytheendof1929,abalance
ofpayments crisisdeveloped, and theexchange ratewas allowed to floatafteronly twoyearsof
participation inthegoldstandard.Recoverybeganin1931,andby193435,outputhadregained its
1929level.
TheArgentineGreatDepressionwasmildandshortlivedby international standards.From itspeak
between1929and1932domesticrealoutputfellby14%andby1935ithadsurpassedits1929level.
Deflationwasabout6%inthe192932period.Inothergoldstandardcountries,suchastheUnited
StatesandCanada, thedecline in realactivity reachedmore than30%andprice levelsdeclinedby
morethan20%.
Major monetary policy actions from 1929 to 1935 were responsible for accommodation of the
negative shocks of the 1930s. In response to the economic difficulties, two major institutional
changes intheconductofmonetarypolicytookplace inthefirsthalfofthe1930s.Thefirstwas in
1931,whenthedecisionwastakenbytheConversionOffice(acurrencyboardestablishedin1910)to
shiftthemonetaryregimefromametallicregimestandardbasedongoldtoafiduciaryregimeandto
revaluethe
monetary
gold
stock
and
devalue
the
currency.
This
resulted
in
amore
flexible
monetary
regimewhichcouldadapttotheeconomiccrisis.Second,aBancoCentral,acentralbank,wascreated
in 1936. This independent institution replaced the Conversion Office and abandoned its nominal
anchorcommitmentdevice.16
Duringthedepression,fiscalpoliciesinArgentinaremainedevenmoreconservativethanincountries
like theUnited States.TheGreatDepression created a suddendecrease in federal revenues.As a
15SeeforinstanceSturzenegger andWerneck(2006).
16Forthedetailsofthereforms,seeDellaPaoleraandTaylor(1999).
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
19/34
18
result, some tax collection responsibilities shifted from the subnational to thenational level. The
federalgovernmentstartedtocollecttaxesthatwerepreviouslyassignedtotheprovinces, invoking
thecriticalsituationclauseintheConstitution.
2.4.2Argentineandebthistory
Thehistory
of
excessive
Argentinean
public
debt
started
early.
The
revolution
from
Spain
in
1810
led
totheconstantexpansionofmilitaryexpendituresandtoadropintraderevenues(resultofSpanish
blockade of the Rio de la Plata). As a result, the Buenos Aires authorities had to issue the first
compulsoryloan.Duringtheperiod18131821,compulsoryloansamountedto2.96millionpesos.In
1819 and 1820, in order to pay the military and public wages, the government issued small
denominationnotestobeusedbythecustoms(seeBordoandVegh,2002).Bythenthedifference
betweenthepublicdebtandmoneyhaddisappeared.Atthattime,theonlysolutiontotheproblem
was to consolidate the total debt and convert it into longterm debt. The funding operation was
carriedoutin1821.Furtherbondissuesin1823and1824werenecessarytocompletetheoperation.
Bytheendofthefundingoperationin1824,6.4millionworthofbondshadbeenissued(seeBordo
andVegh,2002).
In1825,thewarwithBrazilbegan.Tofinancethewar,andgiventhattheinterestratechargedbythe
BancoNacional
was
considerably
below
the
open
market
rate,
the
Buenos
Aires
government
relied
heavilyoncreditfromtheBancoNacional.AsthecreditresourcesoftheBancoNacionalfellshortof
the governments borrowing requirements, the Banco Nacional had to start printing money. The
resultinginflationspiralbeganin1826andcontinueduntilmid1830.Atthebeginningof1830,long
termgovernmentbondsweresellingatanaveragediscountof40percent.
BordoandVegh(2002)arguethattwomaineconomicfactorswouldensurethatmonetaryinstability
wouldcontinueforthenext40years.First,theTreasurycontinuedtodependontradetaxesformost
ofitsrevenues.Second,longtermbondfinancingwasbecomingdifficultasthepublicbecamemore
reticenttobuyadditionalpublicdebtandaLondonloanfor5milliongoldpesoscontractedin1824
wasdefaultedonin1827,andservicingwasnotpermanentlyrestoreduntil1849.
Bytheearly1840s,thetreasurycontinuedtobeheavilydependentontradetaxesandtheprintingof
money.Inaway,theexclusiverelianceonmoneyfinanceafter1840completeda longprocessthat
began in1813with the firstcompulsory loan.During18101821,governmentpaperbecamemoreandmoreliquid.In1822,papermoneywasissuedandsoonbecameinconvertible.Longtermbond
financing became increasingly difficult afterwards. In 1840, the Treasury concluded that bond
financingwasnolongerworthit,andmoneyfinancingbecametheonlyotherimportantfiscaltool(in
additiontotradetaxes).
Duringthenext60years,ArgentinajoinedandlefttheGoldStandardseveraltimes.Oneachoccasion
convertibility wassuspended,mainly inyearsofpoliticalturmoilandrisinglevelsofmoneyfinanced
governmentdeficits.The finalconvertibility suspensionoccurred in1914at theoutbreakofWorld
WarI.Inthe interwarperiodArgentinafollowedconservativemonetaryandfiscalpolicies,returned
togoldduring192729,and in the1930s followedmildlyexpansionarypolicies (seeDellaPaolera,
1995;DellaPaoleraandTaylor,1997,1999).Areturntohighinflationregimes,asinthe19thcentury,
beganwithPeronafterWorldWarII(seeDiTellaandDornbusch,1989).
Continuousgrowthofgovernmentinsuccessivedecadesbroughtpublicexpenditurestoabout50%of
GDP in the second half of the 1990s. During the 1980s, both levels of government borrowed
extensively,reflectingweakfiscalmanagement.Inaddition,both levelsofgovernmentaccumulated
largedebtsonpaymentsforwagesandpensions,tosuppliersandfordebtservice.Lackoffinancial
controlprevailed inparticularattheprovincial level,becomingan importantsourceoffinancialand
macroeconomic instability.
In the late1980s, theprovincesaccounted for roughly40%of thedeficitof theconsolidatednon
financial public sector. These deficits were financed by discretionary transfers and loans from the
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
20/34
19
federal government, but also by loans from the provincial banks and other parts of the financial
system,seeSaieghandTommasi (1999).Theprovincesborrowed from theirprovincialbanks,who
then discounted the debt at the central bank, effectively giving the provinces a share in the
seignoragefrominflation. Thisprocessled,bytheendofthe1980s,toahyperinflation.
During theperiod199294, the federalgovernment financedspecial financialrescueoperations for
seven provinces. Nicolini et al (2002) argue that one of the main sources of deficits in provincial
financeswas
the
state
provincial
pension
system.
Financial
aid
to
provinces
in
difficulties
took
the
form of issuing national treasury bonds. Using this ad hoc mechanism, the central government
grantedhugeloans.
By establishing a currency board arrangement, the Convertibility Law of March 1991 ended
inflationarycentralbankfinancingofpublicsectordeficitsatalllevels.Asetofstructuralreformswas
introduced in the1990s,however,abudgetpolicyora fiscal responsibility law thatwouldcontrol
provincialspendingwasnotdeveloped.Theprovinces,especiallytheProvinceofBuenosAires,were
spending heavily and financing their expenditures through commercial bank borrowing therefore
causingcrowdingout.
AsshowninTable3,thepublicdebtgrewroughly40percentfrom1997until2001.64percentofthis
growthwascontracted locally, implyingthatthedomesticdebtofthegovernmentalmostdoubled.
Thedomestic
debt
was
also
contracted
in
dollars.
The
annual
public
and
private
external
debt
service
amounted to41percentof totalexports,and the totalpublicandprivateexternaldebtstockwas
equivalent toalmost5timestheannualexports.Thegrowth in thedebtwasnotseenasworrying,
partlybecauseof itsoneoffnature,andpartlybecausetheeconomywasnowbelieved tobeona
new,highergrowthpath.Butunderneaththesurface,thedebtwasbecomingunsustainable.
In1998,theArgentineaneconomywasstruckbyaseriesofshockswhichplunged it intorecession.
The 1998s Russian crisis dramatically reduced the inflow of foreign capital available to emerging
countries (seeLischinsky,2003).The first signsof restrictedcreditwere thehigh lending rates the
provinces were charged, which did not impede the excessive borrowing. Further, the recession
decreasedtaxrevenues,thebasisforservicingdebt.Inanycase,Argentinastaxcollectioneffortwas
not impressive,andthetaxsystemwasnotcapableofgenerating largeadditionalresourcesrapidly
(seeMark,2003).Debtserviceasashareofexportswashigh,becausetheArgentineaneconomywas
relatively closed, with exports hovering around 10 percent of GDP. With the resulting revision of
growthprospects,Argentinasfuturecapacitytoserviceitsdebtbegantolookmoreworrisome.Mark(2003)argues thatas thisproblembecameclear tomarketparticipants,spreadsroseonArgentine
paperandmaturitiesshortened,creating increasingdifficulty inrollingoverthedebtand increasing
debtservicingcosts.Thisagainworsenedthedebtdynamics,eventuallyforcingArgentinatodefault
onitsdebt.
This combination of inadequate fiscal adjustment and (external) borrowing in foreign currencies
proved in the end damaging for Argentinas attempt to maintain the currency board and avoid
default. Inaddition,SturzeneggerandWerneck(2006)arguethattheirresponsible fiscalbehaviourof
theprovincesleadingtorunupsinthenationaldebttoGDPratiowasakeyingredientintheprocess
leadingtothiscrisis.
2.4.3Argentinean
federalism
today
ProvincialgovernmentsinArgentinahaveabundantpowerstodecidetheirownrulesofgovernance
aswellas taxingandspendingdecisions,whilemunicipalitiesreporttotheprovincialgovernments.
Although the Argentine Constitution establishes substantial room for subnational taxation, in
practice,provinceshavedelegated to thenationalgovernment the responsibilityof raisinga large
shareoftheirtaxes.SturzeneggerandWerneck(2006)arguethat,atthesametime,theresponsibility
forkeysocialfunctions is inprovincialhands.Forexample,provinceshaveexclusivecompetence in
primary and secondary education and in the provision of most social expenditures on education,
health, poverty programs, and housing. As a result of expenditure decentralisation and tax
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
21/34
20
centralisation, the Argentinean federal system is characterised by a high degree of vertical fiscal
imbalancegap.Thisgap,coupledwiththerelativelylargefractionofgovernmentservicesprovidedat
thesubnationallevel,createsacommonpoolproblemacrossprovinces.Tommasi(2002)arguesthat
asaconsequencesomeoftheprovincialgovernmentsarenotawareofanyhardbudgetconstraint.
Thus they increase spending and reduce local tax effort compared to the case of having to face
bindingbudgetaryrestrictions.
Argentinaaddresses
its
large
vertical
fiscal
imbalance
gap
through
acomplex
and
extensive
system
of
intergovernmental transfers.These transfersandotherrevenuesharingproceedsaccount formore
thanhalfoftotalrevenuesoftheprovinces(column3inTable2).17
Themostimportantcomponent
of this transfer system is the taxsharing agreement called Coparticipacin, which refers to the
process by which shares of the taxes collected by the central government are reallocated to the
provinces.Overtime,thistaxsharingsystemhasbeenoftenmodifiedandseveralnewamendments
have been added to it. Furthermore, some direct transfers appear to be determined by political
considerations. Its complexity and lack of transparency resulted in its description as the fiscal
labyrinth.
WithinArgentinasfederalstructure,alllevelsofgovernmentaregenerallypermittedtoborrowboth
domestically and abroad. However, in many provinces, the provincial Constitution imposes some
restrictionson theborrowingabilityof thegovernment.These restrictionsareveryoftenviolated,
andin
many
provinces
they
are
too
loose
to
be
binding.
In
Table
2,
we
see
that
during
the
1990s
among the five countries studied, Argentina had the highest degree of borrowing autonomy and
reachedalmostfullborrowingautonomyofsubnationalentities.
2.5Brazil
Brazilhasacomplex federation.Threegovernment levelscomprise theUnionof26statesplus the
Federal District, and more than 5500 municipalities. The Constitution explicitly considers
municipalitiestobemembersofthefederation,givingthemamuchhigherstatusandautonomythan
isgenerallyobservedinotherfederations,seeSturzeneggerandWerneck(2006).
The republichasapresidential regimeandabicameral legislatureconsistingof theFederalSenate
and the Chamber of Deputies. Each state is equally represented in the upper chamber by three
senators. Representation in the Chamber of Deputies is not strictly proportional to stateconstituencies. Infact,theConstitutionestablishesthatnostatemayhave lessthan8deputiesand
morethan70.ThisleadstoadisequilibriumsimilartotheonepresentintheArgentineanfederation.
The unpopulated Northern states are overrepresented and the state of Sao Paulo is under
represented.
2.5.1CreationoftheBrazilianfederation
TheBrazilianFederationwascreatedalongwiththeRepublicin1889.Itwasbornoutofthedecision
todividetheunitarystatethatprevailedduringtheImperialRegime.Castanhar(2003)notesthatthe
FederalRegimewasconvenientmainlyforthemostdevelopedprovincesoftheSouthandSoutheast,
inparticularSoPaulo.Theseregionswererichinthenewagriculturalexportproductsatthattime.
Theseprovinceswouldobtainadditionalrevenues from local taxeson theseexports. Inreturn, the
less
developed
regions
were
granted
politicalrepresentation
in
the
government
more
than
proportionaltotheirpopulation.
2.5.2EvolutionoftheBrazilianfederation
ThisfiscalfederalarrangementhasundergonesubstantialchangesoverBrazilshistory.Duringmost
of the nineteenth century when the country had a parliamentary monarchy a high degree of
centralisation prevailed. The power of provincial governments was weak until 1889 as these
17SeealsoCetrngoloandJimnez(2004).
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
22/34
21
governmentshadlittlecontroloverfiscalrevenues.Theprovinceswerenotallowedtocollectimport
taxesor interprovincial trade taxes,but implicitly theyhad the right to collectexport taxes and in
practicetheyalsocollectedinterstatetaxes.In1889,arepublicanmovementoverthrewtheemperor
in a peaceful revolution and established a provisional government in charge of drafting a new
constitution. ThefirstdraftoftheconstitutionwasthencreatedandsubmittedtotheConstitutional
Congressforafinalrevisionandapproval.TheConstitutional AssemblypassedanewConstitutionon
February24,1891,whichprovidedstateswithgreatautonomy,inparticular,therighttotaxexports,
toset
up
their
own
armed
forces,
and
to
have
independent
gubernatorial
elections.
By
not
including
any limitationsto theamountofdebtstatescould issue, theConstitution implicitlygavestates the
righttoissuedebtdomestically andabroad.
Afterthe1891Constitution,staterevenuesfromexporttaxesrepresentedonaveragearound60%of
total revenue between 1914 and 1916. States such as Esprito Santo and Rio Grande do Norte
collected more than 85% of their revenues from export taxes. So Paulo increased its collection
capacitypercapitathreetimesafter1891,collectingalmost40%ofwhatallthestatescollectedwith
onlyhalfof the totalexportsand less thanone fifthof thepopulation. In contrast,GiasandRio
GrandedoSulcollectedonly24%and29%of theirrevenues fromexport taxes.This taxcollection
independenceofstateshadlargerepercussionsonthecostofcapital.Inparticular,stateswithlarger
exports per capita and resulting larger tax income were able to sell more debt in international
marketsandpaidlowerinterestratesforthoseloansseeMartinezFritscherandAldo(2010).
TheGreatDepressionandBrazilianfederalismDuring theGreatDepression,Brazil, likemanyothercommoditydependenteconomieswent intoa
deepcrisis.Thepriceofcoffee(70%ofBrazil'sexportsshareduringthe1920s)droppedfrom22.5
centsapound in1929 to8cents in1931.As in theother federationsstudiedbyus, theeconomic
depression accelerated expansion and consolidation of the centers power. In 1929, Brazil like
Argentinabegantodevalue itscurrencyandasaresultexperiencedonlyarelativelymilddownturn
andhadlargelyrecoveredby1935.
Thecentralgovernmentwasstrengthened furtherduring theauthoritarianVargas regimebetween
1930and1945.Theendof theVargasdictatorshipbroughtanew constitution. Although thenew
constitutiondidnot introduce radicalchanges to the tax system, itpromoted significanteffortsof
decentralisation, givingmoreautonomyaswellassourcesofrevenuetostateandlocalgovernments.
Thisdecentralisation wavewasinterruptedby20yearsofmilitarygovernment,from1964onwards.The end of this regime in 1985 led to another decentralisation movement. The interests of sub
nationalgovernmentsdominatedtheredesignofthefiscalfederalismarrangementestablishedbythe
1988Constitution.
As a reaction to the earlier dictatorial period, the new constitution delegated a large amount of
revenue and politicalpower towards the subnational governments, and inparticular towards the
municipalities. Subnational governments were directly or indirectly given a much more generous
shareoftheaggregatetaxescollectedinthecountry.AlthoughtheConstitutionalreadyenhancedthe
taxing power of subnational governments, it additionally established transfers basedon revenue
sharingrules,seeSturzeneggerandWerneck(2006).
Soon after the approval of the new Constitution and a new tax system in particular, the central
governmentfaced
growing
financial
difficulties.
In
response,
it
undertook
efforts
to
increase
its
tax
revenue.Asaresult, inefficienttaxeswere introduced, i.e.variousformsofturnovertaxesthathad
beeneliminatedfromtheBraziliantaxsysteminthe1960s.
2.5.3PublicdebtinBrazil
The Republican Period was marked by difficulties in domestic and external financing and
restructuring. First, the long stretch of time during which outstanding securities could not be
converted (183989)affected its credibility. Second,due to the largediversityof instrumentswith
differentmaturitiesand interest rates thedebtwashighly fragmented.The last two issuesspelled
7/27/2019 A Fiscal Union for the Euro - Some Lessons From History
23/34
22
troublefordomesticdebtnegotiationandliquidity.In1902consolidationtriedtosolvetheproblem
of debt fragmentation and succeeded, at least initially. Nearly all outstanding securities were
exchangedfo