64 Finance & economics The EconomistAugust 22nd 2020
Q
uick: wouldyou rather face the worst economic crisis in his-
tory as a resident of America’s fiscal union, or Europe’s? An easy
choice, surely; a decade ago, the euro area’s skeletal economic in-
stitutions turned an American-made panic into a near-collapse of
the European project. By 2013 euro-zone output was 3% below its
peak in 2008, whereas America’s was nearly 5% higher. Look again,
though, and the answer is less obvious. Both fiscal federations
have flaws. But the covid-19 crisis shows that Europe may not be so
badly outclassed by America’s fiscal union after all.
The division of the power to tax and spend across many layers
of government—fiscal federalism—has many potential benefits.
Decentralisation allows governments to satisfy a diverse popula-
tion’s policy preferences and cope with regional needs. Given free
movement of labour and capital within a federation, competition
between regional governments can lead to policy innovation and
limit state overreach. At the same time, membership of a federal
entity brings scale economies: access to more resources and a big-
ger market; more effective risk-sharing. Economists reckon that
the task of macroeconomic stabilisation is best left to the highest
level of government. It has a greater capacity to manage local
shocks: as federal-tax receipts in one region fall, revenue is cush-
ioned by those from elsewhere. For a federal authority, the spill-
over of fiscal easing across state borders is not a problem. A shared
currency, too, should be complemented by fiscal powers.
A strong federal budget, though, creates the risk of moral haz-
ard. The lower levels of government may borrow too much, count-
ing on federal bail-outs when things go wrong. Effective fiscal fed-
eralism thus requires a mechanism to constrain states’ borrowing.
America confronted this problem in the 19th century. After fiscal
integration led to reckless state borrowing and defaults, state gov-
ernments adopted balanced-budget rules. All except Vermont are
bound by them, leaving countercyclical policy the prerogative of
the federal government. In downturns, states depend on federal
relief: in the form of reduced federal-tax payments, increased wel-
fare spending, and occasional discretionary stimulus (like the
$1,200 cheques posted to most Americans earlier this year).
No real-world federal system meets the ideal. The euro area, on
the eve of the financial crisis in 2007-09, suffered from dangerousdefects.Monetary power rested with the supranational European
Central Bank (ecb). But member states retained near-total control
over crucial policy levers, like the power to tax and spend, and to
regulate banks. The crisis exposed these weaknesses. Unsure that
the ecbwould act as lender of last resort to troubled member
states, investors shunned vulnerable governments, sending bond
yields soaring and raising the spectre of chaotic exits from the eu.
The predicament contrasted starkly with events in America, where
a fiscally powerful central government backed by a proactive cen-
tral bank stood ready to help hard-hit states and troubled banks.
Many economists urged the euro area to replicate two centuries’
worth of American-style fiscal integration. Instead the zone did
just enough to survive. A promise by the ecb to defend the single
currency persuaded bond vigilantes to retreat.
Even as it limped out of crisis, Europe seemed to sow the seeds
of future troubles. As its crisis abated, the euro area moved to min-
imise moral hazard. Limits on government borrowing agreed in
the late 1990s were strengthened post-crisis: through the intro-
duction of closer monitoring and punitive sanctions, for instance.
But these efforts were not matched by complementary, American-
style mechanisms to provide collective stimulus. The oversight
seemed designed to leave the European project vulnerable, once
again, in the face of any new recession.
Yet for all its missteps, Europe’s fiscal performance compares
surprisingly well with America’s. Government spending contrib-
uted positively to euro-area growth in every year except 2011, when
its effect was neutral, and 2012, when governments’ budgets re-
duced growth by just 0.1 percentage points. Austerity did concen-
trate economic pain in parts of the periphery. But that was also the
case in American states, where balanced-budget rules led states to
make deep spending cuts. Indeed, these were so large that the fed-
eral largesse intended to keep America’s overall fiscal position
stimulative barely managed to offset the cuts. Government spend-
ing at all levels contributed 0.7 percentage points to growth in
2009, but was neutral in 2010 and subtracted 0.7 percentage points
from growth in 2011—even as the federal government provided
roughly half a trillion dollars in aid to states that year.Just you wait
The response to covid-19’s economic devastation looks similar. On
the surface, the staggering stimulus package enacted in America in
the spring, worth about 13% of gdp, looks a far more potent contri-
bution than the eu’s fiscal package, agreed in July. That recovery
fund, supported by collective borrowing, will spend nearly 5% of
eu gdpover several years. But America’s stimulus is largely ex-
hausted, and its dysfunctional Congress has been unable so far to
pass additional measures. Cuts to state and local governments are
already weighing on the economy, subtracting 0.4 percentage
points from the (annualised) growth rate in the second quarter.
The euro area, by contrast, agreed that fiscal rules should not apply
during the pandemic, allowing members to provide economic
support on a par with America’s federal response.
No one will mistake the euro area for an exemplar of federal-
ism. Some member states, such as Italy, Spain and even France,
will exit the crisis with huge public-debt burdens. The suspension
of borrowing rules could deepen anxiety about moral hazard, and
lingering hardships could yet trigger a crisis that threatens the en-
tire European project. But conventional wisdom could use some
revision. American fiscal federalism, so often cited as a model for
the euro area, looks ever less clearly the superior system. 7Free exchange State of the unions
America’s fiscal federalism is less superior to Europe’s than you might think