Fiscal Federalism: US History for Architects of Europe's Fiscal Union

WORKING PAPER 12-1

Fiscal Federalism: US History for Architects of Europe's Fiscal Union

by C. Randall Henning, Peterson Institute for International Economics
and Martin Kessler, Peterson Institute for International Economics

January 2012

European debates over reform of the fiscal governance of the euro area frequently reference fiscal federalism in the United States. The "fiscal compact" agreed by the European Council during 2011 provided for the introduction of, among other things, constitutional rules or framework laws known as "debt brakes" in the member states of the euro area. In light of the compact and proposals for deeper fiscal union, Henning and Kessler review US fiscal federalism from Alexander Hamilton to the present. They note that within the US system the states are "sovereign": The federal government does not mandate balanced budgets nor, since the 1840s, does it bail out states in fiscal trouble. States adopted balanced budget rules of varying strength during the nineteenth century and these rules limit debt accumulation. Before introducing debt brakes for euro area member states, however, Europeans should consider three important caveats. First, debt brakes are likely to be more durable and effective when "owned" locally rather than mandated centrally. Second, maintaining a capacity for countercyclical macroeconomic stabilization is essential. Balanced budget rules have been viable in the US states because the federal government has a broad set of fiscal powers, including countercyclical fiscal action. Finally, because debt brakes threaten to collide with bank rescues, the euro area should unify bank regulation and create a common fiscal pool for restructuring the banking system.

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