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The emerging consensus in Europe nowadays is that only “debtmutualization” in the form of Eurobonds can resolve the euro crisis, withadvocates frequently citing the early United States, when Alexander Hamilton,President George Washington’s treasury secretary, successfully pressed the newfederal government to assume the Revolutionary War debts of America’s states.But a closer look reveals that this early US experience provides neither auseful analogy nor an encouraging precedent for Eurobonds.
First, taking over a stock of existing state debt at the federal level isvery different from allowing individual member states to issue bonds with“joint and several” liability underwritten by all member states collectively. Hamilton did not have toworry about moral hazard, because the federal government did not guarantee anynew debt incurred by the states.
Second, it is seldom mentioned that US federal debt at the time (around$40 million) was much larger than that of the states (about $18 million). Thus,assuming state debt was not central to the success of post-war financialstabilization in the new country; rather, it was a natural corollary of the fact that most of the debt hadbeen incurred fighting for a common cause.
Moreover, the most efficient sources of government revenues at the timewere tariffs and taxes collected at the external border. Even from anefficiency point of view, it made sense to have the federal government service public debt.
Federal assumption of the states’ war debts also yielded an advantage interms of economic development: once states no longer had any debt, they had noneed to raise any revenues through direct taxation, which might have impededthe growth of America’sinternal market. Indeed, after the federal government assumed the states’ debt(already a small part of the total), state revenues fell by 80-90%. The statesthen became for some time fiscally irrelevant.
Finally, the key to the success of financial stabilization was a profoundrestructuring. Hamiltonestimated that the federal government could raise enough revenues to payapproximately 4% interest on the total amount of debt to be serviced –significantly less than the 6% yield on the existing obligations.
Holders of both state and federal bonds were thus offered a basket oflong-dated bonds, some with an interest rate of 3%, and others with 6 % (with aten-year grace period). The basket was designed in such a way as to result inan average debt-service cost of 4%. In modern terms, the “net present value” ofthe total debt (federal and state) was reduced by about one-half if one were toapply the usual exit yield of 9%.
Moreover, the new federal bonds’ very long maturities meant that there wasno rollover risk. It would have been verydangerous to expose the federal government to this danger, given that theoperation was rightly perceived at the outsetas extremely risky.
For the country’s first few years, debt service swallowedmore than 80% of all federal revenues. The slightest negative shock could havebankrupted the new federal government. Fortunately, the opposite happened:federal revenues tripled under the impact of a rapid post-war reconstructionboom, and continued to grow rapidly, aided by the country’s ability to remainneutral while wars ravaged the Europeancontinent.
By contrast, growth prospects in Europe today are rather dim, and interestpayments, even for Greece orItaly,account for less than 20% of total revenues. The real problem is the rolloverof existing debt in a stagnating economy.For example, Italywill soon have a balanced budget in structural terms, but must still face theproblem of refinancing old debt as it matures each year.
Assuaging doubt about thesustainability of public debt in the eurozone would thus probably require adeep restructuring as well. The eurozone crisis could certainly be resolved ifall existing public debt were transformed into 20-year Eurobonds with a yieldof 3%, and a five-year grace period on debtservice. One can easily anticipate the impact that this would have on financialmarkets.
More interesting in view of the current situation in the eurozone is whatfollowed roughly a half-century after Hamiltonacted. In the 1830’s and 1840’s, a number of states had over-investedin the leading transport technology of the time – canals.When the canal-building boom ended, eight states and the Territoryof Florida (accounting for about 10%of the entire USpopulation at the time) were unable to service their debt and defaulted ontheir, mostly British, loans.
British bankers threatened that they would never again invest in theseuntrustworthy Americans. They could point to the precedentset by Hamilton,and had probably invested on the implicit understanding that, if necessary, thefederal government would bail out the states again.
But, despite foreign creditors’ threats, the federal government did notcome to the rescue. The bailout request did not succeed because it could not muster a simple majority of the states(represented by the Senate) and thepopulation (represented by the House ofRepresentatives) under the normal decision-making procedure (the“Community method,” in European Union jargon).
The defaults proved to be costly. The 1840’s were a period of slow growth, and continuedpressure from foreign creditors forced most of the official debtors to resume payments after a while. Default was not aneasy way out, and all US states (with the exception of Vermont) have since embraced balanced-budget amendments to their constitutionsas a way to shore up their fiscalcredibility. Are EU members prepared to take a similar step?
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