Thursday, October 6, 2011

Update on Euro vs US

Some updates on questions I had for myself in a previous post:
I had wondered if the difference between the Euro and the US as a monetary union was solely because states in the US were somehow different from the Euro countries. VoxEu had an argument that this is the case although I am not entirely convinced:

For an idea about how to solve this dilemma it might be useful to look at the US. The US states have many sovereign powers that give them a great deal of financial discretion. They have the power to establish their own tax systems and spending powers. Many states are legally required to balance their budgets, although this is often meaningless in a dynamic sense if they don’t have to fund future obligations. In addition states cannot file for bankruptcy under the US Bankruptcy Code.

So how do the states guard against default and preserve their access to capital markets? In spite of their well-advertised budgetary problems the US states do have access to capital markets and at generally favourable rates. The reason is institutional. Most states give debt service a constitutional priority over other expenditures.

This means that the “sovereign” debt has to be paid out of revenues before other obligations. There are some minor exceptions. In California and some other states for example education funding has a prior claim on revenues – probably a good thing if it prevents them from undermining their long-term growth prospects. This mechanism does not prevent fiscal problems from arising. The problems of states like California are well known and they are severe. But fiscal problems become sovereign political problems, not threats to the stability of the US. It should be noted that their debt levels are quite small relative to sovereign nations.

This point is brought up again in another VoxEu post:

Tom: Well, what I meant by that is a commitment mechanism. The analogy I drew was with the U.S. states. It's well known that many of the U.S. states, some of the biggest ones, like California, Illinois, have faced significant fiscal problems and significant fiscal imbalances. And yet they still have access to capital markets at quite favorable rates. The question is why. The answer is that for most of these states there is a constitutional commitment to service general obligation bonds before all other claims on the tax revenues of the governments of the states.

This kind of takes the issue of fiscal brinksmanship off the table. U.S. states are not allowed to go bankrupt, to file for bankruptcy. They constitutionally have to honor their debts first before they pay the police and firemen and the other local government workers.

That imposes an automatic austerity regime. If the fiscal situation gets out of balance in a given state, it's a problem - and it is very much a problem in some states like California - but it's a problem that is a local problem. It's not a problem for the union.

My only issue is that even if brinkmanship is taken off the table where in the constitution is it explicitly ruled out that it cannot be put on the table. And isn't a constitution subject to amendments?

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