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Friday, May 17, 2013

USA vs. Eurozone: How Many Differences Can You Spot Between These Two Pictures?

How many differences can you spot between these two pictures?

George Soros and Hans-Werner Sinn have been at each other again at Project Syndicate (see my previous two posts on this debate).

While Soros pleads for debt mutualization in the form of Eurobonds as a necessary (but possibly insufficient) condition for Eurozone stability, Sinn reiterates that this is not legally possible under German law nor corresponds with Germany's original intentions in agreeing to the Maastricht Treaty.

I just want to briefly mention a different point Sinn brings up in which he betrays a serious gap in his knowledge of American history and that country's experience with its currency union (otherwise known as the US Dollar, the longest running successful currency zone in history). The first US Treasury Secretary, Alexander Hamilton, mutualized the 13 state debts left over from the Revolutionary War and established the US National Debt based on centrally levied tariffs and a whiskey tax. Many observers have argued that the Eurozone must also go through its "Hamilton moment" before it can graduate to a fully functioning currency zone.

Sinn claims, in contrast, that

George Soros underestimates the risks that debt mutualisation would pose for the future of the eurozone. When Alexander Hamilton, the first US finance minister, mutualised state debts in 1791, he thought this would cement the new American nation. But the mutualisation of debt gave rise to huge moral hazard effects, inducing the states to borrow excessively. A credit bubble emerged that burst in 1838 and drove most of the US states into bankruptcy. Nothing but animosity and strife resulted.

This is a very curious statement, since the US currency zone, when I last looked (and the Republicans hadn't played chicken again with the debt ceiling, their symbolic legislative blackmail weapon), was still going strong after over two hundred years, its creditworthiness still intact, and no Federal state now has a debt burden over 19% of its GDP. 75% of US public debt is Federal, not state, supported by a 19% central government revenue rate on GDP. In the Eurozone, less than 1% of GDP is collected by Brussels as taxes, and there is no central sovereign debt (except for a minor amount issued by the European Investment Bank) but 17 national sovereign debts (not counting the EU countries not using the Euro). In other word, the US is a model of a functioning currency union, while the EU is still stuck in a time warp around 1791. Have "most US states" ever been driven into bankruptcy, and has this been a source of "nothing but animosity and strife"?

A good source of data on US state defaults is at LearnBonds. The first state defaults were in 1841 (9 in all, not "most states", and not 1838), 50 years after Hamilton created the National Debt (the Euro should live so long!), the last in 1933. There was also a wave of six defaults of defeated Southern states after the Civil War in 1870. That's it. Nothing like Sinn's "animosity and strife" (the Civil War was not fought about the 1841 default wave, by which time the problems had already long been repaired). So we are really only talking about the default wave of 1841.

A good paper on this episode is "Debt, Default, and Revenue Structure: The American State Debt Crisis in the Early 1840s". The authors conclude that

  1. very few of these states fully defaulted on their debts with actual losses for creditors;
  2. these nine states returned successfully to bond markets within a few years;
  3. the cause of the default wave was not any moral hazard created by Alexander Hamilton 50 years earlier but the laissez-faire economic policies of the Jackson era. The debts had been raised to finance highly sensible infrastructure projects, but the tax systems of the Western states were not sufficiently developed at that time to support the debt burden. None of these states were bailed out by the Federal government, nor had any of them taken on the debt in the expectation that they would be.
It has become increasingly clear that a currency zone can only function with mutualized sovereign debt supported by a central fiscal and tax structure, and a banking union (the latter something the US only really introduced in 1933 with Federal deposit insurance - before that the US was subject to recurring massive bank runs). Paul de Grauwe, Europe's foremost expert on currency zones, has just restated the case for a European Hamilton Moment at Project Syndicate.

Sinn is within his rights to reject this solution, but then Soros has a point that Germany should be consequential and leave the Eurozone if it can offer no better constructive solution. But Sinn should not invoke a caricature of American history to repeat ad nauseam the strained shibboleth of moral hazard (an important issue) to justify his solution: 20-30% debt-deflation in the EZ periphery, or, as we Americans remember from the Vietnam war, "we had to destroy them to save them."


  1. Anonymous17/5/13 13:02

    "How Many Differences Can You Spot Between These Two Pictures?"
    Well, I've just run two million regressions and there seems to be a strong correlation between internal frontiers and the performance of a currency union: A threshold of 90 per cent of frontiers being straight lines separates optimal from suboptimal unions.

    Silliness apart, don't you think that some debt mutualisation (such as the Schuldentilgungsfond suggested by the German council of economic experts) is likely after German national elections later this year?

  2. Your guess about who will win the German elections and what (if anything) happens afterwards is as good as mine. I can't imagine another Merkel government agreeing to formal debt mutualization or even a real banking union anytime soon, however.

    More likely would be delegating the work again to the ECB (like OMT last summer, a form of debt mutualization that didn't cost anyone a cent but reduced and stabilized bond spreads, exactly as Paul de Grauwe predicted it would). Draghi doesn't have to get reelected and suffer parliamentary review, so as long as the Bundesbank doesn't win against the ECB in its Verfassungsgericht suit, he has a free hand. (Can you really believe the Bundesbank is suing the ECB for a brilliantly successful policy that cost no money? Shades of Michael Kohlhaas!) Something along the lines of Yanis Varoufakis' and Stuart Holland's "Modest Proposal" might be possible, where the ECB issues its own bonds based on fiscal guarantees from the member states ( This would certainly be constitutionally simpler and make legal sticklers like Sinn happier (if it were ever possible to make someone like Sinn happy).

    Of course in a real crisis Merkel might be capable of a complete about-face like with respect to nuclear energy after Fukushima (the first Merkel Moratorium). But don't bet on it.