The FT ran a piece about the fiscal union in the USA and why this system couldn’t be replicated in Europe to help resolve the Euro crisis. I wanted to touch on the author’s main points to highlight some of the errors in the thinking there.
Myth # 1 – “So let’s state three facts about the US fiscal union. First, the argument is ahistorical. The US states successfully shared a currency for a good 150 years before there was any fiscal union to speak of. The federal income tax was, after all, only introduced in 1913. As late as 1936, with the New Deal in full swing, the federal government’s total receipts amounted to just 5 per cent of GDP.”
Reality – The author states that the USA “successfully” shared a currency for 150 years before the fiscal union. This is true if we overlook some minor historical developments such as the FIVE DEPRESSIONS in the 1800’s (starting in 1819, 1837, 1857, 1873 and 1893), regular banking panics and a Civil War that killed 620,000+ people.
More specifically, in the period between 1850-1913 the USA experienced TEN banking panics. Importantly, many of the banking crises that occurred prior to 1913 were a direct result of a lack federal integration. For instance, prior to 1913 and the implementation of the Federal Reserve the private banking system ran its own version of a central clearinghouse. The clearinghouse that dominated this system was the NY Clearinghouse, however, because it was privately managed, it would often stop functioning at the exact times when it was most needed (during banking panics).¹ The Fed was created to leverage the powers of an outside federal entity in order to create stability in the banking system even at times when there was substantial uncertainty in the private banking system.²
It’s true that the 1800’s were a period of rapid economic growth in the USA, but that growth did not come without substantial turmoil, panics and depressions.
Myth #2 – “The bulk of the risk-sharing happens through credit and capital markets – that is to say, private lending, borrowing and investment returns do most of the job of evening out regional shocks.”
Reality – The author’s main point here is that you don’t need a fiscal transfer union to even out the risks inside of a currency union because the private markets can achieve most of this on their own. It’s true that the private sector is the primary “risk manager” in the economy and this is generally a sustainable and well managed process (except when it isn’t in periods like the housing boom). But this point misses the crucial accounting that makes the fiscal union so powerful. That is the fact that a fiscal union allows the entire economic region to leverage what is essentially an off balance sheet transaction across the entirety of the union.
In my paper, Understanding the Modern Monetary System, I describe the essential accounting behind government budget deficits. The key point about a government deficit is that the liability issued during deficit spending is held OUTSIDE of the private sector. This means that the private sector is adding NET financial assets versus the federal government. This disperses aggregate debts in a manner that makes them much more manageable over time.³
Now, when you’re leveraging an economic region as large as the USA (or Europe) you’re really leveraging a reserve currency region that is backed by tremendous amounts of output. This means that the federal entity has a very low risk of currency or solvency crisis. It is, in essence, the largest income generator in the entire economy which makes it the most credible entity in the economic region. The US federal government is not powerful because it hires men with guns to protect it, but because it can leverage 22% of the world’s GDP thanks to the USA’s tremendous output. And its debt is highly sustainable because it taps into a highly credible income source. Aggregating this debt burden reduces the solvency burden of the entire economic union by reducing the solvency risk at the private entity specific level.
Of course, there are going to be potential problems with any fiscal union. The US system is far from perfect. But the highlighted “weaknesses” in the US fiscal union are not nearly as relevant as the Financial Times states.
1 – The Federal Reserve System, Purposes and Functions, Federal Reserve
² – A World Without the Federal Reserve, Roche, 2014
3 – Understanding the Modern Monetary System, Roche, 2011
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.