As the Euro crisis has spread across Europe and resulted in depression in many of the world’s largest countries, analysts, pundits and investors continue to be amazed that the USA has avoided a similar fate. After all, the USA and Europe are extremely similar. They are both single currency monetary systems designed to create an integrated medium of exchange that increases economic efficiencies. So the states in the USA are analogous to the countries in Europe. The difference is that the USA has political unity and a centrally unified institutional design whereas Europe has a disjointed system in which they are not politically unified and the monetary system remains incomplete without a central treasury.
The lack of a central treasury is crucial in understanding why Europe’s monetary system is flawed. As users of the same currency there is no floating exchange rate to help rebalance any trade imbalances that might arise over time. But there is also no central treasury to help redistribute funds to help rectify some of these imbalances. That might sound counterintuitive to some, but a brief review of the federal system in the USA makes this clearer.
The USA also has severe trade imbalances within its borders that result in major economic imbalances. States also have balanced budget amendments which impose fiscal discipline on them. So, if these trade imbalances were allowed to persist without any outside intervention the lack of a floating exchange rate would result in inevitable solvency crises at the state level as the state finances became unsustainable. But the USA has a unique arrangement whereby they take from the rich and redistribute to the poor states. This federal sharing plan helps to keep the poor states from becoming bankrupted over time as they receive federal funds to help maintain their balanced budget amendment and remain solvent.
Of course, the states in aggregate (and the federal government) are not in the business of earning a profit. They are primarily in the business of negative net present value operations. Things like putting out fires aren’t profitable. So these entities all end up needing outside funding at times. States get it from the federal government and the federal government gets it from the rest of us. We essentially leverage our massively productive private sector economy into government aid. But it’s this system of redistribution to the states that keeps them all solvent in the end.
You can better see this through a recent report from CNBC or this report from the Economist. The states who pay the most into the system are New York, New Jersey, Illinois, California and Texas. As a percentage of GDP Delaware, New Jersey, Minnesota and Illinois pay the most into the system. That is, these states receive far less in federal aid than they pay into the overall pot. Interestingly, the states who take the most and pay the least in are “red states” or states where we tend to hear about the evils of “redistribution”. Florida, Louisiana, South Carolina, Hawaii and Virginia receive the most in federal funding when compared to their tax receipts.
I don’t intend to make a political argument here though it might come as such. Rather, I intend to teach a lesson about the institutional design of our monetary system. We have a system that redistributes in a manner that helps sustain the stability of the system over time. Because the Federal government can never “run out of money” it is able to serve as a facilitating and supporting feature of the overall system. And it does this, in part, by redistributing funds from the wealthy states to the poorer states. Europe lacks this federal system. And because of this, they have solvency crises and depressionary conditions in many countries. The USA has implemented Europe’s necessary fix. And because of this the USA has steered clear of massive state solvency crises that would inevitably drive the country into a much deeper hole. So next time you hear your local politician decrying federal redistribution you might inform them that redistribution at the federal level has actually been an enormously positive feature of our monetary system.
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.