Economic News & Analysis—July 9, 2012
The eurozone and wrong lessons from historyBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist, and John Manley, CFA, Chief Equity Strategist
History can be a great teacher, but it can also mislead. When looking at the eurozone debt crisis, I’ve argued that policymakers in Europe can learn a great deal from the early years of the U.S. After all, if the eurozone is part of a grander plan to create the United Countries of Europe, shouldn’t it look at a rather successful experiment that brought together a number of independent states to form the United States of America? While I’m not the first, or only one, to point out that Europe can learn much from the U.S., the consensus view seems to be looking at the wrong phase of U.S. history as a model for Europe.
The Assumption ActOn January 14, 1790, Secretary of the Treasury Alexander Hamilton issued his First Report on the Public Credit, in which he called for the federal government to redeem all the securities issued by the Continental Congress at face value plus 4%. This wasn’t that radical of a proposal because it effectively said that the U.S. federal government should fully honor its debts. The radical component of Hamilton’s proposal was in also saying that the federal government should assume all the debts of the individual states. His proposal was agreed to and became the Assumption Act, passed on June 20, 1790, and signed into law on August 4, 1790. Because of the success of the U.S. that followed, some argue that the eurozone governments need their own Assumption Act where the national debts are assumed by a central authority, financed by issuing eurobonds or something similar.
However, I believe the U.S. Assumption Act is the wrong model for Europe. Indeed, the Assumption Act was not without controversy. Because the U.S. economy—with a gross domestic product (GDP) of approximately $187 million in 1790—was primarily agrarian, the southern states were able to pay off many of their war debts quickly. The federal government’s takeover of state debt effectively forced the southern states to subsidize the northern states. However, Hamilton appealed to both patriotism and self-interest to successfully pass the Assumption Act.
The patriotic angle was easy to play because the states’ debts were incurred during the Revolutionary War with the purpose of uniting the states. But the self-interest angle was more difficult to sell, so Hamilton proposed that every plan to incur debt must be matched by a plan to extinguish the debt, a lesson all politicians should learn. The plan involved using excise taxes on imported wine, spirits, tea, and coffee to pay federal debt, which would favor southern agricultural interests.
In total, the amount of foreign debt owed was $11.7 million and the total amount of domestic debt was $42.4 million, in aggregate, equating to approximately 29% of GDP. Most of the foreign debt was owed to the Netherlands and France, and Hamilton argued that our nascent country had many struggles ahead of it and would need to stay on positive terms with its allies and creditors. Hamilton said that “The debt of the United States was the price of liberty.”
The defaults of the 1840sWhile the federal government assuming the debts of the states in 1790 was the price of liberty, that is likely too high a price for eurozone countries to pay to keep the eurozone project together. The states fought a battle for independence, which helped to justify the Assumption Act, but the eurozone countries don’t have a similar rallying theme. That is why I think the 1840s serve as a better model for the eurozone countries.
Early in U.S. history, it was well established that public infrastructure projects were to be financed by the states, not the federal government. State governments were willing to finance projects in canals, waterways, and eventually railroads as the bonds were viewed to be “self-financing.” It was argued that the infrastructure investment would promote growth, serving as a basis for extinguishing the debt.
During the depression of 1837–1843, eight states (Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, and Pennsylvania) and one territory (Florida) defaulted on their debts. In the early 1840s, Congress debated whether the federal government should step in and bail out the states. Proponents pointed to the precedent of the 1790 Assumption Act. Opponents argued that the precedent wasn’t applicable because the debts leading up to 1790 were incurred for a national purpose while the debts in the 1840s were from financing local projects. Ultimately, the opponents of the bailout won the argument and states defaulted. As a result, by the end of the 1840s, more than half of the states rewrote their constitutions to require year-by-year balanced budgets.
Despite the defaults, states were able to gain access to the debt markets quickly. From that point on, municipal bond yields and local borrowing costs have reflected the credit qualities of the issuers. This is the way debt markets are supposed to work.
For the eurozone, without a central authority to lay and collect taxes and make all disbursements, there is no reason to think a eurobond or a 1790-like solution will work. Instead, an 1840-like plan, where countries are allowed to default and retain their independence, may be the best approach.