Fiscal Discipline in Federations in the After-math of the 2008 Financial Crisis: Can Market Discipline Survive in the USA and EMU?

Policy Study

In February of 2009, with several members of the European Monetary Union facing rapidly growing bond spreads and possible difficulties with debt servicing in the wake of the global financial crisis, the German finance minister, Peer Steinbrück, told reporters that while there was no provision in the EU treaties for helping insolvent countries, “in reality the other states would have to rescue those running into difficulty,” and later added that “we would show our ability to act.” In essence, Steinbrück was trying to assure credit markets that during such extraordinary times, the EMU “no bailout” clause would be circumvented, and countries like Ireland and Greece would not be allowed to default. A few days later, EU Economic Commissioner Joaquin Almunia hinted that the EU already had a secret bailout strategy in place. The words appeared to have some impact, as spreads for the most troubled EMU member states fell almost immediately.

A month later, California Governor Arnold Schwarzenegger was publically pressing the United States federal government to explicitly guarantee its debts as part of a bailout package as the state flirted with insolvency and issued millions of dollars of IOUs to holders of state contracts. The federal government ultimately refused this request. After finally giving up on the idea of an explicit federal bailout, the state legislature and governor reached a deal on a budget featuring an unprecedented $15 billion in spending cuts, as well as a forced “loan” of $2 billion from local governments. Moreover, the state now has the lowest credit rating and highest general obligation bond yields of any U.S. state.

On the surface, these two scenarios would seem to indicate that the United States and the European Monetary Union are on very different paths. Many observers would conclude that the “no bailout” commitment of the EMU was never very credible in the first place, and the words of Steinbrück and Almunia only clarified this. In the United States, one might view the cool reaction of the Obama administration to California’s bailout request as yet another indication of a longstanding commitment of the U.S. federal government not to provide bailouts that dates back to the 1840s (Inman 2003, Rodden 2006).

This essay argues that the truth is more complex, and once placed in a broader comparative theoretical framework, the two systems have more in common than initial appearances would suggest. This brief essay begins by introducing a general framework for understanding the dynamics of budgeting in the aftermath of a large negative shock in a federation. Governments of constituent units in federations, as well as their voters and creditors, make decisions based on their beliefs about the likely future response of the central government to burgeoning solvency problems. Because of the obvious moral hazard problem generated by lower-level governments borrowing with an implicit central government guarantee, central governments have incentives to claim that they are not responsible for the obligations of lower-tier governments, but these claims are often not credible. In order to understand the credibility of the central government’ s “no bailout” commitment, it is useful to look beyond individual high-profile events or word uttered by finance ministers at press conferences, and examine the basic structure of institutions and interests facing the actors.

From this perspective, in contrast to most other higher-level governments in federations, the U.S. federal government as well as the European Monetary Union should be well-positioned to make a firm no bailout commitment and remain aloof when confronted with solvency crises among member states. If market discipline can work in a federation, these are perhaps the two most likely candidates in the world. Yet unfortunately, in recent years both have been unable to resist the temptation to pursue actions (and issue statements) that partially undermine the credibility of their commitment. While Obama appears to have said “no” to bailouts and Steinbrück seems to have said yes, this essay argues that both unions have entered a murky territory in which the basic contract between the key players is unclear. In the worst case scenario, such murkiness can lead to imprudent behavior on the part of subnational governments. As a result, clarification and improvement of the basic fiscal contract between the center and the constituent units should be a high priority on the reform agenda in both unions. In both cases, though reactions to the fiscal crisis have done considerable damage, successful market discipline is still a goal worth pursuing.

A study for FEPS by Jonathan RODDEN, Stanford University