"For a Solution to the Euro Crisis, Look to the States"

Martin Feldstein argues that the eurozone should commit to strict budget rules

For a solution to the euro crisis, look to the states, by Martin Feldstein, Commentary, Washington Post: The Greek budget crisis has made it clear that something must be done to limit fiscal deficits in eurozone countries. The attempt to do so with the group's Stability and Growth Pact has failed. ...

There is now political consensus in Europe that new rules are needed to prevent large deficits, but there is no agreement on what should be done. The European Commission ... proposed last week that the national budgets of each country be examined by the others before they are approved. ...

It would clearly be anathema to the German government to have its spending and tax policies approved by France, let alone by Greece and Portugal. The problem ... is therefore to find a way to prevent excessive deficits while leaving member states free to shape their own spending and tax policies.

Here there may be something to learn from United States. Although the 50 states share a currency and each sets its own spending and tax policies, state deficits remain very low. Even California has a deficit of only about 1 percent of the state's GDP and total general obligation debt of less than 4 percent of state GDP. The basic reason for these small deficits is that each state's constitution prohibits borrowing for operating purposes. ...

In some states, these self-imposed restrictions go back to the 19th century, a time when excessive borrowing led to state defaults. Those states wanted to assure potential lenders that such excess borrowing would not happen again. Over time, all states adopted such rules to help make the bonds they issued for capital expenditures attractive to investors. ... If the EMU governments were to adopt similar constitutional rules, the interest rates on their bonds would fall.

Of course, important differences exist between EMU members and the U.S. states. Because Europe lacks a central fiscal authority, some provision must be made for temporary deficits when economic conditions warrant. European nations also have national security responsibilities that may require surges in defense spending. But if the budget rules are well articulated, the effectiveness of the fiscal discipline will remain.

Germany recently adopted such a constitutional amendment. Germany's central government must reduce its deficit to 0.35 percent of GDP by 2016 unless a decline in GDP causes a larger deficit. ... Other EMU nations could follow Germany's example ...  because doing so would bring down their interest rates. The European Central Bank could accelerate this process by restricting collateral to bonds issued by governments with satisfactory constitutional limits on their deficits. ...

The combination of national self-interest in achieving lower interest rates and an ECB rule on allowable collateral would create a powerful restriction on deficits. ... It would also leave member governments free to determine the structure and levels of their taxes and spending, as long as their decisions did not violate their self-imposed constitutional limits.

Does this still hold if we allocate the national debt to the states? Much of the debt at the national level is for activities that the states would have to do on their own if the federal government did not provide these goods to them (this is also true for stabilization policies during recessions, though in the present case the states didn't get as much help as they need). Thus, shouldn't the debt that is incurred at the national level be included in the comparisons with European countries? Does that change the picture? If countries in Europe could do the same thing -- allow a federal government to accumulate large amounts of debt that is, in essence, on their behalf -- would it change the outcome for individual countries?