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American History Has Lessons for the Euro Crisis

After Independence, America faced similar problems to those troubling Europe today... 

THERE MAY be a precedent for the situation in which the Eurozone finds itself. Across the Atlantic, the United States of America once faced a similar challenge, writes David Howden for the Cobden Centre.

After the revolutionary War, the US was faced with a band of individual member states (emphasis placed on the "States" aspect of the USA). The Articles of Confederation allowed each state the exclusive right to tax its population. The Continental Congress was given the right to issue paper money – "Continentals", as they were known.

Individual states refused to give the Continental Congress the ability to tax, nor did they consent to sharing their tax revenue with it. With no ability to raise funds through taxation, the Continental Congress turned to the only fund-raising means available – issuing new Continentals. The phrase "Not worth a Continental" predictably resulted, as hyperinflation set in.

This course of events prompted Alexander Hamilton and his Federalists to argue for a stronger central government, with the ability to both tax and issue debt. The ratification of the US Constitution in 1789 was the culmination of this drive.

This is the situation roughly analogous to what the Eurozone faces today.

Each of the 17 member states has the ability to tax but not to issue currency. The European Central Bank has the ability to issue currency, but not to tax. Some countries can no longer remain solvent through increasing taxes alone. Two solutions result:

Allow individual states the right to issue money.

Allow for a centralized fiscal agency to collect taxes for redistribution within the Eurozone.

Option 1 amounts to a breakup of the currency union. Option 2 is currently the more popular option. By having a fiscal union with one tax-collecting agency, transfer payments can solve country specific insolvencies. (Of course, longer-term issues remain, but that is for another article.)

Is such a solution as efficient, or equitable, as we are led to believe?

The longevity of the United States suggests that fiscal union is not such a bad idea for a currency union. But important differences exist between the Eurozone and the United States.

First, with no central fiscal agent for the Eurozone there is no central spending required, unlike with the Continental Congress. Each Eurozone member state funds its own activities. For example, there is no joint military that requires funding, as is the case with the United States. Hence, there is no threat that the ECB would hyperinflate the Euro to fund its fiscal activities (as it has none). This was decidedly not the case with the Continental Congress.

Second, has the centralization of fiscal power been beneficial to the US? The longevity argument is not as strong as one might think. America has, after all, defaulted explicitly on its debt four times in its history. It has evaded insolvency numerous times by inflating its liabilities away. But such an action is default by another means. It has taken from the citizens in the form of an inflation tax to pay for its excesses.

Third, with a central fiscal agency, the US Congress has continually seen a strengthening of its role and scope. New agencies to displace the rights of the individual states have become the norm. The bill to fund the increase in federal activities has risen commensurately. The cost of a centralized fiscal agency in the US has been paid with increasing taxes – whether explicitly through the income tax, or implicitly through the inflation tax.

If the Eurozone finds itself amidst a crisis set off by too much government spending (an insolvency crisis) does anyone seriously think the solution is a centralized fiscal agency with the incentive to increase its own indebtedness?

As the United States' own history demonstrates, calls for a centralized fiscal agency to complete a currency union are misplaced at best and damaging at worst. If history is any guide, fiscal consolidation will result in increased indebtedness on a supranational level. This indebtedness is solved in one of two ways: increased taxes on the member states, or increased inflation. Neither of these seems like a welcome option.

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Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

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