At a first glance, pointing out that the U.S. federal government doesn't bail out the state or local governments might seems to make the case that Europe should also avoid such bailouts. But C. Randall Henning and Martin Kessler point out that the historical patterns and potential lessons are more nuanced in "Fiscal Federalism: US History for Architects of Europe's Fiscal Union." It's available here as Working Paper 12-1 from the Peterson Institute for International Economics and also here as part of the Bruegel Essay and Lecture Series. They point out that in some ways, the centrality of the federal level of the U.S. system was created by assuming the debts of the states after the Revolutionary War. But around 1840, the federal government then ended this practice. Here is Henning and Kessler (footnotes and citations omitted):
"The first secretary of the Treasury, Alexander Hamilton, is by all accounts credited with creating a “modern” financial system for the new United States. The magnitude of his achievements emerges from considering the prior condition of the US economy. Before 1790, the United States was effectively bankrupt, in default on most of its debt incurred during the Revolutionary War, and had no banking system, regularly functioning securities markets, or national currency. Reliant on the 13 states to collect and share tax revenue, the federal government was unable to pay war veterans or service, let alone redeem, debts. Under the Articles of Confederation, the federal government had no executive branch, judicial branch, or tax authority...."Hamilton's plan was controversial at the time--so controversial that by around 1790, was a real chance that the new country might break up. Was the plan constitutional? How to deal with the fact that some states had borrowed far more than others, but after the federal government assumed the debt, all states would now need to repay it? Hamilton was also restructuring the debt at about the same time. However, as Hamilton and others perceived, making the federal government central in this way could help bind the states together into a union. In the end, the federal government did assume the debts of the states, did restructure them, and did pay them off. But would this pattern continue? Henning and Kessler:
"The debt assumption plan involved the transfer of state debt to the federal government in the amount of $25 million. Added to existing federal debt incurred to foreign governments (France) and domestic investors in the amount of $11.7 million and $42.1 million, respectively, federal debt would then amount to $79.1 million —a very large sum compared with nominal GDP in 1790 estimated at $187 million."
"[T]he debt assumption of 1790 set a precedent that endured for several decades. The federal government assumed the debt of states again after the War of 1812 and then for the District of Columbia in 1836. During this period, the possibility of a federal bailout of states was a reasonable expectation; moral hazard was substantially present. This pattern was broken in the 1840s, when eight states plus Florida, then a territory, defaulted. ... The indebted states petitioned Congress to assume their debts, citing the multiple precedents. British and Dutch creditors, who held 70 percent of the debt on which states later defaulted, pressed the federal government to cover the obligations of the states. They argued that the federal government’s guarantee, while not explicit, had been implied. Prices of the bonds of even financially sound states fell and the federal government was cut off from European financiers in 1842. ...John Quincy Adams evidently believed that another war with Britain was likely if state debts were not assumed by the federal government."
What were the underlying reasons that caused the U.S. Congress to break the assumption that it would take over the debts of the states as needed?
"However, on this occasion Congress rejected the assumption petition and was able to do so for several reasons. First, debt had been issued primarily to finance locally beneficial projects, rather than national public goods. Second, domestically held bonds were not a large part of the US banking portfolio, and default had limited contagion effects at least through this particular channel. Third, the financially sound states were more numerous than the deeply indebted ones. And, finally, the US economy had matured to the point where it was less dependent on foreign capital. Foreign loans were critical to Hamilton’s plan in 1790, but they were a minority contribution when investments eventually resumed in the 1850s."
"Eventually, most states repaid all or most of their debt as a condition for returning to the markets. ...The rejection of debt assumption established a “no bailout” norm on the part of the federal government. The norm is neither a “clause” in the US Constitution nor a provision of federal law. Nevertheless, whereas no bailout request had been denied by the federal government prior to 1840 , no such request has been granted since, with one special exception discussed below [the District of Columbia in the 1970s].
"The fiscal sovereignty of states, the other side of the no-bailout coin, was thereby established. During the 1840s and 1850s, states adopted balanced budget amendments to their constitutions or other provisions in state law requiring balanced budgets. This was true even of financially sound states that had not defaulted and their adoption continued over the course of subsequent decades, so that eventually three-fourths of the states had adopted such restrictions."Henning and Kessler suggest three lessons from U.S. history that Europeans should consider as they look at whether or how to assume some of the debts of countries like Greece.
"First, debt brakes are likely to be more durable and effective when “owned” locally rather than mandated centrally."
The U.S. states didn't have a no-deficits rule imposed on them. They volunteered for such rules as part of wanting to borrow for infrastructure projects. U.S. states could drop their no-deficits rules at any time if they wanted. This is fundamentally a different situation than having the European Union or the European Central Bank try to imposed debt limits on recalcitrant countries.
"'Second, maintaining a capacity for countercyclical macroeconomic stabilization is essential. Balanced budget rules have been viable in the US states because the federal government has a broad set of fiscal powers, including countercyclical fiscal action.
When a recession hits, U.S. states and their citizens often get some help from the federal government. With a common central bank and a common currency, many countries in the EU have already given up the paper to react to a recession within their borders by cutting interest rates or by depreciating their currency. If they also have debt limits imposed on them, they may be unable to react to a recession with fiscal policy, either. In the modern economy, arrangements that have the effect of preventing governments from reacting at all when their countries are in a recession are not likely to work well.
"Finally, because debt brakes threaten to collide with bank rescues, the euro area should unify bank regulation and create a common fiscal pool for restructuring the banking system."
The interaction between bank failures and government debt needs to be addressed. In some cases, like Ireland, bank failures were the main cause of government debt--when government offered guarantees that the banks would not go under. In other cases, like Greece, excessive government debt risks bringing a wave of bank failures, because Greek debt is so widely held by many large European banks. A unified and funded system of bank regulation across Europe would reduce both of these risks.
I don't have a trail map for how Europe should tiptoe through its current debt and financial crises. The middle of an economic crisis can be a poor time to try to implement the long-term arrangements, that if only they had been in place, would have reduced the risk of the crisis in the first place. But the U.S. model of not bailing out states does depend, in part, on the fact that states adopted their no-borrowing rules themselves, on a powerful federal fiscal authority, and on a unified and funded system of banking regulation. Without these conditions in place, Europe may have set itself up for a situation where intermittent bank bailouts and government debt bailouts are better than the even less-palatable alternatives.
