Tuesday, September 16, 2014
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Why Eurobonds are Un-American

BRUSSELS – The emerging consensus in Europe nowadays is that only “debt mutualization” in the form of Eurobonds can resolve the euro crisis, with advocates frequently citing the early United States, when Alexander Hamilton, President George Washington’s treasury secretary, successfully pressed the new federal government to assume the Revolutionary War debts of America’s states. But a closer look reveals that this early US experience provides neither a useful analogy nor an encouraging precedent for Eurobonds.

First, taking over a stock of existing state debt at the federal level is very different from allowing individual member states to issue bonds with “joint and several” liability underwritten by all member states collectively. Hamilton did not have to worry about moral hazard, because the federal government did not guarantee any new debt incurred by the states.

Second, it is seldom mentioned that US federal debt at the time (around $40 million) was much larger than that of the states (about $18 million). Thus, assuming state debt was not central to the success of post-war financial stabilization in the new country; rather, it was a natural corollary of the fact that most of the debt had been incurred fighting for a common cause.

Moreover, the most efficient sources of government revenues at the time were tariffs and taxes collected at the external border. Even from an efficiency point of view, it made sense to have the federal government service public debt.

Federal assumption of the states’ war debts also yielded an advantage in terms of economic development: once states no longer had any debt, they had no need to raise any revenues through direct taxation, which might have impeded the growth of America’s internal market. Indeed, after the federal government assumed the states’ debt (already a small part of the total), state revenues fell by 80-90%. The states then became for some time fiscally irrelevant.

Finally, the key to the success of financial stabilization was a profound restructuring. Hamilton estimated that the federal government could raise enough revenues to pay approximately 4% interest on the total amount of debt to be serviced – significantly less than the 6% yield on the existing obligations.

Holders of both state and federal bonds were thus offered a basket of long-dated bonds, some with an interest rate of 3%, and others with 6 % (with a ten-year grace period). The basket was designed in such a way as to result in an average debt-service cost of 4%. In modern terms, the “net present value” of the total debt (federal and state) was reduced by about one-half if one were to apply the usual exit yield of 9%.

Moreover, the new federal bonds’ very long maturities meant that there was no rollover risk. It would have been very dangerous to expose the federal government to this danger, given that the operation was rightly perceived at the outset as extremely risky.

For the country’s first few years, debt service swallowed more than 80% of all federal revenues. The slightest negative shock could have bankrupted the new federal government. Fortunately, the opposite happened: federal revenues tripled under the impact of a rapid post-war reconstruction boom, and continued to grow rapidly, aided by the country’s ability to remain neutral while wars ravaged the European continent.

By contrast, growth prospects in Europe today are rather dim, and interest payments, even for Greece or Italy, account for less than 20% of total revenues. The real problem is the rollover of existing debt in a stagnating economy. For example, Italy will soon have a balanced budget in structural terms, but must still face the problem of refinancing old debt as it matures each year.

Assuaging doubt about the sustainability of public debt in the eurozone would thus probably require a deep restructuring as well. The eurozone crisis could certainly be resolved if all existing public debt were transformed into 20-year Eurobonds with a yield of 3%, and a five-year grace period on debt service. One can easily anticipate the impact that this would have on financial markets.

More interesting in view of the current situation in the eurozone is what followed roughly a half-century after Hamilton acted. In the 1830’s and 1840’s, a number of states had over-invested in the leading transport technology of the time – canals. When the canal-building boom ended, eight states and the Territory of Florida (accounting for about 10% of the entire US population at the time) were unable to service their debt and defaulted on their, mostly British, loans.

British bankers threatened that they would never again invest in these untrustworthy Americans. They could point to the precedent set by Hamilton, and had probably invested on the implicit understanding that, if necessary, the federal government would bail out the states again.

But, despite foreign creditors’ threats, the federal government did not come to the rescue. The bailout request did not succeed because it could not muster a simple majority of the states (represented by the Senate) and the population (represented by the House of Representatives) under the normal decision-making procedure (the “Community method,” in European Union jargon).

The defaults proved to be costly. The 1840’s were a period of slow growth, and continued pressure from foreign creditors forced most of the official debtors to resume payments after a while. Default was not an easy way out, and all US states (with the exception of Vermont) have since embraced balanced-budget amendments to their constitutions as a way to shore up their fiscal credibility. Are EU members prepared to take a similar step?

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