a fiscal union for the euro - some lessons from history

7/27/2019 A Fiscal Union for the Euro - Some Lessons From History

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NBER WORKING PAPER SERIES

A FISCAL UNION FOR THE EURO:

SOME LESSONS FROM HISTORY

Michael D. Bordo

Agnieszka Markiewicz

Lars Jonung

Working Paper 17380

http://www.nber.org/papers/w17380

NATIONAL BUREAU OF ECONOMIC RESEARCH

1050 Massachusetts Avenue

Cambridge, MA 02138

September 2011

We have received constructive comments from many. We would like to thank in particular Iain Begg,

Michael Bergman, Daniel Heymann, Sven Langedijk, Paul van den Noord, Jakob von Weizsckerand Guntram Wolff. Michael Bordo started this paper in 2006 when he was a visiting scholar at DGECFIN

in Brussels. The original research was funded by DGECFIN from a grant to him in 2006-2007. The

views expressed herein are those of the authors and do not necessarily reflect the views of the National

Bureau of Economic Research.

2011 by Michael D. Bordo, Agnieszka Markiewicz, and Lars Jonung. All rights reserved. Shortsections of text, not to exceed two paragraphs, may be quoted without explicit permission provided

that full credit, including notice, is given to the source.


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A Fiscal Union for the Euro: Some Lessons from History

Michael D. Bordo, Agnieszka Markiewicz, and Lars Jonung

NBER Working Paper No. 17380

September 2011

JEL No. H10,H70,H73

ABSTRACT

The recent financial crisis 2007-2009 was the longest and the deepest recession since the Great Depression

of 1930. The crisis that originated in subprime mortgage markets was sp read and amplified through

globalised financial markets and resulted in severe debt crises in several European countries in 20 10and 2011. Events revealed that the European Union had insufficient means to halt the spiral of European

debt crisis. In particular, no pan-European fiscal mechanism to face a global crisis is available at present.

The aim of this study is to identify the characteristics of a robust common fiscal policy framework

that could have alleviated the consequences of the recen t crisis. This is done by using the politicaland fiscal history of five federal states; Argentina, Brazil, Canada, G ermany and the U nited States.

Michael D. Bordo

Department of Economics

Rutgers University

New Jersey Hall

75 Hamilton Street

New Brunswick, NJ 08901

and NBER

[email protected]

Agnieszka Markiewicz

Erasmus University, Rotterdam

[email protected]

Lars Jonung

Knut Wicksell Centre of Financial Studies

School of Economics and Management

Lund 8niversity

Box 7080

220 07 Lund

Sweden

[email protected]


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2

Afiscalunionfortheeuro:Somelessonsfromhistory

Introduction

Theeuroarea isaunique formofamonetaryunionwithnohistoricalprecedence.Themember

statesof

the

euro

area

have

assigned

the

framing

of

monetary

policy

to

acommon

monetary

authority,theEuropeanCentralBank(ECB),setupasahighlyindependentcentralbanktoinsurethat

itwillbe able to carryout apolicyofprice stability. Fiscalpolicywithin theEuropeanUnion (EU)

remainsthetaskofthenationalgovernmentsunderasetofrulesgivenintheMaastrichtTreatyand

theStabilityandGrowthPact (SGP).These rules,pertaining to theEconomicandMonetaryUnion

(EMU),covereuroareamemberstatesaswellasmemberstates thathavenotadopted theeuro.

Theyaremonitoredcentrallyby theCommission inapolicydialoguewith thememberstates.This

system represents the existing fiscal policy framework of the euro area that complements the

monetaryunionanditssinglecurrency,theeuro.

Ever since the plans for a single European currency were launched about twenty years ago, the

institutional system for framing fiscal policies and for preserving the fiscal sustainability of the

monetary union has been the subject of a heated debate among economists as well as among

policymakers.

2

The

recent

global

financial

crisis

and

mainly

the

European

debt

crisis

have

added

new

impulsestothedebateabouttheproperfiscalpolicyarrangementswithintheEuropeanUnion.

Several viewsexist.According toone camp, themonetaryunion shouldbe supplementedwith an

extendedsupranationalorpanEuropean fiscalunion tobeviableandsustainable. Inshort, theEU

shouldhaveaccesstoalargerbudgetinordertodesignandcarryitsowncentralfiscalpolicies.Some

experts,likeDeGrauwe(2006)gofurtherandpromotetheideaofadeeperpoliticalunion,toensure

thesuccessoftheeuro.ThepresentdebtcrisiswithintheEMUhas inspiredanumberofproposals

forstrengtheningthefiscalpowerofEU.

Others argue that such an extension of the fiscal powers of "Brussels" would not be accepted

politicallybyEUcitizens,threateningthepoliticalsupport forthemonetaryunion insomemember

states, inparticular inGermany. Instead, it isarguedthatthepresent institutionalsetup isroughly

theproperone.Somecommentatorsproposethatthemonetaryunionisnotinneedofanycentral

fiscal coordination across the member states, or at least of less coordination than presently. Forthem, likeMckay (2005), the fiscalpolicy framework shouldbe solely thebusinessof themember

states.Anotherschoolrecommendsimprovements inthequalityofthefiscalpolicyprocessandthe

fiscalinstitutions acrosstheEUasapromisingwaytoimprovefiscalpolicygovernanceintheEU.3

Sofarthedebatehasshownnosignsofanemergingconsensus.4Rather, it isgettingmoreheated

duetothepresentcrisis.Onereasonforthelackofunanimityisthattheeuroarearepresentsanew

typeofmonetaryunion.Moreprecisely, theeuroarea isthefirstmonetaryunionwheremonetary

policy is set up at the central (European) level while fiscalpolicy is carried out at the subcentral

(national) levels. Thus, the economics profession lacks historical cases to use as guidance for

theoretical and empirical work. Instead, many contributions are based on either theoretical

considerations oreconometriccalibrationsand testsondata, insomecasesoriginatingpriorto the

launchoftheeuro.

Theaimofourstudyistocontributetothisdebatebyturningtothepoliticalandfiscalhistoryoffive

federalstatesforananswertothequestion:Wouldtheadoptionofafiscalunionsimilartothefiscal

2Forearlysurveysofthisdebate,seeforexampleButiandSapir(1998)andHalletetal(1999).Morerecently,ButiandFranco

(2005),Korkman(2005)andWierts(2006)amongothersdealwithfiscalpolicyissuesoftheEMU.SeealsoEuropeanEconomy

(2008)ontherecordofthefirst10yearsoftheEMU.3SeeforexampleWyplosz(2005)andJonungandLarch(2006).

4ThedebateabouttheStabilityandGrowthpactbeforeitsreformin2005isastrikingillustrationofthewidelydivergentviews

morethan100separatecontributions withintheeconomicsprofessionontheroleoffiscalpolicy intheeuroarea.Fora

surveyoftheseviewsontheproperdesignoftheSGP,seeJonungetal(2008).


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arrangements currently in place in the federal countries thatwe study help to avoid some of the

centripetalfiscalforcesthatthreatenthestabilityoftheEuropeanmonetaryunion?Inshort,wetry

tobringoutthe lessonsfromthepastconcerningthefiscalarrangements intheeuroareaoftoday.

Asweareprimarilyconcernedwithmacroeconomicstability issues,we focuson fiscalpolicyasan

instrumentofstabilisation. Wearewellawarethatfiscalpolicymakingcoversmanypolicyareas, in

particular,distributional issuesareclosely related toquestionsofmacroeconomic stabilizationand

insurance.

Therecentcrisishashighlighteddeficienciesinboththefiscalframeworkandthefinancialregulatory

frameworkoftheeuroarea. Inthispaper,however,wedonotanalyzethe issuewhethertheeuro

areaneedsa common financialstabilityauthority.We focussolelyon fiscal issues relevant for the

stabilityoftheeuroarea.

We organise our study in the following way. In section 1, we give a brief overview of some key

concepts and central issues. Next, in section 2, we summarize past and current experience of

monetary and fiscal unions in five countries: the United States, Canada, Germany, Argentina, and

Brazil. In section 3, we condense lessons from our account of the evolution of fiscal federalism.

Section 4 contains a comparison between these lessons and the framework for fiscal policy

governanceintheEU.Section5concludes.

1.Fiscalfederalismandfiscalpolicyinmonetaryunions

1.1.Theconceptofmonetaryandfiscalunions

Amonetaryunioniscommonlydefinedasagroupofstatessharingasinglecurrency.Inthestrictest

senseoftheterm,amonetaryunionmeanscompleteabandonmentofregionalorseparatenational

currenciesandfullcentralisation ofmonetaryauthorityintoasinglejointinstitution. Thisisthecase

of the euro area, a subset of the Economic and Monetary Union (EMU), which covers all the 27

memberstatesoftheEU.5

Theconceptofafiscalunionentailsfiscalfederalismamongitsmembers,whichcouldbeeithersub

national (subcentral or regional) political units or nation states. Fiscal federalism is based on a

cooperative arrangement between the members of the fiscal union regarding the design and

distributionoftaxesandpublicexpenditures.

Thereisnosingledefinitionoffiscalfederalism.Sorens(2008)forexampledefinesthe"idealtype"of

fiscal federalismasconsistingof the following fourelements: (1)subcentralpoliticalentitiesenjoy

independence/autonomy todecide taxes andexpenditures, (2) thesegovernments face fairlyhard

budgetconstraints,thatisanobailoutruleisconsistentwiththeidealtypeoffiscalfederalism,(3)

there is a commonmarketbasedon free trade andmobilitywithin the fiscalunion, thus there is

scope for competition among subcentral governments, and (4) the system of fiscal federalism is

institutionalized inasetof rules.Wewould like toadda fifthelement to this list: (5) thecommon

marketisbasedonacommoncurrency,thatis,thesubcentralaswellasthecentralfiscalauthorities

aremembersofthesamemonetaryunion.

The governance structure of the EU is a challenge to put into the standard framework of fiscal

federalismas

there

is

no

similar

institutional

set

up

anywhere

else

in

the

world.

The

EU

is

different

as

stressedbyBegg(2009):"thefactthattheEUissetupasaunionofcitizensandofMemberStatesis

oneof itsmostdistinctivefeatures."Its"federal"budget,that istheEUbudget, isabout1%ofthe

national incomes of the Member States. This is a much smaller ratio than the size of the federal

budgetsinthetypicalfederalcountry.Asstressedinitially,thecentralizationofmonetarypolicyinthe

ECBandthedecentralization offiscalpolicytotheMemberStatesoftheeuroareaisanotherunique

featureoftheEU.Still, inouropinionthere ismuch inthehistoryoffiscalfederalismthatcanbear

5Presently theeuroarea includes the following17 countries: Austria,Belgium,Cyprus,Estonia, Finland, France,Germany,Greece,Ireland,Italy,Luxembourg,Malta,Netherlands, Portugal,Spain,SlovakiaandSlovenia.


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uponthedesignofEUgovernanceinspiteofthefactthatEMUandtheeuroareuniqueinstitutions

withnohistoricalprecedence.

Musgrave(1959)providestheclassicalapproachconcerningthepolicytasksofthepublicsector.His

scheme identifies three basic policy functions: allocation/efficiency, distribution and stabilization.

Thesefunctionscanbeperformedbydifferentpoliticalentitieswithinafiscalunionaccordingtothe

adoptedfiscalsystem.

Thestudyoffiscalfederalism,asdefinedbyOates(1999),isthestudyofhowtheserolesareassigned

todifferentlevelsofgovernmentandthewaysinwhichtheyrelatetooneanotherthroughdifferent

policy instruments. The stabilization function, that is the implementation of monetary and fiscal

policies, is usually the task of the central government and the central bank. The stabilization of

economicactivityviafiscalpolicycanbeachievedthroughtwomainchannels.Thefirstonerefersto

theroleofautomaticstabilizers, smoothingeconomicactivityviatheautomaticresponseoftaxesand

transfer systems to the business cycle. The second channel consists of discretionary fiscal policy

measures.

Inthispaper,wewilloftenrefertosubnational,regional,localorsubcentralpoliticalentitieswithin

variousfederations. Wewillinterchangeablycallthemjurisdictionsandcommunities.Also,depending

on the federation in question, these regions take different names; states in the United States,

provincesin

Canada

and

Argentina,

Lnder

in

Germany,

and

municipalities

in

Brazil.

1.2Thenormativeargumentsforfiscalfederalism

AsstatedbyOates (1972),The traditional theoryof fiscal federalism laysoutageneralnormative

frameworkfortheassignmentoffunctionstodifferentlevelsofthegovernmentandtheappropriate

fiscalinstrumentsforcarryingoutthesefunctions.Thistheorycontendsthatthecentralgovernment

should have the basic responsibility for macroeconomic stabilization and income distribution. In

additiontothesefunctions,thecentralgovernmentshouldprovidenationalpublicorcollectivegoods

thatservicetheentirepopulationofthecountrysuchasdefence.

Decentralisedorlowerlevelsofgovernmenthavetheirraisondtreintheprovisionofpublicgoods

andserviceswhoseproductionandconsumption is limitedtotheirownjurisdictions.Theeconomic

argument for providing public goods at the subnational level was originally formulated in a

decentralization theoremthatthelevelofwelfarewillalwaysbeatleastashighifParetoefficientlevels of consumption are provided in each jurisdiction than if any single, uniform level of

consumptionismaintainedacrossalljurisdictions,seeOates(1972).

Thus,fiscalfederalismaddressesseveral issues.First, ithasastheobjectivetorespondtodifferent

politicalpreferencesacrossacountry.Second, itproducespositiveexternalitiesas itmaygenerate

benefitsfromintergovernmental competition,improvethefiscalresponsibilityofgovernment,foster

politicalparticipationandasenseofbeingmemberofademocraticcommunity,andhelptoprotect

basiclibertiesandfreedoms(InmanandRubinfeld1997).Finally,fiscalfederalismalsoprovidesaway

ofmaintainingthegovernmentshareofGDPatalowlevel(Sorens2008).

Anobviouscostoffederalismisthelossofautonomybythecentralgovernment.Infact,thebenefits

ofdecentralisation require that the central governments authority is limited (Rodden2006).As a

result,in

highly

decentralised

fiscal

federations,

central

governments

might

find

it

difficult

to

implementcoordinatedeconomicandother typeofpoliciesandprovide federationwidecollective

goods.

Theconclusionthatdecentralisedgovernmentswillprovidetheefficientlevelofpublicgoodsrestson

anumberofassumptions.Oneisthathouseholdsandfirmsarefreelymobilewithinthefederationto

generatecompetitionbetweenjurisdictions.Iffreemobilityisnotthecase,competitionamongsub

central governments may lead to suboptimal outcomes. Another assumption is the lack of

interdependencies between the policies of different jurisdictions. When this is not the case,


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competitionamongsubnationalgovernmentsmaygeneratenegativespilloversorexternalities, and

thussuboptimaloutcomes.

If thereare strong fiscal interdependencies betweensubnationaljurisdictionspolicymakersmight

faceincentivestoincreasetheirexpenditurewhileexternalising thecosttotheothers.Rodden(2004,

2006) argues that this incentive is higher if the central government cannot fully commit to a no

bailoutrule.Furthermore,thecentralgovernmentscommitmentbecomeslesscredibleifsubcentral

governmentsare

heavily

dependent

on

transfers

from

the

central

authority.

Intergovernmental

transfers,asopposedto localtaxation,changebeliefsaboutthe levelsof localexpenditurethatcan

besustainedbycreatingtheperceptionthatthecentralgovernmentwillultimatelyprovidefinancial

help. Transfer dependent local governments usually face weaker incentives for responsible fiscal

behaviour. For this reason, Rodden (2004,2006) recommends a principle of subcentral sovereign

debtwithinfiscalfederationstomaintainoverallfiscaldiscipline.

1.3.Fiscalpolicyinthetheoryofoptimumcurrencyareas

The traditional theory of optimum currency areas (OCA), based on the work by Mundell (1961),

McKinnon(1963)andKenen (1969),also labelledbyMcKinnon (2004)asMundell I, isthestandard

approach used by economists to evaluate and study the optimality (and thus the desirability) of

monetaryunions,inparticularthatoftheeuroarea.Thisapproachweighsthebenefitsforacountry

ofadopting

acommon

currency

against

the

costs

of

abandoning

its

national

currency

and

thus

its

independentmonetarypolicy.

Thebenefitsarehigherifcountrieswillingtojointhemonetaryunionareopeneconomiesandtheir

trade ishighlyconcentratedwithother countrieswilling tojoin theunion.On theotherhand, the

costsarehigherwhenmacroeconomicshocksaremoreasymmetric(countryspecific)andwhenother

adjustmentmechanismsare lesseffective inoffsettingtheseshocks.Thesemechanisms includethe

flexibilityofwagesandpricesand themobilityof labourand capital. If thesemechanismsarenot

sufficiently developed, an appropriate fiscal policy could minimize the loss of the exchange rate

channelforadjustmenttoasymmetricshocks.

Thus, domestic fiscal policy turns into the sole tool of stabilization policy left for a member of a

monetaryunionwheremonetarypolicy iscarriedoutbyacommoncentralbank.Fiscalpolicymay

alsobeorganisedandcoordinatedatthecentrallevelofthemonetaryunion,implyingatransferof

bothmonetaryandfiscalpolicytocommoncentralauthorities.

WhiletraditionalOCAtheoryemphasisesthetradeandadjustmentcharacteristicsofregions/nation

states willing to form a currency union, recent developments of the OCA approach, also labelled

MundellII inspiredbyMundell(1973),focusesontheroleoffinancialintegrationasasourceofrisk

sharing(insurance)andconsumptionsmoothing.

The OCA approach according to Mundell II suggests that monetary unification triggers financial

market integration and the development of marketbased risksharing mechanisms. These

mechanismsmaysubstituteforfiscalpoliciesastheyattenuatetheeffectsofasymmetricshocks.As

Eichengreen (1991, p. 17) notes, Interregional transfers accomplished through federal taxes are

justifiableonly if insurancecannotbeprovidedbythemarket.TheMundellIIOCAtheory identifies

such a channelofprivate insurance. It isanempirical issue towhatextent this channelmay fully

replacefiscal

transfers

within

amonetary

union.

In case the private insurance channel is not sufficient, a monetary union requires a system of

interregional and intertemporal transferswhich canalleviate the consequencesofnegative shocks

such as occurred in the financial crisis of 20072009. Increased public spending, necessary during

economicrecessionscanbefinancedeitherbythefederalorsubnationalgovernmentswhichinturn

couldborrowdomesticallyor internationally. Thebenefitsfromsubnationalsaccesstothefinancial

market are numerous. Yet subnational borrowing, left unregulated, entails the risk of insolvency,

whichthreatenslocalservicedeliveryaswellasmacroeconomicandfinancialsystemstabilityofthe

entiremonetaryunion.According toWebb (2004),subnationaldebtmarketshave three important


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agencyproblems:(i)subnationalborrowershaveanincentivenottorepaytheirlendersasprincipals

if they anticipate bailouts; (ii) subnational borrowers have an incentive not to reveal certain

characteristicsaboutthemselvestolendersasprincipals,resultinginadverseselection;(iii)banksare

implicit agents of the nation, entrusted to maintain the nations payment system and

creditworthiness, and they often abuse this trust by lending to not creditworthy subnational

governmentswiththeexpectationofbailoutsbythefederalgovernmentincaseoftrouble.

Theseagency

problems

related

to

subnational

borrowing

suggest

that

federal

debt

is

asuperior

solution. The empirical literature provides clear evidence that federal bonds are superior to state

bondsbecauseofalowerriskpremium(seee.g.AmihudandMendelson,1991;PoterbaandRueben,

1997;Lemmen,1999).Theriskpremiumonfederalbondsislowerbecausethefederalgovernment

in a monetary union controls money creation, has tax autonomy and has access to more liquid

marketsthandolowerlevelsofgovernment.

AmajorweaknesswiththeOCAapproach,oldaswellasnew,isthelackofattentionpaidtopolitical

and institutional factors.6 The preferences of the public across the member states of a monetary

unionarethemajordeterminantofthesustainability ofmonetaryunification.Thesepreferencesare

influencedbymany factors,politicalaswellaseconomicones.Here thedesignof the institutional

frameworkforfiscalpolicymakingatthenationalaswellasattheunionlevel comesatthecentre.

1.4.Fiscal

policy

in

the

euro

area

Anextensiveliteratureanalyzesthemacroeconomicconsequencesoftheinstitutional frameworkfor

monetaryandfiscalpolicymakingintheEMU.Inparticular,itinvestigatestheimpactoninflationand

debtaccumulationby theexistenceofmany independentnational fiscalauthoritiesandonesingle

centralbank.

The theoretical literature on the interaction of fiscal and monetary policies identifies various

mechanismswhichmay lead to spillovereffects (externalities) acrossmemberstates.Forexample,

DixitandLambertini (2001)showthat ifmonetaryand fiscalauthoritieshavedifferent idealoutput

andinflationtargets,Nashequilibriumoutputorinflationorbotharesuboptimal. Similarly,Chariand

Kehoe(2004)findthatifthecentralmonetaryauthoritydoesnotcommittoafuturepolicypath,the

freeriderproblemleadstoinefficientoutcomes,i.e.excessiveinflationinthewholemonetaryunion

andexcessivedebtissuedbyeachmember.Uhlig(2002)concludesthattheexistenceofindependent

fiscalauthoritiesandonecentralbankwithinasimplestochasticmodel leads, inanoncooperativeNash equilibrium, to higher deficits of the member countries than in the cooperative equilibrium

wheretheywouldbesettozero.

In linewiththepropositionbyRodden(2004,2006),thesestudiespointoutthatasetupofasingle

monetaryauthorityandnumerousfiscalauthoritiesrequiresbindingfiscalpolicyconstraintstoavoid

excessivedeficitsatthesubcentrallevel,thatisonthelevelofthememberstatesinthecaseofthe

euro area. Default by a subnational government can impose a negative externality upon other

subnationalgovernmentsorthefederalgovernmentbyincreasingthecostofborrowingforallfiscal

units.Animportantquestionthatarisesinthesecircumstancesistheimpactofeffectivedisciplineon

borrowingthatisimposedbythemarket.Thesemarketforcescanworkefficientlyonlyifsubnational

governmentshavenoperceivedchanceofabailoutbythecentralgovernment(orthecentralbank).

Lane (1993)argues thatexpectationsofabailoutare themost important reason for the failureof

marketdiscipline.

If

abailout

occurs,

it

might

disturb

or

even

destroy

completely

market

forces

that

preventfiscalunitsfromoverborrowing.

Tosummarizethisliterature,theinterplaybetweenseveralfiscalandonemonetaryauthoritywithin

a federation generates freeriding issues or common pool problems.7 This mechanism works as

6For theshortcomings of theOCAapproach,see i.a.Goodhart (1998)andMongelli (2005).ThetraditionalOCA theoryhas

givenanegativebiastotheviewsofUSeconomistsonthesinglecurrency,seeJonungandDrea(2010).7Thecommonpoolproblemarisesinsituations wherethecostsofanactivity,whichbenefitsasmallgroup,aresharedamong

awidergroupofindividuals,countriesorprovincesasinourcaseofamonetaryunion.


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follows. Each of the individual fiscal authorities sees itself only as a small player who has a little

impactonthecommonmonetarypolicy.Asaresult,itsfiscalpolicychoiceswouldbepurelydrivenby

nationalinterests.Inequilibrium,eachcountryfreeridesandtheoutcomeisworsethantheonethat

couldbereachedinacooperativeequilibrium.

2.Theevolutionoffiscalfederalismwithinfivemonetaryunions

According to Eichengreen (1991), if a country is subject to asymmetric shocks, a systemof fiscal

federalism can, through regional insurance, attenuate these shocks. This proposition reflects the

positive impactof fiscal federalismhighlightedby theory.The argument is that amonetaryunion

accompaniedbyafiscalunionislikelytooperatemoresmoothlythanamonetaryunionwithoutit.A

fiscalunion,however,functionssmoothlyonlyifanumberofassumptions,advancedintheprevious

section,aresatisfied.Historyhasfrequentlyshownthatthenecessaryconditionsmaynotbeinplace.

In that case, fiscal centralisation can lead to damaging fiscal policies and result in large

macroeconomic imbalances reflected in high and variable inflation and unsustainable debt

developments.

Toisolatethecharacteristicsthatwerekeytothecreationofdurablefiscalunions,wefirstpresent

anaccountofthehistoricalexperiencesandthenoftherecentexperienceof fivefiscalunions.We

focusontwogroupsoffederations:firsttheUS,Canada,andGermany;secondArgentinaandBrazil.

Thefirst

group

largely

represents

cases

of

successful

fiscal

unions,

as

measured

by

inflation

and

debt

performance,asdemonstrated inTable1whichcoverstheperiod19802006.Thesecondgroupof

Argentina and Brazil consists of less successful examples of fiscal unions. These federations are

characterized by a much higher average rate of inflation than the US, Canada, and Germany as

illustratedinTable1.

Wedonotaimatdeliveringanexhaustivedescriptionofthehistoriesofthesefederations. Instead,

wefocusonepisodeswhichareparticularlyrelevantforthequestionunderscrutiny.Moreprecisely,

weanalyze(i)thecircumstancesinwhichthefederationswereborn;(ii)theevolutionofthefederal

subnational governments relationships, in particular, their transformation during the Great

Depression;(iii)thedebthistoryofthefivefederations includingthedevelopmentofbondmarkets

andbailouts.

2.1The

United

States

The United States is a constitutional republic. Its government is based on a congressional system

under a set of powers specified by its Constitution. The United States Congress is a bicameral

legislature. Thehistoryof fiscal federalism in theUnited Statesdatesback to the foundingof the

Union in1789.Priortotheestablishment ofthefederalgovernment,thestateshadexercisedtheir

powerstolevytaxesandprovidecertainpublicservices.ThetenthamendmenttotheUSconstitution

explicitlyreservestotheStatesortothepeopleallpowersnotdelegatedtotheUnitedStatesby

theConstitution,norprohibitedbyittotheStates.

2.1.1CreationoftheUSfederation

Duringtheprefederalperiod,theunionthatexistedundertheArticlesofConfederationconstituted

a

league

of

sovereign

states.

It

did

not

have

the

power

of

national

taxation,

or

the

power

to

control

trade,andithadacomparativelyweakexecutive.Itwasaleagueoffriendshipwhichwasopposed

toanytypeofnationalauthority.BoydandFauntroy(1997)arguethatthegreatestweaknessofthe

ArticlesofConfederationwasthattheyonlyestablishedstatesovereigntyandonlydelegatedafew

responsibilities tothecentralauthorities.Asaresult,themajorityofthepowerrestedwiththestates.

Moreprecisely,eachstatehadtheauthoritytocollect itsowntaxes, issuecurrency,andfinance its

ownarmy.Thefederalgovernmentsmainactivitywastocontrolforeignpolicyandconcludetreaties.

AsCongress,undertheArticles,didnothavethepowertocollecttaxes,thecentralgovernmentwas

unabletobalanceitsfinances.Itresultedinadebtof$42millionaftertheRevolutionaryWarwhich


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weakenedconsiderablythegovernmentseconomiccredibility.Thisfinancialobligationwasnotpaid

offuntiltheearly1800s.

The United States Declaration of Independence, an act of the Second Continental Congress, was

adoptedonJuly4,1776.ItdeclaredthattheThirteenColonieswereindependentoftheKingdomof

GreatBritain.TheArticlesofConfederationservedasatransitionbetweentheRevolutionaryWar

and theConstitution. In1789, theUSconstitution wasratifiedand in1790 thefederalgovernment

assumedresponsibility

for

the

war

debt,

which

some

have

called

an

early

form

of

federal

aid.

The

TenthAmendment,addedtotheConstitutionin1791,protectedtherightsofthestatesanddeclared

thatallpowersnotexpresslydelegatedtothecentralgovernmentbytheConstitutionwerereserved

forthestates.Thislaidthefoundationfortheconceptsofstatesrights,limitednationalgovernment,

anddualspheresofauthoritybetweenstateandnationalgovernments(BoydandFauntroy(1997)).

2.1.2Evolutionofthefederal statesgovernmentrelationship

Theperiodfrom1789to1901hasbeentermedtheeraofdualfederalism.8Itwascharacterisedby

little collaboration between the national and state governments. During this period, in particular

between1820and1840,thestatesengagedinextensiveborrowingtofinancetheirinternalactivities

anddevelopmentwhich resulted inhighdebts. Insteadof introducingnew taxesoradjusting their

spending, numerous states demanded bailouts from the federal government. In fact, the states

assumedthat

their

debt

implicitly

carried

afederal

guarantee.

However,

the

Congress

refused

to

bailout indebted states and in 1840 several states defaulted on their debt and had to undertake

painfuladjustmentmeasures.Thus, thefederalgovernmentsentacostlybutclearsignalregarding

thelimitstoitscommitmenttofiscalsupporttothestates.

As a result, in the following decades, the US states developed the fiscal sovereignty that we still

observetoday.AsRodden(2006)puts it,statesmayoccasionallydancearoundthetopicofbailouts

buthopesforthemarenotsufficientlybrightthatstateswouldactuallyrefusetoadjustwhilewaiting

fordebtassumption.

Dualfederalismwasfollowedbyaperiodofcooperativefederalism,from1901to1960.9Thisperiod

wasmarkedbygreatercooperationandcollaborationbetweenthevariouslevelsofgovernment.

The period from 1960 to 1968 was called Creative Federalism by President Lyndon Johnson's

administration. President Johnson'sCreativeFederalism,asembodied inhisGreatSocietyprogram,was an important departure from the past. It further shifted the power relationship between

governmentallevelstowardthefederalgovernmentthroughanexpansionofthegrantinaidsystem

andtheincreasinguseoffederalregulations.

2.1.3AlexanderHamiltonandtherestructuringofUSdebt

UnitedStatesdebthistorybeganwiththeRevolutionaryWar,whichwasmostlyfinanced(85%)by

the issueoffiatmoneybytheCongressandthestates.TheCongresshadvirtuallynotaxingpower,

whilethatof thestateswas too limited topay formore thanasmallfractionof totalexpenditure.

Foreignbond finance deterioratedbyuncertaintyabout thewarsoutcome anddomesticbond

issueswerelimitedbyathinbondmarket.In1782,thefederalgovernment,unabletoraisetaxeson

itsownbothbeforeandafterthe1783ArticlesofConfederation, hadtodefaultonbothitsdomestic

debtand

debts

to

France.

The Constitution of 1789 gave the federal government expanded powers in monetary and fiscal

affairs including the ability to raise tax revenues and the sole right to issue currency. Alexander

Hamilton,theSecretaryoftheTreasurybetween1789and1795,puttogethertheplantorestructure

thepublicdebtand createdeep financialmarkets.BordoandVegh (2002)posit that thepackage

included four elements; (i) funding the national debt,(ii) creation of a Sinking Fund, (iii) securing

8ThetermdualfederalismwasintroducedbyCorwin(1950).

9ThetermCooperative FederalismwasextensivelyusedbyElzar(1966).


10/34

9

sufficienttaxrevenue,(iv)creationoftheBankoftheUnitedStates.Thecentralideaoftheplanwas

to convert outstanding federal and state debt obligations into longterm bonds and to create

mechanisms tobothserviceandamortize thisdebt.Thiswouldhelp increatinganeffectivecapital

marketandhencetofacilitategovernmentborrowinginwartime.

Consequently, Hamilton proposed a plan designed to fund the debt which involved converting

outstanding paper securities of the states and the federal government into specie denominated

securitiesat

the

official

par

of

exchange.

The

debts

of

various

maturities

plus

arrears

were

converted

intoadebtpackagethatgreatlyreducedtheeffectiveinterestratetowellbelowthe6percentrate

stipulatedonmostsecuritiesoutstanding in1789.The issuedbondsweresimilar toBritishconsols

withno specific retirement date.Shortlyafter successful conversion and fundingof thedebt,U.S.

government securitiesbecamequickly accepted both at home and abroad and yields fell to rates

comparabletobondsoftheleadingEuropeanpowers(Perkins,1994,p.218)

Following theBritishexampleof1717,Hamiltonproposedasinking fundasawayofensuring the

credibilityofhisfundingprogram.Theideawastosetasiderevenuesprovidedbyspecifictaxestobe

usedtopurchasepublicsecuritiesontheopenmarket.Theinterestearnedbythesinkingfundwould

beusedtoacquiremorepublicsecuritiesandeventuallypayoffthedebt.Akeyfeaturewasthatthe

revenuesaccumulatedby the fundcouldnotbedivertedby theCongressata laterdate forother

expenditures.ThesinkingfundwascreatedbytheactofMay8,1792.AnactofMarch3,1795made

explicitthe

revenues

to

be

devoted

to

the

fund,

including

part

of

import

duties,

excise

taxes,

and

the

saleofpubliclands.

Another element of Hamiltons debt package was to ensure the governments ability to collect

sufficienttaxrevenues tocontinuouslyservicethedebt.Debtservicewasanimportantingredientof

theprogramofcreatingawellfunctioning,credible longtermcapitalmarket.Hamiltonproposeda

nationaltariffsufficienttogeneraterevenuesequalto10percentof importvalues.Tariffrevenues

weretobesupplementedbyexcisetaxes,andthesaleofpublicland.

AlexanderHamiltonsdebtpackagehadalltheelementsofamodernstabilizationplan.It ledtothe

creation of a U.S. government bond market which in the future would be key to longterm

sustainability oftheU.S.fiscalunion.

2.1.4USfederalismandtheGreatDepressionThe Great Depression played a particularly important role in the reconstruction of the relations

betweenthecentralgovernmentandthestates.Theperiodfrom1929to1941wasthemostserious

economiccrisis inUShistory.RealGDPandprices fellbya thirdand theunemployment rate rose

above20%in19291933.Recoverytothe1929levelwasnotachieveduntilthestartofWorldWarII.

The stateswereunable to respondeffectivelyon theirown to theeconomic consequencesof the

Great Depression leading to a major change in fiscal federal arrangements. In 1933, as a major

componentofhisNewDeal,PresidentFranklinD.RooseveltandtheCongressgreatlyexpandedthe

federalgovernmentsroleinthedomesticeconomy.

TheNewDealerarepresentedaturningpoint inthehistoryofAmericanfederalism,particularly in

theareaof federalstateand local relations.Themain change ingovernment structureduring the

1930swastheshiftinexpendituresfromthelocaltothestateandfederallevels.Wallis(1984)argues

thatthe

emergence

of

"big"

government

in

this

period

was

aresult

of

achange

in

the

relative

importanceof federalandsubnationalgovernments rather thanan increase in thegrowth rateof

governmentexpendituresbyitself.Heshowsthatbetween1932and1940thesharesofgovernment

expendituresoriginatinginfederalandlocalgovernmentswerealmostexactlyreversed.Before1932

relativesharesforeachlevelwereroughly50%local,20%state,and30%federalgovernment.After

1940,30%of relative shareswere local,24% state,and46% federal.Amajorpartof increasing

government expenditures, 75 %, came in programs administered at the federal level but in

cooperationwithstateand localgovernments.Additionally,strongagriculturalpricesupportswere

introduced at the federal level and were not matched by any corresponding shift in subnational

expenses.


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10

Themost importantmodificationof theUS federation frameworkcameasanewrolefor the fiscal

policy of the central government. Before the GreatDepression, the U.S. governmentborrowed in

timeofwar,andmostofthetimeransurplusestopayoffaccumulatedwardebt.Thepossibilityof

using thegovernmentdeficitasa toolofmacroeconomicmanagementwasnever considered.The

GreatDepressionmade it impossible topreserve thispattern.De Long (1996)notes thatboth the

Hoover and the first Roosevelt administrations wished to maintain the pattern of surpluses of

peacetime,but

both

found

the

austerity

necessary

to

achieve

surplus

in

the

time

of

the

Great

Depressiontobepoliticallyimpossible.Intheend,theUSgovernmentacceptedthatlargedeficitsin

timeofrecessionhelpedtoattenuatethebusinesscycle.

2.1.5ContemporaryfederalismintheUS

Contemporary federalism, theperiod from1970 to thepresent,hasbeencharacterisedbyshifts in

the intergovernmental grant system, the growth of unfunded federal mandates, concerns about

federalregulations,andcontinuingdisputesover thenatureof the federalsystem.Therehasbeen

somedevolutionofprogramsbacktothestates,reflecting,inpart,dissatisfaction withtheeconomic

effectsofseverallargefederalprograms.

Americanstates

are

largely

free

in

their

choice

of

tax

bases

and

rates,

subject

to

only

afew

limitations

imposed by the federal constitution. On the expenditure side, most major spending functions are

locatedatthestateorlocalgovernmentlevel,importantexceptionsbeingnationaldefence,pensions

andhealthinsurancefortheelderlyanddisabled.Totalexpendituresoflocalgovernmentsarealmost

aslargeasthoseofstategovernments,andthesumofthesetwo,ascanbeseenincolumn1ofTable

2,isroughlyequaltocentralgovernmentexpenditure,reflectingahighdegreeofdecentralisation in

theUS.

Subnational governments in the United States are, in principle, free to borrow without federal

involvement. In reality, however, nearly all States have some kind of constitutional or statutory

balancedbudgetrequirement. Indeed,according toTable2,column5, theborrowingautonomyof

the subcentral governments is rather limited. The precise nature of the requirements varies

considerablyacrossstates.TheU.S.federalgovernmenthasfollowedanobailoutpolicy(column6in

Table2).

IntheUS,there isneitheroverallfederalstatecoordinationoffiscalpolicynorarevenuesharing

systembetweenthefederalandstategovernments(Shah1995).Infact,atthefederallevel,thereare

notransfersspecifically intendedtodealwithsubnational imbalances. Themost importantfederal

transfersarethosethatfundhealth,educationandtransportprogramsadministratedbythestates.

Althoughthereisanattemptinmanyoftheseprogramstorelatetransferstosuchindicatorsofneed

as incomepercapita income, there isnogeneralsystemofequalisationsimilar for instance to the

Germanone.Thus,theUSstatesarenothighlydependentontransfers.Accordinglytobothmeasures

reported inTable2columns3and4, the transfersbased revenueaccounts foraround30%of the

totalrevenueofstates.

2.2Canada

Canadaisaconstitutional monarchyandaparliamentarydemocracywithafederalsystemandstrong

democratictraditions.Originallyaunionoffourprovinces,Canadaisnowcomposedoftenprovinces

andthreeterritories.Itbecameafederationin1867,whichmakesitthethirdoldestfederationinthe

worldtoday,aftertheUnitedStates.

Canada has a twotiered, highly decentralised system. It can be characterised as a model of dual

federalismwith a coordinating central authority.Whereas federal and provincial governments are

equalpartners in the federation, localgovernmentsdonotenjoy independentconstitutional status

andaresimplythehandmaidenoftheprovinces(Shah1995).Thedistinctfunctionsoftheprovincial


12/34

11

legislaturesandoftheParliamentofCanadawereestablishedintheBritishNorthAmericaAct,which

waslaterrenamedtheConstitutionAct,1867.

2.2.1CreationoftheCanadianfederation

The evolution of the federal system in Canada contrasts significantly with the evolution of the

Americanfederation.Boththeoriginsofthetwosystemsandtheirmajordevelopmentsdiffer.Watts

(1987)argues

that

the

Canadian

federation

was

born

in

pragmatism

rather

than

from

an

anti

imperial

revolutionsentiment.ThemajorincentivefortheunificationoftheCanadiancoloniesin1867wasthe

threatofpolitical,economicandmilitaryabsorptionbytheUnitedStates.

Twodistinctive featuresmarkedthefederationcreatedbytheBritishNorthAmericaAct.First,central

powerswerehighlyconcentrated.Second, theCanadianpoliticalsystemcombinedaparliamentary

formofgovernment(similartotheBritish)withfederalism.

2.2.2PublicdebtinCanada

CanadahadafairlywellestablishedfinancialstructureinplacebeforetheBankofCanadaopenedin

1935. Canadas legal system and strong ties to Britain during its early years supported the early

developmentofabondmarket(seeNowlan2001).

ThehistoryofGovernmentofCanadabondsinthedomesticmarketdatesbackto1868withtheissue

of6%10yearbonds.TheGovernment continued to issuebonds in thedomesticmarket to retire

foreigndebtwhichhadbeen issuedby theprovincesprior toConfederation in1867.At thesame

time,theGovernmentcontinuedtoissuebondsdenominatedinbothsterlingandU.S.dollars,inthe

LondonandNewYorkmarkets.

During theGreatDepression,Canadaborrowedabroadextensively. Inspite the fact that italready

hadconsiderableborrowingfromabroad,theriskpremiumonDominionbondssoldabroaddidnot

significantly increaseduring the1930s.Thissuggeststhat investorsdidnotviewCanadaas likelyto

default,andlendfurthercredencetotheviewthattherewasnoexternaldebtcrisis.Further,during

thefirstandthesecondworldwars,awelldevelopedbondmarketallowedtheCanadiangovernment

tocollect fundsdomestically ata lowcost.DuringWorldWar II,theGovernmentwasable toraise

about $13 billion, all domestically and most of it long term. By the early 1950s, Canada had a

frameworkinplaceforadomesticbondmarketandhadmanyyearsofexperiencefromborrowinginboth domestic and international markets. Although there was no real money market by the early

1950s, shortterm GovernmentofCanada bondswere held in large amountsoutside thebanking

systemandwereactivelytraded.

Duringtherecessionsofthe1980sand1990sseveralprovincesissuedexcessivelyhighlevelsofpublic

debtleadingtoanincreaseinriskpremiaandadowngradingoftheirbondratings,andpressureon

thefederalgovernmentforabailout.Theevolutionoftheshareofprovincialdebtsincethe1970sis

plottedinFigure1.

Since198384,provincialterritorialprogram spendinghasdeclinedasa shareofGDP.Asa result,

someprovincesissuedexcessivelyhighlevelsofpublicdebtleadingtoanincreaseinriskpremiaand

adowngradingoftheirbondratings,andpressureonthefederalgovernmentforabailout.Dueto

thedifficult

public

finance

situation

aconflict

between

the

federal

and

provincial

levels

of

the

government arose. Kneebone (1993) provides the province of Ontario as an example of such a

conflict.AsaconsequenceoftheoverlylaxfiscalpolicyofOntario,theBankofCanadahadtotighten

itsmonetarypolicy.Thisepisodedemonstrateshowthefiscalchoicesofoneprovinceinfluencedthe

decisionsof thecentralbankandhowall theprovinceswere indirectlyaffectedbythebehaviorof

thisprovince.

Intheearly1990s,Canadianprovincesandterritorieswerehithardbytherecession,whichcauseda

significantincreaseinspendingonsocialassistanceandsocialservices.Bythemid1990s,increasingly

largedeficitsanddebtburdens,especiallythoseofthefederalgovernment,ledtofiscalrestraintthat


13/34

12

culminatedinsignificantreductionsacrossawiderangeoffederalexpenditures,includingtransfersto

provincesandterritories.Hence,Canadianprovincesbecamethemainprovidersofsocialprograms

involvingpublicservices,while the federalgovernment is largely restricted to socialprograms that

involve transfers. The fact that such social programs include a significant proportion of program

spendingatbothlevelsofgovernmentemphasisestheimportanceofredistribution asanobjectiveof

governmentpolicy.

TheGreatDepressionandCanadianfederalismLiketheU.S.,Canadasufferedamajordepressionfrom1929to1939.Intermsofoutputloss,itwas

similarinbothtimingandmagnitudetotheGreatDepressionintheUnitedStates.Between1929and

1933,GNPdroppedby43%andexportsshrankby50%.Commodityprices felldramatically around

the world and therefore the regions and communities dependent on primary industries such as

farming,miningand loggingsuffered themost.Theeconomybegan torecover,slowly,after1933.

However,theDepressiondidnotenduntiltheoutbreakoftheSecondWorldWarin1939.

The Great Depression was a turning point for Canadian economic policies. Before 1930, the

government intervened as little as possible, believing the free market would take care of the

economy.DuringtheDepression,thegovernmentofCanadabecamemuchmoreinterventionist and

proposedlegislation

that

paralleled

Roosevelt's

New

Deal

agenda.

In

particular,

it

introduced

high

tariffs toprotectdomesticmanufacturing, a step thatonly createdweakerdemandandmade the

Depressionworse. Italso introducedminimumhourlywages,astandardworkweek,andprograms

suchasoldageassistanceandunemploymentinsurance.TheBankofCanadawascreatedin1934as

acentralbanktomanagethemoneysupplyandbringstabilitytothecountrysfinancialsystem.

In1937,thefederalgovernmentappointedtheRoyalCommissiononDominionProvincialRelations,

commonlyknownas theRowellSiroisCommission. Itsobjectivewas toexamine issuesof taxation,

governmentspending,thepublicdebt,federalgrantsandsubsidiesandtheconstitutional allocation

of revenue sources. Ruggeri (2006) argues that the most important recommendation of the

Commissionwas thepayment to theprovincesby the federalgovernmentofnationaladjustment

grants,asetofunconditionaltransfersaimedatequalising provincial fiscalcapacity. Inreturn, the

federal government acquired exclusivejurisdiction over personal and corporate income taxes and

successionduties.Thisnewdivisionof responsibilitiesbetweendifferent levelsof thegovernment

representedamajorshifttowardsfiscalcentralisation.

In 1938, following the Commission recommendations, the federal government for the first time

consciouslydecidedto increasespendingtocounteractadownturnineconomicactivity.Inaddition

tofiscalexpendituresthegovernmentalsoofferedloanstomunicipalitiesforlocalimprovementsand

passedaNationalHousingAct toencourage thebuildingofhomes.Consistentwith thisKeynesian

approach,thegovernmentalsoreducedtaxesandofferedtaxexemptionsforprivate investors.The

idea of a static and balanced budget was abandoned. In its place fiscal policy would stimulate

economicrecoveryviagovernmentdeficitsandeconomicmeasures.

Thebudgetof1938marksthebeginningofanewconceptoftheroleofgovernmentinCanada.Until

thenthefederalgovernmenthadconcentratedonprovidingpublicservices.Ithadnowundertakena

new and significantly different responsibility: that of smoothing economic activity. It was a most

radicalinnovation

inspired

by

the

Great

Depression.

2.2.3RecentdevelopmentsintheCanadianfederation

SincetheBritishNorthAmericanActof1867,theprovinceshavebeenassignedanincreasingnumber

oftaxes.AsstressedbyShah(1995),today,theyareresponsiblefortaxcollectioninallareasexcept

customs,unemployment insurancepremiums,andcontributionstotheCanadaPensionPlan.10

10SometimesCanadianprovincessharethetaxresponsibilitieswiththecentralgovernment.


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13

Canadahasahighlydecentralisedfederalsystem.Subnationalexpendituresaccountedformorethan

50%of totalpublicexpendituresduring the1990s (column1and2 inTable2).AsnotedbyShah

(1995), in Canada, there are elaborate mechanisms for federalprovincial fiscal coordination. The

majorityofdirectprogramexpendituresareatthesubnational levelbutOttawa (i.e.theCanadian

federalgovernment)retainsflexibilityandachievesfiscalharmonisation throughconditionaltransfers

andtaxcollectionagreements.

In thepast severalyears,provincial concernhasemergedover theuseof federal spendingpower

simplyasameansof transferring revenues to theprovinces.Canada, likealmostall federations, is

characterisedbyaverticalfiscalgap:amismatchbetweentherevenuemeansandexpenditureneeds.

In particular, Canadian federal revenue exceeds what is required by direct and indirect spending

responsibilities of the central government. Regional governments have fewer revenues than their

expenditure responsibilities with the result that excess central revenue being transferred to the

provinces inone formoranother.Over time, the sizeof the verticalgaphasgraduallydecreased,

implyingthatprovinceshavegraduallybecomemoreandmoreselfsufficient.

Much of the discipline on public sector borrowing comes from the financial sector monitoring

deficitsanddebtatall levelsofgovernment.Moreoverfinancialmarkets,especiallybondandstock

markets and provincial electorates impose a strong fiscal discipline at the subnational level. The

borrowingautonomy

index

in

Canada

is

the

lowest

in

the

group

of

countries

under

study

(column

5in

Table 2). Furthermore, national policies explicitly forbid bailouts of provinces at risk of default

(column6inTable2).

2.3Germany

The Federal Republic of Germany consists of a federal (Bund) government, 16 Land (state)

governments,andnumerousmunicipal (or local)governments.There isa formal, indirectlyelected

headof state, thePresidentof the FederalRepublic.Allof the federaland Landgovernmentsare

organisedonthebasisof theparliamentary system.AllLnderhaveunicameral legislatures,whose

membersareelecteddirectlybypopularvote.

2.3.1FoundationoftheGermanfederation

Germanyisarelativelyrecentnationstate.Inthemidnineteenthcentury,Germanywasacollection

of smaller states that were linked together as a German confederation. This confederation was

dominatedbyAustria,whichasan imperialpowerwaspoliticallyandeconomicallysuperior to the

smallerGermanstates. In the1860's, thedominanceofAustriawaschallengedbyPrussiaand the

processofunificationandcodificationofGermanlawbegan.

Agradualprocessofeconomic interdependence from theearly stagesof the IndustrialRevolution

through to the mid19th century saw the German states move towards economic unification. For

example, thegrowthof the railwaynetwork inGermany led toeasieraccess todifferentresources

across the confederation. This helped to stimulate economic growth and meant that economic

prosperitywasincreasinglyreliantuponstronglinksbetweendifferentmemberstatesoftheGerman

confederation.

This led to the introduction of theZollverein customs union, an agreement amongst the German

statestohavepreferentialcustomspoliciesformemberstates.ThiseconomicunionexcludedAustria,

illustrating a growing German sense of identity and a lesser dependency upon the largest of the

Germanstates.

The final national unification of Germany was achieved in two steps: the creation of the North

GermanConfederation in186667andthenoftheGermanReich in1871. In1866awarbrokeout

betweenAustriaandPrussia, lastinga fewweeks.ThePrussianvictoryover theAustrians led toa

clearerdivisionbetweenAustrianandGerman interests.Thisnewsituationalso forced thesmaller


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14

statestoalignthemselveswiththePrussians,withwhomtheysharedmoreeconomictiesduetothe

commonZollvereincustomsagreement.

Atthesametime,between1866and1870,relationsbetweenPrussiaandFranceworsened.In1870,

FrancedeclaredawarthatwaswonbyPrussia.FollowingvictoriesoverFrance, inJanuaryof1871,

PrussiapersuadedotherGermanconfederationmembersthatunificationwasdesirable.Asaresult,

Wilhelm,kingofPrussia,wasproclaimedEmperorofGermanyonJanuary18,1871inVersailles.The

SecondGerman

Reich

was

born.

2.3.2TheevolutionoftheGermanfederation

With unification, Prussia inherited a set of states with already highly institutionalised governance

structuresinplace:welldevelopedpubliceducationsystems,effectivesystemsofpublicfinance,and

stablepopulations, seeZiblatt(2004).Afterunification,theGermanReich increased itsspendingso

thattheshareoftotalgovernmentexpendituresoverGNProsefrom10%in1881to17.7%in1913

whilethecentralgovernmentsshareincreasedfrom2.9to6.2%,Hefeker(2001).

WorldWarIendedindefeatforGermany.Asthegovernmentfinanceditsburgeoning deficitsbythe

monetaryprintingpress,saddledwithenormouswardebtsandreparations,theeconomyslidintoa

hyperinflationin

1922

23.

The

hyperinflation

was

ended

by

astabilisation

package

based

on

fiscal

consolidation.

When,afterthewar,theWeimarRepublicwasfounded,adrivetowardsacentralizedstatestrongly

dominated separatist tendencies and thus limited the possibilities for development of a federal

system.TheWeimarRepublic isdescribedasa "decentralised unitary state, rather thana federal

state.

Inearly1928,Germanyseconomyslipped intorecession,thenstabilisedbeforeturningdownagain

inthethirdquarterof1929.ThedeclineinGermanindustrialproductionduringtheGreatDepression

was roughly equal to that in the United States. Lacking adequate sources of finance, the federal

governmentwasforcedtocoveritsbudgettoalargeextentbyissuingdebt,runningultimatelyintoa

seriousdebtcrisis.TheGermangovernmentdidnotuseactivistfiscalpolicytoattenuatetheeffects

ofthecrises.11

InJanuary1933,HitlerwasappointedReichChancellor.Intermsofeconomicpolicy,theHitlerregime

didnotrepresentaradicalbreakwithpastconservativepolicies,atleastnotuntil1936.Itincreased

spendingformilitarypurposes.TheNaziregimecreatedaunitarystatewithallpowersheldby the

centralgovernmentwhiletheStateswererelegatedtoadministrativedistricts.

AftertheSecondWorldWar,anewtypeoffederalismwas imposedonGermanybyFrance,United

Kingdomand theUnitedStates.Becauseof theNazi totalitarianexperience,aunitarystructure for

postwarGermanywasruledout.Insteadafederalsolutionwasadopted,foundedonthecreationof

newLnderthathadnotexistedbefore.Theywereconceivedasstateunits,clearlydistinctfromthe

federation.ThedistributionofpowersbetweenthecentralandLndergovernmentsaccordingtothe

GermanConstitution,theBasicLaw(Grundgesetz)of1949,stillreflectssomeaspectsoftheWeimar

Republic. However, sinceWorld War II, the federal government has been more limited in several

areas.The

creation

of

the

structure

of

federalism

continued

in

1990

when

six

new

Lnder

were

establishedwithGermanreunification.

ThesystemcreatedbytheBasicLawdidnotfacilitatecooperativefederalismoreventhesharingof

politicalresponsibility betweenfederationandstate.TherathercompetitivestructureoftheGerman

federationreducedthefinancialresponsibilityofthealreadylargelytransferdependentLnder.Asa

rule, the Lnderhave stronglydefended theirauthorityand financial resourcesagainst the central

11Cohn(1992)notesthatGermanyoptedforconservativefiscalpoliciesbecauseofitshugenationaldebt.


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15

government.Althoughthecentralgovernmentofficiallyfollowsthenobailoutrule,thiscommitment

is not fully credible. There is an incentive for the Lnder to borrow excessively as their taxing

authority is rather limited. Indeed, the excessive debts of some of the Lnder and the financial

securityprovidedbythecentralgovernment,aftertheSecondWorldWar,demonstratethe lackof

credibilityandcommitmentoftheLander.

2.3.3German

debt

and

bailouts

AlthoughtheGermanfederalgovernmentandtheBundesbankarefamousforitsprudentmonetary

andfiscalpolicies,thefiscalperformanceofthesubnationalsectorisfarlessadmirable(Rodden

2005).

Intheimmediatepostwarperiod,thelevelofthepublicdebtwasratherlowandevenlydistributed

betweenthethreelevelsoftheGermanfederation.Inthe1970sand1980s,thedebtsofthecentral

governmentandespeciallyoftheLnderhaverisenatasharprate.SomeoftheLnder,whichwere

particularly indebtedandwhichwerealsoused to receivehighamountsof transfers,expected the

centralgovernment tobail themout. Inorder tostrengthen its credibility, thecentralgovernment

couldhaverefused,astheUSfederalgovernmentdid in1840. Instead, inearly1987theLnderof

BremenandSaarlandbegantoreceivespecialsupplementary transfersformthecentralgovernment

explicitlyaimed

at

coping

with

their

high

debts.

In1992 the FederalConstitutional Courthandeddown adecision stipulating that the constitution

requiredtheBundtomakeextratransferstoBremenandSaarland,amountingtoaround30billion

DM over the period from 19942000, see Rodden (2004) and HeppkeFalk and Wolff (2008).12

Furthermore,thesetransferstoBremenandSaarlandhaveneverhadtoberepaid.

The bailout provided by the German government was a signal of its lack of commitment,

demonstratingthedifficultiestocommitintheexistingconstitutional setting,andcreatedincentives

forfurtherirresponsible fiscalbehaviouronthepartoftheLnder.ThehugedebtsattheLnderlevel

werelargelyresponsibleforGermanysproblemoffollowingtheStabilityandGrowthPactin2002.13

Alsoinafederalconstitutional courtrulingof2006onBerlin,nofundamentalchangeoftheprinciple

of solidarity was undertaken and investors continue to price German Lnder essentially similarly

(SchulzandWolff(2009)).

Asecond,interestingfeatureofGermanfederalismisthatallLnderparticipateintheGermanfiscal

equalization system which guarantees a minimum level of annual tax revenues. In practice, the

minimumisveryclosetotheaverageandsomeLnderarepermanentnetrecipientswhileothersare

permanentnet contributors.This fiscalequalization also affects the markets perceptionof a sub

centralgovernments credit risk,as the centralgovernmentmay find ithard to refusebailouts to

stateswhicharepermanentnetrecipientofequalizationgrants.Schuknecht,vonHagenandWolswijk

(2009)findthat,Germanregions,and,inparticular,thosethatwereconsistentlynetrecipientsinthe

Germanequalization scheme,didnotpayriskpremiumsrelatedtotheirfiscalperformanceinexcess

oftheGermanfederalgovernment.

Rodden (2005) argues that the current fiscal federalism in Germany is characterized by structural

weaknesses intheGermanfederalsystemsthathavebeenpresentthroughoutthepostwarperiod.

Specifically,the

collaborative

intergovernmental

system

of

revenue

legislation,

collection,

and

distribution breaks the link between taxing and spending decisions that is critical for effective

governmentprovisionofgoodsandservices.Whilemostspendingandpolicyimplementationoccurs

at theLandorGemeinde level,mostrevenuedecisionsaremadeat theBund level.Rodden (2005)

12ArulingbytheFederalConstitutional Courtin1992introducedthenotionofextremeemergencyasthenecessarycondition

forsupportfromthefederalgovernment.13

SeeHeppkeFalkandWolff(2008)foradiscussion ofthemoralhazardproblemandtheissueofbailoutintheGermanfiscal

federation.


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16

argues thatGermany's complex, interdependent, collaborative styleof federalism tends toweaken

fiscalaccountability andsoftenbudgetconstraints.

2.3.4RecentdevelopmentsinGermanfederalism

TheBasicLawdividesauthoritybetween the federalgovernmentand theLnder,with thegeneral

principlegoverning

relations

articulated

in

Article

30:

"The

exercise

of

governmental

powers

and

the

dischargeofgovernmentalfunctionsshallbeincumbentontheLnderinsofarasthisBasicLawdoes

nototherwiseprescribeorpermit."Thus,thefederalgovernmentcanexerciseauthorityonlyinthose

areasspecifiedintheBasicLaw.Thefederalgovernmentisassignedagreaterlegislativeroleandthe

Landgovernmentsagreateradministrative role.The fact thatLandgovernmentsemploymorecivil

servantsthanfederalandlocalgovernmentscombinedillustratesthecentraladministrative function

oftheLnder.

Originally, theBasic Lawdivided the federal government's legislative responsibilities intoexclusive

powers, concurrent powers, and framework powers. The exclusive legislative jurisdiction of the

federal government extended to defence, foreign affairs, immigration, transportation,

communications, andcurrencystandards.Theseareaswereadditionallyenlargedbyanamendment

totheBasicLaw in1969,whichcallsforjointaction inareasofbroadsocialconcernsuchashigher

education,regional

economic

development,

and

agricultural

reform.

After

the

reform

of

federalism

in

2006,thefederalandLandgovernmentsshareconcurrentpowersinseveralareas.

TheLnderretainnosignificantpowersoftaxation.Therevenueprovidedbythesetaxesisverylow,

relativetototalsubnationalrevenue.Indeed,asindicatedincolumn4ofTable2,taxrateautonomy

isequalto0.04,muchlessthanintheUSandCanada.

Akeyaspectof theGerman federalstate is thesolidaritybetween the individualLnder.However

economicallyweak individualLndermaybe,nosingleLandwillhave lessthan95%of theaverage

per capita budgetary resources. The Basic Law provides for the establishment of equal living

conditionsthroughoutthecountryandthemaintenanceof legalandeconomicunity inthenational

interest.This includes theconstitutionally mandated revenue sharingwith theLnder from federal

taxes.Virtuallyallofthemajorfederaltaxrevenuesourcesareshared inthisway.Theseconstitute

extensivenondiscretionary unconditional transferstotheLnder.

WattsandHobson(2000)notethatinadditiontherearesubstantialintergovernmental transfersboth

from the federalgovernment to the Lnder,andamong the Lnder,which,asa result,arehighly,

transferdependent.When themeasureof the latter includes revenuesharingmechanisms,Lnder

reachthetransferdependenceof70%(column3inTable2).

Ontheotherhand,Lnderareautonomousintheirborrowingactivities(column5inTable2).14

The

centralgovernmenthasnopowertoplacenumericrestrictionsontheborrowingactivitiesofLnder.

Nevertheless, Lnder have their own laws imposing adequate restrictions. Most often, these are

basedon thegoldenrule, i.e.the loan isdesignated for investmentpurposes.However,asRodden

(2006)notes, investment isaslipperyconceptandmanyofthefinancialneedscanbepresentedas

investments.

Inaddition,

the

investment

limits

have

often

been

breached

with

the

argument

that

exceptional

events have triggered expenditure needs. With the currently ongoing financial crisis leading to

massivelyincreasingdeficits,thepoliticalresponsehasbeentoimposefurtherstrictlimitsondeficits.

TheselimitsaresupposedtoapplytothefederalaswellastotheLnderlevel.

14TheLndergetindividual ratingsfromratingagencies.


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17

2.4Argentina

Argentina isa federalrepublicwith24provinces. Ithasapresidential governmentandabicameral

legislatureconsistingoftheChamberofDeputies(257seats)andtheSenate(72seats).Sturzenegger

and Werneck (2006) note that while the Chamber of Deputies supposedly elects deputies in

proportion to their populations, the Argentine system overrepresents the participation of small

provincesthroughaminimumnumberoffivedeputiesperjurisdiction.15

TheSenateisrepresentedby

threesenators

from

each

province,

two

from

the

first

majority

and

athird

from

the

second

party.

2.4.1CreationoftheArgentineanFederation

TheArgentinestatewasbornoutoftheunionofcolonialregionswithdifferingeconomicandsocial

characteristics.Therevolutionof1810againstSpanishcontrolledtothedeclarationofindependence

of the United Provinces of the Rio de la Plata in 1816. Independence revealed strong regional

disparities which had been hidden by Spanish rule. As a result, the establishment of a national

governmentandaconstitution tookalmostfourdecadesaccompaniedbyviolentstruggle.Finally,in

1853 theConstitutionestablishedaconstitutional federalrepublic.Thechanges in theConstitution

introduced in 1860, gave the provinces priority over the central government. The provinces also

gained autonomy in the administration of their territories. Despite some later modifications, the

essential federalist structure of the 18531860 Constitution remains in force today (see Tommasi

(2002)).

Bythebeginningofthetwentiethcentury,Argentinawasoneofthemostdevelopedcountriesinthe

world.However,aftertheGreatDepression,itenteredapathofeconomicdeclinelargelyreflectinga

successionofpooreconomicpoliciesbasedonpopulism.

TheArgentineanFederationandtheGreatDepressionTheGreatDepressionbegan inArgentina inthe late1920s,evenbeforethedateofthestartofthe

Depression in the core countries of NorthAmerica and Western Europe following the Wall Street

crashof1929.Like inmanycountriesof theperiphery,Argentinawasexposedtocommodityprice

shocksand,duringthe1920s,itstermsoftradeworsenedconsiderably. Bytheendof1929,abalance

ofpayments crisisdeveloped, and theexchange ratewas allowed to floatafteronly twoyearsof

participation inthegoldstandard.Recoverybeganin1931,andby193435,outputhadregained its

1929level.

TheArgentineGreatDepressionwasmildandshortlivedby international standards.From itspeak

between1929and1932domesticrealoutputfellby14%andby1935ithadsurpassedits1929level.

Deflationwasabout6%inthe192932period.Inothergoldstandardcountries,suchastheUnited

StatesandCanada, thedecline in realactivity reachedmore than30%andprice levelsdeclinedby

morethan20%.

Major monetary policy actions from 1929 to 1935 were responsible for accommodation of the

negative shocks of the 1930s. In response to the economic difficulties, two major institutional

changes intheconductofmonetarypolicytookplace inthefirsthalfofthe1930s.Thefirstwas in

1931,whenthedecisionwastakenbytheConversionOffice(acurrencyboardestablishedin1910)to

shiftthemonetaryregimefromametallicregimestandardbasedongoldtoafiduciaryregimeandto

revaluethe

monetary

gold

stock

and

devalue

the

currency.

This

resulted

in

amore

flexible

monetary

regimewhichcouldadapttotheeconomiccrisis.Second,aBancoCentral,acentralbank,wascreated

in 1936. This independent institution replaced the Conversion Office and abandoned its nominal

anchorcommitmentdevice.16

Duringthedepression,fiscalpoliciesinArgentinaremainedevenmoreconservativethanincountries

like theUnited States.TheGreatDepression created a suddendecrease in federal revenues.As a

15SeeforinstanceSturzenegger andWerneck(2006).

16Forthedetailsofthereforms,seeDellaPaoleraandTaylor(1999).


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18

result, some tax collection responsibilities shifted from the subnational to thenational level. The

federalgovernmentstartedtocollecttaxesthatwerepreviouslyassignedtotheprovinces, invoking

thecriticalsituationclauseintheConstitution.

2.4.2Argentineandebthistory

Thehistory

of

excessive

Argentinean

public

debt

started

early.

The

revolution

from

Spain

in

1810

led

totheconstantexpansionofmilitaryexpendituresandtoadropintraderevenues(resultofSpanish

blockade of the Rio de la Plata). As a result, the Buenos Aires authorities had to issue the first

compulsoryloan.Duringtheperiod18131821,compulsoryloansamountedto2.96millionpesos.In

1819 and 1820, in order to pay the military and public wages, the government issued small

denominationnotestobeusedbythecustoms(seeBordoandVegh,2002).Bythenthedifference

betweenthepublicdebtandmoneyhaddisappeared.Atthattime,theonlysolutiontotheproblem

was to consolidate the total debt and convert it into longterm debt. The funding operation was

carriedoutin1821.Furtherbondissuesin1823and1824werenecessarytocompletetheoperation.

Bytheendofthefundingoperationin1824,6.4millionworthofbondshadbeenissued(seeBordo

andVegh,2002).

In1825,thewarwithBrazilbegan.Tofinancethewar,andgiventhattheinterestratechargedbythe

BancoNacional

was

considerably

below

the

open

market

rate,

the

Buenos

Aires

government

relied

heavilyoncreditfromtheBancoNacional.AsthecreditresourcesoftheBancoNacionalfellshortof

the governments borrowing requirements, the Banco Nacional had to start printing money. The

resultinginflationspiralbeganin1826andcontinueduntilmid1830.Atthebeginningof1830,long

termgovernmentbondsweresellingatanaveragediscountof40percent.

BordoandVegh(2002)arguethattwomaineconomicfactorswouldensurethatmonetaryinstability

wouldcontinueforthenext40years.First,theTreasurycontinuedtodependontradetaxesformost

ofitsrevenues.Second,longtermbondfinancingwasbecomingdifficultasthepublicbecamemore

reticenttobuyadditionalpublicdebtandaLondonloanfor5milliongoldpesoscontractedin1824

wasdefaultedonin1827,andservicingwasnotpermanentlyrestoreduntil1849.

Bytheearly1840s,thetreasurycontinuedtobeheavilydependentontradetaxesandtheprintingof

money.Inaway,theexclusiverelianceonmoneyfinanceafter1840completeda longprocessthat

began in1813with the firstcompulsory loan.During18101821,governmentpaperbecamemoreandmoreliquid.In1822,papermoneywasissuedandsoonbecameinconvertible.Longtermbond

financing became increasingly difficult afterwards. In 1840, the Treasury concluded that bond

financingwasnolongerworthit,andmoneyfinancingbecametheonlyotherimportantfiscaltool(in

additiontotradetaxes).

Duringthenext60years,ArgentinajoinedandlefttheGoldStandardseveraltimes.Oneachoccasion

convertibility wassuspended,mainly inyearsofpoliticalturmoilandrisinglevelsofmoneyfinanced

governmentdeficits.The finalconvertibility suspensionoccurred in1914at theoutbreakofWorld

WarI.Inthe interwarperiodArgentinafollowedconservativemonetaryandfiscalpolicies,returned

togoldduring192729,and in the1930s followedmildlyexpansionarypolicies (seeDellaPaolera,

1995;DellaPaoleraandTaylor,1997,1999).Areturntohighinflationregimes,asinthe19thcentury,

beganwithPeronafterWorldWarII(seeDiTellaandDornbusch,1989).

Continuousgrowthofgovernmentinsuccessivedecadesbroughtpublicexpenditurestoabout50%of

GDP in the second half of the 1990s. During the 1980s, both levels of government borrowed

extensively,reflectingweakfiscalmanagement.Inaddition,both levelsofgovernmentaccumulated

largedebtsonpaymentsforwagesandpensions,tosuppliersandfordebtservice.Lackoffinancial

controlprevailed inparticularattheprovincial level,becomingan importantsourceoffinancialand

macroeconomic instability.

In the late1980s, theprovincesaccounted for roughly40%of thedeficitof theconsolidatednon

financial public sector. These deficits were financed by discretionary transfers and loans from the


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19

federal government, but also by loans from the provincial banks and other parts of the financial

system,seeSaieghandTommasi (1999).Theprovincesborrowed from theirprovincialbanks,who

then discounted the debt at the central bank, effectively giving the provinces a share in the

seignoragefrominflation. Thisprocessled,bytheendofthe1980s,toahyperinflation.

During theperiod199294, the federalgovernment financedspecial financialrescueoperations for

seven provinces. Nicolini et al (2002) argue that one of the main sources of deficits in provincial

financeswas

the

state

provincial

pension

system.

Financial

aid

to

provinces

in

difficulties

took

the

form of issuing national treasury bonds. Using this ad hoc mechanism, the central government

grantedhugeloans.

By establishing a currency board arrangement, the Convertibility Law of March 1991 ended

inflationarycentralbankfinancingofpublicsectordeficitsatalllevels.Asetofstructuralreformswas

introduced in the1990s,however,abudgetpolicyora fiscal responsibility law thatwouldcontrol

provincialspendingwasnotdeveloped.Theprovinces,especiallytheProvinceofBuenosAires,were

spending heavily and financing their expenditures through commercial bank borrowing therefore

causingcrowdingout.

AsshowninTable3,thepublicdebtgrewroughly40percentfrom1997until2001.64percentofthis

growthwascontracted locally, implyingthatthedomesticdebtofthegovernmentalmostdoubled.

Thedomestic

debt

was

also

contracted

in

dollars.

The

annual

public

and

private

external

debt

service

amounted to41percentof totalexports,and the totalpublicandprivateexternaldebtstockwas

equivalent toalmost5timestheannualexports.Thegrowth in thedebtwasnotseenasworrying,

partlybecauseof itsoneoffnature,andpartlybecausetheeconomywasnowbelieved tobeona

new,highergrowthpath.Butunderneaththesurface,thedebtwasbecomingunsustainable.

In1998,theArgentineaneconomywasstruckbyaseriesofshockswhichplunged it intorecession.

The 1998s Russian crisis dramatically reduced the inflow of foreign capital available to emerging

countries (seeLischinsky,2003).The first signsof restrictedcreditwere thehigh lending rates the

provinces were charged, which did not impede the excessive borrowing. Further, the recession

decreasedtaxrevenues,thebasisforservicingdebt.Inanycase,Argentinastaxcollectioneffortwas

not impressive,andthetaxsystemwasnotcapableofgenerating largeadditionalresourcesrapidly

(seeMark,2003).Debtserviceasashareofexportswashigh,becausetheArgentineaneconomywas

relatively closed, with exports hovering around 10 percent of GDP. With the resulting revision of

growthprospects,Argentinasfuturecapacitytoserviceitsdebtbegantolookmoreworrisome.Mark(2003)argues thatas thisproblembecameclear tomarketparticipants,spreadsroseonArgentine

paperandmaturitiesshortened,creating increasingdifficulty inrollingoverthedebtand increasing

debtservicingcosts.Thisagainworsenedthedebtdynamics,eventuallyforcingArgentinatodefault

onitsdebt.

This combination of inadequate fiscal adjustment and (external) borrowing in foreign currencies

proved in the end damaging for Argentinas attempt to maintain the currency board and avoid

default. Inaddition,SturzeneggerandWerneck(2006)arguethattheirresponsible fiscalbehaviourof

theprovincesleadingtorunupsinthenationaldebttoGDPratiowasakeyingredientintheprocess

leadingtothiscrisis.

2.4.3Argentinean

federalism

today

ProvincialgovernmentsinArgentinahaveabundantpowerstodecidetheirownrulesofgovernance

aswellas taxingandspendingdecisions,whilemunicipalitiesreporttotheprovincialgovernments.

Although the Argentine Constitution establishes substantial room for subnational taxation, in

practice,provinceshavedelegated to thenationalgovernment the responsibilityof raisinga large

shareoftheirtaxes.SturzeneggerandWerneck(2006)arguethat,atthesametime,theresponsibility

forkeysocialfunctions is inprovincialhands.Forexample,provinceshaveexclusivecompetence in

primary and secondary education and in the provision of most social expenditures on education,

health, poverty programs, and housing. As a result of expenditure decentralisation and tax


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20

centralisation, the Argentinean federal system is characterised by a high degree of vertical fiscal

imbalancegap.Thisgap,coupledwiththerelativelylargefractionofgovernmentservicesprovidedat

thesubnationallevel,createsacommonpoolproblemacrossprovinces.Tommasi(2002)arguesthat

asaconsequencesomeoftheprovincialgovernmentsarenotawareofanyhardbudgetconstraint.

Thus they increase spending and reduce local tax effort compared to the case of having to face

bindingbudgetaryrestrictions.

Argentinaaddresses

its

large

vertical

fiscal

imbalance

gap

through

acomplex

and

extensive

system

of

intergovernmental transfers.These transfersandotherrevenuesharingproceedsaccount formore

thanhalfoftotalrevenuesoftheprovinces(column3inTable2).17

Themostimportantcomponent

of this transfer system is the taxsharing agreement called Coparticipacin, which refers to the

process by which shares of the taxes collected by the central government are reallocated to the

provinces.Overtime,thistaxsharingsystemhasbeenoftenmodifiedandseveralnewamendments

have been added to it. Furthermore, some direct transfers appear to be determined by political

considerations. Its complexity and lack of transparency resulted in its description as the fiscal

labyrinth.

WithinArgentinasfederalstructure,alllevelsofgovernmentaregenerallypermittedtoborrowboth

domestically and abroad. However, in many provinces, the provincial Constitution imposes some

restrictionson theborrowingabilityof thegovernment.These restrictionsareveryoftenviolated,

andin

many

provinces

they

are

too

loose

to

be

binding.

In

Table

2,

we

see

that

during

the

1990s

among the five countries studied, Argentina had the highest degree of borrowing autonomy and

reachedalmostfullborrowingautonomyofsubnationalentities.

2.5Brazil

Brazilhasacomplex federation.Threegovernment levelscomprise theUnionof26statesplus the

Federal District, and more than 5500 municipalities. The Constitution explicitly considers

municipalitiestobemembersofthefederation,givingthemamuchhigherstatusandautonomythan

isgenerallyobservedinotherfederations,seeSturzeneggerandWerneck(2006).

The republichasapresidential regimeandabicameral legislatureconsistingof theFederalSenate

and the Chamber of Deputies. Each state is equally represented in the upper chamber by three

senators. Representation in the Chamber of Deputies is not strictly proportional to stateconstituencies. Infact,theConstitutionestablishesthatnostatemayhave lessthan8deputiesand

morethan70.ThisleadstoadisequilibriumsimilartotheonepresentintheArgentineanfederation.

The unpopulated Northern states are overrepresented and the state of Sao Paulo is under

represented.

2.5.1CreationoftheBrazilianfederation

TheBrazilianFederationwascreatedalongwiththeRepublicin1889.Itwasbornoutofthedecision

todividetheunitarystatethatprevailedduringtheImperialRegime.Castanhar(2003)notesthatthe

FederalRegimewasconvenientmainlyforthemostdevelopedprovincesoftheSouthandSoutheast,

inparticularSoPaulo.Theseregionswererichinthenewagriculturalexportproductsatthattime.

Theseprovinceswouldobtainadditionalrevenues from local taxeson theseexports. Inreturn, the

less

developed

regions

were

granted

politicalrepresentation

in

the

government

more

than

proportionaltotheirpopulation.

2.5.2EvolutionoftheBrazilianfederation

ThisfiscalfederalarrangementhasundergonesubstantialchangesoverBrazilshistory.Duringmost

of the nineteenth century when the country had a parliamentary monarchy a high degree of

centralisation prevailed. The power of provincial governments was weak until 1889 as these

17SeealsoCetrngoloandJimnez(2004).


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21

governmentshadlittlecontroloverfiscalrevenues.Theprovinceswerenotallowedtocollectimport

taxesor interprovincial trade taxes,but implicitly theyhad the right to collectexport taxes and in

practicetheyalsocollectedinterstatetaxes.In1889,arepublicanmovementoverthrewtheemperor

in a peaceful revolution and established a provisional government in charge of drafting a new

constitution. ThefirstdraftoftheconstitutionwasthencreatedandsubmittedtotheConstitutional

Congressforafinalrevisionandapproval.TheConstitutional AssemblypassedanewConstitutionon

February24,1891,whichprovidedstateswithgreatautonomy,inparticular,therighttotaxexports,

toset

up

their

own

armed

forces,

and

to

have

independent

gubernatorial

elections.

By

not

including

any limitationsto theamountofdebtstatescould issue, theConstitution implicitlygavestates the

righttoissuedebtdomestically andabroad.

Afterthe1891Constitution,staterevenuesfromexporttaxesrepresentedonaveragearound60%of

total revenue between 1914 and 1916. States such as Esprito Santo and Rio Grande do Norte

collected more than 85% of their revenues from export taxes. So Paulo increased its collection

capacitypercapitathreetimesafter1891,collectingalmost40%ofwhatallthestatescollectedwith

onlyhalfof the totalexportsand less thanone fifthof thepopulation. In contrast,GiasandRio

GrandedoSulcollectedonly24%and29%of theirrevenues fromexport taxes.This taxcollection

independenceofstateshadlargerepercussionsonthecostofcapital.Inparticular,stateswithlarger

exports per capita and resulting larger tax income were able to sell more debt in international

marketsandpaidlowerinterestratesforthoseloansseeMartinezFritscherandAldo(2010).

TheGreatDepressionandBrazilianfederalismDuring theGreatDepression,Brazil, likemanyothercommoditydependenteconomieswent intoa

deepcrisis.Thepriceofcoffee(70%ofBrazil'sexportsshareduringthe1920s)droppedfrom22.5

centsapound in1929 to8cents in1931.As in theother federationsstudiedbyus, theeconomic

depression accelerated expansion and consolidation of the centers power. In 1929, Brazil like

Argentinabegantodevalue itscurrencyandasaresultexperiencedonlyarelativelymilddownturn

andhadlargelyrecoveredby1935.

Thecentralgovernmentwasstrengthened furtherduring theauthoritarianVargas regimebetween

1930and1945.Theendof theVargasdictatorshipbroughtanew constitution. Although thenew

constitutiondidnot introduce radicalchanges to the tax system, itpromoted significanteffortsof

decentralisation, givingmoreautonomyaswellassourcesofrevenuetostateandlocalgovernments.

Thisdecentralisation wavewasinterruptedby20yearsofmilitarygovernment,from1964onwards.The end of this regime in 1985 led to another decentralisation movement. The interests of sub

nationalgovernmentsdominatedtheredesignofthefiscalfederalismarrangementestablishedbythe

1988Constitution.

As a reaction to the earlier dictatorial period, the new constitution delegated a large amount of

revenue and politicalpower towards the subnational governments, and inparticular towards the

municipalities. Subnational governments were directly or indirectly given a much more generous

shareoftheaggregatetaxescollectedinthecountry.AlthoughtheConstitutionalreadyenhancedthe

taxing power of subnational governments, it additionally established transfers basedon revenue

sharingrules,seeSturzeneggerandWerneck(2006).

Soon after the approval of the new Constitution and a new tax system in particular, the central

governmentfaced

growing

financial

difficulties.

In

response,

it

undertook

efforts

to

increase

its

tax

revenue.Asaresult, inefficienttaxeswere introduced, i.e.variousformsofturnovertaxesthathad

beeneliminatedfromtheBraziliantaxsysteminthe1960s.

2.5.3PublicdebtinBrazil

The Republican Period was marked by difficulties in domestic and external financing and

restructuring. First, the long stretch of time during which outstanding securities could not be

converted (183989)affected its credibility. Second,due to the largediversityof instrumentswith

differentmaturitiesand interest rates thedebtwashighly fragmented.The last two issuesspelled


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22

troublefordomesticdebtnegotiationandliquidity.In1902consolidationtriedtosolvetheproblem

of debt fragmentation and succeeded, at least initially. Nearly all outstanding securities were

exchangedfo

a fiscal union for the euro - some lessons from history

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