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Wolfgang Schäuble learns from the wrong history book

German Finance minister refuses transfers to southern Europe. Insofar as regions with different levels of economic development coexist in a currency area, transfers are economically inevitable – that's the lesson of history, writes Florian Schui in the German economic magazine Wirtschaftswoche. A member of VoxEurop community has translated his article here.

Published on 5 August 2015 at 22:28

I have chosen this article because it makes a parallel between the United States, where economic differences among single States are balanced through direct and indirect financial transfers from the Federal government since the very beginning of independence. It's the citizen's feeling that such compensation is politically legitimate – the government is elected by the people and accountable to it – that makes the system work (as id does, after all, in Germany).

A democratically elected European government would be legitimate to run a financial transfer policy that would compensate debt imbalance among member countries. As Florian Schui says –

Much can be learnt from economic history. This also applies to the current debt crisis, but only if you read the right history book. The American administration has recognized that for a long time. As early as 2013 the US Treasury Secretary Jack Lew gave his German counterpart a biography of Alexander Hamilton. It was a broad hint.

In the late 18th century Hamilton solved the debt crisis between the states of the American federation by mutualizing their debts and establishing a strong federal government. Unfortunately, however, Schäuble seems to have ignored the reading recommendation of his American colleague. Instead, he inspires his European policy to a German version of America's economic history that can be found in Hans-Werner Sinn's book The Euro trap. On bursting bubbles, budgets, and beliefs (OUP, 2014).

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One of the last chapters of Sinn's pamphlet is entitled Learning from the United States. It sounds wise and modest, but Sinn's version of US economic history is peculiar. He argues that the US remained stable as a federation using a common currency because it doesn't mutualize debt. Individual states and other local bodies that become insolvent can't rely for help on the federation or on other states. The interregional transfers Sinn dreads don't occur, thus individual states are forced to fiscal discipline. Consequently, for example, the citizens of Athens, Georgia can't allow themselves generous welfare treatments hoping that the inhabitants of Berlin, New Hampshire, will rescue them in case they later have financial difficulties.

Not only has this public finance arrangement succeeded in fostering fiscal discipline. Prohibiting financial rescues has also contributed to the high growth rates of the United States. Here Sinn refers to the classical „crowding-out“ argument that debt-financed public spending is not subject to the same profitability constraints as private investments. Through public expenditure the scarce resources of the economy aren't channeled anymore where they yield the highest gains. The market economy is partially turned off, growth and productivity suffer.

Sinn's argument is theoretically consistent but doesn't correspond to the reality of US economic history. Especially, he overlooks the considerable interregional transfers that are performed through the federal administration. It happens especially through the existing federal social programs and through military expenditures. Social spending is primarily designed to redistribute resources from well-off taxpayers to needy welfare recipients. However, this is often tantamount to regional transfers from rich areas of the US to poorer ones. The phenomenon occurs in this form wherever nationwide social programs are present.

A large proportion of transfers from West to East Germany and between other parts of Germany takes place in this form. The effect of military spending is similar. The military budget is financed by all American taxpayers, but military bases and defense contracts are often deliberately directed to structurally weak areas.

This means the citizens of Athens, Georgia can well under specific circumstances consume goods and services largely at the expense of taxpayers in Berlin, New Hampshire. The difference with the situation in Europe is that interregional transfers in the US do happen, but are not labeled as such and are politically accepted. It is crucial to understand, though, that we're dealing here with a political difference, not with an economic one.

This can be easily seen in a current example. The US territory of Puerto Rico is now on the verge of bankruptcy. Exactly as in Sinn's argument there will be no direct bailout by the federal administration or by any other American institution here. However, there are considerable transfers in the form of federal social benefits and there's a reduction of Puerto Rico's contribution to the federal budget. On top of that the financial difficulties of the territory are treated like a real bankruptcy, i.e. lenders will have to write off a part of their credits to Puerto Rico. In the case of Greece it would have been especially French and German banks.

Insofar as in a currency area there are regions with different levels of economic development transfers are economically inevitable. The question is if they are perceived as politically legitimate by the people like in the US or if they turn out to be politically explosive like in Europe.

In the US they succeeded in combining a stable currency with a federal political framework, but it didn't happen because there are no interregional transfers, but because they could find a way to make the transfers politically acceptable. This depends for one on a feeling of national unity that allows such transfers in established nation states more than in a new political construct like the euro zone. Even more crucial is that in the US the central government carrying out the transfers is democratically legitimized.

The interregional transfers in the USA are politically acceptable because they're performed by a democratically elected government, so American taxpayers in Athens, Georgia and in Berlin, New Hampshire jointly decide about transfers and budgetary issues. Such an instance is missing in Europe. The euro doesn't need an insolvency procedure for its member states or provisions for a temporary exit from the currency union like the one currently proposed by the German Finance Ministry, but rather a democratically elected European government through which German and Greek citizens jointly decide about the fiscal future of Europe. The proposals of the French president Hollande are on the right track there.

The correlation Sinn makes between alleged fiscal discipline and high growth in the USA is also questionable. In fact, the American federal administration is not just a giant "transfer machine", but also an "indebtment machine". American presidents of all political orientations from Roosevelt to Reagan piled up debt to a colossal extent. This contrasts with periods of nearly balanced budgets in other times.

Apparently, this cyclical expansion of the debt burden hasn't damaged the long-term economic development of the US, quite the contrary. Sinn points out exactly how strong is the American growth. A debt-financed expansion of state expenditures doesn't apparently lead to a misallocation of resources and to a consequent decline of growth and productivity. Instead, boosting demand in times of crisis contributes to a stronger economic performance without endangering the stability of the currency or public finances.

The current situation in Europe clearly shows that a stronger central government with its own budget is urgently needed. The European states that are most in need of a stimulus can't provide it due to their fiscal constraints. Moreover, such programs in the troubled countries would make it more difficult to close the competitiveness gaps between euro zone states, because salaries would rise again in the deficit countries as a consequence of the stimulus.

Instead, the economy should be heated up or even overheated by means of deficit spending in the parts of Europe that are not in a crisis. That would lead to growth everywhere in Europe and would increase costs in the healthy regions, which would allow the ailing ones to close the cost gap without internal deflation.

One can learn a lot about the current crisis from economic history, but Sinn's representation of American reality is too selective to be informative. Idealizing representations of American history have a great tradition in Germany. However, when the issue at stake is not the treasure of Silver Lake but the economic future of Europe one should be wary of "German" versions of the American past. Hopefully, at the last moment Wolfgang Schäuble will remember again the reading suggestion from the US. Time is running out.

Photo credit: Armin Kübelbeck

Modified on 8 August 2015.

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