January 17, 2012 / 6:33 PM / 8 years ago

Analysis: What Europe can learn from Alexander Hamilton

LONDON (Reuters) - He was born out of wedlock, stained his reputation with an extra-marital affair and was mortally wounded in a duel.

A bust of Alexander Hamilton, the first treasury secretary of the United States and one of America's founding fathers and signatory of the Constitution, stands atop a monument across the Hudson River at Weekhawken New Jersey, on the site believed to be the spot where Hamilton was shot dead in a duel with former U.S. Vice President Aaron Burr in 1804, July 9, 2004. REUTERS/Mike Segar

In between, U.S. Founding Father Alexander Hamilton, the first Treasury Secretary, laid the foundations of a modern financial system by establishing a national bank, securities markets and the mint.

Crucially, the soldier turned political philosopher also knitted his young country together by having the federal government assume state debts incurred during the American Revolution in return for being granted expanded fiscal powers.

In short, some say, the visionary ideas of this architect of fiscal federalism are exactly what a divided euro zone needs to extract itself from a deep debt mess that threatens the very survival of Europe’s single currency.

“As I see it, Europe is at an Alexander Hamilton moment, but there’s no Alexander Hamilton in sight,” Paul Volcker, a former chairman of the Federal Reserve, the U.S. central bank, told a recent conference in The Hague.

Teasing out conclusions for one continent from the history of another is fraught with risk. For a start, the 27 countries of the European Union will - presumably - never form a unitary state like the United States.

But the evolution of America’s system of fiscal governance that Hamilton started offers valuable insights for the euro zone, especially as it squares up to the possibility of a default by one of its members, Greece.

“The fact that states encountered major debt crises and defaulted, yet the union managed to overcome them intact, points to relevant lessons for European policymakers in the current turmoil,” write Randall Henning and Martin Kessler, researchers at the Petersen Institute for International Economics in Washington.


For instance, the controversy over Hamilton’s 1790 proposal that the federal government should take responsibility for state debt is mirrored in today’s debate over whether to mutualize euro zone debt, perhaps by issuing common bonds.

Wim Boonstra, chief economist of Dutch lender Rabobank, is convinced that Hamilton, were he alive, would be a strong advocate of such a step.

“Without a euro bond scheme, the problems we face will return because the fragmented markets are an invitation for speculators,” said Boonstra, who published a proposal for the common funding of the budget deficits of members of the putative monetary union as far back as 1991.

But just as Germany and other northern euro-zone creditors today oppose a bailout of distressed debtors such as Greece, citing moral hazard, Hamilton’s opponents objected that his plan was unfair to some states and would reward speculators.

They also saw he was immensely strengthening the federal government - in today’s EU context, heading down the road to political union at the expense of national governments.

“The contemporary debate over monetary union in Europe appears polite compared to the ferocity with which Hamilton’s plan was debated in Congress,” Henning and Kessler write in an essay co-published with Bruegel, a Brussels think tank.

Moral hazard did indeed endure until Congress in the 1840s rejected petitions to assume the debts of a number of states that had spent recklessly on railroads and canals.

The no-bailout principle quickly led states to pass balanced-budget provisions. These find an echo in the constitutional ‘debt brakes’ that are a main pillar of plans to put the euro zone on a more solid footing. But a big difference is that they were adopted spontaneously, not imposed by the centre - or by Germany - as a disciplinary mechanism.

“The episode of the 1840s...underscores the importance of crisis as a driver of institutional change, which is reflected in the contemporary European experience,” according to Henning and Kessler.


States’ balanced budget rules are not watertight, as California’s recent woes show. But they have the effect of deepening a downturn by forcing state and local governments to cut spending or raise taxes when slow growth erodes revenues - much as the belt-tightening being forced upon Greece, Portugal and other deficit countries is doing.

During the Great Depression, with the federal government sticking to its no-bailout rule, more than 3,200 local governments had defaulted on $2.4 billion of debt by 1935.

To cushion the economic blow, President Franklin D. Roosevelt ramped up federal spending to prop up demand - a massive policy shift made possible only because Hamilton had established a full range of fiscal powers for the centre, including the power to tax, 140 years earlier.

“This evolutionary perspective is critical to understanding how things worked in the United States,” Henning said in a telephone interview.

“One logical conclusion for the present for Europe is that balanced-budget rules that rob states of the capacity for counter-cyclical fiscal action would be very dangerous unless there is a stronger fiscal union in Europe, which should include euro bonds,” he said.


An important component of Hamilton’s original assumption of states’ debt was an accompanying restructuring. History is repeating itself with today’s negotiations over how big a loss Greece’s private-sector creditors are willing to take.

Hamilton offered a voluntary menu of three debt-swap options, and by the time he left office in 1795, 98 percent of domestic debt had been exchanged on his terms. Foreign debt, mainly to French banks, was repaid in full with a new loan from Dutch lenders.

In striking a balance between creditors and debtors, Hamilton created a sinking fund of revenue set aside to service the debts - an idea recently included in a proposal by the five “wise men” who advise Germany’s government on economic policy.

In what would be music to the ears of German Chancellor Angela Merkel, if not to those of French President Nicolas Sarkozy, Hamilton wrote that he “ardently wishes to see it incorporated as a fundamental maxim in the system of public credit of the United States that the creation of debt should always be accompanied with the means of extinguishment.”

“That is to say, you don’t take on a sovereign debt without also having in place a specific revenue stream with which to pay it down. Europe of 2012 should duly take note,” Declan Ganley, an Irish entrepreneur, and Brendan Simms, a professor of the history of European international relations at Cambridge University, wrote in a recent newspaper article.

So, on Volcker’s point, where is today’s Alexander Hamilton?

Though facing a monumental task, Hamilton had the advantage over today’s European leaders of starting his institution-building with a relatively clean slate, Henning said.

“I don’t think that precludes European policymakers taking the next step to a robust fiscal union. But it makes it more difficult and cries out for leadership and trans-European coalition-building, a task that Chancellor Merkel and President Sarkozy just haven’t been up to so far,” he added.

Additional reporting by Paul Taylor in Paris

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