Hamilton’s Paradox Revisited: Lessons from the Euro Area Crisis for US History

The political economy of fiscal federalism has two stark messages for the euro area: 1) common fiscal backstops come at the cost of market discipline; and 2) federal insurance induces moral hazard of lower tiers of government. Credible commitments to no-bailout of member states can solve both collective action problems. This solution can be seen as a version of Hamilton’s Paradox (Rodden 2006): federal fiscal capacities are effective only if they are weak. These insights are based on extensive research in US history. Theory and evidence thus seems to support the opponents of a fiscal union for the euro area. However, the euro area crisis is hard to explain from this perspective as EU fiscal capacity was credibly weak. The paper revisits the historical US evidence with the knowledge of today, notably that an incomplete monetary union is susceptible to negative feedback loops between financial market panic and weak public finances. The findings suggest that the evidence is incomplete: the sole focus on fiscal federalism has ignored the role of financial markets, their lack of discipline and temptation to endogenous risk taking. This lends support to federal backstops and insurance mechanisms, but not necessarily to a fiscal union for the EMU. The latter does not address the relevant, if incomplete, insights from the political economy of fiscal federalism.