A United States Without Washington?

Imagine if the United States abolished Washington. Not the city but the President, the federal government and Congress. Instead, the 50 state governors would run the country. They would meet in Washington four times per year and take decisions by unanimous vote. How would this change the US?

Many wise commentators say that a currency union without a powerful central government (political union) and transfers (fiscal union) cannot survive due to centrifugal economic forces. If done well, that is probably not wrong. But the world of politics being far from ideal, I would argue that a looser union actually sets better economic incentives for its members.

Americans would be better off doing many things jointly rather than separately. They would probably still have one army, one language and one currency. Borders would remain open and trade would still be free. A common administration, probably based in Washington, would execute the wishes of the governors in the common policy areas.

But policies might diverge between states much more than now. Legal systems would diverge, education might change, reflecting different tastes and circumstances. Some states may prefer more generous welfare for the poor, others less. There is a key limit for divergence, though. Each state would have to fully finance its choices itself, by raising taxes and borrowing in financial markets. Relying on transfers from other states to, say, support free education would not be possible.

Sudden shocks such as natural disasters or financial crises can occur anywhere, anytime. Even the healthiest and most well-run states could suddenly face huge problems. In a loose union, every member would be more vulnerable, but the weakest most. The strong have to help, out of moral obligation but even more because otherwise the troubles might ultimately reach them, too.

The strong would not help automatically and they would want a say in how the help is spent. They could say “no.” As an example, a strong Texas could impose conditions for financial support to a struggling Michigan. This could help politicians in Michigan to overcome domestic vested interests against reforms. People in Michigan would not like interference from Texas. They would try and regain sovereignty by dealing with the problems that make them vulnerable. It will wean itself off help as soon as possible, making the union as a whole a healthier and less vulnerable place.

Abolishing Washington is probably impossible, even if you believe in the advantages of a looser union. The weaker states would not allow it to happen. But in the Eurozone the looser union is the starting situation: A US without Washington would be similar to the situation of the Eurozone today. The 17 nations may not share the same language or common army. Their welfare and education systems vary, reflecting their preferences. But they are a family of nations sharing a common history and destiny, too. They are forced to work together for the common good.

The global financial crisis of 2008/2009 has hit the weakest members of the union very hard. To a large extent that, they only have themselves to blame. Governments, households and companies lived beyond their means, racking up massive fiscal and trade debts and deficits. How should they get out of the mess, if one seemingly easy way out, devaluing the currency and inflating away the debts is not available?

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Like carrots, several easy ways out dangle in front of the noses of the crisis countries’ governments. The European Central Bank could print massive amounts of money to inflate away problems. Or wealthy Germany could underwrite Eurobonds, allowing the crisis countries to borrow with Germany’s AAA-rated guarantee. These look like short-term painless fixes, even if they would probably only perpetuate the problems and make them even worse the next time around.

In the Eurozone, the strong can say “no.” Their governments are looking after their taxpayers’ money. Of course, they help: Germany and the ECB protect reforming, sustainable countries from financial panic and speculation, a key advantage of euro membership. But they impose conditions, demanding fiscal austerity and structural reforms. The labor market is key: many crisis countries of today have priced their workers out of the market by imposing high minimum wages and restraining their flexibility. They have created unsustainable welfare states which take away incentives to work and allowed housing and credit bubbles.

The conditions force countries to tackle the problems the hard way. This is much more likely to avoid recurrence than a central government in Brussels papering them over with cheap money and transfers. Short-term pain, long-term gain. The help is not an act of altruism from the strong countries. The success of the crisis countries is in Germany’s vital interest. It should help compliant countries in every way it can, by easing loan conditions where possible and opening up its own product and services markets to the greatest possible. Conditions should not punish countries to avoid moral hazard, but ensure that countries return to economic virtue as quickly as possible.

The Eurozone needs to stay the course. History shows that a combination of supply side reforms and fiscal austerity can shake up a country and lead to long and sustained periods of growth. Britain did it under Thatcher in the 80s, the Nordic countries in the 90s, Germany under Schroeder in the 2000s. Now it is Southern Europe’s turn. Prepare for the Eurozone to emerge from this crisis as a more dynamic and more competitive place than ever before.

Dr. Christian Schulz joined Berenberg Bank in London as a Senior Economist in April 2011. He covers the Eurozone economy, the ECB, the German economy and global economy. Prior to Berenberg, he worked as an economist at the European Central Bank from 2008 to 2011, mainly in the Directorate General Payment Systems and Market Infrastructure. From 2003 to 2008, Christian was a consultant at The Boston Consulting Group in Frankfurt and Hamburg, Germany, where he was part of the Banking Core Group. Christian holds a doctorate in macroeconomics from the University of Hamburg.