At the end of the first decade of the 21st century, the members of two advanced monetary and economic unions, the nations of the Eurozone and the U.S. states, experienced debt crises with spreads on government borrowing rising dramatically: in a short period of time, Californian spreads rose six-fold, Italian rose ten-fold, Illinois fifteen-fold, and Portuguese twenty-five-fold.
Despite the similar behavior of spreads on public debt, these crises were fundamentally different in nature. In Europe, the crisis occurred after a period of significant increases in government indebtedness from levels that were already substantial, whereas in the United States, state government borrowing was limited and remained roughly unchanged. Moreover, whereas the most troubled nations of Europe experienced a sudden stop in private capital flows and private sector borrowers also faced large rises in spreads, there is little evidence that private borrowing in U.S. states was differentially affected by the creditworthiness of state governments. In this sense, we can say that the US states experienced a public debt crisis, whereas the nations of Europe experienced an external debt crisis affecting both public and private borrowers.
Why did Europe experience an external debt crisis and the U.S. states only a public debt crisis? And why did the members of other economic unions, such as the provinces of Canada, not experience a debt crisis at all despite high and rising provincial public debt levels? In this paper, we argue that these different experiences result from the interplay between the ability of governments to interfere in the private external debt contracts of their citizens and the flexibility of state fiscal institutions. The governments of U.S. states, for example, are less fiscally flexible than the members of other economic unions as a result of state and federal limitations on their ability to change taxes and borrow, but are prevented by the U.S. Constitution from interfering in private contracts. Together, these factors result in public debt intolerance and yet also limit the likelihood of an external debt crisis affecting private sector borrowers within the state. Eurozone nations are more fiscally flexible but have a greater ability to interfere with the contracts of their citizens, particularly if one of them exits the eurozone, which together allows for more public borrowing but also raises the likelihood for external debt crises occurring together with public debt crises. Canadian provincial governments are both fiscally flexible and limited in their ability to interfere in private contracts, which both allows for more public borrowing and limits the likelihood that either a public or an external debt crisis will occur.
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