The Birth of Fiscal Unions

PRINCETON – Fiscal unification is often an effective way to enhance creditworthiness, and it may also create a new sense of solidarity among diverse peoples living within a large geographic area. For this reason, Europeans have often looked toward the model of the United States. But they have never been able to emulate it, because their motivations for union have been so varied.

Desperate countries often consider such unions to be the best way out of an emergency. In 1940, Charles de Gaulle proposed, and Winston Churchill accepted, the idea of a Franco-British union in the face of the Nazi challenge, which had already overwhelmed France.

In 1950, five years after the war, Germany’s first postwar chancellor, Konrad Adenauer, also proposed a union – this time between France and Germany – as a way out of his defeated country’s existential crisis. Political unification was rejected; but economic association has had a brilliant career for more than six decades – until now.

The fundamental idea behind a fiscal union is that poorer, less creditworthy countries can gain from joint debt liability with richer countries. Indeed, one of the most fascinating proposals to this effect came at the beginning of World War I, when the Russian Empire found that its limited capacity to borrow on international capital markets and its low foreign-currency reserves left it unable to create an effective military force.

So the Russian government proposed what would have amounted to a full fiscal union with Britain and France for war-related finances. France latched onto the idea, because its borrowing capacity was also weaker than Britain’s. The British wanted to win the war – but not so much that they were prepared to accept unlimited liability for debt incurred by the French and Russian governments.

In reality, a fiscal union between such diverse political systems would have been unworkable. An autocratic or corrupt regime has a strong incentive to spend in a way that benefits the elite. That incentive increases if it can command the resources of a more democratically governed state, where citizens agree to pay taxes (and pay off future debt) because they also control the government.

The only circumstance in which democracies sign up to such a deal is when a clear security interest is at stake. It was that predicament that gave pre-1914 Russia unique access to the French financial market. Yet, in 1915, the British, even in the face of an ongoing war, were unwilling to assume Russia’s liabilities. Perhaps the sheer degree of uncertainty in pre-war Europe, or the more amorphous nature of the threat, made security concerns trump financial risk.

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