In 1789, the political price for our federal constitution included a bailout of the 13 indebted states. But it was by refusing to bail out the states a second time in the 1840s that the United States preserved its federal system, with substantial fiscal independence for state governments. Facing a similar moment, Europe might learn from our experience.
The 1789 bailout was part of a grand bargain designed by Alexander Hamilton to convert the creditors of the 13 states into advocates of a stronger federal government—one having the ability to raise all revenues required to service the large debts that the Continental Congress and the 13 states had both accumulated to finance that "Glorious Cause," our war of independence.
Hamilton and George Washington wanted those debts to be paid. They had to engineer institutional changes to achieve that goal. Under our first constitution, the Articles of Confederation, the continental government had virtually no power to tax. For revenues it depended on voluntary contributions from the 13 states.
About two-thirds of our total debts were owed by the continental government, the other third by the 13 states. If they had been valued at par, federal and state debts together would have constituted about 40% of gross domestic product. But because tax revenues were not big enough to service them, both federal and state debts traded at very deep discounts, deeper than those we see in Europe today. From the point of view of the creditors of the states and the United States, if not our taxpayers, there was a fiscal crisis in the 1780s. Fiscal crises often end in rearrangements of political institutions designed to sort out which old promises will be broken and which sustained.
Hamilton's Report on Public Credit from 1790 describes the grand bargain and his reasons for advocating it. The Articles were replaced by the new U.S. Constitution, which shifted exclusive authority to levy tariffs from the states to the federal government. In return, the Congress assumed the states' debts in August 1790. The federal government immediately imposed a tariff, and it used about half of the ample revenues that soon rolled in to service its debts. State and federal debts went from trading at deep discounts to par in the early 1790s.
Why did Hamilton and Washington want to honor our debts? Because they wanted the U.S. government to build a good reputation vis-a-vis its creditors. Hamilton reasoned that honoring the existing debts would allow the government to borrow on good terms in the future. That ability to borrow would generate fiscal flexibility by creating a prospective source of revenues beyond current taxes, one that might be used to finance surges in government expenditures associated with wars and other future difficulties and opportunities.
Why did Hamilton and Washington want the federal government to bail out the 13 states? Because they wanted to realign interests in a way that would induce voters to support a federal government with ample ability to tax.
They thus built a good reputation for the U.S. by creating another, potentially troublesome, reputation with the states—the perception that the federal government would bail them out. Although the trade-off was made mainly for political reasons, one of Hamilton's stated reasons for bailing out the states was that most of their debts had been incurred for their contributions to a national public good: acquiring independence from Great Britain. Was that reason authentic or was it just a convenient cover, a rationalization for Hamilton's real goal, which was to convert the creditors of the state governments into advocates of the central government's ability to tax?
Now fast-forward into the next century. To finance canals and railroads, many state governments incurred large debts in the 1820s and 1830s. A financial crisis in the late 1830s pushed many of those state debts into default.
Appealing to the precedent set by the 1789 bailout, state creditors asked the federal government to bail out the states once again. After an enlightening debate, in the early 1840s Congress declined, so many states repudiated their debts.
In the aftermath of those repudiations, many states rewrote their constitutions to require year-by-year balanced budgets, something they had never done before. As noted, fiscal crises, like the one in Europe today, often produce political rearrangements—at best peaceful ones like these.
Did the federal government do the right thing in refusing to bail out the states in the early 1840s? By doing so, the federal government reset its reputation vis-a-vis the states, telling them in effect not to expect it to underwrite their profligacy. In the short run, that cost the federal government substantially in terms of its reputation with its own creditors. Federal credit abroad suffered along with state credit. But in the long run, the decision exposed state governments to continuing market discipline, making future crises and requests for federal bailouts less likely.
If the federal government had chosen to bail out the states a second time, it probably would have taken greater control over state taxes and revenues in order to prevent yet another bailout situation. Refusal to bail out the states was thus a pivot point in sustaining a federal system in the United States. It led the states to discipline themselves by rearranging their constitutions in ways designed to allow them to retain freedom and responsibility for taxing and spending within their borders.
Europeans today might be tempted to say "yes" to bailouts. Or they might also recall a time when Americans preserved their own federal system by saying "no."
Mr. Sargent, winner of the 2011 Nobel Prize in economics, is a professor of economics and business at New York University and a fellow at Chicago University's Becker Friedman Institute for Research in Economics and at Stanford University's Hoover Institution.
