Australia and the Eurozone: a counterfactual account of economic history

If Australia had been founded according to the Eurozone model, our current economic situation would look very different. adam79

Suppose that in 1901 Australia’s founding fathers had designed the Commonwealth differently. The states were to retain all powers to tax and had to finance themselves (including health, education and social security) entirely, either through taxes or through issuing debt. Imagine further that in the interest of fiscal rectitude, the Constitution specified that no state was allowed to lend money to another or, indeed, to borrow on another’s behalf. Also, that a state’s banks were to be supervised by the state government who would be fully responsible for the smooth functioning of the state’s banking sector.

As for the federal government in Canberra, since it would have no capacity to tax, its revenues would come directly from the states, on the basis of some given formula that specified payments from the states to the centre in proportion to each state’s gross domestic product. Canberra would then use these state-sourced revenues to indulge in nation-building projects, provide structural funds for greater convergence between states, fund the Australian Federal Police, armed forces, and so on. Lastly, the Commonwealth would be equipped with one central bank (the Reserve Bank of Australia): the purpose of which would be to act as the guardian of the Australian dollar, targeting inflation as its only policy objective, and explicitly banned from printing money to fund either the federal or the state governments.

Advocates of so-called states’ rights may find such a system heartwarming. It would stop Canberra politicians who have never been to Perth from deciding on how much income tax Western Australians pay. It would allow states leeway to decide how generous they want their social security system to be, as opposed to the current one-size-fits-all. It would create more accountability at a state level. And it would mean that the federal government would never be in deficit while the Reserve Bank concentrates on the sole task of keeping the Aussie dollar inflation-free and creditable around the world.

Be that as it may, had the Commonwealth of Australia been founded on such principles, it would not have survived to this day. Come to think of it, the structure that I described above is that of our embattled Eurozone: a kind of Commonwealth which is imploding precisely because it was structured in this manner. To see why it is disintegrating, consider what would have happened in Australia following the great financial crisis of 2008 had the founding fathers elected the Eurozone model instead of the existing federal-state structures.

Once the credit crunch hit New York, London, Dubai, Europe, etc., two of the above arrangements would have ensured Australia’s fragmentation: one is the notion of perfectly separable banking sectors; the other the idea of perfectly separable budgets or debts. Let’s see how these two principles would unleash destructive forces that would bring down the Commonwealth.

The first effect of a credit crunch is that capital becomes generally scarce and, in particular, flees from states and regions that are deemed riskier. Liquidity recedes like an evil tide and, under the above structure, would dry up totally in deficit states such as Tasmania and South Australia. The Reserve Bank would then step in to refloat all the banks by means of loans in exchange for collateral.

But that would not suffice. Financial markets would know that the more vulnerable states, left to their own devices as they would be, would find it impossible under the new circumstances to fund not only their increasing fiscal deficits, but also the recapitalisation of their insolvent banks. They would instantly require of these states interest rates that they simply cannot afford.

Tasmania would go bankrupt overnight. And so would all the banks in Hobart and Launceston. The Reserve Bank might keep them running by means of liquidity provision, but their insolvency would be common knowledge and the bank run would be unstoppable. Tasmanians would transfer their savings to Perth or Brisbane, they would try to sell their houses to do likewise with the proceeds, house prices would collapse, and jobs would become scarcer than Tasmanian tigers as no sensible business person invests under such dire circumstances. The Hobart government would respond by increasing taxes and cutting wages, thus sinking deeper into the debt-deflationary spiral.

Before long, speculation would be rife that the next domino to fall would be South Australia. Or New South Wales; Victoria, even. Calls will be going out to the resource-rich states of Western Australia and Queensland, asking them to take decisive steps to come to the aid of the “fallen”, or those about to fall. However, the Constitution would have banned such fiscal transfers, not to mention that its citizens would be averse to paying for the other states’ woes. Meanwhile, the Reserve Bank’s governor would protest that his Charter prevents him from doing anything other than providing liquidity (loans) to the banks.

Under the real threat of the Commonwealth’s demise, even if the states were to band together and create a bailout fund for lending to the fiscally stricken states, it would not work as long as this form of solidarity took the shape of loans from one state to another. Indeed, the states would have resembled a group of inane mountaineers that bind each other with a single rope but forget to pin it onto the rock face. Thus, as the weaker mountaineer falls, the rest must bear the additional weight; the result being that the second weakest climber falls too until the strongest (Western Australia) finds it impossible to carry all the rest and cuts the rope to survive.

Once this vicious dynamic begins, nothing but a new arrangement, a drastic re-design of the centre-periphery relationship will do. Alas, in Europe, when the rot set in two years ago, we pretended we could address the crisis by means of loans and austerity that reduces the income from which they will be repaid. Europeans opted for demonisation of the “fallen” (countries like Greece) over a rational analysis of our catastrophe’s causes. They decided to reject as “permanent bailouts” - what Australians sensibly refer to as … Tasmania.