Randy Henning and Martin Kessler have a PIIE/Bruegel paper on this topic – available here.
Synopsis
European debates over reform of the fiscal governance of the euro area frequently reference fiscal federalism in the United States. In light of European decisions to reinforce deficit limits and proposals for deeper fiscal union, we review US fiscal federalism from Alexander Hamilton to the present, highlighting relations between the federal government and the states and the operation of balanced budget rules. Hamilton originally “assumed” the debt of the states and the powers of the federal government grew largely from that decision. Once its authority was established, the federal government shifted to a “no bailout” stance in the 1840s and states became fiscally “sovereign.” States adopted balanced budget rules of varying strength during the nineteenth century on their own accord and these rules limit debt accumulation. However, before euro-area member states introduce strict limits on deficits in their constitutions, “debt brakes,” they should consider three important caveats. First, debt brakes are likely to be more effective when “owned” locally rather than mandated centrally. Second, maintaining a capacity for countercyclical macroeconomic stabilization is essential. Balanced budget rules have been viable in the U.S. states because the federal government holds a broad set of fiscal powers, including countercyclical fiscal action. Finally, because debt brakes threaten to collide with bank rescues, the euro area should unify bank regulation and create a common fiscal pool for restructuring the banking system.