Tax competition among Swiss cantons and municipalities puts downward pressure on taxation, but it does not lead towards a policy of low taxes at any price. Cantons are usually not prepared to implement debt-funded tax cuts. Why is that? Why are Swiss cantons prudent while in other countries governments accumulate large debts?

Their fiscal discipline is often attributed to “debt brakes” (or fiscal rules) that limit the debt and deficit of cantonal and many local governments. But debt brakes have also been adopted also by the European Union for its member states in the 1997 Stability and Growth Pact and in the subsequent Fiscal Compact. Compliance is, however, far from complete in the EU.

Tables 1 and 2 summarise the fiscal performance of Swiss cantons and the federal level and compares it with that of the larger eurozone member states. In Switzerland, the annual deficits of federal, state and local governments were low, leading to a declining debt burden between 2002 and 2012 (Table 1). In the euro area, debt has increased from 68% in 2002 to 96% in 2014 (Table 2).

Table 1: Public finances in Switzerland

Source: Swiss Federal Statistical Office (local data for Switzerland for 2014 is not yet available)

Table 2: Public finances in the EU

Source: OECD Economic Outlook November 2013

Debt breaks plus bailout in the euro zone

Why are debt brakes disregarded in the European Union and observed in Switzerland? Overspending is a general problem of democracies as they have a tendency to spend too much and to postpone taxation via government debt.

Before the euro, EU member states had very different public debt accounts. Some had balanced budgets, low public debts, were reliable borrowers, were unlikely to devalue their currencies and therefore had low interest rates. However, others had large deficits, depended heavily on public borrowing and currency depreciation, and were less reliable borrowers facing higher interest rates. Though the latter governments were unreliable as borrowers they did not tend to renege on debt – they tended to relax monetary policy and allow their exchange rate to fall. The situation of these two groups of countries concerning interest rates is illustrated on the left hand side of Figure 1. Countries with good records such as Germany had low interest rates. Countries with lower ratings such as Greece had to pay higher interest rates.

With the introduction of the euro, exchange rate risks seemed to be eliminated and few expected a member state to default on its debt. Therefore all government bonds had low interest rates.

Yet at the onset of the financial crisis, investors began to ask: who is responsible if one of the large banks in the EU fails? The ecofin ministers wanted to calm the markets and decided on 5^th October 2008 that each member state was responsible for its own banks. Investors then correctly concluded that Southern European countries such as Greece, Italy, Spain, Portugal and, perhaps, France might be unable to absorb the debt of their distressed banks in addition to their own government debt. Interest rates in these countries rose.

After a series of meetings and initiatives, the ECB found a way of, in effect, guaranteeing the debts of the heavily indebted euro zone countries. The joint bailout fund of the euro nations was too small to calm the market. So in 2012, ECB President Mario Draghi proposed the “Outright Monetary Transaction Programme” which effectively guaranteed a full bailout to each government in fiscal distress regardless of whether or not it complied with the debt rules. This calmed the government bond market. As a consequence interest rates of the heavily indebted countries fell. The conclusion for individual euro members was clear: why should they comply with the debt rules brakes when a bailout would be available from the deep pocket of the ECB spending, in effect, taxpayers’ money?

Figure 1: Ten years’ government bond interest rates in euro member states.

The situation of Switzerland is different. The Swiss National Bank cannot afford to act as a lender of last resort. It cannot credibly guarantee the bailout of distressed federal and cantonal governments. If it tried, the value of the Swiss Franc would drop, and international investors would stop buying Swiss federal and cantonal bonds or demand higher interest rates. The federal and cantonal governments in Switzerland cannot count on the Swiss central bank bailing them out.

The no-bailout principle in Switzerland could be called a “dynamically developing credence capital good”. This means that the belief that the policy will be followed grows through its application over time, and debases itself when it is disregarded. Each application of the no-bailout rule strengthens the expectation that it will continue to be applied in the future. Therefore it is important that the no-bailout principle is continuously applied. Once a bailout takes place it takes time for the markets to believe that it will not happen again and borrowing costs rise. When the cantons of Bern, Solothurn, Geneva, Waadt, Appenzell Ausserrhoden and Glarus ran into severe financial difficulties due to the losses of their cantonal banks in the 1990s, they were left to their own devices. The question of whether the federal government would provide a financial injection was not even raised. Instead, both the federal and cantonal governments acted on the assumption of the no-bailout principle, according to which each canton is responsible for its own finances.

If a financially distressed cantonal government approaches the federal government with a petition for a bailout, the federal government would simply reply: “We both have to survive as borrowers on the international credit market. We both enjoy fiscal autonomy, you as a cantonal, and I as a federal borrower. We are free to choose, but we are responsible for our choices. If I fail as federal government, nobody will come to rescue me. If I bail you out, my creditworthiness is undermined and I would have to pay higher interest rates.” Fiscal autonomy buttresses the no bailout regime. The cantons know that they take their own decisions and are responsible for the consequences.

Fiscal discipline in Switzerland is not explained by balanced budget rules as such, but by a credible no-bailout policy. Balanced budget rules are merely a response to this no-bailout policy. The fact that cantons will not be bailed out encourages them to have fiscal rules to stop the build-up of debt. This sends a signal to capital markets and allows them to borrow on more favourable terms. Debt brakes have no value for their own. They are only helpful if they are linked to a credible no bailout position. In the euro area the no-bailout clause of the Lisbon Treaty has gone. Therefore, debt brakes have been hollowed out.

It is not possible to replace a no-bailout position by a better set of budget constraints and fiscal rules such as the Fiscal Compact. Both are necessary.

The problem that the eurozone now faces is that once expectations of “no-bailout” have disappeared it is difficult to convince markets that the principle will be followed in the future. Credit markets in systems with bailouts do not differentiate between good and bad borrowers. As such, the good borrowers, such as Germany, will suffer because of the weakening of the no-bailout position. Investors have no incentive to discover which jurisdiction is more and which is less reliable. Governments also have little interest in building up a good reputation.

The importance of the no-bailout principle is best illustrated by the example of Leukerbad, a small town in the canton of Wallis, which went bankrupt in 1998. After a series of expensive debt-funded investment projects, the council of Leukerbad declared that it could no longer service its debt.

Just as cantons in Switzerland cannot count on federal support, local government cannot count on bailouts by cantons. It is the responsibility of lenders, not cantonal governments, to exert due diligence and monitor loans. Given the unusually large volume of the debt (346 million Swiss francs) and the layered nature of the credit relationships (eight to ten creditors), the control problem turned into a public-good problem. None of the creditors wanted to bear the costs of monitoring alone, so each creditor left the task to the next. Thus, Leukerbad’s financial situation deteriorated.

What should the creditors do in such a situation? They could not break up the municipality as in a private bankruptcy procedure: only a few assets could be sold. Thus, they lobbied the canton of Wallis to bail them out. The cantonal government, however, rejected any responsibility. The federal court in Lausanne, which was called upon to hear the matter, upheld the position of the canton and dismissed the case filed by Credit Suisse First Boston and other creditors. The no bailout principle was applied unambiguously.

With this ruling, the court sent a clear signal. It is the responsibility of the creditors to perform due diligence regarding their prospective borrowers’ creditworthiness. But how could the creditors access information regarding the borrower? This gap has been filled by the establishment of private rating agencies which developed as a consequence of the Leukerbad judgement. The agencies assess the creditworthiness of municipalities on the basis of the state of their finances and possible bailout or no-bailout expectations as inferred from the constitution of the cantons. Ratings are also prepared regularly to give information on the cantons’ fiscal situation. This reduces the information asymmetry between creditors and borrowers, which in turn contributes – and this is the key aspect – to overcoming the previous market failure and improving the efficiency of the credit market. The cantons have an incentive to improve their credit ratings so that they can borrow at lower interest rates and, indeed, this has happened. Out of 26 cantons, seven have an AAA rating and fifteen an AA rating.

If the court had forced Wallis to take over Leukerbad’s debt, the ability of the market to allocate capital efficiently would have been eroded, and the incentive to balance budgets would have been eliminated.

The lessons for the euro zone are clear. Fiscal discipline is not possible without a strong no-bailout constitutional provision which is observed and upheld. Creditors must know that when they lend to particular EU governments they bear the risk which is determined by the creditworthiness of that government. It is from this starting point that fiscal discipline will follow. There is no point in trying to impose fiscal discipline directly, through statutory limits on debt and borrowing. Apart from the resentment this creates, it has not been and will not be effective in promoting sound fiscal policies.

Prof. Dr. Charles B. Blankart is a professor of economics at the Humboldt University Berlin and the University of Lucerne.

An earlier version of this article apeared in EA Magazine.