Articles of Confederation (1781-1787)

League of Friendship between states

Reaction to British Rule.

States had sovereignty and could establish own laws, currency, and tariffs

States had all domestic power, central government had little or no power.

Congress dealt with foreign issues and debt.

Congress had no power to tax and could only ask for donations.

1 state = 1 vote regardless of size or population

13 out of 13 states had to approve changes

No judicial branch to judge and no executive branch to enforce congressional laws

The states under this arrangement could act only on their self interest

Articles of Confederation (1781-1787)

States voluntarily donated money but still enjoyed the protections of the central government regardless if they donated.

Rhode Island donated a grand total of $0.00

States did not have to contribute but still enjoyed the external benefits- classic “free rider” problem

In terms of a repeating prisoner’s dilemma the states that did donate realized that it wasn’t worth supporting all of the states and of course would seek their self interest.

statesnot donate donate

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donate 0, 5 3, 3

Articles of Confederation

Problems Causes Solution

States did not follow Central Government’s laws

That Central Government had no enforcement power

Increase Central Power

The Central Government had no money. It couldn’t pay debts.

The Central Government had no power to tax

Give the Central Government power to tax

Inflation Over printing by both the Central Government and state governments

National Currency

Disputes and division among states

States created inter-state tariffs, taxes and navigational rights disputes

National court system, central control of inter-state trade

No trade or treaties with foreign nations and no reprisals against nations that hurt trade

The Central Government had no power to enforce

Make it easier for the Central Government to act

Instability both economically and politically

No Central Power Increase Central Power

Resources were not allocated to their most useful purpose. The number one dagger in the heart of a free market society is instability.

Articles of Confederation

Problems Causes Solution

States did not follow Central Government’s laws

The Central Government had no money. It couldn’t pay debts.

Inflation

Disputes and division among states

No trade or treaties with foreign nations and no reprisals against nations that hurt tradeInstability both economically and politically

Resources were not allocated to their most useful purpose. The number one dagger in the heart of a free market society is instability.

A Free Rider Problem Under the Articles of Confederation

“The check is in the mail”

Lots of Debts after the War

• The United States had about $35 million in debt after the Revolutionary War.

• $25 million owed to the American people.– Soldiers waiting for back pay.– Businesses which had supplied troops wanting

payment.• $10 million owed to foreign governments.– This needed to be repaid before commercial

relations could be normal.

Collective Interest in Paying Debt

• The national government – as well as all of the state governments – had an incentive to pay the debt.– The country faced internal legitimacy. problems if

it could not pay the former troops and suppliers.– Disgruntled soldiers could be a threat….– Normalized foreign trade was critical to both the

national and state economies.

How to address this collective action problem?

Articles of Confederation

• Congress was responsible for paying the debt.• However, Congress had no taxation powers.• Congress gave each of the states an annual

amount it must pay for its share of the debt.• State legislatures had to determine how to

raise the funds for these annual payments.

How to raise the money?

• In order to raise the money for their annual payment, state legislatures typically had to raise taxes on its citizens.

• Then as now, politicians despised raising taxes!

• Plus, local economies were still very fragile after the War.

What are the states’ options?

Option #1: Raise Taxes

• Pros– Will have enough funds to pay share of debt.

• Cons– Will have to take unpopular step of raising taxes.– May further damage already weakened state/local

economies.

Option #2: Keep Taxes the Same

• Pros– Can keep the tax rate the same.– Be more popular with electorate.

• Cons– Can’t pay allocated share of national debt.

Which option is a politician, primarily concerned about his local

interests, going to choose?

“Option 2!” says State Legislator Smith

• Legislator Smith would like to do what he can to avoid raising taxes on the people of his state.

• Members of his state’s congressional delegation contend that such an attitude would mean that the state would shirk its national responsibility!

• Legislator Smith asks, “What are the ramifications of not paying Congress?”

Enforcement mechanism?

• The Articles of Confederation had no enforcement mechanism to compel states to make their payments.

• Thus, only concern for the collective good of paying down the debt was the motivation for payment.

• Those collective goods are compelling, but wouldn’t they be achieved anyway as long as all the other states (except us!) paid their share?

The Free Rider Problem

• Without an enforcement mechanism, states had an incentive not to pay their allocation of the national debt and hope that other states would pay enough of the debt to provide most if not all of the collective benefits.

• In other words, the “shirking” states had an incentive to “free ride” on the backs of the states that were willing to do what it took to pay their allocation.

Free Rider

A party still receives their share of the shared social benefit without contributing a private cost.

Self-interest:

Depletion of shared resources

In this case- collective security and other purposes of government

The Domino Effect

• Once some states decided to not pay their allocation, other states had extra incentive not to pay their own allocation.– Why should the citizens of only some states bear the

national debt burden?– This results in a Prisoner's Dilemma situation.

• With this free rider problem, it became clear that the national debt was not going to be paid, and that the collective benefits of doing so were not going to be realized.

How the free rider problem was addressed

The Constitution

• Article I, Section 8 gave Congress the power to raise taxes directly.– States would no longer have to raise funds for the

national government.• The national government in return would

assume any of the states’ outstanding debt related to the War.

This free rider problem is solved by centralizing the ability to raise funds with the national government rather than relying on states to collect the

money

1776

Dec. of Independence

Thomas Jefferson Division of PowerInspired by Locke Social Contract

Constitution

Wealth of Nations Division of LaborAdam Smith and Specialization

Economies of scale

Mutual Exchange