Articles of Confederation (1781-1787) League of Friendship between states

1. 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

2. 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. states not donate donate not 1, 1 5,0 states donate 0, 5 3, 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 power to tax Give the Central Government power to tax The Central Government had no money. It couldn’t pay debts. National Currency Inflation Over printing by both the Central Government and state governments States created inter-state tariffs, taxes and navigational rights disputes Disputes and division among states 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 No Central Power Increase Central Power Instability 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.

4. 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 trade Instability 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.

5. A Free Rider Problem Under the Articles of Confederation “The check is in the mail”

6. 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.

7. 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.

8. How to address this collective action problem?

9. 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.

10. 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.

11. What are the states’ options?

12. 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.

13. 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.

14. Which option is a politician, primarily concerned about his local interests, going to choose?

15. “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?”

16. 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?

17. 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.

18. 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

19. 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.

20. How the free rider problem was addressed

21. 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.

22. 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

23. 1776 Dec. of Independence Thomas Jefferson Division of Power Inspired by Locke Social Contract Constitution Wealth of Nations Division of Labor Adam Smith and Specialization Economies of scale Mutual Exchange