After Wall Street and Detroit, the next bailouts will focus on Albany and Lansing. In the face of shrinking revenues and balanced budget requirements, states are facing record budget shortfalls. Governments are offsetting deficits by raising taxes, firing workers and cutting funding to every project in sight.
So while the incoming Obama administration is planning a massive federal stimulus package, the states are busy doing the opposite: reducing jobs and spending just as we need more of both.
Governors are currently asking for more than $1 trillion from the feds just to meet their current obligations. This bailout will be less controversial than those of GM, Bear Stearns and other private businesses. After all, the villains are harder to identify and the costs of doing nothing seem intolerable.
But if this trend is to be reversed, then legislators must address a century-old source of inefficiency. Here's how we propose they do this.
State governments rely on revenue sources that are highly sensitive to the ups and downs of the economy, yet their constitutions prevent them from borrowing to fund deficits during recessions. Various factors, including legal restrictions on revenue growth, undermine saving during good times.
This leads to a familiar pattern: Every time the economy suffers, states fire social workers, teachers and police officers. They cut social services to the poor. They stop building highways. This boom-bust pattern of public finance leads to inefficient resource allocations, which hurts the most vulnerable in our society and deepens recessions.
Erik Wibbels
The pattern also leads to periodic calls for federal bailouts of state governments.
But as with any bailout, the cost goes well beyond the price tag. The danger is a massive federal transfer to the states sends the signal that the federal government provides a guarantee for state obligations. When the smoke clears from the current crisis, creditors would be encouraged to lend, and states to over-spend, all at the ultimate expense of the federal taxpayer. State borrowing under such conditions in Brazil and Argentina led to massive bailouts and economic crises in the 1980s and 90s.
To make matters worse, our emerging system of ad hoc bailouts is subject to Congressional horse-trading, with the money arriving too late to provide much stimulus. Moreover, states have incentives to game the system and position themselves to maximize their bailout, for example by pleading poverty and halting all highway construction, as California has recently done.
Our current predicament has its roots in the 1840s, when a severe recession hit a group of states that had borrowed aggressively. Then, as now, governors and bondholders demanded federal bailouts. The federal government resisted, and a number of states defaulted, clarifying for everyone the lack of federal guarantees for state obligations.
The states ultimately returned to solvency, in part, by introducing the constitutional balanced budget requirements that still bind them today.
The resulting system of autonomous but credit-constrained state governments produced admirable fiscal discipline for more than 150 years. But the increased role of states in the provision of public services during that period has made the unavoidable boom-bust fiscal cycles increasingly unpalatable during recessions. The aloof federal response of the 1840s appears unlikely this time.
Even if the bailout cannot be avoided, now is a good time to lay out the architecture for a better system that places the states on firmer fiscal footing. At a minimum, let us replace ad hoc, politicized and delayed bailouts with a predictable and transparent system of federal grants that combat recessions. The federal government already distributes grants to the states for programs like Medicaid and infrastructure investment. Why not build a simple system of automatic stabilization into those grants? During good times, some share of federal grants would be held back, and when recessions hit, grants would automatically increase according to a clear system of rules.
The states most severely hit by recessions would receive larger shares of the grants, but the duration of the transfers could be explicitly limited to prevent them from serving as permanent subsidies to states in long-term decline. There would be no lengthy battles over earmarks or ideology, no waiting for inauguration day.
Such a reform should appeal to liberals concerned with the impact of recessions on public services and the poor, and to fiscal conservatives who recognize that ad hoc bailouts produce bad incentives. And transfers could be smoothed over the business cycle in a depoliticized, transparent way so that bailouts lose their appeal.
It simply makes no sense to fire school teachers during recessions. But rather than quickly handing billions in ad hoc bailouts to the states and creating the expectation of more in the future, the incoming administration should push for a comprehensive, rule-based system to manage future recessions.