The Moral Hazard of a State Bailout

By Megan McArdle

If the government does bail out the muni bond market, how should it go about things?  The initial assumption is that they'll only guarantee existing debt. Otherwise, it would be like handing the keys to the treasury to every mayor, county board, and state legislature, and telling them to go to town.

But once the treasury has bailed out a single state, there will be a strongly implied guarantee on all such debt.  So you don't give them the keys to the vaults, but you do leave a window open, point out where the money's kept, and casually mention that you've given the armed guards the week off.

I don't see how the government can make a credible committment not to bail out various localities who overspend, if it's already done so.  And if that's the case, there's no way to avoid the moral hazard, so we might as well go ahead and offer the explicit guarantee in exchange for some sort of say in how the money is procured and spent.

Farewell, Federalism . . . we hardly knew ye

This article available online at:

http://www.theatlantic.com/business/archive/2009/05/the-moral-hazard-of-a-state-bailout/17921/