Saving States from Themselves

In the new issue of the New Yorker, James Surowiecki has an article comparing the debt problems of our states to the member states of the EU. Surowiecki points out that unlike European states, our states get "automatic fiscal stabilizers" from the federal government, which eases the problems.

But for all that, I think he's rather too sanguine about the fortunes of American states. For one thing, while it's true that the US government has greater institutional capacity to transfer money from feds to states, Europe may have a larger incentive. If a member state defaults, the euro may well go under, causing havoc across the eurozone as their currency falls apart, and lenders start demanding currency risk premia. If California defaults . . . well, a bunch of other states will get the fish eye from the financial market, but this probably won't translate up to the national level.

Perhaps more importantly, I think he dramatically underweights the risk of moral hazard:

All this aid comes at a price, of course: it increases moral hazard, and it increases the national deficit. But the federal government is able to borrow money at exceptionally cheap rates, and, at a time like this, when the economy is still trying to find its feet, forcing states to cancel building projects and furlough teachers and policemen makes little economic sense. (Indeed, there's a strong case to be made that more of the original stimulus package should have gone to state aid.) The European model would do more harm than good, as American history shows: in the early eighteen-forties, after the bursting of a credit bubble, many states found themselves in a debt crisis. The federal government refused to bail them out, and eight states defaulted--a move that cut off their access to credit and helped sink the economy deeper into depression. The U.S. did then what Europe is doing now, putting the interests of fiscally stronger states above the interests of the community as a whole. We seem to have learned our lesson. If Europe wants to be more than just Germany and a bunch of other countries, it should do the same.

The moral hazard involved is no small thing. We've already introduced quite a lot of it into the banking system, but at least the CEOs of those banks got the sack, and the rest have some genuine fear that regulators will get more involved in their business. The Federal government is constitutionally prohibited from the kind of prudential regulation that would be necessary in the wake of bailouts.

This is particularly worrisome because of the nature of the state problems. This is not a classic sovereign debt issue, where there's a giant overhang of high-interest bonds that can be renegotiated at a haircut, or bought down by money from outsized sources. What the states have is a bunch of other obligations, especially to current and past employees. I don't see how these can be bought down, and there are substantial legal and political (not to say moral) issues with asking, say, current pensioners to "take a haircut."

If the feds bail out these states, they're assuming an ongoing obligation--and encouraging other states to let their fiscal problems get as big as possible, so Uncle Sugar will have to pay off. Leaving aside any ideological questions about robbing Peter to pay Paul, and the proper size of government, the federal government simply cannot afford to take on all these new obligations--and if it did, its ability to borrow money would rapidly become unsustainable.

Sure, there's nothing wrong with giving states temporary assistance to keep the recession from hitting too hard--but we're approaching the point where that's not really what we're talking about. We're talking about letting states make big promises without bothering to find sustainable sources of revenue with which to pay for them. That's not something the federal government can afford to encourage.