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Thursday, April 30, 2020

State Bailout Coming

I have predicted a federal bailout of states for the past ten years. Ever since the European Union and the European Central Bank bailed out euro-zone countries in the aftermath of the Great Recession, I have persistently said that it is only a matter of time before the same happens here.

Illinois Senate President Don Harmon (D-Chicago) has sent a letter to all members of the Illinois Congressional Delegation, seeking $41.6 billion in federal money for the state of Illinois, and among their requests are cash specifically for state and city pension funds.
I have not been alone in predicting this. Back in 2012, Colorado-based economist Barry Poulson noted that a "silent bailout" of states was under way. What Poulson referred to was not the same type of blatant cash infusion into government coffers that the Europeans were engaging in at the time. However, we now seem to have reached that point. Reports the Washington Times:
House Speaker Nancy Pelosi said Tuesday that funding for state and local governments could come in two packages. In a press call with reporters, Mrs. Pelosi, a California Democrat, said she's still discussing funding levels with Republican and Democratic governors, but is considering splitting up the funding in the next coronavirus aid legislation phase. She's considering giving $500 million for states and a "very big figure" in additional funds for county and municipal governments. All of that would be separate from money Democrats want to funnel into Medicaid.
All of this money will, of course, not come from the U.S. Treasury, but from the Federal Reserve. We are heading down a path toward negative interest rats - a path that will have very serious repercussions for our economy going forward. If this was a one-time infusion of cash, especially a loan from the federal government, there could have been practical common sense in it, but we are not looking at a temporary fiscal problem at the state level.

We are looking at a hidden budget deficit that is rarely mentioned in the public debate. And it is not a small one: as Figure 1 explains, states and local governments have been running a combined deficit for the past 40 years. Needless to say, some states have strong finances while others are deep in the red, but that is - unfortunately - of less importance in this context. As much as Senate Majority Leader McConnell (R-KY) wishes to avoid a "blue state bailout", at this point it is pretty much a done deal that states and local governments can now look forward to some big checks from the federal government.

To get an idea of how big those checks would be, as Figure 1 explains, states and local governments fund well in excess of six percent of their spending with borrowed money. These are jurisdictions that cannot even monetize their own deficits, and almost without exception operate under balanced-budget mandates:

Figure 1
Source of raw data: Bureau of Economic Analysis

The help now being discussed is motivated by extraordinary spending increases and revenue losses due to the coronavirus epidemic and lockdowns. However, one does not have to look farther than the request from the Illinois Senate president for $41.6 billion to see what this is really about: a concerted effort by states and their local governments to obtain far more money from Congress than what would be motivated by the costs related to the current public-health situation.

It is about clearing pension debts from the books, and about covering ongoing deficits. The latter is the most urgent problem (pension debts are by definition not due until in the future) and not one that is solved with a one-time infusion of cash. As Figure 1 shows, our states and local governments, again in the aggregate, have been unable to pay for all their spending for a very long time now. That is not going to change with a one-time cash infusion, even if it is a "very big figure". 

In fact, federal money could easily worsen the situation for states and local governments. Their dependency on, respectively, federal and state money has been growing over time and is now at substantial proportions. There are strings attached to the federal funds going into state budgets, strings that require states to spend "matching funds" to keep the federal money coming.  This has in turn driven up state spending beyond what taxpayers can afford; it is conspicuous how the structural deficit in state budgets emerges soon after Medicaid has become a full-fledged program.

Figure 2 reports state-revenue shares from taxes, other in-state revenue and federal funds: 

Figure 2
Source of raw data: Bureau of Economic Analysis

With the federal government already providing a third of state-government revenue, one can only imagine what that share will be if the bailout now being proposed turns into a permanent restructuring of federal aid to states. However, of even more concern is the point made by Speaker Pelosi in the quote above, about how she and the Democrats are considering sending the really big cash straight down to local governments. They are already fiscally dependent, though not on the federal government.

Not yet, at least.

Figure 3 reports the revenue shares for local governments: while only a marginal stream of their cash inflow is from the federal government, they get almost 40 cents of every revenue dollar from states. A good part of this money is for education, but in some states Medicaid funding is passed through state coffers and down to counties. There are also examples of how welfare is run by counties, funded in part with federal money in a manner similar to Medicaid.

Figure 3
Source of raw data: Bureau of Economic Analysis

If the federal government now creates a bailout directly for local governments, there is a substantial risk that this turns into a new, permanent funding program. If so, it will have all sorts of repercussions. Just consider these two for now:

1. Centralization of government powers. For decades, we have been drifting in the direction of an increasingly centralized government structure. While constitutionally we remain a federation, we are fiscally more of an "entangled" government than anything else. It does not take much of federal-funds expansion to tip the scale permanently: as soon as half of state and local government revenue comes from the federal government, there is no longer any point of calling them independent. There are cities in Germany that get 75 percent of their funding from the federal government in Berlin; while inconceivable today, if this bailout becomes a permanent program we are looking down the same path here.
2. Out-of-control deficit. Already before the current economic disruption, Congress was borrowing almost one quarter of every dollar it spent. If a state-and-local government bailout turns into a permanent program, the spending obligations that come with this would be enormous. The structural federal deficit could easily blow up from $1 trillion to $1.5 trillion, down the road having extremely serious consequences for our economy. There is no way the Treasury can sell that big a deficit on an ongoing basis - without monetizing it. And printing money at that pace is a recipe for hyperinflation and macroeconomic destruction.

There is a lot more to be said about this bailout idea. For now, let us just hope that fiscally conservative members of Congress can prevail and put brakes on the current spending frenzy.

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