Nine decades ago, Supreme Court Justice Louis Brandeis popularized the concept that states can be laboratories of democracy, which has morphed over time to include local governments. In 2020's COVID-19 pandemic recession, the concept has taken new meaning on several fronts, ranging from the procurement of personal protective equipment to municipal fiscal relief for residents and businesses. As the nation enters a pandemic dark winter, many local COVID relief efforts are surfacing in these diverse "laboratories."

While federal pandemic relief and the debate over a new round of federal aid get the most media attention, there has been plenty of action on the state and local level as well. More than $9 billion had been funded by states, municipalities and community organizations for small-business relief as of mid-October, according to the Institute for Local Self-Reliance. It has tallied more than 800 such programs, most of them originating in cities and counties and many of them tapping taxpayer funds rather than simply channeling federal CARES Act aid.

As the pandemic recession continues to crush local businesses, we are likely to see more of these initiatives, and it is these local laboratories of democracy that deserve attention: These programs need to be carefully structured so that they make effective use of the funds they disburse while protecting the taxpayers' interests.

The role of government in the private sector is always going to be a contentious topic. Free-market advocates loathe governmental intervention directly into private business. Yet many politicians, including Republicans, make exceptions for what they consider "edge cases," wherein a bailout or lifeline is essential to the broader public interest. At the state and local level, even traditional "chamber of commerce" conservatives nowadays favor loan programs for small businesses and startups, which are a core constituency of their party.

With respect to lending and investments by states and localities, it is worthwhile to return momentarily to the history of the 1850s and the admission of the western states to the U.S. Back then, railroad barons and nefarious industrialists had found their way to the public troughs to finance their capital-intensive ventures. The resulting scandals became so stinky that authors of the California state constitution included an article that prohibited "giving or lending public funds to any person or entity, public or private." Several other western states followed suit. But a century later, these legal restrictions became so confining that some states had to either tweak their constitutions or find legal workarounds to enable their public pension systems to invest in common stocks and their cities to establish redevelopment agencies.

In the context of the current pandemic recession, it is not my purpose to declare loans and grants to businesses by states and local governments to be illegal or inadvisable, but rather to remind us that there were good reasons laws were written over a century ago to block raids on public treasuries. One need only hypothesize the case of a mayor's campaign donor down on her luck because of COVID and seeking grants or loans from a municipal assistance fund to see the potential for corruption.

Step back and imagine yourself the owner of a struggling local business who watches a competing business win a local grant or loan funded by your own tax dollars. It doesn't take much imagination to see the opportunity for mischief, resentment and controversy.

Despite all these red flags, my firsthand investment experience is that federal COVID aid to small businesses, including numerous startups in my local area, has saved many of them and the jobs they provide from extinction. And despite its multitude of abuses, the federal paycheck protection program has clearly helped keep millions off of the unemployment and food-bank lines. Likewise, most of the local money provided to businesses has surely performed a valid public purpose of averting shutdowns that ripple through local communities and their economies. The issue now deserving deeper thought is structural, precautionary and process-oriented.

Just as the U.S. Treasury benefited from the sale of stock in General Motors after the federal bailouts in 2008 and 2009 saved that company from bankruptcy, so should local governments that extend subsidized loan terms to struggling businesses require an equity stake. If the company weathers the COVID storm and ownership proves profitable, shares can be sold to provide seed corn for a revolving loan fund to stimulate new business startups or provide distress funding in the next recession.

The approval process for such financial interventions must be kept independent of the politicians and their appointees. Public-purpose objectives should be explicitly established and verified. Competing local businesses and potential adverse impacts should be identified. Ideally, a local community could establish a nonpartisan, targeted principles-and-rules-based trust fund structure to administer loan, grant and community reinvestment programs with oversight structures that include a pre-approval process for independent review of the applications that have been screened by professionally skilled and competent volunteers.

Every company seeking such local fiscal aid should provide a written business plan with reliable track record data, explicit milestones, credible financial projections, ancillary community-level benefits and a board with relevant independent directors. Where possible, a sliver of matching funding from a traditional financial institution should be required, even if it is given seniority over the public money. As with some of the new federal housing agency debt structures, at least one new financier should be required to accept subordinate status in the capital stack. These arrangements would help assure taxpayers that the business is investment worthy with a reasonable shot at survival and success.

This field is new ground for municipal finance. We should cheer on these experimenting laboratories of democracy. But let's just make sure they read and follow a safety manual so that none of them naively or nefariously cause a chemical explosion in their lab.


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