A key impediment to achieving a congressional compromise on COVID-19 relief and economic stimulus is the level of aid to be given to states and local governments. House Democrats have dropped their $1 trillion proposal from last May and now promote a half-trillion-dollar package for states and localities, which still makes Senate Republicans gag. Many GOP leaders continue to rail against what President Trump calls "Bailout Money for poorly run Democrat cities and states" and underwater public pension funds, which actually have nothing to do with the economics of pandemic revenue shortfalls, as I explained in a column in April.

Nonetheless, to assuage politicians, voters and taxpayers that fiscal aid to state and local governments will not just invite endless lobbying for bailouts in the future, Congress can include two provisions in the pending stimulus legislation to make the level of federal aid to a state or locality contingent on practices that promote sound intergovernmental fiscal management. The first is a requirement for states and municipalities to annually pay into rainy-day funds to prepare for inevitable future cyclical recessions. Second is a partnership with those state and local employers who agree to make clearly serious moves to whittle down massive underfunded pension liabilities.

Rainy-day funds are not new, but their structures and funding vary significantly among the states and municipal governments. Although some policy guidance is provided by professional associations, none of these guidelines are binding. What we do know from 2020 is that the jurisdictions with healthier reserve balances were better able to weather the initial COVID-era revenue shortfalls than those who were caught "swimming naked when the tide went out," as Warren Buffet likes to put it.

Business cycles are a predictable fact of life in a capitalist economy, and extraneous non-cyclical crises such the COVID-19 recession come along as well. They are akin to the inevitable but unpredictable hurricanes and floods that increasingly swamp low-lying properties in floodplains, and that analogy applies here. Congress requires homeowners in designated floodplains to secure federal flood insurance to protect both the borrowers and the government from recurring natural catastrophes. The federal government cannot fully fund revenue shortfalls of states and localities in every future financial crisis without worsening a deepening deficit and inflation risk at the national level, so it's time for Congress to require what might be called "federal fiscal flood insurance."

In the current context, this means that prospective governmental recipients of federal COVID-19 relief funds should be required contractually to agree that they will establish rainy-day funds that receive annual budgetary contributions of at least 2.5 percent of their operating budgets in periods of economic expansion, to be used only during recessions or other qualifying emergencies. Business cycles in the U.S. since the 1980s have been averaging seven years in expansion phases, so that formula would enable these jurisdictions to eventually accumulate a rainy-day reserve of approximately two months' worth of annual expenditures, which is the guideline suggested by the Government Finance Officers Association. Failure to meet these contractual milestones would disqualify the deficient entity from future federal countercyclical and disaster aid.

Liberals may object that this one-size-fits-all formula overlooks economic and demographic disparities, that poor communities will be disproportionately punished by requiring them to save for a rainy day. Progressives would point to favored social programs that the GOP derides, objecting that they would play second fiddle. But this arrangement empowers nonpartisan and centrist state and local officials to explain to these constituencies why budgets must provide for inevitable downturns as well as their causes.

As for the pension funds, a "tough love" compromise solution is the fix that we need. In return for federal fiscal aid, Congress should establish a 15-year contractual reform program for state and local government employers to pay a chunk of their accelerated annual employer pension contributions just for unfunded accrued liabilities. These employer payments can consume 10 to 20 percent of payroll for many struggling employers, and can exceed 30 percent for the shakiest plans. Congress could pay a third to half of those costs. For those opting in, this formula could fully fund today's public pension debts before 2040, instead of kicking the can to unborn taxpayers.

To qualify, public employers would have to limit future pension benefits to formulas similar to (or below) those established by California in its 2013 pension reform law, for both new hires and incumbent employees' unvested service. Investment assumptions cannot exceed the national averages. For the so-called "FICA free lunch" public employers that historically opted out of Social Security, new employees should have to also join that system, with a commensurately adjusted pension formula. Public employers could still offer sidecar 457, 401 or "cash balance" plans so long as these supplemental plans cannot burden taxpayers with future contingent liabilities.

Recipients of federal aid tied to these pension reforms must first stop digging the hole by limiting their pension formulas to sustainable metrics that should never again require taxpayer bailouts. It's true that public employers would still have to negotiate new retirement-plan provisions with their union counterparts, so unions thus could block participation in an offer with such strings attached, but the fault thereafter would be theirs and not the employers': Workers would have to live with the inevitable salary and hiring freezes or staffing reductions that ultimately result from escalating pension costs when unfunded liabilities swamp their systems.

Historically frugal public employers and anti-government conservatives may object to federal bailouts of "poorly managed" underwater public pension plans, but this problem will never go away simply because they yammer about it. These derelicts are the fiscal equivalents of Environmental Protection Agency (EPA) Superfund sites, and the blame game solves nothing. Now is the last chance in their lifetimes for Baby Boomers collectively to foot their share of the intergenerational obligations they ran up. This compromise shares the pain and the gain all around, and nobody can dispute that the end result is in the public's best interests.

At the end of the day, state and local governments, as well as their national policy associations, must come to grips with the increasingly evident reality that Uncle Sam cannot forever come to their rescue with endlessly borrowed money at every bump in the road. Until Beltway politicians put their own federal fiscal house in order and tame the mounting national debt, the U.S. capacity for intergovernmental aid will weaken further, and it will be the local taxpayers, public employees and retirees who ultimately suffer. It's time for bipartisanship, realistic economics, intergenerational equity, fiscal prudence, tough love and post-election healing in our dynamic federal system.


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