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How Should Governments Respond to the Next Budget Crisis?

A new book by Yale law professor David Schleicher explores the benefits and drawbacks of various responses to state and local debt crises. It’s a trilemma that leaders will face again and again, Schleicher says.

September,28,,2014,-,Upstate,New,York,Erie,Canal,Locks
A lock on the Erie Canal, which was built at a time when states were more willing to borrow money to build infrastructure. That willingness to invest ended in the 1840s when several states defaulted.
(Gene ploss/Shutterstock)
Financial crises in state and local governments are a feature of American history, going back to the country’s earliest days. And every individual crisis challenges leaders at higher levels of government with a choice of how to respond. When a city faces a budget crisis, a state has to decide whether to allow the city to default on its debts, force it to cut services to the bone or offer direct financial aid in the form of a bailout.

Federal officials face the same challenge when dealing with states in financial crisis. All three options have benefits and drawbacks, as David Schleicher, a professor at Yale Law School, describes in his new book, In A Bad State: Responding to State and Local Budget Crises. Acknowledging those tradeoffs can help local leaders balance the harms that come with every crisis, Schleicher says.

Schleicher has written and lectured widely on issues of legal theory and local government, including the challenges of local land use and zoning reform. One recent paper argues that the National Basketball Association should create a “Basketball Court,” “a somewhat-independent adjudicatory body that uses the tools of judicial decision-making to interpret league rules in a consistent way.” He is co-host of "Digging a Hole: The Legal Theory Podcast." Schleicher also professes to have been a reader of Governing magazine for as long as he can remember. He recently spoke with Governing about his new book. The conversation has been edited.

Governing: One of my favorite corner bars here in Philadelphia has a sign that says, “Price, Quality, Service: Pick Any Two.” I thought about that when I was reading your book because you use a similar formulation when talking about the potential responses to state and local debt crises. What’s the trilemma you’ve described? 

David Schleicher: Trilemmas have a long history in social science. The basic idea is that a federal policymaker faced with a state or local fiscal crisis has three goals, but they can’t achieve all three. They want to avoid austerity, because state and local budget crises usually come during recessions and cutting spending during recessions is bad for a lot of reasons. They want to avoid defaults, because defaults make lenders less willing to lend to that jurisdiction and to other jurisdictions, which can interfere with future infrastructure development. And they want to avoid moral hazard, because they don’t want state and local officials to get used to bailouts, and they particularly don’t want lenders to get used to bailouts.

The problem is that whatever policy they choose, they can’t achieve all three goals — at least not completely. If they offer money, they can help avoid defaults or austerity but they create the risk of moral hazard. If they stop defaults but they don’t offer aid then they create the problems of recession and austerity. And if they encourage defaults, which they have at different periods, then they avoid moral hazard and they avoid austerity, but they create this other problem of harms to the municipal bond market.

The book doesn’t offer the optimal answer to every fiscal crisis. But it does say, these are problems that will emerge no matter what, and you kind of have to pick your poison and come up with a way to minimize the downside of whatever choice you make.

Governing: One thing that comes through clearly here is the degree to which the health of the municipal bond market is connected to infrastructure investment broadly. Can you say a bit more about how defaults affect those things? 

Schleicher: For almost all of American history the federal government has been a minor player in infrastructure. It’s gone up and down in different periods, but for the most part, state and local governments have built and funded a large percentage of infrastructure in America, particularly if you take into consideration maintenance and operations. So from the beginning of the country we’ve largely let states and cities do the building, but states and cities don’t have the fiscal capacity of the federal government. They have to keep balanced budgets, for both legal and practical reasons. They can’t print money; they need to borrow in order to build. It’s the same reason why you borrow to build a house. You’re going to use it over a long period of time and it makes sense to spread the cost among the periods of use.

The federal government cares very much that states have the capacity to borrow and build because the whole economy of the country depends on these infrastructural investments. The result is that state and local defaults, which harm the ability to borrow, create harms for the jurisdictions that default and for other jurisdictions, because lenders become more skeptical of state and locality municipal bonds as a class. When you’re in a crisis, you have to choose among harms. Defaults are bad, but so is austerity and so is moral hazard. It’s a choice among harms, but defaults are not a free lunch.

Governing: What’s an example of a time when the response to a debt crisis led to a seizing-up of infrastructure investments? 

Schleicher: I’ll give you two examples. In the 1840s, a bunch of states defaulted. Not only did investors become less willing to invest in bonds issued by those states, but because the crises were so bad, the states enacted really sharp limits on their own ability to borrow. This is where the original debt limits and balanced-budget rules come from. The result was that from the 1840s until basically the rise of the automobile, state governments were an extremely minor player in infrastructure. Local governments kept borrowing, but state governments were out of the picture for the most part. That was in really striking contrast with how things worked before, when state governments were building things like the Erie Canal.

Another example I find really interesting is that in the aftermath of Reconstruction, when newly white-dominated governments took over state governments, almost all of the southern states defaulted on almost all of their debt. Southern states and later southern cities were not able to borrow on national bond markets anymore, for many, many years. There are a lot of reasons why the South didn’t develop as quickly economically during the 19th and early 20th centuries, but one of those reasons was that you saw a real inability to borrow money and build infrastructure.

Governing: We’re seeing a lot of transit systems on the verge of big budget crises in the next couple years. The federal government has already stepped in three times in the last few years to offer support and people aren’t expecting much more federal support at least in the short term. So how can state or local officials think through what they should do about transit? 

Schleicher: This is not an uncommon problem in American history. Something structurally changes in the economy, and it leaves entities with too big a set of services for the existing demand for those, or the inability to support those services. That can be because people move out of a place, or because you’re Detroit and suddenly cars are being produced in the South and in Japan or wherever. It used to be that lots of people rode the subway and now fewer people ride the subway. But you have a debt system and, by the way, a system of offerings, that are out of whack with the current demand for them.

One of the things about systems of managed default, like bankruptcy, is they help jurisdictions deal with the debt overhang problem. You can do the same thing with aid. You can pay off the debt and say, "It’s not your fault, transit agency, that COVID happened and people work from home now." But what you want to do when addressing these problems, whether it’s done with default or it’s done with aid, is to get the institution on a stable footing going forward. Get it used to its current situation.

With transit it’s a little more complicated, because, at the same time that we’ve seen this huge decline in demand for transit, there’s a huge perceived social need for increasing the availability of transit to deal with climate change risks. You have a really difficult set of questions. For the perspective of making the transit agencies fiscally sound going forward, they actually need to be doing less, and relatedly have less debt.

On the other hand, if we want them to do more, then higher-level governments are going to need to offer aid, and not just on a one-time basis, but on a going-forward basis. The question with transit agencies is, do you as a state official or state legislature want to make the agencies able to function with their existing resources? Or do you want them to do more or do the same with less of their own revenue? And if you do, then you’re going to have to provide a lot more money.

Governing: You emphasize how every debt crisis is a little different. There’s not a common cause — it’s not always irresponsible budgeting or a pandemic, for example. Does that make it harder to develop solutions to these things in a programmatic way? 

Schleicher: What I hoped to do with the book is not say, "Here’s what you should do, Congress, in each of the next 9,000 state and local fiscal crises." It’s to say, "Here are the questions you should ask, and here are the considerations you should take into account when designing whatever choice you make."

Once they ask the questions, they can assign weight to them however they want. That’s going to depend on conditions but it’s also going to depend on their underlying values. For instance, austerity creates real harm for people right now, but the ability to support infrastructure in the future creates benefits tomorrow. That’s about how much you weigh today versus tomorrow. There’s a completely plausible range of values we can have around that. I don’t attempt to answer for anyone how much we should value the future; that seems like a little much for a short book. But it tries to indicate the way to think about the problem and tries to respect the reader and policymakers enough to say, here’s what you do, conditional on whatever it is that you think.

Governing: You acknowledge that people of different ideological stripes are going to land on different legs of the trilemma at different times. Do your own ideological leanings influence your analysis on this too? 

Schleicher: Of course. You can’t make arguments without having beliefs behind them. What I’m hoping is that there’s just going to be more agreement about these things than there would be about the underlying question. The question of whether the federal government should offer aid to states in crisis is something that people’s ideological priors map onto extremely clearly. There are a lot of policy issues that don’t correlate neatly with Democrats and Republicans. I’ve been very involved with some of the pro-zoning reform movements. This doesn’t correlate with Democrats and Republicans all that neatly. You see Republican-led land-use reform efforts and Democrat-led land-use reform efforts, but you also see opposition from both Democrats and Republicans. I wouldn’t say that the proposals in the book are ideology-free, whatever that would mean. Just that they are not the same questions as some of the most fraught ones that hit this area.
Jared Brey is a senior staff writer for Governing. He can be found on Twitter at @jaredbrey.
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