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Coping with State and Local Fiscal Distress

Chris Pope Senior Fellow, Manhattan Institute
David N. Schleicher Professor of Law, Yale Law School
David Skeel S. Samuel Arsht Professor of Corporate Law, University of Pennsylvania Law School
Allison Schrager Senior Fellow, Manhattan Institute
Thu, Jul 23, 2020 EVENTCAST

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Coping with State and Local Fiscal Distress

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Coping with State and Local Fiscal Distress

Chris Pope Senior Fellow, Manhattan Institute
David N. Schleicher Professor of Law, Yale Law School
David Skeel S. Samuel Arsht Professor of Corporate Law, University of Pennsylvania Law School
Allison Schrager Senior Fellow, Manhattan Institute EVENTCAST 01:00pm—02:00pm
Thursday July 23
Thursday July 23 2020
PAST EVENT Thursday July 23 2020

The coronavirus crisis is becoming a fiscal disaster for America’s states and localities. States alone are facing at least a half-trillion-dollar budget shortfall. Essential public services risk being crowded out by everything from growing pension obligations to mandatory federal entitlements.

Governments, including New York’s, bare are now desperate for aid, but Congress has been wary thus far to send additional financial support. How should governments aid each other in this time of crisis? What are the right policy solutions when budget shortfalls intersect with chronic overspending or insolvency?

On July 23, the Manhattan Institute hosted discussion on how states and localities are coping with fiscal distress with Yale Law’s David Schleicher, David Skeel of the University of Pennsylvania, and the Manhattan Institute’s Chris Pope and moderator Allison Schrager.

Event Transcript

Michael Hendrix:

Welcome to the Manhattan Institute's event on coping with state and local fiscal distress. I'm Michael Hendrix, Director of State and Local Policy here at the Manhattan Institute. We're joined today by a stellar panel of experts on law, finance in the public sector to consider the enormous fiscal pressures facing America's cities and states, as well as the considerations Congress may take in aiding them.

Michael Hendrix:

Throughout our program, please enter your questions in any of the platforms you're watching us on and we'll wrap them into the discussion. Also, please consider subscribing to the Manhattan Institute's newsletters or making a contribution to our mission. We've posted links for doing so right on the screen in front of you.

Michael Hendrix:

Now, for our moderator, Allison Schrager. Allison is a senior fellow at the Manhattan Institute where her research focuses on public finance, pensions, tax policy, labor markets, and monetary policy. She is also the author of An Economist Walks into a Brothel and co-founder of a risk advisory firm. Before that, Allison worked as a journalist at courts also worked in finance, consulted the international organizations and wrote for a host of prominent outlets. Really, if you haven't read her work yet, stop what you're doing after this event and start reading up. Now, Allison, over to you.

Allison Schrager:

Hi. Thank you. Let's get right to it. I'm sure everyone's anxious about this pressing questions that we're going to address. As you might have heard, states are facing unprecedented budgetary pressures. The budget shortfall is expected to be between $600 billion and $1 trillion between now and 2020. But even before the pandemic, a lot of states were facing a lot of financial stress between pensions and Medicaid and falling tax revenue.

Allison Schrager:

Now, the situation is obviously a lot more dire now that we're having a bigger shuffling of where people are living and sort of unprecedented unemployment. As you might expect there are repeated calls from governors all over the country that they need a federal bailout, which has now incited all the sort of usual rage between red states and blue states and even calls for bankrupt, state bankruptcy.

Allison Schrager:

We have a terrific panel. I can't imagine a better group to discuss these issues. We have Chris Pope, a senior fellow here at the Manhattan Institute. He's an expert in healthcare policy particularly Medicare and Medicaid and an expert on federalism as well as being a political scientist. He is the author of many influential op-eds and reports and has done the rounds in DC and many think tanks. He has many great insights for us.

Allison Schrager:

We also have David Schleicher, a professor at Yale Law School who's an expert in election law, land use, urban government, federalism, state, and local finance, and municipal bankruptcy, and urban development. So, everything we need to worry about, he's published widely on this. He's a very sort of well-known voice on all the sort of nuances and problems with bailouts and bankruptcy.

Allison Schrager:

Finally, we have David Skeel, a professor of law at University of Pennsylvania, who is I think of the go-to person when I think about state bankruptcy who's written widely on this in a very sort of thoughtful nuanced way, but he also has expertise in corporate bankruptcy, Christianity and the law. He's written numerous books, commentaries all the top places. I expect this is going to be a great discussion.

Allison Schrager:

Please, add questions. I think we all love sort of a thoughtful discussion with as many people as possible, but I'm going to jump right in. I was thinking we'll start by thinking about sort of the short-term crisis. Then, as the discussion evolves think more about sort of long-term reforms, maybe things that should have happened anyway. Because what I see happening is a lot like a lot of economic trends we're seeing exacerbated.

Allison Schrager:

A shock like this seems to bring to the fort problems that were already happening, but just sort of to an exponential degree. It's not enough to really get through the current financial stress, we should also think about more long-term sustainable solutions. I think this is a very interesting time for federalism and maybe the world has changed in ways that we need to rethink how different states interact with the federal government.

Allison Schrager:

So, to jump right into the question everyone has, a couple months ago, Mitch McConnell suggested that states be able to file for bankruptcy and the world exploded. I saw Andrew Cuomo news conference where he was just deeply, deeply offended that this would happen under his watch. It was considered the most heartless thing.

Allison Schrager:

I mean I think a lot of individuals have sort of confused notions of what bankruptcy means. I'm going to go right to the expert, David Skeel of would states be better off right now declaring bankruptcy? Is that even possible and is that a viable option?

David Skeel:

So, to start with your last point. It's not possible at this point. The way to think about it I think is in the terms that you've already set up, short-term versus long-term. People freaked out I think when Mitch McConnell made that comment about state bankruptcy because they thought it was an either or, either Congress will provide some help for the states during the coronavirus crisis or there'll be state bankruptcy and that will be the only solution.

David Skeel:

I think they were just completely misunderstanding what he said. What he was saying as I understood it was he doesn't want to use the aid package to bail out problems that predate the coronavirus crisis, which personally I think is exactly the right approach. I don't think it's either or at all. It ought to be both end. For the short-term problems I think there ought to be some made to fill in the holes and state's balance sheets as a result of the economic crisis, but that doesn't solve the long-term problems.

David Skeel:

There are numerous states that have serious structural imbalances. I think bankruptcy ought to be an option for helping to deal with that.

Allison Schrager:

The other David, you wrote recently that the one argument against bailouts has been moral hazard, but you point out that we've actually fed some bailed out states continuously throughout history. You could argue that we've already had a form of bailout with the fed buying a lot of muni bonds. In the past have they encouraged moral hazard with these sort of backdoor bailouts we haven't seen and what do they normally look at [inaudible 00:11:52]?

David Schleicher:

So, first of all. Thanks for having me. The first thing I'd say is that the aid packages that are currently being discussed I don't think are properly understood as bailout. If you're giving money to every state there's no real reason to think this would create moral hazard because if you were a state that was well managed going in, you just get more money and unless you imagine some kind of satiation, but they can… If you're a Utah, you can spend it on tax cuts or new roads or whatever else you'd like to spend it on.

David Schleicher:

The kind of historically speaking, the federal government has done some bailout activity a little more than people think. In the New York City fiscal crisis, the federal government offered loans. They did some kind of back door thing during the Arkansas Road Debt Crisis of the 1930s. I guess most famously the federal government assumes state debts after the revolutionary and war of 1812.

David Schleicher:

The mistake I think most people make in thinking about federal responses to state and local fiscal crises is thinking that the federal government has one tool which is bailout or not bailout, but frequently they make choices about if they're not going to bail out how to allocate the harms where they should come up with mechanisms that make bondholders or other creditors liable or should all of the harm fall on today's taxpayers. We varied our approach over time.

David Schleicher:

In terms of among the things the federal government has done in this crisis the Cares Act State Aid I think is probably not thought of as a bailout, but the municipal lending facility is more bailout-ish than other things. In the sense that it targets aid exclusively at jurisdictions that are on facing more severe difficulties than others. The fed's program has been extremely limited exactly because they're worried about moral hazard I think. They've kind of approached the problems of states and cities the way that central bankers traditionally [inaudible 00:13:58]. Thinking about it as a liquidity crisis rather than a solvency crisis, providing emergency loans, short-term loans on kind of penalty terms.

David Schleicher:

I mean so far it's only been used by one jurisdiction, State of Illinois. I think that potentially the way they've designed it so far has not had any real, no reason to think it would have any effect on moral hazard or small effect on moral hazard and the traditional mechanisms for bailouts have also been limited in after other responses. If you take for instance the aid the state of Michigan gave to Detroit, it did after Detroit filled for bankruptcy. It did it after an emergency manager took it over, took over kind of democratic control.

David Schleicher:

The aid to Washington DC, which is probably the purest federal bailout in American history, this is the mid-90s came after a control board basically took over local democracy. There's no reason to think that most jurisdictions want to have local democracy suspended. There have been a few I'd say that maybe the most dangerous in kind of moral hazard terms bailout we've seen in recent years has been Connecticut's bailout of Hartford, which is just kind of quite generous in some ways.

David Schleicher:

That said, it came with limited conditions. That said, the other thing that might make moral hazard less is that the extent that jurisdictions are understood is exceptional, the situations understood as exceptional. So, when the federal government bails out Washington DC, no one thinks any other city in the country bears a relationship to the federal government the same that Washington DC does. It's both the capital, there's no local representation in congress and a few other things.

David Schleicher:

Similarly, we might think that to the extent that a bailout, it's bailing out institution can differentiate the recipients from other ones that there might be less moral hazard.

Allison Schrager:

So, Chris, you have expertise in a lot of these relevant issues, but for a second I'm going to ask you to put on, answer this as a political scientist, which is your training. You've been a long-time critic of federalism and it seems though right now federalism is at a rather critical point. I mean I think for no other reason and that we're seeing one state's choices impact the other in a variety of ways.

Allison Schrager:

We're also hearing a lot of sort of red state, blue state divides about red state saying, "Why should I bail out a blue state?" Then, blue state saying, "Well, we've been subsidizing you the whole time." I mean is any of these sort of criticisms fair? I mean how much have we been subsidizing each other and is anyone I say worthy of bailouts more than the other now?

Chris Pope:

Well, it's certainly the case that as a nation all our resources are somewhat pooled in the sense that we have a national income tax, we have national entitlements. We have national conceptions of need, national conceptions of what policy objectives ought to be, and then we funnel a lot of our activities sort of indirectly through the states which ends up muddling up these questions with a lot of other kind of extraneous purely political calculations.

Chris Pope:

Medicaid is probably the best example of this. We have a program that is in one sense designed as a safety net program for the poor, a way to support individuals who don't have access to care and provide and fund this care, but then we have a funding system whereby the federal government gives money to states according to how much the states themselves put in. The federal government ends up giving more money to the wealthiest states which ends up subverting the fundamental goal of the program which is to concentrate resources on those who need it most who are least able to pay for their own health care.

Chris Pope:

So, federalism I think has sort of a confusion of mission. Obviously, federalism was not something that the federal government initially sort of sat down and designed tabula rasa. The states pre-existed the constitution, they had political power going into the constitution, they insisted on certain rights just because they had power in the federal government when it was set up had to accede to this. That's basically been the case throughout American history through the 20th Century as the welfare state was set up.

Chris Pope:

It wasn't that we sort of designed the role of Medicaid optimally to have because states were better at distributing the money. It was ultimately because the states were powerful and they insisted on a role in the establishment of welfare programs and unemployment insurance considerations associated with Jim Crow were very substantial. The shape of the welfare state that we currently have is at one level sort of designed and intended to meet unmet needs and focus resources in unmet needs.

Chris Pope:

But at the other level, it's very much kind of cut through by these political calculations of states trying to gain resources for themselves, states trying to manage budgets and often states trying to shift costs to the federal government and trying to draw down as many resources as they can get from the federal government. There's almost an inherent invitation to moral hazard interspersed in programs that really in their justification there's no real need for that.

Allison Schrager:

You said something interesting. You're saying the rich or blue states actually get more federal money?

Chris Pope:

Yeah. The Medicaid the way the federal government allocates funds under Medicaid is it basically gives states… For most of the Medicaid program, the federal government provides between $1 and $3 for every dollar that states spend on the program. Now, again, in theory, it gives $3 for every dollar the poorest states spend and just a dollar for every dollar that wealthy states like New York spend, but in practice all states are constrained by their fiscal capacity, by their ability to generate their own matching funds.

Chris Pope:

The limit on every state's ability to spend on the program, there is actually no legal limit on how much they can draw down from the federal government. The only limit is how much they're able to raise in their own tax revenue and how much they would [inaudible 00:20:21] matching funds. It turns out that the difference between having a three-to-one ratio and a one-to-one ratio is outweighed by the variation and contribution between states.

Chris Pope:

You end up with a situation that the wealthiest states like New York, Massachusetts, Vermont consistently get often twice as much per capita as the poorest states that just don't have the ability to put up funds for this. It's particularly notable if you look like a state like Louisiana and contrast that with a state like Massachusetts. Louisiana actually has a higher share of its economy subject to state taxes, a higher share of state income subject to tax, about 10% in Massachusetts, which is about 9.75%, but because Massachusetts is so much of a wealthiest state, Massachusetts can claim more in federal benefits than Louisiana even though it's like making more of an effort in terms of collecting the revenues from its own citizens.

Chris Pope:

We have this fundamental sort of skew within our system of federalism where which kind of subverts the equity objectives that the federal government has with a lot of our entitlement programs.

Allison Schrager:

I don't think that's something that's very well understood at all. So, again, if you have questions, please type them in. We definitely want to make this a vigorous and wide discussion. You don't want to just tear up my questions because I'll probably fall into some sort of pension accounting hole. We want to avoid that.

Allison Schrager:

So, we have a couple, but I'm just going to a few more before we jump in. So, David Skeel, when I think about any sort of fiscal stress a state is going through, I tend to think of it as you have three different groups of creditors, because I think like an economist not a lawyer, which is you have citizens who consume services and you have pensioners and you have bond holders. Generally, the ordering goes is the citizens who want services get shafted first.

Allison Schrager:

I even would think of that as a form of bailout. You think you're going to have libraries and small class sizes, and then you don't. That's a form of a bailout and often that happens even before you're in sort of an official fiscal crisis. So, is that ideal? Is that why bankruptcy might be a better idea because if states in theory could just default? In that case, then who bears that pain?

David Skeel:

I think you've just articulated one of the best reasons to have a bankruptcy option and the important question which you've in a sense raised and answered is what happens if you don't have a bankruptcy option and the state is in severe financial distress? They don't live happily ever after, they have to adjust in some way and the typical way they adjust is by cutting services and the overall effect is that the pain of the distress ends up getting, in my view, visited on one or two constituencies.

David Skeel:

It's the service recipients first. It may be public employees because they get laid off at some point. That's what you're seeing in states like Illinois. They've really cut back their services in the last few years. The advantage of bankruptcy, one of the biggest advantages of bankruptcy as an option, you don't ever want a state to have to file for bankruptcy, but if the distress is severe and it is an option, the benefit of bankruptcy is that it distributes that sacrifice much more evenly. Everybody ends up sacrificing a bit.

David Skeel:

The bonds get restructured a bit. The pensions get adjusted a bit. Services may be tinkered with a bit and it is a much more equitable distribution of this sacrifice. I often say when I talk about this, although Elizabeth Warren would not agree with me on state bankruptcy I don't think, when she was a law professor used to argue that the equitable distribution of the sacrifice is a big benefit of bankruptcy. I think that would be the case with state bankruptcy as well.

Allison Schrager:

We have a question from Lee Rhodes and I feel like other David, this would be a good question for you, but if anyone else wants to weigh in with thoughts, please do. Her question is, do bailouts enable irresponsible governance?

David Schleicher:

In theory they can. This is the moral hazard argument which is like, if we bail out governments then they will act with, they will be more fiscally responsible in advance. The traditional response to that is first off, we don't generally do bailouts in the jurisdiction specific sense. So, we don't face this question. We don't have a ton of information on it.

David Schleicher:

The other thing is that we often give aid generally. Again, as people have proposed that it's unlikely that that would create irresponsible governance because, again, you get the money whether you're responsible or not. So, there's no particular reason to be irresponsible. The last thing is that the effect of bailouts and if you think about like what the IMF does or the World Bank went to structural adjustment, they frequently come with conditions and the conditions can be very painful.

David Schleicher:

So, if you think about Washington DC, it was, again, the purest federal bailout. The federal government managed to suspend state democracy. Again, it's not a state so they were able to do it. There are certain things they did or in Puerto Rico, it's a much more complicated story, but you see a similar thing in the creation of a control board which David can talk about being on the said control board. But the idea here is that if you're going to do straight bailouts of a particular jurisdiction as the say the state senator of Illinois suggested. It's extremely likely to come with conditions, and then in order to think about the moral hazard it creates, you need to think about it about the effects this would have.

David Schleicher:

The last thing I'll say about this is that discussions of moral hazard and the effect of any given bailout are often a little confused as far as I'm concerned in the sense that the belief that a bailout will create moral hazard is a belief that past experience will people project forward, but you might project forward from a failure to bailout also if it goes very badly. If the federal government thinks about not bailing out a jurisdiction and it then suffers a huge set of calamities, the next jurisdiction might think it will get bailed out because the federal government won't want to suffer from that.

David Schleicher:

The argument about moral hazard, you have to kind of build in a couple of interesting assumptions in order to flesh them out, but in theory, the answer is yes. There are other costs. There are cost to not bailing out. When a sub-national jurisdiction gets to the crisis point there are no good options because you're likely if you don't bail out, you're likely to create a huge amount of recession [inaudible 00:27:56] people are going to be firing lots of people into recession.

David Schleicher:

If you let creditors lose, you might imagine that will have effects on the municipal bond market and willingness to lend, and therefore, future state and local investment in infrastructure. If you kind of impose austerity, you're going to get a recession. So, when jurisdiction gets really far down the line, the federal government doesn't have a lot of good answers. Moral hazards are worry, but there are other worries also.

Allison Schrager:

I mean how worried should we be about moral hazard this time? I mean you could argue that this is like what we hope is a once-in-a-lifetime event or once in a historical event, although I mean I guess in the past we dealt with pandemics differently and we'll have them in the future, maybe this is our new normal, but it's probably hopefully a once in a lifetime event for everyone alive now. I mean is there sort of a free pass on moral hazard now?

David Schleicher:

The criticisms of state-specific bailouts take two forms and one is this moral hazard concern and the other one is why should I pay for your, why should I, sitting in Utah or Virginia or a well-governed state or a fiscally governed state be bearing the cost for you Illinois? Both of those things are present now as well as in other situations, in the sense that there's always a crisis coming at some point or another. There's always a recession. This is terrible but don't forget, we had the Great Recession 12 years ago on which was supposed to be a once-in-a-lifetime experience.

David Schleicher:

Being in better shape coming into a crisis is better than being in bad shape coming into it, and so there's still concerns, but I think that your basic sentiment which is that like there are a lot of problems now and moral hazard is one, but it's not the only one, and solving the recession is a major problem. We deal with the same type of problem in other contexts. Should we bail out the banks? Similar type question in a lot of ways.

David Schleicher:

We make short-term versus long-term trade-offs. We attempt to resolve. We attempt to design our bailouts in ways that reduce the harm. We attempt to differentiate the case as you suggest here, right? That we only do this in the case of pandemics. I think the case for state and local aid, especially I think for general state and local aid which create no real moral hazard concerns and is probably a pretty effective form of recession [inaudible 00:30:22] is extremely strong.

David Schleicher:

I think that you get into more concerns when you talk about a state specific. So, if we gave extra money to Illinois to deal with its crisis, then you run into moral hazard. That would be true now as well as other times because that would be true now as well as other times.

Chris Pope:

I do think it's actually possible and certainly been the case that you can have general moral hazard. Again, to sort of think about Medicaid. In each of the, I think the last four recessions, there had been a big Medicaid bailout of every single state across the board. We saw it in the Cares Act. We saw it in the stimulus in 2009, and then even before then in 2003. Every time there's been a major recession there's been a lot of funds distributed to every state.

Chris Pope:

I think there's a real moral hazard there in the sense that every state when it decides whether to expand eligibility, whether to extend benefits tends to be doing so when they're flushed with cash during economic upturns. The downside obviously is in a recession, your enrollment is going up. Your tax receipts are going down, and that's when you would be constrained, but if you know that there's a federal bailout likely to come just to sustain your ability to keep beneficiaries enrolled and I think the fact that this has happened in the last four recessions, each time with a higher matching rate for the bailout.

Chris Pope:

I think it pretty clearly is the case that at least in so far as the matching entitlements that the states have kind of figured out what's happening and got a little bit addicted to the bailout that they know is coming.

David Schleicher:

The thing I'd say is that for exactly that reason, the kind of general state grants are which go beyond the basis of either, like the effect that this tsunami has created, there be some effects or the number of COVID cases were ultimately that are based on population, don't bear any of those traits. Think about the 150 billion in the Cares Act, it doesn't have any of that trait because, again, it goes to you regardless of your prior state decisions, whereas the Medicaid, the increased match rate has a little bit, although it's still not state specific and you don't get into it having, it's not based on your failure to have raised taxes to pay for your benefits, right?

David Schleicher:

It's built on how much you spend, but not built around your level of indebtedness, whereas the most dangerous one, moral hazard, again, I am not one who thinks that moral hazard concerns are should be necessarily front of mind, but the closer it gets to aiming at prior debts, the more problematic it becomes in this respect. Again, you should think of it more as a continuum than as a on/off like a general verse specific.

David Schleicher:

I mean there are problems associated with this, but there are also benefits. I mean the benefit of increasing the Medicaid matches, that's the easiest mechanism for just giving general aid, which is… Again, because it goes to all states. We already have the system. It just sends money directly to the states and unlike the Cares Act, which put in some weird conditions that made it such that states and cities couldn't basically refrain from firing, the Medicaid money kind of just basically is cash for states.

David Schleicher:

The effect not doing it we've seen is that you've seen, so you see on the last jobs report states and cities have fired huge numbers of public employees, just giant numbers and this into a recession. You see places like Akron have furloughed about third of their public workers. That's really bad for the economy and is, in addition to that could be, it's also bad for the provision of public services. Right now we have fewer people working in state and local government than we had before the last recession.

Chris Pope:

Well, the problem, again, with Medicaid is that it rewards the wealthiest states. The first responders Medicaid bump like every uninsured person in Massachusetts got $7800. In Nevada, it was only $600 per uninsured. The difference between 7800 per uninsured and 6000 uninsured, I mean it's… You understand why Massachusetts senators are very eager for such an arrangement, but it doesn't seem like a particularly well focused way of getting unmet needs and getting the funds where they're most needed.

David Schleicher:

I mean for what it's worth for this and for a reason that a questioner asked about the effect on state and local elections. I think the case for removing Medicaid from the states and moving it from [inaudible 00:35:08] is very, very, very strong. The questioner asked question about the like, shouldn't we just elect better officials?

David Schleicher:

One of the problems about a lot of these cooperative federalism regimes is that it becomes really hard to know who's responsible if you're unhappy with your state Medicaid regime like who do you blame? To extent that we can create a little more functional separation in responsibilities, it may be easier to monitor state and local officials. So, I think the case for removing states for Medicaid is pretty strong for federalizing it for some of the reasons you just [inaudible 00:35:42] and some other reasons, but it has benefits and costs as a mechanism for injecting money into the system, into state local governments. I think it's worse than just unconstrained grants given to all states but…

Allison Schrager:

I'm going to combine two questions that wouldn't seem to be related, but I think they are. Lee Rhodes brought up pensions, which is my favorite topic. But also Dr. Steven L. brought up, and this is a question either of you can answer. I'm curious to hear from any of you on this is what conceptual framework should localities consider for determining and remedying fiscal distress?

Allison Schrager:

I mean is it like what liabilities really do matter here? I think it's not actually straightforward of what fiscal distress because I think we think of it as sort of being able to pay your debts, but there's many stakeholders in the economy and sort of in it and that they owed money to as a setting even if you think of services as a liability. So, how should we think about what constitutes physical distress and how can we remedy it?

David Skeel:

That's you, David.

David Schleicher:

Me? Oh. So, I've got two thoughts on this. I want to first, the second one [inaudible 00:36:53]. This has come up in bankruptcy cases. In the Detroit bankruptcy case and in the stocks in case that proceeded it, the court was faced with this question. How do you determine whether a jurisdiction isn't solvent? Because Detroit could have probably made its next payment if it sold city hall.

David Schleicher:

The question was like, is it insolvent or not? It's a requirement to file for municipal bankruptcy, which cities can do and the states can't, to be insolvent. The courts developed an idea called service delivery insolvency, which is like basically, how bad do we think services have to get before we allow you to impair creditors to some degree?

David Schleicher:

This has been the kind of a long fight in our discussions about how we deal with state and local debts. In the 1870s, we had a huge number of instances where the federal courts made debts enforceable against cities that had subsidized railroads and did so despite their claims that the correct claims that this would devastate local services.

David Schleicher:

In other periods say like the 1840, they wiped out debt holders was opposed to making credit, making service recipients pay. We've been fighting about this exact problem for a very, very long time. There's no obvious resolution. It's just that there's a trade-off to be made between, there's a real harm to harming creditors in the sense that it will reduce the capacity of jurisdictions to invest in the future. We've seen this when southern states defaulted [inaudible 00:38:22] country defaulted in the 1840s. Basically lenders stopped lending to a number of states.

David Schleicher:

Then, when in the 1870s, all of the southern states, almost all of the southern states defaulted claiming that the debts incurred during reconstruction were effectively odious debt and creditors respond to this by just not lending to them for a really long time. This explains so for instance, Arkansas which is kind of the American Argentina has defaulted three times and one notable fact is this affected the kind of amount of public goods available in Arkansas because Arkansas couldn't borrow for long parts of the 19th Century and as a result, it didn't build out the type of infrastructure you saw in other states.

David Schleicher:

The last thing I'll say about is about the question about pensions. Other people may have thoughts on both, but like this is a real tension. It's not an easily resolvable one. But then underfunded pensions, how should we think about them? I think the best way to think about underfunded pensions is it's just debt that is not covered by state debt limits. That the decision to underfund pensions is basically a mechanism states have come up with, two states and cities have come up with in order to avoid their debt limits.

David Schleicher:

So, most states and cities have limits on the amount of debt they can issue. They frequently would like to be more indebted than they are because they don't want to balance their budgets. They want to raise taxes. They want to cut spending, and so they underfund their pensions. They make heroic assumptions about returns and this is just a form of debt.

David Schleicher:

It's of course a form of debt that's not backed by any asset. So, unlike a bridge, you're not like spreading the debt. The effect of underfunding pensions is issuing debt to pay your credit card bill is that you're left with debt, but nothing, no asset behind it. But I think that's the best way to think. The pension, it's the same as other debt. It's just another unsecured debt on your balance sheet.

Allison Schrager:

So, Chris, another question has come up, although, again, anyone can answer this. But it does speak to federalism. Brandon Brooks asks, how are we as states and nation meant to approach the need for infrastructure management upgrades in these fiscal crises? I'm sure if you've seen Governor Cuomo talking grandly about his plans, anyway we're in fiscal dire straits to build new airports in Buffalo presumably [inaudible 00:40:50] because this will create jobs, he said, and then I die inside a little.

Allison Schrager:

Then, it is a question. In the Great Depression there was, I mean it's debatable how effective it was. A lot of infrastructure spending at the federal level. Now, most infrastructure is happening at the state level. There are some needs for more infrastructure spending. How is that sort of going to play in? Should we move this more to the federal level or should there be ways to finance it more at the state level?

Chris Pope:

Yeah Well, I think the first part of that question I think raises the issue of the extent to which infrastructure really is shovel ready in the way that it might have been in the 1930s. Obviously, the sort of image people have of the new deal is the infrastructure spending kind of got us cyclically out of the depression and that this is kind of the thing you would turn to to do classic Keynesian spending.

Chris Pope:

Yeah. I think we can set that aside because that it doesn't really change the essence of the debate which is which level of government is best equipped to handle infrastructure. Now, we certainly see many transportation projects. Again, there are a mix of different levels of government. The federal government provides matching funds for programs and you have all these negotiations of things like the replacement of the Hudson Tunnel.

Chris Pope:

I think the conflation of different levels of government really is the problem again here. You sort of have this checking game between the federal government between the states over who actually bears the incidents, the cost of the infrastructure project and this almost this checking game tends to delay and certainly in the case of the Hudson Tunnel, I think it's pretty clear has delayed the development and the deployment of this infrastructure that you would think probably is in the interest of the state and the region where it's about the full cost itself.

Chris Pope:

I think with a lot of our federalism problems, it doesn't matter so much which level of government, whether the federal government or the state government is actually responsible. You can almost make an argument either way, but the real evils of the situation come from the fact that both are involved and that the dynamic where both levels of government are involved and each trying to shift costs to the other and shift responsibility to the other that they're saying inherently dysfunctional with that. It has caused pretty much problems in almost every era of government where you have this confusion of responsibility, especially financial responsibility.

Allison Schrager:

I mean historically has the federal government or state governments been better at picking the right projects? Because my take on infrastructure has always been it's great if you pick the right shovel ready projects but you almost never do.

David Schleicher:

I think that most infrastructure spending for almost the entirety of American history has been state and local. It's been subsidized by the federal government, but in almost no period has the state federal government paid for more if you count operations and management. I mean in maintenance rather [inaudible 00:43:55] the federal government paid for more infrastructure than states and localities. Now, it's a much smaller portion, even on the capital side. I think that there's a real reason to have that the federal government can't really do infrastructure. There's just outsiders and there's two reasons for this.

David Schleicher:

One is information. It's just like hard to know what people need and want from very far away. We see this in the kind of mechanisms that we've come up for deciding what to fund. It's very difficult process. The second thing is that the shape Congress results in federal infrastructure almost always gets spread around the states, which is not exactly what you'd want for targeting. It's possible the Hudson Tunnel is the most valuable infrastructure project. I don't know, but it's possible that's the case, and if that's the case, then it doesn't make sense to spread money into Wyoming if that's the most valuable process for the most people.

David Schleicher:

So, over the course of American history we've kind of settled on a mechanism which is the federal government subsidizes state and local infrastructure, most notably through the interesting exemption for municipal bonds, interest on municipal bonds is tax-exempt and that's a federal subsidy for state and local infrastructure spending. That for a long period of time this had a huge effect. If you look at the say around the turn of the last century, which is, again, this is before the interest exemption, but still there were other forms of federal subsidy.

David Schleicher:

Infrastructure in American cities far [inaudible 00:45:23] anywhere in the world, even cities that were richer at the time. This is because we had a very extensive municipal bond system that allowed cities to borrow, and then not ask permission. In recent years, again, I think that that mechanism has broken down a little bit largely because states and cities have shifted a lot of their spending on investment into two other areas.

David Schleicher:

One is healthcare and the other is on paying for kind of basically pension debt. That to the extent that we have infrastructure problems, it's driven by the kind of move away from investments by states and cities and to basically paying for past services and paying for healthcare.

Allison Schrager:

So, another question-

Chris Pope:

Sorry. Just to make one point on that. I think a big part of that reason is you get a big like three to one match potentially by putting your state funds in the Medicare program on a spending that you can claim a federal matching fund, whereas if it's saying that you have to finance entirely, you start thinking about the disparities of which kind of state function that they earn more or less in the federal government in response to their own spending. It does tend to distort the state spending priorities.

David Schleicher:

It's also that health care spending just generally across all dimensions has gone up a lot, right? So, just the cost of health care indicates that states are responsible for health care the same way that federal spending on Medicare has gone up as well, right?

David Schleicher:

Well, Medicaid growth has quite significantly outpaced Medicare and that's in large part because of the enrollment and they've expanded eligibility to people who previously had private insurance say. A lot of it is the expansion of the program not just the growth of the costs. Medicaid's growth is quite substantially above healthcare growth in general.

Allison Schrager:

We have a question from Charles Bloom. The majority of states have balanced budget requirements. So, I'm going to modify this a bit. The odds are we're going to see some deep cuts in government services unless there's significant bailouts. This is where I'm going to add a bit. He asked, where should governments start cutting first? I'm also going to add to that, where will they probably cut first? Because that might be two different things.

David Skeel:

I'm just going to say a word, and then let… This is another David question I think or maybe a Chris question, because 49 states have balanced budget amendments and the other state acts as if it does, when you have a big hole in your revenues as they do now and additional expenses, it creates an enormous need to cut services if you don't get help from Washington.

David Skeel:

In my view, that's one of the strongest arguments for Washington help helping out, helping out just to the extent of the coronavirus hole. I don't think Congress should be bailing out states for stuff that happened before the coronavirus. It'd be great if the funding took into account pre-coronavirus behavior. One way you could do that, for instance, would be to assume essentially a deductible, assume that every state ought to have set aside a rainy day fund sufficient to handle an ordinary recession and to carve that out of the money that gets sent to the states, but if you don't fill that hole, states are going to have to do some of the things David was talking about that they're already doing which is lay people off and do things of that sort which I think tees up David.

David Schleicher:

So, two things. One is that someone on Twitter, I forgot who it was who said that the only person with an actual plan to defund the police is Mitch McConnell because the truth of when money is scarce, everything gets cut. By the way, I suspect that this will cause, we're going to see some pretty substantial labor conflict in places like New York because the workers are not going to be happy about this and we're going to see… I'm guessing maybe all over the country with teachers and all sorts of things.

David Schleicher:

I think that the question is like, how much are balanced budget amendments the thing that is binding as opposed to either debt limits or real credit constraints is a interesting question that is non-resolved. So, economists like Jim Poterba have claimed for years that balanced budget amendments and other state fiscal constitutional elements really do limit state and local fiscal behavior. They really change it. It affects them.

David Schleicher:

Lawyers have noted for years that any half decent lawyer can come up with, give a state 18 ways around the state budget a balanced budget amendment. You can underfund your pensions, which usually works. You can do lease and buyback arrangements for your, as Arizona did for its state capital. It sold its state capital, and then bought it back and you basically created a form of debt and whether balanced budget managers are doing the work, their inability to issue debt or just that no one wants…

David Schleicher:

So, Illinois had to borrow from the municipal lending facility because no one else would lend to it. The question of is it the law or is it the market or is it the politics that's driving local austerity is unclear. One last thing I'll say about this is that balanced budget managers don't come from nowhere. They weren't handed down by, on stone tablets or something. They are a response to histories of state and local default prices. We started seeing state balanced budget amendments and debt limits after, in 1840s following the defaults of eight states in a territory. We saw more in the 1870s through the 1890s as many cities defaulted.

David Schleicher:

States have adopted [inaudible 00:51:28] because they know that defaulting is really, really, really ugly. I think most people think that an ideal version of a state fiscal constitution would have kind of mandatory savings like a rainy day fund, and then would require balance across a budget cycle, but the question, is there even a legally designed, a legal mechanism that can really force balance if you really are committed to not doing it and people will lend you money it's an interesting and open question. [crosstalk 00:51:57]

Chris Pope:

I think there's actually one opportunity that comes up currently, which is the fact that people aren't going to the hospital and getting surgery done, in theory creates much less utilization on the healthcare side which would traditionally have reduced Medicaid costs quite substantially. Now, one of the big problems the states have faced is that their Medicaid contracts have been run through managed care in recent years like most states are doing this currently.

Chris Pope:

So, what they've done is that they've basically said given the [inaudible 00:52:26] amount to private insurer and so you take care of these lives for so many thousands of dollars each regardless of what happens and expecting a private insurer to insure them. Now, with nobody going to the hospital for three months that means with full profits for the insurers and the states not really seeing any of those savings.

Chris Pope:

Some states are starting to look about restructuring that arrangement and trying to claw back some of the savings from the insurers. They're really windfall savings and try and repurpose those given the current fiscal situation. I think you'll see quite a number of states doing something similar to that, although it probably falls well short of meeting some of their needs in the current situation.

Allison Schrager:

David Skeel, did you have something you were going to say?

David Skeel:

I was just going to make a small tweak of David and this evasion of the balanced budget amendments. If Washington doesn't send another dollar to the states, I don't think anybody's going to be able to get around the balanced budget requirements so effectively that they won't have to make cuts. I mean I think we're going to have massive cuts if… I don't think, well [crosstalk 00:53:32]-

David Schleicher:

I completely agree.

David Skeel:

… the money, but-

David Schleicher:

I also think whether it's credit constraints or the law that's doing it is I don't know. I mean it's possible that no one would lend money to Akron unless it made cuts also, right?

David Skeel:

I suspect both of those will be happening at the same time or would be happening.

Allison Schrager:

I mean should we keep these balance budget requirements if there's just encouraging states to issue debt off balance sheet which makes it less transparent? So, does it serve a purpose?

David Schleicher:

It has an effect. I mean I think that Poterba's research suggests that it does cause jurisdictions to cut when money is tight and rate and it has real effects on spending. I think we should get rid of them mostly because I think that effect is basically bad in the sense that it doesn't encourage the opposite.

David Schleicher:

I think one of the major problems in our state fiscal constitutions is that there's no mechanism for forcing savings in addition to there's requirements that you make payments. So, you saw this really dramatically in the Illinois pension case. So, Illinois did a bunch of pension reforms and the Illinois State Supreme Court said those pension reforms were unconstitutional under the state constitution.

David Schleicher:

In so doing they issued, they discussed what the framers of the Illinois constitution noted, which is that someone in the debate said, "We should… If we're going to offer pensions we should be required to fund them in advance. There should be a legal requirement that we save money in advance." Someone else said, "Well, if we just require that you pay them, the politicians will definitely save in advance. I mean who would be so foolish just to create an obligation and not create money?"

David Schleicher:

Fast forward 40 years, well, it turns out they were just wrong. I think that a much more attractive form of state fiscal constitution would either be balanced across a business cycle and have mechanisms for requiring savings. We've had some elements of this. So, some debt limits have traditionally included requirements that you have a tax to fund them. This was response to the taxless finance that people did when other states tried to copy the Erie Canal and just thought they were going to just make money, they're going to make money the way the Erie Canal did and so that they didn't have taxes.

David Schleicher:

But I think that to the extent we have state fiscal constitutions, they should focus on requiring savings in advance of issuing debt rather than focus on balanced budgets or even on numerical limits on debt.

Allison Schrager:

We have now three policy positions. We're going to get rid of balance budget requirements. We're going to federalize Medicaid. We're going to allow for state bankruptcy. [inaudible 00:56:11] for 15 minutes.

David Schleicher:

It's a program to lose office quickly [crosstalk 00:56:17] that platform and you'll get maybe half of one percent of the vote.

Allison Schrager:

Well, we could throw in better accounting standards for pensions and then-

David Schleicher:

Yes. [crosstalk 00:56:30] We're vote getter.

Allison Schrager:

So, David Skeel, I mean you have had so much experience with Puerto Rico's bankruptcy if that's what we call it and I'm wondering what we can learn from that with states now?

David Skeel:

The first thing we can learn is you don't want to have a hurricane or an earthquake or any of the other things that's happened to Puerto Rico in the last four years, which has made a very difficult situation much, much worse. Where things are as probably a lot of people who are watching will know is oversight board was put in place in 2016. I'm one of the seven members of the oversight board.

David Skeel:

We put as we were authorized to do under the legislation that created the oversight board. We put Puerto Rico into the equivalent of bankruptcy. It's not called bankruptcy in May of 2017, and Puerto Rico is still in this bankruptcy-like process. One lesson is that a major public entity like Puerto Rico, it is really complicated to restructure the debt. So, when people like me talk about the need for a bank state bankruptcy option, we need to be open-eyed about how complicated it is and what some of the difficulties are.

David Skeel:

So, that side of it is kind of a negative lesson in my view. That it's certainly not a silver bullet solution. The other lesson, the more positive lesson that I've taken out of my Puerto Rico experience is one of the concerns people often have about state bankruptcy is the idea that a federal judge is going to be overseeing a state. It just seems optically problematic for a judge to be making decisions that significantly affect the state. That really hasn't been a problem in the Puerto Rico situation in my view.

David Skeel:

The judge in the case has been very mindful of the limits of what her authority is, mindful of the limits of the oversight board's authority as well. It has been much less awkward than I imagined. So, [inaudible 00:58:55] have come out of this experience so far thinking that it's messy, it's not perfect, but if you consider the alternatives for states that are in deep financial distress, it actually still is an attractive option and as one I wish were getting more attention in Washington than it is.

Allison Schrager:

Is there any other way to modify pension promises than a federal bankruptcy?

David Skeel:

Well, it really depends on the state that you're in, whether into what extent that you can modify pension promises, but there are ways to do it in most states. It's almost impossible in Illinois as David was mentioning, but one of the things that people have suggested as a way to nudge states to modify, to use better accounting, for instance, is to do a conditional bailout.

David Skeel:

A bailout of the sort that the IMF does and say this is something Andrew Biggs at AEI has proposed. You could give money to Illinois and say, "We're going to give you $10 billion, $20 billion, whatever the number is if you adopt serious accounting standards for your pensions." You could even go further and say, "If you switch to define contribution rather than define benefit." There are limits on what you can do. In Illinois, you essentially can't alter the benefits of current employees, but you can certainly alter future employee's benefits and there might be things you can do tinkering on the edges even with current employees.

David Skeel:

There are other ways to go at it. I think bankruptcy is the most effective because bankruptcy overrides those state limitations. You don't have to worry in the same way about the Illinois constitutional provision that basically says, "We protect every benefit all the time." The bankruptcy clause of the constitution would override that.

Allison Schrager:

All right. Well, we only have another four minutes left. I guess I just want to ask each of you, do you think that the states should get more support from the federal government and what form do you think that should take?

David Skeel:

I'll start and be quick. So, I think they should as I've already said. I think Congress should try to fill the coronavirus hole and shouldn't try to do more than that. Bob Inman, my colleague at Wharton has come up with some numbers to try to estimate what that is. He comes up with the number 613 billion as the appropriate amount. As far as how we get it to the states, I think ideally from a macroeconomic perspective, you want to be sure to get it to states in a form that's going to be spent as quick as possible, at least, with a big chunk of the money.

Chris Pope:

I think that there probably is going to have to be some degree of bailout. I think from a federal taxpayer point of view, you want to make sure that some reform comes with it so that the next recession comes along we're not just doing it all over again. I think from a structural point of view what we probably want to make sure is how are we moving towards a situation where states are responsible for low variance spending responsibilities, and so that their revenues are also low variance over the business cycle as well.

Chris Pope:

So, if you think of the spending responsibilities, things like schools, things like police, things like transport, those are pretty stable across the business cycle. I think states can pretty sustainably do those and do a pretty good job of them. I think the problem arises with health care, with unemployment benefits, with things that are going to need a lot more money just at the moment when state revenues are in trouble. I think structurally that causes a problem for states.

Chris Pope:

On the revenue side, I think we sort of have a similar thing which the SALT deduction caps has started to push back on which is that a number of states and even local governments if you think of New York City have almost become addicted to high variance revenue streams. The income tax being the most notable. In New York City, you think that the city is highly dependent on a very small percentage of its population for income tax revenues and that tends to disappear or be substantially cut in recessions.

Chris Pope:

Getting rid of the SALT deduction entirely were basically said to get rid of the subsidy for states and local governments to rely on these high variance revenue streams and encourage them to move towards revenue streams that are more stable across the business cycle. So, if you create more stability on the revenue side and on the spending side, I think you can start getting towards the system where we don't just do this every recession to have this conversation about, are we going to do anything about state pensions? No. Let's just throw money into state [inaudible 01:04:05] have some kind of a solution of the problem.

Allison Schrager:

So, another good but politically unpopular idea. David, do you want to have the last word?

David Schleicher:

Yeah. So, I think the case for general state and local aid money going to all state and probably on a number even bigger than what David and Bob came up with is pretty unassailable. I think that the truth that I think, I also agree with Chris, that you should put conditions that are aimed at the future and I proposed tying it to accounting reform, state accounting reform moving to accrual rather than cash accounting, legislatively tying it to municipal bond regulation from basically repealing, what's known as the Tower Amendment that allows states and cities to avoid publishing this certain, about their financial data before they issue bonds, removing that restriction.

David Schleicher:

Then, kind of pairing it with a future oriented reforms where the federal government would be encouraging savings and rainy day funds. The one last thing I want to say is that while we focused a lot on states and even on cities, the most at-risk jurisdictions in the current crisis are neither of those. They have a lot of taxing power, but it's a lot of special authorities that are in a world of hurt.

David Schleicher:

In New York, we focused a lot on the MTA which has lost a huge amount of revenue from the fare box, but you're going to see huge crises in convention center authorities and all sorts of other smaller local governments that can create very large problems and they're going to put, that they themselves will then put pressure on state governments to bail them out. If you're looking for a tip a thing to look for for the future, worry about authorities.

Allison Schrager:

Well, thank you all for joining us. Thanks for everyone in the audience for all their questions and tuning in. Please, consider subscribing to the Manhattan Institute's newsletters or making a contribution to our mission. We've posted links for doing so in the windows on your screen. It was so good to see all of you again. Hopefully, in-person one day soon.

David Schleicher:

Thank you so much.

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