Don't use coronavirus as excuse to bail out state, local governments that have mismanaged finances for decades

If Speaker Pelosi gets her way, coronavirus assistance may turn into a federal bailout of states and municipalities that have mismanaged their finances for decades

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State and local government finances are under immense pressure from the coronavirus contraction. Revenues are plummeting and the billions of dollars that states must spend on COVID-19 expenses will be dwarfed by additional unemployment insurance and Medicaid payments.

The initial motivation for federal help to states and cities was to boost public health measures and support access to short-term loans during the coronavirus disruption. But Speaker Pelosi is calling for major additional federal government action in Phase 4.

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If the speaker gets her way, the coronavirus assistance may turn into a federal bailout of states and municipalities that have mismanaged their finances for decades, and of the bond investors that made money while they did it.

The federal government has already taken very significant steps to prop up state and local government finances during the crisis.

In an unprecedented intervention, the Federal Reserve is now essentially printing money to buy short-term municipal bonds in large quantities. It sounds like a loan, but if the governments cannot repay, the cost ends up with federal taxpayers.

And then there is the hundreds of billions of dollars of direct aid in the recent “stimulus” legislation: $150 billion to state governments for the public health emergency, $30 billion for local educational agencies and institutions, $25 billion for mass transit, and $8.5 billion in community development funding -- all on top of substantial expansions of the federal responsibility for Medicaid and unemployment insurance that Congress had already passed.

These amounts should have been sufficient if states handled their finances properly. The problem is that many of them do not.

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Consider the colossal gaps between the retirement pensions that states promise public employees like teachers and police, and the money they set aside to meet those promises. These unfunded liabilities grew from $2.6 trillion at the end of 2009 to $4.1 trillion at the end of 2019, despite a historic bull market.

Many states under-contributed to pension plans, failed to achieve their hoped-for investment returns, and refused to reform their unsustainable benefits. Surely the federal government should not pick up this tab.

So what will happen if states don’t get bailout money? Their creditors might just have to take a hit, including the individuals who own over $3 trillion worth of municipal bonds. Or states might choose to take a hard look at the sustainability of their defined benefit pension plans.

The idea that all states should come through a downturn without any pain, and without sharing that pain with investors who profited handsomely by taking risks, is grossly unfair to taxpayers and investors that behaved more responsibly.

Furthermore, if disproportionately more aid flows to states facing the greatest financial challenges, then the federal government will oversee not only a massive nationalization of state debts, but also a massive transfer from sober states and their taxpayers to profligate ones.

For example, aware of their need for dry powder in a recession, most states have accumulated rainy day funds. These funds total $72 billion, or an average of 8.3 percent of a year of expenditures.

But some states have saved for rainier days than others. Taxpayers in states such as Wyoming, which had over a year’s worth of expenditures in their rainy day fund, or Texas with 19 percent of a year of expenditures, might ask why they should bail out states such as Illinois, which has zero.

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In unemployment insurance as well, some states prepared much more than others. As of February, only 31 states had set aside in their trust funds the full amounts recommended by the Department of Labor to prepare for a downturn.

New York and California were the worst, with only 36 percent and 21 percent respectively of the recommended savings levels.

Why should more responsible states bail them out?

Federal officials must resist calls for further large-scale aid to states. Congress should not pass legislation that provides such aid, and Federal Reserve Chairman Powell and Treasury Secretary Mnuchin must resist calls for Treasury-backed lending facilities that use medium- or long-term municipal bonds as collateral. There is nothing “systemic” about municipal bondholders.

If the federal government is unable to resist aid, then strings must be attached. If states are too big (or too political) to fail then the federal government must condition this and all future support on reforms to pensions, unemployment insurance, rainy day funds, and Medicaid.

Otherwise, big-spending states will just rack up even larger debts, confident of another bailout in the next crisis.

Joshua D. Rauh is a Senior Fellow at the Hoover Institution and Ormond Family Professor of Finance at the Stanford Graduate School of Business.

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