Hands On! Part I: The Trilemma Facing the Federal Government During State and Local Budget Crises

Abstract

The economic crisis that accompanied the COVID-19 pandemic has left state and local budgets in tatters, with revenue falling quickly while demands for public services increase. The federal government responded in a number of ways, but the public debate over what it should do if there is an acute fiscal crisis – a state or a large city on the edge of default – has been theoretically confused and ahistorical.

This is no accident. The academic literature on state fiscal crises, while very impressive in many ways, is also somewhat confused. It focuses on two contrasting problems: the moral hazard that a federal bailout of an insolvent state government would create and the macroeconomic harm that a failure to bailout an insolvent state government would create. What these two branches of the literature agree on is that the federal government, for good or ill, has since the 1840s taken a “hands off” approach to acute state and local fiscal crises.

This Article and a companion piece will show that federal government simply does not have a history of “hands off” approaches to state and local defaults. While bailouts have been rare, officials from all three branches of the federal governments have intervened repeatedly in state and local fiscal crises to aid creditors and preserve confidence in the municipal bond market. These interventions are part of a long-running federal policy of encouraging states and local governments to borrow money to build civic infrastructure. Concern for the municipal bond market has led the federal government into all sorts of otherwise hard-to-explain policies, from President Ulysses Grant threatening to send troops to Iowa in 1870 to make a small town pay its debts to the Supreme Court’s radical transformation of the doctrine of Swift v. Tyson. Federal policy has been inconsistent, toggling between policies aimed at different and incommensurable goals, even during a fiscal crisis, perhaps most famously when it offered loans to New York City after the famous “Ford to City: Drop Dead” headline suggested aid would not be forthcoming.

Recognizing their real concern for the municipal bond market changes our understanding of what is at stake for federal policymakers when they respond to acute state and local budget crises. Federal officials face a “trilemma.” Whether they promote and/or enable bailouts, austerity, or defaults on municipal debt, federal officials can avoid two of these harms, but not three: (1) moral hazard for state budgets; (2) worsening recessions; (3) reducing future state and local infrastructure investment. The companion piece will suggest how federal officials can navigate this trilemma in the current crisis.

Keywords: municipal bonds; fiscal federalism; Erie; federal courts; 1840s; reconstruction

JEL Classification: H70, H72, H74