Should States Have to Make a “Co-Pay” on Federal Relief?
Most of us these days are worried about the pandemic. If that weren’t enough fun, there’s also economic collapse, especially when — and the tip of the canoe is already edging out over the waterfall — states reach an imminent fiscal cliff. State layoffs, service cuts, and tax hikes contributed very substantially to the Great Recession. For that reason, fiscal relief for states is a key component of the budget deal now being negotiated.
But two Washington Post op-ed writers seem to be more worried about the next recession after this one. The duo are Penn’s Robert Inman, economist and noted austerity guru, and David Skeel, the eminent bankruptcy law scholar. In their piece, they argue that Congress should refuse aid to states except to the extent that states’ fiscal needs exceed what they would have encountered in an “ordinary” recession (the op-ed is a little old but Wharton has been pushing it out again lately as the latest budget battle reheats). Much as the Senate Majority leader argued in April, Inman & Skeel worry that helping states now will lead to “moral hazard,” discouraging them from saving for the 2030 recession (note: all made-up future dates approximate).
When one is echoing Mitch McConnell talking points, it’s a good time for an academic to make sure they’re on firm intellectual ground. Unfortunately, the op-ed does not offer any meaningful defense of its suggestion, except to observe that some states were able to save some money between 2010 and today. This is a data point that if anything undermines the authors’ claims, as we’ll see.
First, though, let’s make the crucial point that worrying about the 2030-ish recession right now, and especially doing it by applying fiscal pressure on state budgets, is terrible, terrible, terrible policy. Three terribles, because at least three reasons it’s terrible. Most importantly, state leaders are struggling against enormous political pressure to restart their economies, even though in most places it now looks as though something like a (hopefully short) complete lock-down is the best available medicine. Yet a lockdown will also blow another huge hole in state and local budgets. If you believe Justice Roberts that fiscal pressure is a “gun to the head” of state officials, we should be doing everything we can to empty the magazine. A truly wise pandemic policy would be to require lockdowns in hotspots, and to deliver huge federal resources to hold localities financially harmless. If we don’t do that, then at the very least we should share a little of the local pain that governments — to say nothing of their residents — incur to protect all of us from contagion.
It’s also absurd to worry about the next recession right now because it’s far away and it probably won’t be as bad. Basic economics says we should transfer money from bad times to good ones. If moral hazard makes the next recession a little deeper, so be it: they likely won’t be as bad off as we are. And, of course, there’s someone else besides the folks living through the next recession who can chip in: the people who live between now and then. They can save to ease the pain of the next recession, or pay off the debts we incur in this one, or both. That is literally why we have social safety net spending.
But most of all, Inman and Skeel never explain why state moral hazard is bad. Will it deepen the next recession by making states less careful with their economies? Probably not. State officials, if they care about anything, know that their success depends on local economic conditions. Nothing the feds do is going to change a governor’s desire to have a thriving economy. The only plausible negative effect is that states won’t save adequately, and will need federal financial assistance next time. Federal tax dollars, it’s worth emphasizing, are usually cheaper & easier to collect — they are harder to dodge and cause fewer economic distortions (no, land taxes, which make up 0% of many state budgets, are not efficient; they are a tax on capital, one of the least efficient taxes we have). In insurance terms, one could say that the federal government is the least-cost insurer, and so it, not states & certainly not cities, should be the one to finance the “tail risk” of deep recessions.
Now, look, I don’t think our current arrangements for state dependence on federal rescues is optimal. As we’re seeing, Congress is too slow, and often too stingy. Many top-tier governments actually bail themselves out at lower-government expense, a phenomenon budget scholars call “passing the pain down.” But these problems could be fixed with “automatic stabilizers” and other tools that relieve Congress of the need to vote big new appropriations. Why would putting a fiscal gun to the heads of pandemic-stricken states be a better alternative than those?
On top of all this, there is little convincing evidence that reducing moral hazard would actually change state behavior. Look at the evidence Inman & Skeel offer: some states saved a fair amount since the Great Recession. Guess what? We bailed them out then. ARRA delivered something like $300-$375 billion in state fiscal relief (estimate on page 3 of the linked NY Fed doc). And they saved anyway. Why? Maybe those states didn’t like the thought of having to wait for Congress and answer to its demands.
Also, lots of states didn’t save. When you see in front of you someone who is not preparing themselves for the future, how do you motivate them? “Pay attention to the future, son, or I will punish you…some time in the future, can’t say exactly when, probably you’ll be out of office by then.” Does that sound like an effective strategy?
Putting these latter points a different way, a key reason to reject the medicine Inman & Skeel are proscribing are because its side-effects are terrible, and there are alternative remedies that are better. Even if you thought now was the right time to worry about 2030 problems, even if you thought preventing the need for 2030 bailouts were important, there are so many other ways to get to that result. I won’t list ’em all here. But you can read them for free.
(Footnote: Insurance econ. geekery. To put the above in more technical terms, a typical optimal insurance contract allocates risk between insurer and insured by balancing on one side their differences in risk tolerance and on the other side the social loss of moral hazard & adverse selection. My point is that 1. the federal government is *far* more able to bear risks than other governments and 2. it’s not clear there’s any social loss at all on the other side. The elasticity of response is small, and there might actually be social *gains* from states waiting on the feds. This is why the Inman & Skeel call for a “co-pay” makes no economic sense.)
