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How equalization makes Canada distinct from the U.S.: David Schleicher on the persistence of local budget crises

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Podcast & Video

This episode of Hub Dialogues features Sean Speer in conversation with Yale law professor David Schleicher about his fascinating new book, In a Bad State: Responding to State and Local Budget Crises.

You can listen to this episode of Hub Dialogues on Acast, Amazon, Apple, Google, and Spotify. The episodes are generously supported by The Ira Gluskin And Maxine Granovsky Gluskin Charitable Foundation and The Linda Frum & Howard Sokolowski Charitable Foundation.

SEAN SPEER: Welcome to Hub Dialogues. I’m your host, Sean Speer, editor-at-large at The Hub. I’m honoured to be joined today by David Schleicher, who’s a professor at Yale Law School and an expert at local governance, federalism, and state and local finances. He’s also the co-host of the podcast Digging a Hole: The Legal Theory Podcast, which is a must-listen. He’s recently published a new book, In a Bad State: Responding to State and Local Budget Crises, which offers a comprehensive look at the history of the state and local budget crises in the U.S. and sets out solutions to put these lower orders of government on a more sustainable footing. Although his focus is on the United States, his analysis and our discussion will have a lot of relevance for those interested in Canada’s own fiscal federalism. David, thanks for joining us at Hub Dialogues, and congratulations on the book.

DAVID SCHLEICHER: Thank you so much for having me.

SEAN SPEER: Let’s start with a basic question. The book’s subtitle asserts that American states and local governments face budget crises. What do you mean? What’s the evidence that there is a crisis, or more precisely, multiple crises?

DAVID SCHLEICHER: The claim is not that right now we’re in a budget crisis. I’ll talk about ‘right now’ in a second, but rather that it has been a persistent feature of American history that state and local governments have faced fiscal crises. It would be weird if they didn’t, on some level. The United States has 50 states and tens of thousands of local governments. There’s a lot of governments, and it would be weird if none of them had crises. It would just be a strange feature.

But it has been something that America has dealt with from the first Congress. Some of you may be fans of Hamilton, the musical. Well, “that plan to assume state debts; what Hamilton forgets”, right? You’ve got a whole business; I’m not going to rap for you. But this has been a persistent feature of American political life, and it has been true from there, at least through COVID.

So the claim is not that we’re facing a crisis right now. We’re facing some stress right now, which I can talk about. But rather that this has been a problem over a long period of time, and it’s worth taking a moment to think about what tools we might use to address it going forward.

SEAN SPEER: As you say, David, the book contains a deep history about American fiscal federalism, starting with Hamilton’s assumption of state debts after the Revolutionary War. I don’t expect you to outline a complete history here, but help our listeners understand the historical evolution that’s led to the current system. What were some of the key policy choices that brought expression to modern fiscal federalism in the United States?

DAVID SCHLEICHER: So the histories—I mean, obviously, there’s a long history, and there are a lot of ups and downs, but America has had both fiscal crises and defaults in its states and cities many, many times. Over the course of the long swath of American history, we’ve developed some legal tools for addressing it, but we’ve gone back and forth between different policy hiccups.

The central claim in the book, the analytical claim—not the recommendations, but the analytical claim—is that when a state or a big city faces a fiscal crisis, federal officials face what I call a trilemma, which is that they have three choices, and all of them are bad. They can offer bailouts, and bailouts will help solve some problems. So if the federal government gives money to a state or city, it will mean it doesn’t have to make severe budget cuts. Those budget cuts are extremely painful, usually because these happen during recessions. It won’t harm the jurisdiction’s ability to borrow going forward, which is, in the American system, very important for the building of infrastructure. But it will create what economists call ‘moral hazard’, the idea that the jurisdictions will come to expect this money and may budget irresponsibly, and lenders particularly will expect them to get money, and so they’ll give money to anyone.

In fact, you saw this after Hamilton’s assumption of state debts. So that is as clear a bailout as you can have. British and Dutch lenders lent money to U.S. states on the clear assumption that the federal government stood behind them. In fact, they almost went to war over it. In the 1840s, when the U.S. states defaulted, the British and Dutch investors were so angry—in fact, it went even further than that. When Britain owed money to the U.S. after World War I, they attempted to make the U.S. government offset those debts by defaults that happened in places like Arkansas and Michigan. So that’s one story.

Another bad thing that can happen is you can force them to buckle down: raise taxes, cut spending, really cut government to the bone in a fiscal crisis. That has benefits. It avoids moral hazard and it avoids harm to the bond market, but it creates enormous economic harm, which is that you are doing the exact opposite of what Keynes would suggest, which is you’re cutting spending right when the economy is bad. And that is bad for the macroeconomy.

The third choice you can—we’ve done that many, many, many times as well. Probably, that’s the most common actual answer. Though, I’ll go into one story in a little bit that might highlight it. But the third thing you can do is allow or encourage defaults. The U.S. has, at different points, either allowed defaults or actively encouraged defaults at different periods in different times. And this creates some benefits. On one hand, you have to cut government by less if the investors are taking some of the harm and you don’t have the same moral hazard concerns about providing bailouts. On the other hand, it harms the people’s willingness to lend to states and cities.

That is really problematic in the American system because from the beginning, the federal government’s been very uninvolved in making actual investments. The old joke about the federal government is that it is an insurance company with an army. They say it provides old-age insurance and has an army, and doesn’t do much else other than give money to states. If you get a service from a government in America, you’re very likely getting it from a state or city. If you can touch something, let’s say, if you can touch a bridge or road, it’s mostly built by state and local governments with state and local money, sometimes subsidized by what they consider operations and maintenance.

A default can really harm the ability of the jurisdiction to build stuff. Here’s an example I really like because it happened at the same time when the federal government took two different choices. In the 1870s and 1880s, there was a variety of local railroad bond defaults. So the local governments had invested a lot in encouraging railroads to come through town. Then there were a lot of defaults because there was some overbuilding of railroads. Actually, the story behind this is a little funny, so I’ll do one second on this, which is that investors would go around to these towns in Iowa or wherever and pitch them on railroads. And it was a dead ringer—if you guys know the Simpsons episode, “Monorail, Monorail, Monorail,” that’s basically, you understand the dynamic that was happening in Iowa in the 1860s and ’70s.

A lot of them had to default, and the question was: Should the Supreme Court do its best to enforce those bonds and make them engage in austerity? The Supreme Court took an extremely pro-bondholder position, and it really socked it to these governments that at one point they were going around ordering federal marshals to order mayors to raise taxes so much that the mayors would hide and that federal marshals would chase them around. The federal marshals would occasionally pretend to be town drunks so that no one would suspect them. But the effect of this was to cause massive austerity during some big economic shocks. At the same time, it preserved municipal bond markets.

If you think about infrastructure in America, almost all of the best stuff was built in this period after the Supreme Court had worked really hard to preserve the municipal bond markets. So the Brooklyn Bridge and the Croton Aqueduct—I’m doing some New York examples—and all the great things happened in Chicago. So there was this kind of trade-off at the same time, or roughly at the same time, in which all the southern states after the end of Reconstruction default, or almost all of them. The Supreme Court remakes the law to make it so that those bonds were easy to default on. This was part of the broad effort to bring the southern states back into the ordinary politics at the end of Reconstruction. But all of these defaults meant that these jurisdictions couldn’t borrow; lenders wouldn’t lend the money; they couldn’t even sell their bonds on markets. They were not available on national bond markets, never mind international bond markets.

The effect of this is that infrastructure in the South really declined. So, you want to know why the South didn’t grow the way that the North did in the boom period of the Gilded Age? Well, there are a lot of reasons, and I mean, this is not causal or anything, but one of the reasons is that they didn’t have the infrastructure to do so, and one of the reasons didn’t have the infrastructure to do so because they couldn’t borrow. So these things have big trade-offs, and we’ve done all of them over the course of American history.

SEAN SPEER: Why don’t you talk a bit about the sources of some of the modern fiscal challenges that the book observes at the state and local level? What are the factors that have contributed to this potential modern crisis?

DAVID SCHLEICHER: I think if you want to tell the contemporary history of fiscal problems in the states and cities, you should probably start with the “Great Recession.” So, in the Great Recession was a huge hit to everything—why we call it “Great.” But one of the reasons the Great Recession was so great was the federal government provided some money right at the beginning to states and cities but then didn’t. They stopped. This is kind of the conflict between President Obama and Congress about stimulus, if you recall all of that. The effect of this was to cause a massive fiscal retrenchment at the state and city level. So states and cities fire a lot of workers. One of the reasons the Great Recession is great and not just bad—we don’t call it the “Really Bad Recession”— is that states and cities fired so many workers that public employment doesn’t return to pre-recessionary periods for another ten years after the recession. Private employment is back in four years, but it’s a huge, huge, huge thing. And that’s one of the reasons why the Great Recession was so great.

So how did states and cities respond to this? Well, they did a lot of things. One is that they didn’t hire a lot of workers. And so part of that is you didn’t have services, and that’s bad. People aren’t getting educated as well or whatever. But also the recession was longer. Another thing they did was they lied. States and cities in America generally have balanced budget requirements and debt limits that limit how much they can borrow.

So what did the states and cities do that faced these fiscal problems? Well, they all have public employee pensions. So they simply didn’t save for their public employee pensions. A huge percentage of debt during the Great Recession period was a period of basically borrowing against the future by not saving for pensions. Pensions are a legal obligation, just like bond payments. So this has one effect, which is that if you look back at America in the post-Great Recession period or during the post-2012 period, you should have seen a huge flowering of investment. So you should have seen interest rates were low, unemployment was high; this is when governments are supposed to come in and build a lot of stuff, right? That’s the normal story, but they didn’t. Anyone who’s been anywhere in America can look around and say, “Where’s the great new infrastructure that we should have gotten during this glory period for American infrastructure?” And we didn’t get it.

One of the reasons why is that the jurisdictions were using their borrowing capacity to underfund their pension liabilities and not to make new investments. So by the time we get to the Trump years, give or take, the states and cities should begin to recover. The period leading into COVID was a nice period for American state and city budgets; the economy’s growing, American local and state budgets are what we call pro-cyclical. When the economy’s doing good, the government gets more money, and they should save it, but they can spend it. And then COVID hit, and everyone’s terrified about lots of defaults. There are a couple of things that happened. One is the federal government gave states and cities a boatload of money. They gave every state and city, no matter what fiscal situation it was in, a boatload of money, far larger than the amount of revenue they lost due to COVID.

Secondly, the amount they lost due to COVID was much less than people expected. So states and cities over the last couple of years have become, mostly states, increasingly reliant on high-end income taxes and capital gains taxes, particularly the Californias and New Yorks of the world. And that did really well during the pandemic. I’m not breaking any news here; the stock market just crushed on it. Also, by the way, the inflationary period has helped a number of jurisdictions because their tax rates are fixed, springing up that affects the dollar amounts, and then if you see inflation, that’s quite good for your revenues and can inflate away some of your debts. And so, coming into relatively recently, states and cities are probably in the best period they’ve been, at least a very, very, very long time. But right now, we’re starting to see a shift.

Right now, in the last, say, four or five months, we’ve seen a real shift. States and cities are—revenues have started to fall, particularly in your New Yorks, Californias and Illinois; the ones that are very income tax dependent. Federal money is starting to run out. You saw a nice moment in this, which is in the debt limit deal. I don’t mean nice like happy, I mean, nice, illustrative. You saw some amount of money that had been given to states and cities or was going to be allocated to states and cities in the ARP, one of the COVID-era bills, has got pulled back. This had an effect: states and cities are going to start to lose revenue.

Now, we’re going to find out in the next period, and in the period afterwards, whether they used their boom period to save and to set things up, or did they play ‘Brewster’s Millions’ with it? For those of you who are fans of the Richard Pryor version or even some of the earlier versions of the movie, it’s the same idea. It’s like, “Did they spend it all? Did they use it to cut taxes and raise spending in ways that are going to be hard reverse and does that mean that they’ll have fiscal crises going forward?”

SEAN SPEER: As we understand these fiscal challenges at the state and municipal level, how much variation is there across the country? Can you give listeners a sense of where the real challenges lie and what, if any, common characteristics those jurisdictions may share?

DAVID SCHLEICHER: Yeah, so two things. One is that there’s enormous variation. America’s just a very big country, and they face lots of different—so while the American economy is linked, there are a lot of parts, and parts of it can boom, and parts of it can combust at different times. And further, Americans, this is something for Canadians; we don’t have fiscal equalization.

SEAN SPEER: We’ll come to that.

DAVID SCHLEICHER: Yeah, we don’t have fiscal equalization the way you do in Canada. And so the result is that states and cities are more—I mean, they get lots of money from the federal government, but it is the case that you’re more on your own in this respect than you’re in a jurisdiction like Canada. And where are we seeing fiscal crises? Well, I’d say there are a couple of places where you’re seeing real, real fiscal stress. One would just be places that have more cyclical revenue. So if you are very reliant on income taxes and high-end income as opposed to sales or property taxes, your revenues are more cyclical, and state revenues have gotten more volatile over time. So jurisdictions that rode the high are going to face the crisis, and that’s going to be your more liberal jurisdictions for the most part.

A second type of jurisdiction that’s going to face real problems are transit agencies. So transit agencies have lost a huge amount of ridership, work-from-home being the major force for this. Which, by the way, this is something that, again, when you talk to people outside of the U.S., it’s a little hard for them to understand how much bigger work from home is in the U.S. than it is in any other country. It’s much bigger in the U.S. than it is in other countries. And the result has been real harm to transit agency budgets.

The third one that’s related is jurisdictions that are heavily dependent on commercial property tax. They say, “The value of office buildings has declined.” Again, a work-from-home effect. And again, with both that and transit agencies guessing about the future and the effects going forward, but it seems somewhat persistent that those types of jurisdictions are the ones facing the biggest problems.

SEAN SPEER: I want to talk a bit about the similarities and differences between Canada and the U.S., if that’s okay.

DAVID SCHLEICHER: Yeah.

SEAN SPEER: In the context of The Great Depression and World War II, Canada had a royal commission on the state of the country’s fiscal federalism. It led to some changes to the jurisdictional responsibilities as well as to the federal transfer system, including, as you mentioned, the establishment of an Equalization program in the mid-1950s. David, has the U.S. system, even within states themselves, gone through similar exercises of “who does what?” And do you think that something like that could be useful in light of the circumstances that the book outlines?

DAVID SCHLEICHER: So at the federal level, I’d say it seems that the answer is no. I mean, there’ve been periods where the federal government has changed its relation to states very dramatically over this period. A couple of—I mean, so one is that the creation of a lot of what we call cooperative federalism programs. So Medicaid, which is healthcare for the poor, generally is run on a matching basis where the federal government gives—and that’s a very large percentage of state budgets. A lot of welfare programs run that way, where the federal government plays a leading role or a major role in financing, if less so in operations. A lot of social welfare works that way. But we have not had a constitutional revision; we’ve got a very old constitution. And specifically, since the Civil War, the Civil War amendments, the type of review. And so the changes that you’re talking about, were not things that have happened.

There are some moments when things are afoot. So for a period roughly in the ’70s to the early ’80s, so-called general revenue sharing, which is a lot like equalization. Well, it’s a lot like federal tax collection for the purposes of states giving money to states. It didn’t have the same effort at equalization, but it is an effort of federal government to subsidize state budgets, but not on a programmatic basis.

But the federal government also does, as a function of the way it taxes and provides money for social welfare programs, distribute money across jurisdictions in a way that doesn’t do full equalization, but it does a lot. So for instance, New Mexico—and this is true across most of the South and Alaska—gets more than $2 for every dollar it sends in taxes to the federal government. New Jersey by contrast gets less than 70 cents for every dollar cents in. Why is that? Well, New Jersey is really, really rich. New Jersey is, by some definitions, the richest political subdivision in, I don’t know, the history of the world. It’s close to it, at least. I mean, it’s a really, really, really rich place. People who think of The Sopranos have got it completely wrong. It’s a really, really, really rich place. So it sends in a lot of money because taxes are progressive, and it gets back less because while it plenty of people, it doesn’t have a disproportionate number, and doesn’t have any military bases or many of them.

The combination is that it doesn’t do—so we have a system that does some equalization, but it’s not structured the same way as Canada does. Because we don’t have in our constitution which is just really old and is premised on ideas from the 1860s and 1870s and from the 1790s or 1780s.

We don’t go through the same structure at the state level with respect to cities, there’s been a lot more action. The big thing at the state-to-city level that’s happened, and this is very much in a Canadian spirit, is state constitutions in America. Generally, they all have provisions that would create a positive constitutional right to education. This has been interpreted by most, but not all, state courts to provide for some degree of required equalization across school districts. School districts are the biggest form of local government, bigger than municipalities in terms of their budgets. And so it’s like teachers, as it is in most countries, is the most common job in America, and a single job title. So there’s been equalization in that, and that’s made real effects on where people live and so on. Again, there are equalization things, but they’re not as well thought out as what we saw in Canada.

SEAN SPEER: Yeah, well, let me put that to you precisely. Josh McCabe, an American sociologist and now a scholar at the Niskanen Centre, has argued that the U.S. should adopt a big-E Equalization program in order to help stabilize state and local budgets and enable greater decentralization. What do you think of that argument, and why do you think it’s failed to get traction in the American political system?

DAVID SCHLEICHER: Yeah, so I almost view it as like, kind of—I don’t know if when you were a kid, a regular assignment in the United States in elementary school is like, “Write your own constitution.”

SEAN SPEER: Yes.

DAVID SCHLEICHER: The idea is, “What if we radically rethought the structure of American government?” And the arguments for equalization are really hostile to the broader principles of the American Constitution, where the states are pre-constitutional sovereigns. So while the federal government does do things to move on, the idea that they would be not actually independent in the way that it is quite antithetical to the broader American Constitution.

That doesn’t mean it’s not a good idea, by the way. If any of you know the Whit Stillman movie, “Last Days of Disco”. There’s a wonderful monologue where one of the characters goes, “You know that Shakespearean admonition, ‘To thine own self be true’? It’s premised on the idea that ‘thine own self’ is something good, to which being true would be admirable. But what if thine self isn’t that good?” Well, you could say the same thing about the American Constitution. There are a lot of ways in which the mission of the American Constitution is a real laggard; it’s old. I’m not blaming anyone; it’s just that other countries have redone their constitutions. We’ve hopefully developed a thought on how constitutional law works. Surely, when America advises other countries on how to write constitutions, it never ever looks like the American Constitution. It looks very, very different. And so this suggests that maybe even there isn’t a ton of confidence in the American constitutional structure even among Americans. But I do think the idea of a strong form of equalization rather than a weird jerry-rigged one are pretty hostile to American constitutional norms.

SEAN SPEER: That’s fascinating. I would just say in parentheses, David, that I’ve seen some analysis that looks at federal transfers in Canada versus federal transfers in the United States. And one of the benefits of a big-E Equalization program is it enables us, I think, to have a cleaner set of intergovernmental transfers because big-E Equalization is carrying out the function of equalizing to an extent and then our other transfer programs are able to run on a more principled per capita basis. Whereas in the U.S., there’s a kind of element of equalization built into so many different intergovernmental transfers, which creates transparency issues.

DAVID SCHLEICHER: Again, I think there’s a lot to be said for Canada’s Constitution, particularly, in the context of Canada, right? So you are solving a variety of types of political problems that are, you know, the Maritimes and incorporating them in the question of what to do about Quebec. And it’s like, these are really difficult problems that Canada’s system is a sensible solution to. Now, one of the things—so I generally tend to like what I call amelioration to solutions, which is like, “How can you make things better without imagining that you can write on a clean slate?” And so I don’t spend too much time worrying about equalization as a structural thing because, again, it’s premised on a really, really different institutional structure and legal structure, and set of ideas about relationships.

I mean, one of the things—well, a state identity has declined in that people don’t think of themselves as Alabamans or Connecticuters, they call them Nutmeggers, but not as their original identity. I think it is safe to say that with the exception of Quebec, there’s a greater other feeling in Canada towards peers, which equalization represents in some way. And so again, I think you can imagine policy responses that are consistent with a variety of types of political attitudes in America, but imagining the U.S. is Canada is like a mug’s game as far as I’m concerned.

SEAN SPEER: Yeah. Point well taken. So let’s focus on some specific dynamics within the U.S. system itself. You mentioned earlier, David, that several states have balanced budget laws or even tax and expenditure limitation laws. What do you think of them? Are they useful for mitigating against budget crises? Or, as you alluded to earlier, can they actually contribute to them in a way?

DAVID SCHLEICHER: Well, it is surely the case that they can contribute to the problem of state budget being pro-cyclical. That is to say, if you have to balance your budget and states have to balance their budget for a couple of reasons, one of them is legal, but another one is they don’t print money, and they’re fiscally independent in a way. And so that they have to, that’s true for countries in the Eurozone who are—there’s real limits on your ability to run deficits, but they exacerbate this, and also states and jurisdictions can figure out ways around them. There’s a big debate between lawyers and economists about whether they’re enforceable or not. Economists say, “Well, in the aggregate, they are.” And lawyers say, “Well, in specific, any smart lawyer can come up with a way around these limits.”

What I’d say is that a better system than our debt limit system would be something like what you see in some European countries that require balanced budgets across a business cycle but allow deficits to be run during rough times, but require savings in good times. One of the things the book argues for is broadening the base for what’s counted as debt. So, one of the ways jurisdictions lie and get around their debt limits and balanced budget is by not funding their pension obligations. But pension obligations are just debt. Yes, you have to pay them and make the payments going forward. They’re a particularly unhealthy form of debt in that they’re not backing an asset; they’re not borrowing to build something or borrowing to buy something, but you have to make the payments, the debt. And so when we calculate debt limits, we should include in them things like pension obligations, but I think that they would be healthier if they required balance across the cycle.

SEAN SPEER: One of the more peculiar aspects of American fiscal federalism is the federal State and Local Tax Deduction which has been somewhat reformed but still enables American tax filers in high-tax states and localities to deduct a portion of these taxes from their federal tax bill. What’s the rationale for the State and Local Tax Deduction, and what are its consequences? How does it fit into your story?

DAVID SCHLEICHER: Yeah. So again, I don’t spend a ton of time on the State and Local Tax Deduction mostly because again, it has been substantially reformed. I actually think the way to understand it is two-fold. One is as a mechanism for equalization, right? So it’s a back or anti-equalization in this case. It’s that rich jurisdictions are giving a lot more to the federal government than poor jurisdictions are, right? They’re giving more and getting less. The State and Local Tax Deduction because richer jurisdictions are, broadly speaking, higher-tax jurisdictions with some degree of variation there. That higher-income people are the ones who take deductions, and they’re more likely to be in rich jurisdictions. It mitigates that to some degree. The other thing is that it fits in with a broader part of the American tax code, which is that charitable contributions are deductible. So there’s an idea of when you’re trying to figure out what someone genuinely owes the federal government is that we deduct the money they’re giving to other people.

And so, again, there’s a logic to it. A professor at NYU named Daniel Hemel has written, what I think, is the best defence of this all that I recommend to any listener who’s interested in this. Now, in the broad scheme of how to think about crises, these things are largely fixed at the time. If a jurisdiction’s going bankrupt or on the edge of bankruptcy, you’re not going to respond to that by fundamentally changing the American tax system; it would just be a non-sequitur. I mentioned that this is like, if Chicago is facing a fiscal crisis, you could imagine responding to that by deregulating financial services because a lot of financial services take place in Chicago, and Chicago would then do better. But that would be a really weird way to respond to a fiscal crisis, and everyone would laugh you out of the room if you proposed it, right? So I could just be nuts. Similarly, you could imagine, let’s say Alaska has a fiscal crisis, and you say, “Well, let’s allow more drilling.” Maybe, but it is not the kind of thing that the book is after, which is really about ways to respond to acute fiscal crises.

SEAN SPEER: Well, that’s a great segue to my next question. As we turn to solutions, what do you think state and local policymakers ought to be doing?

DAVID SCHLEICHER: Well, you mentioned state and local, but the books is aimed at federal policymakers, and relating to state and local, but I can do both.

So, for federal policymakers, I think, when there’s a crisis, and they give aid, including in that aid, conditions to encourage greater fiscal responsibility going forward. Just to be specific, when the federal government was passing the ARP or the CARES Act, giving a lot of money to states and cities, I think they should have included conditions, either tied to that money or tied to other money to avoid some problems the Supreme Court has created, but conditions that jurisdictions budget in accordance with generally accepted accounting principles. That’d be painful for jurisdictions to do so, maybe you could have a lag or give them time to get up to it.

But the idea would be that if the federal government’s going to be giving you money or emergency money when you’re in a pinch, what the federal government should insist on is that you accurately represent your fiscal position, not only when you do backwards-looking accounting statements but when you’re doing forward-looking budgeting. You could even imagine including a requirement that they do what Connecticut just put into its bonds, which are covenants for what are called “volatility caps.” That’s to say, if you’re getting a big burst of money at one point, either because of federal money or because of something, like magic happens to your economy and that’s a one-time thing, that you have to save a certain percentage of that and that it would be enforceable by bondholders. So that’s one class of things, and I have a lot of other ideas that are in that family of ideas.

Another thing is to—America has municipal bankruptcy law, that is to say, as a city goes bank—and some of your listeners may know the story of Detroit or ultimately the story of Puerto Rico, both of which went through—well, Detroit went through the initial bankruptcy system and Puerto Rico went through something that was a lot like it. The idea here is we could make that system a lot more functional. Bankruptcy has some really wonderful tools for spreading harm across both classes of creditors, but also across austerity and default. But it’s been used some including Detroit, San Bernardino, Stockton, blah, blah. But we could make it a more functional system to allow jurisdictions to use it, and maybe we could even make it available to state governments.

Then a final class of things—some of these may not desire—not to suggest constitutional-style reforms but to make the system and government a little more resilient. Again, you have so many state governments and so many local governments. Some of them are going to have crises. One of the things that I suggest—so I suggest some things to make the government more resilient. These ideas are making it easier for people to move. So right now, when jurisdictions face physical crises, rich people leave because, well, they’re rich, they can. But it’s harder for poor people because housing costs are so high in places that have good economies. And so making it easier to make occupational licenses transfer across places for instance.

Again, a whole universe of ideas, including the most constitutional thing I suggest, which is federalizing Medicaid, but the idea is to make the stakes of these crises go down pretty substantially. Those are the types of things that the federal government could do. State and local governments have a lot of tools. They can save money when the economy’s doing well, right? And so the question is: What types of legal tools do we need to create at the state and local level? And what types of political tools, perhaps, do we need to create at the state and local level to encourage better fiscal performance?

SEAN SPEER: In that vein, the progress that we’ve seen in Canada over the years when it comes to fiscal reform at the sub-national level has tended to be catalyzed by crises. I think, for instance, of fiscal reform in Ontario or Saskatchewan, or Alberta in the mid-1990s. So how do you persuade policymakers to take proactive steps along the lines you outlined in the book in order to avoid a crisis in the first place?

DAVID SCHLEICHER: Yeah, one of the goals of the book was just to have a bunch of policy tools lying around such that when a crisis comes up, you can go to the book, right? So that’s actually the kind of structure of what the book’s about. How can I convince them? Well, I don’t know. I wrote a book, we’ll see if they read it. I don’t know. It’s available at bookstores, federal policymakers, you can encourage your staff to buy it. I’m all for it.

I mean, it’s also the case though fiscal reforms in the U.S. have been driven by crisis. Again, it would be strange not to—it would take an extremely forward-looking government to make reforms when no one’s talking about something because they’re painful, they’re hard to do, they’re complicated.

And so municipal bankruptcy law was created in the shadow of a variety of municipal defaults during the Great Depression. It was reformed in the aftermath of New York City—I think New York City’s fiscal crisis in the 1970s. So, again, the U.S. is almost certainly more crisis-driven in its politics. It’s more frantic, less forward-thinking. It’s part of the genius or horror of American politics in that it’s less organized in a lot of ways and more open to entrepreneurship in that way.

But the idea here of the book is to say to policymakers, “When you face a crisis, here are some things you should be thinking about. Here’s the way you should be thinking about what’s happening and how you should respond. And then, also, here are a variety of policy tools you could have at the ready to use in a crisis.”

SEAN SPEER: Final question. From the outset of our conversation, David, you’ve made the case that, really since the beginning of American fiscal federalism, it’s been understood by market participants, markets themselves, and even state and local political actors, that the federal government is ultimately effectively backstopping the fiscal positions of state and local governments. So talk a bit about the incentives for federal policymakers to move in some of the directions that you’ve been talking about in order to protect the federal government itself.

DAVID SCHLEICHER: So, I mean, the federal government has very frequently allowed jurisdictions to default. It is unlike most jurisdictional countries in the world. So most countries in the world, the provinces are very, very, very controlled by the centre. You saw this really change in the mid-1990s when a bunch of provinces defaulted and set off some international financial crises. Federal governments, national governments, have taken greater control over provincial budgets across the world in response to state and local defaults.

In America, that really hasn’t happened to the degree you’ve seen in other places. So again, we have periods when we bailout, and that does lead to a degree of centralization. In fact, Hamilton thought that was the benefit. He wanted centralization so the bailout was part of a true program of centralization. But again, in the 1840s, states defaulted. In the 1870s, states defaulted. In 1932, Arkansas defaulted. Arkansas actually defaulted in all three of those periods. It’s like the American Argentina. It’s a wild, wild place, man.

So it is not the case that federal government is necessarily standing behind these jurisdictions. You can see this, by the way, in bond spreads that say that the borrowing rates for American sub-national jurisdictions are varied based on their fiscal fit and not as you see in other countries that they borrowed at the same rates as the national government because the federal government is standing behind them. So you see, it is not the case that the federal government necessarily stands behind jurisdiction. It has at some times, but not always.

I think the way to encourage the federal government to use its power over state entities to push them to be more responsible is to note that bailouts are a bad outcome. Emergency bailouts are a sign of failure. They may be better in the situation than other alternatives, but they’re a bad outcome. They’re bad for the federal budget, they encourage interstate conflict in ways that are unhealthy, and they create bad incentives on behalf of state and local officials. The argument is “you don’t like bailouts and you shouldn’t, so why don’t you take some steps now to make them less likely going forward?”

SEAN SPEER: That’s a good place to wrap up our conversation. The book is In a Bad State: Responding to State and Local Budget Crises. David Schleicher, thank you so much for joining us at Hub Dialogues.

DAVID SCHLEICHER: Thank you so much for having me

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