The States Are Toast

Even if states do get federal relief, it could come with major strings attached.

A police officer in a face mask walks near a sign that says "Walk-In Urgent Care."
Budgets for state and local police are about to be decimated. David Dee Delgado/Getty Images

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As President Donald Trump has deferred to governors on major aspects of the coronavirus response in recent weeks, a new theme has emerged among commentators that we are entering a new era of federalism. Some have described it as an “Articles of Confederation” moment, where the national government recedes and state governments assert their authority. Earlier this month, the New York Times heralded “The Return of the Governor.”

Rather than making governors ascendant in the long run, however, the COVID-19 crisis is likely to make state governments trim the sails of their policy agendas for years. And it is likely to make states evermore dependent on the federal government. The COVID-19-triggered economic crisis is such that, absent aid from the federal government, states will suffer. But even if the federal government provides substantial amounts of aid to states and cities, there is a good chance it will come with conditions that will substantially undermine state independence. Trump, for his part, indicated on Twitter on Monday that he does not intend to provide the states the funding they desperately need without some kind of fight. “Why should the people and taxpayers of America be bailing out poorly run states,” he wrote. After this crisis is over, it’s likely federalism won’t look the same.

The COVID-19 crisis has been particularly painful for state budgets, which, give or take, need to be balanced, unlike the federal budget. (States have some tools for avoiding constitutional balanced budget requirements and debt limits, from underfunding their pensions to trickier forms of debt management, but they still face substantial limits on running deficits.) The pandemic has particularly decimated sales tax revenue, one of the steadiest forms of state revenue. The numbers are gruesome. Gov. Andrew Cuomo estimated that New York would need to cut education and other areas by as much as 20 percent. Michigan is expected to lose between $1 billion and $3 billion by this June, and then between another $1 billion and $4 billion next fiscal year. And this doesn’t count the budget carnage and already mounting layoffs we see at the municipal, county, school district, and public authority level. Illinois’ state Senate leader earlier this month asked Congress for a $41 billion bailout.

What does this mean? States will have to raise taxes and cut spending drastically to make ends meet. This will worsen the recession—states and cities will have to lay off lots of workers when unemployment is at its worst. And it will mean that all aspects of state spending that are not about COVID-19 will face steep cuts. Transportation and other infrastructure spending, higher education, K–12 reform, affordable housing, and many other state initiatives will all be set back substantially. To the extent that they borrow to get out of the hole, state debt burdens will get bigger and their capacity to do big things going forward will be further reduced. On top of this, local newspapers, declining before the crisis, have been hit hard, and access to the local press is an important means for governors to communicate what is going on in their states. The governors now dominating the airwaves with their popular coronavirus press briefings will likely soon be reduced to the role of grim accountants.

What’s been done by the federal government so far is not nearly enough to make up the COVID-19 shutdown budget shortfalls. Congress authorized $150 billion in aid to states and cities in the CARES Act and provided money to transit agencies and hospitals and for education. The Federal Reserve announced a massive program to provide short-term financing to states and cities. But state aid was left out of the most recent “Phase IV” congressional legislation, and key Republican leaders are already balking on future money. In addition to Trump’s suggestion that he would not “bail out” states, Republican Senate Majority Leader Mitch McConnell has brought up the idea of letting states file for bankruptcy, rather than giving aid. Former South Carolina governor and U.N. Ambassador Nikki Haley also came out against any further state aid.

Trump, McConnell, and Haley are drawing on a deep history. For almost two centuries, the federal government maintained a “no bailouts” policy with respect to state governments. After eight states and a territory defaulted on debt in the early 1840s, Congress rejected a bill to assume state debts, as it had done several times prior to that. The federal government’s “no bailouts” rule largely has been honored, through defaults in the 1870s and in 1933, although somewhat less strictly than many think. (For instance, despite the famous Ford to City: Drop Dead headline, the federal government did provide loans to New York City as part of the response to its financial crisis in the 1970s.)

Scholars like Jonathan Rodden and Robert Inman argue that a bailout regime is inconsistent with state independence. The reason is that getting bailouts creates a “soft budget constraint,” making states less willing to make difficult fiscal choices because they think the feds will come to the rescue. These scholars argue that states that need less aid will resent the bailouts. As a result, these states and then the federal government will demand conditions on aid to needy states when push comes to shove. When national governments provide aid but do not demand conditions, you see debt crises, like those that hit Argentina and Brazil in the 1980s and ’90s. In countries where the national government comes to the aid of states, the national government usually plays a much more active role in monitoring state budgets and in taxing and then transferring it to states.

In contrast, in the U.S., the federal government has traditionally not overseen state budgeting. States are not even required to disclose information about their fiscal situation to sell bonds, as they are exempt from the 1934 Securities Exchange Act.

But the next round of aid, if it is forthcoming, is likely to contain conditions. You can see the writing on the wall. Leading serious conservative thinkers like Andrew Biggs and E.J. McMahon have argued that any aid to Illinois or New York should come with substantial conditions, from changed accounting rules to requirements that defined benefit pensions be moved to 401(k)-style defined contribution plans. The only thing that may save states from substantial conditionality is divided power in Congress and an inability of Democrats and Republicans to agree on the terms of conditions. But that same dynamic can hold up aid entirely, leaving states to cut more dramatically or face financial ruin.

If Congress proposes aid with conditions, states will likely be in no position to turn them down. The Federal Reserve’s aid is less likely to come with its own strings, except for one major one—the money will have to be paid back down the line, as it is providing loans, not grants.

Over the next year, states will be dealing with a continuing public health emergency, huge new demands on public services, radically reduced revenues, insufficient federal aid, increasing debt loads, and potentially new conditions imposed by the federal government, if they even get lifesaving infusions of cash to begin with.

Federalism is changing, but not in the direction of more state power.

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