The Debt Trap, Part (1)

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President Obama didn’t discuss the nation’s massive, swelling debt in his State of the Union address. Mitch Daniels did, and good for him: the flood of red ink really is the Niagara. Our accelerating drift toard the cliff, moreover, entails not only fiscal and economic but also institutional and constitutional consequences of grave import. State and local debts are a comparatively small tributary to the great stream, but they illustrate the point.

State and local debts are composed of about upwards of $4 trillion in unfunded pension obligations; upwards of a half-trillion in other pension benefit obligations (mostly for health benefits), also unfunded; and about $2.9 trillion in municipal (state and local) bonds. These debts will not be paid (at least not in real dollars), because they cannot be paid. The question is how and to whom our federal system is going to administer the haircut—and what changes it is likely to undergo in the process.

Today’s post deals with the background causes and conditions of state debt; tomorrow’s, with federal bailouts; Monday’s, with fiscal federalism’s future. (It’s not the EU. It’s Argentina.)

Debt and the Transfer State: A Brief History

Sovereign debt is the life blood of politics. Every voter will seek to overfish the commons and to free-ride on others’ contributions; every politician will seek to accommodate the demand by robbing from future generations. However, institutional arrangements can dampen or reinforce, retard or accelerate the tendency. Among the major accelerants is “cooperative,” “fiscal federalism”—that is, a system of federal transfer payments to state and local government.

The graph below shows federal transfer payments in 2005 dollars and as a percentage of state and local spending, along with state and local own-source revenues (exclusive of federal transfers) as percent of GDP. After 2008, when the available official data series end, federal, state and local revenues all collapsed; federal transfers increased substantially (for example, under the “Stimulus” bill).

Start with the least conspicuous line: state and local revenues increased from around 9 to 15 percent of GDP. The increase isn’t 6 percent; it’s 67 percent. Go back to 1951 (not shown), when the state and local share was 6 percent: that’s a 150 percent increase over the post-War period. Over the same time frame, the federal tax share of GDP remained within a very narrow band of 18-20 percent of GDP. Mark it down: in fiscal terms, the entire growth of government in the post-War United States is the growth of state and local government. How is this possible, and why did it happen?

Answer: federal transfer programs inflate the demand for government by reducing its perceived cost. Suppose that state taxpayers would refuse to pay $100 for some redistributive program. Then suppose that the federal government offers to chip in $50 for every $50 dollars spent by the state on that same program: taxpayers may well support the scheme, failing to recognize that the federal share is also their tax responsibility. This fiscal illusion isn’t an unfortunate side-effect; it’s the desired effect. Because direct redistribution on a national scale often encounters public resistance, we either disguise programs as a form of (middle-class) self-insurance, as with Social Security or Medicare; or else, we mobilize state governments, bureaucracies, and their clientele in support. Fiscal “federalism” is just about the only form of social democracy we seem to be capable of. It has some very unfortunate feature and consequences.

  • The state-based constituencies and bureaucracies that help to get federal transfer programs enacted will want to get “their” share of the proceeds. Thus, education programs support educators (and children only secondarily); Medicaid supports providers; and so on. Economists estimate this diversion or “flypaper effect”—the  money sticks where it hits—at somewhere between 0.4 and 1.0.
  • Transfer programs are self-enforcing: no state can opt out without leaving its taxpayers’ contribution to the federally financed program on the table. The more generous the federal program, the more difficult a state will find it to replace federal dollars—in the event of an opt-out—with own-source revenues. Over time, transfer programs will crowd out unfunded programs—that is, things that state and local governments have to pay from own-source revenues.
  • Federal transfer programs increase moral hazard. Because the perceived benefits (transfers) have electoral consequences and the real long-term costs generally don’t, officeholders will aggressively seek federal funding even if the long-term fiscal consequences for the state are known to be ruinous. “Take the money and run (for higher office)” is the dominant strategy. When the consequences hit home, the natural response is to ask for yet more generous transfers (see “self-enforcement,” supra).

Given its institutional incentives and dynamics, it’s easy to see why the transfer state has grown by leaps and bounds. Only a massive external shock, such as the advent of the Reagan administration (shaded in gray in the graph), can disrupt the system at least temporarily. Mark that down, too: The only administration with a genuinely federalist bone in its body did not shower yet more money on the states. It cut the transfers.

Life on the Niagara

Lately, the transfer state has bumped up against a fiscal constraint, or rather two.

Look again at the chart: where did all the federal transfer money come from? Pre-1980, it came from inflation, which made it possible to redeem promises to state and local governments in cheaper dollars. In the 1990s, it came from the “peace dividend.” Since then, and especially since the onset of the financial crisis, it’s been entirely debt-financed. That cannot continue.

Look yet again: around 1990 or so, the state and local tax share stopped growing. Ever-more generous federal transfers may have lost the capacity to spur local tax effort.

In that predicament, what are state officials to do—barred as they are, by state constitutions, from running budget deficits? Answer, keep maximizing federal transfers by expanding funded programs; take the money from unfunded programs (local streets, state parks and the like); and run up debt in places where that’s technically permitted. Like, pension funds.

Welcome to our federalism of potholes and pension deficits. Tomorrow, some observations on what happens when “cooperative” federalism’s partners are all broke.